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FBI Corporate Fraud Hotline (Toll Free)
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I'm giving thanks for many things this Thanksgiving Day on November
22, 2012, including our good friends who invited us over to share in
their family Thanksgiving dinner. Among the many things for which I'm
grateful, I give thanks for accounting fraud. Otherwise there were be a
whole lot less for me to study and write about at my Website ---
practitioners and their clients are concerned about the growing
epidemic of tax-related identity theft in America - both refund
theft and employment theft. At the end of fiscal 2013, the IRS had
almost 600,000 identity theft cases in its inventory, according
tothe IRS National Taxpayer Advocate.
AICPA shares members' concerns about the impact of identity theft
and offers the resources below to help them learn more about this
issue and advise clients. We have provided recommendations to
Congress and the IRS Oversight Board on ways to further protect
taxpayers and preparers.
IRS Identity Protection
Specialized Unit at 800-908-4490
It may not be the superhuman robotic police
officer who patrolled the lawless streets of Detroit in the 1987
sci-fi thriller, but corporate filers should be every bit as
concerned about the Securities and Exchange Commission’s (“SEC”) new
Accounting Quality Model (“AQM”), labeled not-so-affectionately by
some in the financial industry as “RoboCop.” Broadly speaking, the
AQM is an analytical tool which trawls corporate filings to flag
high-risk activity for closer inspection by SEC enforcement teams.
Use of the AQM, in conjunction with statements by recently-confirmed
SEC Chairman Mary Jo White and the introduction of new initiatives
announced July 2, 2013, indicates a renewed commitment by the SEC to
seek out violations of financial reporting regulations. This pledge
of substantial resources means it is more important than ever for
corporate filers to understand SEC enforcement strategies,
especially the AQM, in order to decrease the likelihood that their
firm will be the subject of an expensive SEC audit.
The Crack Down on Fraud in Accounting
and Financial Reporting
In his speech nominating Mary Jo White to
take over as chairman of the SEC, President Obama issued a warning:
“You don’t want to mess with Mary Jo.” That statement now seems
particularly true for corporate filers given the direction of the
SEC under her command. Previously a hallmark of the SEC, cases of
accounting and financial-disclosure fraud made up only 11% of
enforcement actions brought by the Commission in 2012. Since taking
over as chairman, Ms. White has renewed the SEC’s commitment to the
detection of fraud in accounting and financial disclosures.
“I think financial-statement fraud,
accounting fraud has always been important to the SEC,” Ms. White
said during a June interview “It’s certainly an area that I’m
interested in and you’re going to see more targeted resources in
that area going forward.” She has backed that statement up with a
substantial commitment of resources. In July, the commission
announced new initiatives which aim to crack down on financial
reporting fraud through the use of technology and analytical
capacity, including the Financial Reporting and Audit Task Force and
the Center for Risk and Quantitative Analytics (“CRQA”). These
initiatives will put financial reports under the microscope through
the use of technology-based tools, the most important of which is
RoboCop: Corporate Profiler
RoboCop’s objective – to identify earnings
management – is not a novel one; rather, it is the model’s
proficiency that should worry filers. Existing models on earnings
management detection generally attempt to estimate discretionary
accrual amounts by regressing total accruals on factors that proxy
for non-discretionary accruals. The remaining undefined amount then
serves as an estimate of discretionary accruals. The fatal flaw in
this approach is the inevitable high amount of “false-positives”,
rendering it useless to SEC examiners.
The AQM extends this traditional approach
by including discretionary accrual factors in its regression. This
additional level of analysis further classifies the discretionary
accruals as either risk indicators or risk inducers. Risk indicators
are factors that are directly associated with earnings management
while risk inducers indicate situations where strong incentives for
earnings management exist. Based on a comparison with the filings of
companies in the filer’s industry peer group, the AQM produces a
score for each filing, assessing the likelihood that fraudulent
activities are occurring.
While the SEC will be keeping their
factor-composition cards close to the chest, the “builder of RoboCop”,
Craig Lewis, Chief Economist and Director of the Division of Risk,
Strategy, and Financial Innovation (“RSFI”) at the SEC, has offered
several clues about the types of information most likely to catch
RoboCop’s attention (Is it just a coincidence that RoboCop’s movie
partner was an Officer Lewis?).
“An accounting policy that could be
considered a risk indicator (and consistently measured) would be an
accounting policy that results in relatively high book earnings,
even though firms simultaneously select alternative tax treatments
that minimize taxable income,” said Mr. Lewis. “Another accounting
policy risk indicator might be a high proportion of transactions
structured as ‘off-balance sheet.’”
Frequent conflicts with independent
auditors, changes in auditors, or filing delays could also be risk
indicators. Examples of risk inducers include decreasing market
share or lower profitability margins. This factor-based analysis
allows for model flexibility, meaning examiners are able to add or
remove factors to customize the analysis to their specific needs.
The SEC will be able to continually update the model to account for
the moves filers are taking to conceal their frauds.
Next Generation RoboCop
One of the perceived weaknesses of RoboCop
is its dependence on financial comparisons between filers within an
industry peer group. As Lewis points out, “most firms that are
probably engaging in earnings management or manipulation aren’t
doing it in a way that allows them to stand out from everybody else.
They’re actually doing it so they blend in better with their peer
To account for this, the SEC’s current
endeavor is expanding the model’s capabilities to include a scan of
the “Management Discussion & Analysis” (“MD&A”) sections of annual
reports. Through a study of past fraudulent filings, analysts at
RSFI have developed lists of words and phrasing choices which have
been common amongst fraudulent filers in the past. These lists have
been turned into factors and incorporated into the AQM
“We’re effectively going in and we’re
saying: what are the word choices that filers make that maximize our
ability to differentiate between fraudsters in the past and firms
that haven’t had fraud action brought against them yet?” Mr. Lewis
explained during a June conference in Ireland.
“So what we’re doing is taking the MDNA
section, we’re comparing them to other firms in the same industry
group, and we’re finding that in the past, fraudsters have tended to
talk a lot about things that really don’t matter much and they
under-report all the risks that all the other firms that aren’t
having these same issues talk quite a bit about.”
Firms engaged in fraudulent activity have
tended to overuse particular words and phrasing choices which are
associated with relatively benign activities. They have also tended
to under-disclose risks which are prevalent among a peer group.
When a filer has engaged in similar behavior, RoboCop will flag
these types of unusual choices for examiner review.
How the SEC Uses RoboCop
Although the SEC has cautioned that the AQM
is not the “robot police coming out and busting the fraudsters,”
filers would be wise to understand the power of this tool. RoboCop
is a fully automated system. Within 24 hours from the time a filing
is posted to EDGAR, it is processed by the AQM and the results are
stored in a database. The AQM outputs a risk score which informs
SEC auditors of the likelihood that a filing is fraudulent. The SEC
then uses this score to prioritize its investigations and
concentrate review efforts on portions of the report most likely to
contain fraudulent information.
The results of RoboCop’s analysis will
likely become the basis for enforcement scheduling and direction of
resources in the near future. A filing’s risk score will determine
whether a filing is given a quick, unsuspecting review, or whether
it is thoroughly dissected by an SEC exam team, possibly leading to
an expensive audit. The SEC has also said it plans to use the risk
scores as a means of corroborating (or invalidating) the
approximately 30,000 tips, complaints, and referrals submissions it
estimates will be received each year through its Electronic Data
Collection Systems or completed forms TCR.
The Investor Protection Trust provides
independent, objective information to help consumers make informed
investment decisions. Founded in 1993 as part of a multi-state
settlement to resolve charges of misconduct, IPT serves as an
independent source of non-commercial investor education materials.
IPT operates programs under its own auspices and uses grants to
underwrite important initiatives carried out by other organizations.
has become a fun passion
project of mine, and I think it serves as a great resource for
to get a degree and start a career in law enforcement. I would
appreciate any feedback, and hope you will find it as a useful
addition to your
When I graduated from college I realized
that forensic accounting was something that a lot of fellow students
were really interested in. However, people knew very little about
what it was or how their skills could be applied to a career in the
field. Basically, I'm trying to create something that acts as both
an educational resource and a primer/gateway for people who want to
learn more about the academic and professional nature of forensic
accounting. The site is located here:
http://www.forensicaccounting.net , and
I'd really appreciate any feedback you might have. If you like it,
I'd be great if you could include it on your site as a resource for
The widespread growth in white-collar crime
and the increased need for homeland security have greatly raised the
demand for forensic accountants, fraud investigators and for
auditors who posses those skills. Federal, state, and local
governmental agencies, such as the Securities and Exchange
Commission, the Internal Revenue Service, and the Offices of
Inspector General all need accountants with forensic investigation
skills. In the private sector, recent legislation (Sarbanes-Oxley
Act of 2002) and auditing standards (Statement on Auditing Standard
No. 99) require companies and their auditors to be more aggressive
in detecting and preventing fraud.
A unique program to answer the
The Division of Accounting has responded to
this demand by developing an academic program designed to prepare
entry-level accountants and others for forensic accounting and fraud
investigative careers. Although many schools have added a single
graduate or undergraduate course to their curricula, very few offer
a multi-course graduate certificate program. This program is the
only one in the region.
The 12-credit graduate Certificate Program
in Forensic Accounting and Fraud Investigation (FAFI) is offered
during the summer. Students may take two paths to earn this
Option 1: Complete a
four course stand-alone non-degree graduate certificate program
Option 2: Complete a
Master of Professional Accountancy (MPA) degree plus two
additional certificate courses.
WVU developed the National
Richard Riley and Bonnie Morris led the
effort to develop national curriculum guidelines for fraud and
forensic accounting programs for the National Institute of Justice.
"What’s Your Fraud IQ?
Think you know enough about corruption to spot it in any of its myriad
forms? Then rev up your fraud detection radar and take this
(deceptively) simple test." by Joseph T. Wells, Journal of
Accountancy, July 2006 ---
Earlier this week we shared with you the
latest analysis from KPMG that listed “key fraudster traits” and
some of them seemed to describe a lot of the people you have worked
or are currently working for. Things like “volatile,”
“unreliability,” “unhappy,” and “self-interested” describes everyone
I’ve ever been in around in the corporate world to one extent or
Since I was skeptical of this list, I asked
Sam Antar what he thought of it. If you’ve been reading us for
awhile, you’re familiar with Sam. If you’re new, I’ll do a quick
refresher. Sam was the CFO of Crazy Eddie’s and was one of the
masterminds behind one of the biggest financial frauds of the 1980s.
While you (and I) were eating cereal in front of the TV on Saturday
morning, Sam and his cousin Eddie were selling electronics and home
appliances to our parents for rock bottom prices, while ripping off
the government and investors for untold millions of dollars. In
other words, the guy is a crook and knew/knows lots of crooks and
knows their hopes (read: money), their dreams (read: money) all that
crap (read: more money) and what they’ll do to get them. With that,
Sam told me what he thought of KPMG’s analysis:
Need advice on choosing a textbook for an
MBA class on fraud (to be taken mostly by Master of Accounting
I am deciding between Albrecht's Fraud
Examination and Hopwood's Forensic Accounting. I also plan to have
students read Cynthia Cooper's book, Journey of a Corporate
I will be teaching a three-week version of
the course this summer as a study abroad, but also will be
converting it into a 16 week semester-long 3 hour course.
Any suggestions would be helpful -
November 3, 2009 reply from Bob Jensen
I'm really not able to give you an opinion
on either choice for a textbook. But before making a decision I
always compared the end-of-chapter material and the solutions manual
to accompany that material. If the publisher did not pay for good
end-of-chapter material I always view the textbook to be a cheap
shot. The end-of-chapter material is much harder to write than the
chapter material itself.
I also look for real world cases and
Financial Statement Fraud: Prevention and
Detection, 2nd Edition Zabihollah Rezaee, Richard Riley ISBN:
978-0-470-45570-8 Hardcover 332 pages September 2009
Don't forget the wealth of material, some
free, at the site of the Association of Certified Fraud Examiners
I would most certainly consider using some of this material on
homework and examinations.
Instead of a textbook you might use the ACFE
online self-study materials ($79) ---
"A Model Curriculum for Education in Fraud and Forensic Accounting,"
by Mary-Jo Kranacher, Bonnie W. Morris, Timothy A. Pearson, and Richard A.
Riley, Jr., Issues in Accounting Education, November 2008. pp. 505-518
(Not Free) ---
There are other articles on fraud and forensic accounting in this November
edition of IAE:
Incorporating Forensic Accounting and Litigation Advisory Services Into
the Classroom Lester E. Heitger and Dan L. Heitger, Issues in Accounting
Education 23(4), 561 (2008) (12 pages)]
West Virginia University: Forensic Accounting and Fraud Investigation (FAFI)
A. Scott Fleming, Timothy A. Pearson, and Richard A. Riley, Jr., Issues
in Accounting Education 23(4), 573 (2008) (8 pages)
The Model Curriculum in Fraud and Forensic Accounting and Economic Crime
Programs at Utica College George E. Curtis, Issues in Accounting
Education 23(4), 581 (2008) (12 pages)
Forensic Accounting and FAU: An Executive Graduate Program George R.
Young, Issues in Accounting Education 23(4), 593 (2008) (7 pages)
The Saint Xavier University Graduate Program in Financial Fraud
Examination and Management William J. Kresse, Issues in Accounting
Education 23(4), 601 (2008) (8 pages)
"Strain, Differential Association, and Coercion: Insights from the Criminology
Literature on Causes of Accountant's Misconduct," by James J. Donegan and
Michele W. Ganon, Accounting and the Public Interest 8(1), 1 (2008) (20
I have been writing regular blogs for The
Guardian, a UK national newspaper. The articles are available at
and offer a critical commentary on business
and accountancy matters. For three days after each article the
website takes readers' comments and colleagues are welcome to add
comments, critical or otherwise. The most recent article appeared on
29 January 2008.
There is now also an extensive database of
corporate and accountancy misdemeanours on the AABA website (
Every organization faces some risk of fraud
from within. Fraud exposure can be classified into three broad
categories: asset misappropriation, corruption and fraudulent
Answering the following 15 questions is a
good starting point for sizing up a company’s vulnerability to fraud
and creating an action plan for lessening the risks. The questions
are based on information from the 2007 edition of the Fraud
Examiners Manual published by the Association of Certified Fraud
1. Do one or two key employees appear to
dominate the company?
If control is centered in the hands of a
few key employees, those individuals should be under heightened
scrutiny for compliance with internal controls and other policies
2. Do any key employees appear to have a
close association with vendors?
Employees with a close relationship to a
vendor should be prohibited from approving transactions with that
vendor. Alternatively, transactions between these parties should be
reviewed on a regular basis for compliance with internal controls.
3. Do any key employees have outside
business interests that might conflict with their job duties?
Take the example of a 32-year-old sales
representative who started a software company using his employer’s
time, equipment and facilities. The software company he worked for
discovered that the employee demonstrated his own products to the
company’s customers. Ultimately, the employee diverted $500,000 in
business away from his employer.
The example illustrates why key employees
should provide annual financial disclosures that list outside
business interests. Many companies, particularly publicly traded
companies, require such disclosures. Interests that conflict with
the organization’s interests should be prohibited. Organizations
should implement an explicit policy that forbids employee business
activities that directly compete with the operations of the
Employees who have something to hide may
lie or omit key facts on the disclosure form, but requiring the step
still has advantages, such as making it easier to fire workers who
fail to reveal potential conflicts. If an employer can show that an
employee had such an interest and failed to disclose it on an annual
reporting form, the employee can be fired simply for failing to
follow company policy.
4. Does the organization conduct
pre-employment background checks to identify previous dishonest or
Organizations should conduct pre-employment
background checks before offering employment to any key applicant.
The scope of a background check varies by position, but a general
list to consider includes: criminal records and convictions; Social
Security number verification; credit history; previous employment;
employment references; personal references; education verification;
professional license verification; driver’s license verification and
driving history check; and civil records and judgments. Employers
should ensure that legal requirements are met for the use of and
access to the information.
For companies that have failed to do
background checks, post-hire screenings may be appropriate in some
cases, but should be conducted on the advice of legal counsel. A
number of legal issues come into play when employers consider
screening workers who are already on the job.
5. Does the organization educate employees
about the importance of ethics and anti-fraud programs?
All employees should receive training on
the ethics and anti-fraud policies of the organization. The
employees should sign an acknowledgement that they have received the
training and understand the policies.
6. Does the organization provide an
anonymous way to report suspected violations of the ethics and
Organizations should provide employees,
vendors and customers with a confidential system for reporting
suspected violations of the ethics and anti-fraud policies.
According to the 2006 ACFE Report to the Nation on Occupational
Fraud and Abuse, frauds are most commonly detected by a tip. The
greatest percentage of those tips comes from employees of the victim
In one instance, an anonymous tip received
by a fraud hotline thwarted a fraud scheme that had drained
approximately $580,000 from a business. The caller reported that the
company’s accounts payable manager was approving fictitious invoices
from his own outside company. The tip clued in company management to
the scheme and brought an abrupt end to the manager’s windfall. The
fraudster was terminated and arrested. The company ultimately
recouped most of its losses.
7. Is job or assignment rotation mandatory
for employees who handle cash receipts and accounting duties?
Job or assignment rotation should be
considered for employees who work with cash receipts and accounting
duties. The frequency of the rotation depends on the individual’s
responsibilities and the number of people available for the
8. Has the company established positive pay
controls with its bank by supplying the bank with a daily list of
checks issued and authorized for payment?
One method for a company to help prevent
check fraud is to establish positive pay controls by supplying its
banks with a daily list of checks issued and authorized for payment.
Banks verify items presented for payment against the company’s list
and reject items that don’t appear on the list.
The use of those controls foiled a fraud
attempt by an employee and his accomplice, who worked for a
check-printing company. The accomplice printed blank checks with the
account number belonging to the perpetrator’s employer. The
perpetrator then wrote more than $100,000 worth of forgeries on the
When the checks were presented to the bank
for payment, they did not appear on the organization’s list of
expected payments. The bank refused to cash them. The organization
was notified, and the fraudsters were arrested.
9. Are refunds, voids and discounts
evaluated on a routine basis to identify patterns of activity among
employees, departments, shifts or merchandise?
Companies should routinely evaluate those
transactions to search for patterns of activity that might signal
10. Are purchasing and receiving functions
separate from invoice processing, accounts payable and general
Segregation of duties is an important
control. The failure to segregate these duties allowed one large,
publicly traded company to be duped by a member of its managerial
staff. The individual managed a remote location of the company and
was authorized to order supplies and approve vendor invoices for
payment. For more than a year, the manager routinely added personal
items and supplies for his own business to orders made on behalf of
his employer. The orders often included a strange mix of items. For
instance, technical supplies and home furnishings were purchased in
the same order.
In addition to ordering personal items, the
employee changed the delivery address for certain supplies so they
were shipped directly to his home or side business. Because the
manager was in a position to approve his own purchases, he could get
away with such blatantly obvious frauds. The scheme cost his
employer approximately $300,000 in unnecessary purchases.
11. Is the employee payroll list
periodically reviewed for duplicate or missing Social Security
Organizations should check the employee
payroll list periodically for duplicate or missing Social Security
numbers that may indicate a ghost employee or overlapping payments
to current employees.
12. Are there policies and procedures
addressing the identification, classification and handling of
To help prevent the theft and misuse of
intellectual property, the company should implement policies and
procedures addressing the identification, classification and
handling of proprietary information.
13. Do employees who have access to
proprietary information sign nondisclosure agreements?
All employees who have access to
proprietary information should sign nondisclosure agreements. It is
easier to sue for breach of a nondisclosure agreement than it is to
sue for theft of information. Nondisclosure agreements afford
companies legal options for the use of nonpublic information, not
simply for information that is considered a trade secret.
In most states, companies without
nondisclosure agreements may be limited to suing for theft of trade
14. Is there a company policy that
addresses the receipt of gifts, discounts and services offered by a
supplier or customer?
Organizations should implement a policy
that sets ground rules about employees accepting gifts, discounts
and services offered by a supplier or customer. If no explicit
policy is in place, employees may find themselves in ambiguous
situations without clear ethical guidelines.
For example, a city commissioner negotiated
a land development deal with a group of private investors. After the
deal was approved, the commissioner and his wife were rewarded by
one of the investors with an all-expenses-paid international
While the promise of the trip may have
influenced the commissioner’s negotiations, this would be difficult
to prove. However, had a clear policy regarding the receipt of gifts
been implemented and enforced, the commissioner would have known
that accepting the free vacation was a violation of the rules. The
ambiguity of the situation would have been avoided.
15. Are the organization’s financial goals
and objectives realistic?
Closely monitor compliance with internal
controls over financial reporting if the financial goals and
objectives appear to be unrealistic. Establish realistic financial
goals and objectives for the organization. Common justifications for
financial statement fraud include a desire to obtain bonuses linked
to goals or frustration with objectives that were unachievable
through normal means.
Joseph T. Wells, CPA, CFE, is founder and chairman of the
Association of Certified Fraud Examiners and a contributing editor
to the JofA. His e-mail address is
John D. Gill, J.D., CFE, is research director for the Association of
Certified Fraud Examiners. His e-mail address is
Hundreds of high-ranking company officials
have been convicted in corporate fraud schemes since 2002, the
Justice Department said Tuesday - a day after a federal judge threw
out charges in one of the largest criminal tax cases in U.S.
Attorney General Alberto Gonzales called the U.S.
District Court ruling,
in favor of 13 former KPMG employees,
disappointing and said he was
"quite confident" the government would appeal.
"Obviously, we're disappointed, and we won't be
discouraged or deterred from pursuing wrongdoing where
we think it exists and following the evidence where it
takes us," Gonzales told reporters following the
long-planned Justice Department announcement regarding
its efforts to curb corporate fraud. "So we're
disappointed but we're going to stay focused on this
very important issue."
federal prosecutors have won 1,236 convictions in
corporate fraud cases and reaped hundreds of millions in
payback for victims over the last five years, said
Deputy Attorney General Paul McNulty.
one-third of the convictions came against company CEOs,
presidents, counsel and other high-ranking officials,
said McNulty, who chaired a government task force aimed
at curbing corporate corruption in the aftermath of the
Enron scandal that wiped out thousands of jobs, more
than $60 billion in market value and more than $2
billion in employee pension plans.
who is leaving the Justice Department by summer's end,
last year authored changes to rules for prosecutors in
corporate fraud cases. The result, known as the "McNulty
Memo," bars prosecutors from charging businesses solely
for refusing to hand over corporate attorney-client
communications. It also prohibits the government from
penalizing firms that pay attorneys' fees for employees
- except in rare cases where the payments result in
blocking the investigation.
say that leaves open the possibility of firms that pay
attorneys fees being publicly viewed as hindering
investigations - a death knell in an ethics-sensitive
business era. Last week, Rep. Bobby Scott, D-Va.,
introduced legislation to bar prosecutors from
pressuring corporations against paying legal fees or
demanding attorney-client information. The bill is
similar to one filed last year by Sen. Arlen Specter,
KPMG case Monday, U.S. District Judge Lewis A. Kaplan in
New York said the government coerced the giant tax firm
to limit and then cut off its payment of the employees'
legal fees - stripping the 13 defendants' constitutional
right to legal representation. The former KPMG employees
were accused of participating in a fraud that helped the
wealthy escape $2.5 billion in taxes.
(Charges are still pending
against several higher ranking KPMG executives.)
was not mentioned during Tuesday's hour-long ceremony,
which doubled as a public send-off for McNulty. The
memo, McNulty said, should encourage firms "to engage in
more robust self-assessment of their internal controls."
The number of companies around the
world that reported incidents of fraud increased 22 percent
in the last two years, according to the 2005 biennial survey
by PricewaterhouseCoopers (PwC), which interviewed more than
3,000 corporate officers in 34 countries. In England, a
recent Ernst & Young survey of the Times Top 1000 indicated
the average cost of each fraud exceeded $200,000. But fraud
is not the only problem. There's also misconduct, unethical
behavior, lying, falsification of records, sexual
harassment, and drug and alcohol abuse.
PwC found that “accidental” ways of
detecting fraud, such as calls to hotlines or tips from
whistleblowers, accounted for more than a third of the
cases. Internal audits were responsible for detecting fraud
about 26 percent of the time.
Steven Skalak, Global
Investigations Leader at PwC, told Reuters: "I think the
investment in control systems is paying off and detecting
more crime." The study found that companies with a larger
number of controls could better determine the full impact of
the fraud, uncovering three times as many losses as
companies with fewer controls.
Many of the new and increased
controls were generated through the passage of The
Sarbanes-Oxley (SOX) Act of 2002, which made having
confidential, anonymous reporting mechanisms a legal
requirement for any publicly traded company. But private,
government and non-profit organizations would be well
advised to also create and implement this important tool.
While executives get the headlines,
43 percent of surveyed people admit to having engaged in at
least one unethical act in the workplace in the last year,
and 75 percent observed such an act and did nothing about
it. Not spoken to the employee in question, not reported it,
nothing. As much as we do not like to admit it, theft, fraud
and malfeasance are common occurrences in companies.
Unfortunately these practices exist in every level of the
organization and irrespective of size or sector. Non-profits
are stolen from in equal measure.
The Association of Certified Fraud
Examiners 2002 Report to the Nation indicates, "the most
common method for detecting occupational fraud is by a tip
from an employee, customer, vendor or anonymous source." It
additionally comments, "the presence of an anonymous
reporting mechanism facilitates the reporting of wrongdoing
and seems to have a recognizable effect in limiting fraud
The report concludes,
"organizations with hotlines can cut their fraud losses by
approximately 50 percent per scheme." To be effective, a
confidential, anonymous reporting mechanism must be operated
by an independent, third party. Employees are understandably
hesitant and reluctant to report another employee. There is
not only the fear of retaliation; there is the fear of
retribution and of being ostracized by co-workers. In fact,
in an independent survey, 54 percent gave this as the main
reason for their silence.
There is also a concern if the
incident involves management, or the person required to take
the report or initiate the investigation. Employees must be
confident in knowing they can report an incident
effectively, confidentially and anonymously. Furthermore,
statistics prove that an internal hotline or reporting
mechanism is rarely perceived as truly anonymous.
You can become aware of and build
upon the positive aspects of employee relations while
proactively addressing and heading off potentially negative
issues with Ethical Advocate’s confidential, anonymous
reporting mechanisms and feedback system.
Confidential, anonymous reporting
mechanisms serves as an early warning system, enabling
organizations to react quickly to investigate issues, and
often resolve problems prior to increased malfeasance,
costly stealing, litigation, or negative publicity. Spending
a few dollars early on can save untold dollars and valuable
time. It also creates a culture of ethical behavior that
over time will diminish the prospects of these actions.
When installed properly,
confidential, anonymous reporting mechanisms can uncover a
variety of information that can improve processes, resolve
issues, and prevent catastrophic financial losses. Like a
computer network and a website, an employee hotline was once
just a good idea that top companies had adopted. Now it's a
mandatory part of doing business.
PricewaterhouseCoopers Global Economic Crime Survey 2005
The threat of fraud from apparently simple
cases of bribery to complex financial misrepresentation is more
prominent than ever on the agendas of company directors and
financial regulators. PwC's third biennial Economic Crime Survey is
based on interviews with more than 3,600 senior executives in 34
countries, and reveals their experiences with fraud, its causes and
losses, their responses and recovery actions and the effectiveness
of fraud prevention measures. Please click to the link below to
access the full survey.
How can we reduce the risk that terrorists
will exploit legitimate trade to attack the United States? One
answer is described in PwC's "Cargo Security White Paper." It
provides an example of the application of internal control processes
to increase protection and expedite cargo. Please click to the link
below to access the white paper.
As we communicated to you in the past, we
have placed a significant focus on our people initiatives. As a
result of these efforts, we have seen a substantial reduction in
turnover; and as external validation of our focus we were pleased to
hear the recent announcement that PwC is on the Fortune "100 Best
Companies to Work For" in 2006. Our emphasis on the development and
retention of our people continues to be a top priority for us.
As always we welcome your feedback and
appreciate hearing from you on how PwC can best support you as
One interesting sidebar
on this was an NBC News feature last night on February 6,
2003. It was pointed out that most of the bad deeds in the
Enron scandal were committed by men (e.g., Skilling, Lay,
Fastow, and Duncan). Most of the white knights in whistle
blowing have been women (the show featured three of those
women). The implication was that we should place more trust in
the feminine gender. Sounds good to me!
Bob, I was turning out what passes for my "home office"
earlier today and came across the Winter 1997 issue of
Contemporary Accounting Research (Vol 14, #4). One of
the articles therein (page 653) is entitled:
Examination of Moral Development within Public Accounting by
Gender, Staff Level and Firm" by Bernardi, R and Arnold, D F
authors' dataset covers 494 managers and seniors from five
"Big Six" firms.
According to the abstract;
"The results indicate a difference in the average level of
moral development among firms.....Second, female managers
are at a significantly higher average level of moral
development than male managers. In fact, average scores for
male managers fell between those expected for senior high
school and college students. The data suggest that a
greater percentage of high-moral-development males and a
low-moral development females are leaving public accounting
than their respective opposites. These results indicate
that the profession has retained, through advancement, males
who are potentially less sensitive to the ethical
implications of various issues."
all of which leads me to wonder whether your comments (about
Enron) re our needing more female executives wasn't right on
target - and also, which accounting firms ranked where in
"average level of moral development".
A new study released today by
Catalyst demonstrates that companies with a higher
representation of women in senior management positions
financially outperform companies with proportionally fewer
women at the top. These findings support the business case
for diversity, which asserts companies that recruit, retain,
and advance women will have a competitive advantage in the
In the study The Bottom Line:
Connecting Corporate Performance and Gender Diversity,
sponsored by BMO Financial Group, Catalyst used two measures
to examine financial performance: Return on Equity (ROE) and
Total Return to Shareholders (TRS). After examining the 353
companies that remained on the F500 list for four out of
five years between 1996 and 2000, Catalyst found:
The group of companies with the
highest representation of women on their senior management
teams had a 35-percent higher ROE and a 34- percent higher
TRS than companies with the lowest women's representation.
Consumer Discretionary, Consumer
Staples, and Financial Services companies with the highest
representation of women in senior management experienced a
considerably higher ROE and TRS than companies with the
lowest representation of women.
"Business leaders increasingly
request hard data to support the link between gender
diversity and corporate performance. This study gives
business leaders unquestionable evidence that a link does
exist," said Catalyst President Ilene H. Lang. "We
controlled for industry and company differences and the
conclusion was still the same. Top-performing companies have
a higher representation of women on their leadership teams."
"The Catalyst study confirms my own
long-held conviction that it makes the best of business
sense to have a diverse workforce and an equitable,
supportive workplace," said Tony Comper, Chairman and CEO of
BMO Financial Group, sole sponsor of the research.
A Note on Methodology
Catalyst divided the 353 companies
into four roughly equal quartiles based on the
representation of women in senior management. The top
quartile is the 88 companies with the highest gender
diversity on leadership teams. The bottom quartile is the 89
companies with the lowest gender diversity. Catalyst then
compared the two groups based on overall ROE and TRS.
"It is important to realize that
our findings demonstrate a link between women's leadership
and financial performance, but not causation," said Susan
Black, Catalyst Vice President of Canada and Research and
Information Services. "There are many variables that can
contribute to outstanding financial performance, but
clearly, companies that understand the competitive advantage
of gender diversity are smart enough to leverage that
From The Wall Street Journal's Accounting Educators'
Reviews on February 14, 2002
SUMMARY: Microsoft is undergoing a continuing SEC
investigation into whether the company has understated its
revenues. Questions relate to issues in unearned revenue.
1.) What is conservatism in accounting? Is it an accepted
2.) In general, what is unearned revenue? How is it
presented in the financial statements? When is this balance
recognized as earned? What accounting adjustment is made at
3.) Why must Microsoft record some unearned revenues from
software sales? Could that practice be supported through
reserves of some cash accounts?
4.) Given Microsoft's recent experiences in testifying
against allegations of violating federal antitrust laws, why
might the company want to understate its income?
5.) Why does the former Microsoft employee, Mr.
Pancerzewski, say that "he disagrees that there is no harm in
a company understating its income"? Do you think there could
be problems in understating income even for companies that are
not facing charges of earning excess profits through
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
The Enron Scandal on Creative Accounting
and Audit Independence
Message to Valero on April 17, 2004
I request that you print this message for all
participants of the workshop that I will present at
Of all the many documents and books that I have read
about derivative financial instruments, the most
important have been the books and documents written by
Frank Partnoy. Some of his books are listed at the
bottom of this message.
The single most important document is his Senate
Testimony. More than any other single thing that I've
ever read about the Enron disaster, this testimony
explains what happened at Enron and what danger lurks in
the entire world from continued unregulated OTC markets
in derivatives. I think this document should be required
reading for every business and economics student in the
world. Perhaps it should be required reading for every
student in the world. Among other things it says a great
deal about human greed and behavior that pump up the
bubble of excesses in government and private enterprise
that destroy the efficiency and effectiveness of what
would otherwise be the best economic system ever
I appreciate this opportunity to meet with Valero
specialists in derivatives and derivatives accounting.
Frank Partnoy is best known as a whistle blower at
Morgan Stanley who blew the lid on the financial graft
and sexual degeneracy of derivatives instruments traders
and analysts who ripped the public off for billions of
dollars and contributed to mind-boggling worldwide
frauds. He is a Yale University Law School graduate who
shocked the world with various books include the
FIASCO: The Inside Story of a Wall Street
FIASCO: Blood in the Water on Wall Street
FIASCO: Blut an den weiÃŸen Westen der Wall
FIASCO: Guns, Booze and Bloodlust: the Truth
About High Finance
Infectious Greed : How Deceit and Risk
Corrupted the Financial Markets
His other publications include the following
"The Siskel and Ebert of Financial Matters: Two
Thumbs Down for the Credit Reporting Agencies" (Washington
University Law Quarterly)
In the end, derivatives are like antibiotics. It's
dangerous to live with them, but the world is better off
because of them. The same can be said about FAS 133 and
its many implementation guides and amendments. Booking
derivatives at fair value is dangerous, but the economy
would be worse off without it. What we have to do is to
strive night and day to improve upon reporting of value
and risk in a world that relies more and more on
derivative financial instruments to manage risks.
Selected works of FRANK
Bob Jensen at
1. Who is Frank Partnoy?
controversial writings of Frank Partnoy have had an enormous
impact on my teaching and my research. Although subsequent
writers wrote somewhat more entertaining exposes, he was the
one who first opened my eyes to what goes on behind the scenes
in capital markets and investment banking. Through his early
writings, I discovered that there is an enormous gap between
the efficient financial world that we assume in agency theory
worshipped in academe versus the dark side of modern reality
where you find the cleverest crooks out to steal money from
widows and orphans in sophisticated ways where it is virtually
impossible to get caught. Because I read his 1997 book early
on, the ensuing succession of enormous scandals in finance,
accounting, and corporate governance weren’t really much of a
surprise to me.
From his insider perspective he reveals a world where our most
respected firms in banking, market exchanges, and related
financial institutions no longer care anything about fiduciary
responsibility and professionalism in disgusting contrast to
the honorable founders of those same firms motivated to serve
rather than steal.
Young men and women from top universities of the world
abandoned almost all ethical principles while working in
investment banks and other financial institutions in order to
become not only rich but filthy rich at the expense of
countless pension holders and small investors. Partnoy opened
my eyes to how easy it is to get around auditors and corporate
boards by creating structured financial contracts that are
incomprehensible and serve virtually no purpose other than to
steal billions upon billions of dollars.
