In Desperate Times: More Savvy and Cooperation at the SEC.

"Tempt not a desperate man," wrote Shakespeare in "Romeo and Juliet." In today's dog-eat-dog economy, burdened by daily dot-com failures and the increasing instability of the markets in the aftermath of the terrorist attacks of Sept. 11, temptations and "desperate companies" abound.

By honoring Shakespeare's admonition, the SEC is becoming more savvy at recognizing the fraudulent techniques of financially desperate companies, and at the same time, more understanding of the effects of desperate times, by offering a way out of prison terms and other harsh penalties for those who come clean and cooperate.

TRENDS IN FINANCIAL STATEMENT FRAUD

Charles Niemeier, SEC chief accountant, division of enforcement, speaking at the UC Berkeley Haas School of Business 12th Annual Conference on Financial Reporting, said that today the SEC is investigating more large companies than ever before. This may be due, at least in part, to a correlating increase in the number of informants who have come forward--many of whom are disgruntled, former employees, he says.

The SEC also is experiencing an increase in investigations into companies' operations outside the United States. "We're in a new world today," says Niemeier. "We are finding disturbing situations in which problems arise only in a company's non-U.S. operations."

Niemeier says that the SEC currently has 260 financial statement fraud cases underway. And, perhaps not surprisingly, revenue recognition continues to be the number one offender as companies attempt to recognize revenue before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.

According to Niemeier, other types of fraud that the SEC is uncovering include:

* Constant changes in estimates that are not disclosed. Niemeier says this is the biggest emerging fraud issue today.

* Bill-and-hold transactions stand out as by far the most common form of revenue recognition fraud, says Niemeier. He says 90 percent of bill-and-hold transactions the SEC has come across have not met the criteria for revenue recognition.

* Channel stuffing, in which a company will "stuff the distribution channel" with products, thereby inflating accounts receivable. Channel stuffing may work for awhile, however problems arise when high sales from past quarters are made at the expense of poor sales in another quarter. Niemeier says the SEC is carefully examining companies' cash flow relative to sales to catch such schemes.

* Companies that have become dependent on acquisitions to make sales or earnings targets or to reflect growth.

* Companies that are netting onetime gains into operating results, especially against operating expenses.

"All of the above are attempts to blur the issues," says Niemeier. "Frauds don't start out to be frauds. It use ally starts out as 'smoothing a quarter' and builds from there."

Niemeier says a particularly keen eye is being kept on technology companies with whom the competition is relentlessly fierce to be first-to-market with a new and better product, and the temptation to fraudulently inflate revenue to keep stock prices up is high.

"Companies need to report not only the good, but also the bad," cautions Niemeier. "Sooner or later the bad will come out and a company will lose credibility. And once that happens, it is difficult, if not impossible, to get it back."

John Morrissey, SEC deputy chief accountant, says CFOs should never be afraid to pick up the phone and call the SEC with questions. "We encourage registrants to come to us to deal with difficult issues," he says. "We will coordinate with team leaders to get your questions answered. Sometimes we will even arrange for a face-to-face meeting."

COOPERATION COULD GET YOU OFF THE HOOK

The SEC issued a report in late October explaining its decision not to take enforcement action against a company it had investigated for financial statement irregularities. The report effectively created a framework for the SEC to evaluate cooperation in determining whether and how to charge violations of the federal securities laws.

The report identifies four broad measures of a company's cooperation:

* Self-policing prior to the discovery of the misconduct, including establishing effective compliance procedures and an appropriate tone at the top;

* Self-reporting of misconduct when it is discovered, including conducting a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely and effectively disclosing the misconduct to the public, regulators and self-regulators;

* Remediation, including dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct, and appropriately compensating those adversely affected; and

* Cooperation with law enforcement authorities, including providing SEC staff with all information relevant to the underlying violations and the company's remedial efforts.

"Crediting those who seek out, self-report and rectify illegal conduct is critical to achieving the commission's goal of real-time enforcement," says Stephen Cutler, SEC director of enforcement.

"We hope that by setting forth a framework for exercising its prosecutorial discretion, the commission will encourage companies to address unlawful conduct swiftly and meaningfully and to cooperate with law enforcement authorities."

Credit for cooperative behavior may range from the extraordinary step of taking no enforcement action at all to bringing reduced charges, seeking lighter sanctions or including mitigating language in documents the SEC uses to announce and resolve enforcement action.

Lynn Turner, former SEC chief accountant, notes that today, half of all Americans are invested in the stock market. "The average stockholder today is the average American who lives next door, an aunt or uncle, a close friend or family member," says Turner.

"Americans more than ever before are willing to place hard-earned savings and trust in the U.S. capital markets. They are willing to do so because they have confidence in the integrity of those markets. It is vitally important to all of us that we keep those markets healthy."

Deanna McCrary is a CalCPA editor/writer.

RELATED ARTICLE: TURNER'S TOP 10 TIPS TO TIPTOE AROUND TROUBLE

Lynn Turner, former SEC chief accountant, offers the following tips for CFOs to avoid getting a phone call from the SEC's enforcement division:

1. Make sure your disclosures are written in plain English. They should not read like a report written by a corporate attorney to be read by a plaintiff's attorney, says Turner. "I encourage you to read the audit committee report for Coca Cola, which I believe is an excellent example of something an average investor can understand. Coca Cola is a household name and this report has been written so investors in households can understand it."

2. Choose accounting principles that reflect what is genuinely going on in the business.

3. Make sure disclosures are robust enough to be understandable. "Times have changed," says Turner. "People are getting into the numbers and they need to be able to understand them."

4. Make sure you are not giving only the bare-bone minimum. And, disclosures should be accompanied by timely information. "Selective disclosure is totally improper," says Turner. "It is the lesson we all learned a long time ago: If you weren't willing to tell your mom about what you were up to, you probably shouldn't have been doing it."

5. Read and follow EITF 93-5, which provides good guidelines for disclosures on restructuring. "Make sure that you have a good, solid plan and that the numbers are provided on a timely basis," says Turner.

6. Avoid pro forma earnings. However, if you use them, follow FEI guidance on pro forma disclosures. "If you're using pro forma disclosures, but don't follow guidance, you're taking your life into your own hands," cautions Turner.

7. Make sure your disclosures, especially those regarding related parties, provide all the facts. Take a lesson from the recent Enron scandal. "Analysts noticed that there was recurring income vs. non-recurring income and had a difficult time figuring out what this meant," says Turner. "Analysts are now getting savvy to these practices."

8. Learn to just say "No!" "CFOs need to establish themselves as strong leaders on the executive management team," says Turner. "They need to have the spine and resolve to just say 'no' when CEOs or others pressure them to manage the numbers, especially when others are having difficulty managing the business."

9. Audits should be fully independent and well compensated. "Audit fees at the low end of the range raise the question of whether the fees are sufficient to ensure the performance of a quality audit," says Turner. "If a company is already having problems, a low audit fee could throw fuel on the fire." The SEC now requires the disclosure of the fees paid to the accounting firm by a public company for the audit of the company's financial statements, as well as the fees paid to the accounting firm for all other services.

10. Get it right the first time so as to avoid restatements. "[Restatements result in] staggering investor losses totaling tens of billions of dollars and aggregating by some estimates to be more than $100 billion in the past six to seven years," says Turner.