Worldcom Scam

Accounting Practices Clearly, there have been cases where management knowingly deceived the auditors. Then there seem to be other instances where the accounting treatment envelope was pushed just a bit too far. In the case of Enron, David B. Duncan, the former Andersen partner in charge of the Enron audit who was the government’s chief witness in the trial against Arthur Andersen, stood behind the decisions that resulted in the widespread use of off-balance sheet financing in the reporting of certain partnership transactions. 3) Certainly he carried out the breadth of the related accounting pronouncements to the extent allowable.

Off-balance sheet financing is a technique generally used by companies entering into a joint venture whereby both invest in a project Monies borrowed to get the venture up and running appear on the newly formed entity’s books. This is a strategy sanctioned by accounting pronouncements so long as proper disclosures are made. Mr. Duncan, however, appeared to have been duped by a situation where management went above and beyond what was allowable. He testified that he had been deceived by Enron officials on at least two matters.

The first of these was the company’s use of what investigators have called a “side agreement” in the establishment of a partnership known as Chewco. If that agreement had been known to auditors, the accounting treatment of the partnership would have changed, according to Mr. Duncan. The result would have been a dramatic difference in the picture presented by Enron’s reported financial statements. Mother situation involved a partnership called Southampton Place. A group of Enron insiders, including its former CFO, Andrew S. Fastow, used it to turn a profit of millions of dollars through an investment in a transaction involving the company.

None of those executives were authorized by the company to make the investment, according to a report of the special committee of Enron’s Board, and Mr. Duncan testified t hat he and Andersen were never told about it. (4) Enron was not alone. Its saga was amazingly intertwined with Global Crossing. According to executives and traders involved in the transaction, these two companies used a complex deal brokered by a third party, Reliant Resources, to sidestep accounting rules. Their March 2001 transaction was designed to help Global Crossing disguise a $17 million loan from Enron and allow each company to book revenue.

The transaction helped camouflage what was essentially an exchange of long-term services. It started out as a 1998 deal to swap fiber optic circuits and services in a non-cash transaction. The companies planned to renegotiate the deal in late 2000 in order to disguise a loan and help each side book a third quarter profit Under the deal, Enron would prepay Global Crossing about $17 million for long term access to a fiber optic network. Global Crossing would, in turn, purchase network services from Enron for about the same value but make monthly payments over about 8 years.

A former Enron executive said that Global Crossing wanted cash EBIDA (earnings before interest, taxes, depreciation and amortization), which is a measure of cash flow, and Wall Street was looking for that at that time. In order for the two companies to book profits on the deal, they would need to make the swap appear to be two separate deals with an independent party, and not a loan. Em-on would sell to the broker, which would then sell to Global Crossing, and then Global Crossing would sell back other services to the broker and then on to Em-on. This kind of “sleaving” was done all the time.

When the deal was completed, the loan was not expected to appear on Global Crossing’s balance sheet since it had been structured as part of a fiber optic transaction. In order to pay Reliant for its role in brokering the deal, Em-on began engaging in numerous losing broadband trades with Reliant One trader involved in the deal said the end result was earnings for Global Crossing. It was earnings management, and that is what the brokers were selling–earnings ma nagement According to a former Em-on executive, the goal was to try to show profit and revenue growth since everyone was on the “Wall Street treadmill” over-reporting their numbers.

Other Companies–Other Improprieties Less-than-scrupulous accounting practices can and have been occurring in numerous companies, not just those in the headlines. Here are some types of these occurrences: Ads by Google Roller Ball Bearings Original UK Ball Transfer Unit Manufacturer Since 1954 www. omnitrack. co. uk Inventory Write-Downs. The impact of these write-downs is fallout waiting to happen. Write-downs taken by technology companies in 2001 could turn into considerable profits when and if the industry recovers. Companies take a charge against earnings when inventory is written off.

If the inventory that has been written down is later sold, earnings will be higher than they would have been before the write-down. (6) Disclosure is the key to help the readers of financial statements discern how much of the increased revenue comes from the sale of previously written-down inventory and the impact on gross profit. More importantly, judgment must he used in deciding whether to write-down or write-off inventory. Would a company continue to commit itself to the inventory carrying costs for such massive amounts of goods if it truly believed the inventory was worthless?