Most importantly, Frank Partnoy opened my eyes to the
psychology of greed. Greed is rooted in opportunity and
cultural relativism. He graduated from college with a high
sense of right and wrong. But his standards and values sank
to the criminal level of those when he entered the criminal
world of investment banking. The only difference between him
and the crooks he worked with is that he could not quell his
conscience while stealing from widows and orphans.
Frank Partnoy has a rare combination of scholarship and
experience in law, investment banking, and accounting. He is
sometimes criticized for not really understanding the
complexities of some of the deals he described, but he rather
freely admits that he was new to the game of complex
deceptions in international structured financing crime.
2. What really happened at Enron?
I begin with the following document the best thing I ever read
explaining fraud at Enron.
Testimony of Frank Partnoy Professor of Law, University of San
Diego School of Law Hearings before the United States Senate
Committee on Governmental Affairs, January 24, 2002 ---
following selected quotations from his Senate testimony speak
Quote: In other words, OTC
derivatives markets, which for the most part did not exist
twenty (or, in some cases, even ten) years ago, now comprise
about 90 percent of the aggregate derivatives market, with
trillions of dollars at risk every day. By those measures,
OTC derivatives markets are bigger than the markets for
U.S.stocks. Enron may have been
just an energy company when it was created in 1985, but by
the end it had become a full-blown OTC derivatives trading
firm. Its OTC derivatives-related assets and liabilities
increased more than five-fold during 2000 alone.
Quote: And, let me repeat, the OTC
derivatives markets are largely unregulated. Enron’s
trading operations were not regulated, or even recently
audited, by U.S. securities regulators, and the OTC
derivatives it traded are not deemed securities. OTC
derivatives trading is beyond the purview of organized,
regulated exchanges. Thus, Enron – like many firms that
trade OTC derivatives – fell into a regulatory black hole.
Quote: Specifically, Enron used
derivatives and special purpose vehicles to manipulate its
financial statements in three ways. First, it hid
speculator losses it suffered on technology stocks. Second,
it hid huge debts incurred to finance unprofitable new
businesses, including retail energy services for new
customers. Third, it inflated the value of other troubled
businesses, including its new ventures in fiber-optic
bandwidth. Although Enron was founded as an energy company,
many of these derivatives transactions did not involve
energy at all.
Quote: Moreover, a thorough
inquiry into these dealings also should include the major
financial market “gatekeepers” involved with Enron:
accounting firms, banks, law firms, and credit rating
agencies. Employees of these firms are likely to have
knowledge of these transactions. Moreover, these firms have
a responsibility to come forward with information relevant
to these transactions. They benefit directly and indirectly
from the existence of U.S.securities regulation, which in many instances both
forces companies to use the services of gatekeepers and
protects gatekeepers from liability.
Quote: Recent cases against
accounting firms – including Arthur Andersen – are eroding
that protection, but the other gatekeepers remain well
insulated. Gatekeepers are kept honest – at least in theory
– by the threat of legal liability, which is virtually
non-existent for some gatekeepers. The capital markets
would be more efficient if companies were not required by
law to use particular gatekeepers (which only gives those
firms market power), and if gatekeepers were subject to a
credible threat of liability for their involvement in
fraudulent transactions. Congress should consider expanding
the scope of securities fraud liability by making it clear
that these gatekeepers will be liable for assisting
companies in transactions designed to distort the economic
reality of financial statements.
Quote: In a nutshell, it appears
that some Enron employees used dummy accounts and rigged
valuation methodologies to create false profit and loss
entries for the derivatives Enron traded. These false
entries were systematic and occurred over several years,
beginning as early as 1997. They included not only the more
esoteric financial instruments Enron began trading recently
– such as fiber-optic bandwidth and weather derivatives –
but also Enron’s very profitable trading operations in
natural gas derivatives.
Quote: The difficult question is
what to do about the gatekeepers. They occupy a special
place in securities regulation, and receive great benefits
as a result. Employees at gatekeeper firms are among the
most highly-paid people in the world. They have access to
superior information and supposedly have greater expertise
than average investors at deciphering that information.
Yet, with respect to Enron, the gatekeepers clearly did not
do their job.
What are some of Frank Partnoy’s best-known books?
Frank Partnoy, FIASCO: Blood in the Water on Wall Street
(W. W. Norton & Company, 1997, ISBN 0393046222, 252 pages).
This is the first of a somewhat repetitive succession of
Partnoy’s “FIASCO” books that influenced my life. The most
important revelation from his insider’s perspective is that
the most trusted firms on Wall Street and financial centers
in other major cities in the U.S., that were once highly
professional and trustworthy, excoriated the guts of
integrity leaving a façade behind which crooks less violent
than the Mafia but far more greedy took control in the
After selling a succession of phony derivatives deals while
at Morgan Stanley, Partnoy blew the whistle in this book
about a number of his employer’s shady and outright
fraudulent deals sold in rigged markets using bait and
switch tactics. Customers, many of them pension fund
investors for schools and municipal employees, were duped
into complex and enormously risky deals that were billed as
safe as the U.S. Treasury.
His books have received mixed reviews, but I question some
of the integrity of the reviewers from the investment
banking industry who in some instances tried to whitewash
some of the deals described by Partnoy. His books have
received a bit less praise than the book Liars Poker
by Michael Lewis, but critics of Partnoy fail to give credit
that Partnoy’s exposes preceded those of Lewis.
Frank Partnoy, FIASCO: Guns, Booze and Bloodlust: the Truth
About High Finance (Profile Books, 1998, 305 Pages)
Like his earlier books, some investment bankers and literary
dilettantes who reviewed this book were critical of Partnoy
and claimed that he misrepresented some legitimate
structured financings. However, my reading of the reviewers
is that they were trying to lend credence to highly
questionable offshore deals documented by Partnoy. Be that
as it may, it would have helped if Partnoy had been a bit
more explicit in some of his illustrations.
Frank Partnoy, FIASCO: The Inside Story of a Wall Street
Trader (Penguin, 1999, ISBN 0140278796, 283 pages).
This is a blistering indictment of the unregulated OTC
market for derivative financial instruments and the devious
million and billion dollar deals conceived by drunken sexual
deviates in investment banking. Among other things, Partnoy
describes Morgan Stanley’s annual drunken skeet-shooting
This is also one of the best accounts of the “fiasco” caused
by Merrill Lynch in which Orange Counting lost over a
billion dollars and was forced into bankruptcy.
Frank Partnoy, Infectious Greed: How Deceit and Risk
Corrupted the Financial Markets (Henry Holt & Company,
Incorporated, 2003, ISBN: 0805072675, 320 pages)
Partnoy shows how corporations gradually increased financial
risk and lost control over overly complex structured financing
deals that obscured the losses and disguised frauds pushed
corporate officers and their boards into successive and
ingenious deceptions." Major corporations such as Enron,
Global Crossing, and WorldCom entered into enormous illegal
corporate finance and accounting. Partnoy documents the
spread of this epidemic stage and provides some suggestions
for restraining the disease.
4. What are examples of related books that are somewhat more
entertaining than Partnoy’s early books?
Michael Lewis, Liar's Poker: Playing the Money
Markets (Coronet, 1999, ISBN 0340767006)
Lewis writes in Partnoy’s earlier whistleblower style with
somewhat more intense and comic portrayals of the major
players in describing the double dealing and break down of
integrity on the trading floor of Salomon Brothers.
John Rolfe and Peter Troob, Monkey Business: Swinging
Through the Wall Street Jungle (Warner Books,
Incorporated, 2002, ISBN: 0446676950, 288 Pages)
This is a
hilarious tongue-in-cheek account by Wharton and Harvard
MBAs who thought they were starting out as stock brokers
for $200,000 a year until they realized that they were on
the phones in a bucket shop selling sleazy IPOs to
unsuspecting institutional investors who in turn passed
them along to widows and orphans. They write. "It took
us another six months after that to realize that we
were, in fact, selling crappy public offerings to
There are other
books along a similar vein that may be more revealing and
entertaining than the early books of Frank Partnoy, but he
was one of the first, if not the first, in the roaring
1990s to reveal the high crime taking place behind the
concrete and glass of Wall Street. He was the first to
anticipate many of the scandals that soon followed. And
his testimony before the U.S. Senate is the best concise
account of the crime that transpired at Enron. He lays
the blame clearly at the feet of government officials
(read that Wendy Graam) who sold the farm when they
deregulated the energy markets and opened the doors to
unregulated OTC derivatives trading in energy. That is
when Enron really began bilking the public.
troubled Enron Corp. the
Long Term Capital Management of the energy markets, or
merely yet another mismanaged company whose executives read
too many of their own press releases? Or is poor Enron just
misunderstood? Those are the questions after another week of
Chinese water torture financial releases from the
beleaguered Houston-based energy concern.
year ago Enron was the hottest of the hot. While tech stocks
were tanking, Enron's shares gained 89% during 2000. Even
die-hard Enron skeptics -- of which there are many -- had to
concede that last year was a barnburner for the company.
Earnings were up 25%, and revenues more than doubled.
bad, considering where the company came from. A decade ago
80% of Enron's revenues came from the staid (and regulated)
gas-pipeline business. No longer. Enron has been selling
those assets steadily, partly fueling revenues, but also
expanding into new areas. By 2000, around 95% of its
revenues and more than 80% of its profits came from trading
energy, and buying and selling stakes in energy producers.
stock market applauded the move: At its peak, Enron was
trading at around 55 times earnings. That's more like
Cisco's once tropospheric valuation than the meager 2.5
times earnings the market affords Enron competitor Duke
Enron management wanted more. It was, after all, a "new
economy" Web-based energy trader where aggressive performers
were lucratively rewarded. According to Enron Chairman and
CEO Ken Lay, the company deserved to be valued accordingly.
At a conference early this year he told investors the
company's stock should be trading much higher -- say $126,
more than double its price then.
Then the new economy motor stalled. The company's president
left under strange circumstances. And rumors swirled about
Enron's machinations in California's energy markets.
Investors pored over Enron's weakening financial statements.
But Enron analysts must have the energy and persistence of
Talmudic scholars to penetrate the company's cryptic
financials. In effect, Enron's troubles were hiding in plain
should have been a warning. Because of the poor financial
disclosure there was no way to assess the damage the economy
was doing to the company, or how it was trying to make its
numbers. Most analysts blithely concede that they really
didn't know how Enron made money -- in good markets or bad.
that Enron didn't make money, it did -- albeit with a
worrisomely low return on equity given the capital required
-- but sometimes revenues came from asset sales and complex
off-balance sheet transactions, sometimes from
energy-trading revenues. And it was very difficult to
understand why or how -- or how likely it was Enron could do
it again next quarter.
Enron's financial inscrutability hid
stranger stuff. Deep inside the company filings was mention
of LJM Cayman, L.P., a private investment partnership.
According to Enron's March 2000 10-K, a "senior officer of
Enron is the managing member" of LJM. Well, that was a
puzzler. LJM was helping Enron "manage price and value risk
with regard to certain merchant and similar assets by
entering into derivatives,
including swaps, puts, and collars." It was, in a phrase,
Enron's house hedge fund.
There is nothing wrong with hedging positions in the
volatile energy market -- it is crucial for a market-maker.
But having an Enron executive managing and benefiting from
the hedging is something else altogether, especially when
the Enron executive was the company's CFO, Andrew Fastow.
While he severed his connection with LJM (and related
partnerships) in July of this year -- and left Enron in a
whirl of confusion last week -- the damage had been done.
stories in this paper have since made clear, Mr. Fastow's
LJM partnership allegedly made millions from the
conflict-ridden, board-approved LJM-Enron relationship. And
recently Enron ended the merry affair, taking a
billion-dollar writedown against equity two weeks ago over
some of LJM's wrong-footed hedging. Analysts, investors, and
the Securities & Exchange Commission were left with many
questions, and very few answers.
be fair, I suppose, Enron did disclose the LJM arrangement
more than a year ago, saying it had erected a Chinese wall
between Fastow/LJM and the company. And in a bull market, no
one paid much attention to what a bad idea that horribly
conflicted relationship was -- or questioned the strength of
the wall. Now it matters, as do other Enron-hedged
financings, a number of which look to have insufficient
assets to cover debt repayments due in 2003.
We didn't do anything wrong is Mr.
Lay's refrain in the company's current round of
entertainingly antagonistic conference calls. That remains
to be seen, but at the very least the company has shown
terrible judgment, and heroic arrogance in its dismissal of
shareholders interests and financial transparency.
Where has Enron's board of directors been through all of
kind of oversight has this motley collection of academics,
government sorts, and retired executives exercised for Enron
shareholders? Very little, it seems. It is time Enron's
board did a proper investigation, and then cleaned house --
perhaps neatly finishing with themselves.
Then I discovered the "tip of the iceberg" article below:
Dealings with a related party have tarnished Enron's (ENE:NYSE
- news - commentary - research - analysis) reputation and
crushed its stock, but it looks like that case is far from
battered energy trader has done business with at least 15
other related entities, according to documents supplied by
lawyers for people suing Enron. Moreover, Enron's new CFO,
who has been portrayed by bulls as opposing the
related-party dealings of his predecessor, serves on 12 of
these entities. And Enron board members are listed as having
directorships and other roles at a Houston-based related
entity called ES Power 3.
extent of Enron's dealings with these companies, or the
value of its holdings in them, couldn't be immediately
determined. But the existence of these partnerships could
feed investors' fears that Enron has billions of dollars of
liabilities that don't show up on its balance sheet. If
that's so, the company's financial strength and growth
prospects could be much less than has generally been assumed
on Wall Street, where the company was long treated with kid
Enron didn't immediately respond to questions seeking
details about ES Power or about the role of the chief
financial officer, Jeff McMahon, in the various entities.
Enron's board members couldn't immediately be reached for
Ten Long Days
Enron's previous CFO, Andrew Fastow, was replaced by McMahon
Wednesday after investors criticized Fastow's role in a
partnership called LJM, which had done complex hedging
transactions with Enron. As details of this deal
and two others emerged, Enron stock cratered.
turmoil that resulted in Fastow's departure began two weeks
ago, when Enron reported third-quarter earnings that met
estimates. However, the company failed to disclose in its
earnings press release a $1.2 billion charge to equity
related to unwinding the LJM transactions. Since then,
investors and analysts have been calling with increasing
vehemence for the company to divulge full details of its
business dealings with other related entities. Enron stock
sank 6% Friday, meaning it has lost 56% of its value in just
Enron's End Run? New financial chief's
involvement in Enron business partners
ECT Strategic Value Corp.
ECT Investments Inc.
Obi-1 Holdings LLC
Oilfield Business Investments - 1 LLC
HGK Enterprises LP Inc.
ECT Eocene Enterprises III Inc.
Jedi Capital II LLC
E.C.T. Coal Company No. 2 LLC
ES Power 3 LLC
LJM Management LLC
Blue Heron I LLC
Whitewing Management LLC
Jedi Capital II LLC
However, Enron has yet to break out a full list of related
entities. The company has said nothing publicly about
McMahon's participation in related entities, nor has it
mentioned that its board members were directors or senior
officers in ES Power 3. (Nor has it explained the extensive
use of Star Wars-related names by the related-party
companies.) It's not immediately clear what ES Power 3 is or
does. So far, subpoenas issued by lawyers suing Enron have
determined the names of senior officers of ES Power 3 and
its formation date, January 1999.
Among ES Power 3's senior executives are Enron CEO Ken Lay,
listed as a director, and McMahon and Fastow, listed as
executive vice presidents. A raft of external directors are
named as ES Power 3 directors, including Comdisco CEO
Norman Blake and Ronnie Chan, chairman of the Hong
Kong-based Hang Lung Group. A Comdisco spokeswoman
says Blake isn't commenting on matters concerning Enron and
a call to the Hang Lung group wasn't immediately returned.
Rating agencies Moody's, Fitch and S&P recently put Enron's
credit rating on review for a possible downgrade after an
LJM deal that led to the $1.2 billion hit to equity. Enron
still has a rating three notches above investment grade. But
its bonds trade with a yield generally seen on subinvestment
grade, or junk, bonds, suggesting the market believes
downgrades are likely.
Enron's rating drops below investment grade, it must find
cash or issue stock to pay off at least $3.4 billion in
off-balance sheet obligations. In addition, many of its swap
agreements contain provisions that demand immediate cash
settlement if its rating goes below investment grade.
Friday, the company drew down $3 billion from credit lines
to pay off commercial paper obligations. Raising cash in the
CP market could be tough when investors are jittery about
This week, a number of energy market players reduced
exposure to Enron. However, in a Friday press release, CEO
Lay said that Enron was the "market-maker of choice in
wholesale gas and power markets." He added: "It is evident
that our customers view Enron as the major liquidity source
of the global energy markets."
McMahon reportedly objected to Fastow's role in LJM,
allegedly believing it posed Fastow with a conflict of
interests. But he will need to convince investors that the
12 entities he's connected to don't do the same. Enron has
said that its board fully approved of the LJM deals that
Fastow was involved in. Now, board members will have to
comment on their own roles in a related entity.
Selected quotations from "Why
Enron Went Bust: Start with arrogance. Add greed, deceit,
and financial chicanery. What do you get? A company that
wasn't what it was cracked up to be." by
Fortune Magazine, December 24, 2001, pp. 58-68.
Enron Went Bust: Start with arrogance. Add greed, deceit,
and financial chicanery. What do you get? A company that
wasn't what it was cracked up to be."
fact , it's next to impossible to find someone outside Enron
who agrees with Fasto's contention (that Enron was an energy
provider rather than an energy trading company). "They were
not an energy company that used trading as part of their
strategy, but a company that traded for trading's sake,"
says Austin Ramzy, research director of Principal Capital
Income Investors. "Enron is dominated by pure trading,"
says one competitor. Indeed, Enron had a reputation for
taking more risk than other companies, especially in
longer-term contracts, in which there is far less
liquidity. "Enron swung for the fences," says another
trader. And it's not secret that among non-investment
banks, Enron was an active and extremely aggressive player
in complex financial instruments such as credi8t
derivatives. Because Enron didn't have as strong a balance
sheet as the investment banks that dominate that world, it
had to offer better prices to get business. "Funky" is a
word that is used to describe its trades.
early 2001, Jim Chanos, who runs Kynikos Associates, a
highly regarded firm that specializes in short-selling, said
publicly what now seems obvious: No one could explain how
Enron actually made money ... it simply didn't make very
much money. Enron's operating margin had plunged from
around 5% in early 2000 to under 2% by early 2001, and its
return on invested capital hovered at 7%---a figure that
does not include Enron's off-balance-sheet debt, which, as
we now know, was substantial. "I wouldn't put my money in a
hedge fund earning a 7% return," scoffed Chanos, who also
pointed out that Skilling (the former Enron CEO who
mysteriously resigned in August prior to the December 2
meltdown of Enron) was aggressively
selling shares---hardly the behavior of someone who believed
his $80 stock was really worth $126.
executives will probably claim that they had Enron's
auditor, Arthur Andersen, approving their every move. With
Enron in bankruptcy, Arthur Andersen is now the deepest
available pocket, and the shareholder suits are already
The Famous Enron Video on Hypothetical
Future Value (HFV) Accounting
The video shot at Rich Kinder's retirement party at Enron
features CEO Jeff Skilling proposing
Hypothetical Future Value (HPV) accounting with in retrospect
is too true to be funny during the subsequent melt down of Enron.
The people in this video are playing themselves and you can
actually see CEO Jeff Skilling, Chief Accounting Officer Richard
Causey, and others proposing cooking the books. You can download my
rendering of a Windows Media Player version of the video from
You may have to turn the audio up full blast
in Windows Media Player to hear the music and dialog.
Skits and jokes by a few former Enron
Corp. executives at a party six years ago were funny then, but now
border on bad taste in light of the events of the past year.
VIDEO Feds Want To See Controversial
Enron Videotape Watch Clips From Enron Retirement Tape
INTERACTIVES The End Of Enron What's The Future Of Enron?
A videotape of a January 1997 going-away
party for former Enron President Rich Kinder features nearly half
an hour of absurd skits, songs and testimonials by company
executives and prominent Houstonians, the Houston Chronicle
reported in its Monday editions.
The collection is all meant in good fun,
but some of the comments are ironic in the current climate of
In one skit, former Administrative
Executive Peggy Menchaca played the part of Kinder as he received
a budget report from then-President Jeff Skilling, who played
himself, and Financial Planning Executive Tod Lindholm.
When the pretend Kinder expressed doubt
that Skilling could pull off 600 percent revenue growth for the
coming year, Skilling revealed how it could be done.
"We're going to move from mark-to-market
accounting to something I call HFV, or hypothetical future value
accounting," Skilling joked as he read from a script. "If we do
that, we can add a kazillion dollars to the bottom line."
Richard Causey, the former chief
accounting officer who was embroiled in many of the business deals
named in the indictments of other Enron executives, made an
unfortunate joke later on the tape.
"I've been on the job for a week managing
earnings, and it's easier than I thought it would be," Causey
said, referring to a practice that is frowned upon by securities
regulators. "I can't even count fast enough with the earnings
Joe Sutton and Rebecca Mark, the two
executives credited with leading Enron on an international buying
spree, did a painfully awkward rap for Kinder, while former Enron
Broadband Services President Ken Rice recounted a basketball game
where employees from Enron Capital & Trade beat Kinder's Enron
Corp. team, 98-50.
"I know you never forget a number, Rich,"
President George W. Bush, who then was
governor of Texas, also took part in the skit, as did his father.
At the party, the younger Bush pleaded
with Kinder: "Don't leave Texas. You're too good a man."
The governor's father also offered a
send-off to Kinder, thanking him for helping his son reach the
"You have been fantastic to the Bush
family," the elder Bush said. "I don't think anybody did more than
you did to support George."
Federal investigators told News2Houston
Tuesday that they want to take a closer look at the tape.
Investigators with the House committee on
government reform are in the process of obtaining a copy of the
tape, according to News2Houston.
Former federal prosecutor Phil Hilder
said that what was a joke could become evidence for federal
"There's matters on there that a
prosecutor may want to introduce as evidence should it become
relevant," Hilder said.
Former employees were shocked to see the
"It's too close to the truth, very close
to the truth," said Debra Johnson, a former Enron employee. "I
think there's some inside truth to the jokes that they portrayed."
Warning Signs That Bad Guys Were Running
Enron and That Political Whores Were Helping
There were some warning signs, but
nobody seemed care much as long as Enron was releasing audited
accounting reports showing solid increases in net earnings. Roger
Collins sent me a 1995 link that lists Enron among the world's "10
Most Shameless Corporations." I guess they are reaping what was
1995, the world's biggest natural gas company began clearing
ground 100 miles south of Bombay,
for a $2.8 billion, gas-fired power plant -- the largest
single foreign investment in India.
claimed that the power plant was overpriced and that its
effluent would destroy their fisheries and coconut and mango
trees. One villager opposing Enron put it succinctly, "Why
not remove them before they remove us?"
Chatterjee reported ["Enron Deal Blows a Fuse,"
Multinational Monitor, July/August 1995], hundreds of
villagers stormed the site that was being prepared for
Enron's 2,015-megawatt plant in May 1995, injuring numerous
construction workers and three foreign advisers.
winning Maharashtra state elections, the conservative
nationalistic Bharatiya Janata Party canceled the deal,
sending shock waves through Western businesses with
investments in India.
officials said they acted to prevent the Houston,
Texas-based company from making huge profits off "the backs
of India's poor." New Delhi's Hindustan Times
editorialized in June 1995, "It is time the West realized
that India is not a banana republic which has to dance to
the tune of multinationals."
officials are not so sure. Hoping to convert the
cancellation into a temporary setback, the company launched
an all-out campaign to get the deal back on track. In late
November 1995, the campaign was showing signs of success,
although progress was taking a toll on the handsome rate of
return that Enron landed in the first deal. In India, Enron
is now being scrutinized by the public, which is demanding
contracts reflecting market rates. But it's a big world.
1995, the company announced that it has signed a $700
million deal to build a gas pipeline from Mozambique to
South Africa. The pipeline will service Mozambique's Pande
gas field, which will produce an estimated two trillion
cubic feet of gas.
The deal, in
which Enron beat out South Africa's state petroleum company
Sasol, sparked controversy in Africa following reports that
the Clinton administration, including the U.S. Agency for
International Development, the U.S. Embassy and even
National Security adviser Anthony Lake, lobbied Mozambique
on behalf of Enron.
outright threats to withhold development funds if we didn't
sign, and sign soon," John Kachamila, Mozambique's natural
resources minister, told the Houston Chronicle. Enron
spokesperson Diane Bazelides declined to comment on the
these allegations, but said that the U.S. government had
been "helpful as it always is with American companies."
Spokesperson Carol Hensley declined to respond to a
hypothetical question about whether or not Enron would
approve of U.S. government threats to cut off aid to a
developing nation if the country did not sign an Enron deal.
been repeatedly criticized for relying on political clout
rather than low bids to win contracts. Political
heavyweights that Enron has engaged on its behalf include
former U.S. Secretary of State James Baker, former U.S.
Commerce Secretary Robert Mosbacher and retired General
Thomas Kelly, U.S. chief of operations in the 1990 Gulf War.
Enron's Board includes former Commodities Futures Trading
Commission Chair Wendy Gramm (wife of presidential hopeful
Senator Phil Gramm, R-Texas), former U.S. Deputy Treasury
Secretary Charles Walker and John Wakeham, leader of the
House of Lords and former U.K. Energy Secretary.
To this I have added
the following :
From the Free Wall
Street Journal Educators' Reviews for November 1, 2001
TITLE: Enron Did
Business With a Second Entity Operated by Another Company
Official; No Public Disclosure Was Made of Deals
REPORTER: John R. Emshwiller and Rebecca Smith
DATE: Oct 26, 2001
LINK: Print Only in the WSJ on October 26, 2001
financial statement disclosures have been less than
transparent. Information is arising as the SEC makes an
inquiry into the Company's accounting and reporting practices
with respect to its transactions with entities managed by
high-level Enron managers. Yet, as discussed in a related
article, analysts remain confident in the stock.
1.) Why must
companies disclose related party transactions? What is the
significance of the difference between the wording of SEC rule
S-K and FASB Statement of Financial Accounting Standards No.
57, Related Party Transactions that is cited at the end of the
2.) Explain the logic
of why a drop in investor confidence in Enron's business
transactions and reporting practices could affect the
company's credit rating.
3.) Explain how an
analyst could argue, as did one analyst cited in the related
article, that he or she is confident in Enron's ability to
"deliver" earnings even if he or she cannot estimate "where
revenues are going to come from" nor where the company will
Reviewed By: Judy
Beckman, University of Rhode Island
Reviewed By: Benson
Wier, Virginia Commonwealth University
Reviewed By: Kimberly
Dunn, Florida Atlantic University
argue that Arthur Andersen LLP has failed to ensure that Enron
Corp.'s financial disclosures are understandable. Enron is
currently undergoing SEC investigation and is being sued by
shareholders. Questions relate to disclosure quality and
1.) The article
suggests that the auditor has the job of making sure that
financial statements are understandable and accurate and
complete in all material respects. Does the auditor bear this
responsibility? Discuss the role of the auditor in financial
2.) One allegation is
that Enron's financial statements are not understandable.
Should users be required to have specialized training to be
able to understand financial statements? Should the financial
statements be prepared so that only a minimal level of
business knowledge is required? What are the implications of
the target audience on financial statement preparation?
3.) Enron is facing
several shareholder lawsuits ; however, Arthur Anderson LLP is
not a defendant. What liability does the auditor have to
shareholders of client firms? What are possible reasons that
Arthur Anderson is not a defendant in the Enron cases?
4.) What is the role
of the SEC in the investigation? What power does the SEC have
to penalize Enron Corp. and Arthur Anderson LLP?
ASSIGNMENT: Should financial statements be understandable to
users with only general business knowledge? Prepare an
argument to support your position.
Reviewed By: Judy
Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
Mayo Clinic's accounting
called into question Court documents pertaining to a
suit brought against the Mayo Foundation by a former
accounting employee under the False Claims Act and settled
in May for $6.5 million, were released Monday to the
Rochester, Minnesota, Post-Bulletin, according to the
Associated Press. The documents had been under seal until
the Post-Bulletin challenged the settlement order, according
to the Associated Press. These documents show that federal
investigators alleged that the Mayo Clinic had serious
problems accounting for research grants, according to the
Associated Press. “The audit team from the Department of
Health and Human Services and the National Institutes of
Health, whose job it is to routinely audit grants, has never
seen an accounting system with such basic failures. Nor have
they ever previously confronted an institution incapable of
being audited in this way,” the Associated Press quotes from
one document, signed by Assistant U.S. Attorney Robyn
"Harsh Criticism for the Mayo Foundation's Accounting
Practices," AccountingWeb, July 21, 2005 ---
SUMMARY: An Italian
university professor and public-debt management expert issued
a report this week explaining how a European country used a
swap contract to effectively receive more cash in 1997. That
country is believed to be Italy although top officials deny
such "window dressing" practices. 1997 was a critical year for
Italy if it was to be included in the EMU (European Monetary
Union) and become a part of the euro-zone. To qualify for
entry, a country's deficit could not exceed 3% of gross
domestic product. In 1996 Italy's deficit was 6.7% of GDP,
however, the country succeeded in "slashing its budget deficit
to 2.7%" in 1997. The question now is whether Italy
accomplished this reduction by clamping down on waste and
raising revenues or engaging in deceptive swaps usage.
1.) Why was the level
of Italy's budget deficit so critical in 1997? How did Italy's
1997 budget deficit compare with its 1996 level?
2.) What is an
interest rate swap? How can the use of swap markets decrease
borrowing costs? What is a currency swap? When would firms
tend to use these derivative instruments?
3.) Does the European
Union condone the use of interest rate swaps by its euro-zone
members as a way to manage their public debt? According to the
related article, who are the biggest users of swaps in Europe?
Do the U.S. and Japan use them to manage their public debt?
4.) According to the
related article, interest-rate swaps now account for what
proportion of the over-the-counter derivatives market? Go to
the web page for the Bank of International Settlement at
Select Publications & Statistics then go to International
Financial Statistics. Go to the Central Bank Survey for
Foreign Exchange and Derivatives Market Activity. Look at the
pdf version of the report, specifically Table 6. What was
average daily turnover, in billions of dollars, of
interest-rate swaps in April 1995? 1998? and 2001? By what
percentage did interest-rate swap usage increase from
5.) According to the
related article, how did the swaps contract allegedly used by
Italy differ from a standard swaps contract? What was the
"bottom line" result of this arrangement?
6.) Assume Italy did
indeed use such measures to "window dress" their financial
situation and gain entry into the euro-zone. What actions
should be taken to prevent such loopholes in the future?
Jacqueline Garner, Georgia State University and Univ. of Rhode
Beverly Marshall, Auburn University
Peter Dadalt, Georgia State University
Enron's financial statements have long been charged with being
undecipherable; however, they are now considered to contain
violations of GAAP. Enron filed documents with the SEC
indicating that financial statements going back to 1997
"should not be relied upon." Questions deal with materiality
and auditor independence.
1.) What accounting errors are reported to have been included
in Enron's financial statements? Why didn't Enron's auditors
require correction of these errors before the financial
statements were issued?
2.) What is
materiality? In hindsight, were the errors in Enron's
financial statements material? Why or why not? Should the
auditors have known that the errors in Enron's financial
statements were material prior to their release? What defense
can the auditors offer?
3.) Does Arthur
Andersen provide any services to Enron in addition to the
audit services? How might providing additional services to
Enron affect Andersen's decision to release financial
statements containing GAAP violations?
4.) The article
states that Enron is one of Arthur Andersen's biggest clients.
How might Enron's size have contributed to Arthur Andersen's
decision to release financial statements containing GAAP
violations? Discuss differences in audit risk between small
and large clients. Discuss the potential affect of client firm
size on auditor independence.
5.) How long has
Arthur Andersen been Enron's auditor? How could their tenure
as auditor contributed to Andersen's decision to release
financial statements containing GAAP violations?
6.) The related
article discusses how Enron's consolidation policy with
respect to the JEDI and Chewco entities impacted the company's
financial statements. What is meant by the phrase
consolidation policy? How could a policy not to consolidate
these entities help to make Enron's financial statements look
better? Why would consolidating an entity result in a $396
million reduction in net income over a 4 year period? How must
Enron have been accounting for investments in these entities?
How could Enron support its accounting policies for these
Reviewed By: Judy
Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
There are some activists
with a much longer and stronger record of lamenting the
decline in professionalism in auditing and accounting.
For some reason, they are not being quoted in the media
at the moment, and that is a darn shame!
The most notable activist is Abraham Briloff
(emeritus from SUNY-Baruch) who for years wrote a column
for Barrons that constantly analyzed breaches of
ethics and audit professionalism among CPA firms. His
most famous book is called Unaccountable Accounting.
I suspect that the fear of activists (other than
Briloff) is that complaining too loudly will lead to a
government takeover of auditing. This in, my viewpoint,
would be a disaster, because it does not take industry
long to buy the regulators and turn the regulating
agency into an industry cheerleader. The best way to
keep the accounting firms honest is to forget the SEC
and the AICPA and the rest of the establishment and
directly make their mistakes, deceptions, frauds,
breakdowns in quality controls expensive to the entire
firms, and that is easier to do if the firms are in the
private sector! We are seeing that now in the case of
Andersen --- in the end its the tort lawyers who clean
up the town.
The problem with most activists against the private
sector is that they've not got much to rely upon except
appeals for government intervention. That's like asking
pimps, whores, and Wendy Gramm to clean up town. You
can read more about how Wendy Gramm sold her soul to
on the above link to view a thirty-minute
archived webcast on the AICPA's newly adopted
you view this webcast, we invite you to
participate on December 4 at 1 p.m. (Eastern
Standard Time) in a live, interactive web
conference. During that web conference, a panel
consisting of representatives from the AICPA
Professional Ethics Executive Committee, the
AICPA Ethics and State Societies and Regulatory
Affairs divisions and NASBA will address your
questions about the rules.
provide us your questions via e-mail after
archived webcast. We will respond to those
questions during the live webcast on December 4.
view/register for the live webcast on December
4, click the "live webcast" button located on
AICPA Video Player.
also has a video that focuses on the supreme
importance of independence in the CPA
40-Minute Video, Financially Correct
(Quality of Earnings)
Big Five firm
Andersen is in the thick of a controversy involving a
20% overstatement in Enron's net earnings and financial
statements dating back to 1997 that will have to be
One of the main causes for the restatements of
financial reports that will be required of Enron
relates to transactions in which Enron issued shares
of its own stock in exchange for notes receivable. The
notes were recorded as assets on the company books,
and the stock was recorded as equity. However, Lynn
Turner, former SEC chief accountant, points out, "It
is basic accounting that you don't record equity until
you get cash, and a note doesn't count as cash. The
question that raises is: How did both partners and the
manager on this audit miss this simple Accounting 101
In addition, Enron has acknowledged overstating its
income in the past four years of financial statements
to the tune of $586 million, or 20%. The misstatements
reportedly result from "audit adjustments and
reclassifications" that were proposed by auditors but
were determined to be "immaterial."
There is a chance that such immaterialities will be
determined to be unlawful. An SEC accounting bulletin
states that certain adjustments that might fall
beneath a materiality threshold aren't necessarily
material if such misstatements, when combined with
other misstatements, render "the financial statements
taken as a whole to be materially misleading."
The recent news
of Enron Corp.'s need to restate financial statements
dating back to 1997 as a result of accounting issues
missed in Big Five firm Andersen's audits, has caused
the Public Oversight Board to decide to take a closer
look at the peer review process employed by public
But the review of Andersen
reflected the limitations of the peer-review process,
in which each of the so-called Big Five accounting
firms is periodically reviewed by one of the others.
