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:
"An Examination of
Moral Development within Public Accounting by Gender, Staff Level and Firm"
by Bernardi, R and Arnold, D F (Sr)
dataset covers 494 managers and seniors from five "Big Six" firms.
According to the
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
- 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 global marketplace.
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
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
"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 diversity."
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 practice?
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 that time?
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
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 anti-competitive
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
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 Valero.
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 following:
FIASCO: The Inside Story of a Wall Street Trader
FIASCO: Blood in the Water on Wall Street
FIASCO: Blut an den weiÃŸen Westen der Wall Street
FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance
Infectious Greed : How Deceit and Risk Corrupted the Financial
His other publications include the following highlight:
"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
Selected works of FRANK PARTNOY
Bob Jensen at
1.Who is Frank Partnoy?
writings of Frank Partnoy have had an enormous impact on my teaching and my
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
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
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 ---
selected quotations from his Senate testimony speak for themselves:
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
derivatives-related assets and liabilities increased more than five-fold
during 2000 alone.
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.
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.
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
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.
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
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
3.What are some of Frank Partnoy’s best-known books?
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 roaring 1990s.
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.
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.
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
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.
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
fraudspushed 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?
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 investors."
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.
Is troubled Enron
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.
A 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.
Not 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
The 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 Energy.
But 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 sight.
It 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.
Not 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.
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.
As 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.
To 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 this?
What 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 unique.
The 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.
The 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 gloves.
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 comment.
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.
The 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 two weeks.
Enron's End Run? New financial chief's involvement in Enron
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.
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.
If 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 Enron's condition.
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."
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
Benthany McLean, Fortune
Magazine, December 24, 2001, pp. 58-68.
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."
In 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.
In 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.
Enron's 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 piling up.
The Famous Enron Video on Hypothetical Future
Value (HFV) Accounting
The video shot at Rich
Kinder's retirement party at
Enron features CEO Jeff
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
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
Videotape Watch Clips From
Enron Retirement Tape
INTERACTIVES The End Of
Enron What's The Future Of
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
The collection is all
meant in good fun, but
some of the comments are
ironic in the current
climate of corporate
In one skit, former
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
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
to something I call HFV,
or hypothetical future
Skilling joked as he read
from a script. "If we do
that, we can add a
kazillion dollars to the
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 rolling in."
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
President Ken Rice
recounted a basketball
game where employees from
Enron Capital & Trade beat
Kinder's Enron Corp. team,
"I know you never forget a
number, Rich," Rice said.
President George W. Bush,
who then was governor of
Texas, also took part in
the skit, as did his
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
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 tape.
"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
Warning Signs That Bad Guys Were Running Enron and That Political Whores
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 sown.
In early 1995, the world's
biggest natural gas company began clearing ground 100 miles south of Bombay,
India for a $2.8 billion, gas-fired power plant -- the largest single
foreign investment in India.
Villagers 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?"
As Pratap 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.
After winning Maharashtra
state elections, the conservative nationalistic Bharatiya Janata Party
canceled the deal, sending shock waves through Western businesses with
investments in India.
Maharashtra 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."
Enron 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.
In November 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
"There were 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.
Enron has 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
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
SUMMARY: Enron's 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
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
Reviewed By: Kimberly Dunn, Florida
SUMMARY: Critics 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 auditor
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?
SMALL GROUP 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
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
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
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 www.bis.org .
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 1995-1998? 1998-2001?
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
Jacqueline Garner, Georgia State University and Univ. of Rhode Island
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
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
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
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 investments?
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
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 Enron at
Click on the above link to
view a thirty-minute archived webcast on the AICPA's newly adopted
After 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.
Please provide us your
questions via e-mail after viewing the
archived webcast. We will respond to those questions during the
live webcast on December 4.
To view/register for the live webcast on December 4, click the "live
webcast" button located on the
AICPA Video Player.
The FASB also has a video
that focuses on the supreme importance of independence in the CPA
FASB 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 restated.
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 rule?"
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 accounting firms.
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 cited.
THE AFTERMATH of Enron,
the tarnished auditing
profession has mounted
what might be called the
"complexity defense." This
seriously, intoning a few
befuddling sentences, then
sighing that audits
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
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
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
Where was Deloitte &
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
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
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 percent.
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
The above article must be juxtaposed against this earlier Washington Post
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 cited.
"At Enron, the Fall Came Quickly:
Complexity, Partnerships Kept Problems From Public View"
By Steven Pearlstein and Peter Behr
Washington Post Staff Writers
Sunday, December 2, 2001; Page A01
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
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
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 gone elsewhere.
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.
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 hearings.
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 revealed.
