Defending managed earnings cases by understanding revenue recognition: protecting clients means that defense counsel must be prepared to traverse a jungle of accounting rules and standards in order to avoid catastrophe.

• Author: Nelson, James D.

IN RESPONSE to the infamous Enron debacle, securities law reform legislation was enacted in the United States in 2002 by way of the Public Company Accounting Reform and Investor Protection Act, better known as the Sarbanes-Oxley Act of 2002? In addition, the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) stepped up the enforcement of existing securities laws. It now seems that hardly a week goes by without another publicly traded corporation announcing plans to restate its earnings.

The typical scenario is, first, a publicly held company is forced to restate its earnings because of past aggressive revenue recognition practices. Next, class action securities fraud and shareholder derivative suits are filed. At the same time, the DOJ and the SEC launch investigations. Thus, the stakes are remarkably high. Miscalculations in the revenue recognition context may lead to financial ruin and jail.

IT'S SIMPLE--OR IS IT?

The recent onslaught of DOJ and SEC investigations probing corporate accounting practices reflects a sea change in the government's approach to enforcement in "managed earnings" cases. One consequence is that many defense counsel have been or soon will be retained to defend these cases. The underlying concepts are simple. Revenue is to be recognized in the period in which it is actually earned. Publicly held corporations are not permitted to implement creative revenue recognition practices designed solely to boost quarterly earnings.

Yet, those seeking to avoid the government's wrath, as well as that of disgruntled investors, must navigate the perilous straits between the Scylla and Charybdis of the revenue recognition provisions of the Generally Accepted Accounting Principles (GAAP), on the one hand, and the SEC staff's accounting bulletins, on the other. Distinguishing what is permitted from what is not permitted can be difficult. It is challenging simply to figure out where to look for answers.

GAAP are the official standards adopted by the American Institute of Certified Public Accountants (AICPA) through its three successor organizations: the Committee on

Accounting Procedure, the Accounting Principles Board (APB), and the Financial Accounting Standards Board (FASB). In In re K-tel International Inc. Securities Litigation, (2) the Eighth Circuit held that a publicly-traded company's financial statements must comply with GAAP. In reality, however, GAAP are far from being a precise, canonical set of rules that ensure identical accounting treatment of identical transactions. Indeed, there are 19 different GAAP sources.

The AICPA Auditing Standards Board Statement of Auditing Standards (SAS), SAS 69, identifies the following as the sources of GAAP:

1. Accounting principles promulgated by a body designated by the AICPA Council to establish such principles, pursuant to Rule 203 of the AICPA Code of Professional Conduct.

2. Pronouncements of bodies, composed of expert accountants, that deliberate accounting issues in public forums for the purpose of establishing accounting principles or describing existing accounting practices that are generally accepted, provided those pronouncements have been exposed for public comment and have been cleared by a body referred to in Category A.

3. Pronouncements of bodies, organized by a body referred to in Category A and composed of expert accountants, that deliberate accounting issues in public forums for the purpose of interpreting or establishing accounting principles or describing existing accounting practices that are generally accepted, or pronouncements referred to in Category B that have been cleared by a body referred to in Category A but have not been exposed for public comment.

4. Practices or pronouncements that are widely recognized as being generally accepted because they represent prevalent practice in a particular industry, or the knowledgeable application to specific circumstances or pronouncements that are generally accepted.

   According to SAS 69, the determination of which accounting principle is applicable under a particular set of conditions is a function of the hierarchy of GAAP categories.

   Compliance with accounting pronouncements...