Deloitte's review did not include Andersen's audits of
bankrupt energy trader Enron Corp. -- or any other
case in which an audit failure was alleged, Deloitte
partners said yesterday in a conference call with
In its latest review, Deloitte
said Andersen auditors did not always comply with
requirements for communicating with their overseers on
corporate boards. According to Deloitte's report, in a
few instances, Andersen failed to issue a required
letter in which auditors attest that they are
independent from the audit client and disclose factors
that might affect their independence.
In a recent letter to the American Institute of
Certified Public Accountants, Andersen said it has
addressed the concerns that Deloitte cited.
IN THE AFTERMATH of
Enron, the tarnished auditing profession has
mounted what might be called the "complexity
defense." This involves frowning seriously,
intoning a few befuddling sentences, then
sighing that audits involve close-call
judgments that reasonable experts could
debate. According to this defense, it isn't
fair to beat up on auditors as they wrestle
with the finer points of derivatives or lease
receivables -- if they make calls that are
questionable, that's because the material is
so difficult. Heck, it's not as though
auditors stand by dumbly while something
obviously bad happens, such as money being
siphoned off for the boss's condo or golf
Really? Let's look at
Adelphia Communications Corp., the nation's
sixth-largest cable firm, which is due to be
suspended from the Nasdaq stock exchange
today. On May 24, three days after the audit
lobby derailed a Senate attempt to reform the
profession, Adelphia filed documents with the
Securities and Exchange Commission that reveal
some of the most outrageous chicanery in
corporate history. The Rigas family, which
controlled the company while owning just a
fifth of it, treated Adelphia like a piggy
bank: It used it, among other things, to pay
for a private jet, personal share purchases, a
movie produced by a Rigas daughter, and (yes!)
a golf course and a Manhattan apartment. In
all, the family helped itself to secret loans
from Adelphia amounting to $3.1 billion. Even
Andrew Fastow, the lead siphon man at Enron,
made off with a relatively modest $45 million.
Where was Deloitte &
Touche, Adelphia's auditor, whose role was to
look out for the interests of the nonfamily
shareholders who own four-fifths of the firm?
Deloitte was apparently inert when Adelphia
paid $26.5 million for timber rights on land
that the family then bought for about $500,000
-- a nifty way of transferring other
shareholders' money into the Rigas's coffers.
Deloitte was no livelier when Adelphia made
secret loans of about $130 million to support
the Rigas-owned Buffalo Sabres hockey team.
Deloitte didn't seem bothered when Adelphia
used smoke and mirrors to hide debt off its
balance sheet. In sum, the auditor stood by
while shareholders' cash left through the
front door and most of the side doors. There
is nothing complex about this malfeasance.
When Adelphia's board
belatedly demanded an explanation from its
auditor, it got a revealing answer. Deloitte
said, yes, it would explain -- but only on
condition that its statements not be used
against it. How could Deloitte have forgotten
that reporting to the board (and therefore to
the shareholders) is not some special favor
for which reciprocal concessions may be
demanded, but rather the sole reason that
auditors exist? The answer is familiar.
Deloitte forgot because of conflicts of
interest: While auditing Adelphia, Deloitte
simultaneously served as the firm's internal
accountant and as auditor to other companies
controlled by the Rigas family. Its real
allegiance was not to the shareholders but to
the family that robbed them.
It's too early to
judge the repercussions of Adelphia, but the
omens are not good. When audit failure helped
to bring down Enron, similar failures soon
emerged at other energy companies -- two of
which fired their CEOs last week. Equally,
when audit failure helped to bring down Global
Crossing, similar failure emerged at other
telecom players. Now the worry is that
Adelphia may signal wider trouble in the cable
industry. The fear of undiscovered booby traps
is spooking the stock market: Since the start
of December, when Enron filed for bankruptcy,
almost all macro-economic news has been better
than expected, but the S&P 500 index is down 2
Crossing-Adelphia, the stock market almost
certainly would be higher. If the shares in
the New York Stock Exchange were a tenth
higher, for example, investors would be
wealthier by about $1.5 trillion. Does anyone
in government care about this? We may find out
when Congress reconvenes this week. Sen. Paul
Sarbanes, who sponsored the reform effort that
got derailed last month, will be trying to
rally his supporters. Perhaps the thought of
that $1.5 trillion -- or even Adelphia's
fugitive $3 billion -- will get their
The above article must be juxtaposed against
this earlier Washington Post article:
But the review of
Andersen reflected the limitations of the
peer-review process, in which each of the
so-called Big Five accounting firms is
periodically reviewed by one of the others.
Deloitte's review did not include Andersen's
audits of bankrupt energy trader Enron Corp.
-- or any other case in which an audit failure
was alleged, Deloitte partners said yesterday
in a conference call with reporters.
In its latest review,
Deloitte said Andersen auditors did not always
comply with requirements for communicating
with their overseers on corporate boards.
According to Deloitte's report, in a few
instances, Andersen failed to issue a required
letter in which auditors attest that they are
independent from the audit client and disclose
factors that might affect their independence.
In a recent letter to the American Institute
of Certified Public Accountants, Andersen said
it has addressed the concerns that Deloitte
the Fall Came Quickly: Complexity, Partnerships Kept
Problems From Public View"
Pearlstein and Peter Behr
Washington Post Staff Writers
Sunday, December 2, 2001; Page
Only a year ago, Ken Lay might have been excused for
feeling on top of the world.
The company he founded 15 years before on the
foundation of a sleepy Houston gas pipeline company
had grown into a $100 billion-a-year behemoth, No. 7
on Fortune's list of the 500 largest corporations,
passing the likes of International Business Machines
Corp. and AT&T Corp. The stock market valued Enron
Corp.'s shares at nearly $48 billion, and it would add
another $15 billion before year-end.
Enron owned power companies in India, China and the
Philippines, a water company in Britain, pulp mills in
Canada and gas pipelines across North America and
South America. But those things were ancillary to the
high-powered trading rooms in a gleaming seven-story
building in Houston that made it the leading middleman
in nationwide sales of electricity and natural gas. It
was primed to do the same for fiber-optic cable, TV
advertising time, wood pulp and steel. Enron's rise
coincided with a stock market boom that made everyone
less likely to question a company if it had "Internet"
and "new" in its business plan.
And, to top it off, Lay's good friend, Texas Gov.
George W. Bush, on whom he and his family had lavished
$2 million in political contributions, had just been
elected president of the United States.
Enron intended to become "the World's Greatest
Company," announced a sign in the lobby of its Houston
headquarters. Lay was widely hailed as a visionary.
A year later, Lay's empire, and his reputation, are a
shambles. Enron's stock is now virtually worthless.
Many of its most prized assets have been pledged to
banks and other creditors to pay some of its estimated
$40 billion debt. Company lawyers are preparing a
bankruptcy court filing that is expected to come as
soon as this week and may be the biggest and most
complex ever. Most of Enron's trading customers have
The company's 21,000 employees have lost much of their
retirement savings because their pension accounts were
stuffed with now-worthless Enron stock, and many
expect to lose their jobs as well this coming week.
Some of the nation's biggest mutual-fund companies,
including Alliance Capital, Janus, Putnam and
Fidelity, have lost billions of dollars in value.
Meanwhile, the Securities and Exchange Commission,
headed by a Bush appointee, is investigating the
company and its outside auditors at Arthur Andersen,
while the House and Senate energy committees plan
It will take months or years to definitively answer
the myriad questions raised by Enron's implosion. Why
did it happen, and why so quickly? What did Enron's
blue-chip board of directors and auditors know of the
financial shenanigans that triggered the company's
fall when hints of them became public six weeks ago?
Should government regulators have been more vigilant?
Even now, however, it is clear that Enron was ruined
by bad luck, poor investment decisions, negligible
government oversight and an arrogance that led many in
the company to believe that they were unstoppable.
By this fall, a recession, the dot-com crash and
depressed energy prices had taken a heavy toll on the
company's financial strength. The decline finally
forced the company to reveal that it had simply made
too many bad investments, taken on too much debt,
assumed too much risk from its trading partners and
hidden much of it from the public.
Such sudden falls from great heights recur in
financial markets. In the late 1980s, its was
junk-bond king Drexel Burnham Lambert. In the 1990s,
it was Long Term Capital Management, the giant hedge
fund. Like Enron, Drexel and Long Term Capital helped
create and dominate new markets designed to help
businesses and investors better manage their financial
risks. And, like Enron, both were done in by failing
to see the risks that they themselves had taken on.
It was in the trading rooms where Enron's big profits
were made and the full extent of its ambitions were
Early on, the contracts were relatively simple and
related to its original pipeline business: a promise
to deliver so many cubic feet of gas to a fertilizer
factory on a particular day at a particular price. But
it saw the possibilities for far more in the
deregulation of electric power markets, which would
allow new generating plants running on cheap natural
gas to compete with utilities. Lay and Enron lobbied
aggressively to make it happen. After deregulation,
independent power plants and utilities and industries
turned to Enron for contracts to deliver the new
The essential idea was hardly new. But unlike
traditional commodity exchanges, such as the Chicago
Board of Trade and the New York Mercantile Exchange,
Enron was not merely a broker for the deals, putting
together buyers and sellers and taking transaction
fees. In many cases, Enron entered the contract with
the seller and signed a contract with the buyer. Enron
made its money on the difference in the two prices,
which were never posted in any newspaper or on any Web
site, or even made available to the buyers and
sellers. Enron alone set them.
By keeping its trading book secret, Enron was able to
develop a feel for the market. And virtually none of
its activity came under federal regulation because
Enron and other power marketers were exempted from
oversight in 1992 by the Commodity Futures Trading
Commission -- then headed by Wendy Gramm, who is now
an Enron board member.
Because it was first in the marketplace and had more
products than anyone else, "Enron was the seller to
every buyer and the buyer to every seller," said
Philip K. Verleger Jr., a California energy economist.
The contracts became increasingly varied and complex.
Enron allowed customers to insure themselves against
all sorts of eventualities -- a rise and fall in
prices or interest rates, a change in the weather, the
inability of a customer to pay. By the end, the volume
in the financial contracts reached 15 to 20 times the
volume of the contracts to actually deliver gas or
electricity. And Enron was employing a small army of
PhDs in mathematics, physics and economics -- even a
former astronaut -- to help manage its risk, backed by
computer systems that executives once claimed would
take $100 million to replicate.
Dominant Energy Supplier
Enron was so dominant -- it was responsible for
one-quarter of the gas and electricity traded in the
United States -- that it became a prime target for
California officials seeking culprits for the energy
price shocks last year and this. It was an image Enron
didn't improve by publicly rebuffing a state
legislative subpoena for its trading records.
How much risk Enron was taking on itself, and how much
it was laying off on other parties, was never
revealed. Verleger said last week that Enron once had
one of the best risk-disclosure statements in the
energy industry. But once the financial contracts
began to outpace the basic energy contracts, the
statements, he said, suddenly became more opaque. "It
was, 'Trust us. We know what we're doing,' " he said.
None of that, however, was of much concern to
investors and lenders, who saw Enron as the vanguard
of a new industry. New sales and earnings justified an
even higher stock price, still more borrowing and more
By 1997, however, after lenders began to express
concern about the extent of Enron's indebtedness,
chief financial officer Andrew Fastow developed a
strategy to move some of the company's assets and
debts to separate private partnerships, which would
engage in trades with Enron. Fastow became the manager
of some of the largest partnerships, with approval of
the audit committee of Enron's board.
Enron's description of the partnerships were, at best,
baffling: "share settled costless collar
arrangements," and "derivative instruments which
eliminate the contingent nature of existing restricted
forward contracts." More significantly, Enron's
financial obligations to the partnerships if things
turned sour were not explained.
When Enron released its year-end financial statements
for 2000, questions about the partnerships were raised
by James Chanos, an investor who had placed a large
bet that Enron stock would decline in the ensuing
months. Such investors, known as short sellers, often
try to "talk down" a stock, and Enron executives
dismissed Chanos's questions as nothing more than
On Oct. 16, however, it became clear that Chanos was
onto something. On that day, Enron reported a $638
million loss for the third quarter and reduced the
value of the company's equity by $1.2 billion. Some of
that was related to losses suffered by the
partnerships, in which Enron had hidden investment
losses in a troubled water-management division, a
fiber-optic network and a bankrupt telecommunications
firm. The statement also revealed that the promises
made to the partnerships to guarantee the value of
their assets could wind up costing $3 billion.
Within a week, as Enron stock plummeted, Fastow was
ousted and the Securities and Exchange Commission
began an inquiry. Then, on Nov. 8, bad turned to worse
when Enron announced it was revising financial
statements to reduce earnings by $586 million over the
past four years, in large part to reflect losses at
the partnerships. It was also disclosed that Fastow
made $30 million in fees and profits from his
involvement with the outside partnerships.
The last straw was Enron's admission that it faced an
immediate payment of $690 million in debt -- catching
credit analysts by surprise -- with $6 billion more
due within a year. Fearful that they wouldn't get paid
for electricity and gas they sold to Enron, energy
companies began scaling back their trading.
Desperate to salvage some future for the company, Lay
agreed to sell Enron to crosstown rival Dynegy Inc.
for $10 billion in stock. Perhaps more important,
Dynegy agreed to assume $13 billion of Enron's debts
and to inject $1.5 billion in cash to reassure
customers and lenders and to keep its operations
going. But when Dynegy officials got a closer look at
Enron's books during Thanksgiving week, it found that
the problems were far worse than they had imagined.
They decided the best deal was no deal.
"The story of Enron is the story of unmitigated pride
and arrogance," said Jeffrey Pfeffer, a professor of
organized behavior at Stanford Business School who has
followed the company in recent months. "My impression
is that they thought they knew everything, which [is]
always the fatal flaw. No one knows everything."
As harsh as it is, that view is shared by many in the
energy industry: customers and competitors, stock
analysts who cover the company and politicians and
regulators in Washington and state capitals. In their
telling, Enron officials were bombastic, secretive,
boastful, inflexible, lacking in candor and
contemptuous of anyone who didn't agree with their
philosophy and acknowledge their preeminence.
Last month, sitting in the lobby of New York's
Waldorf-Astoria hotel, Lay seemed to acknowledge that
pride may have been a factor in the company's fall. "I
just want to say it was only a few people at Enron
that were cocky," he said.
Lay declined to name them, but most would put Jeffrey
Skilling at the top of the list. Lay tapped Skilling,
a whiz kid with the blue-chip consulting firm of
McKinsey & Co. and the architect of Enron's trading
business, to succeed him as chief executive in
Shortly after taking over the top spot, Skilling
appeared at a conference of analysts and investors in
San Francisco and lectured the assembled on how
Enron's stock, then at record levels, was undervalued
nonetheless because it did not recognize the company's
broadband network, worth $29 billion, or an extra $37
Skilling loved nothing more than to mock executives
from old-line gas and electric utilities or companies
that still bought paper from golf-playing salesmen
rather than on EnronOnline.
Skilling once called a stock analyst an expletive for
questioning Enron's policy of refusing to release an
update of its balance sheet with its quarterly
earnings announcement, as nearly every other public
In August, after Enron's stock had fallen by half,
Skilling resigned as chief executive after six months
on the job, citing personal reasons.
As for Lay, some question how much he really
understood about the accounting ins and out. When
asked about the partnerships by a reporter in August,
he begged off, saying, "You're getting way over my
Lynn Turner, who recently resigned as chief accountant
at the Securities and Exchange Commission, said
Enron's original financial statements for the past
three years involve clear-cut errors under SEC rules
that had to have been known to Enron's auditors at
Turner, now director of the Center for Quality
Financial Reporting at Colorado State University, said
that based on information now reported by the company,
he believes the auditors knew the real story about the
partnerships but declined to force the company to
account for them correctly.
Why? "One has to wonder if a million bucks a week
didn't play a role," Turner said. He was referring to
the $52 million a year in fees Andersen received last
year from Enron, its second-largest account, divided
almost equally between auditing work and consulting
Anderson spokesman David Talbot recently described the
problems with Enron's books as "an unfortunate
If Enron's auditors failed investors, the same might
be said for its board of directors -- and, in
particular, the members of the audit committee that is
charged with reviewing the company's financial
statements. The committee is headed by Robert Jaedicke,
a former dean of the Stanford University business
school and the author of several accounting textbooks.
Members include Paulo Ferrz Pereira, former president
of the State Bank of Rio de Janeiro; John Wakeham,
former head of the British House of Lords who headed a
British accounting firm; and Gramm, the former
Commodity Futures Trading Commission chairman.
Wakeham received $72,000 last year from Enron, in
addition to his director's fee, for consulting advice
to the company's European trading office, according to
Enron's annual proxy statement. And Enron has
contributed to the center at George Mason University,
where Gramm heads the regulatory studies program.
Charles O'Reilly, a Stanford University business
school professor, said that while such donations
rarely "buy" the cooperation of directors, they do
indicate the problem when chief executives and
directors develop a "pattern of reciprocity" in which
they do favors for each other and gradually become
reluctant to rock the boat, particularly on complex
"Boards of directors want to give favorable
interpretation to events, so even when they are
nervous about something, they are reluctant to make a
stink," O'Reilly said.
Stock analysts were equally easy on Enron, despite the
company's insistence on putting out financial
statements that, even in Lay's words, were "opaque and
difficult to understand."
Many analysts admit now that they really didn't know
what was going on at the company even as they
continued to recommend the stock to investors. They
were rewarded for it by an ever-rising stock price
that seemed to confirm their good judgment.
"It's so complicated everybody is afraid to raise
their hands and say, 'I don't understand it,' " said
Louis B. Gagliardi, an analyst with John S. Herold
Inc. in Norwalk, Conn.
"It wasn't well understood. At the same time, it
should have been. There's a burden on the analysts. .
. . There's guilt to be borne all around here."
Enron Corp.'s record bankruptcy action rattled its
Houston home base yesterday, as the energy trader
prepared to lay off 4,000 headquarters employees and
began a bitter legal struggle with Dynegy Inc., its
neighbor and would-be rescuer, over the causes of its
Enron told most of its Houston workers to go home and
await word on whether their jobs were gone. Meanwhile,
Dynegy filed a countersuit against Enron demanding
ownership of one of its major pipeline networks -- an
asset Dynegy was promised when it advanced $1.5
billion to Enron as part of its aborted Nov. 9
The legal battle began Sunday, when Enron filed a $10
billion damage suit against Dynegy, claiming it was
forced into a Chapter 11 bankruptcy proceeding when
Dynegy pulled back its purchase offer following
intense negotiations the weekend after Thanksgiving.
Dynegy's chairman and chief executive, Chuck Watson,
said yesterday in a conference call that Enron's
lawsuit "is one more example of Enron's failure to
take responsibility for its own demise."
"Enron's rapid disintegration," he added, follows "a
general loss of public confidence in its leadership
Dynegy's shares fell $3.18, or 10 percent, to $27.17
yesterday because of investors' fears that the
bankruptcy process will tie up Dynegy's claim to the
Omaha-based Northern Natural Gas Co. pipeline, forcing
it to write down the $1.5 billion payment to Enron.
"Dynegy is now entangled in this Enron mess," said
Commerzbank Securities analyst Andre Meade.
"Investors fear the $1.5 billion investment might not
be easily converted into ownership of the pipeline,"
said Tom Burnett, president of Merger Insight, an
affiliate of Wall Street Access, a New York-based
brokerage and financial adviser.
On the broader impact of Enron's bankruptcy, Donald E.
Powell, chairman of the Federal Deposit Insurance
Corp., said in an interview that regulators believe so
far that losses on loans to the ailing energy company
will be painful but not large enough to cause any bank
to fail. However, he said that the ripple effect on
other Enron creditors, who in turn may find it harder
to repay bank loans, is more difficult to gauge.
"Enron is a complex company," said Powell. "It will
take some time to digest the consequences to the
banking industry." The FDIC insures deposits at the
nation's 9,747 banks and thrifts.
Shares of Enron's major European bank lenders also
fell yesterday on overseas markets.
The stock price of J.P. Morgan Chase, one of Enron's
lead bankers, fell 3 percent, or $1.17, to $36.55.
Enron told a bankruptcy court judge in Manhattan that
it has arranged up to $1.5 billion in financing from
J.P. Morgan Chase and Citigroup to keep operating as
it reorganizes under Chapter 11 bankruptcy protection,
according to the Associated Press.
The charges and countercharges between Enron and
Dynegy are the opening rounds in a what legal experts
predict will be a relentless battle between the two
Hundreds of lawyers representing investors and
employees are lining up to question Enron executives
and the former Enron officials who quit or were fired
in the past four months as the fortunes of the
powerful energy trading company disintegrated.
Ahead of them are Securities and Exchange Commission
investigators probing whether Enron concealed critical
information about its problems from shareholders.
Investigators from the House Energy and Commerce
Committee are headed for Houston this week to pursue a
congressional inquiry into the largest bankruptcy
action in U.S. history.
And in the lead position is U.S. Bankruptcy Judge
Arthur J. Gonzalez in New York, who has sweeping
powers under federal law to oversee claims against
Enron, as the company tries to restore its trading
business and settle creditors' claims.
Dynegy's immediate goal is to have the ownership of
the Northern gas pipeline decided in state court in
Texas, where the companies are located, said Dynegy
attorney B. Daryl Bristow of Baker Botts.
"Could the bankruptcy court try to put the brakes on
this? They could. We'll be in court trying to stop it
from happening," Bristow said.
I'm sticking my neck out a bit and offering you all a
PDF file I put together on the Enron Affair. I've
taken a wide variety of sources in an attempt to
explain where I think we are with this case. What
Enron does (or did), what has happened and so on. It's
a sort of position paper that attempts to explain the
facts to non accountants and novice accountants. It's
24 pages long but doesn't take that much time to
download. I have used materials from messages on this
list and hope the authors don't mind and I have
credited them by name. I have used Bob Jensen's
bookmarks, too; as well as a whole host of other
I'd be grateful for any comments on this paper, or
even offers of help to improve what I've done. I have
to say I did it in a bit of a hurry and won't be
offended by any criticism, providing it's
Incidentally, if you haven't been to my site recently
(or at all), you can see my latest news at
http://www.duncanwil.co.uk/news0212.html . I have
a very nice looking Newsletter waiting for you:
complete with Xmas theme. Please check my home page
every week for the latest newsletter as it is linked
from there (take a look now, you'll see what I mean).
At the moment I am managing to add content at a
significant rate; and will point out that I have
developed several new features over the last three
months or so, as well as the materials and pages
My home page (sorry, my Ho! Ho! Home Page) is at
http://www.duncanwil.co.uk/index.htm and is
equally festive (well, with a name like Ho! Ho! Home
Page it would have to be, wouldn't it?)
That's how Jeffrey Skilling, then president of Enron
Corp., summarized his company's startling ascendancy a
year ago, as Enron's revenues were soaring on the
wings of its Internet-based trading model.
It was hard to find fault with Enron's strategy of
brokering energy and other commodities over the
Internet rather than commanding the means of
production and distribution. EnronOnline, its year-old
commodity-trading site, already was handling more than
$1 billion a day in transactions and yielding the bulk
of the company's profits. At its peak, Enron sported a
market cap of $80 billion, bigger than all its
See Also Forum: Enron E-Biz Meltdown: What Went Wrong?
More Enron Stories
Today, Enron is near bankruptcy, the status of
EnronOnline is touch and go, ENE is a penny stock and
Skilling is out of a job. Last year's Fortune 7
wunderkind, hailed by InternetWeek and others as one
of the most innovative companies in America,
overextended itself to the point of insolvency.
So was Enron's "better business model" fundamentally
flawed? With the benefit of 20/20 hindsight, what can
Internet-inspired companies in every industry learn
from Enron's demise?
For one thing, complex Internet marketplaces of the
kind Enron assembled are fragile. Enron prospered on
the Net not so much because it had good technology --
though the proprietary EnronOnline platform is
considered leading-edge -- but because online
customers trusted the company to meet its price and
As Skilling told InternetWeek a year ago, "certainty
of execution and certainty of fulfillment are the two
things people worry about with commodity products."
Enron, by virtue of its expertise, networked
relationships and reputation, could guarantee those
Once it came to light, however, that Enron was playing
fast with its financials -- doing off-balance sheet
deals and engaging in other tactics to inflate
earnings -- customers (as well as investors and
partners) lost confidence in the company. And Enron
came tumbling down.
Furthermore, advantages conferred by superior
technology and information-gathering are fleeting.
Competitors learn and mimic and catch up. Barriers to
market entry evaporate. Profit margins narrow.
Enron, short of incessant innovation, could never hope
to corner Internet market-making, especially in
industries, like telecommunications and paper, that it
didn't really understand. In its core energy market,
perhaps Enron was too quick to eschew refineries and
pipelines for the volatile, information-based business
But it wasn't Internet that killed the beast; it was
management's insatiable appetite for expansion and, by
all accounts, personal enrichment.
It's too easy to kick Enron now that it's down. It did
a lot right. The competition and deregulation and
vertical "de-integration" Enron drove are the future
of all industries, even energy. Enron was making
markets on the Internet well before its competitors
knew what hit them.
Was Enron on to a better business model? You bet it
was. But like any business model, it wasn't impervious
to rules of conduct and principles of economics.
Enron's Former CEO Walks Away With $150 Million
One of the
really sad part of the Enron scandal is that the
thousands of Enron employees were not allowed to sell
Enron shares in their pension funds and were left hold
empty pension funds. One elderly Enron employee on
television last evening lamented that his pension of
over $2 million was reduced to less than $10,000.
But such is not
the case for top executives. According to Newsweek
Magazine, December 10, 2001 on Page 6, "Enron chief
and Bush buddy grabs $150 million while employees lose
their shirts. Probe him."
A year ago, Enron was one of the world's most admired
companies, with a market capitalization of $80
billion. Today, it's in bankruptcy.
Sophisticated institutions were the primary buyers of
Enron stock. But the collapse of Enron is not simply a
financial story of interest to major institutions and
the news media. Behind every mutual or pension fund
are retirees living on nest eggs, parents putting kids
through college, and others depending on our capital
markets and the system of checks and balances that
makes them work.
My firm is Enron's auditor. We take seriously our
responsibilities as participants in this
capital-markets system; in particular, our role as
auditors of year-end financial statements presented by
management. We invest hundreds of millions of dollars
each year to improve our audit capabilities, train our
people and enhance quality.
When a client fails, we study what happened, from top
to bottom, to learn important lessons and do better.
We are doing that with Enron. We are cooperating fully
with investigations into Enron. If we have made
mistakes, we will acknowledge them. If we need to make
changes, we will. We are very clear about our
responsibilities. What we do is important. So is
getting it right.
Enron has admitted that it made some bad investments,
was over-leveraged, and authorized dealings that
undermined the confidence of investors, credit-rating
agencies, and trading counter-parties. Enron's trading
business and its revenue streams collapsed, leading to
If lessons are to be learned from Enron, a range of
broader issues need to be addressed. Among them:
Rethinking some of our accounting standards. Like the
tax code, our accounting rules and literature have
grown in volume and complexity as we have attempted to
turn an art into a science. In the process, we have
fostered a technical, legalistic mindset that is
sometimes more concerned with the form rather than the
substance of what is reported.
Enron provides a good example of
how such orthodoxy can make it harder for investors to
appreciate what's going on in a business. Like many
companies today, Enron used sophisticated financing
vehicles known as Special Purpose Entities (SPEs)
and other off-balance-sheet structures. Such vehicles
permit companies, like Enron, to increase leverage
without having to report debt on their balance sheet.
Wall Street has helped companies raise billions with
these structured financings, which are well known to
analysts and investors.
As the rules stand today,
sponsoring companies can keep the assets and
SPEs off their
consolidated financial statements, even though they
retain a majority of the related risks and rewards.
Basing the accounting rules on a risk/reward concept
would give investors more information about the
consolidated entity's financial position by having
more of the assets and liabilities that are at risk on
the balance sheet; certainly more information than
disclosure alone could ever provide. The profession
has been debating how to account for
SPEs for many years.
It's time to rethink the rules.
Modernizing our broken financial-reporting model.
Enron's collapse, like the dot-com meltdown, is a
reminder that our financial-reporting model -- with
its emphasis on historical information and a single
earnings-per-share number -- is out of date and
unresponsive to today's new business models, complex
financial structures, and associated business risks.
Enron disclosed reams of information, including an
eight-page Management's Discussion & Analysis and 16
pages of footnotes in its 2000 annual report. Some
analysts studied these, sold short and made profits.
But other sophisticated analysts and fund managers
have said that, although they were confused, they
bought and lost money.
We need to fix this problem. We can't long maintain
trust in our capital markets with a
financial-reporting system that delivers volumes of
complex information about what happened in the past,
but leaves some investors with limited understanding
of what's happening at the present and what is likely
to occur in the future.
The current financial-reporting system was created in
the 1930s for the industrial age. That was a time when
assets were tangible and investors were sophisticated
and few. There were no derivatives. No structured
off-balance-sheet financings. No instant stock quotes
or mutual funds. No First Call estimates. And no Lou
Dobbs or CNBC.
We need to move quickly but carefully to a more
dynamic and richer reporting model. Disclosure needs
to be continuous, not periodic, to reflect today's
24/7 capital markets. We need to provide several
streams of relevant information. We need to expand the
number of key performance indicators, beyond earnings
per share, to present the information investors really
need to understand a company's business model and its
business risks, financial structure and operating
Reforming our patchwork regulatory environment. An
alphabet soup of institutions -- from the AICPA
(American Institute of Certified Public Accountants)
to the SEC and the ASB (Auditing Standards Board),
EITF (Emerging Issues Task Force) and FASB (Financial
Accounting Standards Board) to the POB (Public
Oversight Board) -- all have important roles in our
profession's regulatory framework. They are all made
up of smart, diligent, well-intentioned people. But
the system is not keeping up with the issues raised by
today's complex financial issues. Standard-setting is
too slow. Responsibility for administering discipline
is too diffuse and punishment is not sufficiently
certain to promote confidence in the profession. All
of us must focus on ways to improve the system.
Agencies need more resources and experts. Processes
need to be redesigned. The accounting profession needs
to acknowledge concerns about our system of discipline
and peer review, and address them. Some criticisms are
off the mark, but some are well deserved. For our
part, we intend to work constructively with the SEC,
Congress, the accounting profession and others to make
the changes needed to put these concerns to rest.
Improving accountability across our capital system.
Unfortunately, we have witnessed much of this before.
Two years ago, scores of New Economy companies soared
to irrational values then collapsed in dust as
investors came to question their business models and
prospects. The dot-com bubble cost investors
trillions. It's time to get serious about the lessons
it taught us. Market Integrity
In particular, we need to consider the
responsibilities and accountability of all players in
the system as we review what happened at Enron and the
broader issues it raises. Millions of individuals now
depend in large measure on the integrity and stability
of our capital markets for personal wealth and
Of course, investors look to management, directors and
accountants. But they also count on investment bankers
to structure financial deals in the best interest of
the company and its shareholders. They trust analysts
who recommend stocks and fund managers who buy on
their behalf to do their homework -- and walk away
from companies they don't understand. They count on
bankers and credit agencies to dig deep. For our
system to work in today's complex economy, these
checks and balances must function properly.
Enron reminds us that the system can and must be
improved. We are prepared to do our part.
February 2002 Updates
Energy and Commerce and Financial Services Committees
continue their investigation into Enron's finances with
testimony from William Powers, Jr., Chair of the Special
Investigation Committee of the Board of Directors of
Enron, SEC Chairman Harvey Pitt and Joe Berardino,
Andersen CEO. You can access transcripts from the
Financial Services Committee at
, and the Energy and Commerce Committee at
Denny Beresford called my attention to the following
interview. I found it interesting how Joe Berardino got
vague when asked for specifics on "specific changes"
that Andersen will call for in the future. My reactions
are still the same in my commentary below.
The following is only a short excerpt from the entire
interview with Questions being asked by Business Week
and Answers being provided by Joe Berardino, CEO of
Andersen (the firm that audits Enron).
Q: If we can go beyond the immediate issues: What
changes should this lead to in the practice of
That's hell of a good question. And we're giving that
a lot of thought. As I look at this, there needs to be
some changes, no question. The marketplace has taken a
severe psychological blow, not to mention the
financial blow. I think as a profession, we have taken
And so I think we're prepared to think very boldly
about change. I'd suggest to you that I've got two
factors that I will consider in suggesting or
accepting change. No. 1: Will this change -- whatever
it might be -- significantly help us in improving the
public's perception and trust in our profession?
Secondly, will it really make a difference in terms of
helping us improve our practice? And I'd also suggest
that the capital market needs to look at itself and
say whether or not everything performed as well as it
Q: I don't quite understand what specific change
you'd like to see. Some people have said the auditing
ought to be much more tightly regulated, somehow
divorced from the firms...that the government ought to
handle or oversee it. And consulting and auditing
certainly ought to be separated. Do you think such
dramatic changes are necessary?
A: I hear the same things, too.... As each day
goes on, we all are learning something new. And people
are having a broader perspective on what happened. And
I'm not saying this should take forever, but let's
give us a little more time to stand back...before we
rush to solve the problems of the world.
Q: May I ask one quick question specific to Enron?
Where does the fault here lie -- with you, with them,
with the press, the marketplace?
A: I think we're all in the fact-gathering stage,
and the thing that I've been encouraged by, walking
around Capitol Hill today, is our lawmakers are in a
fact-gathering stage. Let's just let this play out a
Arthur Andersen LLP had one
organizational policy that, more than any other single
factor, probably led to the implosion of the firm? What
was that policy and how did it differ from the other
major international accounting firms?
One of the things that I find most fascinating about
the Enron/Andersen saga is how much inside information
is being made public (thanks to our electronic age).
Yesterday the House Energy and Commerce Committee
released a series of internal Andersen memos showing
the dialogue between the executive office accounting
experts and the Houston office client service people.
While I haven't had a chance to read all 94 pages yet,
the memos are reported to show that the executive
office experts raised significant questions about
Enron's accounting. But the Houston people were able
to ignore that advice because Andersen's internal
policies required the engagement people to consult but
not necessarily to follow the advice they received. As
far as I know, all other major accounting firms would
require that consultation advice be followed.
Concerning the Self-Regulation Record of State Boards
of Accountancy: Don't Kick
Them Really Hard Until They Are Already Dying Andersen's failure to comply
with professional standards was not the result of the
actions on one 'rogue' partner or 'out-of-control'
office, but resulted from Andersen's organizational
structure and corporate climate that created a lack of
independence, integrity and objectivity.
Texas State Board of Public Accountancy, May 24, 2002
"Texas Acts to Punish Arthur Andersen," San Antonio
Express News, May 24, 2002, Page 1.
At the time of this news article, the Texas State Board
announced that it was recommending revoking Arthur
Andersen LLP's accounitn license in Texas and seeking
$1,000,000 in fines and penalties.
Bob Jensen's threads on the Enron/Andersen scandals are
far in the Enron scandal, Arthur Andersen has borne all the
weight of the accounting profession's failures. But that's
about to change. BusinessWeek has learned that congressional
investigators are taking a keen interest in
PricewaterhouseCoopers' role -- or roles -- in deals between
Enron and its captive partnerships. A congressional source
says the House Energy & Commerce Committee is collecting
documents and interviewing officials at PwC.
issue is the firm's work for both Enron and those
controversial debt-shielding partnerships, set up and
controlled by then-Chief Financial Officer Andrew Fastow. On
two occasions -- in August, 1999, and May, 2000 -- the
world's biggest accounting firm certified that Enron was
getting a fair deal when it exchanged its own stock for
options and notes issued by the Fastow-controlled
Investigators plan to question the complex valuation
calculations that underlie the opinions. Enron ultimately
lost hundreds of millions of dollars on the deals. A PwC
spokesman says the firm stands by its assessment of the
deals' value at the time.