Revenue recognition continues to be a source of manipulating earnings reported on the income statement In May of 2001, ConAgra Foods, Inc. announced that it would restate three years of financial results. One of its subsidiaries had recorded fictitious sales and improperly recorded revenue on sales. The company had been recording revenue at the time of the sale contract rather than at the time of delivery, a violation of the rules required for recognizing revenue in SFAC No. 5 (Para. 83 and 84), as interpreted for Public companies in SAB 101, as amended by Staff Accounting Bulletins (SAB) 101A and 101B.

But some fanners never took delivery and never paid. (7) Clearly, there is sufficient guidance for companies to follow in these standards if there are revenue recognition issues in question. And where guidance is not as clear, as it was in many cases prior to the issuance of SAB 101, as amended, companies have gone to great lengths to artfully design revenue-boosting scenarios. A former assistant treasurer at Xerox, James F. Bingham, testified that CFO Barry Romeril directed underlings to sell banks the rights to future revenues from Xerox copiers that were on short-term rentals to customers.

In Citibank deals with Xerox, the bank agreed to pay Xerox projected monthly rental revenue from the machines over time. Payments from rental customers were put into an escrow account, from which Citibank would take a small percentage as a fee, the remainder going to Xerox. The transaction meant that rental income that it would receive from customers would be booked all at once. (8) Reserves are another manipulative tool used by companies to mask tough times in leaner years. One of Mr. Bingham’s criticisms of Xerox was its use of reserves.

The company finally restated results and acknowledged that it had “misapplied” accounting rules, including improperly using a $100 million reserve to offset related expenses. (9) Lost credits played an important role in Kmart’s decision to file for bankruptcy. Kmart recorded, in advance, vendor allowances, which were granted as discounts or rebates, expecting to receive them at year-end. Some of the allowances, however, depend on the achievement of a certain level of sales. When Kmart’s sales dropped in the fourth quarter, vendors withheld some of the allowances Kmart had already recorded during the prior three quarters.

By recording partial allowances throughout the year, Kmart reported lower costs and more income on a quarterly basis. (10) Indeed, this creates a reporting problem for the prior quarters when the allowances are not received at year-end. Improprieties in recording transactions have taken even less creative forms. Starting in 2001, WorldCom’s chief financial officer recorded charges paid to local telephone networks as capital expenditures instead of operating expenses.

As a result, what would have been a net loss for the year 2001 and first quarter 2002 looked, instead, like a profit. 11) WorldCom acknowledged it improperly booked $3. 8 billion in expenses as capital expenditures. This improved cash flow and the appearance of profit over a period of five quarters. The company declared bankruptcy in July 2002. (12) One-time write-offs. Wall Street analysts have done little justice to investors, even when a company complies with generally accepted accounting principles (GAAP). One major error has been and continues to be ignoring one-time write-offs. One example is the restructuring charge.

These are charges used for restructuring and/or disposing of operating activities, streamlining operations, outsourcing inventory manufacturing, and other costs incurred to position a company for recovery. But the practice has gotten out of hand. It seems like more and more companies are reporting these “one time charges,” and some are doing it more than once. How often can the same company restructure? The SEC issued SAB 100 in November 1999 to outline what is and what is not considered a restructuring charge.

The FASB also recently issued SFAS 146, which states that entities should recognize a liability and costs associated with exit or disposal activities (often associated with a restructuring) when they are incurred. Yet another example is the major write-down Excite@Home announced in the fourth quarter 2000. The Internet access provider had $169 million in revenue, yet had a $5. 43 billion loss for the quarter, largely due to a $4. 63 billion write-off for goodwill connected with the purchase of Bluemountain. com. The senior analyst ignored the rite-down in his commentary after the earnings release. He retained his buy rating, though lowering his price target from $38 to $15, saying that the company has a long-term asset base and is appropriately valued for long-term investors. Excite@Home filed for bankruptcy protection in September 2001. ” Goodwill write downs have reached epidemic levels in the 2000’s, due to the soft stock market following a period of frenzied acquisitions in the late 1990’s where prices paid exceeded the fair market value of net assets acquired.

This problem is most severe in the telecommunications industry. Anticipating and Preventing Improper Accounting Practices Some people feel that one of the early warning signs lies in the credit-default swap market. This is where institutional investors seek financial protection against corporate bankruptcies. The default swap market may be the most sensitive measure of how market participants view corporate prospects. The credit-derivatives market, for instance, was far ahead of the rating agencies in suggesting that Enron was a weak credit.

