Example from the Stanford Law School Database

From the Stanford Law School Securities Fraud Database --- http://securities.stanford.edu/1022/TTWO01-01/ 

Take-Two Interactive CASE INFORMATION 

Summary: According to a Press Release dated December 21, 2001, the complaint alleges that during the Class Period defendants materially misrepresented Take-Two's financial results and performance for each of the quarters of and full year of fiscal 2000, ended October 31, 2000, and each of the first three quarters of fiscal 2001, ended January 31, 2001, April 30, 2001 and July 31, 2001, respectively, by improperly recognizing revenue on sales to distributors. On August 24, 2001, the truth about the Company's financial condition began to emerge when the effects of defendants' scheme began to negatively impact the Company's financial results. It was not until December 14, 2001 and December 17, 2001, however, that the market began to learn that defendants had caused the Company to improperly recognize revenue for products shipped to distributors, where the distributors did not have a binding commitment to pay for the products, in direct contravention of GAAP. Significantly, defendants' unlawful accounting practices enabled defendants to portray Take-Two as a financially strong company that was experiencing dramatic revenue growth, and which was poised for future success when, in fact, the Company's purported success was the result of improper accounting practices. On December 14, 2001, following rumors of a possible restatement of Take-Two's financial results, Take-Two's common stock fell 31% --$4.72 a share to $10.33 per share. During the Class Period, Take-Two shares traded as high as $24.50 per share. Defendants were motivated to misrepresent the Company's financial results, by among other things, their desire to sell approximately 900,000 shares of Take-Two common stock during the Class Period at artificially inflated prices for proceeds of over $15 million.

INDUSTRY CLASSIFICATION: SIC Code: 7372 Sector: Technology Industry: Software & Programming

NAME OF COMPANY SUED: Take-Two Interactive Software Inc. 

COMPANY TICKER: TTWO COMPANY WEBSITE: http://www.take2games.com 

FIRST IDENTIFIED COMPLAINT IN THE DATABASE Fischbein, et al. v. Take-Two Interactive Software Inc., et al. COURT: S.D. New York DOCKET NUMBER: JUDGE NAME: DATE FILED: 12/18/2001 SOURCE: Business Wires CLASS PERIOD START: 02/24/2000 CLASS PERIOD END: 12/17/2001 TYPE OF COMPLAINT: Unamended/Unconsolidated PLAINTIFF FIRMS IN THIS OR SIMILAR CASE: Milberg Weiss Bershad Hynes & Lerach, LLP (New York, NY) One Pennsylvania Plaza, New York, NY, 10119-1065 (voice) 212.594.5300, (fax) , Rabin & Peckel LLP 275 Madison Avenue, New York, NY, 10016 (voice) 212.682.1818, (fax) , email@rabinlaw.com Schiffrin & Barroway, LLP 3 Bala Plaza E, Bala Cynwyd, PA, 19004 (voice) 610.667.7706, (fax) 610.667.7056, info@sbclasslaw.com 

TOTAL NUMBER OF PLAINTIFF FIRMS: 3

February 28, 2002 message from Allen Plyler

Bob,

Take-Two Interactive just restated their last restatement.

Allen Plyler
Keller Graduate School of Management, Chicago, Illinois.

Important Database --- From the Scout Report on February 1, 2001

LLRX.com: Business Filings Databases http://www.llrx.com/columns/roundup19.htm 

This column from Law Library Resource Xchange (LLRX) (last mentioned in the September 7, 2001 Scout Report) by Kathy Biehl becomes more interesting with every revelation of misleading corporate accounting practices. This is a straightforward listing of state government's efforts to provide easy access to required disclosure filings of businesses within each state. Each entry is clearly annotated, describing services offered and any required fees (most services here are free). The range of information and services varies considerably from very basic (i.e. "name availability") to complete access to corporate filings. The noteworthy exception here is tax filings. Most states do not currently include access to filings with taxing authorities.

I added the above to my evolving monster on accounting and securities fraud at http://www.trinity.edu/rjensen/fraud.htm 

From The Wall Street Journal Accounting Educators' Review on May 23, 2002

TITLE: SEC Broadens Investigation Into Revenue-Boosting Tricks; Fearing Bogus Numbers Are Widespread, Agency Probes Lucent and Others 
REPORTER: Susan Pulliam and Rebecca Blumenstein 
DATE: May 16, 2002 
PAGE: A1 
LINK: http://online.wsj.com/article/0,,SB1021510491566948760.djm,00.html  
TOPICS: Financial Accounting, Financial Statement Analysis

SUMMARY: "Securities and Exchange Commission officials, concerned about an explosion of transactions that falsely created the impression of booming business across many industries, are conducting a sweeping investigation into a host of practices that pump up revenue."

QUESTIONS: 
1.) "Probing revenue promises to be a much broader inquiry than the earlier investigations of Enron and other companies accused of using accounting tricks to boost their profits." What is the difference between inflating profits vs. revenues?

2.) What are the ways in which accounting information is used (both in general and in ways specifically cited in this article)? What are the concerns about using accounting information that has been manipulated to increase revenues? To increase profits?

3.) Describe the specific techniques that may be used to inflate revenues that are enumerated in this article and the related one. Why would a practice of inflating revenues be of particular concern during the ".com boom"?

4.) "[L90 Inc.] L90 lopped $8.3 million, or just over 10%, off revenue previously reported for 2000 and 2001, while booking the $250,000 [net difference in the amount of wire transfers that had been used in one of these transactions] as 'other income' rather than revenue." What is the difference between revenues and other income? Where might these items be found in a multi-step income statement? In a single-step income statement?

5.) What are "vendor allowances"? How might these allowances be used to inflate revenues? Consider the case of Lucent Technologies described in the article. Might their techniques also have been used to boost profits?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

--- RELATED ARTICLES --- 
TITLE: CMS Energy Admits Questionable Trades Inflated Its Volume 
REPORTER: Chip Cummins and Jonathan Friedland 
PAGE: A1 
ISSUE: May 16, 2002 
LINK: http://online.wsj.com/article/0,,SB1021494984503313400.djm,00.html 

One-time Internet booster Henry Blodget, who recently left Merrill Lynch, is reportedly one of several stock analysts being probed for alleged conflicts of interest --- http://www.wired.com/news/politics/0,1283,48992,00.html 

From The Wall Street Journal's Accounting Educator Reviews on January 24, 2002

TITLE: Ex-Official at Leslie Fay Gets Nine-Year Sentence for Accounting Fraud 
REPORTER: Staff Reporter DATE: Jan 21, 2002 
PAGE: B2 
LINK: http://interactive.wsj.com/archive/retrieve.cgi?id=SB1011571420328020280.djm  
TOPICS: Accounting, Accounting Fraud, Accounting Law, Fraudulent Financial Reporting, Legal Liability, Negligent Misrepresentation

SUMMARY: Paul F. Polishan, the former chief financial officer and senior vice president of Leslie Fay, was convicted of 18 felony counts for his role in overstating the earnings of Leslie Fay between 1989 and 1993. Mr. Polishan was sentenced to serve nine years in prison. Questions deal with accountants' liability and consequences of fraudulent financial reporting.