OVERLAP. Perhaps more significantly, Pricewaterhouse was
working for one of the Fastow partnerships -- LJM2
Co-Investment -- at the same time it assured Enron that the
Houston-based energy company was getting a fair deal in its
transactions with LJM2. In effect, PwC was providing tax
advice to help LJM2 structure its deal -- the first of the
so-called Raptor transactions -- while the accounting firm
was also advising Enron on the value of that deal.
Pricewaterhouse acknowledges the overlapping engagements but
says its dual role did not violate accounting's ethics
standards, which require firms to maintain a degree of
objectivity in dealing with clients. The firm says the work
was done by two separate teams, which did not share data.
PwC's spokesman says LJM2's tax structure wasn't a factor in
its opinion on the deal's valuation. And, the spokesman
says, each client was informed about the other engagement.
That disclosure may mean that the firm's actions were in the
clear, says Stephen A. Zeff, professor of accounting at Rice
University in Houston.
Lynn Turner, former chief accountant at the Securities &
Exchange Commission, still has questions. "The standard [for
accountants] is, you've got to be objective," says Turner,
who now heads the Center for Quality Financial Reporting at
Colorado State University. "The question is whether [Pricewaterhouse]
met its obligation to Enron's board and shareholders to be
objective when it was helping LJM2 structure the transaction
it was reviewing. From a common-sense perspective, does this
RECOLLECTION." PwC's contacts on both sides of the LJM2 deal
were Fastow and his subordinates. BusinessWeek could not
determine whether Enron's board, the ultimate client for the
fairness opinion, knew of Pricewaterhouse's dual
engagements. But W. Neil Eggleston, the attorney
representing Enron's outside directors, says Robert K.
Jaedicke, chairman of the board's audit committee, has "no
recollection of this conflict being brought to the audit
committee or the board."
any case, Capitol Hill's interest in these questions could
prove embarrassing to Pricewaterhouse. The firm is charged
with overseeing $130 million in assets as bankruptcy
administrator of Enron's British retail arm. On Feb. 12,
SunTrust Banks said it had dumped Arthur Andersen, its
auditor for 60 years, in favor of PwC. And given the huge
losses Enron eventually suffered on the LJM and LJM2 deals,
the energy trader's shareholders may target PwC's deep
pockets as a source of restitution in the biggest bankruptcy
in American history.
fairness opinions were necessary because Enron's top
financial officers -- most notably Fastow, the managing
partner of LJM and LJM2 -- were in charge on both sides of
these transactions. Indeed, both of PwC's fairness opinions
were addressed to Ben F. Glisan Jr., a Fastow subordinate
who became Enron's treasurer in May, 2000. Glisan left Enron
in November, 2001, after the company discovered he had
invested in the first LJM partnership.
SELLING POINT. Since the deals were not arms-length
negotiations between independent parties, Pricewaterhouse
was called in to assure Enron's board that the company was
getting fair value. Indeed, minutes from a special board
meeting on June 28, 1999, show that Fastow used PwC's
fairness review as a selling point for the first deal.
That complex transaction was designed to let Enron hedge
against a drop in value of its investment in 5.4 million
shares of Rhythms NetConnections, an Internet service
provider. PwC did not work for LJM at the time it ruled on
that deal's fairness for Enron. The firm valued LJM's
compensation to Enron at between $164 million and $204
second deal, involving LJM2, was designed to indirectly
hedge the value of other Enron investments. That deal was
even more complex, and PwC's May 5, 2000, opinion does not
put a dollar value on it. Instead, it says, "it is our
opinion that, as of the date hereof, the financial
consideration associated with the transaction is fair to the
Company [Enron] from a financial point of view."
"CRISIS OF CONFIDENCE." Some documents associated with LJM2
identified Pricewaterhouse as the partnership's auditor. A
December, 1999, memo prepared by Merrill Lynch to help sell
a $200 million private placement of LJM2 partnership
interests listed the firm as LJM2's auditor. In fact, KPMG
was the auditor. The PwC spokesman says his firm didn't even
bid for the LJM2 audit contract. Merrill Lynch declined to
comment on the erroneous document.
PwC spokesman acknowledges that congressional investigators
have been in touch with the firm. "We are cooperating with
the [Energy & Commerce] Committee," he says. On Jan. 31, the
New York-based auditor said it would spin off its consulting
arm, in part because of concerns that Enron has raised about
the accounting profession. "We recognize that there is a
crisis of confidence," spokesman David Nestor told
reporters. As probers give Pricewaterhouse a closer look,
that crisis could become far more real for the Big Five's
blame for failing to protect the public by improving GAAP?
On January 10,
2002, Big Five firm Andersen notified government agencies
investigating the Enron situation that in recent months
members of the firm destroyed documents relating to the Enron
audit. The Justice Department announced it has begun a
criminal investigation of Enron Corp., and members of the Bush
administration acknowledged they received early warning of the
trouble facing the world's top buyer and seller of natural
Enron tottered, it lost trading business. Its remaining
customers began to gouge it—that’s how trading works in the
real world. Don’t blame the usual suspects: stock analysts.
Rather, blame Arthur Andersen, Enron’s outside auditors, who
didn’t blow the whistle until too late. (Andersen says it’s
far too early for me to be drawing conclusions.) Allan
Sloan, Newsweek Magazine
The Gottesdiener Law Firm, the
Washington, D.C. 401(k) and pension class action law firm
prosecuting the most comprehensive of the 401(k) cases
pending against Enron Corporation and related defendants,
added new allegations to its case today, charging Arthur
Andersen of Chicago with knowingly participating in Enron's
fraud on employees. Lawsuit
Seeks to Hold Andersen Accountable for Defrauding Enron
Investors, Employees ---
Andersen was also recently in the middle of two other
scandals involving Sunbeam and Waste Management, Inc. In
May 2001, Andersen agreed to pay Sunbeam shareholders $110
to settle a securities fraud lawsuit. In July 2001,
Andersen paid the SEC a record $7 million to settle a
civil fraud complaint, which alleged that senior partners
had failed to act on knowledge of improper bookkeeping at
Waste Management, Inc. These "accounting irregularities"
led to a $1.4 billion restatement of profits, the largest
in U.S. corporate history. Andersen also agreed to pay
Waste Management shareholders $20 million to settle its
securities fraud claims against the firm.
Berardino quotation from The Wall Street Journal,
December 4, 2001, Page A18 ---
Mr. Berardino places most of the blame on weaknesses and
failings of U.S. Generally Accepted Accounting Standards (GAAP).
reminds us that the system can and must be improved. We are
prepared to do our part. Joe
Berardino, Managing Partner and CEO of Andersen
Feb. 25, 2002 — Securities and Exchange Commission
chairman Harvey L. Pitt said in a speech Friday that the SEC
needs to "ensure that auditors and accounting firms do their
jobs as they were intended to be done."
Addressing securities lawyers in Washington D.C., Pitt
outlined the steps the SEC intends to take to accomplish
Pitt said while "some would try to make accountants
guarantors of the accuracy of corporate reports," it "is
difficult and often impossible to discover frauds
perpetrated with management collusion."
"The fact that no one can guarantee that fraud has not been
perpetrated does not mean, however, that we cannot, or
should not, improve the level and quality of audits," he
SEC chief also mentioned present day accounting standards,
calling them "cumbersome."
Pitt gave a brief overview of the solutions proposed by the
SEC since the Enron crisis began for the accounting
profession. He said the SEC is advocating changes in the
Financial Accounting Standards Board, seeking greater
influence over the standard-setting board and to move toward
a principles-based set of accounting standards. In addition,
the SEC is proposing a private-sector regulatory body,
predominantly comprised of persons unaffiliated with the
accounting profession, for oversight of the profession.
Pitt also said he is concerned about the current structure
where managers and directors are rewarded for short-term
performance. The SEC will work with Congress and other
groups to improve and modernize the current disclosure and
"Compensation, especially in the form of stock options, can
align management's interests with those of the shareholders
but not if management can profit from illusory short-term
gains and not suffer the consequences of subsequent
restatements, the way the public does," he said.
Pitt said the agency will try to recoup money for investors
in cases where executives reap the benefits from such
for dishonest managers, Pitt said the SEC is looking into
making corporate officers and directors more responsive to
the public's expectations and interests through clear
standards of professionalism and responsibilities, and
severe consequences for anyone that does not live up to his
or her ficuciary obligations.
are proposing to Congress that we be given the power to bar
egregious officers and directors from serving in similar
capacities for any public company," said Pitt.
a side note, the accounting profession's "brain drain" did
not go unmentioned by Pitt. He said "the current environment
-- with its scrutiny and criticism of accountants -- is
unlikely to create a groundswell of interest on the part of
top graduates to become auditors."
SEC intends to help transform and elevate the performance of
the profession to deal with this issue, he added.
In its first Webcast meeting, the Securities & Exchange
Commission approved the issuance for comment of rule proposals
ondisclosures about "critical" accounting estimates.
The Commission's rule proposals introduce possible
requirements for qualitative disclosures about both the
"critical" accounting estimates made by a company in applying
its accounting policies and disclosures about the initial
adoption of an accounting policy by a company.
SEC Chairman Harvey
Pitt now has the Herculean task of cleaning up a financial
mess that has been getting worse for years. Will Pitt, a savvy
conservative who's wary of regulation, crack down on corporate
SEC chiefs have come into office with the qualifications
Pitt brings. He knows both the agency and the industries it
regulates intimately. In a quarter-century of representing
financial-fraud defendants he has been exposed to nearly
every known form of chicanery. The Reluctant Reformer has
enormous potential to end the epidemic of financial abuse
plaguing Corporate America. And when it comes to getting
things done, there's a chance that Pitt's conciliatory style
could achieve much more than Levitt's saber-rattling.
Will this historic moment in American business produce a
historic reformer? Or will Pitt succumb to the
pressures--from his party, from Wall Street, and from his
own ideology--and devote himself to little more than calming
the troubled political waters around his President?
Super-lawyer Pitt likes to say that since he took the helm
at the SEC, he now works for "the most wonderful client of
all--the American investor." It's time for him to deliver
for that client as he has for so many others before.
Note: Harvey Pitt
resigned from the SEC following allegations that he was aiding
large accounting firms in stacking the new Public Company
Accounting Oversight Board (PCAOB) created in the
Sarbanes-Oxley Act of 2002.
As the firm
has repeatedly stated, Andersen is committed to getting the
facts, and taking appropriate actions in the Enron matter.
We are moving as quickly as possible to determine all the
of the October 12 e-mail which has been widely reported on
is Ms. Nancy Temple, an in-house Andersen lawyer. Her Oct.
12 email, which was sent to Andersen partner Michael Odom,
the risk management partner responsible for the Houston
office, reads "Mike - It might be useful to consider
reminding the engagement team of our documentation and
retention policy. It will be helpful to make sure that we
have complied with the policy. Let me know if you have any
questions" and includes a link to the firm's policy on the
Andersen internal website. The firm policy linked to her
email prohibits document destruction under some
circumstances and authorizes it under other circumstances.
At the time
Ms. Temple sent her e-mail, work on accounting issues for
Enron's third quarter was in progress. Ms. Temple has told
the firm that it was this current uncompleted work that she
was referring to in her email and that she never told the
audit team that they should destroy documents for past audit
work that was already completed. Mr. Odom has told Andersen
that when he received Ms. Temple's email, he forwarded it to
David Duncan, the Enron engagement partner, with the comment
"More help" meaning that Ms. Temple's email was reminding
them of the existing policy. It is important to recognize
that the release of these communications are not a
representation that there were no inappropriate actions.
There were other communications. We are continuing our
review and we hope to be able to announce progress in that
copies of the two emails and a copy of the Andersen records
following files are available for download in PDF format:
Copy of two
e-mails (15k, 1 page)
statement: Client Engagement Information - Organization,
Retention and Destruction, Statement No. 760 (140k, 26
statement - Practice Administration: Notification of
Threatened or Actual Litigation, Governmental or
Professional Investigations, Receipt of a Subpoena, or Other
Requests for Documents or Testimony (Formal or Informal),
Statement No. 780 (106k, 8 pages)
Commentary on the Above Message From the CEO of Andersen
(The Most Difficult Message That I Have Perhaps Ever
This is followed by replies from other accounting
The Two Faces of Large Public Accounting Firms
I did not sleep a
wink on the night of December 4, 2001. The cowardly side of
me kept saying "Don't do it Bob." And the academic side of me
said "Somebody has to do it Bob." Before my courage won out
at 4:00 a.m., I started to write this module.
Let me begin by
stating that my loyalty to virtually all public accounting
firms, especially large accounting firms, has been steadfast
and true for over 30 years of my life as an accounting
professor. I am amazed at the wonderful things these firms
have done in hiring our graduates and in providing many other
kinds of support for our education programs. In practice,
these firms have generally performed their auditing and
consulting services with high competence and high integrity.
I view a large public
accounting firm like I view a large hospital. Two major tasks
of a hospital are to help physicians do their jobs better and
to protect the public against incompetent and maverick
physicians. Two major tasks of the public accounting firms on
audits is to help corporate executives account better and to
protect the public from incompetent and maverick corporate
executives. Day in and day out, hospitals and public
accounting firms do their jobs wonderfully even though it
never gets reported in the media. But the occasional failings
of the systems make headlines and, in the U.S., the trial
lawyers commence to circle over some poor dead or dying
When the plaintiff's
vultures are hovering, the defendant's attorneys generally
advise clients to never say a word. I fully expected Enron's
auditors to remain silent. The auditing firm that certified
Enron's financial statement was the AA firm that is now called
Andersen and for most of its life was previously called Arthur
Andersen or just AA. Aside from an occasional failing, the AA
firm over the years has been one of the most respected among
all the auditing firms.
It therefore shocked
me when the Managing Partner and CEO of Andersen, Joe Beradino,
wrote a piece called "Enron: A Wake-Up Call" in the December
4 edition of The Wall Street Journal (Page A18). That
article opened up my long-standing criticism of integrity in
large public accounting firms. I will focus upon the main
defense raised by Mr. Beradono. His main defense is that when
failing to serve the best public interests, the failings are
more in GAAP than in the auditors who certify that financial
statements are/were fairly prepared under GAAP. Mr.
Beradino's places most of the blame on the failure of GAAP to
allow Off-Balance Sheet Financing (OBSF). In the cited
article, Mr Beradono states:
many companies today, Enron used sophisticated financing
vehicles known as Special Purpose Entities (SPEs)
and other off-balance-sheet structures. Such vehicles
permit companies, like Enron, to increase leverage without
having to report debt on their balance sheet. Wall Street
has helped companies raise billions with these structured
financings, which are well known to analysts and investors.
As the rules stand today, sponsoring
companies can keep the assets and liabilities of
off their consolidated financial statements, even though
they retain a majority of the related risks and rewards.
Basing the accounting rules on a risk/reward concept would
give investors more information about the consolidated
entity's financial position by having more of the assets and
liabilities that are at risk on the balance sheet ...
There is one failing
among virtually all large firms that I've found particularly
disturbing over the years, but I've not stuck my neck out
until now. In a nutshell, the problem is that large firms
often come down squarely on both sides of a controversial
issue, sometimes preaching virtue but not always practicing
what is preached. The firm of Andersen is a good case in
good news side, Andersen has generally had an executive near
the top writing papers and making speeches on how to really
improve GAAP. For example, I have the utmost respect for
Art Wyatt. Dr. Wyatt (better known as Art) is a former
accounting professor who, for nearly 20 years, served as the
Arthur Andersen's leading executive on GAAP and efforts to
improve GAAP. Dr. Wyatt's Accounting Hall of Fame tribute
Nobody has probably written better articles lamenting
off-balance sheet financing than Art Wyatt while he was at
Andersen. I always make my accounting theory students read
"Getting It Off the Balance Sheet," by Richard Dieter and
Arthur R. Wyatt, Financial Executive, January 1980,
pp. 44-48. In that article, Dieter and Wyatt provide a long
listing of OBSF ploys and criticize GAAP for allowing too
much in the way of OBSF. I like to assign this article to
students, because I can then point to the great progress the
Financial Accounting Standards Board (FASB) made in ending
many of the OBSF ploys since 1980. The problem is that the
finance industry keeps inventing ever new and ever more
complex ploys such as derivative instruments and structured
financings that I am certain Art Wyatt wishes that GAAP
would correct in terms of not keeping debt of the balance
sheet. It is analogous to plugging bursting dike. You get
one whole plugged and ten more open up!
bad news side, Andersen and other big accounting firms,
under intense pressure from large clients, have sometimes
taken the side of the clients at the expense of the public's
best interest. They sometimes dropped laser-guided bombs on
efforts of the leaders like Dr. Wyatt, the FASB, the IASB,
and the SEC to end OBSF ploys. On occasion, the firm's
leaders initially came out in in theoretical favor of ending
an OBSF ploy and later reversed position after listening to
the displeasures of their clients. My best example here is
the initial position take by Andersen's leaders to support
the very laudable FASB effort to book vested employee stock
compensation as income statement expenses and balance sheet
liabilities. Apparently, however, clients bent the ear of
Andersen and led the firm to change its position. Andersen
dropped a bomb on the beleaguered FASB by widely circulating
a pamphlet entitled "Accounting for Stock-Based
Compensation" in August of 1993. In that pamphlet under the
category "Arthur Andersen Views," the official position
turned against booking of employee stock compensation:
From "Accounting for Stock-Based Compensation" in August
Arthur Andersen Views
In December 1992, in a letter to the FASB, we
expressed the view that the FASB should not be
addressing the stock compensation issue and that
continuation of today's accounting is acceptable. We
believe it is in the best interests of the public, the
financial community, and the FASB itself for the Board
to address those issues that would have a significant
impact on improving the relevance and usefulness of
financial reporting. In our view, employers'
accounting for stock options and other stock
compensation plans does not meet that test.
Despite our opposition, and the opposition of hundreds
of others, the FASB decided to complete their
deliberations and issue an ED. We believe the FASB's
time and efforts could have been better spent on more
decide whether it is better to describe the above reply
haughty or snotty --- I think I will call it both.
ill-fated ED that would have forced booking of employee stock
options never became a standard because of the tough fight put
up against it my large accounting firms, their clients, and
the U.S. Congress and Senate.
Returning to Joe Beradino's most current lament of how Special
Purpose Entities (SPEs)
are not accounted for properly under GAAP, we must beg the
question regarding what efforts Andersen has made over the
years to get the FASB, the IASB, and the SEC end
off-balance-sheet financing with SPEs.
Andersen has made a lot of revenue consulting with clients on
how to enter into SPEs
and, thereby, take tax and reporting advantages. Andersen in
fact formed a New York Structured Finance Group to assist
clients in this regard. See
Beradino wrote the following: "Like
many companies today, Enron used sophisticated financing
vehicles known as Special Purpose Entities (SPEs)
and other off-balance-sheet structures." The auditing firm,
Andersen, that he heads even publishes a journal called
Structured Thoughts advising clients on how to enter into
and manage structured financings such as
For example, the January 5, 2001 issue is at
close this with a quotation from a former Chief Accountant of
the Securities and Exchange Commission.
Quote From a Chief Accountant of the SEC
(Well Over a Year Before the Extensive Use of SPEs by
Enron Became Headline News.)
So what does
this information tell us? It tells us that average
Americans today, more than ever before, are willing to
place their hard earned savings and their trust in the
U.S. capital markets. They are willing to do so
because those markets provide them with greater
returns and liquidity than any other markets in the
world and because they have confidence in the
integrity of those markets. That confidence is derived
from a financial reporting and disclosure system that
has no peer. A system built by those who have served
the public proudly at organizations such as the
Financial Accounting Standards Board ("FASB") and its
predecessors, the stock exchanges, the auditing firms
and the Securities and Exchange Commission ("SEC" or
"Commission"). People with names like J.P. Morgan,
William O. Douglas, Joseph Kennedy, and in our
profession, names like Spacek, Haskins, Touche,
Andersen, and Montgomery.
improvements can and should be made. First, it has
taken too long for some projects to yield results
necessary for high quality transparency for investors.
For example, in the mid 1970's the Commission asked
the FASB to address the issue of whether certain
equity instruments like mandatorily redeemable
preferred stock, are a liability or equity? Investors
are still waiting today for an answer. In 1982, the
FASB undertook a project on consolidation. One of my
sons who was born that year has since graduated from
high school. In the meantime, investors are still
waiting for an answer, especially for structures, such
as special purpose entities (SPEs)
that have been specifically designed with the aid of
the accounting profession to reduce transparency to
investors. If we in the public sector and investors
are to look first to the private sector we should have
the right to expect timely resolution of important
"The State of
Financial Reporting Today: An Unfinished Chapter"
research question of interest to me is whether the large
accounting firms, including Andersen, have been following the
same course of coming down on both sides of a controversial
issue. Lynn Turner's excellent quote above stresses that
SPEs have been a known and controversial
accounting issue for 20 years. The head of the firm that
audited Enron asserts that the public was mislead by Enron's
certified financial statements largely because of bad
would like discover evidence that Andersen and the other large
accounting firms have actively assisted the FASB, the IASB,
and the SEC in trying to bring
SPE debt onto consolidated balance sheets or
whether they have actively resisted such attempts because of
pressure from large clients like Enron who actively resisted
booking of enormous
SPE debt in consolidated financial statements.
thing is certain. The time was never better to end bad
SPE accounting and bad accounting for structured financing
in general before Lynn Turner's son becomes a grandfather.
Leonard Spacek was
the most famous and most controversial of all the managing
partners of the accounting firm of Arthur Andersen. It is
really amazing to juxtapose what Spacek advocated in 1958 with
the troubles that his firm having in the past decade or more.
In the link below, I
quote a long passage from a 1958 speech by Leonard Spacek. I
think this speech portrays the decline in professionalism in
public accountancy. What would Spacek say today if he had to
testify before Congress in the Enron case.
What I am proposing
today is the need for both an accounting court to resolve
disputes between auditors and clients along with something
something like an investigative body that is to discover
serious mistakes in the audit, including being a sounding
board for whistle blowing. Spacek envisioned the "court" to be
more like the FASB. My view extends this concept to be more
like the accounting court in Holland combined with an
investigative branch outside the SEC.
Firm reported to reverse its
stance on how companies account for stock options. February
(Reuters) - Accounting firm Ernst & Young has reversed its
opinion on how companies should account for stock options,
saying financial statements should reflect their
bottom-line cost, the New York Times reported
The firm, which is
under fire for advising executives at
Estimates) to set
up tax shelters related to their stock option
transactions, made its change of heart public in a letter
to the Financial Accounting Standards Board (FASB), the
Ernst & Young, along with other major accounting groups,
maintained for years that options should not be deducted
as a cost to the companies that grant them, but the
Times reported that now the firm says options should
be reflected as an expense in financial statements.
The FASB, which
makes the rules for the accounting profession, and the
International Accounting Standards Board, its
international counterpart, are trying to develop standards
that are compatible for domestic and international
In its letter, Ernst
& Young said it strongly supported efforts by both groups
to develop a method to ensure that "stock-based
compensation is reflected in the financial statements of
issuing enterprises," the report said. The firm expressed
reservations about methods that might be used to value
options, but it noted that the current environment
requires that the accounting for options provide relevant
information to investors.
The letter had been in the works for some time and was
unrelated to the recent events surrounding its advice to
the Sprint executives, Beth Brooke, global vice chairwoman
at Ernst & Young, told the Times.
With the Internal
Revenue Service, Congress and even their own clients on
their case, tax-shelter promoters are changing their act to
Using names that
evoke an aggressive Arnold Schwarzenegger movie is
undesirable right now. Which may be why accounting firm
Deloitte & Touche LLP's corporate tax-shelter group has
ditched its informal name, Predator, and morphed into a new
group with a safer, if duller, name: "Comprehensive Tax
KPMG LLP has taken a
similar tack. Last year, it disbanded some teams that
pitched aggressive strategies -- including some named after
the Shakespearean plays "The Tempest" and "Othello" -- to
large corporate clients and their top executives. The firm
also created a separate chain of command for partners
dealing with technical tax issues; those partners handling
ethical and regulatory issues report to different bosses.
also have largely abandoned their strategy of selling
one-size-fits-all tax-avoidance plans to hundreds or even
thousands of corporate and individual clients. IRS
investigators targeted these plans, especially in the past
two years, as the government began requiring firms to
disclose lists of their clients for abusive tax shelters.
Other shelter firms are going down-market, pitching
tax-avoidance plans to real-estate agents and car dealers,
rather than the super-rich. Demand for tax-avoidance schemes
of all kinds is bound to rebound sharply, promoters figure,
especially when the stock market rebounds.
For now, though, some
traditional corporate clients and wealthy individuals are
getting nervous about using aggressive tax-avoidance plans.
The IRS cracked down last year to try to force several big
accounting firms -- KPMG, BDO Seidman LLP and Arthur
Andersen LLP, among others -- to hand over documents about
the tax shelters their corporate clients were using. The
Sprint Corp.'s two top executives, who are being forced
out for using a complicated tax-avoidance scheme, is the
latest big blow to tax shelters.
This week, about 100
financial executives gathered for cocktails at a hotel in
Sprint's hometown of Kansas City, Kan. Milling outside the
dining room, the discussion quickly turned to tax shelters.
The debate: Should executives turn to their company's
outside auditors for personal tax strategies, given that
executives are pitted against the auditor if the tax
strategies turn out to be faulty? The risk for executives
lies not only in getting stuck with back taxes and
penalties, but, as the Sprint case demonstrates, a severely
damaged personal reputation.
Some large accounting
firms once earned as much as $100 million or more in revenue
annually from their shelter-consulting business at the
market's peak around 2000. Now, the revenues are in sharp
decline, partners at Big Four firms say. In some cases,
business from wealthy individuals has dropped about 75% from
a few years ago. Business from corporate clients has
suffered less, because accounting firms have been able to
persuade customers to buy customized, more costly, advice.
Ernst & Young LLP
says a group there that had sold tax strategies for wealthy
individuals has been shut. E&Y does continue to sell tax
strategies to corporate clients, but, a spokesman says: "We
don't offer off-the-shelf strategies that don't have a
Among the downsides
of tax-shelter work: litigation risk. Law firm Brown & Wood
LLP, which is now a part of Sidley Austin Brown & Wood LLP,
is a defendant in two lawsuits filed in December by
disgruntled clients, who allege the law firm helped
accountants sell bogus tax strategies by providing legal
opinions that the transactions were proper. The suits, one
filed in federal court in Manhattan and one in state court
in North Carolina, contend that the law firm knew or should
have known the tax strategies weren't legitimate.
The following is an
important article in accounting. It shows how something
students may think is a minor deal can have an enormous impact
on reported performances of corporations.
It also illustrates
the enormous ramifications of controversial and complex tax
shelters invented by tax advisors from the same firm (in this
case E&Y) that also audits the financial statements. It
appears that one of the legacies of the not-so-lame-duck
Harvey Pitt who's still at the SEC is to continue to allow
accounting firms to both conduct audits and do consulting on
complex tax shelters for the client. Is this an example of
consulting that should continue to be allowed?
YORK -- While
Sprint Corp.'s two top executives have lost their jobs
and face financial ruin over the use of tax shelters on
their stock-option gains, the company itself received big
tax benefits from the options these and other Sprint
Regulatory filings show that Sprint had a tax benefit of
$424 million in 2000 and $254 million in 1999 stemming from
its employees' taxable gains of about $1.9 billion from the
exercise of options in those two years. Sprint, which was
burning through cash at the time as the telecommunications
market bubble burst, had virtually no tax bill in 1999 and
2000, because of sizable business losses. But the Overland
Park, Kan., company was able to carry the tax savings
forward to offset taxes in future years.
the complicated accounting and tax rules that govern stock
options, the exercises also made Sprint's performance look
better by boosting the company's net asset value, an
important measure of a company's financial health.
dilemma facing Sprint and its two top executives over
whether to reverse the options shows how the executives'
personal financial situation had become inextricably
intertwined with the company's interests. In Sprint's case,
the financial interests of the company and its top two
executives had diverged. Both were using the same tax
adviser, Ernst & Young LLP. The matter has renewed debate
about whether such dual use of an auditing firm creates
auditor-independence issues that can hurt shareholders.
Stock-option exercises brought windfalls to Sprint employees
as the company's shares rose in anticipation of a 1999
planned merger with WorldCom Inc., which later was blocked
Chairman and Chief Executive William T. Esrey and President
Ronald LeMay sought to shield their gains from taxes using a
sophisticated tax strategy offered by Ernst & Young. That
tax shelter now is under scrutiny by the Internal Revenue
Service. If it's disallowed, the executives would owe tens
of millions of dollars in back taxes and interest.
recently dismissed the two men and intends to name Gary
Forsee, vice chairman of BellSouth Corp., to succeed Mr.
Esrey. Messrs. Esrey and LeMay are now trying to negotiate
larger severance packages with the company because of their
unexpected dismissals. (See
Sprint, like other companies, was allowed to take as a
federal income-tax deduction the value of gains reaped from
all those stock options that employees exercised during the
year. Between 1999 and 2000, Mr. LeMay exercised options
with a taxable gain of $149 million, while Mr. Esrey
exercised options with a taxable gain of $138 million.
Assuming the standard 35% corporate tax rate on the $287
million in options gains, the executives would have helped
the company realize $100 million of tax savings in those two
company had agreed to unwind the transactions -- by buying
back the shares and issuing new options -- the $100 million
in savings would have been wiped out and the company would
have had to record a $100 million compensation expense,
which would have cut earnings.
would have had a large compensation expense immediately at
the moment of recision equal to the tax benefit they would
have foregone," says Robert Willens, Lehman Brothers
tax-and-accounting analyst. "So there was no way they were
going to do that."
tax savings to Sprint revealed in the filings shed light on
why the company opted not to unwind the now-controversial
options exercises of Messrs. Esrey and LeMay. The executives
wanted to unwind the options at the end of 2000 after
learning that the IRS was frowning on the tax shelters they
had used and the value of Sprint's stock had fallen
markedly. However, the conditions the SEC put on such a move
would have been expensive for the company. The subject
wasn't discussed by the board of directors, according to
people familiar with the situation. It isn't clear what role
Messrs. Esrey and LeMay played in making the decision not to
unwind the options.
tax-law specialists believe the IRS will rule against the
complicated shelters, which the two executives have said
could spell their financial ruin. Because Sprint's stock
price collapsed after Sprint's planned merger with WorldCom
was rejected by regulators in June 2000, the executives were
left holding shares worth far less than the tax bill they
could potentially face if their shelters are disallowed by
telecommunications company had unwound the transactions,
Sprint would have had to restate and lower its 1999 profits.
The company could have seen its earnings pushed lower for
years to come and might have been forced to refile its back
taxes at a time when Sprint's cash was limited, according to
large companywide burst of options activity demonstrates
just what a frenzy was taking place within Sprint in the
wake of its proposed $129 billion merger with WorldCom. In
1998, Sprint deducted only $49 million on its federal taxes
from employees exercising their stock options. That swelled
to $424 million in 2000.
push to exercise options in 2000 was intensified by Sprint's
controversial decision to accelerate the timing of when
millions of options vested to the date of shareholder
approval of the WorldCom deal -- not when the deal was
approved by regulators. The deal ultimately was approved by
shareholders and rejected by regulators. In the meanwhile,
many executives took advantage of their options windfalls,
while common shareholders got saddled with the falling stock
Paragraph on p. A17 of Wall Street Journal, Tuesday,
February 11, 2003, about E&Y's advice to Sprint executives
William Esrey and Ronald LeMay:
Along with selling the executives on the tax shelters, Ernst
& Young advised them against putting Sprint shares aside to
pay for potential taxes and to claim thousands of exemptions
so they would owe virtually no taxes. The accountant advised
Mr. LeMay to claim more than 578,000 [sic] exemptions on his
2000 federal tax W4 form, for example.
this be for real?
Department of Accounting & Business Computer Systems
Box 30001/MSC 3DH New Mexico State University
Las Cruces, NM, USA 88003-8001
course, they aren't binding and don't persuade the IRS or
anybody else, very much. The main effect of "Comfort
Letters" has been that they reduce the likelihood of
penalties on the taxpayer. As such, the accounting
profession has a printing press, for printing money. The
"audit lottery" already exhibits much lower taxes,
statistically. Together with "Comfort Letters" the whole
arrangement makes the CPA a key enabler of financial crime,
an unacceptable moral hazard.
Legislation is needed (A) Whenever a "Comfort Letter exists,
if penalties otherwise applicable on the taxpayer are
abated, those penalties shall be born by the author of the
(B) Whenever such determination is made that a "Comfort
Letter" defense was successfully raised by a taxpayer, the
author of the "Comfort Letter" shall be required to provide
IRS with a list of all clients and TINs, to whom that
position in the "Comfort Letter" was explained or
Here is a brief excerpt from an article entitled "Accounting
Firms demand change, then they resist it".
...Accountants should have been championing change, not
fighting it, several accounting professors said. "They say
they're for motherhood, but they're selling prostitution,"
said Bob Jensen, an accounting professor at Trinity
University in San Antonio, Texas.
When the FASB tried to force FAS 133 (fair value), at least
one, maybe two bills were introduced in congress to bar the
FASB from doing so. Financial executives, fearful of the
impact of stock options on the bottom line and fearful of
what action the IRS might take if the options were to be
valued at fair value, used an incredible amount of pressure
to make sure this method was not adopted. As a result, it is
only recommended. If you read Coca Cola footnote 12, it does
give the fair value measured by Black Scholes.
25 and FAS 133 are applicable. So Coca Cola using APB 25
values options at the difference between the exercise price
and the market price (generally -0-). But Boeing uses FAS
133, the recommended method of using an option pricing
model, such as Black-Scholes, to value options issued at
fair value. FAS 133 is not required, only recommended.
Auditors would need to be competent to evaluate the fair
value valuation if the total is material. However, they
could just hire their own expert to meet the requirement.
On January 11,
2002 Ruth Bender, Cranfield School of Management wrote the
On a related
subject, the front page of the UK journal Accountancy Age
yesterday was full of outraged comments from partners of the
other Big 5 firms. However, what worried me was what it was
that was outraging them.
It wasn't that
Andersen made the 'errors of judgement' - but that Bernadino
> had admitted them in public.
Magazine on January 14, 2002.
days before Enron disclosed a stunning $618 million loss for
the third quarter—its first public disclosure of its
financial woes—workers who audited the company's books for
Arthur Andersen, the big accounting firm, received an
extraordinary instruction from one of the company's lawyers.
Congressional investigators tell Time that the Oct. 12 memo
directed workers to destroy all audit material, except for
the most basic "work papers." And that's what they did, over
a period of several weeks. As a result, FBI investigators,
congressional probers and workers suing the company for lost
retirement savings will be denied thousands of e-mails and
other electronic and paper files that could have helped
illuminate the actions and motivations of Enron executives
involved in what now is the biggest bankruptcy in U.S.
at Arthur Andersen repeatedly reminded their employees of
the document-destruction memo in the weeks leading up to the
first Security and Exchange Commission subpoenas that were
issued on Nov. 8. And the firm declines to rule out the
possibility that some destruction continued even after that
date. Its workers had destroyed "a significant but
undetermined number" of documents related to Enron, the
accounting firm acknowledged in a terse public statement
last Thursday. But it did not reveal that the destruction
orders came in the Oct. 12 memo. Sources close to Arthur
Andersen confirm the basic contents of the memo, but
spokesman David Tabolt said it would be "inappropriate" to
discuss it until the company completes its own review of the
are no firm rules on how long accounting firms must retain
documents, most hold on to a wide range of them for several
years. Any deliberate destruction of documents subject to
subpoena is illegal. In Arthur Andersen's dealings with the
documents related to Enron, "the mind-set seemed to be, If
not required to keep it, then get rid of it," says Ken
Johnson, spokesman for the House Energy and Commerce
Committee, whose investigators first got wind of the Oct. 12
memo and which is pursuing one of half a dozen
investigations of Enron. "Anyone who destroyed records out
of stupidity should be fired," said committee chairman Billy
Tauzin, a Louisiana Republican. "Anyone who destroyed
records to try to circumvent our investigation should be
accounting for a global trading company like Enron is
mind-numbingly complex. But it's crucial to learning how the
company fell so far so fast, taking with it the jobs and
pension savings of thousands of workers and inflicting
losses on millions of individual investors. At the heart of
Enron's demise was the creation of partnerships with shell
companies, many with names like Chewco and JEDI, inspired by
Star Wars characters. These shell companies, run by Enron
executives who profited richly from them, allowed Enron to
keep hundreds of millions of dollars in debt off its books.
