UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7312 / July 24, 1996 SECURITIES EXCHANGE ACT OF 1934 Release No. 37474 / July 24, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 804 / July 24, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9045 -------------------------------- : : ORDER INSTITUTING In the Matter of : PROCEEDINGS AND OPINION AND : ORDER PURSUANT TO RULE PETER C. FERRARO, CPA, and : 102(e) OF THE WILLIAM G. STAYDUHAR, CPA : RULES OF PRACTICE : Respondents. : : -------------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted against Peter C. Ferraro, CPA and William G. Stayduhar, CPA pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice.-[1]- II. In anticipation of the institution of these administrative proceedings, each respondent has submitted an Offer of Settlement for the purpose of disposing of the issues raised in these proceedings. Solely for the purpose of these proceedings and any ---------FOOTNOTES---------- -[1]- Rule 102(e)(1)(ii) of the Commission's Rules of Practice, 17 C.F.R.  201.102(e), provides in pertinent part: "The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter ... (ii) to have engaged in ... improper professional conduct." ==========================================START OF PAGE 2====== other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. Section 201.1, et seq. the respondents, without admitting or denying the findings set forth herein, except that they admit to the jurisdiction of the Commission over them and over the subject matter of these proceedings, consent to the entry of the findings and to the imposition of the sanctions set forth below. III. FINDINGS On the basis of this Order Instituting Proceedings ("Order") and the Respondents' Offers of Settlement, the Commission finds the following:-[2]- A. RESPONDENTS AND OTHER RELATED PARTIES 1. Respondents Ferraro, 36, a certified public accountant in the State of Pennsylvania, is a partner and co-founder of Ferraro, Krebs and McMurtry, and has been a partner since the firm's inception in 1987. He was the engagement partner in charge of the audits of Sulcus Computer Corporation ("Sulcus") financial statements for the years ended December 31, 1990 through December 31, 1993. Stayduhar, 44, a certified public accountant in the State of Pennsylvania, served as the audit manager on the audits of Sulcus for 1990 through 1993. 2. Other Related Parties Ferraro, Krebs and McMurtry ("FKM"), is a public accounting firm with its offices in Pittsburgh, Pennsylvania. FKM audited Sulcus' financial statements for the years ended December 31, 1990, 1991, 1992 and 1993. FKM resigned as Sulcus' auditors on March 3, 1995. Sulcus Computer Corporation, is a Pennsylvania corporation with its principal executive offices in Greensburg, Pennsylvania. Sulcus develops, manufactures, markets and installs microcomputer systems designed to automate the creation, handling, storage and retrieval of information and documents in the hospitality and real estate industries and for the legal profession. At all ---------FOOTNOTES---------- -[2]- The findings herein are made pursuant to the Offers of Settlement submitted by Ferraro and Stayduhar and are not binding on any other person or entity named as a respondent in this or any other proceeding. ==========================================START OF PAGE 3====== relevant times, the Company's common stock was registered pursuant to 12(b) of the Exchange Act and traded on the American Stock Exchange. B. INTRODUCTION This opinion and order relates to FKM's audits of Sulcus' financial statements for the years ended December 31, 1992, and 1991. In both years, FKM issued audit reports stating that they had conducted audits of Sulcus' financial statements in accordance with generally accepted auditing standards ("GAAS"), and containing unqualified opinions that the company's financial statements were fairly presented in conformity with generally accepted accounting principles ("GAAP"). In fact, as explained below, the auditors failed to conduct the 1992 and 1991 audits in accordance with GAAS and Sulcus' financial statements were not presented in conformity with GAAP.-[3]- For both 1992 and 1991, Sulcus' year end financial statements materially overstated Sulcus' earnings.4/ The misstatements resulted from improper accounting employed by Sulcus in connection with a series of acquisitions Sulcus completed during 1992 and 1991. During that period, Sulcus acquired a number of unprofitable domestic and foreign corporations. In connection with each of the acquisitions, Sulcus recorded excess liabilities and/or reserves on its books as of the date of the transaction. After completing the ---------FOOTNOTES---------- -[3]- The Commission issued a cease-and-desist order against Sulcus, Jeffrey S. Ratner, its Chairman and CEO, and John Picardi, the CFO of one of its subsidiaries, finding, among other things, that as a result of the improper accounting, the respondents violated or caused violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, and, Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-1, 13a-13 and 13b2-1 thereunder. Further, the Order denied John Picardi the privilege of appearing or practicing before the Commission with the right to apply for reinstatement after thirty months. See In the Matter of Sulcus Computer Corporation, Admin. Proc. File No. 3-8996, Securities Act Rel. No. 7286, Exchange Act Rel. No. 37160, Accounting and Auditing Enforcement Rel. No. 778 (May 2, 1996). 