Business Ethics VII Essay

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28 CORPORATE FINANCE REVIEW JULY/AUGUST 2015

F ol l ow i n g ye a r s of d e c l i n e , t h e S E C i s i n c r e a s i n g a ccou nt i ng f r aud e n force - ment cases. Exhibit 1 shows the account ing f raud inves-

t igat ions opened by the SEC on a yearly basis. Likew ise, rest atements are dow n in s ome market seg ments (see Exhibit 2).

Wi t h S a r b a n e s – O x l e y a n d D o d d – Fr a n k , e ven SE C of f ic i a ls ag re e t hat t here has been progress. But those same officials a re u nw i l l i ng to conclude t hat accou nt - ing fraud has been reduced simply because of gover nance changes and cer t ificat ions.1

As a re su lt , i n 2 0 1 3 , t he SE C c re ate d t he Financial Repor t ing and Audit Task Force ( or F R Aud ) to i mprove t he a ge nc y’s abi l - it y to de te c t f r aud a nd pre ve nt f i na nc i a l rest atements. The announced fo cus of the t a s k force i nclude d t he fol low i ng : • l o s s r e s e r ve s a n d h ow m a n a g e m e nt

a n d au d i t o r s m a ke d e c i s i o n s w i t h r e s p e c t t o r e s e r ve s ;

• revenue recog nit ion (premature recog nit ion, percent age of complet ion issues, inflat ion of sales numb ers, and bi l ling for incomplete pro duc ts);

• au d i t o r i n d e p e n d e n c e ; • t h e s h i r k i n g o f r e s p o n s i b i l i t i e s

by au d i t c o m m i t t e e s ; a n d • au d i t o r s , i n c l u d i n g t h e w o r k o f

t h e e n g a g e m e nt p a r t n e r, t h e q u a l i t y r e v i e w e r, a n d t h e au d i t f i r m a s a w h o l e .

T he go a l of FR Aud w a s t o s h i f t f r o m e n force me nt me ch a - n i s m s t o p re ve nt i o n o f l o s s e s b y s h a r e - holders through care- f u l r e v i e w o f t h e overs i g ht f u nc t ion a s w e l l a s a n u n d e r - s t a n d i n g o f h o w f i n a n c i a l r e p o r t i n g de c i s ions a re m ade .

I n s h o r t , t h e t a s k force was tr y ing to come up w ith programs a nd d at a t hat cou ld pi np oi nt w he re com - p a n i e s h a d e t h i c a l i s s u e s i n f i n a n c i a l r e p o r t i n g a n d i n t e r v e n e b e f o r e t h o s e e t h i c a l i s s u e s r i p e n e d i nt o r e s t at e m e nt s o r f i n a n c i a l f r a u d a n d l o s s e s . No o n e w a ke s u p o n e d ay a n d d e c i d e s t o c a p i - t a l i z e m i l l i o n s i n o r d i n a r y e x p e n s e s , w h i c h w a s t h e a c c o u n t i n g f r a u d t h a t b r o u g ht d ow n Wo r l d C o m . No r d o C F O s a n d c o nt r o l l e r s d e c i d e t o s p i n 2 5 t o 5 0 p e r c e nt o f t h e i r c o mp a n i e s’ d e b t o f f t h e b o o k s , a s w a s t h e c a s e a t E n r o n a n d L e h m a n . R a t h e r, t h e S E C i s t r y i n g t o u n d e r s t a n d w h e n t h e i n i t i a l d e c i s i o n s a r e m a d e a s w e l l a s w h at t h e c o nve r s a - t i o n s l o o k l i ke o n c a p i t a l i z at i o n ve r s u s o r d i n a r y e x p e n s e s a n d o f f - t h e - b o o k s debt a nd t hen ex a m i ne w he t her s ome one i n t h e o v e r s i g ht f u n c t i o n i s r e v i e w i n g t h e s t r at e g y a n d r e s u l t i n g d e b at e s r e g - u l a r l y to f i n d t h o s e f a i nt s i g n a l s of f r au d in the incept ion. A fraud begins when eth- i c a l d e c i s i o n s a r e m a d e w i t h o u t c a r e f u l a n a l y s i s a n d a r e a l i t y c h e c k f o r w h e r e t a k i n g t h e f i r s t s t e p i nt o a g r ay a r e a c a n l e a d .

T h e fo l l ow i n g d i s c u s s i o n o f fe r s s o m e i ns i g ht s a nd che ck l i s t s for b ot h t he de c i - s i o n p r o c e s s e s a n d t h o s e i n v o l v e d i n o v e r s i g ht t o c o n s i d e r i n o r d e r t o p r e - ve nt t h e g r a du a l d e s c e nt i nt o f r au d .