But once stock analysts and financial journalists heard
about these arrangements, investors began to lose confidence
in the company's finances. The results: a run on the stock,
lowered credit ratings and insolvency.
evidence is only one of the issues that will get close
scrutiny in the Enron case. The U.S. Justice Department
announced last week that it was creating a task force,
staffed with experts on complex financial crimes, to pursue
a full criminal investigation. But the country was quickly
reminded of the pervasive reach of Enron and its
executives—the biggest contributors to the Presidential
campaign of George W. Bush—when U.S. Attorney General John
Ashcroft had to recuse himself from the probe because he had
received $57,499 in campaign cash from Enron for his failed
2000 Senate re-election bid in Missouri. Then the entire
office of the U.S. Attorney in Houston recused itself
because too many of its prosecutors had personal ties to
Enron executives—or to angry workers who have been fired or
have seen their life savings disappear.
attorney general John Cornyn, who launched an investigation
in December into 401(k) losses at Enron and possible tax
liabilities owed to Texas, recused himself because since
1997 he has accepted $158,000 in campaign contributions from
the company. "I know some of the Enron execs, and there has
been contact, but there was no warning," he says of the
reporters that he had not talked with Enron CEO Kenneth L.
Lay about the company's woes. But the White House later
acknowledged that Lay, a longtime friend of Bush's, had
lobbied Commerce Secretary Don Evans and Treasury Secretary
Paul O'Neill. Lay called O'Neill to inform him of Enron's
shaky finances and to warn that because of the company's key
role in energy markets, its collapse could send tremors
through the whole economy. Lay compared Enron to Long-Term
Capital Management, a big hedge fund whose near collapse in
1998 required a bailout organized by the Federal Reserve
Board. He asked Evans whether the Administration might do
something to help Enron maintain its credit rating. Both men
declined to help.
deputy, Peter Fisher, got similar calls from Enron's
president and from Robert Rubin, the former Treasury
Secretary who now serves as a top executive at Citigroup,
which had at least $800 million in exposure to Enron through
loans and insurance policies. Fisher—who had helped organize
the LTCM bailout—judged that Enron's slide didn't pose the
same dangers to the financial system and advised O'Neill
against any bailout or intervention with lenders or
evidence to date, the Bush Administration would seem to have
admirably rebuffed pleas for favors from its most generous
business supporter. But it didn't tell that story very
effectively—encouraging speculation that it has something to
hide. Democrats in Congress, frustrated by Bush's soaring
popularity and their own inability to move pet legislation
through Congress, smelled a chance to link Bush and his
party to the richest tale of greed, self-dealing and
political access since junk-bond king Michael Milken was
jailed in 1991. That's just what the President, hoping to
convert momentum from his war on terrorism to the war on
recession, desperately wants to avoid. The fallout will
swing on the following key questions:
Was a crime
investigation will be overseen in Washington by a seasoned
hand, Josh Hochberg, head of the fraud section and the first
to listen to the FBI tape of Linda Tripp and Monica Lewinsky
in the days leading to the case against President Clinton.
The probe will address a wide range of questions: Were
Enron's partnerships with shell corporations designed to
hide its liabilities and mislead investors? Was evidence
intentionally or negligently destroyed? Did Enron
executives' political contributions and the access that the
contributions won them result in any special favors? Did
Enron executives know the company was sinking as they sold
$1.1 billion in stock while encouraging employees and other
investors to keep buying?
hard to come up with a scenario for indictment here," says
John Coffee, professor of corporate law at Columbia
University. "Enough of the facts are already known to know
that there is a high prospect of securities-fraud charges
against both Enron and some of its officers." He adds that
"once you've set up a task force this large, involving
attorneys from Washington, New York and probably California,
history shows the likelihood is they will find something
already acknowledged that it overstated its income for more
than four years. The question is whether this was the result
of negligence or an intent to defraud. Securities fraud
requires a willful intent to deceive. It doesn't look good,
Coffee says, that key Enron executives were selling stock
shortly before the company announced a restatement of
Arthur Andersen, criminal charges could result if it can be
shown that its executives ordered the destruction of
documents while being aware of the existence of a subpoena
for them. A likely ploy will be for prosecutors to target
the auditors, hoping to turn them into witnesses against
Enron. Says Coffee: "If the auditors can offer testimony,
that would be the most damaging testimony imaginable."
Five Need to Factor in Investors," Business Week,
December 24, 2001, Page 32 ---
http://www.businessweek.com/ (not free to download for
At issue are so-called special-purpose
such as Chewco and JEDI partnerships Enron used to get
assets like power plants off its books. Under standard
accounting, a company can spin off assets --- an the related
debts --- to an
if an outside investor puts up capital worth at least 3% of
of Enron's partnerships didn't meet the test --- a fact
auditors Arthur Andersen LLP missed. On Dec. 12, Andersen
CEO Joseph F. Berardino told the House Financial Services
Committee his accountants erred in calculating one
partnership's value. On others, he says, Enron withheld
information from its auditors: The outside investor put up
3%, but Enron cut a side deal to cover half of that with its
own cash. Enron denies it withheld any information.
that absolve Andersen? Hardly. Auditors are supposed to
uncover secret deals, not let them slide. Critics fear the
New Economy emphasis means auditors will do even less
To Andersen's credit, it has long
advocated a tighter rule. But that would crimp the Big
Five's clients --- companies and Wall Street.
Accountants have helped stall changes.
Enron's collapse may finally breat that logjam. Like it or
not, the Big Five must accept new rules that give investors
a clearer picture of what risks companies run with
rest of the article is on Page 38 of the Business Week
Andersen: How Bad Will It Get?" Business Week,
December 24, 2001, pp. 30-32 ---
http://www.businessweek.com/ (not free to download for
Berardino, a 51-year-old Andersen lifer, may find the firm's
competence in auditing complex financial companies
questioned. While Andersen was its auditory, Enron's
managers shoveled debt into partnerships with Enron's own
ececs to get it off the balance sheet --- a dubious though
legal ploy. In one case, says Berardino, hoarse from
defending the firm on Capitol Hill, Andersen's auditors made
an "error in judgment" and should have consolidated the
partnership in Enron's overall results. Regarding another,
he says Enron officials did not tell their auditor about a
"separate agreement" they had with an outside investor, so
the auditor mistakenly let Enron keep the partnership's
results separate. (Enron denies that the auditors were not
Enron says a special board committee is investgating why
management and the board did not learn about this
arrangement until October. Now that Enron has consolidated
such set-ups into its financial statements, it had to
restate its financial reports from 1997 onward, cutting
earnings by nearly $500 million. Damningly, the company
says more than four years' worth of audits and statements
approved by Andersen "should not be relied upon."
Auditors Be Auditors," Editorial Page, Business Week,
December 24, 2001, Page 96 ---
http://www.businessweek.com/ (not free to download for
But neither proposal (plans proposed
by SEC Commission Chairman Harvey L. Pitt) goes far enough.
GAAP, the generally accepted accounting principles,
desperately need to be revamped to deal with cash flow and
other issues relevant in a fast-moving, high-tech economy.
The whole move to off-balance sheet accounting should be
reassessed. Opaque partnerships that hide assets and debt
do not serve the interests of investors.
Under heavy shareholder pressure from the Enron fallout, El
Paso Corp. just moved $2 billion in partnership debt onto
the balance sheet.
Finally, Pitt should consider requiring companies to change
their auditors who go easy on them, as we have seen time and
Five Firms Join Hands (in Prayer?)
Facing up to a raft of negative publicity for the accounting
profession in light of Big Five firm Andersen's association
with failed energy giant Enron, members of all of the Big Five
firms joined hands (in prayer?) on December 4, 2001 and vowed
to uphold higher standards in the future.
The American Institute of Certified
Public Accountants released a statement by James G.
Castellano, AICPA Chair, and Barry Melancon, AICPA President
and CEO, in response to a letter published by the Big Five
firms last week that insures the public they will "maintain
the confidence of investors." ---
Securities and Exchange Commission has never in the past
brought an enforcement action against an audit committee or a
member of an audit committee, recent remarks by SEC
commissioners and staff indicate this may change in the
future. SEC Director of Enforcement Stephen Cutler said, "An
audit committee or audit committee member can not insulate
herself or himself from liability by burying his or her head
in the sand. In every financial reporting matter we
investigate, we will look at the audit committee."
Message 1 (January 5,
2002) from a former Chairman of the Financial Accounting
Standards Board (Denny Beresford)
might be interested in the following link to an article in
the Atlanta newspaper that mentions my own economic setback
"When Warren Buffett spoke on campus a few months ago, he
said you ought not to invest in something you don't
understand," said Dennis Beresford, Ernst & Young executive
professor of accounting at the University of Georgia.
That's one of the lessons for investors from the Enron case,
according to Beresford and others. Another is that "some
analysts are better touts than helpers these days,''
"Enron was a very complicated company,'' he said. "Beyond
that, its financial statements were extremely complicated.
If you read the footnotes of the reports very carefully, you
might have had some questions."
a lot of individuals and institutional investors did not
have questions, even months into the decline in Enron stock.
least one brokerage house was recommending Enron as a
"strong buy" in mid-October, after the stock had fallen 62
percent from its 52-week high last December. The National
Association of Investors Corp., a nonprofit organization
that advises investment clubs, featured Enron as an
undervalued stock in the November issue of Better Investing
Beresford, a former chairman of the standards-setting
Financial Accounting Standards Board, even bought "a few
shares'' of Enron in October when the price dropped below
book value. But he didn't hold them for long.
became clear to me that the numbers were going to be
deteriorating very quickly and that the marketplace had lost
confidence in the management,'' he said.
Oct. 16, Enron announced a $1 billion after-tax charge, a
third-quarter loss and a reduction in shareholder equity of
$1.2 billion. A little more than a week later, Enron
replaced its chief financial officer.
Nov. 8, the company said it would restate its financial
statements for the prior four years. On Dec. 2, Enron filed
for Chapter 11 bankruptcy protection.
of the issues in Enron's case is its accounting for hedging
transactions involving limited partnerships set up by its
then-chief financial officer. Enron's filings with the
Securities and Exchange Commission reported the existence of
the limited partnerships and the fact that a senior member
of Enron's management was involved. But, as the SEC noted
later, "very little information regarding the participants
and terms of these limited partnerships were disclosed by
"The SEC requires a certain amount of disclosure, but if you
can't understand accounting, you're hobbled,'' said Scott
Satterwhite, an Atlanta-based money manager for Artisan
Partners. "If you can't understand what the accounting
statements are telling you, you probably should look
elsewhere. If you read something that would seem to be
important and you can't understand it, it's a red flag.''
Message 2 (January 8,
2002) from Dennis Beresford, former Chairman of the Financial
Accounting Standards Board
SUMMARY: As a part of a
greater effort to restore public confidence in accounting
work, the Big Five accounting firms have asked the SEC to
provide immediate guidance to public companies concerning some
disclosures. In addition, the Big Five accounting firms have
promised to abide by higher standards in the future.
1.) Why do the Big Five accounting firms need the SEC to issue
guidance to public companies on disclosure issues? What is the
role of the SEC in financial reporting? Why are the Big Five
accounting firms looking to the SEC rather than the FASB?
2.) Why are the Big Five
accounting firms concerned about public confidence in the
accounting profession? Absent public confidence in accounting,
what is the role, if any, of the independent financial
3.) What role does consulting
by auditing firms play in the public's loss of confidence in
the accounting profession? Should an independent audit firm be
permitted to perform consulting services for it's audit
4.) What is the purpose of the
management discussion and analysis section of corporate
reporting? Is the independent auditor responsible for the
information contained in management's discussion and analysis?
5.) Comment on the statement
by Michael Young that, "Corporate executives are being dragged
kicking and screaming into a world of improved disclosure."
Why would executives oppose improved disclosure?
Reviewed By: Judy Beckman,
University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
Reactions and An Editorial from Double Entries on December 13,
big issue this week and one that is likely to dominate the
accounting headlines for sometime is the Enron controversy.
We have three items on Enron this week in the United States
section including a brief summary from Frank D'Andrea and
verbatim statements from the Big Five firms and the AICPA.
We will continue to post the latest news to the website at
http://accountingeducation.com and as per normal a
summary of those items in future issues of Double Entries.
While the Enron story is big, we also have extensive news
from around the world including Australia, Canada, Ireland
and the United Kingdom. It seems that the accrual accounting
in government tidal wave that first started in New Zealand
back in the early 1990s has now swept through Australia, the
United States and now into Canada where the Canadian Federal
government is to adopt accrual accounting. Who is to be
next? Is this the solution to better financial
accounting/accountability in the pubic sector? We welcome
your views on this issue.
 AICPA STATEMENT ON ENRON & AUDIT QUALITY The following
is a statement from James G. Castellano, AICPA Chair and
Barry Melancon, AICPA President and CEO on Enron and audit
quality released on December 4, 2001. The statement has been
reported verbatim for your information. Click through to
the statement [AP].
 STATEMENT FROM BIG FIVE CEOS ON ENRON The following is
being issued jointly by Andersen, KPMG, Deloitte & Touche,
PricewaterhouseCoopers and Ernst & Young. We have reported
the statement verbatim: As with other business failures, the
collapse of Enron has drawn attention to the accounting
profession, our role in America's financial markets and our
public responsibilities. We recognize that a strong,
diligent, and effective profession is a critically important
component of the financial reporting system and fundamental
to maintaining investor confidence in our capital markets.
We take our responsibility seriously. [Click through to
the balance of the statement] [AP].
 ENRON AND ARTHUR ANDERSON UNDER THE LOOKING GLASS All
eyes are on Enron these days, as the Company has filed for
bankruptcy protection, the largest such case in the U.S. The
Enron collapse has the whole accounting and auditing
industry astir. The lack of confidence in Enron by investors
was the result of several factors, including inadequate
disclosure for related-party transactions, financial
misstatements and massive off-balance-sheet liabilities.
Whilst this issue has been extensively covered in the Press,
we provide a brief summary of the story in our full item at
http://accountingeducation.com/news/news2355.html . More
details will follow on this important issue as it continues
to unfold [FD].
Farm: Where's the Crime?
The story is as old as history
of mankind. A farmer has two choices. The first is to
squeeze out a living by tilling the soil, praying for rain,
and harvesting enough to raise a family at a modest rate of
return on capital and labor. The second is to go to the
saloon and bet the farm on what seems to be a high odds poker
hand such as a full house or four deuces.
When CEO Ken Lay says that the
imploding of Enron was due to an economic downturn and
collapse of energy prices, he is telling it like it is. He
and his fellow executives Jeff Skilling and Andy Fastow did
indeed begin to bet the farm six years ago on a relatively
sure thing that energy prices would rise. They weren't
betting the farm (Enron) on a literal poker hand, but their
speculations in derivative financial instruments were
tantamount to betting on a full house or four deuces. And as
their annual bets went sour, they borrowed to cover their
losses and bet the borrowed money in increasingly large-stake
hands in derivative financial instruments.
instruments are two-edged swords. When used conservatively,
they can be used to eliminate certain types of risk such as
when a forward contract, futures contract, or swap is used to
lock in a future price or interest rate such that there is no
risk from future market volatility. Derivatives can also be
used to change risk such as when a bond having no cash flow
risk and value risk is hedged so that it has no value risk at
the expense of creating cash flow risk. But if there is no
hedged item when a derivative is entered into, it becomes a
speculation tantamount to betting the farm on a poker hand.
The only derivative that does not have virtually unlimited
risk is a purchased option. Contracts in forwards, futures,
swaps (which are really portfolio of forwards), and written
options have unlimited risks unless they are hedges.
Probably the most enormous
example of betting on derivatives is the imploding of a
company called Long-Term Capital (LTC). LTC was formed by two
Nobel Prize winning economists (Merton and Scholes) and their
exceptionally bright former doctoral students. The ingenious
arbitrage scheme of LTC was almost a sure thing, like betting
on four deuces in a poker game having no wild cards. But when
holding four deuces, there is a miniscule probability that the
hand will be a loser. The one thing that could bring LTC's
bet down was the collapse of Asian markets, that horrid
outcome that eventually did transpire. LTC was such a huge
farm that its gambling losses would have imploded the entire
world's securities marketing system, Wall Street included.
The world's leading securities firms put up billions to bail
out LTC, not because they wanted to save LTC but because they
wanted to save themselves. You can read about LTC and the
other famous derivative financial instruments scandals at
Given Enron's belated
restatement of reported high earnings since 1995 into huge
reported losses, it appears that Enron was covering its losses
with borrowed money that its executives threw back into
increasingly larger gambles that eventually put the entire
farm (all of Enron) at risk. As one reporter stated in a
baseball metaphor, "Enron was swinging for the fences."
Whether or not top executives
of a firm should be allowed to bet the farm is open to
question. Since Orange County declared bankruptcy after
losing over $1 billion in derivatives speculations, most
corporations have written policies that forbid executives from
speculating in derivatives. Enron's Board of Directors
purportedly (according to Enron news releases) knew the farm
was on the line in derivatives speculations and did not
prevent Skilling, Fastow, and Lay from putting the entire firm
in the pot.
where's the crime?
The crime lies in deceiving
employees, shareholders, and investors and hiding the
relatively small probability of losing the farm by betting on
what appeared to be a great hand. The crime lies in Enron
executives' siphoning millions from the bets into their
pockets along the way while playing a high stakes game with
money put up by creditors, investors, and employees.
The crime lies is accounting
rules that allow deception and hiding of risk through such
special purpose entities (SPEs) that allow management to
keep debt off balance sheets, thereby concealing risk. The
crime lies at the foot of an auditing firm, Andersen, that
most certainly knew that the farm was in the high-stakes pot
but did little if anything to inform the public about the high
stakes game that was being played with the Enron farm in the
pot. Andersen contends that it played by each letter of the
law, but it failed to let on that the letters spelled THE FARM
IS IN THE POT AT ENRON! The crime lies in having an audit
committee that either did not ask the right questions or went
along with the overall deception of the public.
I hesitate to answer that, but
I really like the analysis in three articles by Mark Cheffers
that Linda Kidwell pointed out to me. These are outstanding
assessments of the legal situation at this point in time.
Two of the lowest ranking
officials participating in the conspiracy responsible
for the $11 billion fraud that brought down WorldCom
were sentenced on Friday, August 5. Three more former
WorldCom executives, accounting director Buford Yates,
controller David Myers and chief financial officer Scott
Sullivan, will be sentenced this week. Betty Vinson, a
former mid-level accounting manager at WorldCom, was
sentenced to five months in prison to be followed by
five months of house arrest. Vinson testified for the
government in the trial of Bernard Ebbers, WorldCom’s
former Chief Executive Officer (CEO).
“Had Ms. Vinson refused to do
what she was asked, it’s possible this conspiracy might
have been nipped in the bud,” U.S. District Judge
Barbara Jones said in handing down the sentence, the
Associated Press reports.
Judge Jones ordered Vinson to
begin serving her sentence on November 7, according to
Reuters. Although federal probation officials will make
the final determination regarding where Vinson will
serve her time, Reuters reports her lawyer requested she
be sent to a prison near Jackson, Mississippi so she
could be close to family and friends.
In a separate proceeding in
Judge Jones court, Troy Normand, another former WorldCom
accounting official, was sentenced to three years
probation. Prosecutor David Anders asked for leniency,
telling the court that Normand’s role was simply to see
that WorldCom’s books had been changed and required no
independent thought, according to the Associated Press.
Normand also testified against Ebbers. The Associated
Press reports Normand apologized to the thousands of
WorldCom employees who lost jobs and investors who lost
money in the collapse before he was sentenced.
I watched the AICPA's excellent FBI Webcast today (Nov. 6).
One segment that I really enjoyed was a video of Walter Pavlo,
a former MCI executive who served prison time for fraud. This
was a person with all intentions of being highly professional
on a fast track to being in charge of collecting reseller bad
debts for MCI. In that position, he just stumbled upon too
much temptation for what is tantamount to a kiting scheme.
You can read details about Walter Pavlo's fraud at
This Forbes site was temporarily opened up for the AICPA
Webcast viewers and will not be available very long. If you
are interested in it, you should download now!
an Ex Con Named Walter Pavlo Who Did Time in Club Fed
What you find below is a message (actually three messages and
a phone call) I received from a man involved in MCI's
accounting fraud who went to prison and is now trying to
apologize (sometimes for a rather high fee) to the world.
I watched the AICPA's excellent FBI
Nov. 6, 2003
). One segment that I really enjoyed
was a video of Walter Pavlo, a former MCI executive who
served prison time for fraud. This was a person with all
intentions of being highly professional on a fast track to
being in charge of collecting reseller bad debts for MCI. In
that position, he just stumbled upon too much temptation for
what is tantamount to a kiting scheme.
Message from Walter
Pavlo on February 24, 2004
routinely do a search on my name over the Internet to see if
there are comments on my speeches that I conduct around the
country. I saw that you had a comment on a video in which I
appeared but was unable to find the complete comment on your
extensive web-site. Whether positive or negative I could not
ascertain but am still interested in your thoughts and would
did read some of your comments regarding the stashing of
cash off-shore by executives who commit crimes and the easy
life they have at "club fed". Here I would agree that there
are a few who have such an outcome, but this is not the
norm. However, I would disagree that there is a "club fed"
and on that you are misinformed.
had off-shore accounts and received a great deal of money.
However, the results of story are more tragic. All of the
money is gone or turned over to authorities (no complaints
here, this is justice), I lost my wife of 15 years and
custody of my children, I lost all of my assets (retirement,
etc.) and at 41 I am starting life over with little to show
of my past accomplishments (which were many). Stories like
mine are more common among rank and file middle managers who
find themselves on the other side of the law. There are few
top executives in prison but that appears to be changing.
Time will tell if they fare as well.
Prison, while deserving for a crime of the magnitude that I
and others committed, is a difficult experience and one that
is difficult from which to recover. In the media and in
comments such as the ones your offer, it appears that this
part of the story is not revealed and that it is better to
appeal to the fears and anger of the general population. I
would encourage you to consider other view points for
reasons of understanding the full story. I feel that this is
important for people to know.
Thank you for your time and would appreciate receiving your
125 Second Avenue, #24 New York, NY 10003
Phone: (201) 362-1208
Message 2 from Walter
Palvlo (after he phoned me)
Attached is an article that appeared in Forbes
magazine in the June 10, 2002 issue. I was interviewed for
this article while still in prison and some six months prior
to WorldCom's revelations of the multi-billion dollar fraud
that we know of today.
was a pleasure to speak with you and I hope to correspond
with you more in the future.
Second Avenue, #24 New York, NY 10003
Phone: (201) 362-1208
This is part of a resume
that he sent to me (I think he wants me to promote him as a
Walter "Walt" Pavlo holds an engineering degree from West
Virginia University and an MBA from the Stetson School of
Business at Mercer University. He has worked for Goodyear
Tire in its Aerospace division as a Financial Analyst, GEC
Ltd. of England as a Contract Manager and as a Senior
Manager in MCI Telecommunication's Division where he was
responsible for billing and collections in its reseller
a senior manager at MCI, and with a meritorious employment
history, Mr. Pavlo was responsible for the billing and
collection of nearly $1 billion in monthly revenue for MCI's
carrier finance division. Beginning in March of 1996, Mr.
Pavlo, one member of his staff and a business associate
outside of MCI began to perpetrate a fraud involving a few
of MCI's own customers. When the scheme was completed, there
had been seven customers of MCI defrauded over a six-month
period resulting in $6 million in payments to the Cayman
January 2001, in cooperation with the Federal Government,
Mr. Pavlo pled guilty to wire fraud and money laundering and
entered federal prison shortly thereafter. His story
highlights the corrupt dealings involving the manipulation
of financial records within a large corporation. His case
appeared as a cover story in the June 10, 2002 issue of
Forbes Magazine, just weeks before WorldCom divulged that it
had over $7 billion in accounting irregularities.
Currently, Mr. Pavlo is the Director of Business Development
at the Young Entrepreneurs Alliance (YEA), a non-profit
organization in Maynard, Massachusetts. YEA's mission is to
provide at-risk and adjudicated teens with the opportunity
to attain long-term economic independence by teaching them
about business ownership. Mr. Pavlo's primary responsibility
is to develop the business programs, raising funds through
speaking engagements and charitable donations to YEA.
Pavlo has been invited to speak on his experiences by the
Federal Bureau of Investigation, US Attorney's Office, major
university MBA programs, corporations and various
professional societies. The purpose of these speeches is to
convey to audiences an understanding of the inner-workings
and motivations associated with complex white-collar crimes,
with an emphasis on ethical decision-making.
Walter Pavlo sent me the
following information regarding my question whether he makes
pro-bono presentations. He replied as follows:
the note of pro-bono work, most of what I have done to date
has been pro-bono. Whenever I am in an area with a paying
gig, I try to reach out to universities in the area to offer
my services at no charge. I could have done this for
Trinity when I was in
last year for the
. I'll be sure to look you up if I'm
going to be in the area.
Ernst & Young, the big accounting
firm, was barred yesterday from accepting any new audit
clients in the United States for six months after a judge
found that the firm acted improperly by auditing a company
with which it had a highly profitable business relationship.
The unusual order, which included a
$1.7 million fine, brought to an end a bitter fight in which
the Securities and Exchange Commission had contended that
Ernst violated rules on auditor independence by jointly
marketing consulting and tax services with an audit client,
The overwhelming evidence," wrote
Brenda P. Murray, the chief administrative law judge at the
S.E.C., is that Ernst's "day-to-day operations were
profit-driven and ignored considerations of auditor
independence." She said the firm "committed repeated
violations of the auditor independence standards by conduct
that was reckless, highly unreasonable and negligent."
The rebuke to Ernst, which said it
would not appeal the decision, is the latest embarrassment
for one of the Big Four accounting firms, which have come
under heavy criticism and increased regulation as a result
of accounting scandals in recent years. Those scandals led
to the demise of Arthur Andersen, which had formerly been
among the Big Five.
The judge was harshly critical of
the Ernst partner who was in charge of independence issues,
saying he kept no written records and had failed to learn
enough facts before saying the relationships between Ernst
and PeopleSoft were proper. That partner, Edmund Coulson,
was chief accountant of the S.E.C. before he joined Ernst in
Ernst's consulting and tax
practices used PeopleSoft software in their business, and
the two companies participated in some joint promotion
activities. Ernst contended that it should be viewed as a
customer of PeopleSoft in the relationship, but the judge
said it went far beyond that.
She noted that Ernst had billed
itself in marketing materials as an "implementation partner"
of PeopleSoft and had earned $500 million over five years
from installing PeopleSoft programs at other companies,
which use the software to manage payroll, human resources
and accounting operations.
She issued a cease-and-desist order
against the firm, saying it had refused to admit it had done
anything wrong and that there was no reason to believe it
would not violate the rules again. She also fined it
$1,686,500, the total amount of audit fees the company
received from PeopleSoft in the years that were involved,
plus interest of $729,302, and ordered that an outside
monitor be brought in to assure the firm complied with the
rules in the future.
S.E.C. officials said the decision
would send a message to other firms. "Auditor independence
is one of the centerpieces of ensuring the integrity of the
audit process," said Paul Berger, an associate director of
the commission's enforcement division, adding that the
judge's decision "vindicates our view that Ernst & Young
engaged in a business relationship that clearly violated"
Ernst, based in New York, had
previously denounced the commission for seeking a ban on new
business, saying any such punishment was completely
unwarranted. But last night the firm said it would accept
the ruling and would not appeal. It had the right to appeal
to the full S.E.C. and then to federal courts if the
commission ruled against it.
"Independence is the cornerstone of
our practice and our obligation to the public," said Charlie
Perkins, a spokesman for Ernst & Young. "We are fully
committed to working closely with an outside consultant in
the review of our independence policies and procedures."
Mr. Perkins said the firm had
decided not to appeal because it wanted to put the matter
behind it, and emphasized that it would be able to continue
serving its existing clients.
The six-month suspension appears to
match the longest suspension on signing new business ever
imposed on a leading accounting firm.
In 1975, Peat Marwick, a
predecessor of KPMG, agreed to accept a similar six-month
suspension as part of a settlement of charges it had failed
to properly audit five companies, including Penn Central,
the railroad that went bankrupt.
The day Arthur
Andersen loses the public's trust is the day we are out of
Steve Samek, Country Managing Partner, United States, on
Andersen's Independence and Ethical Standards CD-Rom,
In his eulogy for Arthur Andersen, delivered
on January 13, 1947 the Rev. Dr. Duncan E. Littlefair closed
with the following words:
Mr. Andersen had great
courage. Few are the men who have as much faith in the
right as he, and fewer still are those with the courage to
live up to their faith as he did...For those of you who
worked with him and carry on his company, the meaning is
clear. Those principles upon which his business was built
and with which it is synonymous must be preserved. His name
must never be associated with any program or action that is
not the highest and the best. I am sure he would rather the
doors be closed than that it should continue to exist on
principles other than those he established. To you he has
left a great name. Your opportunity is tremendous; your
responsibility is great.
It is not too much
to expect that principles have a place in business today.
They do. It's too late for this once-great Firm, but there's
still time for the rest of us.
As quoted from pp. 253-254 in Final Accounting, by
Barbara Ley Toffler (Broadway Books, 2003). I might note
that the main message at the start of Barbara Ley Toffler’s
book is that Andersen adopted a policy of overcharging for
services or in her words “padding the bill.” This perhaps was
the beginning of the end!
You can read about Arthur Andersen at
"Our study demonstrates that audit
firms may lie to keep a profitable audit client if the
expected benefits of keeping the client happy outweigh the
expected costs of an audit failure if the firm gets caught,"
said Debra Jeter, co-author of the study and an associate
professor of accounting at the Owen Graduate School of
Management at Vanderbilt.
A study by Vanderbilt University
researchers has found that audit firms are still likely to
produce inaccurate audit opinions to benefit a big client —
as long as company officials think they can get away with
"Our study demonstrates that audit
firms may lie to keep a profitable audit client if the
expected benefits of keeping the client happy outweigh the
expected costs of an audit failure if the firm gets caught,"
said Debra Jeter, co-author of the study and an associate
professor of accounting at the Owen Graduate School of
Management at Vanderbilt.
However, the report also suggests
that increased scrutiny over the auditing industry, brought
about by the accounting scandals of the past two years, may
help improve reporting as the possibility grows that
wrongdoing will be discovered. Pressure brought by
Securities and Exchange Commission enforcement and new rules
set by the Public Company Accounting Oversight Board (PCOAB)
could influence auditors’ decisions.
"If the likelihood that the firms
will get caught if using questionable accounting increases,"
Jeter added, "their auditors, in evaluating the costs of an
audit failure, will think twice and realize that their best
interest lies in insisting on fair reporting."
Audit firms should rotate partners
in charge of large audits, the study says, and audits should
remain independent of consulting work by the same firm.
For companies being audited, Jeter
advised that companies must constantly improve the internal
audit function. "Top management should require managers at
various levels within the firm to certify the numbers they
are responsible for. Companies should make sure that most —
if not all — audit committee members are financially
literate and that they meet more than once a year. This is
The study will be published in the
November/December 2003 issue of the Journal of Accounting
and Public Policy. "The Impact on the Market for Audit
Services of Aggressive Competition by Auditors" is
co-authored by Jeter; Paul Chaney, associate professor of
accounting at the Owen School at Vanderbilt; and Pam Shaw of
August 3, 2003
excerpt from a speech by Art Wyatt (See the link below that
firms need to consider a number of initiatives. The tone at
the top of the firms needs to change. As a starting point,
leadership of the major firms might require that their
managing partners meet the standards established by
Sarbanes-Oxley for the individual on SEC-registrant audit
committees that is designated as a qualified financial
expert. Recent managing partners have too often been chief
cheerleaders promoting revenue growth or individuals with
more administrative expertise than accounting and auditing
expertise. The policies established at the top of the firms
must be approved by and articulated by individuals who have
the professional respect of the managers and staff. The
challenge to restore the primacy of professional behavior in
the conduct of services rendered will not be easily met.
Such restoration likely will not be met at all if the chief
messenger is known throughout the firm as being primarily an
advocate of revenue growth even when that growth may be at
the expense of the firm's reputation for outstanding
professionalism in the delivery of its services.
top leadership in the firms also needs to consider whether
the four largest firms are really effectively unmanageable.
In smaller accounting firms (or when the current four large
firms were smaller), a key partner is able to monitor
partner performance and be able to assess the strengths and
weaknesses of the individual partners. As the large firms
have grown to their current size, the challenge to have such
effective monitoring is substantial. Maybe some
consideration should be given to whether a split-up of a big
firm would enhance the firm's quality control and permit
more effective delivery of quality service. While such a
thought will no doubt be draconian to some, one only has to
consider what might be the end result if one of the current
four large firms meets the same fate as Andersen. Firm
break-ups might then be at the mercy of legislative or
regulatory intervention--an even more draconian thought.
The bottom line, however, is, are the large firms able to
manage their practices effectively to assure top quality
service to their clients and the public?
firms need to place greater internal emphasis on quality
control in audit performance. More effort should be devoted
to assuring that clients have met the intent of the
applicable accounting standards, and less effort should be
devoted to assisting clients to structure transactions to
avoid the intent (and sometimes the letter) of the
standards. In working with the FASB the focus of the firms
should be on pressuring the FASB to develop standards that
are conceptually sound and that avoid compromises that are
designed to keep one segment of society happy at the expense
of sound financial reporting. Too often the accounting
firms have acted at the direction of their clients in
lobbying the FASB on specific technical issues and have not
met the standards of professionalism that the public can
rightfully expect from the leading accounting firms. Too
many of the FASB standards contain conceptual impurities
that encourage gaming the system, and too many firms are
active participants in the gaming activity. Lobbying the
FASB on behalf of particular client interests is not
professional on its face and casts as much of a cloud on the
firm's independence as does providing a range of consulting
services to audit clients.
a side note, I have seen comments by leaders of several of
the Big 4 firms recently suggesting that the real cause of
recent financial statement shortcomings is the failure of
existing accounting standards to reflect the underlying
economics of reporting companies. These statements seem to
be self-serving attempts to deflect criticism from
accounting firm performance to the adequacy of the current
set of generally accepted accounting principles. To test
the sincerity of these comments, I suggest one analyze the
recent firm submission to the FASB on proposed standards
that have emphasized economic reality over "backward-looking
historical cost." I suspect such analysis would suggest the
several firms have missed numerous opportunities to
encourage the FASB in its efforts to adopt standards that
reflect better economic reality and, in fact, have often
taken strongly contrary positions, at least in part at the
urging of their clients.
While on the subject of the FASB, we need to recognize that
the Board fared well in the Sarbanes-Oxley legislation.
