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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of MICHAEL J. MARRIE, CPA,
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INITIAL DECISION
September 21, 2001 |
| APPEARANCES: | James A. Howell and Craig D. Martin for the Division of Enforcement and the Office of Chief Accountant, Securities and Exchange Commission.
James W. Denison, Wrenn E. Chais, and Michael F. Perlis for Respondents. |
| BEFORE: | James T. Kelly, Administrative Law Judge |
The Securities and Exchange Commission (Commission or SEC) instituted this proceeding on August 10, 1999, pursuant to Rules 102(e)(1)(ii) and 102(e)(1)(iv)(A) of its Rules of Practice, 17 C.F.R. §§ 201.102(e)(1)(ii) and 201.102(e)(1)(iv)(A). The Order Instituting Proceedings (OIP) charged that Michael J. Marrie (Marrie) and Brian L. Berry (Berry), each a certified public accountant (CPA), engaged in improper professional conduct in that they "recklessly" violated the applicable professional standards when auditing the financial statements of a public company. The alleged audit failures occurred in connection with an annual financial report for California Micro Devices, Inc. (CMD) for the fiscal year ending June 30, 1994.
The OIP alleges that Respondents' audit of CMD's financial statements was not conducted in accordance with generally accepted auditing standards (GAAS). It further alleges that CMD's financial statements were not prepared in conformity with generally accepted accounting principles (GAAP) and were materially false and misleading.1 The Division of Enforcement and the Office of Chief Accountant (collectively, Division) argue that Respondents should be denied the privilege of appearing and practicing before the Commission.
In their answers to the OIP, Respondents denied that they failed to comply with the applicable professional standards during CMD's fiscal year 1994 audit. Respondents also raised several affirmative defenses. First, they argued that this proceeding is barred by the five-year limitation period in 28 U.S.C. § 2462. Second, they raised the doctrine of laches, contending that the Division unreasonably delayed the institution of this proceeding to their substantial prejudice. Third, they presented due process, ex post facto, and other constitutional challenges to Rule 102(e). They maintain that the OIP should be dismissed.
On August 30, 1999, Marrie and Berry also filed an action against the Commission in the U. S. District Court for the District of Arizona, seeking declaratory and injunctive relief. They challenged Rule 102(e) as unconstitutional and sought to enjoin the hearing in this matter. On February 18, 2000, Judge Earl H. Carroll issued an order dismissing the joint complaint for lack of subject matter jurisdiction. Among other things, Judge Carroll determined that Marrie and Berry were not challenging final agency action, that they had failed to exhaust their administrative remedies, and that the federal courts of appeals have exclusive jurisdiction to review final orders in Commission administrative proceedings.
I held a public hearing in Phoenix, Arizona, on February 28 through March 3, 2000, and in San Francisco, California, on March 6 through 9, 2000. One witness who had been subpoenaed by both sides did not testify at the hearing because he was recuperating from a surgical procedure. The parties took that witness's deposition on May 11, 2000. See Orders of March 14, 2000, April 27, 2000, and May 15, 2000. The parties have filed proposed findings of fact, conclusions of law, and briefs, and the matter is ready for decision.2 I base my findings and conclusions on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied "preponderance of the evidence" as the applicable standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments, proposed findings, and conclusions that are inconsistent with this decision.
FINDINGS OF FACT
Respondents
Marrie and Berry acted as the engagement partner and engagement manager, respectively, for Coopers & Lybrand's (C&L's) audit of the financial statements of CMD for its fiscal year ended June 30, 1994 (1994 audit) (Tr. 15, 225). C&L issued an unqualified report dated August 25, 1994, with respect to those financial statements (JX 19 at 23).
At all relevant times, C&L was an international public accounting and consulting firm headquartered in New York, New York (Answers ¶ 8). C&L acted as independent auditors for CMD from 1990 until January 6, 1995 (Tr. 152, 514-15). The primary services C&L provided to CMD were annual audits and quarterly reviews of CMD's financial statements (Answers ¶ 8). C&L also prepared CMD's corporate income tax returns. Stan Johnson of C&L's office in Boise, Idaho, established the firm's business relationship with CMD (Tr. 14-15, 516; DX 83 at 1). After 1991, C&L performed its services for CMD from its Phoenix office. C&L resigned as CMD's auditors on January 6, 1995, and informed CMD it would not reissue its 1994 audit report (Answers ¶ 8; Tr. 152-53). In 1998, C&L combined with Price Waterhouse LLP to become PriceWaterhouseCoopers LLP.
Marrie, age fifty-three, is a CPA licensed in Arizona (active) and Ohio (inactive) (Marrie Answer ¶ 5; Tr. 10-11). He graduated from Youngstown State University in 1970, with a major in accounting and a minor in economics (DX 83 at 1). Marrie started his employment with C&L in 1970 in Cleveland, Ohio. He became a partner in 1981 and transferred to C&L's Phoenix office in 1985 (Tr. 11-12). Marrie served as the concurring reviewer for C&L's audits of CMD in 1990 and 1991, and as the engagement partner for C&L's audits of CMD in 1992, 1993, and 1994 (Tr. 14-15; DX 83 at 2). In 1994, Marrie spent approximately 30% to 50% of his time auditing clients who filed financial reports with the Commission (Tr. 12, 206). He was also the managing partner of C&L's Phoenix office in 1994 (Tr. 11).
Marrie resigned from C&L at the firm's request on September 30, 1995 (Tr. 12; DX 86). Thereafter, Marrie was a consultant to one of his former audit clients; eventually, he became the executive director of a Phoenix law firm (Tr. 13). He does not prepare or audit financial statements or participate in any business that the law firm may have before the Commission (Tr. 13-14, 168-69).
Berry, age forty, is a CPA licensed in Arizona (active) and Ohio (inactive) (Berry Answer ¶ 6; Tr. 208). He joined C&L's office in Columbus, Ohio, in 1983 and transferred to the Phoenix office in 1991 (Tr. 209-10). While at C&L, Berry advanced through the positions of associate and senior associate. He became a manager in late 1990 or early 1991 (Tr. 210). Berry participated in two or three CMD audits before the 1994 audit (Tr. 42, 156, 224-25; DX 84 at 1).
Berry resigned from C&L in August 1995 and began working as an independent consultant (Berry Answer ¶ 6; Tr. 197). After about a year, he joined Falcon Power, a privately owned company, as its corporate controller (Tr. 214). Since October 1998, Berry has been employed as the corporate controller at Pentegra Dental Group (Pentegra), a company whose securities are traded on the American Stock Exchange (Tr. 213-14, 216). Berry prepares the financial statements that Pentegra files with the Commission (Tr. 215).
CMD's Public Face: Booming Sales, Soaring Income, Only Minor Problems
CMD is a California corporation with principal executive offices in Milpitas, California (Tr. 15-16; JX 19). The company designs, develops, manufactures, and markets high performance integrated passive electronic circuits (IPECs) and certain semiconductor products (JX 19 at 1). CMD's manufacturing plants are located in Milpitas and in Tempe, Arizona, and its accounting offices are located in Tempe (Tr. 15-16, 516-17).
In fiscal year 1994, CMD's common stock was registered with the Commission pursuant to Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act) and its stock prices were quoted on the NASDAQ National Market System (NASDAQ) (JX 19 at 1, 13). As of June 30, 1994, CMD had 269 full-time employees and approximately 3,000 shareholders of record (JX 19 at 11, 13). Chan M. Desaigoudar (Desaigoudar) was CMD's chief executive officer and chairman of the board of directors; Steven J. Henke (Henke) was CMD's vice president, treasurer, and chief financial officer; and Ronald A. Romito (Romito) was CMD's vice president and chief accounting officer (JX 19 at E&Y 1579). All management officials were located in Milpitas, except for Romito, who was located in Tempe (DX 15 at 25).
CMD's Forms 10-Q for the first three quarters of fiscal year 1994 presented a picture of booming sales and soaring income.3 CMD reported that its net income for the quarter ending September 30, 1993, had increased 120% and that its sales were up 23% from the same period in the prior year (First Quarter 10-Q). Net income for the quarter ending December 31, 1993, was reported to be up 135% and sales for the first six months of the fiscal year were reported to be up 24% from the comparable period in the prior year (Second Quarter 10-Q). Net income for the quarter ending March 31, 1994, was reported to be up 182% and sales were reported to be up 38% from the same period the prior year (Third Quarter 10-Q). CMD's Form 10-K for fiscal year 1994 also showed robust growth in sales and income. CMD's reported net sales increased from $33 million in fiscal year 1993 to $38.2 million in fiscal year 1994 (JX 19 at 25). Its reported net income increased from $2 million in fiscal year 1993 to $5 million in fiscal year 1994 (JX 19 at 25).
On March 15, 1994, CMD and Hitachi Metals, Ltd. (Hitachi Metals) agreed to a strategic alliance that expanded the market for CMD's thin film IPECs (JX 19 at 30). The agreement called for CMD to license its technology to Hitachi Metals. Under the terms of the agreement, Hitachi Metals would offer its own line of IPEC products through its direct sales force and would manufacture thin film technology products (JX 23). In return, Hitachi Metals agreed to purchase 880,000 newly issued shares of CMD common stock at $24 per share (JX 23). The transaction resulted in a total cash payment to CMD of over $21.1 million and Hitachi Metal's ownership of approximately 10% of CMD's common stock (JX 1 at 70, JX 19 at 30, JX 23). The agreement did not allocate the amounts paid by Hitachi Metals between the different segments of the contract.
The market price of CMD common stock was $14 per share on March 15, 1994 (JX 14). Following the announcement of the strategic alliance, CMD's stock price rose to $21.25 on March 16, 1994 (RX 402 at 2, JX 14). Trading volume of CMD's shares increased from 52,107 on March 15 to 2,333,561 on March 16 (JX 14). After the Hitachi Metals transaction closed on May 11, 1994, CMD actively worked with investment bankers and underwriters on a public stock offering to raise additional capital (Tr. 878; JX 19 at 30).
Not all of CMD's financial news during fiscal year 1994 was positive. CMD's reported balance of accounts receivable increased from $12.3 million in fiscal year 1993 to $16.9 million in fiscal year 1994 (JX 19 at 24). The reported balance of CMD's inventory increased from $12.9 million at the end of fiscal year 1993 to $13.9 million at the end of fiscal year 1994 (JX 19 at 24-25). Two factors contributed to these developments.
First, CMD's customer base changed. CMD's largest customer in fiscal year 1993 had been Apple Computer (Apple), accounting for 32% of CMD's total product sales (Tr. 517-18; DX 89, binder 1, tab 4 at 2, JX 19 at 16). In the first half of fiscal year 1994, CMD's sales to Apple amounted to only 6% of its total product sales (Tr. 517-18; DX 89, binder 1, tab 4 at 2). For all of fiscal year 1994, CMD's sales to Apple declined by $9.2 million (JX 19 at 15). Apple had paid its bills promptly (DX 89, binder 1, tab 4 at 2).
CMD reported that its net product sales to foreign customers had increased from 52% in fiscal year 1993 to 59% in fiscal year 1994 (JX 19 at 8). CMD's normal sales terms for foreign customers required payment in sixty days (DX 16 at 42). However, shipments to customers in the Far East involved lengthy transit times and some of those customers would not pay until they had received the product (JX 9 at 830C). CMD found it necessary to offer extended payment terms of ninety to 120 days or more to several customers located in the Far East (Tr. 910-12; DX 89, binder 1, tab 4 at 2, RX 401). Thus, the shift in CMD's customer base lengthened the collection time for its accounts receivable (Tr. 517-18; JX 9 at 832, 832A). The number of days of sales that trade accounts receivable were outstanding was 127 on December 31, 1993, and 126 on March 31, 1994, as compared to ninety-four days on June 30, 1993 (Second and Third Quarter 10-Qs).4
Second, CMD experienced problems maintaining revenue linearity. In the high technology industry, it is common for companies to report a significant percentage of their sales at the end of a quarter or year (Tr. 757-59, 912-13; RX 405 at 21).5 As long as cutoff dates between reporting periods are respected, however, there is nothing inherently improper with significant sales at the end of a reporting period (Tr. 758).6 CMD's revenue spikes were extreme: the company historically reported 70% to 90% of its sales in the third month of each quarter (DX 89, binder 1, tab 4 at 15, JX 9 at 830C). CMD invoiced and shipped approximately 70% of its revenue for the second quarter of fiscal year 1994 during the last week of December 1993 (DX 89, binder 1, tab 4 at 2, 14-15). Because CMD reported that its second quarter sales were $10.2 million, 70% of that figure implies that sales between Christmas Day 1993 and New Year's Day 1994 exceeded $7 million. CMD's reported sales during June 1994 were $12 million (31% of its reported sales for the entire fiscal year) (JX 10 at 1027-77). On June 30, 1994, the last day of the fiscal year, CMD's reported sales were $8 million (JX 10 at 1027-77).
CMD management acknowledged these problems in its quarterly reports, but suggested that matters were under control. The Second Quarter 10-Q stated, at 8:
The increase in accounts receivable was a result of increased sales levels, extended payment terms to selected Far East customers, and non-linearity of sales. In response to this increase, [CMD] is tightening its payment terms policy, stepping up its collection efforts and working on improving its sales linearity within the quarter.
Three months later, CMD management stated in the Third Quarter 10-Q, at 8:
The increase in accounts receivable was a result of increased sales levels, extended payment terms to selected customers (largely in the Far East), and non-linearity of sales for the quarter. [CMD] has increased its receivable reserves in conjunction with closely monitoring the payment trends and stepping up collection efforts while striving to improve linearity of its sales.
On May 25, 1994, Kidder, Peabody & Co. (Kidder Peabody) upgraded its rating of CMD's stock from "outperform" to "strong buy" (RX 401). Kidder Peabody, which was serving as the lead investment banker on CMD's proposed public offering, pointed to CMD's strong third quarter operating results, as well as the expected benefits of the Hitachi Metals transaction, as grounds for recommending the stock to the investing public. In relevant part, Kidder Peabody's research report also opined that CMD's reserves against bad accounts receivable were "more than adequate," that CMD took a "conservative accounting position on its revenue recognition," thereby understating earnings to a degree, and that CMD had "conservatively reserved against obsolete inventories" (RX 401 at 2600-01).7
The Auditors Knew Of CMD's Loss Of Sales To Apple And CMD's Problems With Revenue Linearity
During fiscal year 1994, Respondents conducted quarterly reviews at CMD (Tr. 17-18, 88-89, 314). Marrie knew that CMD's sales to Apple had decreased significantly. However, he took "a lot of comfort" from the strategic alliance with Hitachi Metals and did not give much thought to the loss of Apple's business (Tr. 163-64, 190).
CMD's revenue spikes at the end of a reporting period were of longstanding duration. Marrie had noted the phenomenon as early as the 1992 audit. He wrote in the 1992 Business Assurance Client Continuance Supplement that he had adjusted C&L's review and audit procedures to address the issue (DX 89, binder 1, tab 6 at 4, 7).
Marrie and Berry also knew that CMD had problems with revenue cutoff issues in 1992 and 1993 (Tr. 80-82, 102-03, 231-32; DX 84 at 2). CMD's stated policy was to recognize revenue for product sales only upon shipment to customers (JX 19 at 30 note 2). However, in the years prior to 1994, CMD's actual practice had been much more aggressive. According to Romito, the company had recognized sales revenue if the product was ready for shipment on the last day of a reporting period, even if the product was not shipped until later (Tr. 518-19).8 Berry found it unusually difficult to determine what had and had not been shipped (DX 84 at 3).
Romito and Mary Bridges (Bridges), a clerk in CMD's accounting department, each claimed that during the 1993 audit they advised C&L that approximately $400,000 in revenue recognized on shipments to customers should be reversed because the goods had not actually been shipped before the end of the year (Tr. 525-28, 1225-26). Marrie did not recall receiving such a tip, but he reversed the sales (Tr. 103-04, 580-82). On November 24, 1993, C&L wrote a comment letter to CMD management, summarizing the findings of the 1993 audit. In that letter, C&L specifically recommended that CMD only record sales when goods were shipped (DX 66 at 1130, JX 28 at 1789-92 item 8).
Preliminary Planning For The 1994 Audit
Marrie signed C&L's engagement letter for the 1994 audit on December 2, 1993 (Tr. 73-74; JX 1 at 119-25). The letter explained that Marrie and Berry would lead the engagement team and that C&L expected to deliver its report to CMD on or about September 10, 1994 (JX 1 at 119). The estimated fee for the audit was $89,000, plus expenses (JX 1 at 120). In the letter, Marrie stated that C&L would (JX 1 at 119):
[A]udit the financial statements of [CMD] as of and for the period ending June 30, 1994, in accordance with [GAAS]. The objective of an audit is the expression of our opinion concerning whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of [CMD] in conformity with [GAAP].
In explaining the limitations of the auditing process, the letter further stated (JX 1 at 121):
Our audit will include procedures designed to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. As you are aware, however, there are inherent limitations in the auditing process. For example, audits are based on the concept of selective testing of the data being examined and are, therefore, subject to the limitation that errors and irregularities, if they exist, may not be detected. Also, because of the characteristics of irregularities, including attempts at concealment through collusion and forgery, a properly designed and executed audit may not detect a material irregularity.
Similarly, in performing our audit we will be aware of the possibility that illegal acts may have occurred. However, it should be recognized that our audit provides no assurance that illegal acts generally will be detected, and only reasonable assurance that illegal acts having a direct and material effect on the determination of financial statement amounts will be detected. We will inform you with respect to material errors and irregularities, or illegal acts that come to our attention during the course of our audit.
The letter also called for CMD to provide C&L with a management representation letter at the conclusion of the engagement. Among other things, the representation letter would confirm that CMD's management and key employees had not been involved in any irregularities (JX 1 at 122).
Respondents attended CMD's audit committee meeting on April 29, 1994 (Tr. 25, 77, 227-33, 603-04; JX 1 at 215-18).9 CMD's officers and the members of CMD's board of directors were also present at the meeting. Marrie spoke to the audit committee and submitted C&L's written presentation (Tr. 77, 228; JX 28). Listed as factors influencing the 1994 audit were the adequacy of allowance for doubtful accounts, adequacy of product return reserve, adequacy of reserve for slow moving and obsolete inventory, and the progress of the magnetic head and thin film operations (JX 28 at 1782).10
During the meeting, Marrie also discussed the importance of revenue cutoff and he reaffirmed that sales could not be recognized as revenue unless CMD had actually shipped its product prior to the end of the reporting period (Tr. 80-81, 231, 603-04; JX 28 at 1792). Romito addressed the processes that CMD used to identify and review obsolete inventory (Tr. 62-63). Because CMD had eliminated its Magnetic Head Division in Milpitas during fiscal year 1994, the participants in the meeting also discussed what management intended to do with the equipment from the discontinued operations (Tr. 232, 315, 604; DX 13 at 2133, JX 1 at 62). CMD management specifically told Marrie and Berry that the equipment from the Magnetic Head Division was going to be used in the Thin Film Division (Tr. 604).
In January 1994, Romito had asked Marrie to reduce C&L's fee for the upcoming audit (Tr. 44, 252, 553-56; DX 64, JX 1 at 120). After discussion at the audit committee meeting, the fee remained at $89,000 plus expenses, the same amount that C&L had proposed in the engagement letter (Tr. 79, 553-56).11
Audit Staffing, Budgeting, And Scheduling
As managing partner, Marrie was responsible for generating business in C&L's Phoenix office. C&L's national management had been pushing Marrie to increase the firm's share of the Phoenix audit market for some time. The significance that C&L attached to that goal had been underscored in Marrie's 1992 and 1993 performance evaluations (Tr. 145-46; DX 87 at CLB 486, 490). By December 1993, Marrie knew that he had not met his 1993 goal and that C&L was going to reduce his partnership interest for 1994 from 650 shares to 600 shares as a result (Tr. 146-47; DX 87 at CLB 483-87). Marrie received his 1993 performance evaluation on June 10, 1994, confirming the reduction in shares. The written evaluation again emphasized the need for "immediate new business action and results" to replace the billable hours that the Phoenix office had lost on other engagements (DX 87 at CLB 486).
C&L had expended 1,408 hours on the 1993 CMD audit; its budget for the 1994 CMD audit was limited to 1,200 hours (JX 1 at 89, 142-44, 147). C&L had assigned two senior associates to the 1993 CMD audit; its budget for the 1994 CMD audit called for only one senior associate (Tr. 40-42; JX 1 at 89). The OIP alleges that the reduction in budgeted hours and the increased reliance on junior auditors represented corner-cutting by Marrie in reaction to C&L's emphasis on increasing profits in the Phoenix office.
The allegation is based on the assumption that the 1994 audit was the same as the 1993 audit. However, C&L did not audit CMD's 401(k) plan in 1994, as it had in past years, because there were too many unreconcilable discrepancies between CMD's records and those of the plan administrator (DX 84 at 2).
In any event, Respondents offer a much more benign interpretation. They explained that they were able to reduce the number of budgeted hours and the level of staffing for two reasons. First, they credited the firm's Total Engagement Quality program, which required them to spend less time on non-critical audit areas (Tr. 69-71, 257-58; JX 1 at 72-83, 89). Second, they maintained that CMD had hired new employees and had agreed to prepare more schedules in house (Tr. 159-60, 257-58).12 It is not important to resolve the conflict on this issue, in light of certain concessions made by the Division's expert witness at the hearing, as well as the case law discussed below.
The 1994 engagement team consisted of Marrie, who devoted sixty hours to the audit; Berry, who devoted 189 hours; Kristie Lynn Schindele (Schindele), a senior associate who spent 330 hours on the audit; Jeff Jenson (Jenson), an associate who spent 350 hours on the audit; and M. Johnson, an associate (otherwise unidentified), who spent 220 hours on the engagement (JX 1 at 145-47). There is little reliable testimony and no documentary evidence to support Respondents' claim that another senior associate, Brian Newman (Newman), also participated in the early stages of the 1994 engagement.13
Respondents were the principal liaisons between C&L and CMD management (Tr. 22, 28, 295-96, 309, 316). Marrie visited CMD's Tempe offices ten to twenty times during the audit and he met frequently with Romito (Tr. 21, 60-61). Marrie also spoke twice by telephone with Henke, CMD's treasurer and chief financial officer (Tr. 29). Marrie's only contact with Desaigoudar, CMD's chairman and chief executive officer, occurred at the audit committee meeting on April 29, 1994 (Tr. 27).
Schindele earned a bachelor of arts degree in accounting from Santa Clara University in the spring of 1992, and had passed all parts of the CPA examination by November 1992 (Tr. 416-17, 498, 507). She has been licensed as a CPA since 1995 (Tr. 416, 507). Schindele was employed at C&L's Phoenix office from September 1992 to June 1995. During that time, she was promoted from associate to senior associate (Tr. 412-13). Schindele participated very briefly in the 1993 CMD audit, but she had not been involved in any of the quarterly reviews at CMD during fiscal year 1994 (Tr. 42, 250, 413-14; JX 1 at 86).
Schindele was the accountant in charge of the 1994 CMD audit (Tr. 361). She prepared the audit budget and audit strategy memorandum, supervised Jenson and another associate, prepared customer confirmation requests, audited receivables, inventory, and equipment, and assembled a list of the matters for the attention of the engagement partner (Tr. 361, 417, 420, 425, 433, 473, 479-80). Schindele was in frequent contact with Respondents during the field work (Tr. 424-25, 473).
Jenson graduated from Brigham Young University in December 1993 with both bachelor of arts and master of arts degrees in accounting (Tr. 329, 360, 405). He was employed as a staff auditor in C&L's Phoenix office from January 1994 to October 1996 (Tr. 360, 405). The record does not state whether Jenson was licensed as a CPA. Jenson was the primary associate on the 1994 CMD engagement (Tr. 32). The assignment represented not only Jenson's first audit of a public company, but also his first audit of a high technology company (Tr. 44, 361). When the field work started, Jenson had been at C&L for approximately six months (Tr. 256). He had not participated in any of the 1994 quarterly reviews at CMD (Tr. 361).
Jenson devoted about two or three weeks to field work at CMD's Tempe office (Tr. 402). While he was on site, Jenson was in continuous contact with Schindele, his immediate supervisor (Tr. 377, 402, 477). Jenson also had access to Berry when Berry was on site (Tr. 403). Jenson's principal responsibilities were to perform the audit of inventory and to assist in sales cutoff testing (Tr. 361-63, 378-81).
A second associate who was junior to Jensen also assisted in the audit (Tr. 196). The record is silent as to that individual's credentials and experience.
A member of the engagement team observed CMD's inventory count at Tempe on July 5, 1994 (JX 10 at 1144B-54). Another member of the engagement team (purportedly, Newman) partially observed CMD's physical inventory at the Milpitas on July 5 and 6, 1994 (Tr. 241-42; JX 11 at 1206-08, JX 12 at 2366-76). Formal planning for the audit took place from July 14 through July 24, 1994 (Tr. 309, 421; JX 1 at 86-93). During the planning stage, the engagement team met several times to discuss the audit procedures that the auditors would follow (Tr. 34). Field work, the period of time during which the engagement team collected and evaluated evidence to support its audit conclusions, began on July 27 and ended on August 25, 1994 (Tr. 91-92, 95, 421-22; JX 1 at 73). Apart from the partial observation of inventory at Milpitas, all field work performed by C&L took place in Tempe (Tr. 71-72, 242, 490).
CMD's 1994 Financial Performance: What The Auditors Did Not Know
CMD management had recorded revenue on a number of 1994 transactions where there was no realistic prospect of collecting payment (Tr. 528-29). These receivables were uncollectible because the goods had never been shipped, the likelihood of timely payment was in doubt, or there were customer concerns about the quality of the goods (Tr. 528-29).
Every senior CMD officer who attended the audit committee meeting on April 29, 1994, was aware that, for the quarter ending March 31, 1994, CMD had recognized millions of dollars of revenue for products that had not been shipped (Tr. 586-89, 603-04). No one from CMD management revealed this fact to Respondents (Tr. 586-89, 603-04).
CMD management knew that if it did not "clean" the company's books before the end of the fiscal year, C&L was likely to discover the improper revenue recognition during the audit (Tr. 528-30, 588). Accordingly, management decided to issue approximately $12 million in credit memoranda to write off certain accounts receivable during the fourth quarter of fiscal year 1994 (Tr. 528-30, 537, 541-42; DX 13 at 2128).
In July 1994, Romito told Respondents that CMD expected to write off $12 million in accounts receivable (Tr. 116-17, 308). Marrie later told a special agent of the Federal Bureau of Investigation that he was "dumbfounded" by the size of the proposed write-off (DX 83 at 3).14 Marrie believed that the write-off was a positive step for CMD (Tr. 121-22). Meyercord felt the same way (Tr. 919).
In alerting Respondents to the upcoming write-off, CMD management was sharing only a fraction of the full story. Left unmentioned was the fact that CMD's sales, shipping, and accounting personnel, as well as CMD customers, created false shipping documents and invoices to disguise at least a portion of the improperly recorded sales (Tr. 605-06, 706-08, 1213-17). To keep track of the sales, accounting department personnel maintained documents that outlined the exact nature and scope of cash collection activities for accounts receivable (Tr. 571-75). Those documents were hidden from the C&L auditors.15 CMD's officers also lied to C&L in the management representation letter at the conclusion of the audit (Tr. 203, 570-75; JX 1 at 168-71).
C&L Reviews CMD's Valuation Of The Technology Transfer To Hitachi Metals
CMD's transaction with Hitachi Metals provided management with an opportunity to record non-sales revenue to offset the elimination of a large portion of its accounts receivable (Tr. 534-37). During the fourth quarter, CMD management worked simultaneously on determining which accounts receivable to write off and how much revenue to recognize from the technology sale to Hitachi Metals (Tr. 535-36, 541-42).
