PwC Fraud Risks & Controls

Recent Financial Statement Frauds in the

Technology Industry

September 2003

Sources: SEC website

Media searches

Index

  1. Microstrategy
  2. Peregrine Systems
  3. Xerox Corporation
  4. Network Associates
  5. Symbol Technologies
  6. Homestore
  7. Lucent Technologies
  8. WorldCom
  9. ClearOne Communications
  10. Global Crossing
  11. Qwest Communications
  12. Informix
  13. McKesson HBOC
  14. Microsoft
  15. Adelphia Communications
  16. Critical Path

1. Microstrategy – Prepackaged Software and Computer Software Systems

  • Fraud Scheme – Improperly recognized revenue from sales of software as agreements were entered into rather than as services were provided. SEC also alleged that additional accounting errors included the timing of contracts, valuing future obligations, and revenue recognition for barter transactions. In at least three instances, MicroStrategy recognized revenue on transactions that were not completed or signed by either party prior to the close of the quarter. In a separate transaction, MicroStrategy improperly recognized revenue for a license to unspecified future products and failed to recognize a deal as a barter transaction yielding no revenue.
  • Final Result – Restated earnings for fiscal years 1998 and 1999, which caused revenues to be reduced by almost $66 million. Former CEO, COO, and CFO each fined $350,000. Without admitting or denying the charges, the former CEO, COO, and CFO agreed to disgorge a total of approximately $10 million (Saylor – $8,280,000, Bansal – $1,630,000, and Lynch – $138,000) and consent to fraud injunctions, and to each pay $350,000 in penalties.

U.S. regulators barred the PricewaterhouseCoopers partner who led the audit of MicroStrategy Inc. from auditing public companies for at least two years.

2. Peregrine Systems - develops and sells enterprise software

  • Fraud Scheme – Improper Revenue Recognition (Peregrine allegedly filed materially incorrect financial statements with the SEC from the quarter ended June 30, 1999, through the quarter ended Dec. 31, 2001.)

The SEC charged that Peregrine improperly booked millions of dollars of revenue for non-binding sales of Peregrine software to resellers. The resellers were not obligated to pay Peregrine in the arrangement, called "parking" the transaction, the SEC said. According to the complaint, Peregrine personnel parked transactions to achieve sales forecasts.

Peregrine also allegedly entered into reciprocal transactions in which it essentially paid for its customers' purchases of Peregrine software. Further, Peregrine, the commission charged, routinely kept its books open after fiscal quarters ended, and improperly recorded software transactions as revenue for the prior quarter.

When Peregrine booked revenue for the non-binding reseller contracts, and the customers predictably did not pay, receivables--some of them bogus--ballooned on Peregrine's balance sheet. To make it appear to investors that Peregrine was collecting its receivables more quickly than it was, the SEC said, a senior officer entered into financing arrangements with banks to exchange receivables for cash. Peregrine allegedly improperly accounted for these financing arrangements as sales of the receivables, rather than as loans, and removed them from the company's balance sheet. Some of the "sold" receivables were invalid, with no underlying obligation, or fake, according to the commission.

The SEC charged that, as part of the cover up, Peregrine personnel improperly wrote off millions of dollars in uncollectible--primarily sham—receivables - to acquisition-related accounts in Peregrine's financial statements and books and records.

Peregrine allegedly misled investors by not including the write-offs in its pro forma operating results, and by making the write-offs appear on Peregrine's income statement as one-time charges rather than expenses from operations.

Three former officers of Peregrine have pleaded guilty to criminal charges filed by the U.S. Attorney for Southern California: Ilse Cappel, the former senior treasury manager at the firm; Matthew C. Gless, Peregrine's former chief financial officer; and Steven S. Spitzer, a former vice president of sales at the company. The SEC filed civil charges against the same three men in November 2002 and April and June 2003, respectively.

