When Is Planning to Accelerate Earnings “Fraud”?

When Is Planning to Accelerate Earnings “Fraud”?

June 01, 2002

For public companies, events of recent months have spotlighted the question of when financial transactions having the effect of boosting revenues or earnings or reducing taxes may cross the line to constitute a fraud on shareholders or creditors.

Transactions designed to keep debt off a corporate balance sheet, accelerate the reporting of revenues or earnings, or generate losses for income tax purposes should be analyzed with extra care in light of the renewed attention being paid to certain of such arrangements by the Securities and Exchange Commission.

This article summarizes recent actions taken by the SEC in some of these matters.

Senior executives and general counsel of public companies should take particular care in evaluating proposed transactions whose primary effect may be viewed as revenue or earnings management without an independent business purpose or that may otherwise be viewed as potentially misleading to investors if not adequately disclosed.

Background

The collapse of Enron has served as a wake-up call for financial reporting in the energy industry.

In recent weeks, a number of major public energy companies have announced that they are restating their revenues and expenses to disregard so-called “wash” trades in which electricity was simultaneously sold and repurchased from a counterparty with essentially no financial risk or gain involved in the transactions. Other public energy companies have issued public statements as a result of the increased market scrutiny in this area denying that they engaged in such transactions.

The SEC has launched investigations into the use of certain financial arrangements, including in the case of Enron the alleged improper use of special purpose entities to keep large amounts of debt off the parent company’s balance sheet and lack of public disclosure of such transactions. Some companies have restated their balance sheets to bring formerly off-balance sheet debt onto the balance sheet.

The dollar amounts involved in many of these arrangements are huge. Restatements of revenues for some companies have involved billions of dollars of adjustments.

The energy industry is only the latest industry to face questions over the validity of financial reporting for certain types of transactions. In what is clearly a trend crossing several industries, a number of publicly-traded telecommunications companies also are being scrutinized for accounting practices related to alleged improper recognition of revenues in connection with sales of capacity on newly-constructed fiber-optic lines and swap transactions. The SEC has opened investigations into the financial reporting practices of firms such as Qwest Communications and Global Crossing Ltd. as well as Enron in connection with such arrangements.

Lines Drawn by the Law

A number of provisions in the federal securities laws and regulations address the accurate reporting of financial transactions.

Among them is section 13(a) of the Securities Exchange Act of 1934 — called the “Exchange Act” — and the related SEC rules that require issuers of securities registered with the SEC to file annual and quarterly reports with the SEC and to keep the reported information current. Courts have construed this requirement to mean that the reports must be true and correct.

Section 13(b)(2)(A) of the Exchange Act requires public companies to keep books and records that accurately and fairly reflect their transactions and dispositions of assets. SEC Rule 12b-20 requires the inclusion of any additional information that is necessary to make the required financial statements, in light of the circumstances in which they are made, not misleading. Courts have held that information regarding the financial condition of a public company is presumed to be material.

Section 13(b)(2)(B) of the Exchange Act requires public companies to maintain a system of internal accounting controls sufficient to provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, or “GAAP,” and to maintain accountability of assets. Financial statements included in SEC filings must comply with SEC Regulation S-X, which, in turn, requires that such statements be prepared in conformity with GAAP. The SEC’s enforcement actions related to alleged improper accounting for financial transactions by publicly-reporting companies frequently arise under these provisions.

In addition, SEC Rule 10b-5 makes it unlawful for any person, in connection with the purchase or sale of any security, to employ any device or scheme or engage in any act to defraud, or to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading. Section 10b-5 may be used by private litigants as well as the SEC to bring actions against issuers of securities, as well as officers and directors of such issuers, in connection with alleged accounting irregularities.

Good Rule of Thumb

A proposed transaction affecting the timing or amount of revenues or earnings should meet a two-pronged test from a legal point of view.

First, does the manner in which the proposed transaction is to be reported on the company’s financial statements comply with GAAP?

Second, even if the transaction as proposed to be reported complies with GAAP as a technical matter, does the proposed manner of reporting ensure that the transaction is fairly and adequately disclosed to investors when viewed from the broader perspective of the company’s overall business? Recent enforcement actions by the SEC and other Commission pronouncements show the importance of both parts of this test in evaluating a potential transaction.