In mid-July, Romito gave Marrie management's proposal for recording as revenue $6.6 million of the $21.1 million paid by Hitachi Metals (Tr. 119, 536-37). Within a week, Romito told Marrie that CMD wanted to increase that amount to $7 million (Tr. 536-37). These sums represented $7.50 and $8.00 per share, respectively, of the $24.00 per share that Hitachi Metals had paid (JX 14 (Wierwille memorandum)). The reason for the increase was that the write-off of accounts receivable had increased (Tr. 536-37). Marrie characterized the Hitachi Metals transaction as complex and he brought in a C&L valuation specialist to review management's proposal (Tr. 117-18). The specialist determined that a proper valuation of the technology transfer would be $6.53 per fully diluted share (JX 14 (Wierwille memorandum)). The specialist further stated: "Although the above calculat[ion] is less than that which . . . has been determined by the client, it does not appear to represent a material difference, and accordingly, the client's analysis and the determination of the value related to the license and technology transfer appear not unreasonable" (JX 14 (Wierwille memorandum)).16
Marrie Reviews CMD's Allocation Of The Write-Off Of Accounts Receivable
Marrie and Romito had several meetings and discussions to review information and documents about the proposed write-off (Tr. 123, 540, 591). These discussions related to the allocation of the write-off to reversal of sales, sales returns, bad debt, and other categories (Tr. 126-28, 540-41). The issue was not academic: amounts written off for returned product would be deducted directly from reported revenues, while amounts written off as bad debt would be treated as expenses and therefore would not decrease reported revenues. Desaigoudar and Henke wanted CMD's reported revenues to be as high as possible to maintain the impression of growth (Tr. 535, 541-42).
CMD's initial proposal maximized the portion of the write-off allocated to bad debt expense and minimized the portion allocated to sales returns and reversals (Tr. 541-42). This would have had the least negative impact on CMD's reported revenues (Tr. 542). However, when Romito proposed that over $4 million be allocated to bad debt expense, Marrie balked and told Romito that the write-off would have to be reallocated (Tr. 126, 542, 591).
Marrie advised Romito to prepare an analysis setting forth CMD's reasons for writing off each specific receivable for each customer (Tr. 126). He also informed Romito that CMD had to make a determination on a line-by-line basis as to the proper accounting for each adjustment (Tr. 127, 542-44). In response, Romito prepared a schedule listing the receivables and allocating the write-off (Tr. 123-25, 127, 591). The schedule went through a number of changes as Marrie and Romito continued to discuss the allocation issues (Tr. 127-28).
Marrie received materials on the fourth quarter sales adjustments. When later asked to produce his file, Marrie could not do so (Tr. 124-26; DX 83 at 5). C&L's work papers for the 1994 audit do not contain any spreadsheets on the write-off (JX 1-JX 18). Marrie could not identify CMD's "Credit Memorandum Summary Journal Entry, June 1994" as a document he reviewed, although he recalled seeing a document similar in form (Tr. 128-29; JX 26). The Division asks me to infer that JX 26, CMD's "Credit Memo Summary Journal Entry, June 1994," is either the spreadsheet of the accounts receivable write-off that Marrie saw in 1994, or is sufficiently similar to serve as a substitute (Div. Prop. Find. # 60). I agree with the Division and make that inference.
Berry joined Marrie in discussing with Romito the procedures necessary to account for the write-off, but Berry never saw any of the resulting spreadsheets (Tr. 309-10; DX 84 at 3). Beyond reviewing the spreadsheets, Marrie did very little with the information he received on the proposed write-off. He reviewed the sampling criteria he had previously established for confirming CMD's accounts receivable, but ordered no changes in the level of confirmation testing (Tr. 195). He never instructed the engagement team to perform any additional audit procedures (Tr. 130-31, 312, 397).
CMD Reports Its Fourth Quarter Results
On August 3, 1994, during the second week of C&L's field work, Romito gave Respondents a draft of a press release announcing CMD's earnings for the fourth quarter and for fiscal year 1994 (Tr. 132-33, 310-11; DX 73). The draft stated that non-product sales for the quarter had been $7 million, reflecting the sale of technology to Hitachi Metals. The draft then made the following statement about the write-off of accounts receivable:
Offsetting non-product sales were product returns and related expense charges totaling [$8.3 million] for the quarter. [CMD] authorized selected Far East distributors, unable to pay for the product on a timely basis, to return the product [$5.3 million] and in certain cases, these distributor balances were written off to cost of sales [$1.7 million] or bad debt expense [$1.3 million].
Berry reviewed the draft, made sure the numbers that CMD proposed to report for prior periods were mathematically accurate, and then discussed the draft with Marrie (Tr. 311).
On August 4, 1994, CMD issued its press release, publicly disclosing its fourth quarter net income and earnings, as well as an $8.3 million write-off of accounts receivable (DX 39). The press release was unchanged from the prior day's draft, insofar as it announced $7 million in non-product sale of technology. With respect to the write-off, however, the press release stated (emphasis added):
Offsetting non-product sales were product returns and related expense charges totaling [$8.3 million] for the quarter. As a result of the success of establishing second source to thin film IPEC products, [CMD] decided to reduce its emphasis on certain distribution channels by terminating selected distributors. [CMD] authorized these terminated distributors and others who were unable to pay for product on a timely basis, to return the product [$5.3 million] and in certain cases, these distributor balances were written off to cost of sales [$1.7 million] or bad debt expense [$1.3 million].
The bolded language denotes the changes that CMD made after Respondents reviewed the draft (DX 39, DX 73). The identities of the "terminated distributors" were never disclosed to C&L or to anyone else (Tr. 124, 298, 856; Thomsen Dep. at 45; RX 405 at 15).
Respondents received a copy of CMD's August 4 press release, reviewed it, and initialed it (Tr. 143-45, 311-12). They could not recall if they compared the information in the press release to the information Romito previously gave them concerning the write-off, or if they directed the junior auditors to investigate any of the information in the press release (Tr. 136-37, 312).
In addition to issuing the press release, CMD announced its fourth quarter earnings in a telephone conference call to financial analysts on August 4, 1994 (Tr. 544-45; DX 78, DX 79). Romito invited Marrie to listen to the conference call, but Marrie elected not to do so (Tr. 552-53; DX 79). During the conference call, Desaigoudar made an opening presentation for CMD and then he and Henke responded to questions (DX 78, DX 79). Some of the questions raised during the conference call revealed that the financial analysts had a very negative reaction to CMD's write-off of its accounts receivable (Tr. 545-46; DX 79).
Following the press release and the conference call, CMD's stock, which had been trading at over $20 per share, dropped to the lower teens (Tr. 430-32). Kidder Peabody abandoned its efforts on the proposed public offering (Tr. 885-87, 899).17 Shareholder class action lawsuits alleging accounting improprieties followed. Respondents were aware of both the drop in CMD's stock price and the first of the shareholder lawsuits (Tr. 137; JX 1 at 234, JX 19 at 38 note 13). Although they had three weeks of field work remaining, Marrie and Berry did not make any adjustments to the audit plan in response to the write-off or the events of August 4, 1994 (Tr. 130, 312, 397).
C&L's Audit Report
As of June 30, 1994, CMD claimed total assets of $74.5 million on its balance sheet (JX 19 at 24). It included both its accounts receivable and its inventories as current assets. CMD reported its accounts receivable, less an allowance for doubtful accounts of $1.5 million, to be worth $16.9 million. It reported its inventories to be worth $13.9 million. CMD reported its net property and equipment as non-current assets worth $10.4 million. In its statement of operations for fiscal year 1994, CMD reported net income of $5 million on total revenues of $45.3 million (JX 19 at 25).
C&L presented its independent accountants report in a letter addressed to CMD's shareholders and directors. The letter was dated August 25, 1994, the last day of C&L's field work at CMD (JX 19 at 23). In relevant part, the report stated:
We conducted our audits in accordance with [GAAS]. . . . We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements . . . present fairly, in all material respects, the financial position of [CMD] as of June 30, 1994 and 1993, . . . in conformity with [GAAP]. In addition, in our opinion, the financial statement schedules . . . when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
Note 2 to the financial statements identified CMD's significant accounting policies. As here relevant, the note explained that CMD carried its inventories at the lower of cost or market, and that CMD stated its property and equipment at cost (JX 19 at 29).
Note 4 to the financial statements addressed the concentration of CMD's credit risk. In relevant part, the note stated that CMD had customers "who are located in foreign countries. [CMD] generally extends credit to these customers and, therefore, collection of receivables is affected by the [customers'] industries' economy. However, [CMD] monitors extensions of credit and, in the opinion of management, has provided adequate receivable reserves" (JX 19 at 31).
Note 13 to the financial statements addressed pending litigation. In relevant part, the note stated that "[CMD] has been named a defendant in three securities class action lawsuits. . . . [CMD] believes these suits to be without merit and intends to vigorously defend them. . . . Management believes that none of these matters will have a material adverse effect on [CMD's] financial position or results of operations" (JX 19 at 38).
Lastly, note 14 to the financial statements addressed segment information. In relevant part, the note stated (JX 19 at 38):
Foreign sales, primarily in Europe, Canada and Asia, aggregated approximately 59%, 52% and 42% of net product sales in fiscal 1994, 1993 and 1992 respectively. . . .
During fiscal 1994, no customer accounted for more than 10% of net product sales. During fiscal 1993 and 1992, one customer accounted for approximately 32% and 24% of net sales respectively.
Subsequent Developments At CMD
On September 29, 1994, CMD filed its Form 10-K for fiscal year 1994 with the Commission (JX 19). Included within its Form 10-K was the C&L report on the audited financial statements for that year (DX 89, binder 1, tab 3 at 23-38, JX 19 at 23-38). The next day, the Commission's staff requested that C&L produce documents, including work papers, related to CMD's quarterly and annual periods ending December 31, 1993, March 31, 1994, and June 30, 1994.18
Revenue recognition issues and accounts receivable issues persisted at CMD through the end of the first quarter of fiscal year 1995. In early October 1994, CMD retained the law firm of Howard, Rice, Nemerovski, Canady, Robertson, Falk & Rabkin (Howard Rice) to defend the company and its officers in the pending shareholder actions and in the Commission's investigation (Thomsen Dep. at 18-19; RX 374 at 628).
At an audit committee meeting on October 14, 1994, Howard Rice presented its preliminary findings, conclusions, and recommendations (RX 374 at 628, RX 405, Exhibit E, Audit Committee Meeting Document). Howard Rice reported that CMD personnel had been able to obtain false shipping documents from shippers, that CMD had been shipping merchandise to freight forwarders to hold until the merchandise could be shipped to customers, and that CMD personnel had shipped merchandise to false customers (DX 13 at 2128, RX 405, Exhibit E, Audit Committee Meeting Document). The audit committee promptly notified the Commission, NASDAQ, and the U. S. Department of Justice of these preliminary findings (Tr. 924).
On October 17, 1994, CMD announced that its board of directors had appointed a special committee of independent directors to investigate possible revenue recognition and other accounting irregularities that might affect the financial results for earlier periods, including fiscal year 1994 (Tr. 920-21, 924-25; JX 21 at 9). To assist its investigation, the special committee engaged Howard Rice as its counsel (Tr. 1238-39). In turn, Howard Rice retained the special services group of the accounting firm of Ernst & Young (E&Y) (Tr. 1238).
E&Y's mandate was to examine CMD's financial reporting practices and procedures and to advise about the possible restatement of the previously issued financial statements (DX 13 at 2127). This was a forensic accounting, a much more extensive examination than a routine audit (Tr. 1241-44). The special services group of E&Y began its work with the knowledge that C&L were the auditors of record, and the expectation that C&L would sign off on any necessary restatement (Tr. 1284; Thomsen Dep. at 47). E&Y was not hired to evaluate the adequacy or appropriateness of C&L's auditing procedures (Tr. 1269-70, 1277-78; DX 13 at 2127). As E&Y performed its forensic review, CMD employees assisted them and told them what to look for to uncover the accounting irregularities (Tr. 1270-71). E&Y submitted its findings and recommendations in December 1994 (DX 13). E&Y's report focused on sales and shipping issues (DX 13 at 2132). The areas of inventory reserve and the valuation of machinery and equipment, both of which are identified as audit failures in the OIP, were beyond the scope of E&Y's engagement (DX 13 at 2132).
The special committee also hired Carl A. Thomsen (Thomsen) as a consultant to address a wide range of issues (Tr. 925; Thomsen Dep. at 5, 19-20; DX 5). Before accepting the position, Thomsen already knew that there had been accounting irregularities at CMD (RX 374 at 615). He initially examined the publicly available documents and concluded that CMD's inventory was excessive relative to its sales and to the inventory levels of its competitors (Thomsen Dep. at 10-11; RX 374 at 645). After his first day on the job, Thomsen wrote in his diary: "[I]nventory has to be a problem as customers are complaining about delays in shipments despite the major inventory levels" (RX 374 at 618). While he could not identify the origin of these customer complaints, Thomsen concluded that CMD's accounts receivable were too high as a percentage of its reported revenues (Thomsen Dep. at 12-13, 71-73, 75; RX 374 at 651).
Thomsen reported his preliminary findings and recommendations on accounting irregularities to the special committee on October 28, 1994, only eleven days after he started (JX 24).19 Among other things, Thomsen advised the special committee that CMD's fiscal year 1994 accounts receivable were a significant problem and that certain revenue billings also appeared to be improper (JX 24 at 667-70). As Thomsen continued his work, he prepared detailed analyses and recommended significant additional inventory reserves (Thomsen Dep. at 35-36; DX 12, DX 92, JX 25). In December 1994, Thomsen proposed a new inventory valuation policy to be used on a "go forward" or prospective basis (Thomsen Dep. at 29, 62-64; JX 25).
Thomsen resigned his consulting position in January 1995, before CMD's new management restated the 1994 financials (Thomsen Dep. at 63).20 He did not know if his proposed valuation policy changes or his proposed inventory adjustments were ultimately included in CMD's Form 10-K/A (Thomsen Dep. at 62-63).
On January 6, 1995, C&L confirmed that it was terminating its auditing relationship with CMD and would not reissue its audit opinion on CMD's 1994 financial statements (Tr. 152; JX 20 at 50, JX 24 at 678). NASDAQ delisted CMD's stock on January 26, 1995, due to CMD's delinquency with respect to two filings with the Commission, and CMD's inability to meet certain other filing requirements (JX 21 at 11). On February 3, 1995, CMD reached an agreement for the appointment of E&Y as its new independent accountants.21
On February 6, 1995, CMD filed a report with the Commission on Form 10-K/A, restating its results for fiscal year 1994 (JX 20). Upon restatement, CMD reported a net loss of $15.2 million on total revenues of $30.1 million (JX 20 at 22, JX 21 at 12). CMD had previously reported earnings of $5 million on revenues of $45.3 million (JX 20 at 26, JX 21 at 9). The restated balance sheet reduced accounts receivable from $16.9 million to $6.3 million, inventories from $13.9 million to $5.1 million, and net property and equipment from $10.4 million to $7.4 million (JX 19 at 24, JX 20 at 21). The revised financial statements were unaudited.22 The Division presented no witnesses from CMD to explain the basis for the restatement.
The Division struggles to establish that E&Y eventually audited CMD's restated fiscal year 1994 balance sheet when it later audited CMD's financial statements for the nine-month period ending March 31, 1995 (Tr. 1252-53, 1265-66, 1279-81; Div. Reply Br. at 10 n.5). The weight of the evidence does not support this claim.23
Witness Credibility
Fact witnesses. I have addressed the credibility of the principal fact witnesses (Marrie, Berry, Jenson, Schindele, Romito, Kannapan, and Meyercord) throughout this decision. I did not personally observe Thomsen, who testified by deposition, and I have expressed no view as to his credibility. I found several other witnesses (Robert K. Crowe (Crowe), Martin Nachimson (Nachimson), Betty Jo Charles, Hal Schultz, and Manual Alvarez) to be generally credible. The same cannot be said for Guy Steve Hamm (Hamm) or Bridges.
Hamm was the managing partner for C&L's Los Angeles regional cluster in 1994 and 1995 (Tr. 1485). He was Marrie's immediate supervisor (Tr. 1487-89). Hamm testified that C&L's principal reason for requesting Marrie's resignation was that business revenues in the Phoenix office had been flat or declining for several years (Tr. 1497-98). Hamm nonetheless opined that CMD's annual audit fees of less than $100,000 were not significant to the revenues of C&L's Phoenix office or to the those of the Los Angeles regional cluster as a whole, and that C&L's loss of CMD as an audit client was not a factor in Marrie's separation from the firm (Tr. 1499).
Hamm also testified that he did not personally examine Marrie's technical auditing performance and had received only limited input from others on that subject (Tr. 1491, 1499-1500). However, when shown DX 86, Voluntary Withdrawal at the Firm's Request, Hamm recalled that there had been some technical issues dealing with revenue recognition on the CMD audit (Tr. 1493-94). Hamm insisted that these technical issues were the last of many factors he considered when recommending that Marrie withdraw from C&L (Tr. 1496-97). Hamm maintained that he was not aware of any litigation against C&L arising out of the CMD audit when he recommended Marrie's termination (Tr. 1504).
DX 86 stated: "Marrie is being asked to withdraw from the Firm based on his inability to successfully grow the Phoenix practice and a lack of evidence that he is continuing to grow professionally as a partner" (DX 86 at CLB 452). It also gave considerably more weight to Marrie's technical accounting deficiencies than Hamm's testimony acknowledged. For example, DX 86 stated that Marrie's "technical competence has come into question. . . . Mike failed to identify certain technical issues on [the CMD audit] . . . which resulted in our resigning from [the engagement]. Mike has had technical difficulties with other clients in the past . . . ." (DX 86 at CLB 453). DX 86 also recited: "Although Mike has been generally well-liked by his clients, reviewers have indicated that at times he assumes too strong an advocacy role for them and that this may cause him to lose some of his objectivity. He has not always pressed his clients strongly enough, especially when the client has needed to be challenged on technical matters" (DX 86 at CLB 455).
I give considerably more weight to the first three pages of DX 86 than I do to Hamm's testimony that Marrie was asked to resign from C&L only because he had failed to generate adequate business for the firm's Phoenix office.24 Hamm's claim that he was unaware of litigation against C&L, arising out of the CMD audit, was not credible.
While it would not be accurate to classify Hamm as a witness who was overtly hostile to the Division, his demeanor persuaded me that he was giving the Division as little as he possibly could. On cross-examination by Respondents, Hamm availed himself of the opportunity to soften any blows he had been forced to deliver against Marrie on direct examination.
Bridges was generally an untrustworthy witness. She testified falsely that she had no direct contact with the auditors during the 1994 audit (Tr. 1212, 1219-20; JX 9 at 820, 829, 838). In an apparent recantation of prior testimony, she only "vaguely recall[ed]" telling one of the auditors to look at a May invoice register detailing millions of dollars of revenue reversals (Tr. 1221). She could not even recall if her tippee was male or female (Tr. 1221). In contrast, Schindele testified credibly that no one from CMD had tipped her to such matters (Tr. 501-02). Bridges, like Romito, claimed credit for being the whistleblower who alerted the auditors to improper revenue recognition during the 1993 audit (Tr. 1225-26). When discussing misconduct by CMD officers and employees during 1994, Bridges resorted to the passive voice, thus obscuring the identity of the actors: airway bills were falsified, invoices were falsified and provided to the C&L auditors, incriminating documents were thrown away (Tr. 1216-17). In this manner, Bridges attempted to establish misconduct by others at CMD without implicating herself. However, I do credit Bridges's testimony that she did not specifically inform anyone from C&L that CMD was recognizing revenue for products that had not been shipped in 1994 (Tr. 1214).
Expert witnesses. D. Paul Regan (Regan), CPA, a forensic accountant with Hemming, Morse, Inc., of San Francisco, California, appeared for the Division as an expert in accounting matters. Regan's direct testimony is contained in a forty-page report (DX 89). He also testified on cross-examination and redirect examination for more than thirteen hours over three days. Of the 1,525-page transcript in this case, 454 pages (30%) were devoted to Regan.
Ernest L. Ten Eyck (Ten Eyck), CPA, testified as Respondents' expert on accounting issues. Ten Eyck is a director of Ten Eyck Associates, a consulting and litigation support firm in King of Prussia, Pennsylvania. He submitted his direct testimony in a thirty-two-page report (RX 405). He also testified on cross-examination and redirect examination for five hours on a single day (179 pages of transcript).
Both experts were well qualified. Cross-examination of Regan by Respondents was much more contentious than cross-examination of Ten Eyck by the Division. It is difficult to overstate the importance of Regan's testimony to the Division's case. It was thus quite surprising to see the Division's Posthearing Brief, at 3, state: "[W]hile opinions of qualified expert accountants may be helpful, in the last analysis the Commission must weigh the value of expert testimony against its own judgment of what is sound accounting practice." The Division cites Ernst & Ernst, 46 S.E.C. 1234, 1237 (1978), as authority for that proposition, but it ignores the Commission's statement elsewhere on the same page of that opinion. There, the Commission concluded that an Administrative Law Judge had erred in failing to give sufficient weight to expert testimony concerning accounting principles that were generally accepted during the period under consideration. Id. at 1237-38. This decision does not adopt the views of either expert in full, but it does rely on parts of the reports and testimony of each.
Related Cases
In addition to the present proceeding, the events at CMD during 1994 generated many other civil, administrative, and criminal cases. Several are relevant to the OIP's charge of pervasive financial reporting fraud at CMD, to Respondents' defense of laches, and to Respondents' claim that CMD management officials repeatedly deceived them. Of course, settlements are not proof that such fraud actually occurred or that CMD officials deceived the auditors, particularly when the parties involved neither admitted nor denied the allegations. The cases have been cited only to provide context for this proceeding.
Civil Injunctive Actions. On January 4, 1996, the Commission brought a civil action against Romito in the U.S. District Court for the Northern District of California. See SEC v. Romito, SEC Litig. Rel. No. 14776, 60 SEC Docket 3342 (Jan. 4, 1996). The Commission alleged that Romito, together with other officers and employees of CMD, fraudulently inflated CMD's reported revenue for fiscal year 1994 by knowingly recognizing revenue on products that had not been shipped or, in some cases, even manufactured. Id. The complaint charged that, in order to conceal the improper revenue recognition, Romito and others falsified CMD's books and records, overrode CMD's internal accounting controls, and misled CMD's outside auditors. The complaint further alleged that Romito engaged in illegal insider trading by selling CMD stock while in possession of material non-public information. Id.
On January 17, 1996, Romito consented to an order permanently enjoining him from future violations of the securities laws, directing him to disgorge an amount equal to the losses he avoided by insider trading, and prohibiting him from serving as an officer or director of a public company. Romito also consented to the entry of an order in a separate administrative proceeding that prohibited him from appearing or practicing before the Commission as an accountant. See Ronald A. Romito, CPA, 61 SEC Docket 656 (Feb. 1, 1996).
On September 26, 1996, the Commission brought a civil action in the Northern District of California against Surendra Gupta (Gupta), former president of CMD, Bhasker B. Rao (Rao), former vice president and general manager of CMD's Tempe plant operations, and R. Ramana Penumarty (Penumarty), former vice president and general manager of CMD's Milpitas plant operations. See SEC v. Gupta, Rao, and Penumarty, SEC Litig. Rel. No. 15097, 62 SEC Docket 2970 (Sept. 30, 1996). The complaint alleged that all three defendants artificially inflated CMD's publicly reported revenue for fiscal year 1994 by directing employees to falsify documents to create the appearance that certain goods had been shipped to customers when in fact the goods had not been shipped or, in most cases, manufactured. Id. Rao and Penumarty were also charged with engaging in illegal insider trading by selling CMD stock in 1994 while in possession of material non-public information. Id.
On March 25, 1998, without admitting or denying the allegations, Gupta, Rao, and Penumarty consented to permanent injunctions from future violations of the securities laws, to civil penalties, and to be barred from serving as officers or directors of public companies. Rao and Penumarty also consented to pay disgorgement for insider trading. See SEC v. Gupta, Rao, and Penumarty, SEC Litig. Rel. No. 15690, 66 SEC Docket 2768 (Mar. 31, 1998).
On September 30, 1998, the Commission filed a complaint in the Northern District of California against Desaigoudar and Henke. See SEC v. Henke and Desaigoudar, SEC Litig. Rel. No. 15919, 68 SEC Docket 533 (Sept. 30, 1998). The allegations (financial reporting fraud and illegal insider trading) and the relief sought (injunctions, disgorgement, civil penalties, and bars on service as officers and directors of public companies) were similar to those in the Romito, Gupta, Rao, and Penumarty cases described above. Id. at 533-34. The Commission's complaint against Desaigoudar and Henke is still pending.
Criminal Cases. Romito pled guilty to one count of insider trading in CMD stock (Tr. 560). He agreed to cooperate with the government's ongoing investigation of the events at CMD.
Henke, Desaigoudar, and Gupta were indicted on criminal charges in September 1997. Gupta reached an agreement with the government in exchange for his testimony against Henke and Desaigoudar. In July 1998, after a five-week trial, a jury found Henke and Desaigoudar guilty of conspiracy to make false statements to the Commission, making false statements, securities fraud, and insider trading. See United States v. Desaigoudar and Henke, SEC Litig. Rel. No. 15846, 67 SEC Docket 2356 (Aug. 12, 1998). In December 1998, Henke and Desaigoudar were fined and sentenced to thirty-two months and thirty-six months incarceration, respectively.
In August 2000, the U. S. Court of Appeals for the Ninth Circuit reversed the convictions, vacated the sentences, and remanded for a new trial. United States v. Henke, 222 F.3d 633. The court agreed with the defendants that a new trial was necessary because their lawyers' ability to cross-examine Gupta, a key government witness, had been impaired by a conflict of interest arising from a joint defense agreement. According to the court, the joint defense agreement established an implied attorney-client relationship with the co-defendants' attorneys. The court also found reversible error in the admission of Meyercord's testimony that Henke, Desaigoudar, and others were terminated because they must have known about the revenue reporting scheme at CMD.
Shareholder Class Action Lawsuits. Following the August 4, 1994, write-off announcement, shareholders filed eleven class action lawsuits in the Northern District of California against CMD, its current and former officers and directors, C&L, and others. The principal allegation was that CMD and others violated the antifraud provisions of the securities laws by disseminating false and misleading financial statements and reports for fiscal years 1994 and 1993 (JX 21 at 9). The complaints sought damages and attorneys' fees, as well as other relief.
Judge Vaughn R. Walker denied the motions of certain plaintiffs and CMD for preliminary approval of a proposed settlement. He also denied the request of a law firm representing certain plaintiffs to be appointed class counsel. See In re California Micro Devices Sec. Litig., 168 F.R.D. 257, 269-71 (N.D. Cal. 1996) ("CMD I").
Judge Walker later approved a revised settlement proposal. In contrast to the earlier and rejected proposal, which consisted of $1 million in cash and $12 million of CMD stock, the revised proposal offered the class $6 million in cash and stock guaranteed to be worth at least $7 million. The revised proposal also cut attorney fees by over $1 million, and brought in additional cash from two new sources that had not been part of the original agreement.
C&L contributed $4 million in cash to the revised settlement agreement. Judge Walker found this to be "a substantial improvement for the class and . . . particularly impressive because it comes from outside accountants who may well have successfully claimed to have been duped" by CMD. See In re California Micro Devices Sec. Litig., 965 F. Supp. 1327, 1331 (N.D. Cal. 1997) ("CMD II").
DISCUSSION AND CONCLUSIONS
The OIP alleges that Respondents failed to exercise appropriate professional skepticism, obtain competent evidential matter, and properly supervise audit personnel as they audited CMD's property, inventory, and accounts receivable.
The most notable features of the OIP are its length and detail: fifteen single-spaced pages of very specific allegations about what was wrong with CMD's financial statements and how Respondents recklessly violated the applicable professional standards when auditing them. Because the charging document offers so much particularity, it is difficult to imagine that the Commission omitted anything that it considered important.
Nonetheless, the Division and/or its expert witness sought to bring in several fresh allegations that had not been identified in the OIP. The Division never moved to amend the OIP to encompass these new charges, and the time for doing so has expired. This Initial Decision refuses to consider these newly minted allegations. See supra note 16 and infra notes 42, 48, 49.
At the same time, the Division abandoned some of the allegations that are identified in the OIP. For example, the OIP claims that CMD's officers "engaged in a massive financial reporting fraud" (OIP ¶ II.D.4). The Division suggests that this charge is surplussage, and that it is there simply to provide background. I agree with the Division that it need not prove fraud by CMD's management in order to prevail on each of the OIP's allegations of improper professional conduct. The OIP is also brimming with allegations that CMD's audited financial statements contained material misstatements and failed to comply with GAAP (OIP ¶¶ II.A.2, II.A.3, II.A.4, II.D.4, II.D.13, II.D.28, II.D.39, and II.D.45). I agree with Respondents that the wording of the OIP requires the Division to prove each of these GAAP allegations to obtain the sanctions it seeks.