QUESTIONS: 
1.) In what situations is overstating earnings a crime? What other penalties could result from overstating earnings? Do you think overstating earnings should result in a prison sentence? Support your answer.

2.) Were Leslie Fay's financial statements audited? What responsibility does the auditor bear concerning the earnings overstatement?

3.) In what situations would an independent auditor be liable under common law for overstated earnings? What defenses are available to the auditor?

4.) In what situations would an independent auditor be liable under civil law for overstated earnings? What defenses are available to the auditor?

5.) In what situations would an independent auditor be liable under criminal law for overstated earnings? What defenses are available to the auditor?

6.) Who is harmed by overstated earnings? How are each of these groups harmed?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

In particular, it has raised awareness of “hollow swaps”, where two telecoms companies exchange identical amounts of network capacity, then book the purchase cost as capital expense and the sale as revenue. Although C&W says it does not use hollow swaps, it has recently admitted to using another controversial accounting method to book the sale of “indefeasible right of use” (IRU) contracts. C&W booked the contracts, which give access to its telecoms network, as upfront revenue even though they were spread over periods of up to 15 years. Such deals — which were outlawed in 1999 by regulators in America — boosted C&W’s revenues by £373 million in 2001.
Chris Ayres and Clive Mathieson, London Times Online, March 1, 2002 --- http://www.thetimes.co.uk/article/0,,5-222235,00.html 

Association of Certified Fraud Examiners --- http://www.cfenet.com/home.asp 

The Association of Certified Fraud Examiners is an international, 25,000-member professional organization dedicated to fighting fraud and white-collar crime. With offices in North America and chapters around the globe, the Association is networked to respond to the needs of anti-fraud professionals everywhere.

In the April 2002 issue of Journal of Accountancy, Joseph Wells, chairman of the Association of Certified Fraud Examiners (CFE), reviews the results of a survey by CFE and discusses the implications for CPAs. http://www.accountingweb.com/item/77418 

In Congressional testimony on February 14, James G. Castellano, the chairman of the American Institute of CPAs said the Institute plans to release a draft of a new standard by the end of February. The objective of the new standard is to help auditors detect new types of management fraud. http://www.accountingweb.com/item/72560 

A message from Andrew Priest on February 34. 2002

Yahoo! is carrying this news story in respect of Tyco International. Apparently the firm spent $US8 billion in its past three fiscal years on more than 700 acquisitions that were never announced to the public. The story is at http://au.news.yahoo.com/020205/2/3vlo.html  .

Is this another Andersen client? :-) Seriously does anyone know who the auditor is on this one?

Thanks 
Andrew Priest

The auditor is PricewaterhouseCoopers (PwC)

SEC News, Regulations, and Litigation Summaries --- http://www.sec.gov/ 

On May 20, 2002 the Securities and Exchange Commission announced proceedings against Big Five firm Ernst & Young. The case reaches back to the years before E&Y's consulting practice was sold to Cap Gemini. It involves alleged independence violations due to product sales and consulting fees related to PeopleSoft software, while PeopleSoft was an E&Y audit client. http://www.accountingweb.com/item/81348 

Update on June 1, 2002 --- http://www.as411.com/AcctSoftware.nsf/00/prDBD2F8AEEF51127686256BEC00167F9F 

In a ruling Tuesday, Brenda Murray, the chief administrative law judge at the SEC, granted Ernst & Young's motion for summary judgment and dismissed the case without prejudice. Ms. Murray agreed with Ernst & Young that more than one SEC commissioner needed to approve the action for it to be valid.

From Double Entries on July 5, 2002

In the first-ever auditor independence case against a foreign audit firm, the Securities and Exchange Commission has brought a settled enforcement action against Moret Ernst & Young Accountants (Moret), a Dutch accounting firm now known as Ernst & Young Accountants. The case arises from Moret's joint business relationships with an audit client. In today's order, the SEC censured Moret for engaging in "improper professional conduct" within the meaning of Rule 102(e) of the SEC's Rules of Practice, and ordered Moret to comply with certain remedial undertakings, including the payment of a $400,000 civil penalty. This is the first time that the SEC has ordered any audit firm to pay a civil penalty for an auditor independence violation. Moret consented to the order without admitting or denying the SEC's findings. Full details from the SEC in our full article. Just click on through

"SEC List of Accounting-Fraud Probes Grows, Stretching Agencies Resources," The Wall Street Journal, July 6, 2001 --- http://interactive.wsj.com/archive/retrieve.cgi?id=SB994366683510250066.djm 

WSJ Interactive Questions on July 12, 2001

1.) "The most visible indicator of improper accounting-and source of new investigations-is the growing number of restated financial reports." Based on your knowledge of APB Opinion 23, why is this statement true? What other sources of information does the SEC use to trigger investigations?

2.) Why would the SEC want to "ferret out" questionable accounting practices before "word of a company's accounting problems has leaked and battered its stock price"? How does this goal relate to the SEC's responsibilities? What steps are they undertaking to accomplish this goal?

3.) What is fraudulent financial reporting (as opposed to an accounting error)? Why might the current economic circumstances lead to greater incidences of fraudulent financial reporting?

4.) Read the summary of a research study entitled "Fraudulent Financial Reporting: 1987-1997: An Analysis of U.S. Public Companies" at the AICPA web site http://www.aicpa.org/news/p032699b.htm  How do the factors identified in this study provide a basis for helping the SEC to detect questionable accounting practices earlier than is now the norm?

5.) How are executives' compensation packages tied to share prices? What are the benefits of such compensation arrangements? Why do current market conditions enhance the risk that executives may be willing to undertake earnings management practices to enhance their own salaries? What market reactions to earnings announcements exacerbate these incentives to manage earnings?

American Institute of Certified Public Accountants --- http://www.aicpa.org/index.htm 
There are many articles on fraud in the back issues of the Journal of Accountancy --- http://www.aicpa.org/pubs/jofa/joahome.htm 

AICPA Issues Proposed Standard On Fraud Detection
On February 28, 2002, the American Institute of CPAs (AICPA) released a draft of a revised audit standard on Consideration of Fraud in a Financial Statement Audit. If adopted, this updated standard will replace the current standard with the same name, (Statement on Auditing Standards No. 82). http://www.accountingweb.com/item/73718 

From the Journal of Accountancy in July 2002 --- http://www.aicpa.org/pubs/jofa/jul2002/index.htm

Risk Management/Internal Audit
BEYOND TRADITIONAL AUDIT TECHNIQUES
Paul E. Lindow and Jill D. Race
Instead of just reviewing required controls, internal auditors can broaden their approach both within and outside the audit process to identify areas for risk management improvements. Here’s a case study on how the internal audit group at California Federal Bank redefined its role to add more value and become key advisers to the company.