Credit derivatives are an evolving product in which credit risk is transferred from one party to another through a contract that references the actual loss in value of a specified asset, as the result of a credit default or restructuring. A common credit-derivative product is the credit-default swap. In this arrangement, one party swaps the credit risk attributable to an asset (i. e. , a portfolio of loan investments) to a specified entity for a premium (or price). The specified entity then guarantees the cash flows expected from the portfolio investment. These credit swaps are a form of insurance of a particular company’s debt.

If the debt defaults, the buyer of such a swap goes to the seller of the swap and receives 100 cents on the dollar, regardless of how worthless the debt becomes. (14) To many who follow this market, it is better than a company’s stock and bond prices. The price of this insurance often goes up sharply in the several months before a corporate debacle, as it did in the case of both Enron and WorldCom, Inc. Weeks before Enron sought bankruptcy protection, pricing on Enron protection was far more expensive than it should have been, given Enron’s then investment-grade rating.

How extensive is the auditor’s responsibility for detecting fraud? Even the SEC warns that following GAAP may not be enough. Charles Niemeier, chief accountant for the SEC’s enforcement division, said that one could violate SEC laws and still comply with GAAP. (15) The point is that it is not enough to prepare financial statements in accordance with GAAP; they must also present, fairly, the financial position and results of operations of the company. The economics of all transactions must be reflected in the financial statements. According to Mr.

Nierneler, a company should go through two extra tests in determining whether it is correctly accounting for a transaction: (1) does the overall result violate the accounting principles on which the rule is based, and (2) does the answer or result mislead investors as to a material issue, (16) which even if correctly accounted for, is not adequately disclosed in financial statement footnotes! For decades the accounting profession has policed itself. It sought to avoid government regulation and minimize government influence on setting accounting and auditing standards.

FASB pronouncements became accounting standards. In recent years, however, the SEC has become increasingly more aggressive in issuing bulletins and other guidance which would limit accounting firms’ non-auditing services (i. e. independence rules); implementation of these are mandatory. It was becoming more and more difficult for the profession to avoid the control of the SEC. Nonetheless, creative accounting auditing procedures continued, and finally the profession suffered a lethal blow with the recent demise or near demise of several major companies.

Now government regulation is a certainty, and the profession can no longer avoid its supervision. The U. S. Senate voted overwhelmingly to create a new corporate fraud chapter in the federal criminal code this past July. (17) By taking this step, the path was paved for regulation of the accounting industry, as well as stiffer penalties for white-collar crime. As a byproduct of this new mentality on Capitol Hill, the SEC benefits by having more money allocated to its enforcement activities.

At the time of this writing, the Senate is conducting confirmation hearings for nominees to an oversight board. The SEC has authority to establish such a board unless Congress supercedes it with a different legislative approach. The oversight body will be named the Public Accountability Board. There would be a wide range of disciplinary sanctions it could impose against accounting firms and individual accountants including fines, censures, removal from client engagements, and suspension from auditing publicly traded companies.

The board will be comprised of six ndependent members and three accounting professionals, who would not be permitted to vote on disciplinary measures. (18) On July 10, 2002, the Senate toughened its main accounting and corporate-governance overhaul legislation by improving measures that would increase prison time for executives who conspire to commit certain white-collar crimes, create a 10-year prison term to punish perpetrators of schemes used to defraud investors, and toughen obstruction of justice laws. The Senate also lengthened the amount of time in which defrauded investors and plaintiffs’ lawyers can sue corporations.

The Sarbanes-Oxley Act of 2002 creates a five-member Public Company Oversight Board (PCAOB) having the authority to set and enforce auditing, attestation, quality control and ethics standards for auditors of public companies. The auditing operations of public accounting firms which audit public companies may be subject to the Board’s inspection. The Board may also impose disciplinary and remedial sanctions for violations of the Board’s rules, as well as violations of securities laws, professional auditing standards, and accounting standards. 20)

Even before the law was enacted, sanctions against accounting firms had become increasingly more common. In June 2001, the SEC fined Arthur Andersen $7 million in connections with its audits of Waste Management The SEC says that Waste Management used improper accounting to inflate its operating income and other measures of success, primarily by deferring expenses. The auditors questioned numerous accounting practices by the company, but continued to sign off with unqualified opinions.