What does the SEC accounting quality model look like? By 2 0 1 5 , t he F R Aud t a s k force h ad de vel - op e d s om e to ol s for ge t t i n g to f i n a n c i a l re p or t i n g i s s u e s i n t h e i r e t h i c a l d e b ate stages. Also called “Robocop” by the finan- c i a l pre s s , t h e F R Au d t a s k force h a s b e e n ab l e to de ve l op a compute r pro g r a m t h at

M A R I A N N E M . J E N N I N G S i s a p ro f e s s o r e m e r i t u s o f l e g a l an d e t hi c al s t u di e s in b u s in e s s at Ar i z on a State Unive r s it y. S h e re c e ive d an un d e r g ra du ate d e g re e i n f i n an c e an d h e r J. D. f ro m B r i g h a m Yo u n g Un i v e r s i t y, a n d s h e h a s d o n e c o n s u l t i n g w o r k f o r c o m p a n i e s s u c h a s M a t t e l , C o c a - C o l a , B l u e C r o s s B l u e S h i e l d , a n d I B M . Je n n i n g s h a s aut h o re d a nu m b e r o f j o u r n a l a r t i c l e s a n d s i x t e x t b o o k s , i n c lu d i n g C a s e S t u d i e s i n B u s i - n e s s Et h i c s ( 8 t h e d . ) a n d B u s i n e s s : It s L e g a l , Et h i c a l a n d G l o b a l E nv i r o n m e nt ( 1 0 t h e d . ) . S h e c a n b e re a c h e d b y e m ai l at m a r i a n n e . j e n n i n g s @ a s u . e du .

WHAT ACCOUNTING FRAUD LOOKS LIKE AT ITS INCEPTION: COULD YOU SEE IT IN YOUR OWN COMPANY?

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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

29ETHICAL ISSUES JULY/AUGUST 2015 CORPORATE FINANCE REVIEW

e x a m i n e s f i n a n c i a l re p o r t s fo r ou t l i e r s a n d ce r t a i n re d f l a g s i n t h o s e f i n a n c i a l re p or t s . T h e to ol i s on l y a s t a r t i n g p oi nt t h at a l l ow s for hu m a n - j u d g m e nt i nte r - vention based on program reviews that com- puters can quickly perfor m.2 The specifics of Rob o cop are not avai lable, but t he SEC has said that the prog ram al lows it to lo ok

EXHIBIT 1 Accounting Fraud Investigations Opened by the SEC on a Yearly Basis

Year Number of Accounting Fraud Investigations Opened by the SEC

2006 304

2007 228

2008 Numerous (The SECʼs annual report included only a summary of major enforcement cases, but no actual total number was given.)

2009 Only major enforcement actions listed; no overall number was given.

2010 681*

2011 735* (36 were related to financial disclosures by companies involved in the financial crisis.)

2012 79

2013 68

2014 99

* Changes in commissioners over this time frame resulted in different reporting methodologies. The 681 and 735 represent all SEC enforcement cases. The accounting cases were not called out separately in the annual report.

EXHIBIT 2 Restatements on a Yearly Basis*

Number of Year Restatements (Total)a 2006 1,784 2007 1,268 2008 929 2009 711 2010 817 2011 810 2012 738 2013 290b 2014 460

* Restatements appear to be increasing among companies with $75 million or more in capital- ization. Again, sources differ.

a There are slight discrepancies among these numbers. The author used numbers that appeared in more than one source.

b This figure is only for $75 million and above cap. Other figures in the exhibit are for all restatements.

at revenue recog nit ion, valuat ion of assets a n d o bl i g at ions , a n d t i m e l y a n d a cc u r ate d i s c l o s u re of i n for m at i on t o i nve s t or s . L o ok i n g at t h e s e i s s u e s h a s re s u lte d i n a s or t of e t h i c s cont i nu u m ( s e e E x h ibit 3 ) .

T h e i nte re s t i n g dy n a m i c of t h e con - t i nu u m i s t h at t ho s e w ho a re i nvolve d i n this devolution still view themselves as being b a ck i n t he re a s on able jud g me nt ph a s e . T he y s t i l l p e rce ive t he a c t ions t h at t he y are taking as debatable. The average length of t i me for t he cont i nu u m i s s e ve n ye a rs from its beginning to SEC action for fraud.3

T he s low - mov i ng qu a l it y of t he cont i n - uum is what makes fraud possible. The slip- p a ge i s g r adu a l a nd c a n l a s t ove r ch a nge s i n p e rs on nel , aud it com m it te e s t r u c t u re , a nd m a n a ge me nt . T ho s e w ho a re ne w i n the company star t f rom scratch in rev iew- i n g f i n a n c i a l re p or t s , a c c ou nt i n g pr a c - t ices , and are as of judg ment . It t a kes t ime for them to deter mine quest ionable areas. Those who remain w ith the company have b e come u s e d to t he pr a c t ice s .

