Accounting Expert Witness Withstands Daubert Challenge in SEC Case

CASE: SEC v. Lucent Techs., Inc., 610 F. Supp. 2d 342 (D.N.J. 2009)

BACKGROUND: This case regarded the sales of telecommunications equipment by Lucent and its recognition of revenues from those sales in fiscal year 2000. The allegations against all defendants were that defendants authorized or approved verbal side agreements, credits or other incentives in connection with those sales to induce Lucent’s customers to purchase equipment. These extra-contractual commitments, according to the SEC, casted substantial doubt on Lucent’s ability to collect payment on these sales and made recording of revenues improper under GAAP. The improper revenue recognition caused Lucent to materially overstate pre-tax income in its financial statements filed with the SEC. The SEC’s charges against the higher-ups in Lucent’s sales division were based on their role in five transactions with two of Lucent’s top distributors. The SEC’s claims against the executives in charge of Lucent’s ‘AT&T Customer Business Unit’ stemmed from their involvement in Lucent’s sale of four wireless network switches to AT&T Wireless Services.

EXPERT WITNESS: Sally L. Hoffman was the SEC’s accounting expert. She is an expert at litigation consulting, with in-depth expertise in investigations of alleged fraudulent financial reporting, consulting in the application of generally accepted accounting principles (GAAP) and auditing standards (GAAS), damage analyses, fraud investigations, contract and business disputes, and forensic accounting.

Ms. Hoffman is a nationally recognized authority on accounting and auditing standards, professional ethics, and Securities and Exchange Commission (SEC) reporting requirements. She has been active in the profession’s standard-setting process and has served on all three senior technical committees of the American Institute of Certified Public Accountants (AICPA): the Auditing Standards Board; the Accounting Standards Executive Committee; and the Professional Ethics Executive Committee. She also served on the Professional Standards and Practices Committee of the Association of Certified Fraud Examiners. As a member of the Auditing Standards Board’s Fraud Task Force, she helped draft the Statement of Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit and served on the AICPA Fraud Task Force.

DAUBERT CHALLENGE: The executives in charge of the AT&T Customer Business Unit moved to strike the SEC’s accounting expert, Sally L. Hoffman, on the ground that she has made an impermissible “factual finding.” Defendants charged that Ms. Hoffman’s opinion that Lucent violated GAAP was based on her incorrect and unsupported factual determination that Lucent’s trading partner’s oral promise that each would recognize the sale of the four switches as revenue for a future quarter was not contingent on whether they returned the product or not. Defendants noted that if the Court were to strike Ms. Hoffman’s opinion, only their expert’s opinion that Lucent committed no underlying GAAP violation would stand and that the Court should grant summary judgment on that basis.

The SEC argued that defendants’ motion was improper both procedurally and on the merits because defendants were really arguing that the SEC’s expert was substantively incorrect. The SEC asserted that there was no basis to strike Ms. Hoffman’s testimony because her opinion was based on sound accounting principles and ample evidence in the record.

CONCLUSION:

Ms. Hoffman’s principal opinion with respect to the defendants was that “the $53 million transaction did not meet the GAAP criteria for revenue recognition; it should not have been recognized in Lucent’s third fiscal 2000 quarter [ending on June 30, 2000].”

In reaching her opinion, she first explained the following accounting principles:

“GAAP are the entire body of principles generally accepted by accountants as appropriate in accounting for an entity’s financial transactions.”

“Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (“CON 5″), which provides guidance on revenue recognition, requires that ‘in order for revenue to be recognized it must be realized, or realizable, and earned.'”

“Accounting Research Bulletin No. 43 (“ARB 43″), which also addresses revenue recognition, states that revenue should not be recognized at the time of a sale in the ordinary course of business if ‘the collection of the sale price is not reasonably assured.'”

“The concept of “substance over form” requires that the accounting for a transaction should follow its substance, not just the form. Thus, where the form of the transaction (for example, the written contract or other formal evidence of the transaction) differs from the financial impact, the financial impact, not the form should dictate the accounting.”

Applying these principles to the factual record, Ms. Hoffman concluded that the $53 million in revenue was: (1) not realizable; (2) not collectible; and (3) the price of the switches was not fixed and determinable.

The SEC stated that the motion to strike should be denied because this was just two experts offering different opinions. Defendants disputed this, noting that the experts do not disagree on accounting principles. Rather, they said that Ms. Hoffman’s opinion was objectionable to defendants because it was based on a factual assumption not present in the record. Defendants likened Ms. Hoffman to the experts excluded by this Court in another case who had simply relied on speculation and subjective belief of their clients regarding damages. The Court found the comparison to be faulty, however, because unlike the experts in that case, Ms. Hoffman extensively examined the extensive record to arrive at her conclusions.

The Court therefore found no Daubert basis to exclude Ms. Hoffman’s opinion. Ms. Hoffman relied on the factual record and applied sound accounting principles to reach her opinion. The fact she disregarded certain testimony the defendants find particularly helpful to their cause was not a cognizable basis to exclude her expert reports. The Court noted that the appropriate medium to attack any weaknesses in Ms. Hoffman’s opinion would be vigorous cross-examination, not a motion to strike.