The independent auditor of a
company’s financial statements may have acted with scienter with regard to
revenue recognition involving some transactions, ruled a Second Circuit panel. While
at the time the audit firm considered these transactions to be red flags
warranting heightened scrutiny, noted the panel, the firm ultimately approved
the company’s recognition of revenue in connection with each of these
transactions. There was evidence that in
the course of its audit Grant Thornton learned of and advised against the use
of indisputably deceptive accounting schemes, said the appeals court, but
eventually acquiesced in the schemes by issuing an unqualified audit opinion. Thus,
the panel held that the securities fraud claims could go forward since the
investors set out enough facts constituting evidence of conscious misbehavior
or recklessness to survive a motion fir summary judgment. Gould v.Winstar
Communications, CA-2 July 19, 2012.
GT requested that the
company’s counterparties provide additional documentary evidence of the
relevant sales underlying each questionable transaction. By doing so,
consistent with SEC Staff Accounting Bulletin 101, in which the SEC states four
conditions that must be satisfied before revenue can be recognized, GT sought
to obtain independent support for the company’s recognition of revenue for each
transaction, in other words, support from documents that were not generated by the
company itself. As of February 10, 2000, GT still had not received responsive
documents from four of these customers. Nonetheless, it issued an audit opinion
letter opining that the company’s 1999 financial statements accurately
reflected its financial condition and complied with GAAP.
The appeals court found evidence supporting the
contention that GT consciously ignored the company’s fraud when it approved the
company’s recognition of revenue for the suspicious 1999 transactions. This
evidence goes beyond a mere failure to uncover the accounting fraud and, in
general, relates to the company’s recognition of revenue for the sale of
equipment or services without sufficient indicia of delivery, its recognition
of all revenue associated with the incomplete sale of telecommunications
systems, and its recognition of revenue for sales of indefeasible rights of use,
equipment, and services to financially unstable companies to whom the company
paid back large sums under separate contractual obligations. There was also
evidence that GT failed to confirm the company’s representations regarding these
transactions or to retain and review documents evidencing each transaction.