Risk Management/Litigation Services
FIVE TIPS TO STEER CLEAR OF THE COURTHOUSE
Paul Sweeney
As litigation costs continue to mount, businesses want to develop efficient strategies to identify and monitor vulnerabilities and avoid lawsuits. CPAs have the expertise to offer clients solutions to several corporate risk management problems.

From The Wall Street Journal Accounting Educators' Review on March 7, 2002

TITLE: Auditing Standard for Detecting Fraud Is Posed
REPORTER: Dow Jones Newswires
DATE: Mar 01, 200
PAGE: A4
LINK: http://online.wsj.com/article/0,,BT_CO_20020228_009080.djm,00.html
TOPICS: Auditing

SUMMARY: The article implies that a new auditing standard on fraud actually has been issued, but the actual document issued was an exposure draft of a proposed standard.

QUESTIONS:

1.) Access the AICPA web site to read the actual document issued by the Auditing Standards Board at http://www.aicpa.org/members/div/auditstd/consideration_of_fraud.htm 

The article begins with the statement that "the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants issued expanded fraud guidance for U.S. auditors..."  Is this statement correct?

2.) In the second paragraph of the article, the author states, "The guidance comes at a time when questionable accounting practices have surfaced in the wake of bankruptcy-law filings by...Enron Corp. and Global Crossing Ltd."  Were these recent scandals the reason behind the new auditing standard proposal?  If not, what were the ASB's reasons for proposing the new standard?  (Hint:  again see the actual document at the AICPA's web site.)

3.) The proposed new standard would mandate specific requirements to search for fictitious entries and perform other tests to search for fraud under certain circumstances.  Compare and contrast this proposal to current auditing requirements to search for fraud.

SMALL GROUP ASSIGNMENT: The proposed auditing standard requests feedback from respondents to assess each of the major areas of the new standard  (e.g., classification of risk factors for fraud, identification of revenue recognition as the major area for risk of fraud, consideration of the risk of management override of fraud, inquiry of audit committees about fraud, and the attitude of professional skepticism).  Divide the class into small groups and assign one section to each group to draft a response to the questions posed in the exposure draft.

Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University

Institute of Internal Auditors (IIA) --- http://www.theiia.org/ 

Can Internal Auditors truly be independent while being employed by the entity and seen as working for the management to achieve organizational goals? In theory, External Auditors are more likely to be perceived as independent, but is it not the case that Internal Auditors appear to have little or no independence? http://www.accountingweb.com/item/65704 

Articles on Internal Auditing and Fraud Investigation 
Web Site of Mark R. Simmons, CIA CFE 
http://www.dartmouth.edu/~msimmons/ 

Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations.  It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. (Institute of Internal Auditors)

Fraud Investigation consists of the multitude of steps necessary to resolve allegations of fraud - interviewing witnesses, assembling evidence, writing reports, and dealing with prosecutors and the courts. (Association of Certified Fraud Examiners)

This site focuses on topics that deal with Internal Auditing and Fraud Investigation with certain hyper-links to other associated and relevant sources. It is dedicated to sharing information.

Certified Forensic Investigators in Canada --- FAQs --- http://www.homewoodave.com/frequently%20asked%20question.htm 

"Regulators Check the New Economy's Books," by Karl Schoenberger, The New York Times, August 19, 2001 --- http://college2.nytimes.com/guests/articles/2001/08/19/864842.xml 

Responding to widespread concerns that investors were not always given reliable financial information in that time of frantic revenue growth, regional offices of the S.E.C., the Federal Bureau of Investigation and the United States attorney's office here are cooperating in a legal crackdown on accounting violations.

A tough law-enforcement response to accounting irregularities, of course, is not new. In the past year, federal investigators have pursued cases of irregularities at companies like Waste Management (news/quote), Cendant (news/quote) and Sunbeam. But now the government is turning up the heat in Silicon Valley, home to a preponderance of questionable accounting, particularly among software companies, during the Internet boom.

Over the last four years, nearly one in five accounting restatements — red flags for potential misconduct — have been by companies in California, according to a study by Arthur Andersen, the accounting firm. (Arthur Andersen was itself the recent subject of an S.E.C. civil sanction for the way it audited the books of Waste Management, the trash-disposal company, and agreed to a settlement without admitting or denying civil fraud allegations.) In the same four- year period, the total number of restatements for all industries has nearly doubled, Arthur Andersen's report said.

So far in the technology sector, federal investigators and prosecutors here have set their sights on relatively small companies, where a high proportion of problems center on what accountants call improper "revenue recognition" — the recording of revenue that does not exist. It could be, for example, from a pending sale that is misclassified as completed, or a service contract in which money has not yet changed hands.

The Arthur Andersen study of accounting restatements from 1997 to 2000 showed that 27 percent of the restatements nationwide had been filed in the software and computer industries. About 62 percent of the software companies involved had annual gross revenue of less than $100 million.

The rise of accounting fraud investigations, specifically related to overstatement of revenue, reflects a serious white-collar crime trend in the high-technology sector in recent years, said Leslie B. Caldwell, chief of the securities fraud section for the United States attorney's office here.

"The pressure to do this in the technology industry was intense because the expectation for growth was so high, and it wasn't sustainable," she said, without commenting on specific cases.

The inquiry at Indus International focused on revenue for the third quarter of 1999. According to the shareholder lawsuits against the company and former executives, the revenue total included sales derived from "irregular contracts," money that was not received during the quarter in question. Last October, Indus International agreed to settle the suits for $4.3 million without admitting or denying wrongdoing.

Previously, Ms. Caldwell said, her office waited for the S.E.C. to refer cases for criminal investigation. But now, "we're taking the bull in our own hands," she said.

"There are a number of matters under investigation of corporations that cooked their books to meet Wall Street's expectations — expectations that the companies themselves created," she added.

Harris Miller, president of the Information Technology Association of America, a trade group, said accounting problems in the software industry had arisen because of what he called vague rules covering sales of licensing agreements, which resulted in many companies claiming revenue that they expected to receive.

"The rules for revenue recognition were a bit cloudy, not just for software companies but for any company that delivers services over time," Mr. Miller said. His organization, he said, was not making excuses for executives who intentionally violated regulations. "Yes, there was pressure to drive the top line," he said. "But you can never justify misconduct."

