In a speech delivered nearly 20 years ago, SEC Chairman Arthur Levitt warned of the dangers of earnings management. He noted that “companies try to boost earnings by manipulating the recognition of revenue,” and compared revenue reporting to enjoying a bottle of fine wine. “You wouldn't pop the cork on that bottle before it was ready,” he said, but he noted that “some companies are doing this with their revenue, recognizing it 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.”
A generation later, companies and individuals are still drawing the ire of the SEC due to improper revenue recognition. The agency’s Enforcement Division recently charged two former executives of a government contracting firm in connection with a scheme to prematurely recognize nearly $18 million in revenue from a fixed-price aircraft maintenance contract with the U.S. Army. As alleged, David Pruitt, a vice president of finance in the Army Sustainment Division of L3 Technologies Inc., circumvented internal accounting controls and instructed a subordinate to create 69 invoices related to unresolved claims under the contract in L3’s internal accounting system that were not submitted for payment to the Army.
The SEC charged that Pruitt intentionally withheld delivery of those invoices from the Army. By prematurely entering the invoices into its internal accounting system, the company improperly recognized approximately $17.9 million in additional revenue. These amounts enabled employees in the division to barely satisfy an internal target for management incentive bonus payments. Previously, L3 agreed to pay a $1.6 million penalty to settle books and records and internal controls arising from this incident.
According to the SEC complaint, Pruitt caused L3 to violate the Exchange Act’s books and records provisions. He is contesting the charges, which will be heard by an SEC administrative law judge.
The SEC also charged Mark Wentlent, a former division president, with books and records violations. As alleged, Wentlent disregarded certain red flags that should have put him on notice that the company improperly recognized revenue. Wentlent also helped procure a misleading e-mail from the Army which falsely suggested that the Army was prepared to accept invoices on the disputed claims. Wentlent, without admitting or denying the SEC’s findings, consented to the entry of a cease and desist order and agreed to pay a civil money penalty in the amount of $25,000.
Andrew M. Calamari, director of the SEC’s New York Regional Office, said that:
Executives must be held accountable when they’re actively involved in corporate wrongdoing or look the other way. We allege that Pruitt circumvented critical accounting safeguards so improper revenue could be recorded to reach an internal target that enabled management to receive bonuses, and it was unreasonable for Wentlent to rely solely on Pruitt under the circumstances.
Director Calamari’s comments echo the remarks that Chairman Levitt made in 1998, when he observed that earnings management is often “a game among market participants, a game that, if not addressed soon, will have adverse consequences for America's financial reporting system, a game that runs counter to the very principles behind our market's strength and success.” The former chairman added that “increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices.” These enforcement actions indicate that the concerns voiced by Chairman Levitt in 1998 remain relevant to the markets of 2017.
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