1

Corporate Disclosure Response to SEC Litigation Pertaining to

Revenue Recognition

Benjamin VaughanSusan B. Hughes

Barbara ArelThe University of Vermont

2

1999 2001 - 2002 20092006

Accounting and Auditing Enforcement

Release

Litigation Settlement

Hired New CFO

Channel Stuffing

To determine if firms’ revenue recognition disclosures change over the time period of suspected and detected revenue misstatement.

Purpose of the study:

4

Understanding how disclosures change could lead to better detection of fraudulent revenue recognition practices by regulators, auditors and informed users.

Pertinent to the FASB Disclosure Framework & the SEC’s Plain English Initiative

Why it’s important

Literature Review

LITIGATION HURTS MANAGERS.90% of culpable managers lose their jobs, own 9.7% of the firm’s equity and face an average of $8 million in fines and the possibility of jail time. (Karpoff et al 2008)

9%

67%

24%

38% FV Loss Breakdown

(Karpoff et al 2008)

Fines and/or Penalties

Reputational Damages

Market Ad-justment

INVESTORS AVOID THE LITIGATED. Less trading in firms with AAERs, regardless of previous infringements. (Feroz et al 1991)LITIGATION HURTS BUSINES. Firms lose 38% of FV upon litigation release. (Karpoff et al 2008)

Literature Review (cont.)

• Result in lower trading volume and consensus by small investors. (Miller 2010)

• Take longer to be fully represented in the market price. (You & Zhang 2008)

• More complex Revenue Recognition Policies decreases chance of AAER. (Peterson 2011)

MORE COMPLEX DISCLOSURES:

The Incomplete Revelation Hypothesis predicts users read less complex disclosures when analyzing financial statements. (Bloomfield 2002)

Literature Review (cont.)CHANGES DURING AAER Emphasize growth strategies and product lines rather than info related to fraudulent activity. (Hoberg & Lewis 2013)

ALTER DISCLOSURES PRE-LITIGATIONMore readable language, cautionary language, year-to-year disclosure changes(Nelson & Pritchard 2007)

OBFUSCATED DISCLOSURES Lower earnings less readable annual reportsIncreases earning more readable disclosures (Li 2008)

Research Questions

Revenue related Infringement and litigation will trigger changes in footnote significant accounting policy (SAP)

RQ1: Disclosure Readability

RQ2: Disclosure Redundancy between disclosures year-to-

year

9

SampleSelected from the 518 AAER from 2009-2012 listed on the SEC website.

10

1999 2001 - 2002 20092006

Accounting and Auditing Enforcement

Release

Litigation Settlement

Hired New CFO

Channel Stuffing

I.P. A.P.

11

Selections from Sample ProfileCompany Infringement AAER Settlement Data Range Infraction

Arthrocare Corp 2005-2008 2011 2011 2004-2012 Channel Stuffing

Aspen Tech 1999-2002 2009 2007 1998-2008 Recognized revenue on invalid contracts and contingent sales.

Bally Tech. 2003-2005 2011 2008 2002-2009 Improperly recognized bill-and-hold sales.

Basin Water 2006-2007 2011 2011 2006-2008

Recognized revenue on sales with full right of return. Improperly recognized consignment sales, and generated sham transactions.

Cabletron 2001-2002 2011 2007 2000-2005 Improperly recognized revenue on sales with side agreements or full rights of return.

Cardinal Health 2000-2004 2009 2007 1999-2008 Misclassified bulk sales as operating

revenues.

Delphi 2000-2004 2010 2006 1999-2007 Arranged sales with concurrent buy back provisions to boost revenues.

Diebold 2002-2007 2010 2010 2001-2011 Improperly recognized on lease agreement, improper use of Bill-and-hold.

12

• Obtained 10-Ks from year before infringement – year after settlement.

• Extracted SAP disclosures pertaining to revenue recognition. • Relied on Microsoft Office Readability Suite• Captured Word Count and Flesch Reading

Ease Index (FRE) scores• Compared disclosures year over year

• Analyzed word count and FRE data with paired t-tests.