Ms. Caldwell's unit of seven lawyers, responsible for expediting complicated and paper-intensive securities investigations, was created in February 2000 by Robert S. Mueller, United States attorney for the Northern District of California, whom President Bush chose to serve as director of the F.B.I.

Matthew J. Jacobs, a spokesman for the United States attorney's office here, said Mr. Mueller had made the prosecution of accounting fraud a major objective because of its prevalence in both economic booms and declines. Mr. Mueller was not available for comment, the United States attorney's office said on Friday.

In its most prominent case to date, Ms. Caldwell's team obtained indictments last September against two former executives at McKesson, the pharmaceutical and medical technology company based here. The defendants were charged with accounting fraud related to the 1999 merger of McKesson and HBO & Company, a software company based in Atlanta. Prosecutors said $9 billion in shareholder losses resulted. The defendants pleaded not guilty to the charges, and the case is in the pretrial phase.

 

The F.B.I. and federal prosecutors here are investigating about 50 cases of possible criminal securities fraud in the district, more than a dozen of them focusing on companies suspected of accounting fraud.

In addition to Indus International, at least six small and medium-size software companies in Northern California are under federal criminal and civil investigation, according to officials. Among them is Critical Path, a San Francisco company that sells e-mail messaging technology to other businesses and reported $135.7 million in sales last year. In February, after an internal investigation that led to the departure of its chief executive and two other executives, Critical Path restated revenue for the third and fourth quarters of 2000, subtracting a total of $19.4 million from what it had claimed. The company's share price plummeted and class-action suits were filed, contending deception and fraud. Critical Path has said it is cooperating with investigators.

In another case, the S.E.C. filed a civil complaint last September in Federal District Court here against three former executives of the Cylink Corporation (news/quote), a Santa Clara company that makes cryptographic software for computer network security, accusing them of violating accounting rules by recognizing spurious transactions as sales in quarterly earnings statements. The complaint said Cylink recognized more than $900,000 in revenue in the second quarter of fiscal 1998 for sales in which some customers were given a three-month window to cancel their orders.

"When senior officers are involved in this kind of conduct we're going to hold them responsible," Robert L. Mitchell, head of the S.E.C.'s enforcement office in San Francisco, said when the complaint was issued. "Companies only act through individuals." The S.E.C. settled a separate administrative "cease and desist" proceeding with the corporation. In the civil litigation against three former Cylink executives, each was accused of securities fraud, circumvention of Cylink's internal controls and falsification of records.

In July, according to court records, one of the former Cylink executives, Thomas Butler, who had been vice president for sales, signed a consent decree, without admitting or denying the charges, agreeing to pay a $100,000 fine and forfeit a $25,000 bonus he had been awarded by Cylink for his sales performance. Litigation against the two other defendants is still pending. Robert Fougner, Cylink's general counsel, said that he and other company executives could not comment on the case.

In cases in which criminal charges are brought against company executives, potential penalties can be harsh. In addition to fines imposed by the S.E.C., a conviction of an executive on a criminal securities fraud charge can result in a prison sentence of up to 10 years and a fine as high as $1 million. Conviction on a lesser charge, like wire fraud or conspiracy, carries a maximum five- year sentence and $250,000 fine.

Until recently, the pace of these investigations had been plodding, owing to their complexity and a shortage of resources. For example, Scorpion Technologies, a software company that was based in Los Gatos, Calif., and is now defunct, was accused of fraudulently claiming as much as $3.6 million of its $12.4 million in reported 1991 revenue. The S.E.C. filed civil charges and federal prosecutors indicted company executives on securities fraud charges in 1996. The last of the Scorpion defendants, John T. Dawson, was indicted in 1999. Last November, he pleaded guilty to charges that he had helped create offshore companies that masqueraded as buyers of Scorpion software products. Mr. Dawson's sentencing hearing is set for Oct. 2.

The Justice Department has a high threshold for criminal prosecution in these cases, with a distinction being made between misleading accounting practices and criminal fraud, Ms. Caldwell said. A suspicious accounting trick, by itself, cannot be the basis for seeking an indictment without other facts establishing deliberate fraud, she said.

Some major technology companies, including Lucent Technologies (news/quote), have been subject to recent class- action suits contending irregularities in the way the companies accounted for their growing revenue before their businesses weakened. The S.E.C. started examining Lucent's books last November, after the company had disclosed an accounting problem, fired an employee and filed a restatement lowering its revenue for its fiscal year 2000 by $679 million.

Lucent, however, seems an exception. For now, at least, it appears to be the smaller technology companies that are receiving the most scrutiny.

Continued at  http://college2.nytimes.com/guests/articles/2001/08/19/864842.xml  

The Securities and Exchange Commission has filed suit against the founder and five other former top officers of Waste Management Inc. for massive fraud. The complaint charges the defendants with inflating profits to meet earnings targets. http://www.accountingweb.com/item/76329 

Note that Waste Management just announced that it was changing auditors.  The auditor up to now was (guess?) Arthur Andersen.

"Channel stuffing" refers to the practice of building inventories in distribution channels. On July 11, 2002 Bristol-Myers Squibb, one of the world's largest pharmaceutical companies, confirmed that the Securities and Exchange Commission (SEC) has launched an "informal inquiry" into its sales practices. http://www.accountingweb.com/item/85930 

Channel stuffing was (is?) common in the tobacco industry where companies load up sales revenues on deliveries that they know they will have to take back after the freshness dates on packages expire.  More cartons were (are?) sent to customers than can ever be sold before expiration dates.

You can read about more revenue reporting tricks at http://www.trinity.edu/rjensen/ecommerce/eitf01.htm 

Lurking in the shadows behind the public spotlight on Andersen and Enron has been a criminal case against BDO Seidman for failing to report that a client had misappropriated investor funds. Legal steps this week follow a settlement in April with a goal of removing all criminal charges against the firm. http://www.accountingweb.com/item/84264/ee2eE47/3825 

PricewaterhouseCoopers accused of lax audits of Gazprom

Welcome to the first issue of BusinessWeek Online's European Insider. This weekly newsletter contains highlights of news, analysis, commentary, and regular columns that cover Europe specifically, as well as other stories with wide international impact.

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EUROPEAN BUSINESS

Gazprom: Russia's Enron?

Angry investors are accusing PricewaterhouseCoopers of lax audits of Gazprom. Did the accounting firm ignore the energy giant's insider dealing and shady asset transfers?

http://www.businessweek.com/magazine/content/02_07/b3770079.htm?c=bweuropefeb13&n=link1&t=email 

NEWS ANALYSIS

Can UBS Tame Enron's Wild Traders?