  • Result - Financial restatement. Peregrine reduced previously reported revenue of $1.34 billion by $509 million. At least $259 million of that reduction was required because the underlying transactions lacked substance, the SEC said. Without admitting or denying the SEC's allegations, Peregrine agreed to be enjoined from violating the antifraud, reporting, books and records, and internal controls provisions of the federal securities laws. It also agreed to disclose the current condition of its internal controls and financial reporting procedure when it implements its bankruptcy reorganization plan. Company also agreed to comply, on an accelerated basis, with new SEC rules regarding management's report on internal controls and to retain an internal auditor. Finally, Peregrine consented to an order requiring it to appoint a corporate compliance officer to perform an ongoing review of the firm's corporate governance policies and practices, and to begin a firm-wide, compliance-oriented training and education program. The partial settlement provides that the amount of disgorgement and/or civil penalty to be paid by Peregrine, if any, shall be determined at a later date.

3. Xerox Corporation - document solutions, services and systems -- including printers, digital presses, multifunction devices. It also offers associated supplies, software and support.

  • Fraud Scheme – Accused of recognizing revenue on office copier leases too early in cycles Overstated Revenue for more than four years by accelerating the recognition of $3 billion in revenue and inflating earnings by about $1.5 billion. .

Many of the accounting actions related to Xerox's leasing arrangements. Under these arrangements, the revenue stream from Xerox's customer leases typically had three components: the value of the "box" (a term Xerox used to refer to the equipment); revenue that Xerox received for servicing the equipment over the life of the lease; and financing revenue that Xerox received on loans to its lessees. Under GAAP, Xerox was required to book revenue from the "box" at the beginning of the lease, but was required to book revenue from servicing and financing over the course of the entire lease. According to the complaint, Xerox relied on accounting actions to justify shifting more lease revenue to the "box," so that a greater portion of that revenue could be recognized immediately.

The complaint alleges that the two accounting actions with the largest impact on Xerox's financial statements were methodologies that Xerox called "return on equity" and "margin normalization." These two methodologies alone boosted Xerox's equipment revenues by $2.8 billion and its pre-tax earnings by $660 million from 1997 to 2000. Xerox used the return-on-equity method to shift revenue to the "box" that the company had historically allocated to financing. And margin normalization shifted revenue to the "box" that had historically been allocated to servicing. In violation of GAAP, Xerox 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.

Xerox also used approximately $1 billion in other one-time accounting actions to artificially improve its operating results. By using these accounting actions and failing to disclose their use, Xerox violated GAAP as well as disclosure requirements. These additional one-time accounting actions included the improper use of "cushion" or "cookie jar" reserves, the improper recognition of the gain from a one-time event, and miscellaneous lease accounting related actions.

  • Final Result – Agreed to pay $10 million in fines and restate its income for the years 1997-2000. On April 1, 2002, Xerox announced a settlement in principle with SEC that called for a second restatement of its financial results for 1997 through 2000 as well as an adjustment of previously announced 2001 results. On June 28, 2002, Xerox restated its consolidated financial statements for the years ending December 31, 1997, 1998, 1999, and 2000, and revised its previously announced 2001 results. For 1997, net income decreased by $466 million (34.3 percent), 1998 net income decreased by $440 million (161.2 percent), 1999 net income decreased by $495 million (37 percent), and 2000 net loss increased by $16 million (6.2 percent). For the 4-year period, Xerox overstated net income by $1.42 billion (52.3 percent).

The SEC sued three current KPMG partners and one former KPMG partner of securities fraud in claiming the accounting firm fraudulently let XEROX manipulate accounting practices to fill an earnings gap and make it appear to be meeting market expectations.

4. Network Associates Inc - manufacturers and sells computer programs and hardware relating to network security, anti-virus, and network management.

  • Fraud Scheme - multi-part scheme to artificially inflate the revenue generated from the sale of its products to distributors. According to the SEC, the scheme took place from the second quarter of fiscal 1998 through the fourth quarter of fiscal 2000.The scheme included:
  • paying distributors so that they would hold excess inventory and buy more products;
  • giving deep discounts to distributors on amounts that they owed to Network Associates;
  • fraudulently manipulating reserve accounts to, among other things, cover payments and discounts provided to distributors;
  • selling to distributors on consignment in violation of Network Associates' written sales contracts and purported revenue recognition practices; and
  • using a wholly-owned subsidiary to buy products previously sold to distributors to reduce distributor inventory levels and limit product returns.

