KPMG and Gemstar, publisher of TV Guide magazine, agreed to pay the SEC a
$10 million fine as a penalty for overstating revenue from 1999 to 2002. The over statements involved improperly reporting licensing and advertising revenue. The SEC said that the auditors should have known that the company improperly recognized revenue. 16 The SEC stated that KPMG auditors substituted "management representations for competent evidence." 17
The revenue recognition problems were described in an accounting and audit ing enforcement notice disclosing the earnings misstatement. According to the report, the revenue recognition problems were in two areas of revenue: licensing and advertising.
Licensing Revenue and Disclosure in the Footnotes
Gemstar recognized $23.5 million in licensing revenue from AOL in 2000. This revenue represented an upfront fee that should have been recognized over the eight year time period in which the services were to be provided. Gemstar recognized
$113.5 million in licensing revenue from Scientific-Atlanta for 2000-2002 and $18.1 million in licensing revenue from Time Warner Cable (TWC) for 2001-2002.
According to the report, the KPMG auditors should have known that the Scientific Atlanta and TWC revenue recognition did not conform to a financial reporting framework because the contract terms did not meet the requirements. The company did not have a contract with Scientific-Atlanta or TWC, Gemstar had not received any of the revenue, the companies disputed the revenue recognized by Gemstar, and the revenue payments were contingent on then-current contract negotiations.
According to the enforcement notice, KPMG auditors should have known that Gemstar's revenue recognition disclosure in the footnotes did not comply with disclosure requirements consistent with the financial reporting framework. Accounting Principles Board (APB) Opinion No. 22 requires disclosure of all significant accounting policies. Under generally accepted auditing procedures, auditors should read the company's annual report. The disclosure related to the AOL revenue was inadequate because the company disclosed that it recognized revenue over the life of the contract and described the AOL contract as long term but failed to recognize revenue in accordance with the disclosure (it recognized all revenue in the first year of the eight-year contract).
The disclosure for the Scientific-Atlanta and TWC revenue indicated that Gem star had recognized revenue when it received notification that a manufacturer had shipped units using Gemstar technology. According to the SEC, the auditors should have known that Gemstar's disclosure regarding revenue recognition based on licensing revenue was inadequate to describe the actual revenue recognition for this contingent revenue. 18
Advertising Revenue and Disclosure in the Footnotes
Gemstar recognized $60.1 million of advertising revenue in 2001 and 2002 from Motorola, (Chicago) Tribune Company, Fantasy Sports, and various print advertisers that did not conform to the financial reporting framework. The revenue came from noncash arrangements with customers as part of various business transactions. For example, the Motorola revenue originated with an arrangement by which it paid
$188 million to use Genstar's IPG technology, to settle a litigation award, and to purchase $17.5 million of prepaid advertising. The Tribune revenue originated with an arrangement between it and Gemstar in which the Tribune agreed to purchase the WGN distribution business from Gemstar in exchange for $106 million in cash and $100 million in advertising. According to the SEC, KPMG auditors should have known that the Motorola and Tribune revenue were not recognized in accordance with the financial reporting framework. According to the SEC, Gem star could not "reliably, verifiably, and objectively" 19 determine the fair value of the advertising portion of the arrangement because it had not sold IPG advertising that was not part of a related-party or nonmonetary transaction.
The SEC also determined that the auditors should have known that Gemstar's disclosure in its 10-K was inconsistent with the company's method of accounting for the transaction. For example, the company described its substantial growth in the Interactive Sector revenue and attributed the growth to the "successful launch of IPG advertising." 20 However, the company did not disclose that the revenue came from the Motorola and Tribune transactions. The auditor also should have known that the company disclosed the sale of WGN but not the $100 million of advertising revenue associated with the sale.
The SEC censured KPMG, which paid a fine of $10 million to settle the charges of improper conduct. KPMG partners involved in the audit were prohibited from working for public companies for a period of one to three years. At the time, the KPMG fine was the largest ever obtained by the SEC from an accounting firm.
Cash from the settlement went to the Gemstar shareholders.
a. Evaluate Gemstar's revenue recognition decisions related to the licensing and advertising revenue. Explain why the SEC disagreed with the decisions made by management.
b. Why did the SEC determine that the disclosure made by Gemstar was not consistent with the financial reporting framework? Explain the proper disclosure relating to the licensing and advertising revenue.
c. What does the SEC mean that the auditors substituted "management representations for evidence"? What should the auditors have done to verify the revenue?