That's the key question facing the Swiss bank as it prepares to take over the Texas company's energy-trading business

http://www.businessweek.com/bwdaily/dnflash/feb2002/nf2002026_4221.htm?c=bweuropefeb13&n=link2&t=email 

"Economic slowdown brings rise in accounting trickery," by Rachel Beck, The Detroit News, August 18, 2001 --- http://detnews.com/2001/business/0108/20/business-272230.htm 

There are growing concerns that the nation's economic downturn is compelling companies to aggressively seek out ways to make their financial statements look better than they really are.

 Just this year, dozens of companies have been caught in the act. Among them:

   -- Xerox Corp. restated earnings after admitting that it did not properly follow certain accounting rules at a Mexican division.
   -- ConAgra Foods Inc. reduced earnings by more than $100 million after discovering fictitious sales and earnings at one of its subsidiaries.
   -- Kroger Co., the giant supermarket chain, revised down its earnings for 1998-2000, saying executives at its Ralphs Grocery subsidiary conspired to hide cash from auditors and senior management.

Accounting manipulation has become so prevalent that lawmakers in Washington are considering hearings on the issue, while the Securities and Exchange Commission has seen a sharp rise in the number of companies under investigation.

 "There is a big question looming out there: Why is there such a massive deterioration in accounting practices and can it be stopped?" said Joseph Carcello, an accounting professor at the University of Tennessee.

Last year there were 156 financial restatements, up from 150 in 1999 and 91 in 1998. The restatements in the last three years add up to more than the combined total for the previous eight years, according to the Financial Executives International, a Morristown, N.J.-based group representing senior corporate financial officers.

About $31.2 billion in market value was wiped out following restatements, as investors sold stock in such companies, according to FEI.

Many companies claim restatements don't mean they have broken any rules, saying that accounting standards are open to interpretation. Often courts are left to decide whether laws were violated.  Most problems stem from how revenue is counted. Corporations can falsely boost sales figures by recording revenue before delivering products or asking customers to receive goods before they need them. Sometimes they will claim sales before the goods are sold at all.

"There is not a "one-shoe-fits-all" mentality that works in accounting," said Mary Ellen Carter, assistant professor of accounting at Columbia University's Graduate School of Business. "Management is in the best position to know what accounting choices capture their business ... but they also know what accounting choices don't."

Companies hire outside auditors to verify their financial statements, mainly to check if accounting standards are met. Yet accounting firms are known to overlook irregularities, sometimes in an attempt to hold on to their audit contracts and more lucrative consulting services for the same companies.

In June, accounting titan Arthur Andersen LLP agreed to pay a $7 million civil fine to settle federal allegations that it issued false and misleading audit reports for Waste Management Inc. from 1993 to 1996 that inflated the trash hauler's profits by more than $1 billion. Andersen neither acknowledged nor denied the allegations.

"There is supposed to be checks in the system that prevent management from being able to do such things, but it is clear that the checks have eroded," said Michael Lange, a partner in Berman DeValerio Pease Tabacco Burt & Pucillo, a Boston law firm that handles investor lawsuits.  At Centennial Technologies, top executives fabricated sales of "Flash 98," a nonexistent product, to friends of former CEO Emmanuel Pinez. The company also created false sales records by shipping fruit baskets to Pinez' friends and recording the shipments as $2 million in revenues.   The maneuvers made it look like Centennial made a profit of $12 million in 1996, when in reality the company lost $28 million.  Based on the earnings reports, shares of Centennial increased 450 percent in 1996 to $55.50 a share. Faraone managed to get in at $46 a share, but after the fraud was uncovered in early 1997, the stock plunged to $3.

Last year, Pinez was convicted in federal court, and sentenced to five years in prison and a $150 million fine.  Other companies -- blue-chips and startups -- have employed similar schemes.  Sunbeam Corp. and its former CEO Albert Dunlap are accused of creating the illusion of a speedy turnaround after he arrived at the company in 1996. An SEC lawsuit filed in May alleges that the company shifted revenues to inflate losses under the old management and added the sales back to inflate income under Dunlap.  The lawsuit also charges that Sunbeam offered discounts to customers that stocked up on merchandise months ahead of schedule, but failed to disclose that such revenue would hurt future results. Dunlap has denied the allegations.

Xerox, the troubled business machine maker, restated earnings from 1998 to 2000 in May after acknowledging that its Mexican subsidiary improperly booked sales and hid bad debts. Questions over its accounting practices helped push its stock down more than 60 percent in the last year.

ConAgra, whose brands include Bumble Bee tuna and Butterball turkeys, said in May that falsified sales at its United Agri Products Cos. subsidiary would force it to lower earnings from 1998 to 2000 by about $123 million. The company and the SEC are informally investigating the accounting practices.

Last month, software maker AremisSoft Corp. announced it was cooperating with a SEC probe into unaccounted-for revenues. The company claimed $7.1 million in sales to the Bulgarian government last year, but auditors have confirmed receipt of only $1.7 million.

The SEC has become increasingly aggressive in its crackdown against alleged offenders. About 260 investigations now under way, a substantial jump from years past.  Lawmakers are also expressing concern about accounting fraud. Rep. Richard Baker, R-La., chairman of a House subcommittee on capital markets, said last month that he may call hearings on the issue.  There's also been a rise in the number of shareholder lawsuits. A recent study by the audit and consulting firm PricewaterhouseCoopers found that of the 201 class-action federal and state lawsuits filed against corporations in 2000, some 53 percent contained accounting allegations. That's up from less than 40 percent in 1995.

"The spectrum of lawsuits goes across all industries, and all sizes of business" said Harvey Kelly, partner in the corporate investigations practice at PricewaterhouseCoopers. "It shows that no one is immune to these kind of challenges."  Faraone joined a class-action lawsuit against Centennial, never expecting to see any of his losses returned. A settlement of the case in 1998 got him 666 shares back, then valued at about 50 cents each, and he sold them immediately.  The company, however, was bought this year by Solectron Corp. for $108 million. Centennial stockholders collected $13.79 for every share they owned. If Faraone had waited, he could have recovered nearly $9,200.  He, however, has no regrets about selling the stock.

"This company did me wrong in a sneaky way," he said. "I wasn't willing to take any more chances."

It Just Gets Deeper and Deeper for Ernst & Young (E&Y)

"Ernst & Young Gets SEC Penalty For Ties to Client," by Jonathan Weil, The Wall Street Journal, April 19, 2004 --- http://online.wsj.com/article/0,,SB108214408244385161,00.html?mod=home_whats_news_us 

In one of the longest suspensions ever of a major accounting firm, Ernst & Young LLP was barred for six months from accepting any new audit clients among publicly traded companies as punishment for participating in a lucrative business venture with a company whose books it audited.

The ruling Friday by the Securities and Exchange Commission's chief administrative-law judge marks the latest sanction of an accounting firm for violating the agency's auditor-independence rules, which are intended to ensure that accounting firms remain impartial in their evaluations of corporate clients' financial statements. The suspension applies to American or foreign companies whose stock or debt trades on U.S. markets.