Going forward, the Board needs to do a better job in
educating congressmen and senators on their proposed
standards and why the lobbying efforts of constituents are
often far more self-serving than desirable from the
perspective of fair financial reporting. The Board needs to
attack a significant number of its existing standards that
are conceptually unsound and that embody a series of
arbitrary boundaries that attempt to prevent users from
misapplying the standard. We should have learned by now
that standards that contain arbitrary rules in the attempt
to circumvent aberrant behavior really act to encourage that
very behavior. Firm leaders should recognize that their
audit personnel will be far better off in dealing with
aggressive client behavior if the standards that are
operational are soundly based and consistent with the
Board's conceptual framework. Isn't it more important to
provide your staff with the best possible tools to meet
their challenges than it is to gain some short-term warm
feelings by bowing to a client's wishes? The big firms need
to decide that the FASB is their ally, not their opponent,
and become more statesmanlike in pursuing sound accounting
standards. This will require leaders who understand the
nuances of technical accounting requirements and who are
able to grasp that acceptable levels of profitability will
flow from delivering top quality professional service to
The 88th Annual Meeting of the
American Accounting Association was held August 3-6, 2003,
in Honolulu, Hawaii. Opening speaker Arthur R. Wyatt's
presentation garnered a standing ovation. So that his
comments can be shared beyond those able to attend the
meeting the full text of his challenging speech, "Accounting
Professionalism--They Just Don't Get It!" is available
This paper reviews, examines, and
interprets the events and developments in the evolution of the
U.S. accounting profession during the 20th century, so that
one can judge "how we got where we are today." While other
historical works study the evolution of the U.S. accounting
profession,1 this paper examines two issues:
(1) the challenges and crises that faced the accounting
profession and the big accounting firms, especially beginning
in the mid-1960s, and (2) how the value shifts inside the big
firms combined with changes in the earnings pressures on their
corporate clients to create a climate in which serious
confrontations between auditors and clients were destined to
occur. From available evidence, auditors in recent years seem
to be more susceptible to accommodation and compromise on
questionable accounting practices, when compared with their
posture on such matters in earlier years. "How the U.S. Accounting Profession Got Where It Is
Today: Part I," by Stephen A. Zeff,
September 2003, pp. 189-205.
Note from Bob Jensen
Steve's main points are consistent with
Art Wyatt's remarks at the 2003 AAA Annual Meetings in
Hawaii. However, Steve fleshes in more of the historical
detail. I am really looking forward to Steve's forthcoming
Part II continuation.
I might elaborate a
bit on Steve's assertion that: "From available evidence,
auditors in recent years seem to be more susceptible to
accommodation and compromise on questionable accounting
practices, when compared with their more
stolid posture on such matters in earlier
years." Out of context, this implies that auditors of old
were more moral, ethical, and professional. But such behavior
in context is relative to the changing pressures, temptations,
and opportunities of a changed auditing environment.
Just because all the
"stolid" male (virtually all were male before the 1970s)
auditors decades earlier never committed adultery with
Elizabeth Taylor does not mean that they were above
temptation. Such temptation never came their way, because
Elizabeth Taylor in her prime never had any inclination toward
auditors (sigh). Along a similar vein, these "stolid"
auditors only appeared to be less "susceptible to
accommodation and compromise on questionable accounting
practices" because temptations, pressures, and opportunities
in the 1960s and earlier were totally unlike the auditing
climate of the 1980s and 1990s. My point is that auditors are
human beings who have changed much less than the temptation
environments and contractual complexities within which the
audits take place. The same thing has happened in the
profession of journalism in the age of technology, and I
highly recommend the professionalism concerns voiced at
http://www.journalism.org . Journalists have not changed
nearly so much as the journalism environment in the age of
technology and civil strife around the world.
I also get riled when
some analysts (not Steve) suggest that accounting principles
today are too complex and that the simpler standards of the
1960s and earlier are all we need for current financial
reporting purposes (e.g., see Scott McNealy's recommendations
below ). Those simpler standards never envisioned contractual
complexities of the 1990s when newer types of derivative
financial instruments (e.g.,
swaps), newer types of off balance sheet ploys (e.g.,
variable interest entities),
and compound debt/equity instruments were invented. Old
standards are no more effective in modern accounting any more
than battleships are effective in an age of nuclear
submarines, laser-guided missiles, and satellite tracking
systems. My point here is that the FASB and IASB standards of
the 1990s and later are complex because the contracts being
accounted for became so complex. There are no simple
solutions to complex contracting except for simplistically
naive fair value solutions that are out of touch with
I recently read with great interest
the Zeff paper in Horizons, the first part of a two part
paper on the slow decline of the profession - or perhaps
more accurately, its transition from profession to industry
- during the 20th century.
Having lived through a good part of
the period he covered in the first part, I can say it does a
remarkable job of capturing the essence of the events during
the period - a period characterized by by the inexorable
forces on the profession by its publics, and the abandonment
of professionalism for commercialism.
The papers should be required
reading for every young person who wishes to obtain a
professional accounting designation and the subject of
discussion and debate in classrooms.
There was a recent cartoon in the
New Yorker where an executive was sitting at a
boardroom table with other executives and saying "The
auditors are not team players any more." We can only hope. I
hope this is the beginning of a return to professionalism.
Maybe educators can help to make it so.
Zeff's piece is great, and I look
forward to the second part. The blinders came off my eyes
with respect to our profession (I previously thought it was
a few bad apples) when I listened to the tax shelter
testimony live on Oct. 21 via Realplayer (ah, the wonder of
technology). The testimony is available on
. In particular, the PCAOB testimony is interesting. I now
think that public accounting firms should not be able to
audit clients that have purchased a "no business purpose"
tax shelter from the audit firm. Perhaps the solution is to
say that if the corporation is a tax client, you can't audit
the company. That solution is overkill, but I no longer
trust the firms to judge "business purpose." I have asked my
graduate tax students to write their last memo on what
Congress should do to address the tax shelter issue. The
memos should be interesting reading.
Sansing, ever the terse analytic,
would agree with the former IRS Chief Counsel, B. John
Williams, who said the following, "One of the foundation
stones of the credibility of the Service with the American
public is that the Service proceed analytically rather than
emotively. 'Abusive' reflects the indignation that the
Service feels about a transaction, but the Service's
feelings about a transaction do not state a legal basis for
disallowing the tax benefits from a transaction. 'Abusive'
is not an analytical term, it is an emotive term, and the
mission of the Service is to apply the law fairly and
impartially, not to apply the law in a manner that is biased
toward a result the government wants."
Dunbar, ever the emotional
observer, would encourage a little righteous indignation.
Good heavens! Read the testimony of Henry Camferdam (someone
said he was on 60 Minutes). When did our profession lose its
way? Read Zeff!
For those of you are members of the
Public INterest Section of the AAA and have free access to
the section journal, Accounting and the Public Interest,
there is an excellent article by Tony Tinker that sheds
considerable light on this notion of the "decline of the
profession." It's a myth because it presumes there was a
golden era of the profession when it performed in some
ideal, Durkheimian sense. But the profession of accounting
was never very high up in a place it could decline from. Tom
Lee documents that the first chartered accountants (ever) in
Scotland (the primordial swamp from which all CPAs emerged)
garnered their "charter" in order to restrain trade for
their services -- they were a rather unsavory bunch whose
motivation for creating the "profession" was hardly to serve
the public interest. The only way accounting could ever be a
profession in the classical sense in which we seem to be
speaking of it as a service to mankind is that its service
be performed in the employee of mankind, not in the employee
of sizable private interests that are not nearly as
politically and socially benign as Adam Smith's baker.
November 6 reply from Bob Jensen
With due respect, I think there was a "Golden Age" period
where professionalism was quite high. I would argue that it
was in the early part of the 20th Century when the large
firms were formed by high integrity professionals with names
like Andersen, Ernst, Haskins, Sells, Ross, Lybrand, etc.
These were extremely high integrity professionals who set
tough tones at the top for their employees, especially the
outstanding Norwegian (my
Arthur Andersen. Read part of the eulogy for Arthur
Andersen, delivered on January 13, 1947 the Rev. Dr. Duncan
E. Littlefair ---
Interestingly, the early public accounting firms may have
had the highest integrity between 1900 and 1933 when
auditing was not required by the U.S. Government, and CPA's
did not have an auditing monopoly. I think that the early
firms really believed their futures depended upon integrity
and quality of service since the decision to have an audit
was discretionary in the sense of agency theory where having
an audit generally added value to share prices vis-à-vis not
having an audit.
As I have indicated elsewhere, however, this does not
mean that "stolid" (Zeff's term) auditors of the 1950s,
1960s, and 1070s who seemingly remained highly professional
would have blown the whistle on Enron, Worldcom, Xerox,
Sunbeam, etc. in recent years. My comments on this are given
We have also had some outstanding auditors who worked
public servants in government. But in the U.S., the least
professional and most greedy leaders are generally in the
top tiers of government (Congress, Senate, Executive
Cabinet, etc.) These powerful individuals, in turn, exert
pressure on agencies like the FDA, FTC, FPC, FAS, SEC, etc.
to serve the interest of the companies rather than the
Where are the biggest crooks in most nations? Generally
in high levels of government. Hence, I would prefer not to
look to government for people committed to "service (as) an
employee of mankind."
Where does one find an "employee of mankind?" (a Tony
Tinker term) In my opinion, an employee of mankind is a high
integrity professional who is driven by inner morality
forces no matter where she/he happens to be employed (public
or private). Public accounting in theory is neat, because
the integrity is more necessary to survival of the
profession than in other professions that sell more than
The problem is really not one of organizational
structure. It is one of slight moral decay in the midst of
enormous increases in temptation. I suspect the rise in
temptation and opportunity are the main culprits.
In the next edition of New Bookmarks, I will have more to
say about how this problem will be corrected. Look for the
heading "1984+50: Screwed and Tattooed" in the forthcoming
edition of New Bookmarks (probably around October 20).
I just finished watching the AICPA's excellent FBI
Webcast today (Nov. 6). One segment that I really enjoyed
was a video of Walter Pavlo, a former MCI executive who
served prison time for fraud. This was a person with all
intentions of being highly professional on a fast track to
being in charge of collecting reseller bad debts for MCI. In
that position, he just stumbled upon too much temptation for
what is tantamount to a kiting scheme.
You can read details about Walter Pavlo's fraud at
Forbes site was temporarily opened up for the AICPA Webcast
viewers and will not be available very long. If you are
interested in it, you should download now!
The FBI agents in the Webcast made a careful distinction
between career con artists (who jump from con to con before
and after prison because they seem to be inherently addicted
to the game) versus others who commit fraud as a result of
opportunity and temptation that exceeds their will power.
These agents suggested an analogy of a bag of money being
found where there appears to be no possibility of being
detected. People who would never steal might succumb to
"finders keepers" temptations, especially if they thought
the money was lost by drug dealers who had no legitimate
claim to the money in the first place and needed to somehow
Morality has not declined in the professions nearly as
much as temptations and opportunities have created new
environments that test morality. An analogy here is
pornography. Playboy Magazine thrived in the 1960s when
there was little else boys could easily get their hands on
to hide under the mattress (yeah I did that). These boys
were more curious than addicted. In the 21st Century with
millions of free pictures of the hardest core imaginable
only a few mouse clicks away, temptations and opportunities
have created an entirely new addiction environment for both
young people and pedophiles that prey on the young.
The obvious solutions are to do our best to convince
others (e.g., auditors) not to succumb to opportunity, but
it is difficult to raise the morality bar. Another solution
is to reduce the temptations by increasing the probability
of getting caught (e.g., better controls). At this
precarious juncture in the life of our profession, we need
to concentrate on both alternatives.
But it will be a sad day when we go too far, and I will
have more to say about that in the next edition of New
Bob, I appreciate your thoughtful
response. My response to that is that we would tragically
remiss if we simply dismiss what we have observed as the
"decline of the profession" as simply a matter of a few bad
apples. It is a structural/ organizational problem. As the
philospher Colin McGinn noted, "The sure mark of an
ideology, in science and philosophy as in politics, is the
denying of obvious facts." When you attribute the highest
period of auditor integrity to the period 1900 to 1933 how
is it that we experienced the market bubble that led to the
passage of the securities acts? Didn't the profession fail
then? You always demonize government -- it's always the
government's fault. The most corrupt are always at the top
of the government (yet it is the "tops" of multinational
corporations who are being carted off to jail). That is
simply naive and untrue. How many of us participating on
this network have the good life we have today as the result
of the construction and support of universities operated by
the state that gave many of us of humble background access
to education, and experiment unique in the history of the
world (an experement we are, by the way dismantling). Of
course we all deserve what we have by virtue of only our
individual virtue and hard work. I certainly resent being
taxed to afford the same opportunity given to me to someone
For citizens of a democracy to
despise their government is hardly a healthy sign; after
all, who elected these corrupt people? What we need is a
healthy dose of self-reflection; we need to stop blaming
"them." If the profession has declined and we are members of
the profession as its teachers, then we are certainly part
of the problem. Your hero, Arthur Andersen was perhaps the
leading proponent of expanding services to clients to
include consulting; he, more than anyone else, transformed
the profession into one of full service for clients (i.e.
management consulting). Andersen also pioneered the
organizational structure of mass produced services, which
certainly contributed to the severing from the "profession"
of the notion (that is being so romantically bandied about
in this discussion) of the dedicated small practitioner
diligently serving his or her small business client. The AIA
is preparing a white paper on accounting education that is
nearly ready for public consumption. A central theme of that
paper is de-mythologizing accounting instruction. Perhaps it
isn't a coincidence that the ascendance during the 1960s in
the academy of the "Chicago School" corresponds to the
beginning of the decline of the profession according to many
contributors to this conversation.
If, as you say, accounting is about
integrity (accounting education is first of all a moral
one?) what might be the consequences of supplanting the
"golden era of accounting" discourse (that of Andersen,
Ernst, Haskins, etc) with one glorifying the imaginary world
of efficient markets, opportunistic "agents", the sanctity
of disembodied property, and the complete irrelevance of
such "naive notions as fairness." (this is a direct quote
from one of the intellectual leaders of our modern academy).
The accounting you are nostalgic for is an accounting we
haven't taught for at least 25 years. Accounting textbooks
today are little more than dumbed down finance and
The rationales we provide for why
we do what we do are exclusively rationalized on
neo-classical grounds. The FASB justifies its existence as
producing information that leads to more efficient
allocations of capital, yet we have absolutely no idea
whether anything the FASB does actually produces such a
result. We just believe the myth. We serve "investors,"
which is really a euphemism for "a disembodied structure of
technology called capitalism" (I thank Ed Arrington for this
eloquent phrase). And even if this is hat we are about,
recent events should certainly cause us to doubt that the
way we are going about it is working. Wall Street is rigged.
It always has been. The regulations that emerged out of the
market crash were not simply some malicious attempt on the
part of corrupt politicians to frustrate the magical working
of the invisible hand (careful readers of Adam Smith will
know that he never imagined this simple metaphor would
become a priniciple for organizing every aspect of human
life, a prospect he would have found appalling). There were
reasons for those regulations, a lesson we are now
relearning. The free market is, after all, the most
carefully constructed and heavily regulated institution in
human history (Andrew Abbott, Chaos of disciplines). For us
academics in accounting, the current plight of the
profession is an excellent opportunity for us to bring some
intellectual coherence to the activity of accounting. Paton
and Littleton certainly understood the significance for
accounting of the corporate form of business and that
significance lay in its power (made all the more significant
by the Supreme Court bestowing "personhood" on them). As
they noted the humble role of accounting is to implement
social controls. That probably means that the role of
accounting is not to leverage those controls for the benefit
of only a small percentage of the people on the planet.
November 8, 2003 reply from Bob Jensen
As usual you provide an extremely thoughtful and academic
counterargument. It is too involved to respond to quickly
without more time.
However, I still must ask the question as to why white
crime is such good business in every nation? I contend that
it's because business firms and the lawyers who benefit from
business dealings in so many ways literally control the
power centers in government. Certainly this is the case in
Washington DC and all our state legislatures. Serious
reforms are either blocked or watered down with loopholes.
The new SOX legislation is costly for business firms, but
nearly half the respondents in an AICPA poll during
yesterday's FBI Webcast did not have much faith that SOX
will deter white collar crime.
I'm always looking for an example in a large nation where
the government really can be trusted any more than the
executives of industry and labor leaders within that nation.
This just does not seem to evolve in the governance of
nations. Even when an honest white knight like Jimmy Carter
is placed in power, the other power centers will merely
checkmate him/her in some way.
Focusing too much upon structural changes, such as
government takeover of industry, overlooks real issue which
is how to improve morality within any structure.
Anecdotally, the upheaval of the KGB in the Soviet Union did
not do much to improve morality as long as members of the
old KGB merely took on new titles when running a seemingly
"more democratic" government. My simplistic solution is
either to replace the people who cannot change their stripes
with better people or to make it more difficult for old
crooks still in power to get away with what they used to get
away with in the older structure.
Certainly there are no easy answers, but I am still
looking for a government that seriously makes white collar
crime such a serious offense that such crime is seriously
deterred in the private and public sectors.
Free speech probably does more to deter white collar
crime than any government or corporate ethics charter in
history. Put the KGB and Kozlowski types in any power
structure and the system will be corrupted.
What we need is more referendum power. For example, I
would call for a referendum that never opens the door of a
prison any person who intends to live in a luxurious
lifestyle before making all reparations to victims of
his/her crime. This should then be backed by enforcement
since laws are meaningless unless they are enforced.
November 8, 2003 reply from David Fordham
Much of the discussion (including
that in Zeff's article) seems to be perpetuating, rather
than clarifying and eliminating, a basic misunderstanding.
That misunderstanding is the
confusion between the field of "Accounting" and the field of
"Auditing". Take a close look at the posts so far on this
topic, and most of what is said applies to auditing, but
only peripherally (if at all) to many other facets of the
profession of "accounting".
Having been "raised" in the area of
industry accounting (cost accountant, cost analyst, etc.
eventually ending up as Corporate Controller for Paperboard
Industries), I see accounting as being much more than mere
auditing. In fact, I see auditing as a specialty within the
field of accounting, where the term accounting also
encompasses cost, tax, systems design, forecasting,
interpretation, and yes, even advising.
It is the field of auditing which
the public (and regulators) tend to focus on, so that is
what the public seems to equate with accounting. I see very
little of the current controversy applying to most of what I
Perhaps the term CPA should be
renamed "Certified public auditor"?
We as accountants have done an
absolutely pitiful job of informing the public of the true
nature of our profession, and these misunderstandings are
what is, in my opinion, causing some of the problems for us.
If we begin differentiating ourselves and explaining the
differences between bookkeeping, accounting, auditing, tax
advising, etc. and begin clarifying the many myriad and
diverse services we provide as a profession, the public (and
even our own prognosticators and pundits) can better debate
our efficacy and the need for additional (or decremented)
oversight of our profession, or even the posited decline of
E.g., let's use the term
"accounting profession" to really mean the "accounting"
profession, and not just the "auditing" profession.
David R. Fordham
PBGH Faculty Fellow
James Madison University
Tax accountants are out there are
selling "no-business-purpose" shelters. And I certainly
don't think our corporate accountants are blameless. I think
this is about power, and whether the person is an auditor,
consultant or industry accountant, once the person develops
an appetite for power and the money that goes with power,
ethics frequently becomes a dispensable good.
Arising out of the governance
mayhem of the past decade are key lessons for regulators,
auditors, investors, analysts, managers, and directors,
McNichols said. Due to the large and complex nature of the
checks and balances of an evolving system, it is imperative
that each member of the governance system understands how
the role he play fits into the big picture.
For regulators, there is the
sobering fact that redundancy in governance systems do not
preclude failures and that the oversight processes and
self-regulation of auditors, analysts, and boards of
directors are "only as strong as the weakest links." The
focus of the Sarbanes-Oxley Act of 2002 on financial
statements and auditors and strengthening the role of the
audit committee is a move in the right direction, she said.
The key lesson for auditing firms
is to provide auditors with incentives to convey all
relevant information to the board of directors or audit
committee. Regulators will respond to audit failures and
obstruction of justice with very significant penalties.
She argued that for analysts to
generate truly independent research, they must be rewarded
for the quality of the research they provide, and they must
examine the quality of corporate earnings and financial
Corporate managers, for their part,
must understand that distorting financial statements imposes
huge costs on the rest of the economy. Furthermore, she
said, financial statements that provide a
misleadingly-glowing view of future growth may provide
incentives for the company itself to act inappropriately by
making excessive capital investments, as the telecom bubble
Managers, instead, need to
understand that they are best serving investors by
presenting credible financial statements—and that firms with
better reporting will be valued more highly by investors.
Not insignificantly, managers must also take to heart that
"misleading investors can lead to civil and criminal
prosecution," said McNichols.
She argued it is neither possible
nor desirable to turn preparation of financial statements
into a mechanical process. Indeed, the level of discretion
and judgment required to prepare financial statements that
represent the economic state of the organization fairly and
transparently will increase, not decrease, in coming years.
Finally, McNichols outlined a
number of critical lessons for directors. First, the
oversight role of directors has increased substantially,
though the advisory role is no less important. Secondly, the
legal standard for a director is to demonstrate good faith
judgment, and this requires that decisions are arrived at
through a sound process. A critical aspect of a good process
is ensuring that directors receive all relevant information.
McNichols recommended the "TV test"
described by faculty colleague Bill Miller, who attributes
it to the Business School's Dean Emeritus Arjay Miller. His
test for good decision-making was whether he would feel
comfortable explaining the board's decision on the evening
news. "If you're not comfortable with that, you probably
need to go back and examine your process for arriving at
judgments," said McNichols.
Nov. 15, 2002 (Associated Press) —
Federal regulators, after an initial failure, alleged for a
second time Wednesday that Ernst & Young violated rules
designed to keep accountants independent from the companies
they audit when it engaged in business with a software
The Securities and Exchange
Commission took the action again against the big
accounting firm now that there are enough SEC
commissioners without a conflict of interest in the case.
An administrative law judge at the SEC dismissed it
several months ago because only one commissioner had voted
to authorize the action.
New York-based Ernst & Young disputed the SEC's
allegations, as it did when they were first raised in May.
"Our position has remained the same throughout: Our
conduct was entirely appropriate and permissible under the
profession's rules," firm spokesman Les Zuke said in a
"It did not affect our client,
its shareholders or the investing public, nor has the SEC
claimed any error in our audits or our client's financial
statements as a result of them. The commission's
proceedings are focused on consulting, which, because we
sold our consulting business in May 2000, is now a moot
point," the statement said.
The issue of auditor independence
was among those at the heart of the Enron affair, which
raised questions about Enron's longtime accountant, Arthur
Andersen, having done both auditing and consulting work
for the energy-trading company.
Andersen was convicted in June of
obstruction of justice for destroying Enron audit
In its administrative proceeding,
the SEC said that Ernst & Young was auditing the books of
business software maker PeopleSoft Inc. at the same time
it was developing and marketing a software product in
tandem with the company. Ernst & Young engaged in the dual
activities from 1993 through 2000, according to the SEC.
The SEC said the product, named
EY/GEMS, incorporated some components of PeopleSoft's
proprietary source code into software previously developed
and marketed by Ernst & Young's tax department. The SEC
alleged that Ernst & Young tried to gain a competitive
advantage by putting the source code into its product and
agreed to pay PeopleSoft royalties of 15 percent to 30
percent from each sale of the product.
When the case arose in May, there
were only three commissioners on the five-member SEC:
Chairman Harvey Pitt, Cynthia Glassman and Isaac Hunt.
Pitt and Glassman removed themselves from voting on
whether to take the action against Ernst & Young because
Pitt had represented the firm as a private securities
lawyer and Glassman had been an Ernst & Young executive.
That left only Hunt to authorize
the SEC attorneys to proceed, prompting the administrative
law judge's dismissal.
A new hearing will be scheduled
before a law judge to determine whether any sanctions
should be imposed on Ernst & Young, the SEC said.
It was the second time the SEC
had brought an auditor independence action against Ernst &
Young. The firm settled a 1995 action by agreeing to
comply with independence guidelines.
Robert Herdman, who resigned as
the SEC's chief accountant last Friday in the controversy
over the selection of former FBI director William Webster
to head a special accounting oversight board, also had
been an executive of Ernst & Young before coming to the
In a similar case, the SEC in
January censured another Big Five accounting firm, KPMG,
for allegedly violating the auditor independence rules.
The agency said KPMG invested $25 million in a mutual fund
at the same time it was auditing the fund's books.
KPMG, which was not fined, agreed
to the SEC's censure without admitting or denying the
allegations and agreed to take measures to prevent future
The SEC adopted the independence
rules in November 2000 after a bitter fight between the
accounting industry and Arthur Levitt, then the SEC
chairman. He and others worried that accountants in some
cases had become too cozy with the companies they audited,
threatening the integrity of financial reports and
undermining investor confidence.
The rules identified several
services as inconsistent with auditor independence,
including bookkeeping, financial systems design and
implementation, human resources and legal services.
Packers Versus the Giants:
A Great Ethics Video Clip
A very short video
clip mentioned below concerns an incident instigated by Green
Bay Packer quarterback Brett Favre in the Green Bay's last
regular season game this season. What is neat is that students
will probably never forget the video clip if you show it in
The video clip plays
a scene from the last game between the Packers and the New
York Giants. The commentator, George Wills, then points out
that all a star defensive player for the Giants, Michael
Strahan, only needed one sack of the quarterback to set an NFL
record. Near the end of the game, the Packers were certain to
win, and both teams were going through the agonizing necessity
of playing the game out.
On a snap of the
ball, all-pro Brett Favre runs straight at Strahan and allows
himself to be easily tackled. This gives Strahan the record,
and Brett Favre is roundly patted on the back as a "Great Guy"
by players from both teams while Strahan appears to be bowed
in a prayer of gratitude. The questionable "sack" was allowed
to stand on the record books ---
In the videotaped
commentary, George Wills raises a serious question of whether
what Favre did was ethical. Was it fair to the current record
holder who, possibly, earned every sack the hard way? Did it
make a mockery out of the NFL, and make it more like the phony
game of professional wrestling where virtually everything is
The video clip then
very briefly questions other great records. For example,
opposing teams bent over backwards one year to give Joe
DiMaggio his hitting record.
I find this video
clip fascinating. It is at the end of an ABC video on the
Enron scandal. Enron takes up most of the half-hour video, and
the George Wills NFL commentary is about five minutes at the
end of the tape. What I am saying is that the George Wills
piece is very short, but it is very powerful about the
importance integrity and independence. Geroge Wills is most
certainly opposed to what Brett Favre did by openly giving
Strahan an easy sack. One might say that it sacked the
integrity of the NFL.
As a faculty member,
I wonder if professors sometimes do the same thing when
bumping "good guy" grades upward. It may be applauded by most
other students, but does it compromise the integrity of the
grading system? I have overlooked some matters of student
integrity recently, and it is now bothering my conscience.
In accountancy, I
wonder if auditors sometimes do the same thing when
"overlooking" certain discrepancies, because it is applauded
by clients and current shareholders even though it compromises
the integrity of the auditing system.
Sam Donaldson's Sunday
Morning (January 13) ABC show called "This Week." You can
purchase it for $30 at <http://www.abcnewsstore.com/product-details.cgi?_item_code=B020113+01>
The show and video are entitled "The Collapse of Enron." The
unrelated NFL ethics issue takes up about five minutes near
the end of the tape.
Contextual Integrity and
The major problem with
integrity is that there is nearly always a time when integrity
either is or should be compromised in certain situations,
usually situations where there is no harm done by a "white
lie" or a "silence" about something that otherwise would cause
harm or embarrassment. What is confusing is that second order
effects are not always taken into account! For example, the
direct effects of what Brett Favre did for Michael Strahan
(see the above module) on surface seemed like a good thing to
do at the time. But think of those second order effects:
The record set will always
be demeaning to Strahan, because it was not earned fair and
square in good sportsmanship. His record becomes known as a
sham throughout history.
If the former record holder
earned the record the hard way, the loss of that record to
Strahan is an injustice.
The NFL's system of
designating records is put into question and no longer
Brett Favre will always be
mistrusted as if he is hoping for the return of a favor. If
he is approaching an NFL passing record, will NY Giants
defensive backs ease off of receivers in future games to
repay Brett for the favor he did for Strahan? Respect for
his motives and accomplishments may in fact be demeaned
because of what he did for Strahan.
What students must learn is
that situational integrity/ethics compromise the system,
degrade the legitimate achievements of their peers, and become
inherently unfair. Questions regarding those situations
include the following:
Is what you are doing
something you would proudly admit to your parents, your
minister, and your best friend?
Does your breach of
integrity directly or indirectly harm any person now or in
Does your breach of
integrity potentially harm trust and faith in the system and
Does your breach of
integrity, however small, pave the way to similar actions in
the future by you or by others who follow your precedent?
For example, if only one person ever shoplifted the loss to
society is virtually zero. If one person gets away with
shoplifting and, thereby, inspires others to do so, the loss
to society becomes enormous.
it be up to you whether more good than bad comes from your
breach of integrity? For example, a leading executive at
Trinity University justifies what Brett Favre did as
follows: "The new record holder, Michael Strahan, is a
nearly perfect role model whereas the former record holder
was a drug-dealing junkie even while he was playing
defensive end for the New York Jets." In other words, good
guys deserve to be helped when attempting to beat the
records of bad guys. If this how Brett Favre also reasoned
when helping Strahan break the record, I would contend that
Brett Favre has no right to make such a judgment and in
doing so may do more harm than good.
If other persons are
getting away with a breach of integrity, say by copying
homework, does this justifying your joining in on their
Message from Steven Bachrach
(Department of Chemistry at Trinity University)
New York Times this past weekend (1/13/02) has a very
interesting article on the "integrity" of sports records
that clearly indicates that the Favre-Strahan controversy is
Sales, opened up the last game of her college career
hobbling onto the floor due to a ruptured Achilles tendon
and was allowed to unopposedly sink a basket to set a career
skates for 47 seconds in a minor league hockey game to set
the "record" for being the first athlete to compete in 6
grooves 3 pitches to Mickey Mantle so that Mantle can hit a
home run, passing Jimmie Foxx into 3rd place all time.
David Robinson scores 71 points (thanks to exclusive feeding
of the ball) in the last game of the 1993-1994 season to
pass Shaq as the scoring leader. A similar situation lead to
Wilt Chamberlin's famous 100 point game.
to wonder whether there is any point to a discussion of
ethics when it comes to sports records, especially those
involved in team sports.
Thank you for the update Barbara.
It is interesting to juxtapose the Tribune's article on E&Y
(my former employer) against "How Accounting Can Get Back Its
Good Name," by Jim Turley, Chairman, Ernst & Young which you
can read near the very bottom of
We expect professions to fail, but why is our profession
failing so badly and so often?
A message from Barbara Leonard
on February 8, 2002
This story (from the Chicago
Tribune) may be of possible interest
in the discussion on "independence".
auditor also consulted --------------------
Ernst & Young's dual role at bank
called a conflict
By Melissa Allison Tribune staff
February 8, 2002
WASHINGTON -- Ernst & Young LLP,
the auditing firm accused of inadequately overseeing the
books of now-failed Superior Bank FSB, also received
consulting fees from the bank that totaled at least twice as
much as the fees it received for its accounting services, a
federal regulator said.
"It was a direct conflict," said
Gaston Gianni, inspector general for the Federal Deposit
Insurance Corp., in testimony to the Senate Banking
At the hearing, the FDIC, the
Treasury Department and the General Accounting Office placed
the blame for Superior's failure on poor management, lax
oversight by regulators and inadequate oversight by Ernst &
The only committee member present
was its chairman, Sen. Paul Sarbanes (D-Md.), who likened
Superior's downfall to another corporate failure attracting
close congressional scrutiny.
"It's a little bit like Enron,
isn't it?" Sarbanes quipped after hearing about the
shortcomings of Superior's management, auditors and
regulators. He later suggested that Congress might need to
more closely oversee the activities of bank regulators to
prevent future failures.
The July 2001 failure of Oakbrook
Terrace-based Superior, which was owned equally by the
Pritzker family of Chicago and the Dworman family in New
York, could cost the Savings Association Insurance Fund $300
million to $350 million, making it the most expensive thrift
failure since 1992.
In its consulting capacity, Ernst &
Young approved of the method Superior used to value certain
complex assets. As the bank's auditor, the accounting firm
for years affirmed that those same assets had been properly
valued, Gianni said. The FDIC did not disclose the amount of
fees paid by Superior to Ernst & Young.
In fact, those so-called "residual"
assets--generated by portions of loans the bank kept for
itself after selling the rest of the loans to
investors--were so overvalued on Superior's books that, when
they were adjusted in 2001 to meet regulators' requirements,
the bank became significantly undercapitalized and
Ernst & Young spokesman Les Zuke
said, "We're surprised by the description of our fees." He
would not confirm or deny that the firm did consulting work
for Superior, but said the firm continues to work with
regulators investigating Superior's failure.
In a statement, the accounting firm
blamed Superior's failure on three factors: a substantial
high-risk loan portfolio, multiple and rapid declines in
interest rates beginning early in 2001, and a quickly
deteriorating economy that had a disproportionate impact on
borrowers to whom Superior catered.
Red flags missed
Gianni and others blamed the Office
of Thrift Supervision, Superior's primary regulator and an
agency of the Treasury Department, for not acting sooner to
remedy the bank's problems, which they said were evident
beginning in the mid-1990s.
"Superior exhibited many of the
same red flags and indicators reminiscent of problem thrifts
of the 1980s and early 1990s," said Jeffrey Rush Jr.,
inspector general of the Treasury Department.
Rush later said his office is
working with regulators and the Department of Justice to
determine whether there were violations of federal law in
connection with Superior's failure. OTS examiners were aware
of unusual methods the bank used to value its so-called
residual assets, but continued to believe that Superior
officials and Ernst & Young knew what they were doing.
Rush attributed the lack of
regulatory skepticism to an OTS belief that "the owners
would never allow the bank to fail, Superior management was
qualified ... and external auditors could be relied on to
attest to Superior's residual asset valuations. All of these
assumptions proved to be false."
No one at the OTS has been fired
because of Superior's failure, OTS spokesman Sam Eskenazi
said, but there have been personnel moves among people
involved with the case. He would not elaborate on those
Panelists praised the FDIC for
reaching an agreement recently with other bank regulators
that allows the agency to take part more frequently in
financial institution examinations. The OTS had denied an
FDIC request to participate in a 1999 exam of Superior.
Whatever the shortcomings of
Superior's auditors and regulators, the people most to blame
were its management, directors and owners, according to the
Subprime lending a culprit
They pointed particularly to
Superior's 1993 move into subprime lending, a riskier form
of lending that targets customers with poor credit
histories, and its overvaluation of assets connected to
loans that were sold to investors.
The failure "was directly
attributable to the bank's board of directors and executives
ignoring sound risk management principles," Gianni said.
"Numerous recommendations contained in various OTS
examination reports beginning in 1993 were not addressed by
the board of directors or executive management."
A Pritzker family spokesman had no
comment about that accusation, and a Dworman spokesman did
not return telephone calls.
In November, the FDIC approved the
sale of $1.1 billion in deposits and about $45 million in
assets from the defunct Superior to Cleveland-based Charter
One. It is expected to sell the rest of Superior's old
business, the subprime lender Alliance Funding, soon.