What does the continuum look like in action? Ro b o c op o n l y g e t s u s t h e at - r i s k a r e a s . T h e g o a l o f t h e Ro b o c op m o d e l i s s p o t - t i n g p r o b l e m s b e f o r e t h e l o s s e s . P r e - vention of fraud requires us to step in after

30 CORPORATE FINANCE REVIEW JULY/AUGUST 2015 ETHICAL ISSUES

t h e a r e a o f r i s k i s d e t e r m i n e d , a n d t h i s p h a s e of t h e c o nt i nu u m i s i mp o r t a nt fo r p r o a c t i v e p r e v e n t i o n s t e p s . A s p e c i f i c e x a mp l e f r o m t h e Ro b o c op r i s k m o d e l c a n i l lu s t r at e h ow t o s p o t t h e e ve nt s a n d c h a r a c t e r i s t i c s o f t h e p h a s e s o f t h e c o n - t i nu u m . Re ve nu e r e c o g n i t i o n i s o n e o f t h e a r e a s t h at Ro b o c op e x a m i n e s i n i t s g l o b a l v i e w o f c o m p a n i e s ’ f i n a n c i a l r e p o r t s . Ab o u t 4 1 p e r c e nt o f t h e S E C ’s f r a u d c a s e s i n t h e h i g h a c t i v i t y y e a r s ( 2 0 0 0 – 2 0 0 6 ) i nv o l ve d r e ve nu e r e c o g n i - t i o n . 4 A n d t h e s a m e i s s u e s i n r e v e n u e r e c o g n i t i o n ke e p c o m i n g u p ; o n l y t h e n a m e s o f t h e c o m p a n i e s c h a n g e . F o r e x a mp l e , i n 2 0 0 0 t h e S E C c h a r g e d t h e Xe r ox C o r p o r at i o n w i t h f r au d ( c h a r g e s that Xerox ultimately settled in 2002). What t h e S E C r e fe r r e d t o a s “t h e m o s t s i g n i f - i c a nt a n d p e r v a s i ve a c c ou nt i n g a c t i o n s” r e s u l t e d i n m a n i p u l at i o n o f r e ve nu e s i n t h e a c c o u n t i n g f o r X e r o x ’s c u s t o m e r le a s e s of e qu ipme nt . Xe rox le a s e d e qu ip - m e nt w i t h s e r v i c e c ont r a c t s for t h e l e a s - ing customers. Revenue from those leasing c o nt r a c t s s h o u l d h ave b e e n s p r e a d ove r t h e l i fe o f t h e l e a s e o r l e n g t h o f t h e s e r - v i c e c o nt r a c t . Xe r ox op t e d fo r r e c o g n i - t i o n i n o n e fe l l s w o op o n c e t h e c o nt r a c t w a s s i g n e d . T h e re s u l t w a s t h at t h e c o m - pany, in highly competitive times, was able t o b o o k e ye - p opp i n g re ve nu e . How e ve r, w h e n t h e r e i s a m a r k e t o r e c o n o m i c d ow nt u r n a n d a c o mp a ny h a s t a ke n a l l i t s r e ve nu e i n p r e v i o u s ye a r s , t h e d i ve

i n r e ve nu e i s w o r s e . Xe r ox w a s fo r c e d t o r e s t at e $ 6 b i l l i o n i n r e ve nu e s . 5

I n 2 0 1 5 , c o m p a n i e s h a v e s t i l l n o t l e a r n e d t h e X e r o x r e v e n u e - b o o k i n g le s s ons . T he comp a ny na me cha nge s , but the revenue-recognit ion issues remain the s a me . S ab a S of t w a re p a id a $ 1 . 7 5 m i l l ion f i n e a n d r e s t at e d a l l o f i t s r e ve nu e fo r a fo u r- ye a r p e r i o d b e c au s e i t w a s m a n i p - ulating “all of its professional ser v ices rev- e n u e” d u r i n g t h a t p e r i o d f o r s e r v i c e s re l at e d t o i t s s o f t w a re l i c e n s e s w i t h c u s - t o m e r s . C o n s u l t a nt s re c o rd e d f a l s e t i m e f o r t h e i r w o r k o r d i d n o t r e c o r d t h e i r w o r k i n o r d e r t o m a n i p u l at e t h e s e r v i c e r e ve nu e fo r p e r i o d s , u n d e r i n s t r u c t i o n f r o m m a n a g e r s . 6 C o p y m a c h i n e s a n d sof tware licenses both have ser v ice ag ree- m e n t s t h a t g o h a n d - i n - h a n d a n d v e r y c l e a r r u l e s fo r w h e n r e ve nu e i s b o o ke d . B o t h comp a n i e s w e re w ron g i n h ow t h e y m a d e t h e i r d e c i s i o n s o n b o o k i n g .