The OIP raises two types of GAAP-related claims: first, that CMD's financial statements contained material misstatements in violation of GAAP; and second, that Respondents recklessly violated GAAS because they lacked a sufficient basis to opine that the financial statements complied with GAAP. The Division specifically disavowed an intention to prove the former type of charge (Division's Designation of Expert Witness, dated Oct. 29, 1999 (omitting CMD's alleged violations of GAAP from the list of issues that Regan would address); Prehearing Conference of Nov. 12, 1999, at Tr. 22, 25-30; Resp. Prehearing Br. at 34-37; Tr. 1244-51, 1267-68; Resp. Prop. Find. # 9 n.10; Div. Reply Br. at 13 n.8). This decision finds that, by doing so, the Division has narrowed the scope of the practice sanction that is appropriate under Rule 102(f) if it prevails on the merits of the GAAS charges. See infra note 32 and associated text.
This decision rejects Respondents' claims that the proceeding is barred by the statute of limitations and/or by the doctrine of laches. It next examines the contours of recklessness under the applicable case law, and concludes that the Division cannot establish recklessness under Rule 102(e)(1)(iv)(A) by merely stringing together separate acts of auditing negligence that might have satisfied Rule 102(e)(1)(iv)(B)(2). It then reviews the term "applicable professional standards" in Rule 102(e)(1)(iv)(A) and concludes that C&L's internal policy and guidance manual is not part of the applicable professional standards for purposes of Rule 102(e).
The OIP focuses on Respondents' audit of three estimates made by CMD's management. These estimates are "soft" numbers; their reliability depends upon the quality of the assumptions on which they are based. The process of creating adequate reserves is inexact to begin with, and it is a daunting task for the Division to demonstrate that the audit of those estimates was reckless.
This decision finds that the weight of the evidence does not support the claims that Respondents recklessly violated GAAS in auditing CMD's estimates of the value of its property and equipment or the value of its obsolete inventory. In these two areas, this decision also finds that no GAAS violations were proven. It further finds that Respondents committed negligent, but not reckless, violations of GAAS when auditing CMD's sales revenues, accounts receivable, and estimate of sales returns. Finally, the decision finds that the weight of the evidence fails to sustain the charges that CMD's financial statements materially misstated its property and equipment, its obsolete inventory, and its revenues and accounts receivable in violation of GAAP.
Based on these findings and conclusions, the Initial Decision dismisses all the charges as to both Respondents.
1. This proceeding is not time-barred by 28 U.S.C. § 2462.
Respondents argue that 28 U.S.C. § 2462, the five-year limitation period for actions to enforce a penalty, bars this proceeding. They observe that much of the professional conduct at issue-including the audit planning, most of the field work, and the August 4, 1994, write-off that the Division contends should have alerted Marrie and Berry to CMD's fraud-occurred more than five years before the OIP was issued. In support of their request for dismissal, Respondents cite Johnson v. SEC, 87 F.3d 484, 488-90 (D.C. Cir. 1996), and 3M Co. v. Browner, 17 F.3d 1453, 1456-61 & n.14 (D.C. Cir. 1994).
The Division contends that 28 U.S.C. § 2462 does not apply because this proceeding is remedial in character, not punitive. See Johnson, 87 F.3d at 489 n.7 ("Where a licensing agency is only evaluating an individual's current competence, it is not clear that there would be a date at which the `claim first accrued' for purposes of § 2462."); cf. Janik Paving & Constr., Inc. v. Brock, 828 F.2d 84, 90-91 (2d Cir. 1987) (finding that debarment is not a penalty). In the alternative, the Division argues that the limitation period did not start to run until C&L "rendered" its audit report on September 27, 1994 (JX 1 at 75-77). Only then, the Division claims, did Respondents end their opportunity to take further corrective action with respect to the report.
The Commission has never explicitly held that 28 U.S.C. § 2462 governs Rule 102(e) disciplinary proceedings. See George Craig Stayner, CPA, 67 SEC Docket 425 (May 14, 1998) (dismissing a Rule 102(e) proceeding that had not been instituted until eight years after the alleged improper professional conduct occurred, without determining whether the rationale of Johnson applied); cf. Russell Ponce, 72 SEC Docket 442, 465-67 (Aug. 31, 2000) (finding in a mixed enforcement proceeding and Rule 102(e) disciplinary proceeding that the respondent had waived the statute of limitations argument, but observing in dicta that two of the four audited financial statements at issue had been prepared and filed within five years before the OIP).
However, the Commission has acquiesced in Johnson when resolving the aged administrative enforcement proceedings on its docket. See Terry T. Steen, 53 S.E.C. 618, 623-25 (1998) (holding that the Commission will look only to wrongful conduct within the five-year period before the OIP to establish liability, but stating that it may consider a respondent's earlier conduct, when relevant, to establish the respondent's motive, intent, or knowledge); Richard D. Chema, 53 S.E.C. 1049, 1052 n.8 (1998) (following Steen, but referring to "transactions" instead of "conduct"); Joseph J. Barbato, 53 S.E.C. 1259, 1278-79, 1281 (1999) (looking only to conduct within the five-year period to assess sanctions); Jacob Wonsover, 69 SEC Docket 694, 713-14, 716 (Mar. 1, 1999) (looking only to conduct within the five-year period to establish liability and assess sanctions).
The limitation period in 28 U.S.C. § 2462 is subject to equitable tolling if a continuing violation or ongoing conduct is involved. See Newell Recycling Co., Inc. v. EPA, 231 F.3d 204, 206-07 (5th Cir. 2000); InterAmericas Inv., Ltd. v. Bd. of Governors of the Fed. Reserve Sys., 111 F.3d 376, 382 (5th Cir. 1997). Respondents are wrong to focus on the date that a junior auditor completed a particular step during field work; the relevant date for commencing the running of the limitation period is when Marrie and Berry determined that all the procedures had been performed to their satisfaction. Had Respondents been dissatisfied with the work in a given area, they could have directed that additional work be performed. For that reason, I conclude that the audit involved a continuous course of conduct. As a result, the Commission's "claim first accrued" when Marrie certified C&L's unqualified audit report, thereby giving up the ability to take further corrective action.
Ponce is of limited assistance in determining when the limitation period should begin to run. Sections 12(b)(1)(J) and (K) of the Exchange Act require that an issuer's financial statements be "certified" by an independent public accountant. Commission Regulation S-X, 17 C.F.R. § 210.1-02(f), provides that financial statements are "certified" when an independent auditor completes an examination and issues a report expressing an opinion. AU § 530.01 states that the date of completion of field work is generally used as the date of the independent auditor's report. Under AU § 530.02, an auditor has no responsibility to make any inquiry or carry out any auditing procedures for the period after the date of his report. These provisions strongly suggest that the appropriate date to commence the running of any limitations period is the date the auditor certifies his report.
If an auditor certifies his report too early (before the field work has been completed), the Commission has not hesitated to charge improper professional conduct for violating AU § 530.01. See Lester Witte & Co., 47 S.E.C. 409, 419 (1981) (settled case); see also Indep. Accountants, Mandatory Peer Review, 37 SEC Docket 1825, 1836 n.53 (Apr. 10, 1987) (rulemaking proposal to amend the Regulation S-X definition of "certified" financial statements to require that such financial statements be examined by an independent accountant who has undergone a peer review within three years prior to the date of the completion of the examination, and using AU § 530.01 (the end of field work) as the date of the completion of the examination).25 If an auditor reopens the field work because he is not satisfied with the work already performed, AU § 530.05 contemplates that he will adjust his report date to reflect that fact.
Assuming that 28 U.S.C. § 2462 applies to Rule 102(e) disciplinary proceedings, I conclude that the limitation period began to run on August 25, 1994, the certification date on C&L's unqualified audit report.26 The limitation period had not expired when the OIP was issued on August 10, 1999.
2. There is no merit to Respondents' affirmative defense of laches.
Laches is an equitable doctrine by which a court denies relief to a claimant who has unreasonably delayed or been negligent in asserting a claim, when that delay or negligence has prejudiced the party against whom relief is sought. See Black's Law Dictionary 879 (7th ed. 1999). The doctrine is based on the maxim that equity aids the vigilant, not those who sleep on their rights. See Ikelionwu v. United States, 150 F.3d 233, 237 (2d Cir. 1998).
Respondents cannot use the doctrine of laches to shrink the limitations period they say is applicable to this proceeding. If there is a limitation period, and if the limitation period has been met, that is the end of the matter. See Holmberg v. Armbrecht, 327 U.S. 392, 395 (1946); Lyons P'ship, L.P. v. Morris Costumes, Inc., 243 F.3d 789, 797-98 (4th Cir. 2001) (holding that "separation of powers principles dictate that an equitable timeliness rule adopted by courts cannot bar claims that are brought within the legislatively-prescribed statute of limitations"); Patton v. Bearden, 8 F.3d 343, 348 (6th Cir. 1993) (holding that, absent compelling reasons, there is a strong presumption against applying the doctrine of laches where the statute of limitations has not expired).
Respondents' laches argument fails for an additional reason. Laches cannot be invoked against federal government agencies acting in a sovereign capacity to protect the public interest. See David Disner, 52 S.E.C. 1217, 1223 (1997); Kingsley, Jennison, McNulty & Morse, Inc., 51 S.E.C. 904, 911 n.30 (1993); Richard N. Cea, 44 S.E.C. 8, 21 (1969) and cases cited therein. The Commission has entertained laches defenses raised against non-governmental self-regulatory organizations. See Raphael Pinchas, 70 SEC Docket 1516, 1529-30 (Sept. 1, 1999); Stephen J. Gluckman, 70 SEC Docket 418, 431-32 (July 20, 1999). I am aware of no cases in which the Commission has found a laches defense to be meritorious.
As evidence of prejudice resulting from unreasonable delay, Respondents assert that original documents they sought to retrieve from CMD had been lost or destroyed and that they were unable to find a potential witness. They also find it galling that the Division repeatedly cites to the audit team's inability to recall the details of what it did during the audit as grounds to conclude that it did nothing.
I agree with Respondents that the delay in commencing this proceeding was regrettable and undesirable.27 However, I do not find that Respondents' legal rights have been prejudiced. The fact that original documents may have been missing from CMD headquarters was of no consequence because microfilmed copies of the documents were still available from CMD's attorneys at Howard Rice (Prehearing Conference of Jan. 13, 2000, at Tr. 6-8). The Division's prospective witness list provided a current address for Henke, the allegedly missing witness. Respondents could have pursued that lead if they wished to do so.
The failing recollections of various witnesses presents a closer issue. Certain witnesses' memories were clear when they were asked to recall events that could burnish their own reputations as whistleblowers. Thus, both Romito and Bridges took credit for tipping Marrie to revenue recognition problems during the 1993 audit (Tr. 525, 1225-26). These tips were one of the things that Marrie claimed not to recall (Tr. 103-04). Meyercord had little difficulty recalling his vehement disagreement with Romito at a February 1994 board meeting over management's decision to grant extended payment terms to Far East distributors (Tr. 910-12). However, other parts of Meyercord's testimony were sprinkled with "I don't recall" answers (Tr. 908, 914-16, 924). Other witnesses' memories were clear only when they had exculpatory information to offer. For example, Jenson had a precise recollection of the time Marrie stood up to Romito, refusing to direct the engagement team to work weekends after CMD had delayed in getting materials to the auditors (Tr. 401-02). On the other hand, Jenson was unable to remember the details of certain audit procedures he performed. Marrie had no difficulty recalling that he lost a client because he had too much integrity for the client's liking (Tr. 169-70). Marrie's ability to recall events closer to the heart of the case was much more limited. Thus, Marrie could not recall being "dumbfounded" when learning of the prospective write-off of $12 million in receivables. In contrast, Kannapan, a witness with a much more peripheral involvement in the case, had no difficulty remembering that he was shocked when he learned of the same information. I cannot find that Respondents have been unfairly prejudiced by the "I don't recall" testimony.
3. In attempting to show that Respondents were reckless, the Division has assumed a formidable burden of proof.
Rule 102(e) provides the Commission with a means to ensure that the professionals on whom it relies in executing its statutory duties perform their tasks diligently and with a reasonable degree of competence. The Commission has stated that it did not promulgate the rule to augment its enforcement arsenal, but simply to protect the integrity of its administrative processes from future harm that would result from continuing professional misconduct. See William R. Carter, 47 S.E.C. 471, 472-78 (1981) (discussing the background and operation of Rule 2(e), the predecessor of Rule 102(e)).28
Although there is no express statutory provision authorizing the Commission to discipline the professionals appearing before it, three reviewing courts have held that the rule was validly promulgated under the Commission's broad authority to adopt those rules and regulations necessary for carrying out its designated functions. See Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995); Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986); Touche Ross & Co. v. SEC, 609 F.2d 570, 577-82 (2d Cir. 1979).
Scienter And Rule 102(e)
The mental state required to violate the Commission's rule against improper professional conduct has been a point of considerable controversy. Representatives of the accounting profession, some prior Commissioners, and various legal commentators have argued that sanctioning an accountant for negligence extends beyond the realm of protective discipline and thrusts the Commission into substantive regulation over a professional's work-a function they view as reserved to the state boards of accountancy and professional organizations. Cf. SEC v. Pros Int'l, Inc., 994 F.2d 767, 769 (10th Cir. 1993) ("The SEC's authority does not extend to general regulation of the accounting profession . . . ."); SEC v. Arthur Young & Co., 590 F.2d 785, 788 (9th Cir. 1979). These critics have suggested that the text of Rule 102(e)(1)(ii) must be read in its entirety and that, just as an accountant cannot "negligently" be lacking in character or integrity or act unethically, so too, an accountant cannot "negligently" engage in improper professional conduct. They have contended that it is unfair for the Commission to apply a more stringent standard for accountants (sanctioning them for negligence) than for attorneys (sanctioning them only for recklessness or knowing misconduct).
In Davy, 792 F.2d at 1422, the U.S. Court of Appeals for the Ninth Circuit stated that "there may be cases where the SEC should not be empowered to determine the standards by which accountants, or attorneys for that matter, are to be judged," but it concluded that Davy's breaches of GAAP and GAAS were "so clear and so uncontroverted that any vagueness in the Rule is not at issue here."
In David J. Checkosky, 50 S.E.C. 1180 (1992), a majority of the Commission found that two accountants had engaged in improper professional conduct in violation of former Rule 2(e). It suspended them from practice for two years. The Commission stated that "a mental awareness greater than negligence is not required" to establish a violation of the rule, but it "noted" that the two accountants' conduct "did in fact rise to the level of recklessness." Id. at 1197.
In Checkosky v. SEC, 23 F.3d 452 (D.C. Cir. 1994) (Checkosky I), the court of appeals remanded the case to the Commission, holding that the agency had failed adequately to explain the standard of conduct it had applied under the rule. There was a very brief opinion of the court; each of the three judges also issued a separate expression of views. All three judges found substantial evidence to support the Commission's findings that the two accountants had failed properly to interpret GAAP and to act in accordance with GAAS. They differed on whether the violations of GAAP and GAAS constituted negligence or recklessness and whether negligence was sufficient for sanctions under the rule.
On remand, the Commission affirmed the suspensions. David J. Checkosky, 52 S.E.C. 1177 (1997). The majority opinion found that "improper professional conduct by accountants encompasses a range of conduct" and that the rule "does not mandate a particular mental state." Id. at 1190-91. It concluded that the accountants had behaved recklessly, but at the same time insisted that negligent deviations from GAAP or GAAS could violate Rule 102(e).
The two accountants again petitioned for judicial review, and again argued that the Commission had failed to articulate an intelligible standard for "improper professional conduct" under Rule 102(e). In Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (Checkosky II), the court of appeals again remanded. The court found that, notwithstanding the prior remand, the Commission had failed to offer an adequate explanation of the mental state that violated the rule. Citing the Commission's "persistent failure to explain itself" and "the extraordinary duration" of the proceedings, id. at 222, 227, the court determined that further proceedings would be futile. It instructed the Commission to dismiss the charges.
In response to Checkosky II, the Commission instituted a notice-and-comment rulemaking proceeding to "clarify" the standard of intent it would apply when determining whether accountants engage in improper professional conduct. Proposed Amendment to Rule 102(e) of the Commission's Rules of Practice, 67 SEC Docket 1006 (June 18, 1998) (Proposed Amendment). It adopted an amendment on October 19, 1998, and specified three types of conduct that would constitute improper professional conduct by an accountant under Rule 102(e)(1)(ii). Amendment to Rule 102(e) of the Commission's Rules of Practice, 68 SEC Docket 707 (Rule Amendment).
New Rule 102(e)(1)(iv)(A) defined "improper professional conduct" by an accountant to mean "[i]ntentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards." In addition, new Rule 102(e)(1)(iv)(B) defined "improper professional conduct" by an accountant as "[e]ither of the following two types of negligent conduct: (1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted[; or] (2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission." Rule Amendment, 68 SEC Docket at 709.
The notice of proposed rulemaking requested the public to comment on what definition of "recklessness" would be appropriate. Proposed Amendment, 67 SEC Docket at 1009. Several commenters suggested the definition of "recklessness" used in cases brought under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. In adopting the Rule Amendment, the Commission agreed: "Although the standards of professional practice are not fraud based," for purposes of consistency, "recklessness" in the amended rule "should mean the same thing as courts have defined `recklessness' to mean under the antifraud provisions." Rule Amendment, 68 SEC Docket at 710.
Retroactive Application Of Rule 102(e)(1)(iv)(A)
Respondents argue that the Commission is estopped from retroactively applying Rule 102(e)(1)(iv)(A) to professional conduct that occurred in 1994 (Answers at 14; Resp. Br. at 35-37). They believe that the Commission must measure their 1994 professional conduct against the pre-1998 version of Rule 102(e)(1), the version the Commission has stated "does not mandate a particular mental state."
In promulgating the amended rule, the Commission stated that the purpose it served and the relief it provided are forward-looking. For those reasons, it said that it would use the clarified standard "in all cases considered after the amendment's effective date . . . regardless of when the conduct in question occurred." Rule Amendment, 68 SEC Docket at 708. The Commission did not specifically state that the amended version of the rule would be applied retroactively, but only that the clarified "standard" would be used "regardless of when the conduct in question occurred."
Paragraphs II.D.14 and II.D.48 of the OIP charge that Respondents "recklessly" violated applicable professional standards, while Paragraph II.D.48 specifically invokes Rule 102(e)(1)(iv)(A).29 Clearly, the 1998 rule amendment is being applied to pre-1998 conduct.
Application of a statute to conduct that occurred before its issuance is disfavored, but it is permissible if the provision simply embodies the law in existence at the time of the conduct and thus does not attach new legal consequences to events completed before its enactment. See Landgraf v. USI Film Prods., 511 U.S. 244, 269-70 (1994); SEC v. First Pac. Bancorp, 142 F.3d 1186, 1193 n.8 (9th Cir. 1998). Where the intervening statute authorizes or affects the propriety of prospective relief, application of the new provision is not retroactive. See Landgraf, 511 U.S. at 273.
However, absent clear Congressional intent, an agency may not give retroactive effect to statutes or rules that impair rights a party possessed when he acted, increase a party's liability for past conduct, or impose new duties with respect to transactions already completed. See id. at 280; see also Koch v. SEC, 177 F.3d 784, 789 (9th Cir. 1999) (holding that the Remedies Act did not authorize the Commission to impose a penny stock bar on an individual whose alleged misconduct predated the enactment of that statute); Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996) (stating that because there was "substantial uncertainty" in the Commission's interpretation of a rule, the respondent did not have reasonable notice that his conduct might violate the rule); Carter, 47 S.E.C. at 508 (declining to find "improper professional conduct" by two attorneys because the applicable standards "have not been so firmly and unambiguously established that we believe all practicing lawyers can be held to an awareness of generally recognized norms" and because "the Commission has never articulated or endorsed any such standards").
In the three years since it adopted the rule amendment, the Commission has held that the clarified standard of intentional or knowing conduct by an accountant, including reckless conduct, "is not novel and was not created by the amendment to Rule 102(e). Rather, it is a standard that we have used in proceedings that predate both the Checkosky opinion and [the respondent's] own 1995 conduct." Albert Glenn Yesner, CPA, 70 SEC Docket 2743, 2748 (Oct. 19, 1999); Ponce, 73 SEC Docket at 465 n.52, 467 n.57; see also Potts v. SEC, 151 F.3d 810, 812-13 (8th Cir. 1998), cert. denied, 526 U.S. 1097 (1999) (recklessness by a concurring review partner). But see Checkosky II, 139 F.2d at 225-26 ("[T]he Commission had to make a choice. There is no justification for the government depriving citizens of the opportunity to practice their profession without revealing the standard they have been found to violate."); Yesner, 70 SEC Docket at 2752 (Johnson, Comm'r, dissenting) (criticizing the Commission's majority for treating the relevant version of Rule 102(e)-the one that existed prior to the October 1998 amendment-as if it had a severable "recklessness" element that survived Checkosky II); but cf. Natl. Mining Assn. v. U.S. Dept. of the Interior, 177 F.3d 1, 18-19 (D.C. Cir. 1999).
The Commission opinions in Yesner and Ponce stand for the proposition that intentional, knowing, or reckless conduct that did not comply with the applicable professional standards was "improper professional conduct" under Rule 102(e) before and after the Rule Amendment. Both opinions state that the "recklessness" standard was "not novel." Those opinions are binding on Administrative Law Judges, and are followed here. If Respondents contend that they had no idea, prior to October 19, 1998, that reckless violations of professional auditing standards would be treated as "improper professional conduct," or if they believe that Checkosky II, Koch, Upton, or Carter compel a different result on the retroactivity or fair notice issues, or on any of their other constitutional challenges, they must ask the Commission to reconsider its position.
Scienter And Auditing Under The Federal Securities Laws
The term "scienter" refers to "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). The Division can establish scienter by proving either actual knowledge or recklessness. See Disner, 52 S.E.C. at 1222 & n.20; cf. In re Software Toolworks, Inc., Sec. Litig., 50 F.3d 615, 628 (9th Cir. 1994); In re Phar-Mor, Inc., Sec. Litig., 892 F. Supp. 676, 685 (W.D. Pa. 1995). Recklessness is narrowly defined. It involves not merely simple, or even inexcusable negligence, but an extreme departure from the standard of ordinary care and which presents a danger of misleading buyers or sellers that is either known to the actor or is so obvious that the actor must have been aware of it. See SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 & n.7 (9th Cir. 1990) (en banc); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044-45 (7th Cir. 1977).30 Recklessness is a lesser form of intent, not a greater degree of ordinary negligence. It is not just different from negligence in degree, but also in kind. See Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977).
The contours of auditing recklessness are particularly troublesome because an audit by nature involves considerable estimation and judgment exercised against materials prepared by others. See Bily v. Arthur Young & Co., 834 P.2d 745, 762 (Cal. 1992) ("An auditor is a watchdog, not a bloodhound. As a matter of commercial reality, audits are performed in a client-controlled environment.").
The type of recklessness that is actionable against an outside auditor must approximate an actual intent to aid in the fraud being perpetrated by the audited company. See Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120-21 (2d Cir. 1982). Scienter requires more than evidence that an outside auditor has misapplied accounting principles. The Division must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. See SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992). If a respondent shows that his accounting decisions were reasonable, he negates the Division's attempt to establish scienter. See In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994).
The case law is clear about what is not sufficient to establish scienter.31 First, violations of GAAP, by themselves, do not constitute circumstantial evidence of scienter. See Chill v. Gen. Elec. Co., 101 F.3d 263, 270 (2d Cir. 1996); Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1020-21 (5th Cir. 1996); Software Toolworks, 50 F.3d at 626-27; Worlds of Wonder, 35 F.3d at 1426; Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 362 (1st Cir. 1994). The same is true for violations of GAAS, standing alone. See Danis v. USN Communications, Inc., 73 F. Supp. 2d 923, 941 (N.D. Ill. 1999); Marksman Partners, L.P. v. Chantal Pharm. Corp., 46 F. Supp. 2d 1042, 1049 n.5 (C.D. Cal. 1999), aff'd, 2000 U.S. App. LEXIS 21708 (9th Cir. Aug. 22, 2000) (unpublished table decision); In re Health Mgmt., Inc. Sec. Litig., 970 F. Supp. 192, 203 (E.D.N.Y. 1997). Second, it is not enough for the Division to show that a reasonable accountant "would, might, or should have handled the matter differently." Price Waterhouse, 797 F. Supp. at 1241. Third, an accountant's scienter may not be inferred solely from the magnitude of the client's fraud. See Reiger v. Price Waterhouse Coopers, LLP, 117 F. Supp. 2d 1003, 1013 (S.D. Cal. 2000); In re Livent, Inc., Sec. Litig., 78 F. Supp. 2d 194, 217 (S.D.N.Y. 1999). Fourth, an auditor's desire to receive professional fees, or to profit from a continuing relationship with a client, does not suffice as evidence of scienter. See Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994); DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990); Health Mgmt., 970 F. Supp. at 202; Price Waterhouse, 797 F. Supp. at 1242 & n.60. Fifth, scienter is not established by demonstrating an auditor's lack of curiosity, or by using hindsight. See Chill, 101 F.3d at 270; Software Toolworks, 50 F.3d at 627; DiLeo, 901 F.2d at 628.
In contrast, the courts have been willing to infer scienter when GAAP or GAAS violations are combined with other circumstantial evidence of recklessness. First, scienter will exist when an auditor ignores multiple "red flags" that should have heightened his professional skepticism. See Danis, 73 F. Supp. 2d at 941-42; Miller v. Material Sci. Corp., 9 F. Supp. 2d 925, 928-29 (N.D. Ill. 1998); Health Mgmt., 970 F. Supp. at 203; Van de Velde v. Coopers & Lybrand, 899 F. Supp. 731, 737 (D. Mass. 1995); In re Leslie Fay Cos., Inc. Sec. Litig., 871 F. Supp. 686, 699 (S.D.N.Y. 1995), modified on other grounds, 918 F. Supp. 749 (S.D.N.Y. 1996). Second, scienter may be based on the magnitude of the reporting errors, if the accused was in a position to detect the errors. See Chu v. Sabratek Corp., 100 F. Supp. 2d 815, 824 (N.D. Ill. 2000); Chalverus v. Pegasystems, Inc., 59 F. Supp. 2d 226, 234 (D. Mass. 1999) (collecting cases); In re Miller Indus., Inc. Sec. Litig., 12 F. Supp. 2d 1323, 1332 (N.D. Ga. 1998); In re Leslie Fay Cos., Inc. Sec. Litig., 835 F. Supp. 167, 175 (S.D.N.Y. 1993) (holding that "tidal waves of accounting fraud" raise an inference of scienter for an accountant). The magnitude of an underlying fraud will also support an inference of scienter if it enhanced the auditor's suspicion of specific transactions or made the overall fraud glaringly conspicuous. See Reiger, 117 F. Supp. 2d at 1013. Third, scienter may be found if unusual transactions have been completed at or near the end of an accounting period, or if the audited company has violated its own internal policies in a way that violated GAAP. See Provenz v. Miller, 102 F.3d 1478, 1490 (9th Cir. 1996); In re Ikon Office Solutions, Inc. Sec. Litig., 66 F. Supp. 2d 622, 630-31 (E.D. Pa. 1999) (Ikon I); Chalverus, 59 F. Supp. 2d at 234-35; In re Cirrus Logic Sec. Litig., 946 F. Supp. 1446, 1458 n.10 (N.D. Cal. 1996); Van de Velde, 899 F. Supp. at 734-36. Fourth, scienter may be found if there is evidence that the accused participated in drafting misleading documents. See Software Toolworks, 50 F.3d at 629.