Davis (who held various positions at NA, including VP and Corporate Controller) took action to conceal the fraud. For example, in many instances, Davis improperly recorded, or caused others to improperly record, the payments to distributors in Network Associates' books and records. Davis, encouraged by at least one other senior employee at Network Associates, made a series of fraudulent entries in Network Associates' general ledger to release a tax-related reserve in order to disguise the distributor payments and discounts and increase inadequate sales reserves.

  • Current Status - Terry W. Davis pleaded guilty June 11 to securities fraud over his alleged role in a scheme to inflate his company's stock price by overstating revenue and earnings. In April 2002, Network Associates announced that it would restate its earnings and revenue for 1998-2000. The commission added that its investigation into the matter is continuing. Meanwhile, in the criminal case, Davis faces a prison term of up to 10 years and $250,000 fine, plus restitution up to the amount of the loss caused by his misconduct, including insider trading proceeds of $1.4 million.

5. Symbol Technologies - engaged in the design, manufacture, marketing and servicing of information management systems using bar code scanners and similar devices.

  • Fraud Scheme – (Much greater detail in SEC doc) From 1998 through 2002, defendant Korkuc engaged in a fraudulent scheme that inflated the reported financial results. Korkuc and others rigged the results that Symbol reported in press releases and periodic reports filed with the Commission by manipulating millions of dollars in revenue, net income and other measures of financial performance while Korkuc was Director of Corporate Accounting and then Chief Accounting Officer. Among other fraudulent accounting practices, Korkuc and others manipulated reserves and made other improper adjustments to Symbol's raw financial data to conform the reported results to market expectations.
  • Topside Adjustments and Cookie Jar Reserves - Korkuc played a central role in Symbol's fraudulent use of topside adjustments and excess "cookie jar" reserves to manipulate financial results to match projections. One of the consolidated financial reports that Korkuc prepared for senior management each quarter was known within Symbol as a "Tango sheet." In the Tango sheets, Korkuc not only consolidated the raw results, but he also compared those results to the forecast that management had provided to the board of directors and identified adjustments that would conform the raw numbers to the forecast, which reflected market expectations. Members of senior management authorized those adjustments and, in some cases, directed Korkuc to make other, more advantageous adjustments without regard to GAAP or other financial reporting requirements. During 2001, a Symbol officer and other employees created an excessive reserve of $10 million for obsolete inventory in a gross inventory account maintained on the books of Symbol's operations division. This $10 million cushion was a "cookie jar" reserve designed for use when the operations division failed to meet its quarterly forecast, and it exceeded any reasonable estimate of Symbol's exposure for obsolete inventory. In the Tango sheet process for the fourth quarter of 2001, members of senior management authorized Korkuc to release the excess $10 million into earnings in the fourth quarter of 2001. By making this and other adjustments that quarter, Symbol reported net income of $13.4 million rather than a $2.4 million loss, and hit the quarterly forecast right on the nose. The reversal of this "cookie jar" inventory reserve and the favorable impact on reported earnings were not disclosed to the public.
  • Recognizing Revenue before Product is Shipped - Korkuc was also involved in Symbol's fraudulent practice of recognizing revenue on purchase orders that were processed in one quarter but not shipped until the following quarter.
  • Three-Way Channel Stuffing Transactions - To help meet senior management's revenue targets, Symbol employees also engineered fraudulent "channel stuffing" transactions with resellers, including what were known as "candy" deals. In these three-way transactions, Symbol paid off resellers to "purchase" large volumes of Symbol product from another distributor at the end of a quarter so that Symbol could then induce that distributor to place new orders to meet this illusory demand.
  • Manipulation of Receivables to Hide the Effects of Channel Stuffing - Korkuc and others engineered the DSO reduction by artificially reducing the amount of outstanding accounts receivable, principally through the undisclosed reclassification of trade receivables from channel partners into notes receivable. At a series of meetings in June 2001, management decided to reduce the DSO figure by requiring channel partners with large outstanding receivables to sign notes for those amounts. After sales personnel and others secured the notes, Korkuc made or directed a reclassification entry to the general ledger converting over $30 million of trade receivables into notes receivable, which are not included in the DSO calculation. Korkuc knew that the purpose of the reclassification was to manipulate Symbol's DSO figure.
  • Current Status - The Company is currently in the process of restating it’s financials. According to an April 2003 press release, Symbol's planned restatement will cover 1998 through 2002. In its complaint, the SEC is seeking a permanent injunction against Korkuc from violating certain federal securities laws, a fine, and a bar against acting as an officer or director in a public company. SEC is also charging Robert Asti, a former executive at Symbol Technologies, Inc. ("Symbol"), with engaging in a vast fraudulent scheme to manipulate Symbol's reported financial results.

