==========================================START OF PAGE 1====== UNITES STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Securities Exchange Act of 1934 Release No. 37702 / September 19, 1996 Accounting and Auditing Enforcement Release No. 818 / September 19, 1996 Administrative Proceeding File No. 3-9086 ------------------------- : In the Matter of : : ORDER INSTITUTING PROCEEDINGS : PURSUANT TO SECTION 21C OF THE ELI BUCHALTER, CPA, and : SECURITIES EXCHANGE ACT OF 1934 ELI BUCHALTER ACCOUNTANCY: AND RULE 102(e) OF THE CORPORATION, : COMMISSION'S RULES OF PRACTICE : AND FINDINGS AND ORDER OF Respondents : THE COMMISSION : : -------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that proceedings be, and they hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Eli Buchalter ("Buchalter") and the Eli Buchalter Accountancy Corporation ("the Buchalter Corp.") caused violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 13a-1 and 12b-20 thereunder in connection with the filing by Comparator Systems Corporation ("Comparator" or "the Company") of annual reports on Form 10-K for the fiscal years ended June 30, 1994 and 1995, and that proceedings be, and they hereby are, instituted against Buchalter and the Buchalter Corp., pursuant to Rule 102(e) of the Commission's Rules of Practice, to determine whether Buchalter and the Buchalter Corp. engaged in improper professional conduct in connection with audits of Comparator's financial statements for the fiscal years ended June 30, 1994 and June 30, 1995. Accordingly, IT IS HEREBY ORDERED that said proceedings be, and hereby are, instituted. ==========================================START OF PAGE 2====== II. Buchalter and the Buchalter Corp. (collectively "Respondents") have submitted Offers to the Commission in which Respondents, prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R.  201.1 et seq., and without admitting or denying any of the Findings of this Order, except that Respondents admit the jurisdiction of the Commission with respect to the matters set forth herein, solely for purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, consent to the issuance of the Order: 1) ordering Respondents to cease and desist from violating or causing violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 13a-1 and 12b-20 thereunder; and 2) permanently denying Respondents the privilege of appearing or practicing before the Commission as accountants as is set forth in Paragraph IV. of the Order. Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the Respondents' Offers and to impose the sanctions consented to therein. III. The Commission makes the following findings: A. RESPONDENTS 1. Eli Buchalter is a certified public accountant, licen- sed in the State of California. He has practiced before the Com- mission within the meaning of Rule 102(f) of the Commission's Rules of Practice in connection with the audits by the Buchalter Corp. of Comparator's financial statements for the fiscal years ended June 30, 1994 and 1995.-[1]- 2. The Eli Buchalter Accountancy Corporation, a California corporation, is the corporate entity through which Buchalter has practiced public accounting. It is, and at all relevant times ---------FOOTNOTES---------- -[1]- On May 31, 1996, the Commission filed a complaint in the United States District Court for the Central District of California captioned SEC v. Comparator Systems Corporation, Robert Reed Rogers, Scott Hitt and Gregory Armijo, Civ. No. 96-3856 (LGB) (C.D. Ca.) alleging, inter alia, violations of the anti-fraud, reporting, internal controls, and books and records provisions of the federal securities laws concerning the overvaluation of assets on Comparator's financial statements as incorporated in its 1994 and 1995 Forms 10-K. That matter remains pending. ==========================================START OF PAGE 3====== was, wholly owned by Buchalter. It has no employees other than Buchalter. ==========================================START OF PAGE 4====== B. COMPARATOR'S FALSE FINANCIAL STATEMENTS In its Commission filings on Form 10-K, Comparator reported assets of $5.7 million and $6 million at June 30, 1995 and June 30, 1994 respectively. These assets were substantially comprised of: (1) patents and licenses, (2) investments, (3) accounts receivable, and (4) prepaid fees.-[2]- Buchalter, through the Buchalter Corp., as Comparator's independent accountant, issued reports containing an unqualified opinion with respect to Comparator's fiscal 1994 and 1995 financial statements.-[3]- In those reports, he stated that Comparator's balance sheet was presented fairly in all material respects, in conformity with Generally Accepted Accounting Principles ("GAAP"). In addition, Buchalter stated that his audit was conducted in accordance with Generally Accepted Auditing Standards ("GAAS"). At fiscal year-end 1994 and 1995, however, the above assets, representing in excess of 82% of Comparator's total reported assets, should not have been recognized under GAAP in that they embodied no future economic benefit, were recorded improperly, or did not exist. The elimination of the misstated assets would have changed shareholders' equity from a positive to a negative amount in both years. Furthermore, Buchalter's audits of the Company's fiscal 1994 and 1995 financial statements failed to follow basic auditing standards as set forth in GAAS. 1. Patents and Licenses Comparator reported patents and licenses, net of amortiza- tion, of $2.7 million at June 30, 1994 and $2.4 million at June 30, 1995. None of the purported assets in this category, however, should have been recognized