Materiality, GAAS, GAAP, And Scienter
The cases cited above, holding that scienter may be inferred in part from the magnitude of the reporting errors, offer judicial recognition of the close relationship between materiality and scienter under the antifraud provisions of the securities laws. The converse is equally true: immaterial errors will not support an inference of scienter. See Coates v. Heartland Wireless Communications, Inc., 55 F. Supp. 2d 628, 638 (N.D. Tx. 1999) ("It cannot be strongly inferred that a person who conceals immaterial information acts with intent to defraud."); Geiger v. Solomon-Page Group, Ltd., 933 F. Supp. 1180, 1191 (S.D.N.Y. 1996) (holding that it cannot be conscious misbehavior or recklessness for a defendant to fail to disclose information in a prospectus that is not material). In fact, because materiality is an element of an offense under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the courts often will not even consider the thorny issue of scienter if the materiality of an alleged misstatement or omission has not been established. See Press v. Quick & Reilly, Inc., 218 F.3d 121, 130 (2d Cir. 2000); Grossman v. Novell, Inc., 120 F.3d 1112, 1125 (10th Cir. 1997).
The Commission has rejected a suggestion that the filing of a materially false or misleading document should always be a threshold requirement for a finding of improper professional conduct by an accountant under Rule 102(e). In so ruling, the Commission reasoned:
[A]n accountant can demonstrate a lack of competence even if his conduct did not result in the filing of a false or misleading document. An auditor who fails to audit properly under GAAS-whether recklessly or highly unreasonably-should not be shielded [from a Rule 102(e) proceeding] because the audited financial statements fortuitously turned out to be accurate or not materially misleading.
Rule Amendment, 68 SEC Docket at 711. According to Respondents, this shows that the Commission is not simply interested in protecting the integrity of its processes, but is attempting to engage in the general regulation of the accounting profession. Absent evidence of GAAP violations and material misstatements in financial statements that could harm investors, Respondents claim that the Commission should stay its hand.
GAAS consists of three general standards, three standards of field work, and four standards of reporting. Certain activities subject to GAAS concern matters other than submitting documents. Thus, materiality is simply not relevant to such GAAS issues as the auditor's technical training and proficiency, or the auditor's need to maintain an independent mental attitude. Regan offered an additional hypothetical example of a GAAS violation without a corresponding GAAP violation: a client could have prepared a fair statement of its assets, liabilities, income, expenses, and the like, with all the appropriate footnotes, yet the auditor could have failed to perform any audit at all (Tr. 1109). In Regan's judgment, such circumstances would involve an audit that failed to comply with GAAS, although the client's financial statements complied with GAAP.
In other situations, however, whether "materiality" is an "element of the offense" will depend on whether it is an element of the specific professional standard alleged to have been violated. See Robert D. Potts, CPA, 65 SEC Docket 1376, 1385-87 (Sept. 24, 1997), aff'd, 151 F.3d 810 (8th Cir. 1998); see also Greebel v. FTP Software, Inc., 194 F.3d 185, 205 (1st Cir. 1999) (GAAP violations); In re Segue Software, Inc., Sec. Litig., 106 F. Supp. 2d 161, 169-71 (D. Mass. 2000) (GAAP violations); Ponce, 73 SEC Docket at 460-61 (GAAP violations).
The applicable professional literature is to the same effect. The statements interpreting GAAS recognize that materiality "underlie[s] the application of all [GAAS], particularly the standards of field work and reporting." AU § 150.03; see also AU § 150.04 ("The concept of materiality is inherent in the work of the independent auditor."); AU § 312.03 ("The concept of materiality recognizes that some matters, either individually or in the aggregate, are important for fair presentation of financial statements in conformity with [GAAP], while other matters are not important."); AU § 312.08 ("The auditor should consider audit risk and materiality both in (a) planning the audit and designing auditing procedures and (b) evaluating whether the financial statements taken as a whole are presented fairly, in all material respects, in conformity with [GAAP]."); AU §§ 312.13, 326.23, 411.06, 420.02, 431.02, 508.08. Accordingly, to prove improper professional conduct where the allegation is the expression of a faulty opinion on the client's financial statements taken as a whole, the Division must demonstrate materiality.
Should the Division prove that Marrie and Berry recklessly violated GAAS, yet fail to prove that CMD's audited financial statements were materially misstated in violation of GAAP, remedial sanctions would be limited to the particular deficiencies proven on the record. The Division professes to be aghast at this prospect, even going so far as to argue that Administrative Law Judges and the Commission lack the power to tailor the scope of a practice sanction under Rule 102(f)(2), 17 C.F.R. § 201.102(f)(2), to anything less than its full breadth (Posthearing Conference of Aug. 30, 2000, at Tr. 31-33). In advocating this extreme position, the Division fails to consider that it bears the burden of proof as the proponent of an order imposing sanctions. See 5 U.S.C. § 556(d) ("Except as otherwise provided by statute, the proponent of a rule or order has the burden of proof."). The Division also fails to explain why there is no merit to the recommendations of the American Bar Association's Section of Business Law, Committee on Federal Regulation of Securities, Task Force on Rule 102(e) Proceedings.32 The Task Force Report stated:
A respondent who understands GAAP but has an inadequate appreciation of GAAS . . . should not be precluded from participating in the preparation of financial statements as, for example, a member of the finance and accounting department of a public company, as opposed to having ultimate responsibility for the application of the auditing standards to those financial statements.
Scienter Cannot Properly Be Inferred From Evidence Of Nothing More Than Repeated Auditing Negligence
As stated in Sanders, 554 F.2d at 793, recklessness is a lesser form of intent, not a greater degree of ordinary negligence, and it differs from negligence not only in degree, but also in kind. See McLean v. Alexander, 599 F.2d 1190, 1198 (3d Cir. 1979) ("[N]egligence, whether gross, grave or inexcusable cannot serve as [a] substitute for scienter."); Reiger, 117 F. Supp. 2d at 1014 ("[N]o degree of negligence can satisfy the substantive element of scienter, or raise a strong inference of scienter under the [PSLRA.]").
Although the Commission assesses an auditor's performance in light of the "total audit environment," see Ernst & Ernst, 46 S.E.C. at 1262, the OIP does not challenge the CMD audit in its entirety. Rather, the OIP focuses on three specific aspects of the audit: accounts receivable, obsolete inventory, and discontinued equipment. Of course, it is theoretically possible that the more negligent acts an auditor commits during a given interval, the likelier it may be that the auditor knew he was creating risk of a greater degree and a different kind. But the courts have not been receptive to such hair-splitting. Cf. Wells v. Monarch Capital Corp., [1998 Supp.] Fed. Sec. L. Rep. (CCH) ¶ 90,110 at 90,152 (1st Cir. 1997) (holding that the fact that the outside auditors made "many mistakes" did not support a finding of scienter). Given Checkosky I and Checkosky II and the Commission's determination not to wade into this swamp in the 1998 rulemaking,33 the Division cannot bootstrap its way to victory in an auditing recklessness case by stringing together separate acts of auditing negligence.
The OIP does not allege auditing negligence. If the evidence shows nothing more than auditing negligence, dismissal would be appropriate. In these circumstances, the Division cannot pursue a Rule 102(e)(1)(iv)(A) recklessness theory based on nothing more than evidence of multiple Rule 102(e)(1)(iv)(B)(2)-type negligence. If that is what the Commission had intended to allow in its 1998 rulemaking, it would have said so explicitly. To the extent that the Division's evidence proves only negligence, even repeated instances of negligence, I have not considered that evidence as probative on the question of whether Respondents were reckless.
Not All Missed Audit Clues Are "Red Flags" That Demonstrate "Recklessness"
The Division cannot establish scienter by labeling every missed audit clue, no matter how slight, as a separate "red flag." The courts have required considerably more precision than that. See Reiger, 117 F. Supp. 2d at 1012 (holding that purported "red flags" consisted of documents which, if properly reviewed pursuant to GAAP or GAAS, would have raised an inference of gross negligence, but not fraud); In re MicroStrategy Sec. Litig., 115 F. Supp. 2d 620, 653-54 (E.D. Va. 2000) (holding that "the probative value of allegations that an auditor ignored `red flags' is a function of the nature and number of such flags"); Cheney v. Cyberguard Corp., 2000 U.S. Dist. LEXIS 16351, at *43-44 (S.D. Fla. July 31, 2000) (finding alleged "red flags" insufficient to support a strong inference of scienter). As explained in Reiger, 117 F. Supp. 2d at 1012 (footnote and citations omitted):
Plaintiffs rely on several decisions handed down by district courts . . . that found a strong inference of scienter by combining accounting improprieties with an accountant's alleged disregard of "red flags." . . . The warning signs in these cases more closely resembled "smoking guns" than "red flags." Each case included specific facts suggesting the independent accountant consciously entertained doubts about the veracity of its client's financial disclosures, either from a client or third party informing the accountant of the client's fraud, or from contemporaneous statements made by the accountant.
4. The C&L Accounting and Auditing Manual is not part of the applicable professional standards for purposes of Rule 102(e).
C&L prepared a policy and guidance manual known as the C&L Accounting and Auditing Manual (C&LAAM) (DX 43, DX 89, binder 1, tab 1 at 55-63 and binder 3, tab 1). C&LAAM includes the firm's interpretations of authoritative accounting and auditing literature, discussions of C&L's audit approach, and discussions of engagement conduct and administration. The Division contends that C&LAAM "operationalizes" GAAS, providing guidance to C&L employees in implementing GAAS on particular engagements (Div. Prehearing Br. at 5, 7; Tr. 713-15, 1106-08; DX 89, binder 1, tab 1 at 4-5).
At the early stages of this case, the Division and its expert witness took the unequivocal position that C&LAAM is one of the applicable professional standards (Div. Prehearing Br. at 5,7; DX 89, binder 1, tab 1 at 40-53). After Respondents hit back hard on this issue, the Division retreated to the position that C&LAAM is simply relevant to whether Respondents violated the applicable professional standards (Div. Reply Br. at 3, 18 n.16). This last-minute attempt to shift theories is fundamentally unfair to Respondents.
The OIP does not identify C&LAAM by name. However, paragraphs II.A.4, II.D.4, and II.D.19 of the OIP allege that Marrie should have increased the intensity of the audit after his supervisor completed the Business Assurance Client's Continuance Form, recommending CMD for addition to C&L's special attention list.34 The special attention list was a creation of C&LAAM (DX 43 at §§ 51310-314).
Additionally, paragraphs II.D.23, II.D.26, and II.D.28 of the OIP allege that Respondents' acceptance of initials or signatures of junior associates on audit program steps without additional documentation of the work performed was also an audit failure. C&LAAM requires such documentation (DX 43 at § 34205). GAAS requires something less (Tr. 843).35 The Division argues that the absence of additional documentation permits an inference that the auditors gave no particular consideration to these transactions and events, and that Respondents therefore lacked an adequate basis for their audit opinion.36 In these and other areas, C&LAAM violations are a key part of the Division's case.
I agree with Respondents that internal auditing manuals do not establish the standards against which auditors' conduct is to be judged under Rule 102(e). First, the case law predating the OIP is against the Division. See In re Mid American Waste Sys., Inc., Sec. Litig., 1997 U.S. Dist. LEXIS 22752, *4-10 (D.N.J. Dec. 9, 1997); Gohler v. Wood, 162 F.R.D. 691, 694-96 (D. Utah 1995); Tonnemacher v. Sasak, 155 F.R.D. 193, 195 (D. Ariz. 1994); In re Worlds of Wonder Sec. Litig., 147 F.R.D. 214, 215-17 (N.D. Cal. 1992); In re ContiCommodity Serv., Inc., Sec. Litig., 1988 U.S. Dist LEXIS 4812, *2-5 (N.D. Ill. May 23, 1988).37 These cases recognize that an accounting firm's internal manuals are not publicly available. They hold that such manuals do not and cannot create industry-wide norms, or alter a firm's obligations to follow GAAP or GAAS. They recognize that it would not be fair to punish a firm's auditors if the firm imposes standards upon itself that may be stricter than the industry-wide standards. Missing from the Division's presentation was testimony that C&LAAM's requirements are no more demanding on C&L auditors than GAAS are on auditors from firms without internal manuals, or than other firms' internal manuals are on their employees. As a result, the Division's reliance on C&LAAM creates a double standard: while one auditor could be held reckless for failing to follow his firm's internal procedures, another auditor whose firm's internal manuals did not set similar standards could be exonerated for the same conduct.
If there were any doubt on the subject, it has been put to rest by the recent opinion in SEC v. GLT Dain Rauscher, Inc., 254 F.3d 852, 858 (9th Cir. 2001) ("GAAS guidelines establish accounting standards that are explicitly defined in authoritative, publicly available pronouncements issued by recognized sources and utilized throughout the accounting profession.").
The Division observes that AU § 161.02 requires auditing firms to establish quality control policies and procedures to provide it with reasonable assurance of conforming to GAAS in its audit engagements. The Division reasons that, if an auditing firm must implement quality control policies, then logically the firm's members and employees should not be free to disregard those policies (Div. Reply Br. at 3). The argument makes sense insofar as it recognizes that an auditor who disregards his employer's policies will likely face disciplinary action by the employer. The argument is rejected insofar as it suggests that the Commission should enforce the employer's policies in a Rule 102(e) disciplinary proceeding. AU § 161.02 recognizes that the nature and extent of a firm's quality control policies and procedures depend on factors such as the firm's size, the degree of operating autonomy allowed its personnel and its practice offices, the nature of its practice, its organization, and appropriate cost-benefit considerations. For those reasons, acceptance of the Division's argument (and reliance on such internal policies and procedures) would inject uncertainty, not clarity, into Rule 102(e) proceedings.
Second, the Division's expansive interpretation of Rule 102(e)'s term "applicable professional standards" fails to provide Respondents with fair notice of sanctionable conduct. The Commission did not identify accounting firms' internal manuals when it reviewed the types of materials that comprise the applicable professional standards for a Rule 102(e) proceeding. In the preamble to the October 19, 1998, Rule Amendment, the Commission stated that it would look "primarily" to GAAP, GAAS, the AICPA Code of Professional Conduct, and its own regulations when determining what constitutes the applicable professional standards for an auditor. See Rule Amendment, 68 SEC Docket at 709. It continued: "Also included are generally accepted standards routinely used by accountants in the preparation of statements, opinions, or other papers filed with the Commission." Id. The Commission found that the term "applicable professional standards" was broad enough to accommodate changes to the body of professional guidance in the future, such as international accounting standards (should they be adopted) or pronouncements of the Independence Standards Board or "other bodies yet to be established." Id. It stated that such provisions "would become" or "would come to form" the applicable professional standards in the future. Id.
If the Commission had intended to treat accounting firms' internal manuals as "generally accepted" by the accounting profession, it would have said so in the preamble to the Rule Amendment. It was then, and remains now, the Commission's practice to look at brokerage firms' compliance manuals and supervisory manuals when considering allegations of failure to supervise under the safe harbor provisions of Section 15(b)(4)(E) of the Exchange Act. In light of that practice and the existence of contrary case law involving reliance on internal accounting manuals (such as Mid American, Gohler, Tonnemacher, Worlds of Wonder, and Conti) the Commission's determination to omit all mention of accounting firms' internal manuals when describing the applicable professional standards could not have been inadvertent.
Third, the testimony of the expert witnesses provided virtually no support for the Division's position. Ten Eyck emphasized that the notion of "special attention" was C&L's nomenclature, not GAAS (RX 405 at 10-11). Regan testified that C&L's special attention list did not mandate a change in the way that an audit should be conducted, although in his judgment, it would have been wise for Marrie and Berry to design an audit program with the client's special attention status in mind (Tr. 762-64). The Division must show that Respondents were reckless, not just that a different approach was perhaps wiser. Regan also testified that, when an auditor signs off on an audit step, he assumes the auditor performed the step, even without documentary backup, unless there is evidence to the contrary (Tr. 933). I consider that testimony by the Division's expert to be tantamount to a concession that C&L's requirement for additional documentation in the work papers exceeded what was "generally accepted" by the accounting profession.
Where a duty arises only as a result of an accounting firm's internal policy, as opposed to a generally accepted national standard, conduct violating that duty falls outside the jurisdiction of a Rule 102(e) proceeding. Of course, internal accounting firm policies and generally accepted national auditing standards may coincide in some instances, but ultimately, the proper frame of reference in setting the standard of conduct to be applied will be the national standard. Cf. In re Ikon Office Solutions, Inc. Sec. Litig., 131 F. Supp. 2d 680, 699-702 (E.D. Pa. 2001) (Ikon II) (rejecting plaintiff's claim that Ikon's internal accounting practices were substantially equivalent to GAAP and that, therefore, deviations from Ikon's internal accounting practices were also deviations from GAAP; holding that, even if such deviations from GAAP were established, they would not provide evidence of scienter).
5. The weight of the evidence fails to show that Respondents were reckless in auditing CMD's estimate of the value of its property and equipment. The weight of the evidence also fails to show that CMD materially misstated the value of its property and equipment in violation of GAAP.
Allegations. It is undisputed that CMD discontinued its Magnetic Head Division operations during fiscal year 1994, yet included $3 million of the Magnetic Head Division's property and equipment on its fiscal year 1994 balance sheet. It is also undisputed that when new management restated CMD's 1994 financials on February 6, 1995, it reduced that amount to zero. The OIP alleges that Marrie and Berry recklessly failed to follow GAAS when auditing CMD's property and equipment (OIP ¶ II.A.4). The OIP also charges that CMD's failure to write off the $3 million resulted in a material overstatement of its net income, that the valuation of property and equipment on CMD's financial statements was materially false and misleading and violated GAAP, and that new management's restatement of property and equipment was "highly material" (OIP ¶¶ II.A.2, II.A.3, II.D.45).
Audit procedures performed. Based on the 1993 audit, the quarterly reviews during fiscal year 1994, and the 1994 audit planning, Marrie and Berry were well aware that the carrying value of the equipment used in the Magnetic Head Division was a critical audit issue (DX 89, binder 1, tab 1 at 38-40 and tab 18 at 1-12, JX 1 at 91 item 1). During the April 29, 1994, audit committee meeting, CMD management specifically told Respondents that the equipment from the eliminated Magnetic Head Division was going to be used in the Thin Film Division (Tr. 55, 315, 604). No one at the audit committee meeting, which included the members of CMD's board of directors, disputed management's representations or indicated that the magnetic head equipment was going to be sold or abandoned.
Following the audit committee meeting, Respondents and Schindele had separate discussions with Romito regarding the use of the magnetic head equipment (Tr. 55-56, 315-17, 485-90). Schindele's conclusions are documented in the work papers (Tr. 488, citing JX 8 at 589):
Per Ron Romito, all assets in the [Magnetic Head] Division . . . are being used in the production of thin films, and therefore, are properly still included in [property, plant, and equipment (PP&E)]. C&L reviewed the [Magnetic Head] PP&E detail, noting that it represents machinery, leased assets and leasehold improvements. The leased assets represent equipment/machinery. Per Ron, the machinery can be used in the thin film production. No assets are idle and CMD is able to recover the carrying value of the assets. This appears reasonable and is included in our representation letter.
The work papers also include audit steps taken by C&L to "ascertain the completeness of property, plant and equipment by reviewing fluctuations in the repair and maintenance accounts" (JX 8 at 583). Some of the repair and maintenance work papers document a significant increase in repair and maintenance costs attributable to the thin film PP&E, with a corresponding decrease in magnetic head PP&E. In accordance with the audit steps, C&L performed analytical procedures on repairs and maintenance and questioned why the Thin Film Division's repairs and maintenance had increased (JX 8 at 704-06). The work papers document a discussion between Raj Kapur (Kapur), CMD's controller, and Schindele concerning the repairs and maintenance (Tr. 496; JX 8 at 705). The work papers also show that rental leases for thin film equipment increased significantly and that rental leases for magnetic head equipment decreased to zero (Tr. 339-40; JX 8 at 704).
Schindele's memorandum of matters for attention of the engagement partner dealt summarily with the Magnetic Head Division. She wrote: "CMD eliminated this division in the current year. This item is properly disposed of in the work papers. A current year [Matter for the Attention of the Partner] is deemed unnecessary" (JX 1 at 62).
The Division's theory is that Respondents violated GAAS when they failed to make an independent verification of management's representations about the value and actual use of the magnetic head equipment. According to the Division, there is no evidence that Romito, who worked in Tempe, had seen the equipment, which was in Milpitas, or that he had firsthand knowledge about its current use (Tr. 316-17, 489-90). Also absent from the record is reliable evidence that anyone from C&L personally observed the magnetic head equipment in Milpitas to confirm management's representations about its current use (Tr. 56, 318-20, 489-90; JX 8 at 584).38 In Regan's view, the auditors did no audit work to corroborate management's representations and thus had no reasonable basis to opine on the recovery value of the discontinued assets (DX 89, binder 1, tab 1 at 40).
Applicable professional standards. With respect to the carrying value of property, plant, and equipment, Vincent M. O'Reilly et al., Montgomery's Auditing 553 (11th ed. 1990) states as follows:
The auditor is concerned with recoverable value of noncurrent assets only in considering whether there has been a material permanent decline in value. . . .
[T]he concept of a permanent decline in value is difficult to apply in practice because the existing accounting literature does not provide specific authoritative guidance on accounting for the inability to fully recover the carrying values of long-lived assets. As indicated by current practice, the existing literature is being interpreted as permitting or requiring write-downs of long-lived assets to estimated recoverable value only in rare situations. Thus, a loss should be recognized only when it becomes obvious that the remaining net book value of property cannot be recovered through sale or use.
During an audit, management makes many representations to the auditor, both oral and written, in response to specific inquiries or through the financial statements. Such representations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for his opinion on the financial statements. AU § 333.02.
Assertions are representations by management that are embodied in financial statement components. AU § 326.03. Assertions about valuations deal with whether asset components have been included in the financial statements at the appropriate amounts. AU § 326.07. Corroborating evidential matter includes information obtained by the auditor from inquiry, observation, inspection, and physical examination, and other information developed by, or available to, the auditor that permits him to reach conclusions through valid reasoning. AU § 326.16.
AU § 342 provides guidance to auditors on obtaining and evaluating sufficient competent evidential matter to support significant accounting estimates in an audit of financial statements in accordance with GAAS.
An auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. AU § 342.04. When planning and performing procedures to evaluate management's accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors involved in management's estimation process. Id. However, management's estimation process need not be documented or formally applied. AU § 342.05.
The auditor's objective when evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that all accounting estimates that could be material to the financial statements have been developed, those accounting estimates are reasonable in the circumstances, and the accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed. AU § 342.07.
GAAS do not require that any particular procedures be used to audit accounting estimates, but rather provide choices. In evaluating reasonableness, the auditor should obtain an understanding of how management developed the estimate. AU § 342.10. Based on that understanding, the auditor should use one or a combination of three approaches: (a) review and test the process used by management to develop the estimate; (b) develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate; and/or (c) review subsequent events or transactions occurring prior to completion of field work. Id.
Conclusions. First, Regan's testimony that Respondents had no basis to express an audit opinion on the estimated value of the magnetic head equipment is based on a misunderstanding of the facts. The work papers documented the fluctuations in repair and maintenance costs. Marrie and Berry also discussed the expected future use of the equipment with the audit committee and the board of directors. The Division would apparently have me discount that discussion because it took place in April 1994 and not during the field work. I decline to make such a ruling.
Even if the Division had shown that Respondents violated AU § 333.02 by failing to apply auditing procedures to test management's representations about the value and use of the equipment, such a showing alone would not prove that the omission of these audit procedures was reckless. Cf. The Limited, Inc. v. McCrory Corp., 683 F. Supp. 387, 394-95 (S.D.N.Y. 1988) (failing to take sufficient audit steps required under GAAS, such as interviewing the client's personnel, proves no more than negligence).
Second, the Division has failed to offer any proof that the magnetic head equipment was "entirely idle" on June 30, 1994 (OIP ¶ II.D.46). In contrast, Respondents have introduced some evidence to refute that charge. Work papers testing fluctuations in CMD's repair and maintenance costs are consistent with continued use of the equipment. In any event, even if the equipment had been idle, that fact would not be dispositive on the question of valuation. For that reason, inspection of the equipment by the auditors was not critical.
I agree with Ten Eyck that an entity's equipment need not be "in service" at any one point in time to maintain future economic value (Tr. 1418-21; RX 405 at 29-31). Ten Eyck's testimony is fully consistent with the case law that has developed under the income tax code. See Walsh v. United States, 163 F. Supp. 421, 424 (D. Neb. 1958) (holding that abandonment must be shown by some affirmative act, and that discontinued equipment is not abandoned until it is scrapped); Ewald Iron Co. v. Comm'r, 37 B.T.A. 798, 799 (1938) ("While abandonment necessarily involves nonuse, proof of nonuse is not sufficient to constitute abandonment."). The Division never offered any evidence to show that CMD advertised the magnetic head equipment for sale or otherwise disposed of it during fiscal year 1994. Likewise, the Division has not shown that the $3 million valuation of the magnetic head equipment was an unreasonable estimate, or that the valuation failed to conform with applicable accounting principles when it was made. Cf. Thor Power Tool Co. v. Comm'r, 439 U.S. 522, 544 (1979) (recognizing that GAAP tolerate a range of reasonable treatments, leaving the choice among alternatives to management, and holding that management's accounting decisions, even if open to debate, are not necessarily improper, much less intentionally misleading).
Third, the fact that new management's restatement wrote off the full value of CMD's magnetic head equipment does not establish an audit failure by Marrie and Berry (Tr. 1269). The revised financial statements are insufficient to prove a violation of GAAS or GAAP in connection with the original financial statements. Cf. Malone v. Microdyne Corp., 26 F.3d 471, 478-80 (4th Cir. 1994) (holding that a revised Form 10-K is a subsequent remedial measure that cannot be used to prove negligence or culpable conduct in connection with the original Form 10-K); Krouner v. Amer. Heritage Fund, Inc., 899 F. Supp. 142, 147 (S.D.N.Y. 1995) (same, as to a subsequent prospectus).39
Fourth, the Division has not shown that the restatement process was reliable in valuing the magnetic head property and equipment at zero. As late as December 1994, CMD still had not made any estimate as to the possible scrap or sale value of the magnetic head equipment (DX 13 at 2133, 2139). The special services group of E&Y did not examine new management's proposed write-off of that equipment (Tr. 1272-74; DX 13 at 2132). The Division did not offer the testimony of anyone from CMD to explain new management's rationale for the write-off of that equipment. Nor did it offer the testimony of anyone from E&Y who participated in the audit of CMD as of March 31, 1995.40 Accordingly, the Division has not shown that the restated valuation of zero was a reasonable estimate that complied with applicable accounting principles.
Respondents observe that new management's $3 million write-off was consistent with the sort of "big bath" restructuring charges that former Commission Chairman Arthur Levitt, Jr., has condemned (Resp. Prop. Find. ## 20 n.15, 228).41 They also argue that, if it was wrong for them to rely solely on old management's representation that CMD would continue to use $3 million worth of magnetic head equipment in its thin film operations, the Division cannot prove they were wrong by relying solely on new management's representation that the equipment lacked all value. In both instances, management's uncorroborated representation was the only supporting evidence. I find that these defenses have merit.
Paragraphs II.D.45 and II.D.46 of the OIP are accordingly dismissed.
6. The weight of the evidence fails to show that Respondents were reckless in auditing CMD's estimate of the value of its obsolete inventory. The weight of the evidence also fails to show that CMD materially misstated the value of its inventory in violation of GAAP.
Allegations. The OIP alleges that Marrie and Berry recklessly failed to follow GAAS in auditing CMD's obsolete inventory (OIP ¶ II.A.4). It further charges that CMD's inventory as originally reported was not valued properly and that, as a result of CMD's failure to comply with GAAP in this area, CMD materially overstated its fiscal year 1994 net income by approximately $9.3 million (OIP ¶¶ II.D.4, II.D.39). Finally, the OIP asserts that the February 6, 1995, restatement of CMD's fiscal year 1994 results made "highly material" adjustments to inventory, thereby establishing that CMD had overstated its inventory by $10.2 million (OIP ¶ II.A.3).42
The Division's theory is that Respondents properly assessed the risk of inventory obsolescence as high and considered that assessment in designing the procedures included in the audit program. However, the Division argues that Jenson signed off on the audit program step without performing the procedure (DX 89, binder 1, tab 1 at 37).