Methods

13

Column A B C

Period Pre-Infringement Infringement Post-Infringement

n 29 30 30

Mean 261 330 382

Range 19 - 756 35 - 1176 35 - 959

Std. Dev. 201 280 251

SAP Word Count Distribution

14

SAP Word Count Test Results

Paired t-Tests using the logged data (t, 2-tailed p value)

A-B -2.317, p=.028

B-C -2.602, p=.014

A-C -4.082, p=.000

Announcement period results NOT significant

15

Column A B C

Period Pre-Infringement Infringement Post-Infringement

n 29 30 30

Mean 18.96 18.20 19.86

Range 2.0-48.0 3.1-36.1 8.0-38.6

Std. Dev. 9.7 8.6 8.2

SAP FRE Scores Distribution

16

Column A B C Period Pre-Infringement Infringement Post-Infringement Paired t-Tests using the logged data (t, 2-tailed p value) B-A -.375, p = .710 C-B 1.591, p = .122 C-A .818, p = .420 Wilcoxon Signed Ranks Test Z, Asymp. Sig. (2-tailed) B-A -.973, sig. = .330 C-B 1.875, sig. = .061 C-A -.706, sig. = .480

SAP FRE Scores Results

17

Significant increases in the word counts throughout the infringement period.

Significant change in the readability of disclosures after the year of infringement.

Results: Word Counts & FRE Scores

18

Column A B C

Period Pre-Infringement Infringement Post-Infringement

n 29 29 30 30

Mean 2.09 2.40 2.29 2.41

Range 1 – 34 2 - 53 2- 37

Std. Dev. .867 .858 .871 .847

Number of Sentences: LN Infringement

19

Number of Sentence Results

Paired t-Tests (t, 2-tailed p value)

B-A 2.580, p = .015

C-B 2.288, p = .030

C-A 3.226, p = .003

Wilcoxon Signed Ranks Test

Z, Asymp. Sig. (2-tailed)

B-A 2.549, sig. = .011

C-B 2.213, sig.=.027

C-A 2.902, sig. = .004

20

• Using Word Compare identified and tallied the number of sentences deleted, added, changed or retained

• SAP SAP • Determined redundancy percentages =

• (New, Modified or Carried Yr. 1) / (Total Sentences Yr. 2)

• (Deleted Yr. 2) / (Total Sentences Yr. 1). • Redundancy data was analyzed with the

Wilcoxon Signed Ranks Test.• Pre-infringement – Infringement,• Infringement – Post-infringement.

Redundancy Methods

21

M

D

D

C

C

D

22

Period

Pre- Infringement to Infringement

Infringement to Post-Infringement

Pre-announcement to Announcement

Announcement to Post- Announcement

n 29 30 24 24

Mean % 12.51 24.10 12.57 11.26

Range % 0.00 - 57.14 0.00 - 100.00 0.00 - 47.83 0.00 - 88.57

Std. Dev. 17.92 29.27 17.34 22.17

Wilcoxon Signed Ranks Test (post to pre)

Asymptotic Sig. 0.032 0.586

Number of Deleted Sentences

No significant change in the number of new or carry-forward sentences.

ResultsTotal words increase significantly throughout the

infringement period: p = 0.000

Disclosures became significantly more readable from the year of infringement – year after:

Sig. = 0.061

Firms added new sentences throughout the infringement period:

Sig. = 0.001

No significant changes in word count or readability in the announcement period.

23

ConclusionFirms undertake significant disclosure creation around the period of infringement, but not around the period of litigation settlement announcement.

Further investigation around the period of infringement may yield more disclosure trends.

Increasing sample size and adding control variables may clarify the results around announcement period.

24

Further WorkMultivariate Tests – Panel data including firm size, profitability, leverage, operating cash flows, changes in auditor, CEO/CFO and GAAP.

Extended Redundancy Disclosure Analysis to time between the alleged infraction and the settlement of litigation.

Disclosure Coding – examine disclosures for % of boilerplate-type disclosures, method disclosures, tonal variation, other changes.

25

26

THANK YOU