T h e s e c a s e s prov i d e i n s i g ht s i nto h ow t h e c o nt i nu u m m ove s a l o n g . T h e j u d g - m e nt p h a s e b e g i n s w h e n t h e c o mp a n i e s f a c e a l e g i t i m a t e a c c o u n t i n g / f i n a n c i a l r e p o r t i n g q u e s t i o n . Re a s o n a b l e m i n d s c a n d i f fe r o n h ow c op y m a c h i n e s e r v i c e c a l l s a n d s o f t w a re c o n s u l t i n g a s s i s t a n c e s h o u l d b e r e c o r d e d fo r a g i ve n p e r i o d . Ac c o u n t a n t s a n d a u d i t o r s m a ke j u d g - ment calls on how much goes into any one m o nt h . Re a s o n a b l e m i n d s c o u l d d i f fe r o n w h at a f i g u r e fo r a p a r t i c u l a r m o nt h s h o u l d b e . How e ve r, i n t h e r e a s o n a b l e

EXHIBIT 3 The Financial Reporting Continuum from Reasonable Judgment to Fraud

Reasonable judgment

Repeating patterns of use of

gray areas

Increasing reliance on judgments and

interpretation Tweaking numbers

Misrepresentation through

withholding of information or

falsification (fraud)

31ETHICAL ISSUES JULY/AUGUST 2015 CORPORATE FINANCE REVIEW

judg ment phase, the debates are about the c l i e n t , t h e m a c h i n e , t h e s o f t w a r e , a n d t h e a m o u nt o f s e r v i c e / c o n s u l t i n g t h a t w i l l b e d e v o t e d t o a p a r t i c u l a r c o nt r a c t i n a ny p a r t i c u l a r m o n t h . Ac c o u n t a n t s may var y on amounts a l lo c ated, but t here is no d is ag re e me nt t hat t he re ve nue f rom ongoing ser v ice and consult ing cont r ac ts mu s t b e a l l o c ate d a n d n ot b o oke d a s on e g i a nt s a l e i n o n e m o nt h .

T h e r e p e a t i n g p a t t e r n s p h a s e g o e s h a n d - i n - h a n d w i t h t h e j u d g m e n t c a l l p h a s e i n s i t u a t i o n s s u c h a s t h o s e s u r - r o u n d i n g X e r ox a n d S a b a . T h i s Ro b o - c op h o t s p o t mu s t c o nt i nu e a s a n a r e a o f re v i e w a n d au d i t com m i t te e at te nt i on s o t h at t h e j u d g m e nt r e m a i n s s o u n d .

T h e i n c r e a s i n g r e l i a n c e p h a s e b e g i n s w h e n t h e d e c i s i o n s o n b o o k i n g t h e r e v - enues are no longer a function of reasonable judg ment . Rat her, t he de cis ions are t ur n - i n g o n m e e t i n g e a r n i n g s o r r e ve nu e t a r - g e t s . T h e r e i s d i a g n o s i s b i a s a n d e v e n i m p a i r e d j u d g m e n t w h e n t h e d r i v e t o m e e t go a l s d om i n ate s t h e d e te r m i n at i on o f w h e n r e ve nu e i s b o o ke d . T h e d e b at e i s n o l o n g e r b a s e d o n a c c o u nt i n g p r i n - c iple s . T he deb ate is how to ju s t if y b o ok - i n g r e ve nu e d e s p i t e b e t t e r j u d g m e nt .

I n t h e nu m b e r s t w e a k i n g p h a s e , t h e re i s a s h i f t f r o m d e b a t e t o w h a t h a p p e n e d a t S a b a S o f t w a r e . M a n a g e r s t h e r e d i r e c t e d c o n s u l t a n t s ( l o c a t e d i n I n d i a ) t o f a i l t o r e c o r d h o u r s t o c o n c e a l b u d - ge t ove r r u ns or f a l s ely re cord hou rs t he y h a d n o t y e t w o r ke d . T h r o u g h t h i s h o u r s p r a c t i c e , S a b a a l w ay s m e t i t s q u a r t e r l y t a r g e t s f o r f o u r y e a r s . At t h a t c o m p a ny, t h e d i s c u s s i on a n d p h i l o s op h i c a l d e b ate were no longer b eing done. The managers h a d a l r e a d y a g r e e d t o b e v e r y f l e x i b l e o n r e v e n u e b o o k i n g ; t h e i s s u e w a s h o w t o g e t t h e r e . I n t h i s p h a s e , c o m p a n i e s s w i t c h f r o m d e b a t e s t o p hy s i c a l f r a u d . M a n a g e r s a r e c o n t r o l l i n g t h e h o u r s r e p o r t e d f o r s e r v i c e c a l l s a n d c o n s u l t - i n g . O r m a n a g e r s a r e m o v i n g t h e h o u r s f r o m o n e q u a r t e r t o a n o t h e r i n o r d e r to meet revenue and ear nings project ions. S i m i l a r a c t i v i t y w o u l d b e l o a d i n g - d o c k f r a u d , w h e r e i n s a l e s a r e b o o ke d o n t h e b a s i s o f 3 2 - o r 3 3 - d a y m o n t h s . T h e s e c omp a n i e s a re n o l on g e r d e b at i n g a b out w h e n s h i p m e nt o c c u r s . T h e y a r e a d d i n g d ay s t o t h e m o n t h i n o r d e r t o i n c l u d e

s h i p m e nt s m a d e p a s t t h e c u t o f f d at e f o r s h i p m e n t w i t h i n t h e m o n t h’s r e v e n u e .

