Accounting & Tax

Accounting Issues Drive Securities Lawsuits

Cases involving such things as earnings management, use of "cookie jar" reserves, and underestimation of reserves and allowances made up 61 percent...
Stephen TaubAugust 4, 2004

From the point of view of corporate finance, the good news about private securities class-action lawsuits is that their numbers have been declining. On the negative side, however, is the recent finding that accounting issues have continued to dominate the overall number of cases.

Last year, there were 175 private securities class-action cases, down from 218 in 2002, and the fewest number since 1997, when 167 cases were filed, according to the recently released 2003 PricewaterhouseCoopers Securities Litigation Study.

But PwC predicts that a number of factors will soon combine to reverse the trend: the Sarbanes-Oxley Act; new rules from the Public Company Accounting Oversight Board (PCAOB); the special effects of Sarbox 404, which mandates certification of financial internal controls and which must be implemented by the end of the year; and recent private class-action settlements and court decisions. Indeed, in a preliminary look at this year’s data, PwC found that 111 cases were filed in just the first seven months.

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Accounting issues were a major source of the lawsuits last year, the Big Four firm found. Altogether, 61 percent of the 175 cases filed in 2003 stemmed from alleged accounting irregularities. To be sure, that’s down from 74 percent of the total cases filed in 2002. But it’s a higher percentage than all other years going back to 1996. So far this year, 57 percent of the cases filed are accounting-related.

The most popular issue among the accounting-related cases is improper revenue recognition, which was charged in more than 50 percent of the cases in 2003. Two allegations emerging in last year’s accounting-related cases were accounting estimates and internal controls, according to the PwC study. Each of these allegations appeared in over 40 percent of the accounting cases.

Accounting-estimate charges concern earnings management, use of “cookie jar” reserves, underestimation of reserves and allowances, and estimates relating to impairment of long-lived and intangible assets, according to the study.

In another finding, CFOs were named as defendants in 86 percent of the cases filed in 2003 while chief executive officers were named in 98 percent of the cases, according to the study.

The firm also found that case settlements were getting more costly last year. In 2003, average settlement values rose by 20 percent, to $23.2 million, from $19.4 million the prior year. From 1996 through 2000, the average settlement worked out to less than $15 million.

PwC points out that the large cost boost last year was driven in large part by six mega-settlements that each exceeded $100 million. Three settlements amounted to at least $300 million or greater, while one of those settlements topped $500 million.

Excluding several partial settlements, including the recent $2.65 billion partial WorldCom settlement, the average settlement in the first six months of 2004 surged to over $32 million, the study noted.

So far this year, 14 settlements have been announced for $30 million or greater, five of which settled for $100 million or more.

The average accounting case, led by five case settlements over $100 million each, settled for over $38 million.

The PwC study also reports a sharp rebound in the number of what it calls “Triple Jeopardy” cases, in which companies are subject to securities class actions along with SEC and Department of Justice investigations.

So far this year, at least 13 companies are facing “triple jeopardy.” That’s up from just eight last year, which is closer to the historic norm, according to PwC.

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