Ernst had fiercely contested the SEC enforcement division's allegations that it compromised its independence by engaging in a joint venture with PeopleSoft Inc. at the same time that it was the software maker's outside auditor, at one point calling the allegations "outrageous." On Friday, Ernst, the nation's third-largest accounting firm, said it wouldn't appeal the decision.

The conduct occurred in the 1990s, at a time when accounting firms' fees weren't disclosed and the prevailing culture within the major firms was to use audits as a loss leader to generate other, more-lucrative business with clients.

Three of the four major accounting firms, including Ernst, since have sold their consulting practices in response to pressure from regulators. Only Deloitte & Touche LLP continues to maintain a sizable consulting practice, though it too has come under pressure to part ways with its consulting business. Nowadays, companies with publicly traded securities must disclose how much they pay their independent accounting firms for audit and nonaudit work.

Continued in the article

"Big Auditing Firm Gets 6-Month Ban on New Business," by Floyd Morris, The New York Times, April 17, 2004 ---  http://www.nytimes.com/2004/04/17/business/17ERNS.html 

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, PeopleSoft Inc.

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 1991.

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" the rules.

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.

Reports coming out of the US tell us that Ernst & Young has been selling wealthy US citizens four legal techniques for reducing their income tax bill, one of which experts claim could be illegal.
Accountancy Age, June 21, 2002 --- http://www.financialdirector.co.uk/News/1129611 

"SEC Begins Probe Into Ernst's Pacts: Regulator to Weigh If Ties To AMR, Others Met Rules For Auditor-Independence," by Jonathan Weil, The Wall Street Journal, December 8, 2003 --- http://online.wsj.com/article/0,,SB107084523554066200,00.html?mod=mkts_main_news_hs_h

The Securities and Exchange Commission's enforcement division has begun an inquiry into Ernst & Young LLP's business relationships with three major audit clients, including American Express Co., and whether the dealings were appropriate under federal auditor-independence rules.

Ernst's contracts with American Express, AMR Corp.'s American Airlines, and Continental Airlines for travel services came to light this autumn in connection with a lawsuit in an Arkansas state circuit court where Ernst and other accounting firms are contesting allegations that they overbilled clients for travel expenses. In a court filing last week, attorneys for the plaintiff said they received a request from a federal agency for documents relating to Ernst's relationships with the three companies, which were the subject of Wall Street Journal articles on Nov. 20.

"We will fully cooperate with the SEC in its review of this matter," Ernst said in a statement, confirming the agency's identity. An SEC spokesman declined to comment.

One October 1996 contract called for American Express, as Ernst's exclusive travel agent, to receive commissions on all Ernst airfare, hotel rooms and car rentals and return a portion to Ernst. A section called "profit sharing" said Ernst would receive 53% and American Express 47% "of the net profit of Total Commission Revenue and pooled expenses." Ernst also received portions of commissions paid to American Express on leisure travel booked by Ernst employees.

Continued in article

Risk-Based Auditing Under Attack

Auditors looking into the fraud at HealthSouth have found it to be far more extensive than originally thought-as much as $4.6 billion in all. Initially, estimates put the fraud at $3.5 billion at the Birmingham, AL-based operator of rehabilitative clinics.  The auditing firm implicated in the HealthSouth scandal is Ernst & Young --- http://www.AccountingWEB.com/cgi-bin/item.cgi?id=98609 

"Behind Wave of Corporate Fraud: A Change in How Auditors Work:  'Risk Based' Model Narrowed Focus of Their Procedures, Leaving Room for Trouble,' " by Jonathan Weil, The Wall Street Journal, March 25, 2004, Page A1

The recent wave of corporate fraud is raising a harsh question about the auditors who review and bless companies' financial results: How could they have missed all the wrongdoing? One little-discussed answer: a big change in the way audits are performed.

Consider what happened when James Lamphron and his team of Ernst & Young LLP accountants sat down early last year to plan their audit of HealthSouth Corp.'s 2002 financial statements. When they asked executives of the Birmingham, Ala., hospital chain if they were aware of any significant instances of fraud, the executives replied no. In their planning papers, the auditors wrote that HealthSouth's system for generating financial data was reliable, the company's executives were ethical, and that HealthSouth's management had "designed an environment for success."

As a result, the auditors performed far fewer tests of the numbers on the company's books than they would have at an audit client where they perceived the risk of accounting fraud to be higher. That's standard practice under the "risk-based audit" approach now used widely throughout the accounting profession. Among the items the Ernst & Young auditors didn't examine at all: additions of less than $5,000 to individual assets on the company's ledger.

Those numbers are where HealthSouth executives hid a big part of a giant fraud. This blind spot in the firm's auditing procedures is a key reason why former HealthSouth executives, 15 of whom have pleaded guilty to fraud charges, were able to overstate profits by $3 billion without anyone from Ernst & Young noticing until March 2003, when federal agents began making arrests.

A look at the risk-based approach also helps explain why investors continue to be socked by accounting scandals, from WorldCom Inc. and Tyco International Ltd. to Parmalat SpA, the Italian dairy company that admitted faking $4.8 billion in cash. Just because an accounting firm says it has audited a company's numbers doesn't mean it actually has checked them.

In a September 2003 speech, Daniel Goelzer, a member of the auditing profession's new regulator, the Public Company Accounting Oversight Board, called the risk-based approach one of the key factors "that seem to have contributed to the erosion of trust in auditing." Faced with difficulty in raising audit fees, Mr. Goelzer said, the major accounting firms during the 1990s began to stress cost controls. And they began to place greater emphasis on planning the scope of their work based on auditors' judgments about which clients are risky and which areas of a company's financial reports are most prone to error or fraud.

Auditors still plow through "high risk" items, such as derivative financial instruments or "related party" business dealings between a company and its executives. But ostensibly "low risk" items -- such as cash on the balance sheet or accounts that fluctuate little from year to year -- often get no more than a cursory review, for years at a stretch. Instead, auditors rely more heavily on what management tells them and the auditors' assessments of a company's "internal controls."

Old and New

A 2001 brochure by KPMG LLP, which claims to have pioneered the risk-based audit during the early 1990s, explained the difference between the old and new ways. Under a traditional "bottom up" audit, "the auditor gains assurance by examining all of the component parts of the financial statements, ensuring that the transactions recorded are complete and accurate." By comparison, under the "top down" risk-based audit methodology, auditors focus "less on the details of individual transactions" and use their knowledge of a company's business and organization "to identify risks that could affect the financial statements and to target audit effort in those areas."

So, for instance, if controls over a company's sales and customer IOUs are perceived to be strong, the auditor might mail out only a limited number of confirmation requests to companies that do business with the audit client at the end of the year. Instead, the auditor would rely more on the numbers spit out by the company's computers.

