Post on 18-Jan-2016
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Corporate Disclosure Response to SEC Litigation Pertaining to
Revenue Recognition
Benjamin VaughanSusan B. Hughes
Barbara ArelThe University of Vermont
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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:
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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
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SampleSelected from the 518 AAER from 2009-2012 listed on the SEC website.
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1999 2001 - 2002 20092006
Accounting and Auditing Enforcement
Release
Litigation Settlement
Hired New CFO
Channel Stuffing
I.P. A.P.
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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.
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• 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
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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
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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
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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
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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
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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
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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
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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
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• 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
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M
D
D
C
C
D
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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.
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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.
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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.
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THANK YOU