4 On May 17, 1994, Sulcus restated its financial statements for 1991 and 1992, which resulted in restated net income of $1,692,338 and $3,221,786, respectively. This resulted in a decrease of 13 percent and 38 percent respectively from the originally reported net income of $1,937,090 and $5,180,292. Approximately 40 percent of the 1992 restatements related to the financial statements of Sulcus' foreign subsidiaries that were not audited by FKM. acquisitions, Sulcus used the excess reserves/liabilities to improve post-acquisition earnings. On most occasions this was done by improperly understating current period operating expenses (e.g. salaries) by charging them against the reserves on the purported theory that they were "acquisition related" expenses. In other instances, it was done by reversing the reserves/liabilities and improperly reporting a corresponding amount as revenue. Finally, in two transactions Sulcus improperly recorded revenue with respect to the entity acquired. Ferraro and Stayduhar were the audit partner and manager, respectively, for the 1992 and 1991 audits. As described below, Ferraro and Stayduhar engaged in improper professional conduct within the meaning of Rule 102(e) in that they failed to conduct the 1992 and 1991 Sulcus audits in accordance with GAAS. Ferraro and Stayduhar (1) failed to obtain sufficient competent evidential matter to afford a reasonable basis for FKM's opinions on Sulcus' financial statements (SAS No. 31, AU 326.01); (2) failed to assess properly whether the company's financial statements were fairly presented in accordance with GAAP; and (3) failed to exercise due professional care in the performance of the audits (SAS No. 1, AU 230.02). C. Specific Audit Failures by Ferraro and Stayduhar Ferraro and Stayduhar failed to exercise professional skepticism (as required by SAS No. 53, AU 316.16) and accepted the unusual pattern of financial results achieved as a result of Sulcus' improper accounting for its acquisitions. Sulcus repeatedly acquired companies with a history of losses, and by improperly accounting for those entities, caused them to immediately begin to contribute substantially to Sulcus' reported earnings. The lack of professional skepticism Ferraro and Stayduhar demonstrated as auditors and their failure to perform basic auditing procedures enabled Sulcus to overstate its financial results by accounting for its acquisitions in a fashion that was improper and inconsistent with GAAP. 1. The 1992 Audit a. The Unisys Settlement Sulcus acquired Lodgistix, Inc. ("Lodgistix") in February 1991. Prior to its acquisition by Sulcus, Lodgistix had made a commitment to purchase $2.5 and $2.3 million of computer equipment from the Unisys Corporation ("Unisys") in 1991 and 1992, respectively. Lodgistix failed to meet the purchase requirement in 1991, and by early 1992 had stopped ordering Unisys equipment altogether. In addition, at that time, Sulcus had open accounts payable to Unisys in excess of $300,000 as well as other unrecorded payables which were being disputed. By late 1991, Sulcus and Unisys had begun settlement discussions to ==========================================START OF PAGE 4====== resolve these matters. In April 1992, Sulcus made a retroactive $575,000 adjustment to Lodgistix' opening balance sheet to create a reserve, purportedly for a settlement of the outstanding claims with Unisys. There was no basis for making the adjustment in that amount. Together with the accounts payable to Unisys already on Sulcus' books, the adjustment raised the total recorded liability to Unisys to approximately $870,000. Four months later when Sulcus reached a global settlement with Unisys for a maximum exposure of $620,000, Sulcus improperly applied the $250,000 excess reserve as a reduction in cost of goods sold, thereby reporting a material income benefit. Ferraro and Stayduhar failed to properly audit those adjustments. In early 1992, Sulcus informed Ferraro that Sulcus had recorded the $575,000 adjustment in anticipation of settling its outstanding claims with Unisys. Neither Ferraro nor Stayduhar, however, evaluated Sulcus' basis for recording this adjustment or inquired as to why Sulcus was unable to fulfill its commitment. During the 1992 audit, both Ferraro and Stayduhar reviewed copies of the Unisys settlement agreement. Ferraro and Stayduhar decided that because the $620,000 settlement amount with Unisys was "close" to the $575,000 retroactive adjustment, there was no need to inquire further. This comparison did not recognize critical provisions of the settlement agreement, in particular that it resolved all other material liabilities to Unisys, including Sulcus' previously recorded accounts payable. Ferraro and Stayduhar did not consider the effect of the settlement agreement on the Unisys accounts payable, or the accounting treatment of those payables. As a result, they were unaware of the excess liabilities that resulted from the settlement agreement, and failed to detect that Sulcus improperly reversed them to its advantage, reducing cost of sales and thereby increasing reported income. b. The Squirrel Acquisition In March 1992, Sulcus acquired Squirrel Companies, Inc. ("Squirrel").5/ In May 1992, John Picardi ("Picardi"), CFO of Sulcus Hospitality Group, directed Squirrel's CFO to record, as of the acquisition date, an additional $1.7 million in liabilities and reserves. These adjustments, which aggregated to more than one third of Squirrel's total assets before the acquisition and wholly eliminated Squirrel's net worth, were excessive. 