For inventory, the lower the perceived risk of errors or fraud, the less frequently junior-level accountants might be dispatched on surprise visits to a client's warehouses to oversee the company's procedures for counting unsold goods. If cash and securities on the balance sheet are deemed low risk, the auditor might mail out only a relative handful of confirmation requests to a company's banks or brokerage firms.

In theory, the risk-based approach should work fine, if an auditor is good at identifying the areas where misstatements are most likely to occur. Proponents advocate the shift as a cost-efficient improvement. They also say it forces auditors to pay needed attention to areas that are more subjective or complex.

"The problem is that there's not a lot of evidence that auditors are very good at assessing risk," says Charles Cullinan, an accounting professor at Bryant College in Smithfield, R.I., and co-author of a 2002 study that criticized the re-engineered audit process as ineffective at detecting fraud. "If you assess risk as low, and it really isn't low, you really could be missing the critical issues in the audit."

Auditors can't check all of a company's numbers, since that would make audits too expensive, particularly in an age of sprawling multinationals. The tools at auditors' disposal can't ensure the reliability of a company's numbers with absolute certainty. And in many ways, they haven't changed much over the modern industry's 160-year history.

Auditors scan the accounting records for inconsistencies. They ask people questions. That can mean independently contacting a client's customers to make sure they haven't struck undocumented side deals -- such as agreeing to buy more products today in exchange for a salesperson's oral promises of future discounts. They search for unrecorded liabilities by tracing cash disbursements to make sure the obligations are recorded properly. They examine invoices and the terms of sales contracts to check if a company is recording revenue prematurely.

Auditors are supposed to avoid becoming predictable. Otherwise, a client's management might figure out how to sneak things by them. It's also important to sample-test tiny accounting entries, even as low as a couple of hundred dollars. An old accounting trick is to fudge lots of tiny entries that appear insignificant individually but materially distort a company's financial statements when taken together.

Facing a crush of shareholder lawsuits over the accounting scandals of the past four years, the Big Four accounting firms say they are pouring tens of millions of dollars into improving their auditing techniques. KPMG's investigative division has doubled to 280 its force of forensic specialists, some hailing from the Federal Bureau of Investigation. PricewaterhouseCoopers LLP auditors attend seminars run by former Central Intelligence Agency operatives on how to spot deceitful managers by scrutinizing body language and verbal cues. Role-playing exercises teach how to stand up to a company's management.

But the firms aren't backing away from the concept of the risk-based audit itself. "It would really be negligent" not to take a risk-based approach, says Greg Weaver, head of Deloitte & Touche LLP's U.S. audit practice. Auditors need to "understand the areas that are likely to be more subject to error," he says. "Some might believe that if you cover those high-risk areas, you could do less work in other areas." But, he adds, "I don't think that's been a problem at Deloitte."

Mr. Lamphron, the Ernst & Young partner, and his firm blame HealthSouth's former executives for deceiving them. Mr. Lamphron declined to comment for this article. Testifying before a congressional subcommittee in November, he said he had looked through his audit papers and "tried to find that one string that, had we yanked it, would have unraveled this fraud. I know we planned and conducted a solid audit. We asked the right questions. We sought out the right documentation. Had we asked for additional documentation here or asked another question there, I think that it would have generated another false document and another lie."

The pioneers of the auditing industry had a more can-do spirit. In Britain during the 1840s, William Deloitte, whose firm continues today as Deloitte & Touche, made a name for himself by helping to unravel frauds at the Great Eastern Steamship Co. and Great Northern Railway. A growing breed of professionals such as William Cooper, whose name lives on in PricewaterhouseCoopers, began advertising their services as an essential means for rooting out fraud.

"The auditor who is able to detect fraud is -- other things being equal -- a better man than the auditor who cannot," wrote influential British accountant Lawrence Dicksee in his 1892 book, "Auditing," one of the earliest on the subject.

But in the U.S., the notion of the auditor as detective never quite took off. The Securities and Exchange Commission in the 1930s made audits mandatory for public companies. The auditing profession faced its first real public test in 1937, when an accounting scandal broke open at McKesson & Robbins: More than 20% of the assets reported by the drug company were fictitious inventory and customer IOUs. The auditors had been fooled by forged documents.

The case triggered some reforms. Auditing standards began requiring that auditors perform more substantive tests, such as contacting third parties to confirm customer IOUs and physically inspecting clients' warehouses to check inventories. However, the American Institute of Certified Public Accountants, the group that set auditing standards, repeatedly emphasized the limitations on auditors' ability to detect fraud, fearing liability exposure for its members.

By the 1970s, a new force emerged to erode audit quality: price competition. For decades, the AICPA had barred auditors from publicly advertising their services, making uninvited solicitations to rival firms' clients or participating in competitive-bidding contests. The institute was forced to lift those bans, however, when the federal government deemed them anticompetitive and threatened to bring antitrust lawsuits.

Bidding wars ensued. The pressures to hold down hours on a job "inadvertently discouraged auditors to look for" fraud, says Toby Bishop, president of the Association of Certified Fraud Examiners, a professional association.

Increasingly, audits became a commodity product. Flat-fee pricing became common. The big accounting firms spent much of the 1980s and 1990s building more-lucrative consulting operations. Many audit clients soon were paying their independent accounting firms far more money for consulting than auditing. The audit had become a mere foot in the door for the consultants. Economic pressures also brought a wave of mergers, winnowing down the number of accounting firms just as the number of publicly traded companies was exploding and corporate financial statements were becoming more complex.

Even before the recent rash of accounting scandals, the shift away from extensive line-by-line number crunching was drawing criticism. In an October 1999 speech, Lynn Turner, then the SEC's chief accountant, noted that more than 80% of the agency's accounting-fraud cases from 1987 to 1997 involved top executives. While the risk-based approach was focusing on information systems and the employees who fed them, auditors really needed to expand their scrutiny to include top executives, who with a few keystrokes could override their companies' systems.

Looking back, the risk-based approach's flaws are on display at a variety of accounting scandals, from WorldCom to Tyco to HealthSouth.

When WorldCom was a small, start-up telecommunications company, its outside auditor, Arthur Andersen LLP, did things the old-fashioned way. It tested the thousands of details of individual transactions, and it reviewed and confirmed the items in WorldCom's general ledger, where the company's accounting entries were first logged.

But as WorldCom grew, Andersen shifted toward what it called a risk-based "business audit process." By 1998, it was incurring more costs to audit WorldCom than it was billing, making up the difference with fees for consulting and other work, according to an investigative report last year by WorldCom's audit committee. In its 2000 audit proposal to WorldCom, Andersen said it considered itself "a committed member of [WorldCom's] team" and saw the company as a "flagship client and a crown jewel" of the firm.