under GAAP. Prior to fiscal year-end 1994, Comparator s patents and licenses either had expired or had passed irretrievably into the public domain for failure to pay required maintenance fees to the U.S. Patent and Trademark Office. In his audits of Comparator's fiscal 1994 and 1995 year-end financial statements, Buchalter failed to take proper steps to ---------FOOTNOTES---------- -[2]- There was little change in the carrying values of these assets between fiscal year-end 1994 and 1995. -[3]- Both reports, however, contained an emphasis para- graph which stated that it was uncertain whether Comparator could continue as a going concern without additional infusions of capital. ==========================================START OF PAGE 5====== determine the actual value of Comparator's patents and licenses. The only documentation contained in his working papers concerning this issue consists of legal agreements relating to the purchase of patents and licenses. Buchalter followed no procedures, in either his 1994 or 1995 audits, to determine whether these patents and licenses remained valid and enforceable, or otherwise to determine that their carrying value was appropriate. 2. Investments At both fiscal year-end 1994 and 1995, Comparator reported investments of $1.2 million. This amount was primarily comprised of three investments: 49.76% of the common stock of Valcorp, Inc. ( Valcorp ) valued at $408,000; 100% of the common stock of the Malaysian company Wira Assets Sdn Bhd, ( Wira Assets ), valued at $500,000; and 250,000 shares of the preferred stock of Interdec Corp. ( Interdec ), valued at $250,000. Each of these investments was acquired by the issuance of Comparator common stock. a. Valcorp, Inc. Valcorp has been inactive and has possessed no significant assets since at least calendar year 1993, and has provided no financial information to Comparator since 1988. A June 30, 1995 letter from the former owner of Valcorp to Comparator's Chief Executive Officer, Robert Reed Rogers, stated that Valcorp has virtually been abandoned and that all of its proprietary information has been transferred to another company. Buchalter s audit files on the Valcorp investment consisted of 1988 and earlier financial statements of Valcorp, and the June 30 letter to Rogers and legal papers filed against a Valcorp related entity by the original owner of Valcorp. In his testimony before the staff, Buchalter stated that he did not conclude from Roger's statements as to the current status of Valcorp that Comparator's investment in that entity had no value. He testified that, to the contrary, he determined that the Company's valuation of its Valcorp investment was appropriate, based on the following additional language in Rogers' June 30, 1995 letter: [n]evertheless, it is felt that a substantial recovery can be had by the institution (not Comparator) of such a law suit. I am not able to give an exact figure for this recovery but certainly the damages suffered by Comparator Systems Corporation will be recognized and appropriate compensation given. In his testimony, Buchalter was unable to explain how a company that had virtually no assets would satisfy a judgment against it. Furthermore, his working papers did not indicate that there existed any agreement, written, oral or otherwise, between Comparator and the original owner of Valcorp that would have provided Comparator with any of the proceeds if the law suit was successful. Notwithstanding these facts, Buchalter accepted ==========================================START OF PAGE 6====== the recorded value of Valcorp and did not require the Company to write-off its investment in Valcorp. b. Wira Assets In November 1993, Comparator acquired 100 percent of the outstanding shares of Wira Assets for 5 million shares of Compar- ator common stock, valued for purposes of this transaction at $0.10 per share.4/ Under GAAP, Comparator was required to con- solidate its financial statements with those of this wholly-owned subsidiary, rather than report the amount of its investment in Wira Assets as an asset on its balance sheet. Accounting Research Bulletin No. 51, 1. Buchalter, however, did not require Comparator to follow appropriate accounting practices in this matter. In his testimony in his this investigation, he was able to offer no explanation for his failure to do so. Moreover, Buchalter obtained no competent evidence in his audits of the Company's fiscal 1994 and 1995 financial statements to support the reported value of Comparator's interest in Wira Assets. In an August 3, 1995 handwritten note to Buchalter, Rogers stated that Wira is inactive and we can t get any information and have no influence at this time over the Company. We expect to reactivate it to use as a Malaysian Marketing Company. Despite this indication that Wira Assets was not an operating entity, and despite the obvious inconsistency in Roger's claim that Comparator had no influence over a wholly- owned subsidiary, Buchalter s working papers for the fiscal 1994 and 1995 audits contain no further documentation concerning Comparator's valuation of its investment in Wira. c. Interdec Corporation At fiscal year-end 1994 and 1995, Comparator carried 250,000 shares of the preferred stock of Interdec at a value of $250,000 in its financial statements. At least by June 30, 1995, Interdec was not an operating company. At the time of Buchalter's 1994 audit of Comparator's financial statements, the most recent financial statements of Interdec available to him were over two years old. When, during the course of his 1995 audit of Comparator's financial statements, Buchalter inquired whether Interdec had engaged new auditors, he was told by Interdec s in- house accountant that Interdec did not have funds to do so. Inexplicitly, Buchalter did not ask the in-house accountant the status of the financial condition of Interdec. In discussions with management, Buchalter concluded that a little more time ... 