This paper presents an historical and rhetorical analysis of
auditor independence concepts. This analysis is relevant as
the newly formed Independence Standards Board in the U.S. is
beginning work on a conceptual framework of audit
independence to use as a basis for regulation. Debate about
independence concepts has a long history and some elements
of the accounting profession are suggesting that a radical
turn away from historical and philosophical conceptions of
independence is currently needed. Independence concepts are
both defined and limited by the metaphors used to convey
them. These metaphors in turn reflect culturally significant
narratives of legitimation. Both the metaphors and
legitimating narratives surrounding auditor independence are
historically rooted in the moral philosophy framework of the
ethics of rights. Current independence proposals represent a
shift from the profession=s traditional moral philosophy
grounding to a basis in economic concepts and theory. The
character of the independent auditor is changing from
"judicial man” to "economic man.” A number of consequences
to the standing of the profession in the public's eyes, as
well as to its internal character, may arise from the
changing narrative of auditor independence
Messages from Paul Williams and Elliot Kamlot on January 11,
From: Paul Williams
Sent: Friday, January 11, 2002 7:40 AM
Subject: Re: Professionals
Has the time finally arrived when serious discussion needs
to occur about the absurdity of "independence" and having
profit motivated individuals perform an activity that they
apparently have no spirit for? The classic functionalist
notion of professional connoted someone who performed an
activity for its own sake and performing it excellently was
the objective (MacIntyre's notion of the excellence of a
practice). Doing it only for the money, though it is the
model of human nature that dominates our discourse, is not
conducive to one becoming a "classic" professional. And if
classic professionalism is indeed an impossiblity in a world
jaded by "wealth creation," then, since the audit function
is essentially a regulatory activity, let regulators do it.
On 10 Jan 02, at 17:04,
> If Andersen doesn't quit it, we accountants will go from
> clowns. I'm ready to sue them for their impact on the
profession of which
> I am a member! >
Reply from Bob Jensen
on January 11, 2002
Try to sue the government for
a bad audit or a bad investigation. At least when the Big Five
lets investors down, investors can unleash tort vultures that
hover over the Big Five offices daily waiting for a chance to
swoop down. Investors like the University of California are
suing Andersen big time at the moment, but try suing the SEC
if it should happen to conduct a bad investigation of Andersen
What we have to keep in mind
is how easy it is for large industries (whether or not they
are oligopolies) to manipulate government watchdogs in
virtually all types of government in any part of the world. I
am not at all in favor of turning audits over to bureaucrats
directly under the thumbs of government leaders ---
bureaucrats immune from lawsuits because they work for the
government. How many of our present watchdog agencies such as
the FPC, the FDA, etc. are more like chearleaders than
regulators for the industries they are supposed to be watching
Consider the Enron scandal. It
is still unclear, at the start of the investigation, just how
"independent" Andersen was in its internal and external
auditing performance. It is clear, however, that many top
government officials in both the Executive and Legislative
branches of U.S. government were directly involved as
employees of Enron, its industry friends, or its auditor.
The Vice-President of the U.S.
is a very close friend of Enron's CEO Ken Lay, and President
Bush admits to a rather long friendship dating back to his
days as Governor of Texas. Our Attorney General Ashcroft has
had to bow out of the Justice Department's new criminal
investigation of Enron because of large donations to Ashcroft
by Enron and his close ties with Enron executives. It turns
out that many of our top government bureaucrats are former
Enron employees who probably got their appointments because of
Enron's ties with top government leaders. Even the new
Chairman of the SEC, Harvey Pitt, was a Lawyer for Enron's
internal and external auditors (Andersen).
My point is that investors
should not sleep easier if the SEC or some other government
agency becomes the auditor of business firms. If fact, I think
it will become an even bigger nightmare of influence peddling,
because elected officials sell out so easily and cheaply. The
present system has huge flaws, but I think it works better
than the Agriculture Department works in preventing frauds in
farm subsidy programs.
Try to sue the government for
a bad audit or a bad investigation. At least when the Big Five
lets investors down, investors can unleash tort vultures that
hover over the Big Five offices daily waiting for a chance to
swoop down. Investors like the University of California are
suing Andersen big time at the moment, but try suing the SEC
if it should happen to conduct a bad investigation of Andersen
Perhaps independence is the
wrong goal. Possibly public accounting auditors should someday
"insure" their audits and cut out the tort lawyers.
For a more
thoughtful and analytical discussion of "moral breakdown"
(the current one about which the rant below laments began in
the 19th century) see Chapter 7 of Andrew Abbott's, Chaos
of disciplines (University of Chicago Press, 2001).
In all, "about 18,000 to
20,000 employees lost money because their retirement accounts
were invested in Enron stock," says Karl Barth, an attorney
for Hagens and Berman, a Seattle law firm that's suing the
energy trader on behalf of the employees. Chances for quick
recovery appear nonexistent; the lawsuits won't be completed
for years, corporate bankruptcy filings typically send
shareholders to the back of the creditors line and, on Jan.
15, the New York Stock Exchange delisted Enron's stock. ---
This message contains
two messages from Steve Zeff (Rice University) and one from
me. I will begin with my message. Dr. Zeff, former President
of the American Accounting Association, is one of our most
dedicated accounting historians. In November 2001, Stephen A.
Zeff received the Hourglass Award from the Academy of
Accounting Historians. His homepage is at
Steve's first message
below deals with the "state of professional decline" in public
His second message
(at the bottom) was prompted by my appeal to him to bring more
of his vast knowledge of history to bear upon our exchanges on
I think both of his
messages tell us a lot about the state of affairs that led up
to the Enron scandal (which sadly centers in his own home
The only thing that I
take exception with is his statement that I am one of the few
who really cares about the state of professional decline.
There are, in fact, many who have been far more courageous
than me to document the decline in professionalism in
accounting practice, scholarship, and research, headed by such
critical scholars as Steve Zeff, Abraham Briloff, Eli Mason,
Tony Tinker, Paul Williams, and others willing to speak out
over the past three decades. See
I hope you will
carefully read the two messages from Dr. Zeff that follow my
From: Jensen, Robert
Sent: Sunday, December 30, 2001 2:13 PM
To: 'Stephen A. Zeff'
Subject: RE: threads on accounting fraud
What a nice message to encounter in my message box. Thank
you for the kind words.
think your remarks should be shared with accounting
educators. Would you mind if I place your remarks in my next
(probably January 5) edition of New Bookmarks? The archives
hear from you so rarely that it is really a pleasure when I
get a message from you. I have more respect for your
dedication to our craft than you can ever imagine. I wish
that you, like Denny Beresford, would share your vast
storehouse of accounting knowledge and history with
accounting educators on the AECM ---
younger accounting educators communicating on the AECM are
very bright and skilled in technology, but they are usually
a mile wide and an inch deep when it comes to accounting
don't recall if I ever told you this, but your efforts to
find Marie in the Rice alumni database led to the subsequent
marriage between her and my friend Billy Bender. Both were
well into their eighties on the wedding day. They were
engaged while both attended Rice University in the 1940s,
but the war called Billy away to be a Navy pilot. They had
no subsequent contact for over 50 years until you helped
Billy find Marie.
Yesterday I happened across your Threads on Accounting
Fraud, etc. (the Enron case) at
http://www.trinity.edu/rjensen/fraud.htm , and I found
it to be fascinating reading. I had already seen quite a few
of the items, but I knew I could count on you to pull
everything--and I mean everything--together. You do wonders
on the Internet.
don't know if you recall seeing my short article, "Does the
CPA Belong to a Profession?" (Accounting Horizons, June
1987). The previous year, I was invited by the chairman of
the Texas State Board of Public Accountancy to give a
15-minute address to newly admitted CPAs at the Erwin Center
in Austin in November. Even though I am not a CPA, I
accepted. I asked if they would mind if I were to say
something controversial. They said no. Some 2,500
candidates, relatives and friends, and elders of the
profession were in attendance, the largest audience to which
I have ever spoken. Typically at such gatherings, the
speaker enthuses about the greatness of the profession the
candidates are about to enter. Instead, I opted to discuss
whether the CPA actually belongs to a profession, and my
view came down heavily on the skeptical side. Some of the
questions I raised are being raised today about the
supposedly independent posture of auditors and about the
teaching of accounting. Fifteen years have passed, and
things don't seem to have changed.
address raised the question of whether the CPA certification
constitutes a union card, a license to practice a trade, or
admission to a profession. I reviewed a number of recent
trends, including the growing commercialization of the
practice of accounting, the increasing number of points of
possible conflict between the widening scope of services and
the attest function, the decline in the vitality of the
professional literature, and the even greater emphasis on
the rule-bound approach to teaching accounting in the
universities. My conclusion was that accounting was in a
state of professional decline that should concern all of its
Following the address, I expected to be taken to task for
using such a solemn occasion, at which speakers are normally
heard to celebrate the profession, to deliver a pessimistic
message. I was, however, astonished that not one of the
professional leaders in attendance uttered a word of
criticism. When I pointedly asked several of the senior
practitioners for their reaction to my remarks, the general
response was a shrug of their shoulders. Yes,
professionalism is not what it once was, but there seemed to
be little that one could, or should, do to attempt to
reverse the trend. This wholly unexpected reaction led me to
conclude that I had underestimated the depth and
pervasiveness of the malaise in the profession.
wish you and Erika a Happy New Year.
Subsequent Message received from Steve Zeff
It's always a delight to hear from you. Yes, of course you
have my permission to place my remarks in your Bookmarks.
fact, a lot of what I know about accounting history was
packed into my recent book, Henry Rand Hatfield: Humanist,
Scholar, and Accounting Educator (JAI Press/Elsevier, 2000).
some years in the early 1990s, I wrote to successive
directors of the AAA's doctoral consortium to persuade them
that a session should be provided on the history of
accounting thought. When the directors replied (which was
less than half the time), they said that their planned
programs were already full with the standard people and the
standard subjects. They typically do bring a standard setter
in (usually Jim Leisenring), but the last time someone held
a session on accounting history at the consortium was in
1987 (I was the presenter, and the students told me that the
subject I treated was entirely new to them.).Virtually no
top doctoral programs in the country treat accounting
history or even accounting theory. They deal only with how
to conduct analytical or empirical research, and the
references given to the students are, with a few exceptions
(Ball and Brown, and Watts and Zimmerman), from the last six
or eight years. Small wonder that tyro assistant professors
struggle to learn what accounting is all about once they
start teaching the subject. Our emerging doctoral students,
for years, have had no knowledge of the evolution of the
accounting literature, even the theory that is now finding
its way in the work of Stephen Penman and Jim Ohlson.
think that one of the aims of the consortium should be to
"round out" the intellectual preparation of the doctoral
students. Instead, the consortium goes deeper in the areas
Keep up the good work. You are one of the very few people in
our field who really cares. And you have done a great
deal--more than anyone else I know--to broaden the vision
and knowledge base of our colleagues.
Stephen A. Zeff
Herbert S. Autrey Professor of Accounting
Jesse H. Jones Graduate School of Management
Rice University 6100 Main Street Houston, TX 77005
of the most prominent
CPAs in the world sent me the following message and sent the
Bob, More on Enron.
It's interesting that this matter of performing internal
audits didn't come up in the testimony Joe Beradino of
Andersen presented to the House Committee a couple of days
addition to acting as
Enron Corp.'s outside auditor, Arthur Andersen LLP also
performed internal-auditing services for Enron, raising
further questions about the Big Five accounting firm's
independence and the degree to which it may have been
auditing its own work.
That Andersen performed "double duty" work for the
Houston-based energy concern likely will trigger greater
regulatory scrutiny of Andersen's role as Enron's
independent auditor than would ordinarily be the case after
an audit failure, accounting and securities-law specialists
also potentially could expose Andersen to greater liability
for damages in shareholder lawsuits, depending on whether
the internal auditors employed by Andersen missed key
warning signs that they should have caught. Once valued at
more than $77 billion, Enron is now in proceedings under
Chapter 11 of the U.S. Bankruptcy Code.
Internal-audit departments, among other things, are used to
ensure that a company's control systems are adequate and
working, while outside independent auditors are hired to
opine on the accuracy of a company's financial statements.
Every sizable company relies on outside auditors to check
whether its internal auditors are working effectively to
prevent fraud, accounting irregularities and waste. But when
a company hires its outside auditor to monitor internal
auditors working for the same firm, critics say it creates
an unavoidable conflict of interest for the firm.
Still, such arrangements have become more common over the
past decade. In response, the Securities and Exchange
Commission last year passed new rules, which take effect in
August 2002, restricting the amount of internal-audit work
that outside auditors can perform for their clients, though
not banning it outright.
certainly runs totally contrary to my concept of
independence," says Alan Bromberg, a securities-law
professor at Southern Methodist University in Dallas. "I see
it as a double duty, double responsibility and, therefore,
double potential liability."
Andersen officials say their firm's independence wasn't
impaired by the size or nature of the fees paid by Enron --
$52 million last year. An Enron spokesman said, "The company
believed and continues to believe that Arthur Andersen's
role as Enron's internal auditor would not compromise
Andersen's role as independent auditor for Enron."
Andersen spokesman David Tabolt said Enron outsourced its
internal-audit department to Andersen around 1994 or 1995.
He said Enron began conducting some of its own
internal-audit functions in recent years. Enron, Andersen's
second-largest U.S. client, paid $25 million for audit fees
in 2000, according to Enron's proxy last year. Mr. Tabolt
said that figure includes both internal and external audit
fees, a point not explained in the proxy, though he declined
to specify how much Andersen was paid for each.
Additionally, Enron paid Andersen a further $27 million for
other services, including tax and consulting work.
Following audit failures, outside auditors frequently claim
that their clients withheld crucial information from them.
In testimony Wednesday before a joint hearing of two House
Financial Services subcommittees, which are investigating
Enron's collapse, Andersen's chief executive, Joseph
Berardino, made the same claim about Enron. However, given
that Andersen also was Enron's internal auditor, "it's going
to be tough for Andersen to take that traditional tack that
'management pulled the wool over our eyes,' " says Douglas
Carmichael, an accounting professor at Baruch College in New
Tabolt, the Andersen spokesman, said it is too early to make
judgments about Andersen's work. "None of us knows yet
exactly what happened here," he said. "When we know the
facts we'll all be able to make informed judgments. But
until then, much of this is speculation."
Though it hasn't received public attention recently,
Andersen's double-duty work for Enron wasn't a secret. A
March 1996 Wall Street Journal article, for instance, noted
that a growing number of companies, including Enron, had
outsourced their internal-audit departments to their outside
auditors, a development that had prompted criticism from
regulators and others. At other times, Mr. Tabolt said,
Andersen and Enron officials had discussed their arrangement
Accounting firms say the double-duty arrangements let them
become more familiar with clients' control procedures and
that such arrangements are ethically permissible, as long as
outside auditors don't make management decisions in handling
the internal audits. Under the new SEC rules taking effect
next year, an outside auditor impairs its independence if it
performs more than 40% of a client's internal-audit work.
The SEC said the restriction won't apply to clients with
assets of $200 million or less. Previously, the SEC had
imposed no such percentage limitation.
The Gottesdiener Law Firm, the
Washington, D.C. 401(k) and pension class action law firm
prosecuting the most comprehensive of the 401(k) cases pending
against Enron Corporation and related defendants, added new
allegations to its case today,
charging Arthur Andersen of Chicago with knowingly
participating in Enron's fraud on employees. Lawsuit Seeks
to Hold Andersen Accountable for Defrauding Enron Investors,
Andersen and the other firms "shifted their focus from
prestige to profits --- and thereby transformed the firm. "
The same thing happened in Morgan Stanley and other
investment banking firms. Like it or not, the quote below from
Frank Partnoy (a Wall Street insider) seems to fit accounting,
banking, and other firms near the close of the 20th Century.
From Page 15 of the most depressing book that I have ever
read about the new wave of rogue professionals. Frank Partnoy
in FIASCO: The Inside Story of a Wall Street Trader (New York:
Penguin Putnam, 1997, ISBN 0 14 02 7879 6)
This was not the Morgan Stanley of
yore. In the 1920s, the white-shoe (in auditing that would
be black-shoe) investment bank developed a reputation for
gentility and was renowned for fresh flowers and fine
furniture (recall that Arthur Andersen offices featured
those magnificent wooden doors), an elegant partners' dining
room, and conservative business practices. The firm's credo
was "First class business in a first class way."
However, during the banking heyday
of the 1980s, the firm faced intense competition from other
banks and slipped from its number one spot. In response,
Morgan Stanley's partners shifted their focus from prestige
to profits --- and thereby transformed the firm. (Emphasis
added) Morgan Stanley had swapped its fine heritage for
slick sales-and-trading operation --- and made a lot more
I refer you back to the Fortune
article some years ago (old timers may remember it) that
referred to then AA&Co as the "Marine Corp of the accounting
Profession." In those days there were no "rogue partners." I
wonder what changed?
survey of Canadian business executives shows immense
support for auditing reforms. The reforms that scored
Making it illegal to have liabilities off the balance
Barring accountants from providing both auditing and
consulting to the same client.
This response seems somewhat surprising in view of two other
Few executives feel strongly that the accounting
profession is responsible for high profile collapses, such
as Enron and past meltdowns in Canada.
Most say they have a high level of confidence in the
ethics of the accounting or auditing firm employed by
their own organizations. The executives ranked the ethics
of their own auditors a very high 6.0 out of a possible 7.
press accounts attribute the seemingly contradictory
results to differences between big accounting firms and
smaller ones. They point out that many survey respondents
typically come from small to mid-sized companies not audited
by large accounting firms.
When asked how much confidence they have in the ethics of
the (presumably larger) firms auditing large publicly traded
companies, the executives were decidedly less kind, ranking
these firms only a 4.7 out of a possible 7.
A Research Study
On Audit Independence Prior to the Enron Scandal
External Auditing Combined With Consulting and Other
Assurance Services: Audit Independence?
Independence and Earnings Quality"R AUTHORS:
Richard M. Frankel MIT Sloan School of Business 50 Memorial
Drive, E52.325g Cambridge, MA 02459-1261 (617) 253-7084
Marilyn F. Johnson Michigan State University Eli Broad
Graduate School of Management N270 Business College Complex
East Lansing, MI 48824-1122 (517) 432-0152
Karen K. Nelson Stanford University Graduate School of
Business Stanford, CA 94305-5015 (650) 723-0106
email@example.com DATE: August 2001 LINK:
have found that the provision of consulting services to
audit clients can have a serious effect on a firm's
And the new
SEC rules designed to counter audit independence violations
could increase the pressure to provide non-audit services to
clients to an increasingly competitive market.
study (pdf format), by the Stanford Graduate School of
Business, showed that forecast earnings were more likely to
be exceeded when the auditor was paid more for its
suggests that earnings management was an important factor
for audit firms that earn large consulting fees. And such
firms worked at companies that would offer little surprise
to the market, given that investors react negatively when
the auditor also generates a high non-audit fee from its
used data collected from over 4,000 proxies filed between
February 5, 2001 and June 15, 2001.
concluded: "We find a significant negative market reaction
to proxy statements filed by firms with the least
independent auditors. Our evidence also indicates an inverse
relation between auditor independence and earnings
the least independent auditors are more likely to just meet
or beat three earnings benchmarks – analysts' expectations,
prior year earnings, and zero earnings – and to report large
discretionary accruals. Taken together, our results suggest
that the provision of non-audit services impairs
independence and reduces the quality of earnings."
rules mean that auditors have to disclose their non-audit
fees in reports. This could have an interesting effect, the
study warned: "The disclosure of fee data could increase the
competitiveness of the audit market by reducing the cost to
firms of making price comparisons and negotiating fees.
addition, firms may reduce the purchase of non-audit
services from their auditor to avoid the appearance of
Lancaster University study in February this year found
that larger auditors are less likely to compromise their
independence than smaller ones when providing non-audit
services to their clients.
sister site, AccountingWEB-UK, reports that
research by the Institute of Chartered Accountants in
England & Wales (ICAEW) showed that, despite the prevalence
of traditional standards of audit independence, the
principal fear for an audit partner was the loss of the
Researchers Mark L. DeFond and K.R.
Subramanyam at USC's Leventhal School of Accounting (part of
the Marshall School of Business), with K. Raghumandan at
Texas A&M International University, find no association
between consulting service fees and the auditor's propensity
to issue a going concern opinion. Issuing a going concern
opinion means that the auditor must be able to objectively
evaluate firm performance and withstand client pressure to
issue a clean opinion.
The SEC recently adopted new
regulations requiring public companies to disclose all fees
paid to their outside auditors. The SEC suspects that
accounting firms are too dependent financially on their
clients that purchase both auditing and consulting services
to be objective, to maintain independence and to report
possible conflicts of interests.
Contradicting the SEC's concerns,
DeFond and Subramanyam and their co-author also demonstrate
that higher audit fees (after controlling for consulting
fees) actually encourage greater auditor independence. Firms
are more likely to issue going concern opinions for clients
paying higher audit fees.
The study analyzes 944 financially
distressed firms with proxy statements that include audit
fee disclosures for the year 2000, including 86 firms
receiving first-time going concern audit reports. Examining
the total fees charged, the researchers find that consulting
fees have no effect on the incidence of going concern
reports, and that higher audit fees actually increase the
propensity of auditors to issue going concern reports,
contrary to SEC suspicions.
The authors conjecture that the
reputation and litigation damages associated with audit
failure are greater for larger clients (for example such as
Enron), encouraging auditors to be more conservative with
respect to their larger clients.
"The loss of reputation and
litigation costs provide strong incentives for auditors to
maintain their independence," says DeFond. "Our study
provides evidence that these incentives outweigh the
economic dependency created by higher fees."
DeFond specializes in
economics-based accounting and auditing research. He serves
as the Joseph A. DeBell Professorship in Business
Administration at USC's Leventhal School of Accounting, part
of the Marshall School of Business, and is a CPA with six
years' experience at a "Big Five" firm.
K.R. Subramanyam (SU-BRA-MAN-YAM)
specializes in earnings management and valuation. His
research on the effects of the SEC's fair disclosure rule
earned him national attention in 2001.
A Bit of Accountancy Humor Inspired by Enron and
the Scandals That Follow and Follow and . . .
Possible headlines on the Enron saga
following the guilty plea of Michael J. Kopper:
Kopper Wired to the Top Brass (with reference to his
promise to rat on his bosses)
The Coppers Got Kopper
Kopper Cops a Plea
Kopper’s Finish is Tarnished
Kopper in the Kettle
A Kopper Whopper
These are Jensen originals, although I probably shouldn’t
audits got "behind!"
When Waste Management audits ignored smelly stuff.
Andersen's unveilings bottomed out,
When Victoria Secret audits turned into doubt.
the latest criminal issue,
Is Andersen's clean wipe of American Tissue.
AccountingWEB US - Mar-12-2003 - In yet another black mark
against the now-defunct accounting firm of Arthur Andersen,
LLP, a former senior auditor of the firm has been arrested
in connection with the audit of American Tissue, the
nation's fourth-largest tissue maker. Brendon McDonald,
formerly of Andersen's Melville, NY office, surrendered
Monday at the United States Courthouse in Central Islip, NY.
He could face as much as 10 years in prison for his role in
allegedly destroying documents related to the American
McDonald is accused of deleting e-mail messages, shredding
documents, and aiding the officers of American Tissue in
defrauding lenders of as much as $300 million. American
Tissue's chief executive officer and other executives were
also arrested and charged with various counts of securities
and bank fraud and conspiracy.
According to court documents, American Tissue inflated
income and diverted money to subsidiaries in an attempt to
make the company eligible to borrow additional money. "The
paper trail of phony sales transactions, bogus supporting
documentation and numerous accounting irregularities ended
quite literally with the destruction of the falsified
documents by American Tissue's auditor," said Kevin P.
Donovan, an assistant director of the Federal Bureau of
Investigation, according to a statement that appeared in The
New York Times ("Paper Company Officials Charged," March 11,
With tongue in cheek,
New Yorker and writer Andy Borowitz has penned a new
book that successfully captures what humor can be found in the
recent rash of corporate malfeasance ---
A friend told me the
following story about a former Enron accountant who gave up
his CPA position to become a farmer. The first thing he
decided to do was to buy a mule.
He dickers with a
local farmer at the general store, and they agree that the
local will sell the accountant a mule for $100. The Enron
accountant gives the man $100 cash, and the man agrees to
deliver the mule the next day.
Next morning, the man
shows up at the Enron accountant's place without the mule.
"I'm sorry," he explains, "but the mule died last night. I
guess I owe you the $100 back."
"Hey, no problem,"
says the accountant. "Just keep the money, and as for the
mule, hey, go ahead and dump him in my barn anyway. I'll
raffle him off."
"Ain't nobody around
here going to buy a dead mule," says the local farmer.
"Leave that to me. I
worked for Enron," replies the accountant.
A week later, the
farmer meets the accountant back at the general store, and
asks, "So, how'd you make out with the dead mule?"
"Great," replies the
accountant. "I sold over 1000 raffle tickets for $2 each, to
my former stockholders and debtholders. Nobody ever bothered
to ask if the mule was alive or not."
"But didn't the
winner complain when he found out?" asked the farmer.
"Yep, he sure did,
and being the honest, ethical man that I am, I refunded his $2
to him promptly."
"So my profit, after
deducting my $100 cost for the dead mule and the $2 sales
allowance, is $1898. By the way, do you have any chickens?"
Exodus of Enron employees carrying all their
Accounting firm Arthur Andersen took another beating
Thursday night, but this time it was at a minor league
baseball game instead of in a Texas courtroom.
Portland Beavers, the triple-A farm team for the San Diego
Padres, held "Andersen Appreciation Night" during its game
with the Edmonton Trappers at PGE Park.
While Edmonton won the game, 9-1 -- that's the real score --
the team announced record attendance of 58,667. But there
were only 12,969 fans who actually attended the game. The
fans bought $5 tickets but were given $10 receipts for
accounting purposes as a one-time "nonrecurring charge."
game also featured a trivia quiz, where the prize was
awarded to the fan whose guess was furthest from the correct
answer. The question was: "How many career pitching wins
[did] Gaylord Perry have?" A woman won by guessing in the
single digits -- she was off by about 320.
Fans were encouraged to bring their own documents that could
be destroyed at "shredding stations" throughout the park.
addition, the 90 people with either "Arthur" or "Andersen"
in their names who attended were given free admission. Two
people named Arthur Andersen were among them.
Roger Devine of Portland, who attended the game, said some
fans were momentarily befuddled by inflated player stats
that appeared on the scoreboard during the first inning.
"The people sitting next to me were from out of town and
they were going 'This guy's batting .880? What the hell?'"
Pro-Formalist Movement Gets WorldCom, Andersen Off Hook;
Washington, D.C. (SatireWire.com) - In a surprise decision
that exonerates dozens of major companies, the U.S. Supreme
Court today ruled that corporate earnings statements should be
protected as works of art, as they "create something from
nothing." One plus one is two. That is math. That is science.
But as we have seen, earnings and revenues are abstract and
original concepts, ideas not bound by physical constraints or
coarse realities, and must therefore be considered art," the
Court wrote in its 7-2 decision. The impact of the ruling was
widespread. Investigations into hundreds of firms were
canceled, and collectors began snatching up original balance
sheets, audits, and P&L statements from WorldCom, Enron, and
Global Crossing. Meanwhile, auditing firms such as Arthur
Andersen (now Art by Andersen) were reclassified as art
critics, whose opinions are no longer liable. "Before we had
to go in and decide, 'Is it right, or is it wrong?'" said KPMG
spokesman Dan Fischer. "Now we must only decide, 'Is it
In Congress, all
further hearings into irregularities were abandoned in favor
of an abstract accounting lecture given by Scott Sullivan,
former Chief Financial Artist of WorldCom, which had been
charged with fraud for improperly accounting for $3.85
billion. "Art should reflect life, so what I was really trying
to accomplish with this third quarter report was acknowledge
that life is an illusion," said Sullivan, explaining his
acclaimed work, "10Q for the Period Ending 9/30/01." U.S. Rep.
Billy Tauzin of Louisiana, however, was forced to apologize,
admitting he could only see a lie. "Yes, well, a man with a
concretized view of the world may only be able to see numbers
that 'Don't add up,'" said a haughty Sullivan. "But someone
whose perceptions are not always chained to reality - a stock
analyst, say - may see numbers that, like the human spirit,
aspire to be greater than they are." Several Sullivan pieces
are now part of a new show at New York's Museum of Modern Art
entitled, "Shadows; Spreadsheets: The Origins of
Pro-Formalism." Robert Weidlin, an SEC investigator and avid
collector, was among the first to peruse the Enron exhibit,
which takes up an entire wing of the museum. "You look at
these works, and you say 'Is this a profit, or a loss? Is this
firm a subsidiary, or a holding company?'" said Walden. "I
have stood in front of this one balance sheet for hours, and
each moment I come away with something different." Like other
patrons, Weidlin said he didn't know whether to be impressed
or outraged, a reaction that pleased Andrew Fastow, the former
Enron CFA who is a leading proponent of the Trompe
L'Shareholder style. "An artist should not be afraid to be
shocking," said Fastow. "
As did the
Modernists, we should fearlessly depart from tradition and
embrace the use of innovative forms of expression. Like, say,
'Special Purpose Entities' and 'Pooling of Interests.'"
Sullivan, meanwhile, said he was influenced by the Flemish
Masters, particularly Lernout Hauspie, the Belgian speech
recognition software company that collapsed last year after an
audit discovered the firm had cooked its books in 1998, 1999,
and 2000. "Lernout Hauspie simply invented sales figures, just
willed them out of thin air and onto the paper," he said. "Me?
I must live with a spreadsheet a long time before I begin to
work it. You must be patient and wait until the numbers reveal
themselves to you." And what about the reaction to his work?
"I realize people are angry, people are hurt. But I cannot
concern myself with that," he said. "As with all true artists,
I don't expect to be understood during my lifetime." (The MOMA
exhibit runs through Sept. 3. Admission is $8, excluding a
one-time write down of deferred stock compensation and other
costs associated with the carrying value of inventory.)
TIMING IS EVERYTHING in humor, but the jokes told by a few
former Enron executives on a recently surfaced videotape
border on bad taste in light of the events of the past year.
Home Video Uncovered by the Houston Chronicle, December
19, 2002 Skits for Enron ex-executive funny
then, but full of irony now ---
http://www.chron.com/cs/CDA/story.hts/metropolitan/1703624 (The above link includes a "See it Now" link to
download the video itself which played well for me.)
Question: How does former Enron CEO Jeff Skilling define
tape, made for the January 1997 going-away party for former
Enron President Rich Kinder, features nearly 30 minutes of
absurd skits, songs and testimonials by company executives
and prominent Houstonians. The collection is all meant in
good fun, but some of the comments are ironic in the current
climate of corporate scandal.
one skit, former administrative executive Peggy Menchaca
plays the part of Kinder as he receives a budget report from
then-President Jeff Skilling, who plays himself, and
financial planning executive Tod Lindholm. When the pretend
Kinder expresses doubt that Skilling can pull off 600
percent revenue growth for the coming year, Skilling reveals
how it will be done.
"We're going to move from mark-to-market accounting to
something I call
or hypothetical future value accounting," Skilling jokes as
he reads from a script. "If we do that, we can add a
kazillion dollars to the bottom line."
Richard Causey, the former chief accounting officer who was
embroiled in many of the business deals named in the
indictments of other Enron executives, makes an unfortunate
joke later on the tape.
"I've been on the job for a week managing earnings, and it's
easier than I thought it would be," Causey says, referring
to a practice that is frowned upon by securities regulators.
"I can't even count fast enough with the earnings rolling
Texas' political elite also take part in the tribute, with
then-Gov. George W. Bush pleading with Kinder: "Don't leave
Texas. You're too good a man."
Former President George Bush also offers a send-off to
Kinder, thanking him for helping his son reach the
"You have been fantastic to the Bush family," he says. "I
don't think anybody did more than you did to support
Borden showed me that it is possible to download and save
this video using Camtasia. Thank you Jim. It is not a
perfect capture, but it gets the job done.
develop new skills, generally technical ones -- often by
To see the full Buzzword Compliant Dictionary. Click here.
http://www.buzzwhack.com According to Ed Scribner, former Enron
employees have a different definition for "upskilling."
The corporate scandals are
getting bigger and bigger. In a speech on Wall Street,
President Bush spoke out on corporate responsibility, and he
warned executives not to cook the books. Afterwards, Martha
Stewart said the correct term was to saute the books.
Martha Stewart denied
allegations that she had been given inside information to
sell 4,000 shares of a stock in a biotech firm about to go
under. Stewart then showed her audience how to make a
festive, quick-burning yule log out of freshly-shredded
financial documents. Dennis Miller
In New York the other day, there
was a pro-Martha Stewart rally. Only four people showed up
... and three of them were made out of crepe paper! Conan O'Brien
When reached for comment on the
charges, Martha didn't say much, (only) that a subpoena
should be served with a nice appetizer.
NBC is making a movie about
Martha Stewart that will cover the recent stock scandal.
They are thinking of calling it 'The Road To Extradition."
Things are not looking good for
Martha Stewart. Her stock was down 23 percent yesterday.
Wow, that dropped quicker than Dick Cheney after a
Tom Ridge announced a new
color-coded alarm system. ... Green means everything's okay.
Red means we're in extreme danger. And champagne-fuschia
means we're being attacked by Martha Stewart.
EBITDA Earnings Before I Tricked the Dumb Auditor
EBIT Earnings Before Irregularities and Tampering
CEO Chief Embezzlement Officer
CFO Corporate Fraud Officer
NAV Nominal Andersen's Valuation
FRS Fantasy Reporting Standards
P/E Parole Entitlement
EPS Eventual Prison Sentence
Paul Zielbauer in The New York Times reports on the
new Enron lexicon developing:
To "enronize" means "to hide fiscal shortcomings through
slick financial legerdemain and bald-faced lies."
It is "enronic" when a seemingly invincible person goes
down in flames.
"Enronica" refers to cheap souvenirs like Enron stock
"Enrontia" is the burning desire to shred things.
"Enronomania" is the mania for reform sweeping the
nation – the first good kind of mania the market has seen in
a very long time.
Note the 1995 Year Below The accountants at Arthur Andersen
knew Enron was a high-risk client who pushed them to do things
they weren’t comfortable doing. Testifying in court in May,
partner James Hecker said he wrote a parody to that effect in
The Financial Times of London reported: "To the tune of the
Eagles hit song ‘Hotel California,’ Mr. Hecker wrote lines
such as: ‘They livin’ it up at the Hotel Cram-It-Down-Ya, When
the [law]suits arrive, Bring your alibis.’"
[BizEthics@lb.bcentral.com] on May 15, 2002
I don't know who
wrote the following, but it was forwarded by a former student
who is at the local office of Arthur Andersen.
A take-off from the movies "A Few
Good Men" (Some phrases are in the original script and some
Tom Cruise: "Did you order the
Jack Nicholson: "You want answers?"
Tom Cruise: "I think I'm entitled."
Jack Nicholson: "You want
Tom Cruise: "I want the truth!"
Jack Nicholson: "You can't handle
Jack Nicholson: "Son, we live in a
world that has financial statements. And those financial
statements have to be audited by men with calculators. Who's
gonna do it? You? You, Dept. of Justice? I have a greater
responsibility than you can possibly fathom. You weep for
Enron and you curse Andersen. You have that luxury. You have
the luxury of not knowing what I know: that Enron's death,
while tragic, probably saved investors. And my existence,
while grotesque and incomprehensible to you, saves
investors. You don't want the truth. Because deep down, in
places you don't talk about at parties, you want me on that
audit. You need me on that audit! We use words like
materiality, risk-based, special purpose entity...we use
these words as the backbone to a life spent auditing
something. You use 'em as a punchline. I have neither the
time nor the inclination to explain myself to a man who
rises and sleeps under the blanket of the very assurance I
provide, then questions the manner in which I provide it.
I'd prefer you just said thank you and went on your way.
Otherwise, I suggest you pick up a pencil and start ticking.