T h e m i s r e p r e s e n t a t i o n p h a s e o f t e n b e g i n s w h e n t h e re i s t h e re a l i z at i o n t h at t h e r e i s n o l o n g e r a ny r e ve nu e t o m ove i nt o a s i n g l e q u a r t e r. O n c e a c o mp a ny b e g i n s m ov i n g r e ve nu e u p a n d a r o u n d , i t c a n n o t s t op. T h e r e s u l t i s t h e n t h e u s e of o t h e r t a c t i c s t o m a ke up for t h e l o s s e s that were always there but just not booked s o a s t o b e s e e n by i nve s t o r s . Fo r e x a m - p l e , t h e S E C d e s c r i b e d Xe r ox ’s d e s c e nt into non-judgment (non-GAAP) areas once i t c o u l d n o l o n g e r u s e t h e “ b o o k a l l t h e r e ve nu e” s t r at e g y :

Xerox employed a w ide range of tools to enhance i t s r e ve nu e a n d e a r n i n g s p i c t u r e , u s i n g t h e m as re qu i re d to me e t Wa l l St re e t e ar ni ng s ex p e c - tat ions. Xerox know ingly or recklessly increased r e v e n u e s a n d e a r n i n g s b y a c c e l e r a t i n g t h e r e c o g n i t i o n o f r e ve nu e s t h r o u g h m o s t l y n o n - G A A P a ccou nt i n g a c t i ons , ove r s t ate d it s e a r n - i n g s by u s i n g s o - c a l l e d ‘c o o k i e j a r ’ r e s e r v e s a n d i n t e r e s t i n c o m e f r o m t a x r e f u n d s , d i s g u i s e d l o a n s a s a s s e t s a l e s , a n d o t h e r w i s e m a n i p u l a t e d i t s a c c o u n t i n g i n v i o l a t i o n o f G A A P. 7

Wh at b e g a n a s a jud g me nt c a l l on how mu ch re ve nu e to b o ok for mu lt i ye a r s e r - v i c e c o n t r a c t s e n d e d w i t h m a k e - b e l i e v e a c c o u n t i n g . T h e s a m e o c c u r r e d at S a b a : C o n s u l t a nt s w e r e p r e - b o o k i n g t h e i r s e r v i c e s a s r e v - e nu e o r p r e t e n d i n g t h a t t h e r e w e r e n o s e r v i c e s . W h a t b e g a n a s a j u d g - m e nt c a l l o n w h e n t o b o o k s o f t w a re s e r v i c e s e n d e d u p w i t h f a l s i f i c at i o n o f t i m e c a r d s . I n b o t h s i t u a t i o n s , b e c a u s e t h e j u d g m e n t c a l l h a d a l r e a d y b e e n m a d e a b o u t f l e x i b i l i t y i n a l l o c a t i o n o f r e v e n u e s , t h o s e i nv o l v e d t u r n e d t h e i r a c t i o n s i nt o a c h a l l e n g i n g g a m e . “A l l o c at i o n h a s f lex ibi l it y” w a s t he i r p s ycholo g ic a l com - f o r t a s f r au d g r e w.

How can movement along the continuum be stopped? Wi t h t h e s t a g e s d e f i n e d , t h e n e x t c h a l - l e n g e i s t o p u t i nt o p l a c e t h e k i n d s o f s t r u c t u r e s , p o l i c i e s , a n d ove r s i g ht t h at c u r b s f lex ibi l it y a nd / or prov ide s aut hor - i t y a n d i n s i g h t f o r s t o p p i n g t h e p r o - g r e s s i o n i n t o f r a u d . H o w e v e r, a s t h e b o ok i ng of re ve nu e e x a mpl e s i l lu s t r ate s ,

ACCOUNTANTS MAY VARY ON AMOUNTS ALLOCATED, BUT THERE IS NO DISAGREEMENT THAT THE REVENUE FROM ONGOING SERVICE AND CONSULTING CONTRACTS MUST BE ALLOCATED AND NOT BOOKED AS ONE GIANT SALE IN ONE MONTH.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

32 CORPORATE FINANCE REVIEW JULY/AUGUST 2015 ETHICAL ISSUES

t h e r e i s a p o i nt at w h i c h t h e j u d g m e nt b e c o m e s p r e p o s t e r o u s . Wh at h e lp s s t op t h e j o u r n e y d ow n t h e c o nt i nu u m ?

