Corporate Disclosure Response to
SEC Litigation Pertaining to
Revenue Recognition
Benjamin Vaughan
Susan B. Hughes
Barbara Arel
The University of Vermont
1
Hired
New
CFO
Channel
Stuffing
Litigation
Settlement
1999
2001 - 2002
2006
2
Accounting
and Auditing
Enforcement
Release
2009
Purpose of the study:
 To determine if firms’ revenue recognition
disclosures change over the time period of
suspected and detected revenue
misstatement.
Why it’s important
 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
4
Literature Review
INVESTORS AVOID THE LITIGATED.
Less trading in firms with AAERs, regardless of previous
infringements. (Feroz et al 1991)
38% FV Loss
LITIGATION HURTS BUSINES.
Breakdown
Firms lose 38% of FV upon litigation
(Karpoff et al 2008)
release. (Karpoff et al 2008)
LITIGATION HURTS MANAGERS.
9%
Fines and/or
90% of culpable managers lose
Penalties
24%
their jobs, own 9.7% of the firm’s
Reputational
equity and face an average of $8
Damages
67%
million in fines and the possibility of
Market
jail time. (Karpoff et al 2008)
Adjustment
Literature Review (cont.)
The Incomplete Revelation Hypothesis predicts
users read less complex disclosures when
analyzing financial statements. (Bloomfield 2002)
MORE COMPLEX DISCLOSURES:
• 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)
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-LITIGATION
More readable language, cautionary language, yearto-year disclosure changes
(Nelson & Pritchard 2007)
OBFUSCATED DISCLOSURES
Lower earnings  less readable annual reports
Increases 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
Sample
Selected from the 518 AAER from 2009-2012
listed on the SEC website.
9
Hired
New
CFO
Channel
Stuffing
I.P.
1999
10
2001 - 2002
Litigation
Settlement
Accounting
and Auditing
Enforcement
Release
A.P.
2006
2009
Selections from Sample Profile
Company
Infringement AAER Settlement Data Range
Infraction
Arthrocare
Corp
2005-2008
2011
2011
2004-2012 Channel Stuffing
Aspen Tech
1999-2002
2009
2007
1998-2008
Bally Tech.
2003-2005
2011
2008
2002-2009 Improperly recognized bill-and-hold sales.
Basin
Water
2006-2007
2011
2011
2006-2008
Cabletron
2001-2002
2011
2007
2000-2005
Cardinal
Health
2000-2004
2009
2007
1999-2008
Delphi
2000-2004
2010
2006
1999-2007
Diebold
2002-2007
2010
2010
2001-2011
11
Recognized revenue on invalid contracts and
contingent sales.
Recognized revenue on sales with full right of
return. Improperly recognized consignment
sales, and generated sham transactions.
Improperly recognized revenue on sales with
side agreements or full rights of return.
Misclassified bulk sales as operating
revenues.
Arranged sales with concurrent buy back
provisions to boost revenues.
Improperly recognized on lease agreement,
improper use of Bill-and-hold.
Methods
• 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.
12
SAP Word Count Distribution
Column
Period
n
A
B
C
Pre-Infringement Infringement Post-Infringement
29
30
30
Mean
261
330
382
Range
Std.
Dev.
19 - 756
35 - 1176
35 - 959
201
280
251
13
SAP Word Count Test Results
Paired t-Tests using the logged data (t, 2-tailed p value)
A-B
B-C
A-C
-2.317, p=.028
-2.602, p=.014
-4.082, p=.000
Announcement period results NOT significant
14
SAP FRE Scores Distribution
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
9.7
8.6
8.2
Std. Dev.
15
SAP FRE Scores Results
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
C-B
C-A
16
-.973, sig. = .330
1.875, sig. = .061
-.706, sig. = .480
Results: Word Counts & FRE Scores
Significant increases in the word counts
throughout the infringement period.
Significant change in the readability of disclosures
after the year of infringement.
17
Number of Sentences: LN Infringement
Column
Period
n
A
B
Pre-Infringement
C
Infringement Post-Infringement
29
29
30
30
Mean
2.09
2.40
2.29
2.41
Range
1 – 34
2 - 53
2- 37
.871
.847
Std. Dev.
18
.867
.858
Number of Sentence Results
Paired t-Tests (t, 2-tailed p value)
B-A
2.580, p = .015
C-B
C-A
2.288, p = .030
3.226, p = .003
Wilcoxon Signed Ranks Test
Z, Asymp. Sig. (2-tailed)
B-A
C-B
C-A
19
2.549, sig. = .011
2.213, sig.=.027
2.902, sig. = .004
Redundancy Methods
• 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.
20
M
D
D
C
C
D
21
Number of Deleted Sentences
Period
n
PreAnnouncement to
Infringement to Infringement to
Pre-announcement to PostInfringement
Post-Infringement Announcement
Announcement
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
No significant change in the number of new or
carry-forward sentences.
22
Results
Total 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
Conclusion
Firms 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 Work
Multivariate 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
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