5 Squirrel develops and markets software systems and hardware for the hospitality industry. Upon acquisition Squirrel became part of SHG, and immediately constituted one of the largest segments of Sulcus' operations. ==========================================START OF PAGE 5====== After the acquisition, Sulcus improperly used the excess reserves and liabilities to increase its post-acquisition earnings. Sulcus accomplished this by charging current period expenses against the pre-acquisition reserves and liabilities. The journal entries through which the expenses were charged against the reserves were usually in large round dollar amounts. There was no contemporaneous documentation to justify the entries, or even to explain which expenses were being capitalized. On the contrary, Picardi simply estimated an amount of expenses that he thought were acquisition-related. As a result, Sulcus capitalized approximately $1.3 million of "acquisition costs," at least $264,500 of which should have been expensed. The auditors conducted little examination of the costs capitalized by Sulcus during 1992 in connection with the Squirrel acquisition. Stayduhar requested documentation of Sulcus' capitalized acquisition costs, and received in response a one page "Analysis of Accrued Expenses" schedule. The schedule identified only $653,000 of capitalized acquisition costs, versus the $1.3 million in acquisition costs actually recorded by Sulcus in their books and records. Stayduhar included the schedule in the audit workpapers. Although Stayduhar claimed to have tested the $653,000 of costs included on the schedule, the schedule contained no tickmarks and there is no other evidence of audit procedures performed to test those amounts. If Stayduhar had compared the capitalized costs summarized on the schedule to Sulcus' general ledger, he would have realized that Sulcus had actually capitalized almost twice that amount, and further would have discovered that the actual "transitional employee" salary costs capitalized by Sulcus during 1992 were $625,700, rather than the $345,500 contained on Sulcus' schedule. Stayduhar also should have learned that Sulcus had capitalized "ongoing" payroll costs for certain employees, which in some cases exceeded one full year of wages, and that payroll costs were capitalized for employees hired after Squirrel had been acquired. Neither Stayduhar nor Ferraro took exception to these practices. Late in the 1992 audit, Ferraro realized in auditing Sulcus' goodwill account that the acquisition costs incurred by Sulcus as a result of the Squirrel acquisition were materially larger than what was reflected in the schedule. Ferraro concluded that Stayduhar had "only tested about 50 percent of the cost." Ferraro discussed the issue with Sulcus management and was told that the difference comprised costs "that were similar" to those contained on the schedule. Despite learning of the omission of material amounts of acquisition costs from the schedule, Ferraro did not consider whether Stayduhar's audit of the capitalization costs was insufficient. Rather, he simply accepted management's explanation and performed no other procedures on the additional ==========================================START OF PAGE 6====== capitalized costs, which he understood were included in the financial statements but had been omitted from the schedule. c. The Income Tax Provision In preparing its 1992 financial statements, Sulcus adopted Financial Accounting Standard No. 109, Accounting for Income Taxes. Ferraro's audit of the Company's income tax provision was inadequate. The audit workpapers do not document that any audit procedures were performed on the Sulcus-prepared tax provision schedules. Moreover, those schedules did not reconcile with certain amounts that were reported on the financial statements and in the income tax footnote. In its restatement, Sulcus reduced its originally reported income tax provision for 1992 by $338,700, and simultaneously reduced the cumulative benefit recognized on its statement of operations from the adoption of FAS No. 109 by an approximate amount. The balance sheet income tax deferred accounts were also restated. The FAS 109 restatement reduced Sulcus' 1992 net income by $7,500. 