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 electricity.
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
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.
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
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 investment.
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.
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
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 that.
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.
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 February.
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 a share.
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.
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 corporation does.
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 head."
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 Arthur Andersen.
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 services.
David Talbot recently described the problems with Enron's books as "an
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.
$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 accounting matters.
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
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
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.
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."
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 monumental collapse.
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 takeover agreement.
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
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."
disintegration," he added, follows "a general loss of public confidence in
its leadership and credibility."
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
"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
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 Houston
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
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.
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.
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 constructive.
you haven't been to my site recently (or at all), you can see my latest news
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 themselves.
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 competitors combined.
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
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 delivery
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 things.
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.
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.
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
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 bankruptcy.
If lessons are to be
learned from Enron, a range of broader issues need to be addressed. Among
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.
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 liabilities of
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
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
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.
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
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.
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 security.
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
http://www.house.gov/financialservices/testoc2.htm , 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
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 accounting?
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 a hit.
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 could
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
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 little bit.
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
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
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 at
So 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.
At 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
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
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.
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
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 make sense?"
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."
In 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
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.
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.
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 million.
The 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."
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.
The 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 No. 1.
Where is the
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 gas.
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
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 ---
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.
A Joe 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).
Enron 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."
securities lawyers in Washington D.C., Pitt outlined the steps the SEC
intends to take to accomplish this goal.
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 added.
The 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 regulatory
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 practices.
As 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
"We 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
As 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."
The 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
THE RELUCTANT REFORMER
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
Few 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 facts.
The author 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
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 regard
Attached are copies of the
two emails and a copy of the Andersen records retention policy.
The following files are
available for download in PDF format:
Copy of two e-mails (15k, 1
Policy statement: Client
Engagement Information - Organization, Retention and Destruction, Statement
No. 760 (140k, 26 pages)
Policy 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
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 carcass.
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:
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
As the rules
stand today, sponsoring companies can keep the assets and liabilities of
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 ...
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 point.
On the 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 is at
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!
On the 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:
Quote From "Accounting
for Stock-Based Compensation" in August of 1993.
Arthur Andersen Views
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.
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 important projects.
I can't decide whether
it is better to describe the above reply haughty or snotty --- I think I will
call it both.
The 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
Joe 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
SPEs. For example, the January 5, 2001
issue is at
I will close this with a
quotation from a former Chief Accountant of the Securities and Exchange
Quote From a Chief Accountant of the SEC
(Well Over a Year Before the Extensive Use of SPEs by Enron Became
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.
But again, 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
"The State of Financial
Reporting Today: An Unfinished Chapter"
The 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 accounting for
Thus I 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
February 14, 2003
NEW YORK(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 article said.
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
With the Internal Revenue Service,
Congress and even their own clients on their case, tax-shelter promoters are
changing their act to survive.
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 Solutions."
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
Shelter promoters 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
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 travails of
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
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 business
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
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?
NEW 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
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
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
Under 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
The dilemma facing Sprint
and its two top executives
over whether to reverse
the options shows how the
financial situation had
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
issues that can hurt
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 by regulators.
Sprint 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.
Sprint 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
If the 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
which would have cut
"They 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
analyst. "So there was no
way they were going to do
The tax savings to Sprint
revealed in the filings
shed light on why the
company opted not to
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
Many 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
If the 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 tax experts.
The 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
The 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
Paragraph on p. A17 of
Wall Street Journal,
Tuesday, February 11,
2003, about E&Y's advice
to Sprint executives
William Esrey and Ronald
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
Can this be for real?
Department of Accounting &
Business Computer Systems
Box 30001/MSC 3DH New
Mexico State University
Las Cruces, NM, USA
Of 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,
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
and (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
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.
APB 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
On January 11, 2002 Ruth Bender,
Cranfield School of Management wrote the following:
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.
From Time Magazine on
January 14, 2002.
Just four 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. history.
Supervisors 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 explosive issue.
Though there 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
The 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.
Shredded 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.
Texas 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 collapse.
Bush told 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.
An O'Neill 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
On the 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 committed?
The justice 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?
"It's not 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
Enron has 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 earnings.
As for 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
"The Big Five Need to
Factor in Investors," Business Week, December 24, 2001, Page 32 ---
http://www.businessweek.com/ (not free to download for non-subscribers)
At issue are so-called special-purpose entities
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
an outside investor puts up capital worth at least 3% of the
SPEs total value.
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 probing.
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
The rest of the
article is on Page 38 of the Business Week Article.
How Bad Will It Get?" Business Week, December 24, 2001, pp. 30-32 ---
http://www.businessweek.com/ (not free to download for non-subscribers)
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 so informed.)