4/ At that time Comparator common stock was trading on the National Association of Securities Dealers SmallCap Quotation System at approximately 3› bid, 6› ask. ==========================================START OF PAGE 7====== was reasonable to take in determination the carrying value of this investment and Buchalter agreed. 3. Accounts Receivable Comparator s reported accounts receivable of $798,000 at June 30, 1995 and $800,000 at June 30, 1994 consisted primarily of amounts which Comparator claims were owed to it by a former officer, Kay Churchill, as a result of her alleged embezzlement of Comparator stock in fiscal years 1991 through 1994. However, in litigation with Comparator, Churchill has claimed that the stock was owed to her by the Company for services rendered. Moreover, in an unsolicited letter to the Buchalter Corp. dated July 26, 1995, Churchill stated that the amount listed as a receivable from her: " ...is very seriously disputed. I do not owe this money and even if I did, I would have no possible means of paying this company $844,977." Buchalter did not retain the the July 26, 1995 letter from Churchill in his working papers because, he contended: [i]t wasn't a response as to the amount. It was a threat to take the receivable off the books. Buchalter testified that he discussed the Churchill receivable with Rogers, who told him that because Churchill arranged to have the legend removed from a substantial amount of the shares she held and then sold them that it was quite possible that this could have been collected. Buchalter did not confirm with the stock transfer agent that indeed the legend had been removed and Churchill had sold the shares, purportedly: because [the stock transfer agent] records were all messed up. He testified that he recommended that something be written down but again they [Rogers] felt that they did not want to write it down because they felt at the time that everything could be retrieved. 5/ On this basis, Buchalter aceeded to mangement's request that: as soon as we knew whether or not it was fully collectible then we would have to at that time make the decision.... 4. Prepaid Fees Comparator reported prepaid fees to an outside consultant of $280,000 at June 30, 1994 and $240,000 at June 30, 1995, and prepaid fees to officers and employees of Comparator of $336,000 at June 30, 1994 and $252,000 at June 30, 1995. In both cases, the fees had been paid by the issuance of Comparator common stock. a. Prepaid Consulting Fees 5/ No such discussion was documented in Buchalter's working papers. ==========================================START OF PAGE 8====== In 1991, Comparator retained an individual to perform consulting services concerning the potential marketing of Comparator products in Russia. As an initial payment for his services, the consultant received 10 million shares of Comparator stock. The Company recorded the issuance of these shares as a $400,000 "prepaid fee" in fiscal 1992. As of June 30, 1995, the consultant had yet to perform any services for Comparator, but the "prepaid fee," as amortized on a ten year schedule, continued to be reported as an asset on Comparator's balance sheet. Buchalter performed no audit procedures to determine whether the original transaction gave rise to an asset of Comparator and, if so, whether that asset had any continuing value to Comparator at fiscal year-end 1994 and 1995. He contends that he believed it was appropriate for Comparator to carry the fee's amortized value as an asset based on the accounting concept of "matching revenues with expenses." Because Comparator has never sold any product in Russia, however, this explanation is without merit. b. Prepaid "Malaysia Service Fees" On June 9, 1993 the Board of Directors of Comparator author- ized the issuance of 42 million shares of Comparator common stock, in varying amounts, to all of the officers and certain of the employees of the Company. The minutes of the Board meeting, the only documentation on this purported asset in Buchalter's audit files, state that this stock issuance constituted a "bonus" to those individuals who kept the Stateside offices operating effectively while the President and one director have worked digilently (sic) to get the Malaysian Manufacturing and Produc- tion facility up and running. Comparator recorded the issuance of this stock at $420,000 in fiscal 1994. Buchalter testified that what was written in the Board minutes was not the purpose for the shares being issued although that was the only work paper in his audit files in support of the prepaid Malaysa service fees balance. Buchalter claims that in discussions with managment (not documented in his working papers), he was told that the shares were issued for the efforts expended in negotiating the deal in Malaysia. Because he believed that there was going to be a manufacturing operation and we are talking about matching our revenues and expenses and since this was part of the deal with Malaysia who in the future was going to be doing the manufacturing I felt at the time it would have been a ... distortion of the income statement to show this as being written off before manufacturing has been done and then amortize it over a period of at least five years. As with the consulting agreement, however, no revenues were generated from Comparator's Malaysia operations. 