Fraudulent Revenue Recognition Causes Rift at the SEC

A settlement agreement has been reached In the Matter of Lynn R. Blodgett, Adm. Proc. File No. 3-16045 (August 28, 2014), but without consensus on the part of the Securities Exchange Committee (“SEC”) as to the appropriate penalty. The underlying circumstances involve a financial fraud action against two executives at Affiliated Computer Services, Inc. (“ACS”), Lynn Blodget, the president and CEO, and Kevin Kyser, the CFO. The SEC alleged that Mr. Blodget and Mr. Kyser improperly recorded revenues in an effort to meet analyst expectations.

According to the SEC complaint, ACS took fraudulent measures to increase revenues and meet company guidance and analyst expectations  ACS violated generally accepted accounting principles (“GAAP”) by recording revenues associated with having inserted itself after the fact into pre-existing sales transactions between a manufacturer and a reseller.  Company transaction documents gave the false appearance that ACS was involved in the transaction, but the equipment was shipped directly from the manufacturer to the reseller’s customers at their normal prices without ACS ever taking possession. The reseller’s customers were not even aware of ACS’ claimed involvement in the transactions and there was no economic substance to the $125 million of revenues recorded.

The SEC ordered Mr. Blodgett and Mr. Kyser to (i) accept a cease and desist order regarding future violations, and (ii) pay disgorgement of $351,050 and $133,192 respectively. Both men are also required to pay prejudgment interest and a $52,000 civil penalty.

Commissioner Luis A. Aguilar vehemently disagreed with this resolution, writing in his dissent:

“The importance of a strong and robust Enforcement program cannot be overstated.  It is a vital component of an effective capital market on which investors can rely….Given the egregious conduct that Mr. Kyser engaged in at ACS, the Commission’s settlement, which lacks fraud charges or a timeout in the form of a Rule 102(e) suspension, is a wrist slap at best….

Accountants—especially CPAs—serve as gatekeepers in our securities markets.  They play an important role in maintaining investor confidence and fostering fair and efficient markets.  When they serve as officers of public companies, they take on an even greater responsibility by virtue of holding a position of public trust.  To this end, when these accountants engage in fraudulent misconduct, the Commission must be willing to charge fraud and must not hesitate to suspend the accountant from appearing or practicing before the Commission….”

The SEC’s growing focus on data analytics should allow for increased identification of earnings management and unexpected data relationships. However, when perpetrators only face relatively small penalties such as the ones describe above, the incentives to engage in fraudulent behavior may be found to greatly outweigh the risks associated with “getting caught”.  A related article provides additional information regarding this case and insights into enforcement trends and their implications.

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