In April 2002, Xerox Corporation agreed to pay a $10 million fine and signed a consent order with the SEC in connection with its practices in booking certain lease revenues, to settle an SEC complaint alleging that Xerox used so-called “accounting actions” to manage its earnings improperly and disguise its true operating performance over a four-year period. According to the SEC’s release, the use of the special “one-time actions” and other “accounting opportunities” were closely tracked by senior management and accounted for as much as 37% of Xerox’s operating profit during at least part of the period in question. The release noted that without those special accounting arrangements, Xerox’s earnings would have fallen short of market expectations, often by a wide margin, in almost every reporting period from 1997 through 1999.

Xerox’s accounting actions related largely to its leasing arrangements, which typically involved a single monthly payment under a bundled contract with the customer that covered three components: the lease of the equipment itself, a servicing component and a financing component. Under GAAP, Xerox was required to book revenue from the equipment component at the beginning of the lease, but was required to book revenue from the servicing and financing components over the term of the lease. According to the SEC’s complaint, Xerox used complex accounting actions to shift revenue that the company had historically allocated to the servicing and financing components of the leases to the equipment component, thereby increasing revenues and earnings in the near-term periods by material amounts.

The SEC alleged that “[i]n violation of GAAP, Xerox had failed to disclose these methodologies, and the numerous changes it made to them, to investors, creating the appearance that the company was earning much more from its sales of equipment than it actually was.” The complaint “alleges that the failure to disclose the changes in accounting methods and estimates was fraudulent.” Without admitting or denying the SEC’s charges, Xerox agreed as part of the settlement to restate its financial statements for the years 1997 through 2000 to make appropriate adjustments in the timing and allocation of its lease revenue recognition. It was also granted a 90-day extension to file its Form 10-K for the year 2001 to make similar adjustments.

Edison Schools, Inc., which operates public schools on a for-profit basis, recently settled charges with the SEC regarding alleged improper recognition of revenues and other securities law violations. Edison receives management fees from school districts in a stated per-pupil amount. Management contracts between Edison and the school districts generally provide that Edison is responsible for operating the schools from these fees. However, teachers in schools operated by Edison often remain employees of local school districts and are paid by the districts directly from funds withheld from the per-pupil payment to Edison.

Under GAAP, if Edison was deemed the primary obligor for the teacher salaries, it would be appropriate for Edison to report its revenues on a gross basis — in other words, to book as its revenues the total per-pupil amount including amounts paid directly by the school districts to the teachers. On the other hand, if Edison was not the primary obligor for the teacher salaries, Edison would have to report its revenues on a net basis, excluding the teacher payments from the per-pupil amounts.

In its SEC filings, Edison included as revenue all per-pupil fees that the districts were obligated to pay it under the management agreements, without disclosing that there was any set-off for teacher salary amounts that were paid directly by the school districts to teachers. Edison did report the offsetting expense for the teacher salaries, so there was no effect on Edison’s net income from reporting revenues on a gross rather than a net basis.

The SEC charged that Edison violated federal securities laws by failing to disclose that the teacher salary component of its revenues was never actually received by Edison but was paid directly by the school districts to the teachers, with the effect that Edison’s revenues were inflated by such amounts. The SEC determined that the school districts retained a level of control over the teachers’ salaries such that Edison was not a “primary obligor” with respect to the amounts and that, accordingly, the amounts should not have been included in Edison’s reported revenues — even though this practice did not affect reported earnings or income. The SEC noted, “technical compliance with GAAP in the financial statements will not insulate an issuer from enforcement action if it makes filings with the Commission that mischaracterize its business, or omit significant information.”

The SEC recently opened an investigation into the accounting practices of Global Crossing and Qwest with respect to recognition of revenues on their financial statements. One issue is the manner in which “round-tripping” transactions were booked. In one such situation, according to published reports, Qwest sold capacity on its US fiber optic network to Global Crossing for $200 million while Global Crossing sold capacity on its international fiber optic network to Qwest for the same amount. As reported, Qwest recorded its US capacity sales as operating revenue and then offset that amount completely by expensing its cost of purchasing the international capacity, while Global Crossing also booked the sale of its international capacity to Qwest as operating revenue but did not offset that amount by the amount Global Crossing paid for the US capacity. Instead, Global Crossing recorded its purchase of US capacity from Qwest as a capital expenditure on its balance sheet, with no offsetting immediate effect on its income statement. As reported, both companies claim that the accounting treatment given to their respective transactions complies with GAAP.

