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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Apr 18

Written by: Jack Ciesielski
4/18/2005 6:42 AM 

Some interesting settlements out of the SEC lately.

First there was the EasyLink Services settlement on Friday. And last Monday, the SEC announced a settlement with four defendants of the now-defunct Chancellor Corporation, a Boston-based transportation equipment company, along with their auditor. The defendants included Chancellor's former president and an outside director; the other two defendants were the Chancellor's auditing firm and lead partner on the job. The penalties for all parties, as usual, are cash out of pocket, but also as usual, include limits to their future involvement with public companies.

From 1998 through 2001 - probably the golden era of financial scamming - Chancellor's former Chairman, CEO and controlling shareholder, magnified Chancellor's assets, revenue and profits via phony accounting, with a little help from bogus documents and a compliant auditor, BKR Metcalf Davis of Atlanta.

BKR Davis failed to notice a few things in Chancellor's financial statements - after their suspicions should have been aroused by Chancellor's firing of the previous auditor. What kind of transactions went ignored?

- The 1998 revenue was overstated by approximately 177% through the consolidation of $19 million in revenue from a subsidiary Chancellor actually until 1999. This was the matter leading to the firing of the previous auditors, according the SEC complaint.

- Related party transactions between the CEO/controlling shareholder and firms he controlled, worth several million dollars for bogus acquisition consulting services. More galling, these were booked as assets, inflating income to $850,000 instead of the proper net loss of $2.45 million.

- In 2000, even after an SEC review resulted in a restatement of 1998 and 1999 financials, the CEO still misrepresented the fees earned by one of his entities in the related party transactions and did not disclose a $3.71 million interest-free loan to him.

A couple of take-aways from this caper. One, even though it occurred in the golden era of financial scamming and involved the overstatement of revenues and profits, plain old acquisition accounting was the modus operandi for inflating the results - not round-trip transactions or special purpose entities. That alone makes it unique. Second, it's a reminder that related party transactions are something to be examined closely by investors - when they're properly disclosed, at least. Small-cap investors need to be particularly aware because small firms are often so closely aligned with the original owners/founders that they can't really separate their identities from the company. And third, always wonder what's up when an auditor is replaced by another one.