Audit procedures performed. The fact that companies in high technology industries experience rapid product change is not disputed. In planning the 1994 audit, Marrie understood that inventory was a critical audit area (Tr. 35; DX 15 at 5, JX 1 at 92). During the audit committee meeting, Marrie discussed inventory and the related reserve calculations with CMD's management and board of directors (Tr. 61-63). He also relayed to the committee and the board the problems that C&L had experienced when auditing inventory at Milpitas in 1993 (JX 28 at 1790-92, items 3-5). Marrie believed that inventory at Milpitas was difficult to value because CMD lacked appropriate systems (DX 4 at 685). He knew that inventory costs at Milpitas had not been updated since 1991 (DX 16 at 53, JX 1 at 91).
The audit of inventory involved two steps: observation and valuation. While the inventory observation checklist and work papers for Tempe are reasonably complete (JX 10 at 1145-54), the corresponding documents relating to inventory observation at Milpitas are not (JX 11 at 1206-08). The work papers for Milpitas make clear that the counting and recording of inventory were not observed (DX 16 at 49 ("For Milpitas, management regulated when physical inventories were performed."), JX 12 at 2369 item 20 ("count was completed prior to arrival")). The work papers also raise questions about the thoroughness of the inventory count at Milpitas (JX 10 at 879 ("During the physical inventory count at Milpitas, the employees counting were not aware of the written inventory instructions.")). That evidence is troubling when considered in conjunction with the witnesses' inability to identify who (if anyone) actually observed the inventory count at Milpitas, see supra note 13, and the fact that no one from the engagement team went to Milpitas after the inventory observation (Tr. 490).43 However, the Division has not specifically addressed this issue in its pleadings, and the OIP focuses on alleged audit failures in connection with inventory valuation, not inventory quantities. The matter will not be considered further.
Jenson performed the 1994 field work relating to inventory valuation at both Milpitas and Tempe (Tr. 361-62, 378-94). He did the work at Tempe. Schindele, who had tested inventory during the 1993 audit, spoke with Jenson constantly about inventory and reviewed Jenson's work (Tr. 413-14, 474-75, 477; JX 10 at 852-53, 879).
CMD prepared schedules that identified its slow-moving inventory and it assigned reserve percentages by product category (JX 11 at 1209-22). The Division acknowledges that Jenson tested the mathematical accuracy of the schedules and then compared the 1994 reserve to that of the prior year. The parties disagree as to whether Jenson did anything more.
Step 61 of C&L's audit program required the engagement team to discuss sales orders received, future marketing forecasts, and current production requirements with CMD management to determine whether obsolete items were adequately identified (JX 10 at 868). Jenson signed off on this step (JX 10 at 868). Jenson also initialed work papers that addressed reserves for slow moving inventory (JX 11 at 1209-22). The auditors noted no exceptions during their testing of CMD's reserve for excess and obsolete inventory (JX 10 at 908, JX 11 at 1214).
The audit budget called for Jenson to devote 230 hours to inventory and for Schindele to devote sixty-nine hours to review and supervision (JX 1 at 143). During the audit, Marrie discussed inventory five to ten times with Romito and two to five times with Kapur (Tr. 60-61). Berry also discussed inventory issues with Romito (Tr. 295-96, 305-07). Berry relied solely on the work papers to determine that the audit program with respect to excess and obsolete inventory had been completed (Tr. 285-86, 290-94, 392).
CMD's management representation letter stated that a provision had been made to reduce all slow-moving, obsolete, or unusable inventories to their estimated net realizable values; that the reductions were in excess of $3.1 million on June 30, 1994; and that the reductions were sufficient to provide for any losses that might be sustained from lack of sales (JX 1 at 170). The engagement team concluded that CMD had performed an adequate review of the net realizable value of its inventory and that the reserves were appropriate (JX 1 at 66-67). C&L's draft management comment letter offered several suggestions for facilitating the audit of inventory in the future (JX 1 at 160-66, items 1, 2, 14-16, 18).
In the audited financial statements for fiscal year 1994, CMD reported inventories of $13.9 million (JX 19 at 24). When new management restated CMD's balance sheet on February 6, 1995, it reduced the fiscal year end 1994 inventories to $5.1 million (JX 20 at 21). The difference was attributable to significantly higher reserves for slow moving and obsolete inventory.
Applicable professional standards. GAAP require that inventory be carried at the lower of cost or market value. See Accounting Research Bulletin No. 43, Chapter 4 (1953). GAAS require the auditor to determine the reasonableness of management's valuation of inventory before opining on the financial statements. AU § 342.04. An inventory reserve is intended to provide an estimate of inventory that will be sold or disposed of at less than cost. An audit of inventory reserves, like an audit of the expected future use of property and equipment, involves an estimate subject to AU §§ 342.04, 342.07, and 342.10.
GAAS recognize that the risk of material misstatement of the financial statements is generally greater when account balances and classes of transactions include accounting estimates rather than essentially factual data because of the inherent subjectivity in estimating future events. Estimates, such as those for inventory obsolescence, are subject not only to the unpredictability of future events, but also to misstatements that may arise from using inadequate or inappropriate data or misapplying appropriate data. AU § 312.29. Since no one accounting estimate can be considered accurate with certainty, the auditor recognizes that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may be reasonable, and such difference would not be considered to be a likely misstatement. Id.
A management representation letter is one kind of competent evidence, but it is not sufficient in itself to provide the auditor with a reasonable basis for forming an opinion. See Montgomery's Auditing, supra, at 604.
Conclusions. There is no direct evidence that Jenson did not perform the audit work set out in Step 61 of C&L's audit program.44 At the hearing, Jenson could not recall the details about the procedures he performed during the audit or the names of those in CMD management with whom he discussed inventory obsolescence (Tr. 389-94). Because of Jenson's poor recollection, and because the procedures and conversations were not further documented in the work papers, the Division asks me to infer that Jenson did not perform the procedures or discuss inventory with management (Div. Prop. Find. # 185, Div. Reply Br. at 9). The Division contends that, absent evidence that Jenson asked management the right questions, I should infer that he did not ask management any questions at all.
I decline to make that inference. The requirement of full documentation in the work papers is a creation of C&LAAM, not GAAS. See supra note 35 and accompanying text. As the Division's expert acknowledged, when an auditor signs off on an audit step, the expectation is that the auditor performed the step, even without documentary backup, unless there is evidence to the contrary (Tr. 933). Based on Jenson's demeanor at the hearing, I find that he was credible when he testified that he performed the Step 61 procedures (Tr. 389-91). The audit budget states that Jenson devoted 230 hours to inventory issues. Accepting the Division's theory would require me to infer that he devoted all of that time to checking management's mathematical calculations. The record shows that Jenson discussed slow moving inventory issues with Lorraine Schriever, a CMD accountant (JX 10 at 907). It also shows that the reserve percentages were generally increased from the prior year (JX 10 at 907). Jenson's initials on the work papers are entitled to weight. As to Jenson, I have no reason to depart from the expectation that the Division's expert considered appropriate. The work papers on this issue are unquestionably poor. However, the best evidence is that Jenson performed the audit steps.
Regan opined that inventory obsolescence was one of the most difficult areas of the audit (Tr. 1043). Respondents do not challenge that characterization, and I accept it as accurate. I conclude that the daily supervision the in-charge accountant provided to Jenson on inventory issues was adequate. Marrie and Berry were also actively involved in the audit of inventory through their discussions with Romito and Kapur.
To measure the magnitude of the alleged audit failure, the Division relies on the inventory analysis that Thomsen performed between October 1994 and January 1995. The Division contends that Thomsen only did what Jenson should have done a few months earlier. In essence, the Division argues that, because Thomsen performed certain work and came to certain conclusions, therefore, Respondents must have been reckless in not reaching the same conclusions.
The argument fails because Thomsen had access to information that Marrie and Berry did not. For example, Thomsen had the cooperation of CMD employees that had been denied to Marrie and Berry. He also had access to inventory figures and operating results for the first and second quarters of fiscal year 1995, as well as knowledge that 1994 sales would be restated and reduced from $38 million to $22 million. Thomsen relied on different data about return percentages and he crafted a new inventory valuation policy (DX 12, DX 92, JX 24 at 8). Finally, Thomsen's preliminary report might fairly be interpreted as inviting CMD's board of directors to take "big bath" restructuring charges on its inventory (RX 374 at 652):
I can't comment on whether the inventory is properly valued. My opinion would certainly be that if a customer orders a small number of parts for a prototype build for example, the total production run should be expensed at that time. Any subsequent sales of the additional "chips" produced on the first run would be 100% profit-a pleasant pick up for the company and the shareholders.
The fact that Thomsen's inventory reserve recommendation was different from old management's reserve estimate does not establish that the latter was unreasonable when made, or that it failed to conform with applicable accounting principles.45 Nor does it necessarily establish that Thomsen's recommendation for inventory reserves was itself a reasonable estimate that complied with applicable accounting principles.
Kannapan testified that he became concerned about the very high level of CMD's inventory while working on CMD's contemplated stock offering (Tr. 879-82). The Division contends that Kannapan saw the same things Thomsen saw, and it urges me to find that Marrie and Berry ignored the "red flag" of excessive inventory. Insofar as Kannapan's testimony expressed his thinking before August 4, 1994, I decline to give it much weight. At that time, Kannapan's employer, Kidder Peabody, was informing the public that CMD had "conservatively reserved against obsolete inventories," that inventories were "declining gradually," and that there was some old inventory that CMD was "contractually obligated to hold" (RX 401 at 2601, 2605).
Thomsen's inventory reserve recommendation was based on information he gathered in late 1994 and early 1995; it called only for a prospective change in CMD's inventory valuation policy (Thomsen Dep. at 29, 63-64). After Thomsen had resigned from his consulting position, CMD's new management took Thomsen's "going forward" inventory valuation recommendation and used it retroactively to restate the company's inventory for fiscal year end 1994. As noted, the Division has failed to prove that the restatement process was reliable. Under Malone and Krouner, the restatement of inventory is not probative as to whether old management's estimates violated GAAP or whether C&L's audit of the inventory reserve violated GAAS. On the contrary, the restatement raises concerns that CMD's new management may have violated Accounting Principles Board Opinion No. 20 (1971) (APB Opinion No. 20).46 The special practice group of E&Y did not review Thomsen's recommendations for an increased inventory reserve (DX 13 at 2132-33). The revised financial statements that CMD filed with the Commission on February 6, 1995, were unaudited (JX 20 at 55). While E&Y's audit opinion on CMD's financial statements for the period ending March 31, 1995, stated that E&Y had also audited CMD's restated balance sheet as of June 30, 1994, which were then presented for comparative purposes, the audit opinion and the notes to those financial statements are silent about the restatement of inventory. The Division presented no testimony on that matter, either from CMD's new management or from E&Y's auditors.
Regan's expert report also analyzed CMD's inventory reserve. Regan opined that, had Respondents followed the audit procedures set forth in their audit program, it was "likely" that they "would have determined" that the lack of demand for the inventory on hand required an obsolescence reserve that was "much higher" than that recorded by CMD (Tr. 986-88; DX 89, binder 1, tab 1 at 37-38 and Exhibit 4). Analyzing only the inventory at Milpitas, Regan concluded that CMD's reserve should have been at least $2.2 million higher than it was (DX 89, binder 1, tab 1 at Ex. 4). At best, that testimony provides only partial support for the OIP's claim that CMD had overstated its inventory by $10.2 million.
Regan's expert testimony is insufficient to establish that Respondents were reckless when they concluded that CMD's inventory valuation appeared reasonable. See McCrory, 683 F. Supp. at 394-95 (holding that failure to take sufficient audit steps required under GAAS, such as testing the adequacy of reserves, is negligence only); Ikon II, 131 F. Supp. 2d at 700-01 ("The fact that plaintiffs' expert finds it reasonable to calculate the reserve differently is not evidence of an extreme departure from ordinary care."); Mathews v. Centex Telemanagement, Inc., [1994-1995 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,440 at 91,037 (N.D. Cal. 1994) (granting summary judgment for defendants because plaintiffs' claims about how reserves should have been calculated "are only differences in business judgment viewed from hindsight"); In re Software Toolworks, Inc. Sec. Litig., 789 F. Supp. 1489, 1504 (N.D. Cal. 1992) (holding that whether inventory reserve should have been higher was a matter of judgment on which the parties disagreed, not a basis on which to infer scienter), aff'd in relevant part and rev'd in part, 50 F.3d 615, 628-29 (9th Cir. 1994); cf. DiLeo, 901 F.2d at 626-28 (holding that a plaintiff must show why the failure to increase a reserve was so apparent at the time, rather than in hindsight).
I conclude that this aspect of the OIP should also be dismissed.
7. The weight of the evidence shows that Respondents were negligent, but not reckless, in auditing CMD's sales revenues and accounts receivable. The weight of the evidence fails to show that CMD materially misstated its revenue and accounts receivable in violation of GAAP.
The OIP principally alleges that Marrie and Berry failed to exercise appropriate professional skepticism, obtain sufficient competent evidential matter, and properly supervise the audit of CMD's revenues and receivables (OIP ¶ II.D.12). It charges that Respondents recklessly ignored a variety of "red flags" in the area of revenue recognition. The "red flags" related to the assessment of audit risk, a major write-off of receivables, suspect confirmation responses, sales returns, sales cutoffs, and cash collections (OIP ¶ II.D.14).
The OIP also claims that CMD improperly recognized material amounts of accounts receivable and revenue on unshipped product throughout fiscal year 1994 (OIP ¶ II.D.13). The OIP alleges that, as a result of the failure to comply with GAAP in this area, CMD materially overstated its accounts receivable and net income for 1994 by $10.6 million and $9.7 million, respectively (OIP ¶ II.D.13).
a. GAAP.
The conceptual basis for revenue recognition is contained in the Financial Accounting Standards Board's (FASB's) Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (December 1984). Paragraph 83(b) states that revenues may not be recognized until they are earned, and that revenues are earned only when a business has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. Paragraph 84(a) states that revenues from manufacturing and selling activities are commonly recognized at the time of sale, usually meaning delivery.
FASB's Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right Of Return Exists (June 1981) (FAS No. 48), specifies how a business should account for sales of its product if a buyer has a right to return the product either as a matter of contract or as a matter of existing practice. Revenue from those sales transactions may be recognized at the time of sale only if six conditions have been met.
The six conditions are: (a) the seller's price to the buyer is substantially fixed or determinable at the date of sale; (b) the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; (c) the buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product; (d) the buyer acquiring the product for resale has economic substance apart from that provided by the seller; (e) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and (f) the amount of future returns can be reasonably estimated. FAS No. 48 ¶ 6.
If those conditions have not been met, revenue recognition must be postponed. If sales revenue is recognized because the six conditions have been met, any costs or losses that may be expected in connection with any returns must be accrued in accordance with FASB's Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (1975). Sales revenue and cost of sales reported in the income statement must be reduced to reflect estimated returns. FAS No. 48 ¶ 7. As with other FASB Statements of Financial Accounting Standards, the provisions of FAS No. 48 need not be applied to immaterial items. FAS No. 48 ¶ 20.
The ability to make a reasonable estimate of the amount of future returns depends on many factors and circumstances that will vary from one case to the next. FAS No. 48 ¶ 8 describes four factors that may impair, but not necessarily preclude, the ability to make a reasonable estimate: (a) the susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand; (b) relatively long periods in which a particular product may be returned; (c) absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances, such as changes in the selling enterprise's marketing policies or relationships with its customers; and (d) absence of a large volume of relatively homogeneous transactions. FAS No. 48 ¶ 8.
CMD reported $38.2 million of net product sales and $16.9 million of net accounts receivable at the end of fiscal year 1994 (JX 19 at 24-25). When new management restated the fiscal year 1994 results on February 3, 1995, the company reduced revenue from net product sales to $22.3 million and net accounts receivable to $6.3 million (JX 20 at 21-22). Based on the testimony of Nachimson (Tr. 1269), E&Y's forensic accountant, and the holdings of Malone and Krouner, however, the mere existence of the unaudited restatement does not prove that the original financial statements were materially misstated.
E&Y's December 1994 report offers the best available explanation about how CMD allegedly overstated its fiscal year 1994 revenues (DX 13). E&Y also recommended adjustments to correct the overstatement. Regan offered his own estimate of an appropriate reserve for CMD's anticipated sales returns (DX 89, binder 1, tab 1 at Exhibit 3). Regan's estimate was approximately seven times larger than CMD's estimate. In Regan's judgment, CMD substantially understated its anticipated sales returns and that factor alone resulted in the material misstatement of its financial statements in violation of GAAP (DX 89, binder 1, tab 1 at 20, 25, 35). But see Bily, 834 P.2d at 763 ("Using different initial assumptions and approaches, different sampling techniques, and the wisdom of 20-20 hindsight, few CPA audits [are] immune from criticism.").
Both E&Y's report and Regan's report suggest that CMD materially misstated its revenues and accounts receivable, but neither is sufficient to show that CMD did so by $10.6 million, as alleged in OIP ¶ II.D.13. The Division stated that it would not prove GAAP violations by CMD, and I decline to rely on E&Y's report and Regan's estimate as evidence that such violations occurred. See supra at 25.
Even if the Division had shown that CMD's financial statements materially misrepresented revenues and receivables in violation of GAAP, such GAAP violations alone would not suffice to prove that Marrie and Berry conducted a reckless audit. See AU § 316.08 (subsequent discovery that material misrepresentation exists in the financial statements does not in and of itself evidence inadequate planning, performance, or judgment on the part of the auditors); see also In re Milestone Scientific Sec. Litig., 103 F. Supp. 2d 425, 474 (D.N.J. 2000) (holding that alleged violations of FAS No. 48 will not by themselves support a strong inference of scienter); In re Peritus Software Servs., Inc., Sec. Litig., 52 F. Supp. 2d 211, 223-24 (D. Mass. 1999) (holding that recognition of revenue in violation of FAS No. 48 does not automatically establish recklessness); Marksman, 46 F. Supp. 2d at 1048 (concluding that, although the client recognized revenue in violation of FAS No. 48 when it claimed sales of $3 million, no recklessness was shown on the part of the outside auditors in their audit of the client's estimated sales returns).
I thus consider those aspects of the OIP alleging that Respondents' audit of revenue and receivables recklessly violated GAAS. Marrie insisted that the engagement team considered the criteria of FAS No. 48 (Tr. 167-68, 185-86). Berry had no recollection of considering FAS No. 48 during the audit (Tr. 277-78). There is no mention of FAS No. 48 in the work papers.
b. The mistaken assessment of audit risk for revenue (OIP ¶¶ II.D.15-II.D.20).
The heading to this aspect of the OIP is curious: it alleges only that Respondents were "mistaken" in their assessment of audit risk for revenue. Even if proven, mistakes alone would not establish recklessness. Cf. Rolf v. Blyth, Eastman Dillon & Co., Inc., 637 F.2d 77, 83 (2d Cir. 1980) (finding mistakes not so reckless as to constitute scienter); Selective Disclosure and Insider Trading, 73 SEC Docket 3, 5 (Aug. 15, 2000) (promising that the Commission will not bring enforcement actions under Regulation FD for mistaken materiality determinations that are not reckless).
The reference in OIP ¶ II.D.15 to risk assessment for the entire audit is also curious. AU § 312 requires consideration of audit risk, but there is no concept in GAAS of audit risk being "maximum" or any other particular level (RX 405 at 9). C&L's Audit Strategy Memorandum did not assess "audit risk" for the CMD engagement (RX 405 at 9-11, JX 1 at 86-93). To the extent that paragraph II.D.15 of the OIP alleges otherwise, it is simply wrong. Paragraph II.D.20 of the OIP claims that Marrie and Berry should have revised the designation of audit risk in the Audit Strategy Memorandum after August 4, 1994. That allegation fails for the same reason.
The risk of material misstatement in financial statement assertions includes inherent risk, control risk, and detection risk. AU § 319.28. Inherent risk is the susceptibility of an assertion to a material misstatement assuming there are no related internal control structure policies or procedures. Control risk is the risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity's internal control structure policies or procedures. Id. Detection risk is the risk that the auditor will not detect a material misstatement that exists in an assertion. Id.
The Audit Strategy Memorandum did contain a section that addressed the control risk for system-derived accounts (JX 1 at 89). In the context of assessing control risk, "maximum" means the auditor believes the client's internal policies and procedures are unlikely to pertain to an assertion, are unlikely to be effective, or that evaluating their effectiveness would be inefficient. AU § 319.29. Assessing control risk at "below the maximum level" involves identifying specific internal control structure policies and procedures relevant to specific assertions that are likely to prevent or detect material misstatements in those assertions; and performing tests of controls to evaluate the effectiveness of such policies and procedures. AU § 319.30. Some control risk always exists because of the possibility that supervisory personnel can override controls.
Assessing control risk at below the maximum enables the auditor to adjust the nature, timing, and extent of the substantive audit tests, for example, by performing fewer tests, obtaining less persuasive and presumably less costly evidence, performing tests before year end, or reducing sample size. When the auditor assesses control risk at below the maximum level, he should still obtain sufficient evidential matter to support that assessed level. AU § 319.46. The evidential matter that is sufficient to support a specific assessed level of control risk is a matter of auditing judgment. Id. The auditor selects tests of client controls from a variety of techniques such as inquiry, observation, inspection, and reperformance of a policy or procedure that pertains to an assertion. AU § 319.47. No one specific test of controls is always necessary, applicable, or equally effective in every circumstance. Id.
Respondents reviewed and tested CMD's internal control environment, policies, and procedures (DX 1, DX 15, DX 16, JX 5 at 427-30). I find that they did so in a manner that complied with the applicable professional standards. I agree with Ten Eyck that an assessment of CMD's control risk at "maximum" would have had little impact on the planning and performance of the 1994 audit (RX 405 at 10). An assessment of higher control risk would have required an audit that emphasized substantive testing, and the substantive testing performed by the auditors in the area of revenues and receivables was already extensive (RX 405 at 10). The fact is that several CMD officers and employees circumvented the company's internal controls to present false information on CMD's financial condition to the engagement team. In that broader context, Respondents' assessment of CMD's internal controls was largely irrelevant to the audit failure that occurred (RX 405 at 9). See Novak v. Kasaks, 216 F.3d 300, 309 (2d Cir. 2000) (holding that the failure of an accounting firm to identify problems with the client's internal controls and accounting practices does not constitute reckless conduct sufficient for liability under Section 10(b) of the Exchange Act); Reiger, 117 F. Supp. 2d at 1009 n.5 (characterizing allegations that an audited company had weak internal accounting controls and needed to report strong revenues as boilerplate "red flags" that are present in almost every securities fraud suit and are not strong indicia of scienter); Albert Glenn Yesner, CPA, Initial Decision, 75 SEC Docket 220, 260-61 (May 22, 2001) (refusing to find inadequate internal controls simply because controls had been intentionally overridden and circumvented), final, 75 SEC Docket 648 (June 19, 2001).
Paragraph II.D.16 of the OIP alleges that CMD's customer base had changed dramatically during fiscal year 1994, and that the new customers carried with them a greater risk of uncollectible revenue. Respondents knew during the 1994 audit that CMD's sales to Apple had decreased significantly, but they took comfort that CMD had entered into a strategic alliance with Hitachi Metals late in the fiscal year. Their assessment was shared by Kidder Peabody (RX 401). Respondents were also aware that CMD had granted extended payment terms to some foreign customers. CMD management and Bridges told C&L that accounts receivable had increased because product sold and shipped to foreign customers could take as long as six weeks to arrive and that some of these customers considered the beginning of the payment period to begin upon receipt of the product (JX 9 at 830C). In anticipation of an increase in uncollectible accounts due to the increased accounts receivable and the extended payment terms granted by CMD to certain customers, C&L proposed that CMD increase its bad debt reserve from $500,000 to $1.5 million (DX 13 at 2138, JX 9 at 725-26). That recommendation was not shown to be insufficient under GAAS.
Paragraph II.D.17 of the OIP alleges that C&L concluded during its second quarter review that the risk of product returns from foreign customers was "low." The Division presented no such proof at the hearing and it has identified none in its posthearing pleadings (Div Prop. Find. ## 113-17). Paragraph II.D.18 of the OIP alleges that Marrie and Berry were later on notice that their "earlier assumptions" about product returns had been wrong. Absent proof of any such earlier assumptions, the charge has not been sustained.
Paragraph II.D.19 of the OIP contends that the addition of CMD to C&L's special attention list "required" Marrie to consider whether he should assign to the audit team personnel with greater experience or industry expertise, or communicate with CMD's audit committee or board of directors. This charge fails for several reasons. First, the Division did not establish that CMD was on the special attention list while the audit was in progress, as alleged in OIP ¶¶ II.D.9 and II.D.19. Marrie and Berry each completed a portion of the C&L Business Assurance Client Continuation Form, and then forwarded the document to Hal Schultz (Schultz), C&L's Assurance Partner In Charge (Tr. 97-99; DX 38). Marrie testified credibly that, after completing a portion of the form on July 19, 1994, he did not see the form again during the audit (Tr. 97-101, 761-64). Schultz recommended CMD for special attention on July 28, 1994 (DX 38). Under C&LAAM, however, Schultz did not have the final word on the subject. A client could not be added to the special attention list until C&L's client service vice chairman gave his approval (DX 43 at § 51310.3). There is no evidence of such approval here. The Business Assurance Client Continuation Form was not part of the work papers. That supports Marrie's testimony that he did not get back the completed forms and that his supervisors had never informed him that any of his audit clients had been added to the list (Tr. 100). Second, the special attention list itself was a creation of C&LAAM, not GAAS, and a failure to follow C&LAAM is not a violation of the applicable professional standards. Third, the only issue that caused CMD to be added to the special attention list was a two-year negative operating cash flow. Marrie knew of CMD's negative operating cash flow, and there is no evidence that he failed to plan or conduct the audit in accordance with that knowledge. The significance of the negative operating cash flow had been considerably diminished by the fact that CMD held $27 million in cash on June 30, 1994. In any event, CMD did not have a negative cash flow, as alleged in the OIP (Tr. 759-60).47 Fourth, the Division's expert testified that special attention designation did not mandate a change in the way the audit was conducted, although in his opinion it would have been wise to design an audit program with the client's special attention status in mind (Tr. 762-64). Because the Division must show that Respondents were reckless, expert testimony that they possibly displayed a lack of wisdom is not sufficient to sustain the charge.
The weight of the evidence does not establish that Respondents violated GAAS in evaluating audit risk for revenue. I conclude that paragraphs II.D.15 through II.D.20 of the OIP should be dismissed.
c. Failure to examine a major write-off of receivables (OIP ¶¶ II.D.21-II.D.23).
Allegations. The OIP charges that the auditors paid almost no attention to the write-off announced on August 4, 1994, even though it involved a large percentage of CMD's accounts receivable and even though a substantial portion of the audit field work remained to be done (OIP ¶¶ II.D.6-II.D.8, II.D.21, II.D.23). It also asserts that Respondents' failure to examine the write-off was an extreme departure from professional standards (OIP ¶ II.D.22).
Audit procedures performed. The auditors recognized that accounts receivable were an important audit area and that the write-off of $12 million was unusual (Tr. 308, 434). Marrie and Berry discussed the proposed allocation of the write-off with Romito. However, neither Romito's spreadsheets nor CMD's August 4 announcement prompted Respondents to order any additional field work (Tr. 130-31, 312, 397). Marrie explained that he reviewed the sampling criteria for confirming the accounts receivable after learning of the write-off, but made no changes (Tr. 195). He stated that he was comfortable with the percentage of dollar coverage of the receivables the planned audit procedures would test (Tr. 195).
There is very little mention of the write-off in the work papers. There are copies of documents prepared by CMD, namely, the draft and final press release and the Form 10-K (DX 39, DX 73, JX 2 at 18). Schindele referenced the write-off in her review of fourth quarter adjusting journal entries and concluded that the treatment appeared reasonable (Tr. 439-41; JX 5 at 481). She did not recall if her conclusion was based on observation or only on conversations with Marrie or Berry (Tr. 441). Jenson discussed the write-off briefly in a note to the purchases/returns analytic (JX 10 at 880). When questioned by the FBI, Marrie stated that he could not find the file with the fourth quarter sales adjustments (DX 83 at 5).
Before the end of the field work, the auditors knew that the announcement of the write-off had been followed by one lawsuit (JX 1 at 234, 305, JX 5 at 461, 469). To learn about that suit, Schindele made an initial inquiry of CMD's in-house counsel and Romito on August 22, 1994, and a supplemental inquiry on August 25, 1994 (JX 1 at 234, JX 5 at 461). She wrote in the work papers that the likelihood of an unfavorable outcome or any settlement amount in the suit was unknown (JX 1 at 234).