Income was overstated by at least 15% in 1992 to 1996 and the auditors decided that the accounting misstatements were not material. Yet, according to Andersen’s managing partner in North America, the SEC had not questioned the underlying quality or effectiveness of Andersen s overall audit methodology. (21) In 2000, while Arthur Levitt was Chairman of the SEC, he tried to improve independence by restricting the non-audit consulting work that accounting firms could do for their audit clients. But he backed down in the face of strong opposition from the accounting firms. 22)

In July 2002, PriceWaterhouse Coopers (PWC) agreed to pay the SEC $5 million to settle three separate enforcement actions alleging violation of independence standards and improper accounting. The SEC believes the settlements are highly significant because they demonstrate how consulting fee arrangements allegedly led directly to the audit clients’ improper accounting. It is believed that Pinnacle holdings, with approval from PWC, improperly wrote off the cost of the auditor’s continuing consulting services as part of a merger-related reserve.

It is also believed that Avon Products, Inc. should have written off the cost of the accounting firm’s work on a nonoperating management system project, but instead kept a portion of the cost on its book s as an asset It is thought that Avon should have known that it was not probable that the software project would be implemented, and therefore the entire cost should have been written off. A third case involves independence violations by PWC’s broker-dealer, PWC Securities. (23) The SEC has advocated many reforms, most of which are in effect today.

The most dramatic SEC rule requires the chief executives and chief financial officers to sign declarations in annual and quarterly reports that “to the best of their knowledge” the filings are correct, and that they are an accurate picture of the company’s current condition and prospects. The CEO and CFO must also certify a report that they have good internal controls that will be disclosed in an attestation report by auditors. Of late, several companies have acted to name lead directors in an effort to restore investor confidence.

If the New York Stock Exchange goes through with a proposed listing rule that all independent directors meet regularly without the chief executive, more companies may follow suit The function of the lead director should be to act as a moderator of a panel on public issues, to subordinate his or her views in the hopes of bringing out everyone else’s. The lead director is someone to whom the CEO can go when he/she has questions. Some corporate governance experts are going further to suggest that companies separate the roles of the chairman and chief executive.

Regaining the Public’s Trust For decades the accounting profession has struggled with the “expectation gap. ” The public perception that an audit of financial statements is guaranteed to find fraud has been a misconception. Clearly, the auditor’s opinion states that the financial statements “present fairly” the financial condition of the company being audited. A 100% audit of the numbers would be too timely and too costly. Consequently, the basic tenet of the audit process rests on the auditor’s reliance on internal controls and on a test of the transactions.

Since it is too costly to examine each and every transaction, the auditor must draw statistical conclusions on the entire population from a sample drawn which is representative of that population. This is the fundamental audit process of which the public and politicians are unaware. Auditors are indeed responsible for employing a “heightened sense of awareness” throughout the audit, especially in cases where the client is particularly aggressive in recording transactions and the corporate culture tends to be aggressive.

Collusion will certainly circumvent the audit process, by virtue of the fact that auditors are testing transactions, not examining every one. The environment for uncovering fraud has been the classic client “slip up. ” Auditors do indeed need to be cognizant of such opportunities for fraud detection. And finally, the profession has been, at best, passive in educating the readers of financial statements that the responsibility for the financial statements lies with management, not the auditor.

Indeed, even many managers and company executives are not aware of this fact Former SEC Chairman, Harvey Pitt, worried increases in the SEC’s budget would create the expectation that the agency can catch fraud at every public company. He claimed that there is no system and no amount of money that will guarantee that there will be no problems. (25) Below, some members of the accounting profession – specifically, an academic, a partner of a major accounting firm, and a state regulatory agency–offer lessons to be learned by the accounting profession.

James A Largay II, editor of Accounting Horizons, has made the following observations, which are paraphrased here. 1. Public accountants advise on accounting matters and are to object when management’s financial reports fail to provide the transparency necessary to alert the capital markets to the entrails of the corporation’s activities. But it is management who must ultimately bear responsibility for issuing misleading information, although expert accounting and legal advisers can inadvertently help management deceive themselves, as well as those who rely on the management’s disclosures. 2.

Many make fun of the loopholes or flexibility in GAAP. Yet there are not enough rules, nor can they be promulgated fast enough, to contain those who are intent on circumventing full and fair disclosure. The only answer is the rebirth of professional judgment in an environment characterized by incentives that make the prudent exercise of judgment the only viable alternative. 3. Providing non-audit services to clients should be tightly constrained to tax advice and other services not easily separated from the audit Mandatory rotation of audit firms, on three to five year cycles, is an old idea whose time has come. Collegiate education is a key solution.