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By Quinton F. Seamons and
Robert W. Rouse

The administrative proceeding of Checkosky v. SEC was reconsidered and finalized on January 21, 1997, in response to the remand from the U.S. Court of Appeals for the District of Columbia with the issuance of another opinion of the Securities and Exchange Commission (SEC). The origins of Checkosky began "long ago and far away" in August 1980 and involved the Savin Company.

Checkosky v. SEC addresses the standards of conduct under Rule 2(e) for all professionals practicing before the SEC--in this instance, the accountants. Violations of these standards will result in sanctions consisting of a bar from practice or a suspension or censure. Rule 2(e) has always been part of the Rules of Practice of the SEC and was adopted in 1935 primarily to ensure that professionals practicing before the commission meet standards of integrity and character and exhibit proper professional conduct. Rule 2(e) was recently renumbered Rule 102(e) through revisions to the Rules of Practice. While this case was initiated under the old rule, there are no substantive differences between the former and the current rule.

Savin's Decision to Manufacture Copiers

Savin had been marketing copiers manufactured by Ricoh Company. In the late 1970s Ricoh informed Savin that its distribution contract with Savin would not be renewed. Savin decided to manufacture its own line of copiers and undertook to acquire the necessary expertise and productive capability.

In early 1980, Savin developed a prototype that illustrated certain working components and was accompanied by design drawings. However, the prototype did not actually produce any copies. Development of the copier continued, and Savin disclosed in its August 1982 10-Q filing that developments were on schedule and the introduction of the new copier was expected in early 1983.

The technical issue in Checkosky was the proper accounting for expenditures incurred in developing the new copier. The primary guidance for such accounting was SFAS No. 2, Accounting for Research and Development Costs. SFAS No. 2 essentially provides that "research and development costs" are to be expensed at the time expenditures are made. "Startup costs," however, can be capitalized as an asset, deferred, and amortized.

As early as 1980, the company concluded that there was basis for capitalizing these expenditures as startup costs and presented its position to the audit engagement partner. The company's rationale was that the costs should be capitalized because it had developed a functioning copier that would lead to a normal production cycle.

In the fall of 1980, during the audit of Savin's financial statements for the fiscal year ended April 30, 1981, the partner concluded that Savin's expenditures were no longer research and development but were startup costs that could be capitalized. He testified that he saw a prototype making copies in January 1981, but did not document his observations in the workpapers. In addition he apparently did not inquire at any length regarding the company's efforts to bring the copier into full-scale production.

Savin did display several model copiers at a convention of the National Office Machine Dealers Association in July 1982. The models, however, did not incorporate new technology, such as liquid toner, and could only produce smudged copies. In September 1982, management informed the board of directors that production had to be deferred until fall 1983 because the quality of the copy with the new toner was not as good as existing dry toner machines.

The copier continued to experience defects including leaking toner, overheating, and production errors. In early 1983 the company informed the audit staff that it was redesigning the original "Rhino" model to create a high end machine--the "Pegasus."

The audit partner apparently had no knowledge of the continuing difficulties involving the delay of the new copier. SFAS No. 2 suggested a follow-up assessment of the feasibility, reliability, and marketability of the new product to continue to capitalize costs, but such follow-up was never completed. It was not until the audit of Savin's 1984 financial statements that the audit partner realized Savin was substantially behind in its production schedule and had missed an economic window for introducing its new copier.

Based upon this information, the firm issued a "subject to" audit report on the 1984 annual financial statements stating that the recoverability of the deferred costs depended upon the production and sale of a sufficient number of manufactured copiers at adequate profit levels. Savin's financial statements, included in the 1984 10-K, disclosed $68 million of "deferred start-up costs" as an asset.

The SEC Response

Troubled by the large amounts involved, the SEC investigated and ultimately concluded that $37 million was attributable to the copier and should have been expensed and not capitalized and deferred because the copier never progressed beyond the research and development stage; i.e., it never produced copies on any economically acceptable basis.

The SEC brought an enforcement action in November 1985 that Savin settled neither admitting nor denying the commission's allegations. Savin was enjoined from any further violations of the Federal securities laws and agreed to restate its 1983 and 1984 financial statements. By December 1985, Savin ceased any further development of the copier because of the engineering and production obstacles.

Without explaining why any action should be taken against the accountants, particularly seven years later, the commission issued an administrative opinion and order on August 26, 1992, concluding that the accountants did not comply with generally accepted auditing standards (GAAS) and incorrectly interpreted generally accepted accounting principles (GAAP). The engagement partner and a manager on the audit were found to have engaged in improper conduct, and were suspended from practicing before the commission for two years.

Commissioner Roberts dissented in part because of the age of the proceedings, stating: "In sum, the facts of this case are about the same age as petrified wood. It is difficult to understand what possible message could be delivered to the accounting community on the basis of facts this old."