Applicable professional standards. An audit of financial statements in accordance with GAAS should be planned and performed with an attitude of professional skepticism. AU § 316.16. The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. Id. Rather, the auditor recognizes that conditions observed and evidential matter obtained, including information from prior audits, need to be objectively evaluated to determine whether the financial statements are free of material misstatement. Id. If an auditor remains in substantial doubt about any assertion of material significance, he must refrain from forming an opinion until he has obtained sufficient competent evidential matter to remove such substantial doubt, or he must qualify or disclaim his opinion. AU § 326.23.
In Ten Eyck's judgment, GAAS did not require an audit of CMD's fourth quarter adjusting journal entries or the August 4 press release (RX 405 at 13-14). He further opined that increased professional skepticism was not required because the write-off removed revenues and receivables from the financial statements under audit. Id. Under the circumstances, he considered it sufficient that Marrie met with Romito to discuss the spreadsheets. Id.
Regan agreed that the write-off left nothing on the balance sheet to audit as to the receivables and sales, but he opined that the write-off still had a potential impact on the income statement that needed to be audited (Tr. 963-67).
Conclusions. Certain allegations in OIP ¶ II.D.22 involve speculation and require the impermissible use of hindsight. They are identified by the formulaic recitation "if the auditors had done . . . , they would have learned . . . ." OIP ¶¶ II.D.28 and II.D.46 present similar allegations, as do the Division's pleadings (Div. Prop. Find. ## 92, 148, 169, 188). What the auditors would have found had they performed some particular audit procedure is not relevant; the appropriate inquiry here is whether the applicable professional standards were or were not met by the audit procedures performed (RX 405 at 14).
Ten Eyck is technically correct that GAAS did not require Respondents to audit, review, or even look at CMD's August 4 press release (RX 405 at 13). However, the fact remains that Marrie and Berry did discuss and sign off on the press release. They were not free thereafter to close their eyes to the information it contained.
I cannot fault the auditors for failing to state in the work papers that they had examined the allegations in the class action lawsuits filed after the write-off announcement (Div. Prop. Find. # 129). As of August 25, 1994, Schindele knew of only one suit. As late as September 23, 1994, only two such suits (out of the eventual total of eleven) had been served upon CMD (JX 19 at 12, 38). The evaluation of the first suit in the work papers was sufficient, and the fact that other suits were filed after the end of the field work is not relevant.
A substantial portion of CMD's claimed June 1994 sales, which the auditors included in the accounts receivable confirmation testing, represented sales to the same entities that had returned inventory for credit in May 1994 (DX 90, JX 9 at 738-39, JX 10 at 1027-77, JX 26; Div. Prop. Find. # 134). Romito's spreadsheets and the August 4 announcement, when examined in conjunction with the June 1994 sales data in the work papers, support an inference that CMD was engaged in the practice of "refreshing" its stale receivables, or distorting the age and collectability of its receivables. I agree with the Division that the audit should have included a thorough review of the write-off. I conclude that Respondents violated their duty to exercise professional skepticism and to obtain sufficient competent evidential matter when they failed to address that issue. Cf. Ben Franklin Retail Stores, Inc. v. Kendig, 2000 U.S. Dist. LEXIS 276, at *26 (N.D. Ill. Jan. 12, 2000) (holding that a company commits fraud through the practice of "freshening" the due date of accounts receivable, thereby allowing an otherwise out-of-date account to be included in the eligible accounts, which were then used to determine the amount of credit available).
d. The analysis of suspect confirmation responses (OIP ¶¶ II.D.24-II.D.28).
Allegations. The OIP alleges that the process of confirming accounts receivable was deficient. According to paragraph II.D.24 of the OIP, a "significant number" of the confirmation responses that C&L received "raised serious questions" about CMD's revenue recognition practices. At issue are twelve confirmation responses returned by CMD's customers with discrepancies noted.48 The OIP acknowledges that C&L proposed adjustments for particular items, but charges that C&L (which is not a party to the case) failed to determine whether the exceptions were isolated problems or indications of deeper irregularities (OIP ¶¶ II.D.26-II.D.27). The discrepancies required skepticism and investigation, yet Marrie and Berry assertedly "ignored" the questions the discrepancies raised (OIP ¶ II.D.28).
The OIP charges that, had the auditors conducted follow-up discussions with management or reviewed underlying sales documentation, they "would have learned" that there were "significant" sales on consignments and sales with virtually unlimited rights of return, thereby negating recognition of material amounts of revenue or requiring material increases in allowances (OIP ¶ II.D.28).
Audit procedures performed. To confirm CMD's accounts receivable balances as of June 30, 1994, the auditors selected all balances greater than or equal to $100,000 and randomly selected twenty additional balances under $100,000 (Tr. 445-46; JX 9 at 732). Using this stratification plan, C&L selected fifty-four customer accounts (Tr. 450; JX 9 at 738-39). With this sample, the auditors tested 92% of accounts receivable and 100% of accounts over $100,000 (Tr. 203; JX 9 at 733-34). Confirming a large percentage of accounts receivable through letters to customers was Respondents' strategy in response to CMD's problems with cutoffs and year-end sales spikes (DX 83 at 4, DX 84 at 3).
Of the fifty-four accounts tested, twenty-five customers confirmed 100% of their outstanding balances, twelve confirmed a portion of their outstanding balances, and seventeen did not confirm any portion of the receivables balance (JX 9 at 738-39). For each account balance that the customer did not fully confirm, C&L performed alternative procedures to test the unconfirmed amounts (Tr. 450-51; JX 9 at 738-808).
Schindele investigated confirmation discrepancies by examining subsequent payments, reviewing shipping documents, and discussing matters with CMD management or with customers (Tr. 455-60; JX 9 at 738-808). For those balances that could not be corroborated, she proposed adjustments to sales and the bad debt reserve (Tr. 459-60; JX 9 at 741).
Berry reviewed a summary of the confirmations and alternative procedures and he thought he discussed the results with Schindele (Tr. 276-77). The auditors were not aware that some customers colluded with CMD by signing and returning confirmation letters to C&L confirming receivables for product they knew had not been shipped or for which they had no obligation to pay (Tr. 596-98).
In five of the suspect confirmation responses identified by the Division, the customers could not confirm receipt of specific merchandise. The OIP alleges that these five responses "suggested" that CMD had recognized revenue on unshipped product at the end of the fiscal year (OIP ¶ II.D.25). The issue for decision is whether the alternative procedures the auditors performed provided adequate support for CMD's assertions.49
CMD claimed receivables of $213,411 for product it shipped to GSS/Array Technology (GSS) during June 1994 (JX 9 at 739, 786-87). Of that total, $204,465 was for product shipped on June 30, 1994 (JX 9 at 787). GSS's accounts payable department in San Jose, California, confirmed the full amount due on August 5, 1994 (JX 9 at 786). However, five days later, the auditors received a facsimile on the letterhead of GSS's Singapore office, denying any obligation to CMD over $10,556 (JX 9 at 785). Most of the remaining unconfirmed amounts, GSS Singapore advised, represented cancellation charges that "were invoiced to us without our prior agreement" (JX 9 at 785).
Schindele wrote in the work papers that she had confirmed GSS owed an additional $100,000 for the disputed receivables, based on shipping documents and conversations with Romito (JX 9 at 739-40). She proposed to write off the remaining $102,855 because she believed its collectability to be in doubt (Tr. 464; JX 9 at 785).
The record is unclear as to whether CMD shipped the disputed product to GSS in San Jose or in Singapore, or whether it shipped anything at all. The work papers do not explain the audit steps taken to resolve the discrepancies among GSS's first written confirmation response (JX 9 at 786), its second written confirmation response (JX 9 at 785), and its third (apparently verbal) confirmation response (JX 9 at 740). If there was a purchase order authorizing the disputed transaction, the auditors did not confirm its existence.
CMD also claimed receivables of $148,067 for products shipped to Solectron, Inc., of San Jose, California, during June 1994. Solectron informed the auditors that it owed CMD only $33,017 (JX 9 at 739, 789-90). The disputed amount ($115,050) arose from two shipments CMD claimed to have sent to Solectron on June 30, 1994. On August 12, 1994, Solectron stated that it had no record of those shipments, and it asked the auditors to provide a copy of its purchase orders for the products in question (JX 9 at 789-90).
Schindele wrote in the work papers that she reviewed unidentified shipping documents showing that $115,050 in product had been shipped "right before year end" and represented "goods in transit" (Tr. 464; JX 9 at 789). There is no evidence that Schindele ever looked for the Solectron purchase orders or inquired as to why goods shipped the short distance from Milpitas to San Jose had not arrived at their destination forty-two days later.
With respect to Charles Industries, Inc., of Casey, Illinois, the auditors sent a letter requesting confirmation of a receivables balance due of $8,536 (JX 9 at 778). Charles Industries responded by confirming that it owed CMD $4,656. It stated that the product for the remaining balance was not received until July 26, 1994 (JX 9 at 778-79). Schindele reviewed CMD's shipping records regarding the $3,880 discrepancy. She determined that the product had been shipped from Tempe before the end of the fiscal year, and she cleared the exception (Tr. 471-72; JX 9 at 738, 778).
CMD also claimed receivables of $215,375, owed by Analogic, Inc., of Peabody, Massachusetts (JX 9 at 783-84). On August 18, 1994, Analogic confirmed that it owed CMD $143,440. It stated that CMD's invoices for that amount had been paid or were about to be paid (JX 9 at 783). Analogic also reported that the remainder of $71,935 claimed by CMD was not on its records and could not be verified (JX 9 at 783).
Schindele determined that two of the disputed invoices related to sales in prior quarters and she proposed a write-off of $11,132 (JX 9 at 739-41, 783). The remaining $60,803 in dispute related to shipments that CMD claimed to have made to Analogic on June 30, 1994 (JX 9 at 784). Schindele wrote in the work papers that she had reviewed CMD's shipping documents for the items on the six invoices that Analogic had not received (JX 9 at 739, 783). There is no evidence that Schindele ever inquired as to why a product that was shipped from Milpitas to Massachusetts had not arrived at its destination forty-eight days later.50
CMD claimed that National Semiconductor Corporation (NSC) of Santa Clara, California, owed it $1,288,767 for receivables (JX 6, JX 9 at 739). In response to a confirmation request, NSC did not specifically verify the amounts it owed to CMD as of June 30, 1994. Rather, it identified a total of $949,624 as arising from open invoices, unmatched invoices, invoices received from June 26 through June 30, and open receipts (JX 9 at 788). Schindele spoke to NSC and learned that due to NSC's accounting period cutoff, the customer was only able to confirm shipments received up to June 26, 1994 (Tr. 465-66; JX 9 at 788). Schindele treated the balance of $949,624 as confirmed.
Schindele also reviewed subsequent payments and confirmed that NSC had paid $163,339 (JX 9 at 739). She then traced the remaining balance of $175,803 to CMD's shipping records, noting that the items were shipped prior to the end of the fiscal year (Tr. 793-98; JX 9 at 739-40, 788).
One confirmation response raised questions about a consignment sale. The auditors requested UPC Electronics (UPC) of Singapore to confirm a balance due of $278,000 as of June 30, 1994 (JX 9 at 739). In its response, UPC stated that many items had only been ordered on consignment, that some of the items were still sitting in its warehouse, and that Ashok Chalaka (Chalaka), a CMD sales officer, was making arrangement to transfer those items to Westech Electronics (JX 9 at 792-96).
Schindele followed up by having a discussion with UPC. In that discussion, UPC confirmed a balance owing of $76,407 (JX 9 at 792). UPC also informed Schindele that it was returning $147,615 in product to CMD (JX 9 at 792). Schindele then reviewed CMD's shipping documents for the remaining $53,978 in claimed product sales and she proposed a revenue adjustment of $147,615 for the product UPC told her it was returning (Tr. 467; JX 9 at 739-40, 792).
The final suspect confirmation response identified in the OIP involved YHK International, Ltd. (YHK) of Hong Kong. The auditors sent YHK a letter requesting confirmation of a receivable balance due of $144,747 (JX 9 at 774). YHK responded by stating that it was in negotiation with CMD for the return of some amount of the product (JX 9 at 774, 776). YHK later requested that it be allowed to return $103,750 of product (JX 9 at 776-77). Schindele discussed the matter with YHK, confirmed an accounts receivable balance of $40,998 and recommended a write-off of $103,750 for the products that YHK was requesting to return (Tr. 331-32; JX 9 at 738-41, 776).
Applicable professional standards. Confirmation is the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions. AU § 330.04. When evidential matter can be obtained from independent sources outside an entity, it provides greater assurance of reliability for the purposes of an independent audit than that secured solely within the entity. AU § 326.19a.
The auditor should assess whether the evidence provided by confirmations reduces audit risk for the related assertions to an acceptably low level. AU § 330.09. When the auditor concludes that evidence provided by confirmations alone is not sufficient, additional procedures should be performed. Id. The auditor should exercise an appropriate level of professional skepticism throughout the confirmation process. AU § 330.15.
There may be circumstances, such as for significant, unusual year-end transactions that have a material effect on the financial statements, in which the auditor should exercise a heightened degree of professional skepticism relative to the customer's objectivity and freedom from bias with respect to the audited entity. AU § 330.27.
When the auditor has not received replies to positive confirmation requests, he or she should apply alternative procedures to the nonresponses to obtain the necessary evidence to reduce audit risk to an acceptably low level. AU § 330.31. In the examination of accounts receivable, alternative procedures may include examination of subsequent cash receipts (including matching such receipts with the actual items being paid), shipping documents, or other client documentation to provide evidence for the existence assertion. AU § 330.32.
After performing any alternative procedures, the auditor should evaluate the combined evidence provided by the confirmations and the alternative procedures to determine whether sufficient evidence has been obtained about all the applicable financial statement assertions. AU § 330.33. In performing that evaluation, the auditor should consider: (a) the reliability of the confirmations and alternative procedures; (b) the nature of any exceptions, including the implications of those exceptions; (c) the evidence provided by other procedures; and (d) whether additional evidence is needed. Id. If the combined evidence provided by the confirmations, alternative procedures, and other procedures is not sufficient, the auditor should request additional confirmations or extend other tests, such as tests of details or analytical procedures. Id.
Irregularities are intentional misstatements or omissions of amounts or disclosures in financial statements. AU § 316.03. Irregularities are extremely hard to detect, if not impossible to detect, if those within an audited company add collusion of customers to a concealment scheme. AU § 316.34(8).
Conclusions. The auditors confirmed an extremely high percentage of the receivables outstanding as of June 30, 1994. They followed up on all significant exceptions by conducting some type of alternative procedure. The Division intimates that this was just the same sort of confirmation testing, with the same level of sampling, that C&L had employed during the 1993 audit (Div. Prehearing Br. at 22-23). However, the Division introduced no evidence upon which to make a comparison (Tr. 192-94; Posthearing Conference of Apr. 17, 2000, at Tr. 4-5).
The OIP's claim that there were "a significant number of discrepancies" on customer confirmation responses is pure hyperbole. While twelve customer responses (out of thirty-seven) noted discrepancies, most of those involved established customers of CMD about which there were no known significant issues concerning their existence or their ability to pay. Most of the twelve customers reporting exceptions confirmed the majority of the balance due. I agree with Ten Eyck that there was little unusual about the exceptions noted by such customers in responding to the auditors' confirmation requests (RX 405 at 15-19). Nonetheless, there were occasional GAAS violations as to four of the twelve responses that noted discrepancies, and those are the focus of the Division's case.
(i). The auditors violated GAAS in evaluating confirmation responses and performing alternative procedures as to Solectron, Analogic, NSC, and GSS. As to Solectron and Analogic, CMD's shipping documents, suggesting that products shipped from Milpitas on June 30 still had not yet arrived in San Jose forty-two days later or in Massachusetts forty-eight days later, warranted further inquiry. In both instances, the auditors failed to exercise appropriate professional skepticism and obtain sufficient competent evidential matter.51 The auditors' review of cash collections from Analogic and NSC was unacceptable as an alternative procedure because it failed to match the gross cash receipts with the actual items being paid, as required by AU § 330.32. GSS provided three different answers when asked to confirm the balance owed on receivables. The auditors accepted all three answers at face value, a violation of their duty to exercise appropriate professional skepticism.
(ii). There is no evidence that CMD made "significant" sales on consignment. The OIP alleges that CMD was counting consignment sales as actual sales and recording the anticipated revenue (OIP ¶¶ II.D.27-.28). Such a practice, if proven, would violate GAAP. See Worlds of Wonder, 35 F.3d at 1418; Chu, 100 F. Supp. 2d at 821 n.4; Marksman, 927 F. Supp. at 1305. The OIP also charges that Respondents were reckless because they failed to take steps to determine the possible existence of additional consignment sales to other customers after receiving UPC's confirmation response (OIP ¶ II.D.27).
Regan's report asserted, as if it were an established fact, that CMD had an "improper practice of shipping goods to customers on consignment but reporting them as sales" (DX 89, binder 1, tab 1 at 31). Ten Eyck quite properly took Regan to task for extrapolating a widespread practice as to multiple customers from audit evidence of consignment sales to a single customer (RX 405 at 17). Regan then clarified his intent (Tr. 1064-69). Among other things, he stated: "I'm not taking the affirmative position that there was a practice, but it is an area of inquiry which was appropriate to undertake" (Tr. 1069).
The Division has not shown that CMD engaged in "significant" consignment sales, as alleged in OIP ¶ II.D.28. It did not identify the approximate number of consignment sales that CMD improperly reported as revenue, the customers involved (other than UPC), or the approximate amount by which CMD overstated its revenue as a result of the allegedly improper reporting of consignment sales. The Division's failure to do so is understandable. After analyzing CMD's sales with the full benefit of hindsight in December 1994, E&Y could identify no consignment sales other than those to UPC (DX 13 at 2130-31 & n.11).
I conclude that Respondents' evaluation of UPC's confirmation response and the follow-up discussion with UPC complied with the obligations imposed by AU § 330.33. While Respondents could have done more, the failure to do more did not violate GAAS. The allegations in paragraph II.D.27 of the OIP are dismissed.
(iii). There is no evidence that Respondents recklessly failed to investigate whether one customer's negotiation for the return of parts was an isolated problem or an indication of deeper irregularities. YHK was one of the Far East customers to whom CMD had offered extended payment terms (Tr. 340-41; JX 9 at 834-36). Notwithstanding management's explanation of the need for such terms, Schindele recommended disallowing $103,750 in revenue because YHK wanted to return that amount to CMD. In doing so, she discounted correspondence from CMD's sales department to Romito stating that the sales department expected YHK's returns to be no more than $12,000 (JX 9 at 775).
There are other documents in the record showing that the product shipped to YHK was no more than a contingent sale (DX 89, binder 2, tab 7 at 22-23). Regan relied on these documents in his expert report (DX 89, binder 1, tab 1 at 28-29). I decline to do so. CMD never provided these documents to the engagement team and they were not a part of the work papers (Tr. 820-22, 1183-84, 1475-76). No findings adverse to Marrie and Berry may properly be made on the basis of the documents.
I conclude that Respondents' follow-up to the YHK confirmation response was appropriate under GAAS. While Respondents could have done more, the failure to do more did not violate GAAS. Accordingly, the allegations in paragraph II.D.26 of the OIP are dismissed.
(iv). There is no evidence to support the speculation that a more searching analysis of the suspect confirmation responses would have negated material amounts of revenue or required material increases in allowances. Schindele proposed to write off revenue CMD claimed on shipments to GSS, Analogic, UPC, and YHK, and others. In each instance, Marrie and Berry posted the amounts to C&L's Summary of Unadjusted Differences (Tr. 1062). In essence, Respondents summarized the collection of adjustments and determined that it was unnecessary for CMD to make them in order to prevent the financial statements from being materially misstated (Tr. 1187-88; JX 1 at 65). The Division did not even attempt to show that the results of this process were flawed, or that Respondents' determination of "immateriality" was just a guise.
The OIP speculates about what additional audit steps would have shown, but the Division has failed to demonstrate that Respondents ignored circumstances warranting such additional steps. The appropriate inquiry is not what additional steps would have shown, but whether Respondents were at least reckless in not taking such steps.
I conclude that the Division has not shown that Respondents' analysis of the twelve suspect confirmation responses left them with an insufficient basis to opine on CMD's revenue and receivables. The allegations in paragraph II.D.28 of the OIP are dismissed.
d. Sales returns (OIP ¶¶ II.D.29-II.D.33).
Allegations. The OIP alleges that Respondents' analyses of both CMD's sales returns and the adequacy of its allowance for returns were defective and resulted in an understated product return allowance of $4 to $5 million. Among other things, the OIP faults the auditors' returns analysis for relying on historical percentage data from a time when Apple was still a significant customer; for accepting management's uncorroborated representation that most returns were made within two months of sale, even though CMD had a one-year return policy; for wholly ignoring the product returns announced in the August 4 press release; for ignoring several indications of irregularities in CMD's practices relating to rights of return; and for failing to follow up evidence that CMD's sales personnel had granted extended payment terms to customers without the prior approval of CMD's chief accounting officer.
Audit procedures performed. Respondents recognized CMD's sales return reserve as a significant audit issue (JX 28 at 1779 item 3, 1782). CMD recorded customer returns of products on its Returned Material Authorizations. The auditors prepared two analyses regarding Returned Material Authorizations. In their sales returns analytic, the auditors compared CMD's sales to its returns (JX 9 at 842-47). They used the resulting ratio to estimate the returns in fiscal year 1995 on sales made in fiscal year 1994. The auditors performed a second analysis of returns in reviewing CMD's accounting for inventory (JX 10 at 880).
In reviewing CMD's sales return reserve calculation of $789,904, the auditors compared a year of sales to a year of returns and calculated a ratio of returns to sales for Milpitas (20%) and Tempe (3%) (Tr. 505-07; JX 9 at 846). The auditors then applied the calculated return percentage to the May 1994 and June 1994 sales for Milpitas and Tempe, respectively (JX 9 at 846). Kapur and Bridges told the auditors that "virtually all returns are made within [two] months of purchase," and the auditors therefore used two months of sales as the basis of their computations (JX 9 at 846). The auditors then compared their independently derived estimate of returns with CMD's estimate to corroborate the reasonableness of management's estimate. AU § 342.10b. C&L calculated an estimated return reserve of $772,498, which was $17,406 less than CMD had recorded (JX 9 at 846).
The auditors also calculated quarterly sales return ratios for fiscal year 1994 (JX 10 at 880). Using this analysis, the auditors calculated CMD's average return ratio for the year to be 10.53% (JX 10 at 880). They noted a substantially higher rate of returns in the fourth quarter (JX 10 at 880). Step 14 in the trade accounts receivable audit program, which required the audit team to review fluctuations in sales or return patterns near year-end, also referenced the analytical results regarding the inventory (JX 9 at 715).
In the management representation letter, CMD stated that its gross receivables represented valid claims and were not subject to discounts except for normal cash discounts (JX 1 at 169). Management also stated that a reserve of $789,904 was sufficient to provide for any losses that might be incurred on sales recorded on or before June 30, 1994 (JX 1 at 169-70).
The auditors knew that sales personnel did not seek approval from Romito before granting extended payment terms to customers, even though such approval was required by CMD policy (JX 9 at 730). They included a comment regarding such unapproved extensions in the management comment letter for the 1994 audit (JX 1 at 163).
Applicable professional standards. Respondents' analysis of CMD's allowance for sales returns involved the audit of another management estimate. It was subject to the same provisions of AU § 342 as the audit of CMD's estimates of the valuation of property, plant, and equipment and obsolete inventory. See supra topics 5 and 6.
FAS No. 48 ¶ 8 recognizes that the ability to make a reasonable estimate of future returns may be impaired by technical obsolescence, a long return period, and/or the absence of relevant historical experience.
One additional professional standard was implicated by the August 4 write-off. AU § 342.13 recognizes that events or transactions sometimes occur subsequent to the date of the balance sheet, but prior to the completion of field work, that are important in identifying and evaluating the reasonableness of accounting estimates or key factors or assumptions used in the preparation of the estimate. In such circumstances, an evaluation of the estimate or of a key factor or assumption may be minimized or unnecessary as the auditor can use the event or transaction in evaluating their reasonableness.
An auditor should consider whether there might be oral modifications to agreements, such as unusual payment terms or liberal rights of return. AU § 330.25. When the auditor believes there is a moderate or high degree of risk that there may be significant oral modifications, he or she should inquire about the existence and details of any such modifications to written agreements. Id.
Also relevant to this aspect of the OIP are AU § 333.02, regarding confirmation of management representations, and AU § 326.19a, regarding evidential matter obtained from outside sources. See supra topic 5.
Conclusions. Four of the charges in this segment of the OIP lack merit and will be dismissed. First, there is no basis to fault the auditors for relying on historical return percentages derived from a time when Apple was a major CMD customer. The language of the OIP is surprisingly nebulous: it asserts only that the foreign customers replacing Apple "presumably" required more time to accept shipments and complete returns than domestic customers such as Apple (OIP ¶ II.D.30). No such presumptions are warranted. The Division must prove that CMD was dealing with a new class of customers. The Division presented no analysis demonstrating that Apple's sales returns were statistically less significant than those of CMD's other customers. Regan simply assumed that it was so (Tr. 727-30; DX 89, binder 1, tab 1 at 21). Likewise, there is little justification for the Division's assumption that Apple should be considered a domestic customer (and thus different from CMD's foreign customers) simply because Apple's corporate headquarters were near Milpitas. A review of the work papers demonstrates that Apple returned product to CMD from its production plants in Singapore and Ireland (JX 9 at 843, JX 26). The Division now contends only that the shift from Apple to other customers "had the potential" to understate the rate of returns on sales (Div. Prop. Find. # 154).
It is instructive to compare this case to Segue Software, 106 F. Supp. 2d at 169-70 (finding that Segue's historical estimates of sales returns had been remarkably accurate for the three previous years, that actual returns in those years were well within estimated limits, and that a substantially higher reserve in the current year tended to negate an inference of scienter). CMD's sales return reserves were $264,000 for fiscal year 1992 and $300,000 for fiscal year 1993 (DX 89, binder 1, tab 4 at 13, tab 14 at 5). The Division has not demonstrated that CMD's reserves in those years were too low. Rather, it confines its "lack of historical experience" argument to CMD's fiscal year 1994 estimate of $789,904. CMD's 1994 estimate was twice its 1993 estimate and triple its 1992 estimate. I reject the Division's argument, based on the reasoning of Segue Software.
Second, the Division excoriates Schindele and Berry for understating the return ratio by comparing thirteen months of sales data to twelve months of return data (Div. Prehearing Br. at 30; DX 89, binder 1, tab 1 at 19, citing JX 9 at 846). Although Schindele explained that the thirteen-month reference in the work papers was probably nothing more than a typographical error (Tr. 505-07), the Division would have me dismiss her testimony as speculation, and hold Berry liable for failing to catch the error (Div. Prop. Find ## 151-52).52 It is time to put this canard to rest. By comparing sales data from Regan's report (DX 89, binder 1, tab 4 at 14), the August 4 press release (DX 39), and CMD's quarterly reports, on the one hand, with the sales data in the sales returns analytics (JX 9 at 846), on the other hand, one can readily see that the Sales Returns Analytics reflected CMD's sales from April 1993 through March 1994, a twelve-month period. I find as a fact that the reference in JX 9 at 846 to sales from April 1993 through April 1994 was nothing more than a typographical error. I reject the Division's arguments to the contrary.
Third, the OIP alleges that the auditors failed to assess the accounting implications of CMD's stock rotations (OIP ¶ II.D.32). In fact, the work papers document only one stock rotation: Elkay International, Inc. (Elkay), of Susquehanna, New Jersey, was issued a Returned Material Authorization for $85,100 on July 8, 1994 (JX 9 at 844). At the time, Elkay owed CMD $85,082 for products shipped more than 180 days before the end of fiscal year 1994 (DX 89, binder 1, tab 11 at 3, JX 10 at 1075). However, the Division presented no other facts about this transaction (Div. Prop. Find. # 162). Although Elkay itself is not otherwise identified, I infer that it was an end-use customer, not a distributor. If an end-use customer exchanges one item for another of the same kind, quality, and price, the stock rotation does not constitute a return. FAS 48 ¶¶ 6(f) n.3, 21. In any event, the transaction was fully reserved (Tr. 342-43). I find nothing reckless in the audit of that stock rotation transaction, and no basis for holding that the one stock rotation should have had wider auditing implications.