Definitive rules. T h e a r e a o f j u d g m e nt flexibilit y that to ok WorldCom into f raud t e r r i t o r y, t h e c a p i t a l i z at i o n o f o r d i n a r y e x p e ns e s , i s i ns t r u c t ive w h e n it com e s to m a n a g i n g t h e c o nt i nu u m . T h at t h e r e i s j u d g m e nt i n d e t e r m i n i n g w h at i s a c a p - i t a l a n d w h at i s a n o r d i n a r y e x p e n s e i s a n u n a s s a i l a b l e prop o s i t i on . S om e c om - p a n i e s h av e c u t o f f t h e c o nt i n u u m o n t h i s i s sue b e c au s e t he te mp t at ion to s h i f t expenses to the balance sheet is great. Oper- at ing expenses reduce profits and thereby r e d u c e b o n u s e s a n d c o m p e n s a t i o n — t h e r e fo r e p r ov i d i n g i n c e nt i ve s t h at m ay c l o u d j u d g m e nt . T h e c u t o f f o n t h e c o n - t inuum comes f rom pre-established com- pany r ules. Those r ules may set minimum requirements for what is a capital expense. For e x a mpl e , n o c apit a l e x p e n d it u re w i l l b e c o n s i d e r e d u n l e s s a c e r t a i n d o l l a r a m o u nt i s r e a c h e d . Wi t h t h i s c l e a r r u l e i n p l a c e , t h o s e i nv o l ve d i n t h e j u d g m e nt c a n n o t g r o u p t o g e t h e r t i ny op e r at i o n s e x p e n s e s i nto c a p i t a l e x p e n s e s . T h e go a l i s t o i s s u e d e f i n i t i ve r u l e s s o t h at t h o s e w i t h i n t h e a c c o u nt i n g a n d f i n a n c e a re a s of the comp any are w ithin the same p ar a- m e t e r s i n t h e i r j u d g m e nt s a b o u t c a p i t a l v e r s u s op e r a t i o n s e x p e n s e s . T h e c o m - p a n i e s w i t h out d e f i n i t ive r u l e s a re t h o s e m o s t l i ke l y t o e n d u p f u r t h e r d ow n o n t h e cont i nu u m i n t h e n a m e of j u d g m e nt .

Transparent determinations. T h e re a re a host of accounting and financial issues that re qu i re jud g me nt c a l l s . For t u n ately, t he y c a n b e c a l l e d out c l e a r l y s o t h at comp a - n i e s c a n ch a n ge t h e i r pro ce s s e s for m a k - i n g t h a t c a l l . F o l l o w i n g a r e t h e i t e m s b e yon d re ve nu e re co g n it i on t h at re qu i re s om e on e’s j u d g m e nt i n com i n g up w it h a nu m b e r f o r t h e b a l a n c e s h e e t o r t h e i n com e s t ate m e nt , a n d t h e s e ite m s h ave a l l b e e n t h e re a s on b e h i n d SE C a ccou nt - i n g f r au d i nve s t i g at i on s s i n ce 2 0 0 0 : • d e p r e c i at i o n a m o u nt s ; • d e t e r m i n at i o n o f g o o d w i l l ; a n d • o f f - t h e - b o o k s d e b t .

T h e s e a r e a s c a n b e c o mp l e x i n s t r u c - t u r e a n d c o mp u t a t i o n . Ho w e v e r, e v e r y c o m p a n y h a s g o o d w i l l a n d d e p r e c i a - t i o n . Ev e r y b o a r d a n d au d i t c o m m i t t e e m e m b e r s h o u l d h a v e a c l e a r u n d e r -

standing of the company’s accounting poli- c i e s a n d j u d g m e n t s w h e n i t c o m e s t o d e p r e c i a t i o n a m o u n t . F o r e x a m p l e , Wa s t e M a n a g e m e nt’s f r au d c e nt e r e d o n w i l d nu m b e r s f o r d e p r e c i a t i o n d e du c - t i o n s . I f t h e au d i t a n d b o a r d c o m m i t t e e m e m b e r s h a d s i m p l y a s k e d a b o u t t h e f l u c t u a t i o n s i n Wa s t e M a n a g e m e n t ’s d e p r e c i a t i o n nu m b e r s , t h e y c o u l d h av e h a l t e d t h e t r e k d o w n t h e c o n t i n u u m . Ev e r y t h i n g f r o m s a l v a g e v a l u e s t o t h e e q u i p m e n t l i f e p e r i o d s w a s i n o u t l i e r t e r r i t o r y a n d n o t w i t h i n t h e p a r a m e t e r s f o r j u d g m e nt c a l l s .

I n c o m p a n i e s m a k i n g a c q u i s i t i o n s , s u c h a s Ty c o , Wo r l d C o m , a n d , t o d a y, Ya h o o, t h e q u e s t i o n o f g o o d w i l l s h o u l d b e a d d r e s s e d at e ve r y au d i t c o m m i t t e e a n d b o a r d m e e t i n g . Ju d g m e n t c a n b e p o o r w h e n c o m p a n i e s u n d e r p r e s s u r e u s e a c q u i s i t i o n s a n d , t o o m a ny t i m e s , a c q u i s i t i o n a c c o u n t i n g t o p a i n t a d i f - fe r e nt p i c t u r e o f p e r fo r m a n c e .

In add it ion to ge ne r a l ove rs i g ht , m a n - a g e m e n t a n d t h e b o a r d c a n d e v e l o p p r o c e s s e s f o r r e v i e w, d i s c u s s i o n , a n d e v e n a p p r o v a l w h e n n e c e s s a r y f o r t h e j u d g m e nt c a l l s . G e n e r a l r u l e s o n d e p r e - c i at i o n c a n s e t p a r a m e t e r s fo r d e p r e c i - at i o n nu m b e r s .