Either way, I don't give a damn what you think you're
Tom Cruise: "Did you order the
Jack Nicholson: "You're damn right
Remember how the consulting divisions called Andersen
Consulting split off of Aurther Andersen and became a company
known as Accenture. Now you can also read about Indenture ---
November 2001 message from Ken Lay, CEO of Enron
This past weekend, I was rushing around in Houston, Texas
trying to do some holiday season shopping done. I was
stressed out and not thinking very fondly of the weather
right then. It was dark, cold, and wet in the parking lot as
I was loading my car up. I noticed that I was missing a
receipt that I might need later. So mumbling under my
breath, I retraced my steps to the mall entrance. As I was
searching the wet pavement for the lost receipt, I heard a
quiet sobbing. The crying was coming from a poorly dressed
boy of about 12 years old. He was short and thin. He had no
coat. He was just wearing a ragged flannel shirt to protect
him from the cold night's chill. Oddly enough, he was
holding a hundred dollar bill in his hand. Thinking that he
had gotten lost from his parents, I asked him what was
wrong. He told me his sad story. He said that he came from a
large family. He had three brothers and four sisters. His
father had died when he was nine years old. His Mother was
poorly educated and worked two full time jobs. She made very
little to support her large family. Nevertheless, she had
managed to skimp and save two hundred dollars to buy her
children some holiday presents (since she didn't manage to
get them anything during the previous holiday season).
young boy had been dropped off, by his mother, on the way to
her second job. He was to use the money to buy presents for
all his siblings and save just enough to take the bus home.
He had not even entered the mall, when an older boy grabbed
one of the hundred dollar bills and disappeared into the
night. "Why didn't you scream for help?" I asked. The boy
said, "I did." "And nobody came to help you?" I queried. The
boy stared at the sidewalk and sadly shook his head. "How
loud did you scream?" I inquired.
soft-spoken boy looked up and meekly whispered, "Help me!"
realized! that absolutely no one could have heard that poor
boy cry for help. So I grabbed his other hundred and ran to
Happy Thanksgiving everyone!
Kenneth Lay Enron CEO
A potential investor
came to seek investment advice from a financial analyst (F.A.).
The F.A. told the investor, " I have the experience, you have
Several weeks later,
after the investor has lost all the money from following the
advice of the F.A., the investor came to see the F.A. and the
F.A. said to the investor:
"You have the
experience, I have the money!"
I liked the one below about
Teaching Accounting in the 1970s. It is so True!
Also forwarded by
Accounting in 1950:
A logger sells a
truckload of lumber for $100.
His cost of
production is 4/5 of the price.
What is his profit?
Accounting in 1960:
A logger sells a
truckload of lumber for $100.
His cost of
production is 4/5 of the price, or $80.
What is his profit?
Accounting in 1970:
A logger exchanges a
set "L" of lumber for a set "M" of money.
The cardinality of
set "M" is 100. Each element is worth one dollar.
Make 100 dots
representing the elements of the set "M."
The set "C", the cost
of production contains 20 fewer points than set "M."
Represent the set "C"
as a subset of set "M" and answer the following
question: What is the
cardinality of the set "P" of profits?
Accounting in 1980:
A logger sells a
truckload of lumber for $100.
His cost of
production is $80 and his profit is $20.
Underline the number 20.
Accounting in 1990:
By cutting down
beautiful forest trees, the logger makes $20.
What do you think of
this way of making a living?
Topic for class
participation after answering the question:
How did the forest
birds and squirrels feel as the logger cut down the trees?
There are no wrong
Teaching Match in
A logger sells a
truckload of lumber for $100.
His cost of
production is $120.
How does Arthur Andersen determine that his profit margin is
In an Enron tort
litigation trial, the defense attorney was cross-examining a
Attorney: Before you
signed the death certificate, had you taken the pulse?
Attorney: Did you
listen to the heart?
Attorney: Did you
check for breathing?
Attorney: So, when
you signed the death certificate, you weren't sure the man was
dead, were you?
Coroner: Well, let me
put it this way. The man's brain was sitting in a jar on my
desk. But I guess he still managed to audit Enron.
Forwarded by George Lan
1. Enronitis : A company suffering from accounting
2. To do an "enron" : To do an end-run
One of my colleages keeps referring to "getting 'Layed.'"
Forwarded by Glen Gray
A company is interviewing
candidates for a new position.
The first candidate is an engineer.
The interviewer says, "I only have one question, what is 2
plus 2?" The engineer pulls out his calculator and punches
in the numbers and says, "4.000000."
The next candidate is a lawyer. She
says 4, but wraps her answer in legalize.
The third candidate is a CPA. When
asked what is 2 plus 2, he looks around and looks at the
interviewer and says, "Whatever you want it to be."
You have two cows. Your lord takes some of the milk.
You have two cows. The government takes both, hires you to
take care of them, and sells you the milk.
You have two cows. Your neighbors help take care of them and
you share the milk.
You have two cows. The government takes them both and denies
they ever existed and drafts you into the army. Milk is
You have two cows. You sell one and buy a bull. Your herd
multiplies, and the economy grows. You sell them and retire
on the income.
You have two cows. You sell three of them to your publicly
listed company, using letters of credit opened by your
brother-in-law at the bank, then execute a debt/equity swap
with an associated general offer so that you get all four
cows back, with a tax exemption for five cows. The milk
rights of the six cows are transferred via an intermediary
to a Cayman Island company secretly owned by the majority
shareholder who sells the rights to all seven cows back to
your listed company. The annual report says the company owns
eight cows, with an option on one more.
You have two cows. You borrow 80% of the forward value of
the two cows from your bank, then buy another cow with 5%
down and the rest financed by the seller on a note callable
if your market cap goes below $20B at a rate 2 times prime.
You now sell three cows to your publicly listed company,
using letters of credit opened by your brother-in-law at a
2nd bank, then execute a debt/equity swap with an associated
general offer so that you get four cows back, with a tax
exemption for five cows. The milk rights of six cows are
transferred via an intermediary to a Cayman Island company
secretly owned by the majority shareholder who sells the
rights to seven cows back to your listed company. The annual
report says the company owns eight cows, with an option on
one more and this transaction process is upheld by your
independent auditor and no Balance Sheet is provided with
the press release that announces that Enron as a major owner
of cows will begin trading cows via the Internet site COW
(cows on web).
case you were wondering how Enron came into so much trouble,
here is an explanation reputedly given by an Ag Eco
professor at Texas A&M, to explain it in terms his students
have two cows.
sell one and buy a bull.
Your herd multiplies and you hire cowhands to help out on
the ranch. You sell cattle.
economy grows and eventually you can pass the business on
and your cowhands can retire on the profits.
ENRON VENTURE CAPITALISM:
have two cows. You sell three of them to your publicly
listed company, using letters of credit opened by your
brother-in-law at the bank, then execute a debt/equity swap
with an associated general offer so that you get all four
cows back, with a tax exemption for five cows.
milk rights of the six cows are transferred via an
intermediary to a Cayman Island company secretly owned by
the majority shareholder who sells the rights to all seven
cows back to your listed company.
annual report says the company owns eight cows, with an
option on one more.
do you see why a company with $62 billion in assets is
"President Bush didn't help the company's image, joking
over the weekend that Saddam Hussein has now agreed to weapons
inspections. "The bad news is he wants Arthur Andersen to do
it," Bush said."
The founder-namesake of the
Enron-racked accounting megafirm (Arthur Andersen)
was born in 1885, the stalwart son of
new Norwegian immigrants, and to his dying day in 1947 at age
61, he maintained a passion for preserving Norwegian history.
He even held an honorary degree from St. Olaf College. And
would you believe he straightened out the finances of a
pioneering energy empire and won his reputation for honesty by
keeping it from bankruptcy? Is that a cosmic joke, or what?
Not if you bought Enron stock at $80 a share, it's not. Ken Ringle Washington Post Staff Writer ---
(There are some humorous and some sobering parts of this
article by Ken Ringle that Don Ramsey pointed out to me.)
neither hunters nor gatherers. We are accountants..
New Yorker Cartoon
to you now Miller. The only thing that can save us is an
New Yorker Cartoon
life's report card.
New Yorker Cartoon
is craft. Billions is art.
New Yorker Cartoon
strength is the strength of ten, because I'm rich. New Yorker Cartoon
Picture a Pig Ready for Market
Basic economics --- sometimes the parts
are worth more than the whole.
New Yorker Cartoon
drive yourself too hard. You really must learn to take time
to stop and sniff the profits.
New Yorker Cartoon
I was on
the cutting edge. I pushed the envelope. I did the heavy
lifting. I was the rain maker. Then suddenly it all crashed
when I ran out of metaphors.
New Yorker Cartoon
we might, sir, our team of management consultants has been
unable to find a single fault in the manner in which you
conduct your business. Everything you do is a hundred per
cent right. Keep it up! That will be eleven thousand
dollars. New Yorker Cartoon
I rolled out this morning...ACEMers had email systems on
AccountingWeb tells of an audit failure long after old Enron
SmartPros shows us how accounting careers have grown dicey
It's gonna get worse you see, we need a change in policy
There's a Wall Street Journal rolled up in a rubber band
One more sad story's one more than I can stand
Just once, how I'd like to see the headline say
Not much to print about, can't find any frauds today
Nobody cheated on taxes owed
No lawsuits filed, no investors got POed
No new FASB rules, no unaccounted stock options in our pay
We sure could use a little good news today
I'll come home this evening...I'll bet that the news will
be the same
Ernst & Young's fired a partner, PwC's been found to blame
How I wanna hear the anchor man talk about a county fair
And how we cleaned up the air...how everybody's playing fair
Whoa, tell me...
Nobody was cheated by their brokers
And the mutual funds all played square
And everybody loves everybody in the good old USA
We sure could use a little good news today
Nobody embezzled a widow on the lower side of town
Nobody OD'd, only the courthouses got burned down
Nobody failed an exam...nobody cussed out FAS 133
Now that would surely be good news for me
I am looking for an "accounting"
song. I would like to be able to have a popular song and
change some of the lyrics to include basic accounting
principles but my creative juices do not flow in that way.
Does anyone know of such a parody?
--- end of quote ---
"Enron-Ron-Ron" (on the Capital Steps CD, "When Bush comes
to shove") and "When IRS Guys are Smilin'" (Capital Steps, "Unzippin'
My Doodah"). Also, the first part of "I want to be a
producer" (The Producers) deals with accounting.
Richard C. Sansing Associate
Professor of Business Administration Tuck School of Business
at Dartmouth 100 Tuck Hall Hanover, NH 03755
In a $2.1 billion action
against accounting firm Grant Thornton, a Baltimore Circuit
Court is investigating a possible violation involving the
withholding and willful destruction of audit records in a
manner likened to the contemporary but more- publicized Enron
case. A court action also alleges that a former director of
risk management and senior partner of the firm, "willfully,
knowingly, and intentionally destroyed (client) documents with
the full understanding that litigation was imminent."
Big Five firm Ernst & Young
has been hit with a lawsuit by Bull Run Corp., a company that
provides, among other things, marketing and event management
services to universities, athletic conferences, associations,
and corporations. The lawsuit alleges that E&Y failed to
discover material errors in its audit of a company that Bull
Run acquired in late 1999.
Andersen: The Enron Scandal's Other Big Donor
record-breaking 1999-2000 fund-raising cycle, very few
companies outpaced Enron's prolific giving to George W.
Bush. In fact, only 11 companies gave more money to the
Bush-Cheney ticket, and one of them was Arthur Andersen, the
embattled energy giant's now equally troubled auditor.
the fifth biggest donor to Bush's White House run,
contributing nearly $146,000 via its employees and PAC.
Furthermore, Andersen fielded one of Bush's biggest
individual fund-raisers that year. D. Stephen Goddard, who
until yesterday was the managing partner of Andersen's
Houston office, was one of the "Pioneers," individuals who
raised at least $100,000 for the Bush campaign during
1999-2000. (Goddard was among the employees "relieved of
their duties" Tuesday by Andersen.)
only the tip of the iceberg when it comes to Andersen's
political ties to Washington. As Congress prepares to launch
hearings into the Enron collapse, lawmakers will be
examining two companies whose political giving has affected
the bottom line of nearly every campaign on Capitol Hill.
Since 1989, Andersen has contributed nearly $5 million in
soft money, PAC and individual contributions to federal
candidates and parties, more than two-thirds to Republicans.
Enron's giving was concentrated mainly in big soft money
gifts to the national political parties, Andersen's
generosity often was targeted directly at members of
Congress. For instance, more than half the current members
of the House of Representatives were recipients of Andersen
cash over the last decade. In the Senate, 94 of the
chamber's 100 members reported Andersen contributions since
biggest recipients, members of Congress now in charge of
investigating Andersen's role in the Enron debacle-a list
that includes House Energy and Commerce Committee chairman
Billy Tauzin (D-La.), who, with $47,000 in contributions, is
the top recipient of Andersen contributions in the House.
In the fall
of 2000, Tauzin helped broker a deal between the Securities
and Exchange Commission and the Big Five accounting firms,
including Andersen, which essentially dropped the SEC's push
to restrict auditors from selling consulting services to
their clients. The provision had been aimed at ending what
the SEC had deemed a major conflict of interest between
accountant's duties as an auditor and the money they earn to
consult on behalf of that same client.
SEC could act, however, the accounting industry unleashed a
massive lobbying campaign to block the proposed rule. In
Andersen's case, it nearly doubled its campaign
contributions-going from $825,000 in overall spending during
the 1997-98 election cycle to more than $1.4 million in
1999-2000. In lobbying expenditures alone, Andersen spent
$1.6 million between July and December 2000-compared to
$860,000 for the first six months of that year.
what kind of impact, if any, the proposed rule might have
had on the Enron collapse. Andersen, according to press
reports, collected $25 million in auditing fees and $27
million in consulting fees from Enron during 2001.
for a breakdown of Andersen contributions, including
contributions to members of Congress and presidential
candidates, as well as information on the company's lobbying
expenditures and other money in politics stats:
article is much too long to do justice to in a few quotes. I
did, however, extact the quotes connected with Andersen, the
firm that audited and certified the Enron financial statements
prior to Enron's meltdown.
collapse came swiftly for Enron Corp. when investors and
customers learned they could not trust its numbers. On
Sunday, six weeks after Enron disclosed that federal
regulators were examining its finances, the global
energy-trading powerhouse became the biggest bankruptcy in
Like all publicly traded companies in the United States,
Enron had an outside auditor scrutinize its annual financial
results. In this case, blue-chip accounting firm Arthur
Andersen had vouched for the numbers. But Enron, citing
accounting errors, had to correct its financial statements,
cutting profits for the past three years by 20 percent --
about $586 million. Andersen declined comment and said it is
cooperating in the investigation.
number of corporations retracting and correcting earnings
reports has doubled in the past three years, to 233, an
Andersen study found. Major accounting firms have failed to
detect or have disregarded glaring bookkeeping problems at
companies as varied as Rite Aid Corp., Xerox Corp., Sunbeam
Corp., Waste Management Inc. and MicroStrategy Inc.
Corporate America's accounting problems raise the question:
Can the public depend on the auditors?
"Financial fraud and the accompanying restatement of
financial statements have cost investors over $100 billion
in the last half-dozen or so years," said Lynn E. Turner,
who stepped down last summer as the Securities and Exchange
Commission's chief accountant.
shareholder losses resulting from accounting fraud or error
could rival the cost to taxpayers of the savings-and-loan
bailout of the early 1990s, he said. Enron investors,
including employees who held the company's stock in their
retirement accounts, lost billions.
Accounting industry leaders deny they are to blame. They say
that the number of failed audits is tiny in relation to the
many thousands performed successfully, and that it's often
impossible for auditors to see through a sophisticated
Quotations Relating to the Andersen Accounting Firm
Accounting firms cite a number of
reasons for the rise in corrections. It's tough to apply
standards that are nearly 70 years old to the modern
economy, they say. And the SEC has made matters worse by
issuing new interpretations of complex standards. "The
question is not how does this reflect on the auditors,"
Arthur Andersen said in a written statement. Instead, the
firm asked: "How is it that auditors are able to do so well
in today's environment?"
A case study posted on Arthur
Andersen's Web site under "Success Stories" shows how the
firm sees itself. As auditor for TheStreet.com Inc., a
financial news service, Arthur Andersen said, it helped its
client prepare for an initial public offering of stock,
develop a global expansion strategy and secure a weekly
television show through another client, News Corp.
of Arthur Andersen's "greatest strengths . . . is developing
full-service relationships with emerging companies and then
using all of our capabilities to find inventive ways to help
them continue to grow," auditor Tom Duffy is quoted as
year, Gene Logic Inc., a Gaithersburg biotechnology firm,
fired Arthur Andersen, saying it was disappointed with the
outside auditor's level of service and cost. Andersen said
in a letter included in an SEC filing that, before Andersen
was fired, the accounting firm had told the company it
thought it was trying to book $1.5 million of revenue from
new contracts prematurely. Gene Logic spokesman Robert
Burrows said the revenue disagreement had nothing to do with
the auditor's dismissal.
Arthur Andersen said it quickly resigned or refused to
accept more than 60 auditing jobs last year after its
background checks turned up questions about the integrity of
the clients' management.
industry veterans say audits have become loss leaders -- a
way for firms to get their foot in a client's door and win
Arthur Andersen disagreed, telling The Post that audits are
among the more profitable services the firm provides, adding
that "lower pricing in some years" is "made up over time."
Indeed, accounting firms say that if the audit becomes more
complicated than initially expected, their contracts
generally allow them to go back to their clients and adjust
a long-running lawsuit, Calpers, the giant pension fund for
California public employees accused Arthur Andersen of doing
such a superficial job auditing a finance company that the
"purported audits were nothing more than 'pretended audits.'
Andersen assigned a young, inexperienced auditor "who has
candidly testified he did not even know what a Contract
Receivable was, then or now," consultants for Calpers wrote
in a September 2000 report prepared in support of the
Andersen didn't test any of those accounts while the unpaid
balances soared, and it failed to recognize that a
substantial amount was uncollectible, the report said.
Andersen declined to comment on the case, which was settled
cases illustrate the potential conflicts in the accounting
business as vividly as the one involving Arthur Andersen and
Many investors may not realize they were victims because
they held Waste Management stock indirectly, through mutual
funds and retirement plans. Lolita Walters, an 80-year-old
retired New York City government employee who suffers from
diabetes and a heart condition, can count what she lost --
more than $2,800, enough money to pay for almost a year of
think it's unconscionable," Walters said of Andersen's role.
According to the SEC, Andersen lent its credibility to Waste
Management's annual reports even though it had documented
that they were deeply flawed.
Waste Management eventually admitted that, over several
years, it had overstated its pretax profits by $1.4 billion.
a civil suit filed in June, the SEC accused Arthur Andersen
of fraud for signing off on Waste Management's false
financial statements from 1993 through 1996. For example,
during the 1993 audit, the SEC said, the auditors noted $128
million of cumulative "misstatements" that would have
reduced the company's earnings, before including special
items, by 12 percent. But Andersen partners decided the
misstatements were not significant enough to require
correction, the SEC said.
Andersen memorandum showed the accounting firm disagreed
with the approach Waste Management used "to bury charges"
and warned Waste Management that the practice represented
"an area of SEC exposure," but Andersen did not stop it, the
SEC order noted that, from 1971 until 1997, all of Waste
Management's chief financial officers and chief accounting
officers were former Andersen auditors. The Andersen partner
assigned to lead the disputed audits coordinated marketing
of non-audit services, and his compensation was influenced
by the volume of non-audit fees Andersen billed to Waste
Management, the SEC said.
Over a period of years, Andersen and an affiliated
consulting firm billed Waste Management about $18 million
for non-audit work, more than double the $7.5 million it was
paid in audit fees, which were capped, the SEC said.
Andersen said some of the non-audit work was related to
Andersen, which continues to serve as Waste Management's
auditor, agreed to pay a $7 million fine to the SEC, and
joined with Waste Management to settle a class-action
lawsuit on behalf of shareholdersfor a combined $220
million. Andersen did not admit wrongdoing in either
"There are important lessons to be learned from this
settlement by all involved in the financial reporting
process," Terry E. Hatchett, Andersen's managing partner for
North America, said in a statement after the SEC action.
"Investors can continue to rely on our signature with
Starting in the mid-1980s, he oversaw the outside audits of
JWP Inc., an obscure New York company that bought a string
of businesses and transformed itself into a
multibillion-dollar conglomerate. The job required LaBarca,
a partner at the big accounting firm Ernst & Young LLP, to
scrutinize the work of JWP's chief financial officer, Ernest
W. Grendi, a running buddy and former colleague.
1992, a new president at JWP discovered rampant accounting
manipulations, and the company's stock sank. When the
numbers were corrected, the 1991 earnings were slashed from
more than $60 million to less than $30 million.
After hearing extensive evidence in a bondholders' lawsuit,
a federal judge criticized "the seeming spinelessness" of
"Time and again, Ernst & Young found the fraudulent
accounting at JWP, but managed to 'get comfortable' with
it," Judge William C. Conner wrote in a 1997 opinion. "The
'watchdog' behaved more like a lap dog."
Today, LaBarca is senior vice president of financial
operations and acting controller at the media conglomerate
AOL Time Warner Inc., where his duties include overseeing
Securities and Exchange Commission filed and settled fraud
charges against Grendi but took no action against LaBarca.
Neither did the American Institute of Certified Public
Accountants (AICPA), a 340,000-member professional
organization charged with disciplining its own, or the state
of New York, which licensed LaBarca.
LaBarca declined to discuss the JWP case but
maintainedduring thetrial that the accounting was "perfectly
within the guidelines."
Ernst & Young spokesman said the firm was confident it
upheld a tradition "of integrity, objectivity and trust."
Grendi declined comment.
Washington Post analysis of hundreds of disciplinary cases
since 1990 found that, when things go wrong, accountants
face little public accountability.
"The deterrent effect that's necessary is just not there,"
said Douglas R. Carmichael, a professor of accountancy at
the City University of New York's Baruch College. That
"makes investing like Russian roulette," he added.
theory, the system has several complementary layers of
review. In practice, it is undermined by a lack of
resources, coordination and will.
SEC can bar accountants from auditing publicly traded
companies for unprofessional conduct. The agency, however,
has the personnel to investigate only the most egregious
examples of auditing abuse, officials say. It typically
settles its cases without an admission of wrongdoing, often
years after the trouble surfaced.
Between 1990 and the end of last year, the SEC sanctioned
about 280 accountants, evenly divided between outside
auditors and corporate financial officers, The Post's review
AICPA can expel an accountant from its ranks, whichcan
prompt the accountant's firm to reassign or fire him. The
trade grouptook disciplinary action in fewer than a fifth of
the cases in which the SEC imposed sanctions, The Post
found. About one-third of the accountants the SEC sanctioned
weren't AICPA members and thus were beyond its reach.
Even when the AICPA determined that accountants sanctioned
by the SEC had committed violations, it closed the vast
majority of ethics cases without disciplinary action or
President Bill Clinton's SEC chairman, Arthur Levitt Jr., a
frequent critic of the industry, said the AICPA "seems
unable to discipline its own members for violations of its
own standards of professional conduct."
membership group works as a lobbying force for accountants
and often battles SEC regulatory efforts.
State regulators have the ultimate authority. They can take
away an accountant's license. But some state authorities
acknowledge that their efforts are hit-or-miss.
only find out about violations on the part of regulants
[licensees] in two ways: One, somebody complains, or two, we
get lucky," said David E. Dick,assistant director of
Virginia's Department of Professional and Occupational
Regulation, which until recently administered discipline for
the state's accountants.
When the SEC settles without a court judgment or an
admission of culpability, state authorities must build their
case from scratch, said regulators in New York, where many
corporate accountants are licensed.
"You could probably fault both state boards and the SEC for
not having worked cooperatively enough with one another over
the years," said Lynn E. Turner, who stepped down this
summer as the SEC's chief accountant. He added that the
agency has tried harder over the past year and a half to
share investigative records with state regulators.
of June, the state of New York had taken disciplinary action
against about a third of the New York accountants The Post
culled from 11 years of SEC professional-misconduct cases.
While prosecutors occasionally file criminal charges against
corporate officials in financial fraud case, they hardly
ever bring criminal cases against independent auditors, in
part because the accounting rules are so complex. The
AICPA's general counsel could recall only a handful of
"From my perspective, this was very hard stuff," said a
federal prosecutor who investigated a major accounting
fraud. "The prospect of litigating a case against people who
actually do this stuff for a living and at least in theory
are the world's experts . . . is a daunting prospect."
Investor lawsuits sometimes lead to multimillion-dollar
settlements. But they rarely shed light on the performance
of individual auditors because accounting firms generally
get court records sealed and settle before trial, limiting
accounting firms say they discipline those who violate
professional standards, including removing them from audits
or terminating their employment.
Barry Melancon, president of the AICPA, said "you cannot
look at discipline alone" when assessing accountability in
the accounting profession.
profession's emphasis is on preventing rather than punishing
mistakes, he added. Thus, it invests heavily in
quality-control efforts, such as periodic "peer reviews" of
the paperwork accounting firms generate during audits.
disciplinary cases, the AICPA's goal is to rehabilitate
accountants, not to expel them, officials said. "While it
may feel good and it may give somebody something to write
about when somebody is disciplined, the most important thing
is whether or not this profession does a good job doing
audits or not," Melancon said.
bankruptcy of Enron -- at one time the seventh-largest
company in the U.S. -- has underscored the need to reassess
not only the adequacy of our financial reporting systems but
also the public watchdog mission of the accounting industry,
Wall Street security analysts, and corporate boards of
directors. While the full story of what caused Enron to
collapse has yet to be revealed, what is clear is that its
accounting statements failed to give investors a complete
picture of the firm's operations as well as a fair
assessment of the risks involved in Enron's business model
and financing structure.
Enron is not unique. Incidents of accounting irregularities
at large companies such as Sunbeam and Cendant have
proliferated. As Joe Berardino, CEO of Arthur Andersen, said
on these pages, "Our financial reporting model is broken. It
is out of date and unresponsive to today's new business
models, complex financial structures, and associated
is important to recognize that losses suffered by Enron's
shareholders took place in the context of an enormous bubble
in the "new economy" part of the stock market during 1999
and early 2000. Stocks of Internet-related companies were
doubling, then doubling again. Past standards of valuation
like "buy stocks priced at reasonable multiples of earnings"
had given way to blind faith that any company associated
with the Internet was bound to go up. Enron was seen as the
perfect "new economy" stock that could dominate the market
for energy, communications, and electronic trading and
have sympathy for the Enron workers who came before Congress
to tell of how their retirement savings were wiped out as
Enron's stock collapsed and how they were constrained from
selling. I have long argued for broad diversification in
retirement portfolios. But many of those who suffered were
more than happy to concentrate their portfolios in Enron
stock when it appeared that the sky was the ceiling.
Moreover, for all their problems, our financial reporting
systems are still the world's gold standard, and our
financial markets are the fairest and most transparent. But
the dramatic collapse of Enron and the rapid destruction of
$60 billion of market value has shaken public trust in the
safeguards that exist to protect the interests of individual
investors. Restoring that confidence, which our capital
markets rely on, is an urgent priority.
my view, the root systemic problem is a series of conflicts
of interest that have spread through our financial system.
If there is one reliable principle of economics, it is that
individual behavior is strongly influenced by incentives.
Unfortunately, often the incentives facing accounting firms,
security analysts, and even in some circumstances boards of
directors militate against their functioning as effective
guardians of shareholders' interests.
While I will concentrate on the conflicts facing the
accounting profession, perverse incentives also compromise
the integrity of much of the research product of Wall Street
security analysts. Many of the most successful research
analysts are compensated largely on their ability to attract
investment banking clients. In turn, corporations select
underwriters partly on their ability to present positive
analyst coverage of their businesses. Security analysts can
get fired if they write unambiguously negative reports that
might damage an existing investment banking relationship or
discourage a prospective one.
Small wonder that only about 1% of all stocks covered by
street analysts have "sell" recommendations. Even in October
2001, 16 out of 17 securities analysts covering Enron had
"buy" or "strong buy" ratings on the stock. As long as the
incentives of analysts are misaligned with the needs of
investors, Wall Street cannot perform an effective watchdog
some cases, boards of directors have their own conflicts.
Too often, board members have personal, business, or
consulting relationships with the corporations on whose
boards they sit. For some "professional directors," large
fees and other perks may militate against performing their
proper function as a sometime thorn in management's side.
Our watchdogs often behave like lapdogs.
it is on the independent accounting profession that we most
rely for assurance that a corporation's financial statements
accurately reflect the firm's condition. While we cannot
expect independent auditors to detect all fraud, we should
expect we can rely on them for integrity of financial
reporting. While public accounting firms do have reputations
to maintain and legal liability to avoid, the incentives of
these firms and general auditing practices can sometimes
combine to cloud the transparency of financial statements.
my own experience on several audit committees of public
companies, the audit fee was only part of the total
compensation paid to the public accounting firm hired to
examine the financial statements. Even after the divestiture
of their consulting units, revenues from tax and management
advisory services comprise a large share of the revenues of
the "Big Five" accounting firms. In some cases auditing
services may be priced as a "loss leader" to allow the
accounting firm to gain access to more lucrative non-audit
such a situation, the audit partner may be loath to make too
much of a fuss about some gray area of accounting if the
intransigence is likely to jeopardize a profitable
relationship for the accounting firm. Indeed, audit partners
are often compensated by how much non-audit business they
can capture. They may be incentivized, then, to overlook
some particularly aggressive accounting treatment suggested
by their clients.
Outside auditors also frequently perform and review the
inside audit function within the corporation, as was the
case with Andersen and Enron. Such a situation may weaken
the safeguards that exist when two independent organizations
examine complicated transactions. It's as if a professor let
students grade their own papers and then had the
responsibility to hear any appeals. Auditors may also be
influenced by the prospect of future employment with their
Unfortunately, our existing self-regulatory and
standard-setting organizations fall short. The American
Institute of Certified Public Accountants has neither the
resources nor the power to be fully effective. The institute
may even have contributed to the problem by encouraging
auditors to "leverage the audit" into advising and
Financial Accounting Standards Board has often emphasized
the correct form by which individual transactions should be
reported rather than the substantive way in which the true
risk of the firm may be obscured. Take "Special Purpose
Entities," for example, the financing vehicles that permit
companies such as Enron to access capital and increase
leverage without adding debt to the balance sheet. Even if
all of Enron's SPEs had met the narrow test for balance
sheet exclusion (which, in fact, they did not), our
accounting standard would not have illuminated the effective
leverage Enron had undertaken and the true risks of the
Given the complexity of modern business and the way it is
financed, we need to develop a new set of accounting
standards that can give an accurate picture of the business
as a whole. FASB may have helped us measure the individual
trees but it has not developed a way to give us a clear
picture of the forest. The continued integrity of the
financial reporting system and our capital markets must be
insured. We need to modernize our accounting system so
financial statements give a clearer picture of what assets
and liabilities on the balance sheet are at risk. And we
must find ways to lessen the conflicts facing auditors,
security analysts, and even boards of directors that
undermine checks and balances our capital markets rely on.
possibility is to require that auditing firms be changed
periodically the way audit partners within each firm are
rotated. This would incentivize auditors to be particularly
careful in approving accounting transactions for fear that
leniency would be exposed by later auditors.
The SEC will not tolerate a pattern
of growing restatements, audit failures, corporate failures
and massive investor losses," Pitt said in a news conference.
"Somehow we have got to put a stop to the vicious cycle that
has now been in evidence for far too many years."
Securities & Exchange Commission Chairman Harvey Pitt called
Thursday for reform of the way accounting firms are
monitored and regulated in the United States in an effort to
restore public confidence in the profession in the wake of
scandals involving Enron Corp. and other companies.
"This commission cannot and will not tolerate a pattern of
growing restatements, audit failures, corporate failures and
massive investor losses," Pitt said in a news conference.
"Somehow we have got to put a stop to the vicious cycle that
has now been in evidence for far too many years."
Pitt proposed the creation of a new body, composed mostly of
representatives from the public sector, to oversee and
discipline accounting firms, and he called for a reform of
the triennial peer review process, which has been criticized
"with some merit," Pitt said.
suggestions were prompted mostly by the recent collapse of
energy trader Enron and the revelations of accounting
irregularities that led to it. Its auditor, Arthur Andersen,
has come under intense scrutiny for failing to discover or
disclose problems with Enron's books that hid massive debt
and helped the company avoid paying taxes.
Enron's shares lost almost all their value as the
disclosures came to light, the company filed for bankruptcy
and investor confidence in the accuracy of companies'
financial disclosures was shaken.
place restoring the public's confidence in the auditing
profession to be immediate goal number one," Pitt said
Pitt said he and others in the SEC were still trying to work
out the details of the new oversight group, which would have
the power to compel testimony and the production of
documents, and were investigating the circumstances of
Despite Pitt's proposals, Sen. Jon Corzine, D - New Jersey,
told CNNfn's The Money Gang that the SEC should be policing
the accounting firms. (WAV 597KB) (AIFF 597KB).
Pitt did say he thought the SEC should have oversight of the
new body's decisions and actions.
particular interest to the SEC may be the actions of
Andersen, which admitted to intentionally destroying Enron
documents -- excepting the important "work papers"
associated with an audit -- and recently fired the partner
heading up its work on Enron.
Andersen's actions were only the latest in a series of
stumbles by accounting firms. Andersen was recently fined $7
million by the SEC, the largest penalty ever, for
irregularities connected with its work on Waste Management
Inc. Other venerable firms like PricewaterhouseCoopers and
Ernst & Young have also had their share of trouble.
Note: Harvey Pitt
resigned from the SEC following allegations that he was aiding
large accounting firms in stacking the new Public Company
Accounting Oversight Board (PCAOB) created in the
Sarbanes-Oxley Act of 2002.
In a surprise response to last
week's SEC announcement, the Public Oversight Board, the
independent body that oversees the self-regulatory function
for auditors of companies registered with the Securities &
Exchange Commission, passed a resolution stating its intent to
close its doors no later than March 31, 2002.
Note: Harvey Pitt
resigned from the SEC following allegations that he was aiding
large accounting firms in stacking the new Public Company
Accounting Oversight Board (PCAOB) created in the
Sarbanes-Oxley Act of 2002.
Warren Buffett Three years ago the Berkshire Hathaway CEO proposed three
questions any audit committee should ask auditors:
the auditor were solely responsible for preparation of the
company's financial statements, would they have been done
differently, in either material or nonmaterial ways? If
differently, the auditor should explain both management's
argument and his own.
the auditor were an investor, would he have received the
information essential to understanding the company's
financial performance during the reporting period?
The opportunity to cross to-do's
off the list came just one week later, on Feb. 12. That day,
the Enron board's audit and compliance committee held a
meeting, and both Mr. Duncan and Mr. Bauer from Andersen
attended. At one point, all Enron executives were excused
from the room, and the two Andersen accountants were asked
by directors if they had any concerns they wished to
express, documents show.
Subsequent testimony by board
members suggests the accountants raised nothing from their
to-do list. "There is no evidence of any discussion by
either Andersen representative about the problems or
concerns they apparently had discussed internally just one
week earlier," said the special committee report released
Tone at the Top
COMMITTEE MEMBERS AND BOARDS of directors are taking a fresh
look at potential risks within their organizations following
the Enron debacle. What financial reporting red flags and key
risk factors should your organization know? Read more in Tone
at the Top,
The IIA’s corporate governance newsletter for executive
management, boards of directors, and audit committees.
In response to the
Enron situation, The Institute of Internal Auditors (IIA) is
conducting Internet-based “flash surveys” of directors and
chief audit executives (CAEs). The purpose of these surveys
is gaining information — and sharing it in an upcoming Tone
at the Top — on how audit committees and other governance
entities monitor complex financial transactions. We
encourage you to participate by typing in