The head of accounting in the SEC’s enforcement division is quoted as saying that even if the transactions were reported in compliance with GAAP, if there is no business purpose in the round-tripping transactions, then the recording of revenues from the transactions could be “materially misleading” and, if the purpose of the transactions was to mislead investors and the impact of the transactions was material, the SEC could consider the transactions to be fraudulent.

Enron is also alleged to have inflated its revenues — by counting as revenues the value of transactions in which the same quantity of electricity or gas was sold and repurchased in multiple transactions without any profit or loss. Some of the transactions were between Enron and the supposedly independent partnerships that have been subject to scrutiny. Again, such transactions raise the question of whether there was any proper business purpose for the transactions, even if the accounting treatment given the transactions was appropriate.

Useful Reading

General counsel would be wise to read a US appeals court decision in a 1969 case called US v. Simon, 425 F.2d 796 (2d Cir. 1969), cert. denied, 90 S.Ct. 1235 (1970).

Simon involved an appeal of a criminal conviction of two partners and an associate of a major public accounting firm for preparing and certifying a false and misleading financial statement of a public company called Continental Vending. The issue before the lower court concerned the treatment in Continental’s financial statements of a receivable from an affiliated entity whose collectability was doubtful and the collateral for which was determined to be inadequate. Continental’s financial statements did not note these deficiencies in the quality of the receivable.

The accountants testified at trial that the treatment of the receivable was not inconsistent with GAAP. However, the trial judge instructed the jury that whether or not the accounting treatment of the receivable was permissible under GAAP was not dispositive; rather, the issue was whether the financial statements as a whole “fairly presented the financial position of Continental.”

In upholding the trial court’s determination, the US appeals court stated that “[g]enerally accepted accounting principles instruct an accountant what to do in the usual case where he has no reason to doubt that the affairs of the corporation are being honestly conducted. Once he has reason to believe that this basic assumption is false, an entirely different situation confronts him.... If ... he finds his suspicions to be confirmed, full disclosure must be the rule, unless he has made sure the wrong has been righted and procedures to avoid a repetition have been established. At least this must be true when the dishonesty he has discovered is not some minor peccadillo but a diversion so large as to imperil if not destroy the very solvency of the enterprise.”

The appeals court decision in Simon is important because it has been cited by SEC Chairman Harvey Pitt and other enforcement officials recently for the proposition that financial transactions, even if reported on a basis consistent with GAAP, may nonetheless be deemed misleading in violation of federal securities laws without adequate additional disclosures.

The SEC’s position in the Edison Schools matter is illustrative. Whether or not the accounting treatment of the portion of the per-pupil amounts paid by school districts directly to teachers was consistent with GAAP seems to have been considered less significant by the SEC than the fact that Edison did not disclose the existence of the arrangements in its public filings and the fact that the amounts were never actually received by Edison even if appropriately included in its revenues as an accounting matter.

The SEC noted that by including such amounts in its revenues, Edison was able to report significant gross revenues for providing educational services to school districts that in fact paid Edison relatively little cash. The SEC concluded that “the revenues reported as total Per Pupil Funding do not fully describe the realities of Edison’s operations.”

Similarly, the SEC’s complaint against Xerox asserted that the failure to disclose the specific accounting techniques used to enhance revenues at the outset of the leases created the misleading appearance that Xerox was earning much more from the transactions than it actually was.

Tax strategies used to increase corporate earnings have also come under increased scrutiny in the wake of the Enron collapse. A recent press report suggested that tax-related transactions accounted for as much as 30% of Enron’s earnings in the year 2000, based on information released by Enron’s tax department. It is an open question whether public companies that use highly aggressive tax strategies run the risk of being accused of inadequate disclosures in their financial statements if such strategies are not adequately explained.

Conclusion

The recent SEC actions against a number of companies, both in the energy industry and in other industries, show that the US government is taking a more aggressive posture with respect to financial transactions that may present a misleading picture of a company’s revenues or earnings without more detailed disclosures. The SEC is taking action even in situations where the accounting treatment for the transactions conforms to GAAP. Public companies must review proposed transactions to boost revenues or earnings from the broader perspective of the adequacy of the disclosures about such transactions to be made in the company’s SEC filings.