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."
"Let Auditors Be
Auditors," Editorial Page, Business Week, December 24, 2001, Page 96
(not free to download for non-subscribers)
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 time again.
Big 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." ---
Although the 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
Message 1 (January 5, 2002) from a
former Chairman of the Financial Accounting Standards Board (Denny Beresford)
You might be
interested in the following link to an article in the Atlanta newspaper that
mentions my own economic setback re: Enron.
"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."
But a lot of
individuals and institutional investors did not have questions, even months
into the decline in Enron stock.
At 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 magazine.
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.
"It 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.
On 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.
On 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.
One 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
"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 statement audit?
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 clients?
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
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
Reviewed By: Judy Beckman, University of Rhode
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
International Reactions and An
Editorial from Double Entries on December 13, 2001
The 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
http://accountingeducation.com/news/news2363.html for the statement
 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
http://accountingeducation.com/news/news2362.html for 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].
Betting the 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.
Derivative financial 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.
So where's the
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 things as
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.
So who should pay?
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.
U.S. Bankruptcy Judge Arthur Gonzalez
has ordered WorldCom to stop paying its external auditor KMPG after 14 states
announced last week that the Big Four firm gave the company advice designed to
avoid some state taxes ---
AccountingWEB.com - Mar-24-2004 -
U.S. Bankruptcy Judge Arthur Gonzalez has ordered WorldCom to stop paying
its external auditor KMPG after 14 states announced
last week that the Big Four firm gave the company advice designed to
avoid some state taxes.
WorldCom called the
judge’s move a "standard procedural step," which occurs anytime a party in a
bankruptcy proceeding has objections to fees paid to advisors. A hearing is
set for April 13 to discuss the matter, the Wall Street Journal reported.
Both KPMG and MCI,
which is the name WorldCom is now using, say the states claims are without
merit and expect the telecommunications giant to emerge from bankruptcy on
schedule next month.
confident that we'll win on the merits of the motion," MCI said.
Last week, the
Commonwealth of Massachusetts claimed it was denied $89.9 million in tax
revenue because of an aggressive KPMG-promoted tax strategy that helped
WorldCom cut its state tax obligations by hundreds of millions of dollars in
the years before its 2002 bankruptcy filing, the Wall Street Journal
states joined the action led by Massachusetts Commissioner of Revenue Alan
LeBovidge, who filed documents last week with the U.S. Bankruptcy Court for
the Southern District of New York. The states call KPMG’s tax shelter a
"sham" and question the accounting firm’s independence in acting as
WorldCom’s external auditor or tax advisor, the Journal reported.
KPMG disputes the
states’ claims. George Ledwith, KPMG spokesman, told the Journal, "Our
corporate-tax work for WorldCom was performed appropriately, in accordance
with professional standards and all rules and regulations, and we firmly
stand behind it. We are confident that KPMG remains disinterested as
required for all of the company's professional advisers in its role as
WorldCom's external auditor. Any allegation to the contrary is groundless."
Worldcom Inc. emerged from federal bankruptcy
protection this morning with the new name of MCI, about 21 months
after the scandal-tainted company sought protection from creditors in
the wake of an $11 billion accounting fraud.
"It really is a great day for the company,"
Michael D. Capellas, MCI's president and chief executive, said in a
conference call with reporters. "We come out of bankruptcy with
virtually all of our core assets intact. But it's been a marathon with
The bankruptcy process has allowed MCI to
dramatically pare its debt from $41 billion to about $6 billion. And
although that cutback will reduce debt service payments by a little
more than $2 billion a year, the company still faces some hurdles in
its comeback effort.
In addition to changing its new name, the
company added five people to its board.
Richard Breeden, the former chairman of the
Securities and Exchange Commission who serves as MCI's court-appointed
monitor, has imposed some restrictions on board members to make their
actions more transparent. Those include a requirement that directors
give two weeks' notice before selling MCI stock.
Even though MCI has emerged from bankruptcy,
Judge Jed S. Rakoff, the federal district judge who oversaw the
S.E.C.'s civil lawsuit against the company, has asked Mr. Breeden to
stay on for at least two years.
For the time being, MCI shares will trade
under the symbol MCIAV, which has been the symbol since the company
went into bankruptcy.
Peter Lucht, an MCI spokesman, said it will
be "several weeks, not months" before MCI lists its shares on the
In early morning trading, MCIAV was quoted at
$18, down $1.75 a share.
It was just about a year ago that Worldcom
unveiled its reorganization plan, which included moving its
headquarters from Clinton, Miss., to Ashburn, Va., and renaming the
company after its long-distance unit, MCI.
