SEC Seeks Reimbursement of CEO’s Bonuses and Stock Profits Earned During Period of Accounting Fraud at Public Company
Thursday, 13 August 2009 17:12

SEC Seeks Reimbursement of CEO’s Bonuses and Stock Profits Earned During Period of Accounting Fraud at Public Company

Complaint filed in the U.S. District Court for the District of Arizona alleg ing violations of § 304 of the Sarbanes-Oxley Act of 2002.

Background Facts:

In March 2009, the SEC filed a civil injunctive action in federal court charging the former president and chief operating officer, former chief financial officer, former controller, and former director of credits and receivables of CSK Auto Corporation, an automotive parts and accessories retailer headquartered in Arizona, with securities fraud, among other charges. In May 2009, the SEC instituted settled cease-and-desist proceedings against CSK and found that the company had fraudulently filed false financial statements as set forth above for fiscal years 2002 through 2004. In that settled proceeding, the SEC ordered CSK to cease and desist from committing or causing any violations and any future violations of the antifraud, reporting, books and records, and internal control provisions of the federal securities laws. CSK, in agreeing to that settlement, neither admitted nor denied the SEC’s findings.

Allegations:

According to a complaint filed on July 22, 2009, the SEC asked the U.S. District Court for the District of Arizona to order the former chief executive officer of CSK Auto Corporation, Maynard L. Jenkins of Scottsdale, Arizona, to reimburse the company and its shareholders more than $4 million that he received in bonuses and stock sale profits while CSK was committing accounting fraud during 2002-2004.

Although CSK had various vendor-allowance programs, its largest was its “Let’s Work Together” program (“LWT”). Typically, LWT agreements covered a one-year period, which CSK referred to as the “program year.” Although the LWT agreements varied, CSK generally earned LWT allowances at a set dollar amount, as a percentage of the amount CSK spent to purchase the vendor’s product, or as a certain number of cents per item CSK purchased from the vendor.

CSK recognized LWT allowances ratably, on a monthly basis, based on its estimate of the total allowances it expected to earn for the entire program year. In theory, CSK’s estimate was based on the LWT agreements and CSK’s expected purchases from its vendors. As CSK recognized LWT allowances for a given program year, it increased the LWT account receivable for that program year. Each LWT program year had its own account receivable. As CSK collected LWT allowances for a particular program year, GAAP required that CSK reduce the outstanding receivable for that same LWT program year.

During fiscal years 2002, 2003, and 2004, CSK was unable to collect all of the vendor allowances it had recognized. As a result, large accounts receivable built up for each LWT program year.

GAAP required that CSK write off the uncollectible LWT accounts receivable. Specifically, under Statement of Financial Accounting Standards No. 5 (“SFAS No. 5”), Accounting for Contingencies, Paragraph 8, an estimated loss from a loss contingency shall be accrued by a charge to income if: (a) information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired at the date of the financial statements; and (b) the amount of the loss can be reasonably estimated. SFAS No. 5, Paragraph 3 defines “probable” to mean that the future event or events are likely to occur. SFAS No. 5, Paragraph 4 states that examples of loss contingencies include collectibility of receivables. A write-off of the uncollectible LWT allowance receivables would have increased CSK’s expenses during the fiscal year the write-off was made, resulting in a decrease in pretax income.

Instead of writing off CSK’s uncollectible LWT accounts receivable and taking the requisite reduction to pretax income, CSK concealed its uncollectible LWT accounts receivable by: (a) applying millions of dollars of LWT allowances earned and collected for later LWT program years to prior LWT program year accounts receivable (referred to within CSK as “filling the bucket”); and (b) incorrectly accounting for millions of dollars of LWT allowances it paid back to vendors. As a result, CSK avoided writing off tens of millions of dollars in uncollectible LWT receivables, which it had previously recognized.

CSK “filled the bucket” by taking LWT allowances collected for later program years and applying them to reduce an earlier LWT program year’s account receivable. Specifically, CSK: (a) made baseless journal entries reducing the account receivable for a prior LWT program year with an offsetting increase to the account receivable for a later LWT program year; and (b) applied LWT allowance collections for a later LWT program year to an earlier program year’s LWT account receivable.

CSK also failed to write off LWT allowances it had over-collected for prior LWT program years and ultimately paid back to its vendors. Instead of writing off amounts CSK paid back, which would have reduced its pretax income, CSK increased a later LWT program year’s account receivable, making it appear that it had collected an older account receivable when all CSK had done was move the outstanding receivable balance to a more recent year. This accounting treatment was contrary to GAAP because, by paying an amount back to a vendor for a prior LWT program year, CSK acknowledged its uncollectibility and should have written off the amount.

In 2002, 2003, and 2004, CSK failed to write off approximately $11 million, $24 million, and $21 million, respectively, of uncollectible vendor allowances it had recognized in previous years, most significantly as part of the 2001 LWT program year. In addition, in 2003 CSK improperly and prematurely recognized $6 million in vendor allowances and improperly recognized an additional $4 million of LWT allowances. As a result, in 2002, 2003, and 2004, CSK overstated its pretax income by approximately $11 million, $34 million, and $21 million, respectively. CSK was required to prepare an accounting restatement for fiscal years 2002, 2003, and 2004.

Remedies by Consent:

The Complaint asks the Court to order Jenkins to reimburse CSK for his bonuses and other incentive-based and equity-based compensation, and profits from CSK stock sales, pursuant to Section 304 of the Sarbanes-Oxley Act of 2002.

[Editor’s Note: This is the SEC’s first enforcement action brought solely under Section 304 of the Sarbanes-Oxley Act of 2002.]

 

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