Know specific accounting practices within the areas of judgment calls. I n a d d i t i o n t o k n ow i n g t h e g e n e r a l a r e a s o f j u d g m e nt c a l l s , m a n a g e r s a n d b o a r d m e m b e r s should be required to memor ize the t y pes o f c o n d u c t t h a t t h e S E C h a s r u n i n t o w h e n i nve s t i g at i n g re ve nu e - re co g n i t i on a c c o u nt i n g f r au d s . B e yo n d t h e a l l o c a - t ion issues noted w ith Xerox and Saba are t h e f o l l o w i n g a r e a s t h a t c o u l d i nv o l v e judg ment ca l ls but can b e pressure points fo r r e ve nu e r e c o g n i t i o n : • s w a p s , b a r t e r, e t c . ( a s w h e n m a r ke t -

i n g p r o g r a m s a r e p a r t o f a s a l e s t r a n s a c t i o n ) ;

• c o nt i n g e n c i e s i n c o nt r a c t s ; • b i l l - a n d - h o l d s a l e s ( m a d e i n f a m o u s

t h r o u g h A l D u n l a p’s p r o g r a m at Su n b e a m ) ; 8

• n o t c l o s i n g t h e b o o k s i n o r d e r t o b r i n g i n r e ve nu e a f t e r t h e c l o s e - o f - q u a r t e r o r e n d - o f - m o nt h ; a n d

• r e c o g n i t i o n o f r e ve nu e w h e n d e l i v - e r y i s n o t c o mp l e t e ( c o mp l e t i n g i n t h e f i e l d s t r at e g y ) .

IN ADDITION TO KNOWING THE GENERAL

AREAS OF JUDGMENT

CALLS, MANAGERS AND BOARD

MEMBERS SHOULD BE

REQUIRED TO MEMORIZE THE

TYPES OF CONDUCT THAT

THE SEC HAS RUN INTO WHEN INVESTIGATING

REVENUE- RECOGNITION ACCOUNTING

FRAUDS.

33ETHICAL ISSUES JULY/AUGUST 2015 CORPORATE FINANCE REVIEW

If a c o mp a ny d o e s d o b i l l - a n d - h o l d t r a n s a c t i o n s , t h e n t h e au d i t c o m m i t t e e and an inter na l g roup should b e involve d i n a c o n s t a nt r e v i e w p r o c e s s t o d e t e r - m i n e w h e t h e r t h e r e i s s l i pp a g e i nt o r e v - enue f a nt as y f rom re venue clas s if ic at ion . Au d i t c o m m i t t e e s p l ay a c r i t i c a l r o l e i n u n d e r s t a n d i n g re ve nu e s ou rce s a n d a s k - i ng t he probi ng que s t ions at b o a rd me e t - i n g s o r t a l k i n g w i t h i nt e r n a l au d i t a n d m a n a g e r s a b o u t t h e s e a r e a s o f r e ve nu e r e c o g n i t i o n . A v i s i t t o t h e l o a d i n g d o c k m a y p r o v i d e c l u e s a s t o h o w l o n g t h e m o nt h s r e a l l y a r e at t h e c o mp a ny.

Follow industry practices and SEC inves- tigations. Pe r h a p s o n e o f t h e m o s t p r o - fou nd qu e s t ions t h at a n aud it com m it te e m e m b e r c a n a s k w o u l d b e t h i s o n e : “ I r e a d t h at t h e S E C i s i nv e s t i g at i n g _ _ _ for how it do es its account ing for rebates. Ho w d o w e h a n d l e r e b a t e s ? ” O r : “At a c o n f e r e n c e , a p a n e l r a i s e d q u e s t i o n s a b ou t b o o k i n g of e x p e n s e s . He re a re t h e i s sue s t he y r a i s e d . Whe re a re we on t he s e p r a c t i c e s ? ” O r : “A n o t h e r s o f t w a r e c o m - p a ny p a i d a f i n e fo r q u e s t i o n s a b o u t i t s q u i d - p r o - q u o p r a c t i c e s o n m a r ke t i n g . D o w e h ave a ny o f t h e s e t y p e s o f s a l e s a r r a n g e m e nt s ? ”

T h e c o nt i nu u m i s h a l t e d by a r e a l i t y c h e c k . S o m e o n e o u t s i d e t h e i n n e r c i r c l e o f j u d g m e nt h a s t o b e s h ow n a n e x a m - p l e f r o m o u t s i d e t h e c o mp a ny i n o r d e r t o r e c o g n i z e t h at t h e y h ave e i t h e r d o n e t h e s a m e t h i n g o r a r e h e a d e d d ow n t h at p at h . B r e a k i n g t h e c o nt i nu u m r e q u i r e s r e m o v i n g t h e p s y c h o l o g i c a l s h e l t e r o f j u d g m e nt .