Fourth, Ten Eyck opined that price protection clauses are routine and generally do not preclude revenue recognition under GAAP (RX 405 at 24). I conclude that CMD's prices were substantially fixed or determinable on the date of sale, within the meaning of FAS No. 48 ¶ 6(a).
The weight of the evidence supports the remaining charges of GAAS violations in this segment of the OIP. Marrie and Berry knew that sales personnel did not seek Romito's approval before granting extended payment terms to customers, as required by company policy. AU § 330.25 obliged the auditors to inquire further about the extent of such oral modifications. It was not sufficient simply to incorporate into the management comment letter a gentle recommendation that CMD should in the future start to comply with its existing policy. This was evidence that the sales personnel had the ability to override CMD's established internal controls. The extent of the oral modifications was important audit evidence, because the modifications may have precluded revenue recognition. Additional inquiry was required.
Nor should Marrie and Berry have accepted management's uncorroborated representation that virtually all returns were made within two months after a purchase. CMD policy allowed returns up to one year. The assertion that foreign customers returned products within two months was also inconsistent with management's other representation that shipments to foreign customers frequently took six weeks to deliver (JX 9 at 830D, 838).
I cannot give much weight to Respondents' theory that customers who did not receive shipments for six weeks would still have had an opportunity to request a Returned Material Authorization within the two-month period (RX 405 at 20; Resp. Prop. Find. # 172). Most sales returns involved defective products, unsatisfactory quality, or shipments of the wrong product (JX 9 at 846). It is illogical to argue that a customer could determine that such conditions existed before it received and inspected the product. Respondents did not show how easy or difficult it was for a dissatisfied customer to obtain a Returned Material Authorization from CMD: whether physical return of the product was required or whether a telephone call would suffice. In the absence of such evidence, I conclude that Marrie and Berry violated AU § 333.02 when they failed to corroborate management representation that all returns occurred within two months of a sale. Respondents violated AU § 326.19a when they failed to obtain such corroboration from customers.
In calculating the sales returns, the auditors used a figure of $7,016,544, reported as product sales in May and June 1994 in management's monthly trend reports (JX 9 at 846). As already noted, however, sales of more than $8 million were recorded for June 30 alone, and more than $12 million in sales were recorded for the month of June. Jenson's purchases and returns analysis stated that sales for the fourth quarter were $10,258,746 (JX 10 at 880). The aged trial balance for the end of fiscal year 1994 showed $12,165,351 in accounts receivable less than thirty days old (JX 9 at 734BBB). CMD's August 4 press release stated that the company had product sales of $12.7 million for the quarter, without considering returns (DX 39). These are major discrepancies and the auditors should have reconciled them. I agree with Regan that their failure to do so violated GAAS (DX 89, binder 1, tab 1 at 19-21).
The auditors' computation of the sales return ratio used $4,504,288 as returns for all of fiscal year 1994 (JX 9 at 846). However, CMD's August 4 press release disclosed returns in the fourth quarter of $5.3 million (DX 39). The work paper for the reserve for returns makes no mention of the returns authorized in the fourth quarter. Under AU § 342.13, the auditors should have considered the actual fourth quarter returns in evaluating the reasonableness of management's estimate for a year's worth of returns (DX 89, binder 1, tab 1 at 19).
After the August 4 announcement, there was really no need for the auditors to confine themselves solely to developing their own independent expectation to corroborate the reasonableness of management's sales return estimate. Rather, the auditors should also have used the information available from Romito's spreadsheets and the August 4 announcement to evaluate management's sales return reserve estimate.
e. Failure to conduct adequate cutoff testing (OIP ¶¶ II.D.34-II.D.36).
Allegations. The OIP alleges that Marrie and Berry knew that revenue cutoff had been a significant issue in prior CMD audits and that CMD regularly claimed to earn most of its revenue from sales late in a quarter or a fiscal year. It contends that the cutoff tests that Marrie and Berry performed were an extreme departure from professional standards. In particular, the OIP faults Respondents for a lack of professional skepticism and for obtaining insufficient evidential support in three areas: testing only five transactions per plant, ignoring evidence that one of the tested transactions pulled in revenue from fiscal year 1995, and failing to follow up discrepancies involving non-sequential invoice numbers.
Audit procedures performed. Respondents knew that CMD had problems with revenue cutoff issues in 1992 and 1993. During the 1993 audit, Marrie reversed approximately $400,000 in revenue because CMD had not shipped the goods before the end of the fiscal year. As he prepared for the 1994 audit, Marrie reminded CMD management not to record sales until it had shipped the product. He did so in the November 23, 1993, comment letter, and again in written and oral presentations to CMD's audit committee, board of directors, and senior management on April 29, 1994. See supra at 7-8. CMD management accepted Marrie's admonition and gave outward assurances that it would comply with his directions (JX 28 at 1792 item 8). On June 10, 1994, Romito even sent a memorandum to CMD management and key employees reminding them that the fiscal year cutoff date was June 30, that product must be shipped by then to be counted as fiscal year 1994 revenue, that the auditors would review shipping and sales invoice documents to ensure that an outside freight company had signed for the product by June 30, and that the auditors would allow no exceptions to this policy (Tr. 577-78; RX 350).
C&L's trade accounts receivable audit program required the auditors to review possible cutoff errors for selected sales before and after the end of the fiscal year (JX 9 at 715). Schindele signed off on this audit step. The inventory audit program also included audit steps to examine proper cutoff (Tr. 363-69; JX 10 at 857). The work papers document the cutoff procedures performed for Milpitas and Tempe (JX 10 at 1171-99, JX 12 at 2372, 2382-92). The auditors reviewed the last five shipments sent in fiscal year 1994 from each location, agreed those amounts to the accounts receivable aging, and noted that the items were properly included in accounts receivable as of June 30, 1994 (JX 10 at 1171-99, JX 12 at 2382). The auditors then reviewed the first five shipments sent in fiscal year 1995, cross-checked to the accounts receivable aging, and noted that the items were properly excluded from accounts receivable as of June 30, 1994 (JX 10 at 1195-99, JX 12 at 2382-92, RX 405 at 22).
One of the cutoff shipments the auditors reviewed was for Synerdyne, Inc. (Synerdyne), in Tokyo, Japan (JX 10 at 1172-82). CMD's shipper/invoice forms reflect that product valued at $210,000 was shipped from CMD in Tempe to Synerdyne in Tokyo on June 30, 1994. CMD's shipper/invoice forms have a column with the heading "request date." A request date of November 10, 1994, was listed in the request date column for the Synerdyne shipment (Tr. 370-71). The work papers also contain a copy of certain shipping documentation for the Synerdyne shipment (Tr. 371-73; JX 10 at 1182). The shipping document reflects that Air Cargo Transit picked up the Synerdyne shipment at 7:50 p.m. on June 30, 1994, at Tempe for transport to Tokyo World Transport in Redondo Beach, California (JX 10 at 1182). The shipper/invoice form notes that the products were licensed by the United States for an ultimate destination in Japan and the shipping document reflects that the Synerdyne shipment was to become part of an ocean consolidation (Tr. 398-99; JX 10 at 1172, 1182). CMD commonly engaged in such intermodal shipments (Tr. 342). The auditors subsequently received confirmation from Synerdyne that CMD's claimed outstanding receivable balance was correct, without exception (Tr. 399-400; JX 9 at 755).
According to the work papers, the highest invoice number on a fiscal year 1994 shipment the auditors tested was # 166562 (JX 10 at 1193). That was 140 invoice numbers higher than the last Synerdyne shipment, which left CMD's facility at 7:50 p.m. on June 30, 1994 (JX 10 at 1172-82). The highest invoice number on a fiscal year 1994 sale recorded by CMD was # 166601. The invoice number on that sale was thirty-nine numbers higher than the highest invoice number the auditors tested (DX 89, binder 1, tab 1 at 17, JX 10 at 1067, 1193).
Conclusions. The record establishes that Marrie and Berry knew that revenue cutoff had been a significant problem in prior audits. They caught the problem in 1993 and they fixed it. There is no basis for criticizing their 1993 audit performance. The weight of the credible evidence does not support the Division's claim that Marrie permitted CMD to pull in out-of-period revenue in prior audits. See supra note 8.
The Division argues that CMD shipped product to Synerdyne well in advance of the requested delivery date in order to inflate its fiscal year 1994 revenue. In support of its position, the Division offered a shipper/invoice form showing a request date more than four months after the shipping date.
The discrepancy between the shipping date and the customer request date on the face of the Synerdyne shipper/invoice form, coupled with the absence of a customer instruction to ship earlier than the request date, permits an inference of impropriety as to that one customer. It is troubling that the auditors failed to obtain evidence of Synerdyne's consent to accept the shipment early (in contrast, certain other shipper/invoice forms clearly stated "ship ASAP" or the like). However, Respondents rebutted the inference by showing that Synerdyne responded to their confirmation request by confirming the full balance due without exception (JX 9 at 738, 755). Cf. Greebel, 194 F.3d at 202-03 (holding that there is nothing inherently improper if an audited company persuaded its customer to take a shipment early). Ten Eyck persuasively testified that if there were pull-in sales, customers could be expected to "scream bloody murder" to the auditors (Tr. 1451-52).53 Synerdyne did not complain to the auditors. Ten Eyck opined that the initial discrepancy was satisfactorily addressed by Synerdyne's confirmation response. I concur.
The Division also emphasizes that the Synerdyne shipment was directed to a third-party warehouse, rather than the end-use customer. The Division asks me to infer that the Redondo Beach warehouse was little more than an off-site hideaway where CMD parked its unsold inventory, and that further inquiry was required.54 In the absence of evidence from the customer (either contemporaneous instructions showing that the warehouse was Synerdyne's desired interim destination, or testimony the warehouse was not Synerdyne's desired interim destination), I am left to draw inferences from the face of the shipper/invoice form and shipping documents. I decline to draw the inference the Division seeks. There were no other known examples of shipments to warehouses, beyond the Synerdyne shipment. There was no evidence that product remained in storage at the Redondo Beach warehouse for any length of time. In addition, other entries on the Synerdyne shipper/invoice and the shipping document demonstrate that the product in question was licensed for export to Japan and was intended to become part of an ocean consolidation.
In prior cases, shipments to locations other than the buyer's business address have often raised a question of whether revenue was recognized before the completion of the earnings process. Here, however, the documents provided a satisfactory explanation. The weight of the evidence did not support the charge of an impermissible pull-in sale.
The Division also points to a June 20, 1994, shipment from CMD in Tempe to Teltone Corporation in Bothell, Washington, as evidence of an impermissible pull-in (Div. Prop. Find. # 146). CMD claimed revenues of $7,526 on that shipment, but the auditors wrote off $1,672 of the claimed amount to accommodate the customer's complaint that there was a lower price per unit (Tr. 468; JX 9 at 738). Regan seized upon the statement in the customer's confirmation letter that the shipment was "due in July" as evidence of a potential pull-in (DX 89, binder 1, tab 1 at 29, JX 9 at 738). To be thorough, the auditors should have placed one more telephone call to determine whether Teltone expected the shipment in question on July 1 or July 31. If the due date were July 1, the prospect of a pull-in could have been ruled out. If the due date were July 31, there would have been evidence that CMD had pulled in $5,854. Because immaterial errors will not support an inference of scienter, the failure to make that telephone call was at worst borderline negligence.
The phenomenon of the non-sequential invoice numbers merits little discussion. The Division never showed that CMD processed the underlying transactions in numerical sequence. Emery Worldwide Express (Emery) picked up shipments for three customers at CMD's Tempe plant at 10 p.m. on June 30, 1994 (JX 10 at 1183-92). Of those items picked up by Emery, shipments to Sabre Advanced Micro, Ltd., and to Milgray Electronics, Inc., had both higher and lower invoice numbers than the Synerdyne shipments that Air Cargo Transit had picked up earlier in the evening (JX 10 at 1183-92). The fact that an invoice number was high did not necessarily mean that it was the last shipment to leave the plant before the end of the fiscal year. The engagement team did not test for sequential invoice numbers as part of its cutoff testing. Regan agreed with Ten Eyck that testing for sequential invoice numbers was neither required by GAAS nor inherently more reliable than the testing procedure utilized by Marrie and Berry (Tr. 1083-85; RX 405 at 23).
The most troublesome aspects of the sales cutoff testing were the determination not to have an auditor present on the loading docks at Milpitas and Tempe on the evening of June 30 to observe last-minute shipments; the end-of-period sales spikes routinely claimed by CMD; and the determination to test no more than five shipments per plant before and after the cutoff-the same number of shipments that C&L routinely examined as to all its audit clients. However, the parties agree that cutoff testing is not required by GAAS (Tr. 932; RX 405 at 21).
I conclude that the professional standards applicable in 1994 did not require Marrie and Berry to engage in greater cutoff testing because of CMD's lack of sales linearity. Meyercord testified that the "hockey stick effect" was not unusual in high technology industries, although he did not consider it a good business practice (Tr. 912-13). Regan agreed, and he initially conceded that there was nothing improper about the phenomenon as long as sales cutoff dates were respected (Tr. 758). Regan later testified that CMD's sales at the end of fiscal year 1994 were aberrational in comparison to the "hockey stick effect" CMD usually experienced, and he opined that the claimed volume of sales in late June 1994 should have caused Marrie and Berry to increase their cutoff testing (Tr. 1081-82, 1114-16). After reviewing the annual sales figures with the benefit of hindsight, Thomsen also expressed doubts about CMD's claimed end-of-fiscal-year sales (Thomsen Dep. at 24, 39, 42; RX 374 at 631 ("shipment skew doesn't pass smell test")), as did E&Y (DX 13 at 2131 ("unusual amount of sales activity at quarter and fiscal year ends")).
Documentary evidence from 1992 indicated that Marrie had increased C&L's review and audit procedures to address CMD's end-of-period sales spikes (DX 83 at 2, DX 89, binder 1, tab 6 at 4, 7). Respondents told the FBI that the high level of shipper confirmation requests was their principal auditing tool for doing so.
Respondents portray CMD's lack of revenue linearity as a neutral phenomenon (neither good or bad, but simply a fact of life in the industry). The Division insinuates that it represented cynical game-playing by CMD management to manipulate the revenue figures. In the Division's view, the practice raised serious management credibility issues, and should have drawn the auditors' heartiest skepticism.55
Of course, the applicable professional standards have long required auditors to pay particular attention to large and unusual transactions recorded at or near the end of a reporting period. AU § 316.20. The June 30 sales here were collectively large, but large sales at the end of the reporting period were routine in the semiconductor industry and at CMD. I am aware of no judicial decisions holding that a lack of revenue linearity was the "red flag" the Division believes it to be. One court has recognized that the "hockey stick effect" makes forecasting sales earlier in the reporting period extremely difficult, but it credited testimony that the phenomenon was well known in the industry in question. See Bentley, 849 F. Supp. at 432.
Professional literature contains several recent articles warning auditors that the "hockey stick" phenomenon increases the risk that cutoff errors may have occurred. See, e.g., Gary D. Zaune, CPA, "Auditors Will Be Required To Detect Fraud," Bus. Credit Mag. (Sept. 1996); Laurie B. Smilian, Financial Fraud: How To Detect, Prevent, and Resolve Accounting Irregularities, Prac. L. Inst., at 669 (2000). However, most such articles describe the responsibilities of auditors after the effective date of Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit (SAS No. 82). SAS No. 82 was not in effect at the time of the 1994 CMD audit.
At the request of former Commission Chairman Levitt, the Public Oversight Board appointed the Panel on Audit Effectiveness (Panel) in October 1998 to assess whether independent audits of the financial statements of public companies adequately serve and protect the interests of investors. On May 31, 2000, the Panel issued its Report and Recommendations (Report). In section 2.134 of its Report, the Panel specifically addressed cutoff testing in the circumstances presented here. The Panel recommended that the Auditing Standards Board:
Require that auditors test the cutoff of revenue when inherent or control risks over such transactions are other than low and specifically when there is a high level of sales transactions or individually significant sales transactions near the end of the reporting period. Cutoff tests should be more extensive than tests of only a few transactions before and after the close of the period. Cutoff testing often should require the auditor's physical presence at the entity's location(s) at period end.
Reconsider its standard on the confirmation process (SAS No. 67) and clarify the circumstances in which confirmation of the terms of transactions should be required. The terms of revenue transactions should be confirmed whenever the transactions are individually significant and the risks associated with revenue recognition or the existence of receivables [is] high.
There is a strong intuitive appeal to the Division's claim that increased cutoff testing was appropriate in light of CMD's lack of revenue linearity. However, if the Panel believed it necessary in 2000 for the Auditing Standards Board to establish standards requiring the audit procedures Marrie and Berry are alleged to have failed to perform in 1994, it is difficult to credit the Division's claim (and Regan's testimony) that those procedures were already part of the applicable professional standards at the time of the audit. The evidence shows not that Marrie and Berry deviated from the applicable professional standards, but that the standards themselves lacked vitally important specificity.
Paragraphs II.D.34 through II.D.36 of the OIP are accordingly dismissed.
f. Ignoring the decrease in cash collections (OIP ¶ II.D.37).
Allegations. The OIP charges that Marrie and Berry "failed to consider" a significant decrease in CMD's cash collections from the prior fiscal year. It further asserts that CMD's increase in aged receivables and the corresponding decrease in collections put Respondents on notice that additional procedures designed to address the validity and collectability of the receivables were required.
Audit procedures performed. Marrie and Berry knew that CMD had granted extended payment terms to some foreign customers (Tr. 358; DX 16 at 54, JX 9 at 725, 830C, 832, 832A, 834, 835, 838). The audit program for trade accounts receivable instructed the engagement team to ascertain the collectability of accounts receivable and to assess the adequacy of the allowance for doubtful accounts, giving consideration to cash collections subsequent to the valuation date (JX 9 at 716-17, 825-36). Schindele completed these audit steps.
The work papers document that CMD's trade accounts receivable over sixty days old increased almost 100% from prior years (JX 9 at 730). The work papers also document that July collections as a percentage of accounts receivable decreased by over 50% from the prior year (JX 9 at 730). The work papers contain analytics comparing the accounts receivable days sales outstanding for fiscal years 1992 through 1994 (JX 9 at 830D). The average days sales outstanding for accounts receivable increased from 111 days in 1993 to 146 days in 1994 (JX 9 at 830D). In anticipation of an increase in uncollectible accounts due to the increased accounts receivable and extended payment terms granted by CMD to certain customers, C&L proposed an increase in CMD's bad debt reserve from $500,000 to $1.5 million (JX 9 at 725-26, JX 19 at 25).
Conclusions. Documents identifying the exact scope and nature of CMD's cash collection activities were withheld from the auditors (Tr. 573-75). That fact is not acknowledged by the OIP. The Division argues that customer collections should have been designated as a critical audit issue and a matter for the attention of the engagement partner, and that Respondents should have discussed collection issues with CMD's sales personnel or senior management and not just with CMD's accounting personnel (Div. Prop. Find. ## 172-73). The Division fails to identify the provisions of GAAS that require an auditor to take such steps, and Regan did not discuss these charges in his expert report. The fact that Respondents increased CMD's bad debt reserve by $1 million refutes the assertion that they "failed to consider" the cash collection issue. Paragraph II.D.37 of the OIP is therefore dismissed.
g. Negligence vs. recklessness.
This Initial Decision dismisses several of the charges relating to the audit of CMD's revenues and accounts receivable. It finds certain GAAS violations relating to the failure to examine the write-off of receivables, the audit of suspect confirmation responses, and the audit of sales returns. The evidence relating to the write-off of receivables could well have supported a finding that Respondents engaged in highly unreasonable conduct under Rule 102(e)(1)(iv)(B)(1). The other proven GAAS violations could well have supported a finding that Respondents engaged in repeated instances of unreasonable conduct under Rule 102(e)(1)(iv)(B)(2). However, no such charges were filed.
Respondents' audit of CMD's revenues and accounts receivables was by no means acceptable. Indeed, it is no stretch to characterize this aspect of the audit as grossly negligent. However, McLean teaches that negligence, whether gross, grave or inexcusable, cannot serve as a substitute for scienter. Sanders teaches that recklessness is not just different from negligence in degree, but also in kind. In response to Checkosky II, the Commission clarified Rule 102(e). Under the clarification, Rule 102(e)(1)(iv)(A) covers a different (and more egregious) sort of professional misconduct than is embraced by Rule 102(e)(1)(iv)(B)(1) and (B)(2).
The audit of revenue and receivables did not involve a situation where Respondents performed "no audit at all," in the wording of Price Waterhouse. If the proven GAAS violations in the audit of revenue and accounts receivables are considered collectively, they do not demonstrate recklessness under Rule 102(e)(1)(iv)(A). All charges relating to the allegedly reckless audit of revenues and accounts receivable are therefore dismissed.
8. The weight of the evidence fails to establish that Respondents' staffing decisions, the hours they budgeted for the audit, and their purported unfamiliarity with CMD's business violated GAAS. Respondents' supervision of certain aspects of field work violated GAAS, but the violations were not shown to be reckless.
Allegations. The OIP alleges that Marrie chose to assign inexperienced staff and to decrease budgeted hours on the 1994 CMD audit in an effort to keep down C&L's costs (OIP ¶¶ II.D.9, II.D.10). It further charges that neither Marrie nor Berry understood key aspects of CMD's business (OIP ¶ II.D.10). Finally, the OIP asserts that both Respondents violated GAAS by failing adequately to supervise field work (OIP ¶ II.D.11).
Several of these allegations were brushed off by the Division's own expert witness, or were simply abandoned. As a result, only the failure to supervise allegation remains as an issue for decision.
There is no longer a dispute about the technical training and proficiency of the junior auditors. Ten Eyck opined that the staff on the 1994 audit was sufficient in number and had suitable credentials and experience for their positions (RX 405 at 8). Regan did not opine that the junior auditors were unqualified to perform their assigned duties, but only that their relative lack of experience required Marrie and Berry to provide more extensive supervision of their work (Tr. 715-18). Nor is there any remaining dispute about the reduction in audit hours budgeted from 1993 to 1994. Regan did not reach an opinion as to the number of hours required to conduct an adequate audit of CMD and his report was not predicated on a failure by Respondents to allocate a sufficient number of hours to the 1994 audit (Tr. 770-71). In any event, the Division's argument that Marrie was motivated to cut corners finds little support in the case law. A long line of cases, including Melder, DiLeo, Health Management, and Price Waterhouse, establishes that assumptions about an auditor's financial self-interest alone will not support a finding of scienter.
The Division offered no evidence to support the OIP's sweeping claim that Marrie and Berry did not understand CMD's business. In contradiction to the OIP, Regan believed it "evident" that the auditors were aware of CMD's right of return policy (DX 89, binder 1, tab 1 at 8-9). The record shows that Marrie discussed return reserves with the audit committee (Tr. 61-62), while Berry reviewed and initialed the distributor agreement and international distributor agreement (JX 22 (cover sheet)). Those documents discussed CMD's return policies.
Applicable professional standards. The first general standard of GAAS states that the audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor. AU §§ 150.02, 210.01. The junior assistant, just entering upon an auditing career, must obtain his professional experience with the proper supervision and review of his work by a more experienced superior. The nature and extent of supervision and review must necessarily reflect wide variances in practice. The auditor charged with final responsibility for the engagement must exercise a seasoned judgment in the varying degrees of his supervision and review of the work done and judgment exercised by his subordinates, who in turn must meet the responsibility attaching to the varying gradations and functions of their work. AU § 210.03.
Supervision involves directing the efforts of assistants who are involved in accomplishing the objectives of the audit and determining whether those objectives were accomplished. AU § 311.11. Elements of supervision include instructing assistants, keeping informed of significant problems encountered, reviewing the work performed, and dealing with differences of opinion among firm personnel. Id. The extent of supervision appropriate in a given instance depends on many factors, including the complexity of the subject matter and the qualifications of the persons performing the work. Id.
Assistants should be informed of their responsibilities and the objectives of the procedures that they are to perform. They should be informed of matters that may affect the nature, extent, and timing of procedures they are to perform, such as the nature of the entity's business as it relates to their assignments and possible accounting and auditing problems. The auditor with final responsibility for the audit should direct assistants to bring to his attention significant accounting and auditing questions raised during the audit so that he may assess their significance. AU § 311.12. The work performed by each assistant should be reviewed to determine whether it was adequately performed and to evaluate whether the results are consistent with the conclusions to be presented in the auditor's report. AU § 311.13.
Conclusions. As to the supervision of field work, the record demonstrates that Schindele discussed audit issues frequently with Marrie and Berry (Tr. 424-25, 473). Marrie was on-site at Tempe ten to twenty times during the audit, although he spent most of that time with Romito (Tr. 21, 60-61). Berry was also on-site several times and Jenson had access to him if there was a question (Tr. 403). The expert witnesses disagreed about whether this was sufficient supervision. Ten Eyck opined that the junior auditors had adequate opportunities to raise issues and voice concerns during the audit (RX 405 at 6-7). Regan expressed the view that GAAS required more. In his judgment, Marrie and Berry needed to provide positive supervision, direction, and influence to the junior auditors, not just reactive supervision (Tr. 1005-06, 1155-64).
There is no evidence that the junior auditors spent more time on field work than had been budgeted and thus no basis to infer that they had encountered difficulties they were unable to resolve. There is no evidence that Marrie and Berry were preoccupied with other matters during the CMD audit or were otherwise distracted from supervising Jenson and Schindele.
I do not agree with Regan's apparent suggestion that Marrie and Berry needed to sit right next to the junior auditors to provide direct assistance during the field work. I do agree with the Division that Respondents provided inadequate supervision as to certain discrete aspects of the field work: (1) they failed to inform Jenson about revenue cutoff problems encountered in prior audits; (2) Berry failed to go beyond the four-page summary when reviewing Schindele's work on customer confirmation responses and her performance of alternative procedures; (3) Marrie and Berry failed to insist that the junior auditors obtain additional evidential support to confirm management's representation that virtually all returns occurred within two months of a sale; and (4) Marrie and Berry failed carefully to review the junior auditors' calculation of the allowance for product returns.
These supervisory failures involved matters of professional judgment. I conclude that the supervisory failures were negligent, but not reckless.56 The charges in OIP ¶¶ II.D.9-II.D.11 are therefore dismissed.
RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on August 31, 2000, as amended on September 25, 2000.
ORDER
Based on the findings and conclusions set forth above, IT IS ORDERED that the proceeding against Respondents Michael J. Marrie, CPA, and Brian L. Berry, CPA, is dismissed.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this Initial Decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the Initial Decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this Initial Decision as to that party. If a party timely files a petition for review, or the Commission acts to review as to a party, the Initial Decision shall not become final as to that party.