2. The 1991 Audit Ferraro and Stayduhar's audit of Sulcus' 1991 financial statements was also deficient. In a 1991 year-end transaction, Sulcus had acquired the assets of Belvoir PTY ("Belvoir"), its Australian licensee. As part of that transaction, Sulcus improperly recorded $195,000 of revenue and a receivable from Belvoir. The receivable was immediately forgiven as part of the purchase price. During the 1991 audit, FKM did not examine the financial statements of the new Australian subsidiary or Sulcus' acquisition accounting for it because its total sales were less than 2% of Sulcus 1991 sales and its assets were less than 1% of Sulcus' total assets. However, the improperly recorded revenue of $195,000 was equal to about 10% of Sulcus' 1991 net income, and should not have been recorded as revenue as part of that acquisition. Because Ferraro and Stayduhar failed to adequately audit this acquisition or the Lodgistix revenue, they did not discover the improperly recorded amounts. D. Ferraro and Stayduhar's Improper Professional Conduct Ferraro and Stayduhar engaged in improper professional conduct, within the meaning of Rule 102(e) of the Commission's Rules of Practice, by failing to conduct their audits of Sulcus for 1992 and 1991 in accordance with GAAS. In sum, Ferraro and Stayduhar failed to obtain sufficient competent evidential matter with respect to Sulcus' accounting for its acquisitions and failed to assess properly whether Sulcus' accounting for its acquisitions was in conformity with GAAP. Further, the audit failures described above demonstrate the auditors did not ==========================================START OF PAGE 7====== exercise due professional care in the performance of their audits. IV. ORDER IMPOSING REMEDIAL SANCTIONS Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the offer of settlement submitted by the respondents and accordingly, IT IS HEREBY ORDERED, effective immediately, that: 1. Ferraro is denied the privilege of appearing or practicing before the Commission as an accountant. 2. Two years from the date of this Order, Ferraro may apply to the Commission by submitting an application to the Office of the Chief Accountant which requests that he be permitted to resume appearing or practicing before the Commission as: a. a preparer or reviewer, or a person responsible for the preparation or review, of financial statements of a public company to be filed with the Commission upon submission of an application satisfactory to the Commission in which Ferraro undertakes that, in his practice before the Commission, his work will be reviewed by the independent audit committee of the company for which he works or in some other manner acceptable to the Commission; b. an independent accountant upon submission of an application containing a showing satisfactory to the Commission that: (1). Ferraro, or any firm with which he is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent accountant; (2). Ferraro or the firm has received an unqualified report relating to his or the firm's most recent peer review conducted in accordance with the guidelines adopted by the SEC Practice Section; and (3). Ferraro will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he appears or practices before the Commission as an independent accountant. ==========================================START OF PAGE 8====== c. The Commission's review of any request or application by Ferraro to resume appearing or practicing before the Commission may include consideration of, in addition to the matters referenced above, any other matters relating to Ferraro's character, integrity, professional conduct, or qualifications to appear or practice before the Commission. 3. Stayduhar is denied the privilege of appearing or practicing before the Commission as an accountant. 4. One year from the date of this Order, Stayduhar may apply to the Commission by submitting an application to the Office of the Chief Accountant which requests that he be permitted to resume appearing or practicing before the Commission as: a. a preparer or reviewer, or a person responsible for the preparation or review, of financial statements of a public company to be filed with the Commission upon submission of an application satisfactory to the Commission in which Stayduhar undertakes that, in his practice before the Commission, his work will be reviewed by the independent audit committee of the company for which he works or in some other manner acceptable to the Commission; b. an independent accountant upon submission of an application containing a showing satisfactory to the Commission that: (1). Stayduhar, or any firm with which he is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent accountant; (2). Stayduhar or the firm has received an unqualified report relating to his or the firm's most recent peer review conducted in accordance with the guidelines adopted by the SEC Practice Section; and (3). Stayduhar will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he appears or practices before the Commission as an independent accountant. c. The Commission's review of any request or application by Stayduhar to resume appearing or practicing before the Commission may include consideration of, in addition to the ==========================================START OF PAGE 9====== matters referenced above, any other matters relating to Stayduhar's character, integrity, professional conduct, or qualifications to appear or practice before the Commission. By the Commission. Jonathan G. Katz Secretary ==========================================START OF PAGE 10======