Conclusions T h e S E C ’s F R Au d t a s k forc e h a s re s u lte d i n s o m e i mp o r t a nt t o o l s fo r i t s i nve s t i -

gat ions. Addit ionally, the task force open- n e s s h a s g i ve n c o mp a n i e s t h e a b i l i t y t o s te p b a c k a n d re f l e c t , n ot i n g t h e i r pl a ce s o n t h e c o nt i nu u m a n d u s i n g c h e c k s a n d b a l a n c e s t o s t op t h e m a r c h f r o m j u d g - m e nt t o f r au d . ■

N OT E S 1 C e r e s n ey, A . , “ F i n a n c i a l r e p o r t i n g a n d a c c o u n t i n g

f r a u d ,” Re m a r k s a t t h e A m e r i c a n L aw I n s t i tu t e C o n - t i n u i n g E d u c a t i o n S e m i n a r ( S e p t 19 , 2 013 ) . Ava i l - a b l e a t : h tt p : / / w w w. s e c . g ov / N ew s / S p e e ch / D e t a i l / S p e e ch / 13 7 0 5 3 9 8 4 5 7 7 2 .

2 E a g l e s h a m , J. a n d R a p o p o r t , M . , S E C g e t s b u s y w i t h a c c o u n t i n g i n v e s t i g a t i o n s , W a l l S t r e e t J o u r n a l ( J a n 2 0 , 2 01 5 ) . A v a i l a b l e a t : h tt p : / / w w w. w s j . c o m / a r t i c l e s / s e c - g e t s - b u s y - w i t h - a c c o u n t i n g - i nve s t i g a t i o n s - 14 2 17 9 7 8 9 5 .

3 “ Te n t h i n g s a b o u t f i n a n c i a l s t a t e m e n t f r a u d — Th i r d e d i t i o n : A r e v i e w o f S E C e n f o r c e m e n t r e l e a s e s 2 0 0 0 – 2 0 0 8 ,” D e l o i tt e Fo r e n s i c C e n t e r ( Ju n e 2 0 0 9 ) . Available at: http://www.corporatecompliance.org/ Portals/1/Users/169/29/60329/10%20Things%20about%20 f i n a n c i a l % 2 0 s t a t e m e n t % 2 0 f r a u d . p d f. T h e l e n g t h o f t i m e h a s i n c r e a s e d f r o m f i ve ye a r s i n 2 0 0 0 .

4 “ Te n t h i n g s a b o u t f i n a n c i a l s t a t e m e n t f r a u d : A r ev i ew o f S E C e n fo r c e m e n t r e l e a s e s 2 0 0 0 – 2 0 0 6 ,” D e l o i tt e Fo r e n s i c C e n t e r ( Ju n e 2 0 0 7 ) . Ava i l a b l e a t : https://www.financialexecutives.org/eweb/upload/FEI/ B O O K - 10 % 2 0 T h i n g s % 2 0 o n % 2 0 F r a u d % 2 0 f r o m % 2 0 S E C % 2 0 e n fo r c e m e n t % 2 0 l e tt e r s . p d f. Th e p e r - cent age dropped to 38 percent in 20 08, but it still represents the largest category of financial fraud cases.

5 SEC v. Xerox Corporation, #02-272789 (20 02). Avail- a b l e a t : h tt p s : / / w w w. s e c . g ov / l i t i g a t i o n / c o m p l a i n t s / c o m p l r 174 6 5 . h t m .

6 “ S E C ch a r g e s s o ft wa r e c o m p a ny i n S i l i c o n Va l l ey and two former executives behind fraudulent account- i n g s ch e m e : C E O a g r e e s t o r e t u r n $ 2 . 5 m i l l i o n u n d e r c l a w b a ck p r o v i s i o n ,” S E C ( S e p t 2 4 , 2 014 ) ( p r e s s r e l e a s e ) . Ava i l a b l e a t : h tt p : / / w w w. s e c . g ov / N e w s / P r e s s R e l e a s e / D e t a i l / P r e s s R e l e a s e / 13 7 0 5 4 3 0 3 5 9 9 2 . Th e S E C u s e d i t s c l aw b a ck p r ov i - s i o n s t o c o l l e c t b o n u s e s f r o m o ff i c e r s a t t h e c o m - p a n y b e c a u s e t h e b o n u s e s w e r e b a s e d o n t h e fa l s i f i e d r eve n u e f i g u r e s .

7 O p . c i t . n o t e 5 . 8 Ag a i n , t h e r e a r e j u d g m e n t c a l l s . Fo r ex a m p l e , i t i s

n o t u n u s u a l fo r s e a s o n a l i t e m s t o b e p r e o r d e r e d by c u s t o m e r s ( C h r i s t m a s m e r ch a n d i s e o r s e a s o n a l m e r ch a n d i s e s u ch a s b a r b e q u e s ) . Re t a i l e r s o r d e r early from manufacturers because they do not want t o b e w i t h o u t i nve n t o r y w h e n t h e d e m a n d p e r i o d a r r i ve s . H oweve r, t h ey d o n o t wa n t t o s t o r e t h e i nve n t o r y. S o t h ey m a ke t h e p u r ch a s e a n d t h e m a n - ufacturer stores the set-aside goods for the ret ailer. However, bill-and-hold was never intended to be used a s a r eve n u e - e n h a n c i n g s t r a t e g y.

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