_________________________
James T. Kelly
Administrative Law Judge
| 1 | "Generally accepted accounting principles" are the basic postulates and broad principles of accounting pertaining to business enterprises. These principles establish guidelines for measuring, recording, and classifying the transactions of a business entity. "Generally accepted auditing standards" are the standards prescribed for the conduct of auditors in the performance of an examination of management's financial statements. See SEC v. Arthur Young & Co., 590 F.2d 785, 788 nn.2 & 4 (9th Cir. 1979). |
| 2 | On April 14, 2000, the parties submitted a joint list of proposed corrections to the hearing transcript. The proposed changes are hereby accepted. The answers to the OIP will be cited in this Initial Decision as "Marrie Answer ___," "Berry Answer ___," or, if both are cited, as "Answers ___." The hearing transcript, as corrected, will be cited as "Tr. ___." The Division's exhibits, Respondents' exhibits, and the parties' Joint Exhibits will be cited herein as "DX ___," "RX ___," and "JX ___," respectively. The May 11, 2000, deposition of Carl A. Thomsen will be cited as "Thomsen Dep. ___." The Division's Proposed Findings of Fact and Conclusions of Law and the Division's Posthearing Brief, both dated June 13, 2000, will be cited herein as "Div. Prop. Find. ___" and "Div. Br. ___," respectively. Respondents' Proposed Findings of Fact and Conclusions of Law, dated July 17, 2000, will be cited as "Resp. Prop. Find. ___." The corrected copy of Respondents' Posthearing Brief, dated July 26, 2000, will be cited as "Resp. Br. ___." The Division's Reply Brief, dated August 1, 2000, will be cited as "Div. Reply Br. ___." |
| 3 | CMD filed its quarterly reports with the Commission and official notice of those documents is permissible under Rule 323 of the Commission's Rules of Practice, 17 C.F.R. § 201.323. CMD filed its Form 10-Q for the first quarter of fiscal year 1994 on November 15, 1993 (First Quarter 10-Q). It filed its Form 10-Q for the second quarter of fiscal year 1994 on February 14, 1994 (Second Quarter 10-Q). It filed its Form 10-Q for the third quarter of fiscal year 1994 on May 16, 1994 (Third Quarter 10-Q). |
| 4 | Days sales outstanding is a standard financial calculation that measures the age of a company's oldest uncollected account receivable (Thomsen Dep. at 17). |
| 5 | Distributors and resellers sometimes delay placing orders until the end of a reporting period in an effort to negotiate a better price on purchases from suppliers that they know want to report good sales performance. The practice may result in a normal pattern of increased sales volume at the end of a reporting period. See American Institute of Certified Public Accountants (AICPA) Staff Publication, Audit Issues In Revenue Recognition 23 (1999). |
| 6 | A late surge in sales at the end of a reporting period is known as the "hockey stick" effect, because a graph of quarterly sales revenue resembles a slightly inclined hockey stick. Cf. Fecht v. Northern Telecom, Ltd., 116 F. Supp. 2d 446, 452 (S.D.N.Y. 2000); Bentley v. Legent Corp., 849 F. Supp. 429, 432 (E.D. Va. 1994), aff'd, 50 F.3d 6 (4th Cir. 1995). |
| 7 | Respondents urge me to give weight to Kidder Peabody's research report (Resp. Prop. Find. ## 86, 125, 213; Resp. Br. at 6). However, the Commission has recently expressed its concern about the independence of stock analysts and it is examining whether analysts give overly optimistic ratings on the shares of companies that have investment banking relationships with the analysts' employers. See SEC, Investor Alert: Analyzing Analyst Recommendations (modified July 13, 2001), available at http://www.sec.gov/investor/pubs/analysts.htm. Kidder Peabody had such a relationship with CMD here, although a witness from Kidder Peabody insisted that the firm maintained separation between its research analysts and its investment bankers (Tr. 878, 890, 894). The research report will be considered with this concern in mind. |
| 8 | Romito testified that Stan Johnson permitted CMD to pull in out-of-period revenues when he was the engagement partner in charge of the 1990 and 1991 audits, and that Marrie acquiesced in the practice after he became the engagement partner in charge of the 1992 and 1993 audits (Tr. 518-21). Marrie denied the accusation (Tr. 81-82, 106-07; DX 83 at 1-2). Although the OIP does not raise any allegations about improper professional conduct during the audits before 1994, the dispute is relevant to Marrie's state of mind during the 1994 audit. Romito is a convicted felon, and the parts of his testimony that attempted to shift responsibility to others for the revenue recognition practices at CMD were unpersuasive. Based on my observation of his demeanor, I found Romito to be only marginally credible. The Division has failed to prove, by the weight of the credible evidence, that Marrie permitted CMD to pull in out-of-period revenues during the 1992 and 1993 audits. |
| 9 | Although the audit committee was supposed to function as an independent check on management, Desaigoudar, CMD's chief executive officer and controlling shareholder, was chairman of the audit committee (DX 15 at 31). The other members of the audit committee were outside directors. |
| 10 | Wade Meyercord (Meyercord), an independent director and member of CMD's audit committee, recalled that C&L's representatives were only present at the meeting for a short time (Tr. 915). Marrie's account of the meeting suggested a more extensive dialogue (Tr. 62-63, 80-81). The minutes of the meeting, which stated that C&L presented a "comprehensive report," supported Marrie (JX 1 at 215). |
| 11 | Marrie and Romito testified that the audit fees for 1994 were the same as the audit fees for 1993 (Tr. 79, 578). However, contemporaneous documents show that C&L's fee was $92,750 for the 1992 audit and $97,000 for the 1993 audit (DX 89, binder 1, tab 6 at 1, 8). Because Marrie's memory was faulty on this subject (Tr. 44), I give more weight to the contemporaneous documents. |
| 12 | C&L long considered the CMD audit to be a messy engagement because CMD's accounting office was chronically understaffed and its personnel were not very timely in presenting documents (Tr. 92-93; DX 84 at 1, DX 89, binder 1, tab 6 at 5, 7). In prior years, numerous reconciling items had been recorded (DX 16 at 37). The engagement letter for the 1994 audit informed CMD that there had been delays in receiving necessary information during the 1993 audit and it identified a lack of an adequate number of CMD accounting personnel as the principal cause (JX 28 at 1780 item 9). The letter specifically required CMD to provide audit schedules and supporting information in a timely manner. It stated that, if CMD was unable to do so, C&L would adjust its estimated fee to reflect the additional services required of it (JX 1 at 120). Romito attempted to increase CMD's accounting staff during fiscal year 1994, but he was not successful. He never told C&L otherwise (Tr. 558-60). |
| 13 | Newman had worked on the 1993 audit (Tr. 32-33, 41). He was scheduled to be the accountant in charge of the 1994 audit, but Schindele replaced him after he left C&L for other employment (Tr. 242, 328, 415). Schindele testified that Newman observed "part" of the physical inventory at CMD's Milpitas plant (Tr. 415). Marrie testified that someone observed the inventory count, but he did not know who that was (Tr. 54, 56). Berry was not sure either (Tr. 241-42). |
| 14 | To appreciate the magnitude of the write-off, one need only recall that CMD's Third Quarter 10-Q reported accounts receivable at $19.3 million. At the hearing, Marrie could not recall telling the FBI that he was dumbfounded (Tr. 121). I find his purported amnesia on this point incredible. |
| 15 | At the time, Romito thought that CMD was engaged in zealous sales practices, but not dishonest activity (Tr. 581-82). I find his testimony incredible. Romito did not alert Marrie to any management integrity issues (Tr. 581-82). |
| 16 | Respondents object to the Division's assertion that they turned a blind eye to CMD's attempt to manipulate the accounting for the Hitachi Metals transaction (Div. Prehearing Br. at 19-20, 22; Tr. 64-67, 118-19). Neither the OIP nor the Division's expert witness report challenged this aspect of the audit. I agree with Respondents that the issue is beyond the scope of the OIP. |
| 17 | Ken Kannapan (Kannapan), the lead investment banker for Kidder Peabody, was struck by the similarity between the amount of the write-off and the amount of revenue recognized from the Hitachi Metals transaction and he found it very hard to believe that the numbers would net out by happenstance (Tr. 884). Kannapan was quite shocked that a write-off of that magnitude was required and he felt that it called into question how CMD got into that position in the first place (Tr. 884-85). |
| 18 | See letter from Joni T. Hiramoto, Commission staff attorney, to David McClean, an attorney with C&L, dated September 30, 1994, and filed as Exhibit B to Respondents' Request for Leave to File Motion for Summary Disposition, dated January 24, 2000. The Division had opened its informal investigation on August 8, 1994 (Div. Opposition to Issuance of Subpoenas at 5, dated February 17, 2000). |
| 19 | Thomsen did not conduct an audit; in fact, his CPA license was inactive at the time (Thomsen Dep. at 5-6, 51). Thomsen met with Marrie at least twice and spoke with Marrie by telephone, but he could not recall the substance of those discussions (Thomsen Dep. at 46, 48, 62; DX 3 at 653, 659-61). Thomsen may have looked at some of C&L's work papers, but he did not read them all (Thomsen Dep. 26, 55-56). Although Thomsen testified that he did not evaluate C&L's audit (Thomsen Dep. at 26), his diary notes suggest otherwise (RX 374 at 632 ("C&L did an adequate audit-probably")). |
| 20 | From October 1994 through January 1995, CMD's board of directors cleaned house, terminating several officers and appointing replacements (JX 20 at 50). By late January 1995, new management was in place. |
| 21 | See CMD's Form 10-Q for the first quarter of fiscal year 1995, filed with the Commission on February 6, 1995 (official notice). |
| 22 | E&Y's letter of February 3, 1995, which was included in CMD's Form 10-K/A, stated: "We have not conducted an audit in accordance with [GAAS] of any financial statements of [CMD] as of any date or for any period" (JX 20 at 55). |
| 23 | CMD's 1995 Annual Report contained audited financial statements for the nine-month period ending March 31, 1995 (JX 21). Those audited financial statements also presented the restated fiscal year 1994 results on a comparative basis with the current period. On February 3, 1995, E&Y had already disclaimed an opinion on CMD's restated fiscal year 1994 financials (JX 20 at 55). Nonetheless, on May 19, 1995, E&Y offered an audit opinion on the same restated 1994 financials (JX 21 at 18). JX 21 at 12 stated that, because C&L withdrew its reports, the restated revenues and restated net loss for fiscal year 1994 were unaudited. JX 21 at 22 note 2 stated that, because C&L withdrew its reports, CMD's "statements of operations, shareholders' equity, and cash flows for the years ended June 30, 1994 and 1993 [were] unaudited." JX 21 at 37 note 1 stated that the allowance for doubtful accounts for fiscal year 1994 was unaudited. Section 508 of the Codification of Statements on Auditing Standards (AU § 508), published by the Auditing Standards Board of the AICPA, discusses reports on audited financial statements. AU § 508.73 provides that piecemeal opinions (expressions of opinions as to certain identified items in financial statements) should not be expressed after the auditor has already disclaimed an opinion on the financial statements taken as a whole because the piecemeal opinion tends to overshadow or contradict the disclaimer of opinion. See also AU §§ 508.77-.78. Because E&Y's report of May 19, 1995, contained so many caveats about the restated 1994 financials, it is tantamount to a piecemeal opinion. Under the circumstances, the auditor's certification cannot speak for itself. The Division did not present testimony from an E&Y auditor who could explain the scope of the audit procedures that E&Y may have performed on the fiscal year 1994 balance sheet between the February 3, 1995, disclaimer of opinion and the May 19, 1995, piecemeal opinion. |
| 24 | I reject Respondents' claim that the last three pages of DX 86 are unreliable and entitled to no evidentiary weight (Resp. Prop. Find. # 30 n.17). Respondents correctly observe that Hamm, who was the only witness to testify regarding the document, was unclear as to when those pages were drafted or whether they were ever finalized. The record establishes that the human resources director for C&L's Los Angeles cluster prepared the draft at Hamm's instruction and that Hamm "probably" reviewed it (Tr. 1492, 1497, 1502). The technical review partner for C&L's Los Angeles cluster provided the underlying information (Tr. 1493-94). Furthermore, Hamm believed the draft to have been accurate as of the time it was created (Tr. 1495-96). The draft pages are entitled to limited weight. |
| 25 | While settlements are of dubious precedential value, Lester Witte is the only Commission action of which I am aware to consider AU § 530. The proposed rule on mandatory peer review was never adopted. |
| 26 | September 27, 1994, the date the Division asserts that Marrie released the audit report, and September 29, 1994, the date that CMD filed its Form 10-K with the Commission, cannot properly serve as the "claim accrual date" for purposes of 28 U.S.C. § 2462. Those dates are inconsistent with AU § 530.02. |
| 27 | Marrie and Berry attempt to establish the Division's lack of diligence in several ways. First, they fault the Division for failing to gather investigative testimony from C&L employees until January 1998. They assert that, by then, the engagement team's recollection of facts about the 1994 audit had diminished significantly. Second, they maintain that Marrie was the victim of lulling conduct by the Assistant U. S. Attorney who prosecuted Henke and Desaigoudar. To persuade Marrie to cooperate as a witness in the criminal case, the prosecutor purportedly told him: "Don't worry, I'll take care of the SEC." Third, they claim that the Division never raised the charge of improper professional conduct until after the criminal trial against Henke and Desaigoudar was finished. The jury returned a verdict in July 1998 and Judge Walker pronounced sentences in December 1998. Respondents state that they were first notified of the prospect of a Rule 102(e) proceeding in January 1999. Fourth, they allege that the Commission postponed this disciplinary proceeding until after it revised Rule 102(e) in October 1998. Fifth, they assert that the Division vacillated among different theories of negligence and causation before ultimately settling on a recklessness theory, further delaying the institution of the proceeding until August 1999. The weight of the evidence does not support Respondents' claim that Crowe, the former Assistant U. S. Attorney, lulled Marrie into complacency by assuring Marrie that he would "take care of the SEC" (Tr. 1290-99). Ironically, that conclusion is compelled by the fact that Crowe's recollection of the relevant conversations was dim (Tr. 1292-93). In any event, Crowe lacked the authority to bind the Commission, and Respondents could not reasonably have relied on such assurances. The Division has remarkably little to say about Respondents' lack-of-diligence charges. It acknowledges pursuing other CMD claims before turning to Respondents. It observes, correctly, that the Commission has discretion to commence enforcement actions and disciplinary proceedings in any order that it chooses (Div. Reply Br. at 20). It assumes, wrongly, that the choice lacks collateral consequences. See Johnson, 87 F.3d at 490 n.9 ("If the SEC really viewed Johnson as a clear and present danger to the public, it is inexplicable why it waited more than five years to begin the proceedings to suspend her."); id. at 492 n.14 ("[O]nce the SEC has delayed more than five years in proceeding against a broker it considers a grave threat to the public, the bulk of the harm has already been done."). |
| 28 | Administrative disciplinary proceedings against accountants originate with a recommendation to the Commission by the Office of the Chief Accountant. See 17 C.F.R. § 200.22. Until December 1993, the Office of General Counsel handled the prosecution. The Commission then transferred prosecution responsibility to the Division. See SEC News Release No. 93-62 (Dec. 9, 1993). The rule was renumbered as Rule 102(e) in 1995 as part of a comprehensive revision of the Rules of Practice, but was not changed in substance. See Rules of Practice, 59 SEC Docket 1546, 1554-55 (June 9, 1995). |
| 29 | Little guidance comes from the OIPs in comparable cases, alleging pre-1998 reckless professional conduct by accountants, but issued after the 1998 rule amendment. Like the present OIP, the OIP in Scott E. Edwards, CPA, Admin. Proc. 3-10220 (June 8, 2000) at ¶ 28, also invoked Rule 102(e)(1)(iv)(A). In contrast, the OIPs in Barry C. Scutillo, CPA, Admin. Proc. 3-9863 (Apr. 1, 1999), and Carroll A. Wallace, CPA, Admin. Proc. 3-9862 (Apr. 1, 1999), cited only to Rule 102(e)(1)(ii), but did not invoke Rule 102(e)(1)(iv)(A). |
| 30 | Respondents rely on a decision by a panel of the Ninth Circuit stating that recklessness must be "deliberate" or "conscious" (Resp. Br. at 22-23). The panel did not define the terms and did not make clear whether its "deliberate recklessness" requirement differed in any respect from Sunstrand or Hollinger. See In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 974-75 & n.3 (9th Cir.), reh'g denied, 195 F.3d 521 (1999). The panel majority's use of these terms has been criticized by a strong dissent, see 183 F.3d at 991-96, by five judges dissenting from the denial of rehearing en banc, see 195 F.3d at 522, and by other circuits, see Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1281-84 & n.21 (11th Cir. 1999); Greebel v. FTP Software, Inc., 194 F.3d 185, 199-201 (1st Cir. 1999). Subsequently, the Ninth Circuit explained that the Private Securities Litigation Reform Act of 1995 (PSLRA) "did not alter the substantive requirements for scienter" under the antifraud provisions of the securities laws and that scienter includes recklessness, defined as courts of appeals have traditionally defined it. Howard v. Everex Sys., Inc., 228 F.3d 1057, 1063-64 (9th Cir. 2000). |
| 31 | Private plaintiffs alleging securities fraud filed most of the cited cases. Many of the decisions involved rulings on motions to dismiss complaints under Federal Rule of Civil Procedure 9(b) (failure to plead fraud with particularity). Others involved rulings on motions to dismiss complaints under the heightened pleading requirements of PSLRA. None involved adjudications under Rule 102(e). While the PSLRA creates new pleading standards applicable to private plaintiffs distinct from the pleading standards governing the Division, there has been no change in the substantive law regarding what constitutes scienter under the federal securities laws. The Division might not be precluded from initiating or maintaining an antifraud case as easily as an ordinary civil plaintiff, but it is not sufficient for the Division to rest its case on evidence of scienter that would be inadequate to plead or prove a case in a civil antifraud suit under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. A ruling to the contrary would render meaningless the Commission's representation, with regard to Rule 102(e)(1)(iv)(A), that "for purposes of consistency under the federal securities laws, `recklessness' in subparagraph (A) of the rule amendment should mean the same thing as courts have defined `recklessness' to mean under the antifraud provisions" of the federal securities laws. See Rule Amendment, 68 SEC Docket at 710. |
| 32 | Report of the Task Force on Rule 102(e) Proceedings: Rule 102(e) Sanctions Against Accountants, 52 Bus. Law. 965, 987 n.84 (May 1997) (Task Force Report). Neither Marrie nor Berry has audited public companies for several years. Berry performs GAAP duties for his current employer. |
| 33 | See Rule Amendment, 68 SEC Docket at 721 (Johnson, Comm'r, dissenting) ("I support the intentional or reckless part of the amendment without reservation. As to that part addressing a pattern of negligence, I would generally reach the same result as the majority, but through a different analysis [i.e.,] . . . only if the pattern of negligence supports an inference that the accountant acted recklessly.") (footnote omitted). |
| 34 | C&L acknowledged that certain clients for whom the firm provided assurance services may require special attention because they present an increased risk to the users of the firm's work product and/or to the firm itself (DX 43 at § 51310.1). Under C&L's internal policy, either the engagement partner or the assurance partner-in-charge was authorized to determine that special attention was required. In such situations, either partner could take any number of actions, including changing or supplementing the engagement personnel to provide greater experience or additional industry expertise, communicating issues to the client's audit committee or board of directors, increasing fees, requiring additional levels of review, or terminating the relationship with the client (DX 43 at § 51310.2). Adding a client to the special attention list required approval of C&L's client service vice chairman (DX 43 at §§ 51308.5, 51310.3). |
| 35 | AU § 339.01 provides that the information contained in the work papers constitutes the principal record of the work that the auditor has done and the conclusions that he has reached concerning significant matters. Under AU § 339.05(c), work papers should ordinarily include documentation showing that the 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. However, note 3 to AU § 339.01 could not be clearer: "There is no intention to imply that the auditor would be precluded from supporting his report by other means in addition to work[ ] papers." See Carroll A. Wallace, CPA, 73 SEC Docket 3969, 4022 n.37 (Dec. 18, 2000), petition for review granted (holding that if an auditor cannot show through documentation that he obtained sufficient competent evidential matter, he may still do so through credible testimony). The Division's pleadings blur the question of whether Respondents are alleged to have violated AU § 339, or C&LAAM, or both (Div. Reply Br. at 9). |
| 36 | The Division repeatedly invokes the provisions of C&LAAM to make its case (Div. Prop. Find. ## 3, 34, 41, 85, 101, 102, 104, 106, 107, 118, 120). Even when the Division does not cite to C&LAAM, it relies on Respondents' failure to provide the additional documentation in the work papers that C&LAAM requires (Div. Prop. Find. ## 126, 127, 129, 135, 141, 142, 173, 185, 187). |
| 37 | One decision allowed the plaintiff to obtain internal accounting manuals during pretrial discovery, but specifically left open the issue of whether the manuals or any testimony about them would be admissible at trial. See Fields v. Oliver's Stores, Inc., 1990 U.S. Dist. LEXIS 2271, *3 (S.D.N.Y. Mar. 2, 1990). Fields was found to be unpersuasive in Tonnemacher, 155 F.R.D. at 195. |
| 38 | Given the lack of reliable evidence that Brian Newman played any role in the 1994 audit, I do not give much weight to Marrie's speculation that the individual who observed the physical inventory in Milpitas also observed the magnetic head equipment (Tr. 54, 56, 71-72). See supra note 13. |
| 39 | Both Malone and Krouner involved the application of Rule 407 of the Federal Rules of Evidence (subsequent remedial measures are inadmissible to prove negligence or culpable conduct in connection with the event that prompted the measures). The Commission has invoked Federal Rule of Evidence 407 in a disciplinary proceeding brought under former Rule 2(e). See Peat, Marwick, Mitchell & Co., 45 S.E.C. 789, 871 n.95 (1975) (settled case). Other agencies also apply Federal Rule of Evidence 407 in their administrative proceedings. See, e.g., 29 C.F.R. § 18.407 (Dept. of Labor). |
| 40 | The audited balance sheet included in CMD's Form 10-K for the period ending March 31, 1995, also presented the restated balance sheet for fiscal year 1994 for comparative purposes. See supra note 23. The Division presented no evidence as to how E&Y was able to express an opinion on the restated balance sheet value of property and equipment as of June 30, 1994, after it had already disclaimed an opinion on that restatement (JX 20 at 55, JX 21 at 18). |
| 41 | In a "big bath" write-off, a company manipulates its financial statements to make poor results look even worse in a bad year, so as to enhance the next year's earnings. By doing so, new management is able to blame the poor results on the previous management (Tr. 765-69, 772-74, 1001-02). See SEC, Remarks by Chairman Levitt at the New York University Center for Law and Business, The "Numbers Game" (Sept. 28, 1998), at 3-4, available at http://www.sec.gov/news/speech/speecharchive/1998/spch220.txt:
Problems arise, however, when we see large charges associated with companies restructuring. These charges help companies "clean up" their balance sheets-giving them a so-called "big bath." . . . [I]f these charges are conservatively estimated with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates change or future earnings fall short. |
| 42 | The Division also argues that Respondents failed to conduct the audit with an attitude of independence when they failed to test inventory obsolescence and other matters (DX 89, binder 1, tab 1 at 24, 36, 41-42; Div. Br. at 4, 13). The OIP did not identify any alleged violations of the auditor independence standards. Accordingly, the Division's effort to inject auditor independence issues into the case is specifically rejected. See Ponce, 73 SEC Docket at 464 n.49 (refusing to consider the Division's allegation about improper professional conduct by an accountant when the conduct at issue had not been identified in the OIP). |
| 43 | When inventory quantities are determined solely by means of a physical count, and all counts are made as of the balance-sheet date or as of a single date within a reasonable time before or after the balance-sheet date, it is ordinarily necessary for the independent auditor to be present at the time of count. AU § 331.09. By suitable observation, tests, and inquiries, the auditor should satisfy himself respecting the effectiveness of the methods of inventory-taking and the measure of reliance which may be placed upon the client's representations about the quantities and physical condition of the inventories. Id. |
| 44 | For example, no one from CMD ever told Thomsen that C&L did not discuss obsolete or slow-moving inventory with CMD during the audit (Thomsen Dep. at 62). |
| 45 | As an illustration, C&L voiced no exception to the 75% reserve that CMD took against Part No. 8880. The Division contends that, because CMD had not sold that part in the past year, the appropriate reserve should have been 100% (Tr. 286-90; JX 10 at 900). CMD held 478,804 units of Part No. 8880 in inventory as of June 30, 1994, and a 100% reserve would have cut the inventory valuation by $316,174. Several months after the audit, Thomson identified a potential customer that would purchase 50,000 units per month of Part No. 8880 (DX 92 at 8). He nonetheless recommended a 100% reserve because the current stock was quite old (DX 92 at 8). |
| 46 | Paragraph 31 of APB Opinion No. 20 states in relevant part: "The Board concludes that the effect of a change in accounting estimate should be accounted for in (a) the period of change if the change affects that period only or (b) the period of change and future periods if the change affects both. A change in an estimate should not be accounted for by restating amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods." |
| 47 | The Division's emphasis on CMD's negative cash flow is reminiscent of the claims that certain parties advanced when they were pressing Judge Walker to approve the cash-poor settlement proposal in CMD I, 168 F.R.D. at 266-70 (dire warnings of CMD's grave financial condition and imminent bankruptcy). Judge Walker was unimpressed with the argument and rejected the settlement proposal. |
| 48 | The Division strays well beyond the allegations in OIP ¶¶ II.D.24-II.D.28 when it argues that customers who confirmed the balance due without exception also raised red flags warranting further inquiry (Tr. 1060-61, 1152-53, 1190; JX 9 at 750, 764; Div. Prop. Find. # 147). |
| 49 | Regan opined that the auditors blundered in designing the confirmation letter, which asked customers to confirm only the dollar amount of outstanding receivables. In Regan's judgment, the letter also should have asked customers to confirm the substantive terms of the underlying transactions (DX 89, binder 1, tab 1 at 23-25). Regan further observed that many of the confirmation responses were received by facsimile, but there was no evidence that the auditors had attempted to validate the source of the responses. He viewed the entire confirmation process as seriously flawed, in violation of GAAS (DX 89, binder 1, tab 1 at 25-32). In so opining, Regan wandered far beyond the narrow issues identified in paragraphs II.D.24 to II.D.28 of the OIP. The only relevant inquiry for this aspect of the OIP is whether the auditors violated GAAS when evaluating the results of the confirmation procedures for the identified suspect responses. |
| 50 | Respondents cannot rely on the fact that C&L reviewed CMD's subsequent collections for certain customers, including Analogic (Resp. Prop. Find. # 158). The work papers did not identify subsequent collection activity as an alternative confirmation procedure Schindele had performed for Analogic (JX 9 at 739). In addition, the auditors conducted their cash collection review as of August 15, 1994. This predated Analogic's confirmation response of August 18, 1994. |
| 51 | The burden of proving recklessness remains on the Division throughout the proceeding. However, once the Division demonstrated that CMD's shipments to Solectron and Analogic took an unusually long time in transit, that created an inference that Respondents failed to exercise professional skepticism and obtain sufficient competent evidential matter. The burden then shifted to Respondents to prove otherwise. Respondents failed to present credible testimony or documentary evidence to show that they exercised an appropriate level of skepticism and obtained sufficient competent evidence when they accepted CMD's shipping documents as a satisfactory explanation for transit times of six to seven weeks. The shipping time of three and one-half weeks from CMD in Tempe to Charles Industries in Illinois is far weaker evidence of a violation of professional standards. I conclude that the Division has not met its burden of showing that the claimed transit time was implausible on its face. I further conclude that the auditors had adequate evidential support for treating the disputed shipment to Charles Industries as confirmed. |
| 52 | Given the allegation that CMD's sales revenues were non-linear, with most of its quarterly sales occurring late in a reporting period (OIP ¶¶ II.D.17, II.D.34), it is somewhat incongruent for the Division to argue that sales in the first month of the fourth quarter of fiscal year 1994 (April 1994) were large enough to skew the analysis to a meaningful extent. |
| 53 | Regan testified that an auditor cannot assume that customers will be truthful in confirmation requests (Tr. 951-58). In view of the evidence that Charles Industries "screamed bloody murder" over a shipment valued at only $3,880, that testimony was not persuasive. |
| 54 | E&Y later concluded that CMD had pulled in revenue of $2.1 million during fiscal year 1994 (DX 13 at 2131). However, that knowledge was gained only with the benefit of hindsight and with the cooperation of CMD's employees. |
| 55 | The "hockey stick effect" is not unknown to the Division. See Audit Report No. 253, Administrative Proceedings, Nov. 7, 1997, issued by the Commission's Office of the Inspector General. In that report, the Inspector General determined that, between fiscal years 1992 and 1996, 30% of the contested adjudicatory cases brought by the Division were initiated in September, the last month of the federal government's fiscal year. The Inspector General noted that there was no basis to presume that such cases were not meritorious simply because of their timing. Id. Just as there is nothing inherently suspect about the "hockey stick effect" when it involves the Division, so too, professional skepticism did not require Respondents to assume the worst when faced with the "hockey stick effect" at CMD. |
| 56 | Although scienter is not an element of a failure to supervise violation under the Exchange Act, the Commission considers the reasonableness of supervision when imposing sanctions. See Clarence Z. Wurts, 74 SEC Docket 2559, 2569 (Jan. 16, 2001). Under Rule 102(e)(1)(iv)(A), however, a violation of the applicable professional standards, including the supervisory provisions of GAAS, must be shown to be reckless. |
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