Under the revised audit approach, Andersen used sophisticated software to analyze WorldCom's financial statements. The auditors gathered for brainstorming sessions, imagining ways WorldCom might cook its books. After identifying areas of high risk, the auditors checked the adequacy of internal controls in those areas by reviewing the company's procedures, discussing them with some employees and performing sample tests to see if the procedures were followed.

'Maximum Risk'

When questions arose, the auditors relied on the answers supplied by management, even though their software had rated WorldCom a "maximum risk" client, according to a January report by WorldCom's bankruptcy examiner, former U.S. Attorney General Richard Thornburgh.

One question that Andersen auditors routinely asked WorldCom management was whether they had made any "top side" adjustments -- meaning unusual accounting entries in a company's general ledger that are recorded after the books for a given quarter had closed. Each year, from 1999 through 2002, WorldCom management told the auditors they hadn't. According to Mr. Thornburgh's report, the auditors conducted no testing to corroborate if that was true.

They did check to see if there were any major swings in the items on the company's consolidated balance sheet. There weren't any, and from this, the auditors concluded that follow-up procedures weren't necessary. Indeed, WorldCom executives had manipulated its numbers so there wouldn't be any unusual variances.

Had the auditors dug into specific journal entries -- the debits and credits that are the initial entries of transactions or events into a company's accounting systems -- they would have seen hundreds of huge entries of suspiciously round numbers that had no supporting documentation.

The sole documentation for one $239 million journal entry, recorded after the close of the 1999 fourth quarter, was a sticky note bearing the number "$239,000,000," according to the WorldCom audit committee's report. Sometimes the "top side" adjustments boosted earnings by reversing liabilities. Other times they reclassified ordinary expenses as assets, which delayed recognition of costs. Other unsupported journal entries included one for precisely $334 million in July 2000, three weeks after the second quarter's books were closed. Another was for exactly $560 million in July 2001.

Andersen signed its last audit report for WorldCom in March 2002, saying the numbers were clean. Three months later, WorldCom announced that top executives, including its former chief financial officer, had improperly classified billions of dollars of ordinary expenses as assets. The final tally of fraudulent profits hit $10.6 billion. WorldCom filed for Chapter 11 reorganization in June 2002, marking the largest bankruptcy in U.S. history. Now out of business, Andersen is appealing its June 2002 felony conviction for obstruction of justice in connection with its botched audits of Enron Corp.

"No matter what kind of audit you do, it is virtually impossible for an auditor to detect purposeful fraud by management," says Patrick Dorton, an Andersen spokesman. "And that's exactly what happened at WorldCom."

PricewaterhouseCoopers also fell prone to faulty risk assessments. In July, the SEC forced Tyco, the industrial conglomerate, to restate its profits, which it inflated by $1.15 billion, pretax, from 1998 to 2001. The next month, the SEC barred the lead partner on the firm's Tyco audits from auditing publicly registered companies. His alleged offense: fraudulently representing to investors that his firm had conducted a proper audit. The SEC in its complaint said that the auditor, Richard Scalzo, who settled without admitting or denying the allegations, saw warning signs about top Tyco executives' integrity but never expanded his team's audit procedures.

Mr. Scalzo declined to comment. A PricewaterhouseCoopers spokesman declined to comment on the SEC's findings in the Tyco matter.

Like Tyco and WorldCom, HealthSouth grew mainly by buying other companies, using its own shares as currency. So it needed to keep its stock price up. To do that, the company admitted last year, it faked its profits.

In their audit-planning papers, Ernst & Young auditors noted HealthSouth executives' "excessive interest" in maintaining or increasing its stock price and earnings. Twice since the 1990s, the Justice Department had filed Medicare-fraud suits against HealthSouth.

But none of that shook the Ernst & Young audit team's confidence in management's integrity, members of the team later testified. And at little more than $1 million annually, Ernst & Young's audits were fairly low cost. The firm charged slightly less to audit HealthSouth's financial statements than it did for one of its other services for HealthSouth: performing janitorial inspections of the company's 1,800 health-care facilities. The inspections, performed by junior-level accountants armed with 50-point checklists, included checking to see that the toilets and ceilings were free of stains, the magazine racks were neat and orderly, and the trash receptacles all had liners.

Most of HealthSouth's fraud occurred in an account called "contractual adjustments." This is an allowance on the income statement that estimates the difference between the gross amount charged to a patient and the amount that various insurers, including Medicare, will pay for a specific treatment. The company manipulated the account to make net revenue and bottom-line earnings look higher. But for every dollar of illicit revenue, HealthSouth executives had to make a corresponding entry on the balance sheet, where the company listed its assets and liabilities.

An Ernst & Young spokesman, Charlie Perkins, says the firm "performed appropriate procedures" on the contractual-adjustment account.

At an April 2003 court hearing, Ernst & Young auditor William Curtis Miller testified that his team mainly had performed "analytical type procedures" on the contractual adjustments. These consisted of mathematical calculations to see if the account had fluctuated sharply overall, which it hadn't. As for the balance-sheet entries, prosecutors say HealthSouth executives knew the auditors didn't look at increases of less than $5,000, a point Ernst & Young acknowledges. So the executives broke up the entries into tiny pieces, sprinkling them across lots of assets.

The company's ledger showed thousands of unusual journal entries that reclassified everyday expenses -- such as gasoline and auto-service bills -- as assets. Had the auditors seen those items, one congresswoman noted at a November hearing, they would have spotted that something was wrong. Mr. Lamphron conceded her point.

March 27, 2004 reply from MacEwan Wright, Victoria University [Mac.Wright@VU.EDU.AU] 

-----Original Message----- 
From:  
Sent: Saturday, March 27, 2004 10:29 PM 
Subject: Re: Attacks on Risk-Based Auditing

Dear Bob, 

I wonder if this is not a case of throwing the baby out with the bathwater. I mean the idea of risk based auditing is not in itself a bad idea, The problem is that the idea of what constitutes risk is not properly understood. As I interpret it - risk means probability of event multiplied by cost of event. Risk as used in audit planning means probability of event. It is obvious that the team did not do enough to properly evaluate the inherent risk or more properly stated - the probability that management wouold lie and cheat for profit.

It is am American attitude problem. An American executive posted to an Australian company found the amount of work put into finding out how honest potential employees were a waste of time - "just bond them and sack them and claim the bond insurance if they cheat". Bonding is virtually unheard of in Australia.

I feel that attitude may encourage fraud - the game is what can each party get away with!

Sorry about the social implications. 

Kind regards, 

Mac Wright

March 27, 2004 reply from Bob Jensen

Hi Mac,

You are correct about the fact that risk-based auditing has led to game playing. Somehow the HealthSouth executives figured out that the risk of getting caught with fraudulent transactions under $6,000 each was nearly zero under