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(The article featured below is a selection from Corporate Governance Guide Update, which is available to subscribers of that publication.)

SEC Enforcement Action Alleges that Senior Officers Misled Outside Auditors in Revenue Recognition Scheme

An SEC enforcement action alleged that senior corporate officials misled the company’s outside audit firm as part of a fraudulent accounting scheme to inflate revenues. The SEC alleged that the company overstated its sales revenues by booking false sales and engaging in improper revenue recognition practices. The Commission charged the company’s former CEO and CFO and corporate secretary for their roles in the fraudulent accounting scheme. The SEC also charged the former controller and the former director of financial services for improper accounting. SEC v. NutraCea, DC Ariz. CV-11-0092-PHX-DGC, AAER No. 3324.

Without admitting or denying the SEC's allegations, the former CEO, corporate secretary, controller and financial services director agreed to settle the action and to the entry of permanent injunctions. The CEO was permanently barred from serving as an officer or director and the secretary agreed to a five year bar. The accounting professionals agreed to be barred for at least one year from SEC practice. The action continues against the former CFO, alleging that he violated and aided and abetted violations of the antifraud, books and records, financial reporting, internal controls, and lying to auditors provisions of the federal securities laws.

The SEC said that in the second quarter of fiscal year 2007 the company improperly recorded a $2.6 million sale of four different products to a purported customer. The company had attempted to book revenue from the sale of these same products to three different customers in the previous quarter, but the outside auditors disagreed with the company’s assessment that revenues from the sales were appropriately recognized. The CEO fought hard to convince the outside auditors that the revenue from these first quarter sales should be booked. However, the outside audit firm refused to change its position and made the company reverse the revenue, causing a shortfall in revenues by 47% from the same period one year before.

In the next quarter, the CEO was determined to recognize revenue from the sale of these same products. Specifically, he approached the customer’s president and asked him to issue purchase orders for $2.6 million of product. According to the SEC, this transaction was a complete sham since the customer had no intention of purchasing and selling these products.

Under SEC SAB No. 104, collectability must be reasonably assured before revenue can be recognized. In this instance, reasoned the SEC, collection of the receivable could not be reasonably assured because of the customer’s precarious financial condition and the dubious nature of the sales arrangement. To further substantiate this sham sale and to support recognizing the entire sale in the second quarter, the CEO worked out a $1 million loan from the company’s former COO to the customer to enable the customer to make a down payment on the $2.6 million purchase

Despite their knowledge that the $1 million down payment on the $2.6 million sale was from the company’s former COO’s loan, the CEO, CFO and the two accounting professionals failed to disclose this information to the outside auditors. Instead, they affirmatively misled the auditors when they all signed a management representation letter related to the auditors’ review of the interim financial information of the second quarter Form 10-Q falsely representing that the interim financial information was presented in accordance with GAAP. All financial records and related data were made available to the auditors, and they had no knowledge of any fraud or suspected fraud affecting the company involving management, employees who had significant roles in the internal control, or others where fraud could have a material effect on the interim financial information.