The Appeal

The case was appealed to the United States Court of Appeals for the District of Columbia because a review of an SEC administrative proceeding can be obtained only in an appellate court. On August 20, 1994, the Appellate Court remanded the proceeding to the commission "for a more adequate explanation of Rule 102(e) and its application to this case." Interestingly, the firm produced four additional boxes of Savin audit workpapers the District of Columbia Circuit apparently considered, even though these documents had not been available to the commission when it issued its opinion.

The reviewing panel of the Appellate Court disagreed as to what standard of conduct applied under Rule 102(e) or even what standard the SEC had applied in its administrative opinion. The Appellate Court pointed out the dramatic impact a violation of Rule 102(e) has on a professional's career and required the SEC to state clearly on remand the standard of conduct that should apply in a Rule 102(e) proceeding.

The Dilemma

This case was a challenging case for the SEC because it involved professionals who did not act with fraudulent intent or in bad faith, but at most made a mistake in judgment in applying GAAS and interpreting GAAP that allegedly constituted "improper professional judgment." If scienter--an intent to deceive--had been found, the accountants may well have been included as defendants in the SEC enforcement action against Savin in November 1985.

The issue of what constitutes unprofessional conduct to require discipline for Rule 102(e) purposes remained unresolved. The Appellate Court's opinion concluded that the SEC did not know where to draw the line with respect to the applicable standard or what message to send to practicing professionals. A negligence standard under Rule 102(e) would have far reaching consequences because the commission could arguably regulate day-to-day professional practices. Furthermore, a lower threshold of culpability, such as negligence, would likely mean any deviation from GAAS or GAAP would result in a violation of Rule 102(e).

The Final Decision

Nevertheless, on January 21, 1997, after reconsideration, the commission continued to believe the accountants had engaged in improper professional conduct and grounds existed for remedial sanctions. Indeed, despite the criticism of the Appellate Court, the commission confirmed its original order imposing sanctions and seemed to view the sanction issue as moot because the accountants had already completed their two-year suspensions.

The accountants had argued that reckless behavior was insufficient for a Rule 102(e) violation because the commission did not allege the accountants acted with scienter. However, the majority opinion of the commission held that Rule 102(e) does not require "a particular mental state, and that negligent actions by a professional may, under certain circumstances, constitute improper professional conduct."

The opinion further noted that Rule 102(e) does not require that the conduct be willful and scienter is not required to violate the rule. While observing that Section 10(b) and Rule 10b-5 of the Exchange Act require scienter, the opinion pointed out that other provisions of the securities laws that affect professionals may not require scienter.

The commission rejected the position that an auditor acting in good faith does not engage in improper professional conduct. Rather, the commission held that a single mispresentation characterized as "careless and unprofessional" may warrant discipline. In refusing to vacate the order, the commission disagreed with the accountants that their failures were "isolated or merely negligent." Chairman Levitt and Commissioner Hunt adopted the majority opinion; Commissioner Wallman did not participate in the proceeding, and Commissioner Johnson dissented; the remaining position on the commission was vacant.

The Dissent

Commissioner Johnson dissented on two bases: first, the mental state of the professional necessary for a violation, and second, the age of the proceedings. Commissioner Johnson advocated sanctioning a professional only when the professional acts with scienter. This contrasted totally with the majority opinion that professionals can be sanctioned under Rule 102(e) for negligent conduct. Commissioner Johnson pointed out that, while the commission can determine who practices before it, this mandate is a limited one and should be levied only after self-restraint and meeting a scienter standard.

In Commissioner Johnson's view, a professional exercises the "best independent judgment" only when the professional has the freedom to make innocent--in some cases, careless--mistakes without fear of losing the privilege of practicing before the commission. Commissioner Johnson also concluded that, even if the accountants had acted with scienter, the age of the proceedings was a sufficient basis for a dismissal because the proceeding had been pending for many years.

Raises More Questions than It Answers

The record in this case demonstrates the difficulty of adjudicating accounting issues upon a record consisting of thousands of pages of transcript and hundreds of exhibits involving five audit years from 1981 to 1985. In light of the Appellate Court's opinion, professionals should realize that an appeal may be necessary to obtain full consideration whether sanctions are appropriate under the rule. However, the appeal process was obviously too long and imposed a substantial burden upon the accountants' professional status.

From a jurisprudence standpoint, it is unfortunate the opinion failed to receive support of a unanimous commission. The opinion was endorsed by only two commissioners, and a full commission might have reached a different conclusion. More unfortunate is the fact that Commissioner Johnson's dissent may indeed state the better position regarding the proper standard applicable to professionals under Rule 102(e).

Checkosky also demonstrates the difficulty of explaining the subjective nature and complexity of professional judgments involving GAAP and GAAS and the related mental states in which these judgments are made. There is little consensus whether recklessness, negligence, or scienter is the appropriate standard for professionals under Rule 102(e). The end result is that Checkosky raised more questions than it answered, and the ambiguities as to the proper standard will continue. *

Robert W. Rouse, PhD, CPA, is a professor and chair of the department of accounting and legal studies at the College of Charleston. Quinton F. Seamons, Esq., is a partner of Beus, Gilbert & Morrill, P.L.L.C. in Phoenix, Arizona.

Gary Illiano
Grant Thornton LLP

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