5. Other Assets ==========================================START OF PAGE 9====== In its 1995 fiscal year-end financial statements, Comparator reported additional accounts and notes receivable aggregating approximately $121,000. No documentation supporting this valu- ation was obtained by Buchalter other than the August 3, 1995 handwritten note from Rogers. With respect to each receivable, Rogers stated in that note: We intend to sue for recovery. Buchalter did no audit tests to substantiate the value of these purported receivables, such as confirming the balances with the debtors, or determining the debtor's financial wherewithal. Nor did he question Company counsel as to the likelihood of recovery from any lawsuit filed to collect upon these receivables. Comparator reported exactly the same dollar amount for inventory from fiscal year-end 1993 through fiscal year-end 1995. In each case, the notes to Comparator's financial statements reported raw materials of $30,779.79, work-in-process of $36,179.06 and finished goods of $12,094.95. Without questioning why no change had occurred in the disposition of Comparator's inventory over a three year period, Buchalter accepted management representations that the inventory was still valuable because it could be sold in "underdeveloped" countries. In fact, any inventory remaining in Comparator's possession was technologically obsolete by fiscal year-end 1994. Although his audit working papers document no such procedures, Buchalter contends that he observed and performed test counts of Comparator's inventory as part of his fiscal 1995 audit of Comparator. The investigative record, however, establishes that everything Comparator owned of value was sold in 1993 at a marshal s lien sale to satisfy creditors levy. C. LEGAL ANALYSIS 1. Buchalter Caused Comparator's Violations of the Reporting and Anti-fraud Provisions Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder ("the reporting provisions") require issuers with securities registered with the Commission pursuant to Section 12 of the Exchange Act to file with the Commission complete and accurate annual and quarterly reports on Forms 10-K and 10-Q, respectively.6/ SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Financial statements included in Commission filings are required to conform to Regulation S-X, which in turn requires conformity 6/ Rule 12b-20 requires that reports filed pursuant to Section 13(a) contain, in addition to all expressly required disclo- sures, such other information as is necessary to ensure that the statements made in the reports are not materially misleading. ==========================================START OF PAGE 10====== with GAAP. Regulation S-X, Rule 4-01(a)(1). Material misstatements and omissions violative of the reporting provisions, if made with scienter, also violate Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). In the financial statements incorporated in its 1994 and 1995 Forms 10-K, Comparator violated the reporting provisions by including on its balance sheet material assets that did not comport with GAAP. First, its reported patents and licenses that had expired or become unenforceable and therefore held no future benefit to Comparator. For an asset to be properly recognized under GAAP, it must embody "a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows (emphasis added). Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements (December, 1985), 26, 81. At June 30, 1994 and 1995, the Company reported invest- ments in Valcorp, Wira, and Interdec totalling approximately $1.2 million. The carrying value of each of these assets, however, had become permanently impaired. FASB Statement of Financial Accounting Standards No. 12, "Accounting for Certain Marketable Securities," 21, and FASB Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity," 16, state that if the decline (in the carrying value of an investment) is judged to be other than temporary, the cost basis of the individual security shall be written down to its fair value and the amount of the write down shall be accounted for as a realized loss. See also SEC Staff Accounting Bulletin, Topic 5-M, "Accounting for Noncurrent Marketable Equity Securities (September 5, 1985). As discussed above, the evident impairment to each of these assets was so substantial that their carrying values should have been written down to little or nothing. Comparator's purported account receivable from Churchill was clearly uncollectible due to her inability to pay. Hence it should have been written off. FASB Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," 21. In addition, assuming arguendo that Comparator had a legitimate claim against Churchill for return of the Company s common stock, GAAP requires that the common stock component of the receivable be reported as a reduction of shareholders equity, not a receivable. See FASB Emerging Issues Task Force Consensus No. 85-1; SEC Staff Accounting Bulletin No. 40 (Jan. 23, 1981), topic 4-E ( Receivable from Sale of Stock ). Similarly, the advance paid in Comparator common stock to the consultant for the Russian project should have been recorded ==========================================START OF PAGE 11====== as a reduction to shareholders' equity. In substance, the transaction is similar to a stock subscription receivable. Nothing of value was received by Comparator in exchange for the stock; nor was any value to the Company created by the issuance of the stock. Id. In addition, the purported "prepaid fees" to employees should have been recorded at the date