6. Homestore Inc – Internet Real Estate provider

  • Fraud Scheme - three former senior executives of Homestore Inc. arranged "round-trip" transactions for the sole purpose of artificially inflating Homestore's revenues in order to exceed Wall Street analysts' expectations.

Bogus Barter Transactions - Homestore engaged in a series of complex round-trip barter transactions to inflate revenues and meet Wall Street estimates. The essence of these transactions was a circular flow of money by which Homestore recognized its own cash as revenue. Specifically, Homestore paid inflated sums to various vendors for services or products; in turn, the vendors used these funds to buy advertising from two media companies. The media companies then bought advertising from Homestore either on their own behalf or as agents for other advertisers. Homestore recorded the funds it received from the media companies as revenue in its financial statements, in violation of applicable accounting principles. As a result of a significant revenue shortfall in the first quarter of 2001, the company devised a plan to use a major media company as an intermediary in some round-trip transactions. The overall scheme required Homestore to "refer" vendors to the media company, and the vendors to purchase online advertisements from that company. In return, the major media company purchased online advertising from Homestore for which the media company acted as a media buyer. Using this structure, Homestore paid a total of $49.8million to various vendors in the first two quarters of 2001. These vendors then paid $45.1million to a major media company to purchase online advertisements. Homestore, in turn, recorded $36.7million in revenue from the major media company's related purchase of Homestore online advertisements. In short, Homestore recycled its own money to generate revenues. Homestore used this same general plan with another media company in the second and third quarters of 2001 to fraudulently recognize an additional $9.7 million in revenue.

  • Final Result – The individuals charged and the terms of their settlement are:
  • John Giesecke Jr., 42, of Malibu, Calif., who was Homestore's COO from January through December 2001 and before that its CFO. Giesecke, a Calif. CPA, settled the Commission's action without admitting or denying the allegations in the complaint. Giesecke agreed not to commit future violations of the charged federal securities laws, to repay $3,445,021, including interest, from the exercise of his Homestore stock options, and to pay a $360,000 civil penalty. Giesecke will also be permanently barred from serving as an officer or director of a public company and suspended from appearing or practicing before the Commission as an accountant.
  • Joseph J. Shew, 37, of West Chester, Pa., who was Homestore's CFO from about February through December 2001. Shew, a Pennsylvania CPA, settled the Commission's action without admitting or denying the allegations in the complaint. Shew agreed not to commit future violations of the charged federal securities laws and to repay $1,053,751, including interest, from the exercise of his Homestore stock options. Shew will be permanently barred from serving as an officer or director of a public company and suspended from appearing or practicing before the Commission as an accountant.
  • John DeSimone, 33, of Hermosa Beach, Calif., who was Homestore's Vice President of Transactions from approximately January through December 2001. DeSimone settled the Commission's action without admitting or denying the allegations in the complaint. DeSimone agreed not to commit future violations of the charged federal securities laws and to return $177,796, including interest, from the exercise of his Homestore stock options. DeSimone will be barred from serving as an officer or director of a public company for 10 years.

The returned ill-gotten gains of approximately $4.6 million will be paid to the benefit of Homestore shareholders. In addition, the Commission is seeking the permission of the Court to have Giesecke's civil monetary penalty of $360,000 paid to the benefit of shareholders under the Fair Funds provision of the recently enacted Sarbanes-Oxley Act of 2002.