of issuance as a period cost and expensed by the Company as employee compensation. See FASB Statement of Financial Accounting Concepts No. 5, 86(b). Finally, a significant part of Comparator's reported inven- tory did not exist or was of no economic value throughout the two year period ended June 30, 1995. The recording of assets that do not exist or have no value is not in accordance with GAAP. FASB Statement of Financial Accounting Concepts No. 6, 26, 81. The assets described above were so clearly lacking in economic substance that Comparator management either knew or was reckless in not knowing that they did not comport with GAAP. Hence, the Company acted with scienter in reporting these assets in its filings on Form 10-K for fiscal years 1994 and 1995, in violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Buchalter and the Buchalter Corp. caused, for pur- poses of Section 21C of the Exchange Act, Comparator's violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 13a-1 and 12b-20 thereunder by issuing unqualified audit opinions on Comparator's 1994 and 1995 financial statements, despite the failure of those financial statements to comport with GAAP. 2. Buchalter and the Buchalter Corp. Engaged in Improper Professional Conduct for Purposes of Rule 102(e) of the Commission s Rules of Practice Rule 102(e) of the Commission s Rules of Practice provides, in pertinent part, that the Commission may deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission: "... (ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct...." Rule 102(e) is designed to preserve the integrity of the Commission s process. The audits performed by Eli Buchalter, under the name of his company, the Buchalter Corp., of Comparator's fiscal 1994 and 1995 financial statements did not meet applicable GAAS standards. Of the general auditing standards, Buchalter violated at least the third general standard, "Due Care in the Performance of Work." American Institute of Certified Public Accountants, Codification of Statements on Auditing Standards ("AU"), Section 230.02. As described above, Buchalter failed to use due care in obtaining and evaluating evidence to support the Company's valuation of its reported assets, and in the application of ==========================================START OF PAGE 12====== generally accepted accounting principles to the financial statements of Comparator. Buchalter's lack of substantive working papers for the 1994 and 1995 Comparator audits illustrates that Buchalter also failed to comply with the third standard of field work, which requires the auditor to obtain sufficient competent evidential matter through inspection, observation, inquiries, and confirmations to afford a reasonable basis for his opinion regarding the financial statements of the company. AU, Section 336.01.7/ Rather than properly document the Company's reported assets, Buchalter based his audit reports primarily on the uncorroborated representations of Comparator management. For example, Buchalter relied on Rogers' August 3, 1995 note as his only documentary support for the value of a material amount of Comparator's reported assets. AU Section 333, however, states that oral or written representations from management are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion on the financial statements. AU, Section 333.02. Indeed, even when other evidence conflicted with management representations, such as occurred with the Churchill "receivable" and the Valcorp "investment," Buchalter did nothing to determine independently what the proper carrying values for these purported assets should be. Finally, Buchalter engaged in improper professional conduct because his reports stated that Comparator s financial statements for fiscal 1994 and 1995 were prepared in accordance with GAAP when they were not and that his audits were performed in accordance with GAAS when they were not. 7/ AU, Section 339.05 state that the quantity, type, and content of work papers vary with the circumstances but should be sufficient to show . . . that the applicable standards of field work have been observed. The work papers ordinarily should include documentation showing that . . . [t]he audit evidence obtained, the auditing procedures applied, and the testing performed have provided sufficient competent evidential matter to afford a reasonable basis for an opinion, indicating observance of the third standard of field work. ==========================================START OF PAGE 13====== IV. Based upon the foregoing, the Commission finds that: A. In connection with the audits of Comparator's fiscal 1994 and 1995 financial statements, Eli Buchalter and the Eli Buchalter Accountancy Corporation caused Comparator's violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 13a-1 and 12b-20 thereunder, and engaged in improper professional conduct for purposes of Rule 102(e) of the Commission's Rules of Practice; and B. It is appropriate and in the public interest to impose the sanctions consented to in the Offers submitted by Eli Buchalter and the Eli Buchalter Accountancy Corp. Accordingly, IT IS HEREBY ORDERED that: A. Buchalter and the Eli Buchalter Accountancy Corporation cease and desist from violating or causing violations of Sections 10(b) and 13(a) of the Exchange Act and Rules 10b-5, 13a-1 and 12b-20 thereunder; and B. Buchalter and the Eli Buchalter Accountancy Corporation be, and hereby are, permanently denied the privilege of appearing or practicing before the Commission as accountants, pursuant to Rule 102(e) of the Commission's Rules of Practice. By the Commission. Jonathan G. Katz Secretary