Worldcom had merged with MCI in a transaction
that was announced in 1997.
Although its outstanding debt has been
dramatically reduced, MCI faces daunting challenges, not the least of
which are pricing pressures in what remains a brutally competitive
MCI has already warned it expects revenues to
drop 10 percent to 12 percent this year.
To offset the revenue decline, the company
has taken steps to cut costs.
Last month, MCI announced plans to lay off
4,000 employees, reducing its work force to about 50,000.
"It's going to be a tough year," Mr. Capellas
said. "But the good news about our industry is that people do
communicate, and they communicate in more ways."
Mr. Capellas cited four areas where he saw
growth potential for MCI: increased business from the company's
current customers; global expansion; additions to MCI's array of
products; and expansion of the company's security business.
"Even though there are certain areas in the
industry that are compressing, we think there is some space to grow,"
In the course of the bankruptcy, MCI said it
lost none of its top 100 customers. And in January the federal
government, which collectively is MCI's biggest customer, lifted a
six-month ban that had prohibited the company from bidding for new
To a certain extent, MCI's growth prospects
will be hampered by its bondholders, whose primary interest is to
ensure they are repaid for their investment as soon as possible.
Even though many who contributed to the
Worldcom scandal are gone, it will probably be some time before
memories of what happened fade.
All of the senior executives and board
members from the time when Bernard Ebbers was chief executive are no
longer with the company.
Five executives, including Scott Sullivan,
Worldcom's former chief financial officer, have pleaded guilty to
federal charges for their roles in the scandal and are cooperating
with the government in its investigation.
Mr. Ebbers has pleaded innocent to charges
including conspiracy and securities fraud.
What are the three main
problems facing the profession of accountancy at the present time?
under greed, with stock options and tax shelters for all.
Proposed revision of the U.S. Pledge of Allegiance following a June 26, 2002
U.S. court decision that the present version is unconstitutional.
CLINTON, Miss., June
25, 2002 – WorldCom, Inc. (Nasdaq: WCOM, MCIT) today announced it intends to
restate its financial statements for 2001 and the first quarter of 2002. As a
result of an internal audit of the company’s capital expenditure accounting,
it was determined that certain transfers from line cost expenses to capital
accounts during this period were not made in accordance with generally
accepted accounting principles (GAAP). The amount of these transfers was
$3.055 billion for 2001 and $797 million for first quarter 2002. Without these
transfers, the company’s reported EBITDA would be reduced to $6.339 billion
for 2001 and $1.368 billion for first quarter 2002, and the company would have
reported a net loss for 2001 and for the first quarter of 2002.
The company promptly
notified its recently engaged external auditors, KPMG LLP, and has asked KPMG
to undertake a comprehensive audit of the company’s financial statements for
2001 and 2002. The company also notified Andersen LLP, which had audited the
company’s financial statements for 2001 and reviewed such statements for first
quarter 2002, promptly upon discovering these transfers. On June 24, 2002,
Andersen advised WorldCom that in light of the inappropriate transfers of line
costs, Andersen’s audit report on the company’s financial statements for 2001
and Andersen’s review of the company’s financial statements for the first
quarter of 2002 could not be relied upon.
The company will
issue unaudited financial statements for 2001 and for the first quarter of
2002 as soon as practicable. When an audit is completed, the company will
provide new audited financial statements for all required periods. Also,
WorldCom is reviewing its financial guidance.
The company has
terminated Scott Sullivan as chief financial officer and secretary. The
company has accepted the resignation of David Myers as senior vice president
WorldCom has notified
the Securities and Exchange Commission (SEC) of these events. The Audit
Committee of the Board of Directors has retained William R. McLucas, of the
law firm of Wilmer, Cutler & Pickering, former Chief of the Enforcement
Division of the SEC, to conduct an independent investigation of the matter.
This evening, WorldCom also notified its lead bank lenders of these events.
restatement of operating results for 2001 and 2002 is not expected to have an
impact on the Company’s cash position and will not affect WorldCom’s customers
or services. WorldCom has no debt maturing during the next two quarters.
management team is shocked by these discoveries,” said John Sidgmore,
appointed WorldCom CEO on April 29, 2002. “We are committed to operating
WorldCom in accordance with the highest ethical standards.”
“I want to assure our
customers and employees that the company remains viable and committed to a
long-term future. Our services are in no way affected by this matter, and our
dedication to meeting customer needs remains unwavering,” added Sidgmore. “I
have made a commitment to driving fundamental change at WorldCom, and this
matter will not deter the new management team from fulfilling our plans.”
Actions to Improve
Liquidity and Operational Performance
previously announced, WorldCom will continue its efforts to restructure the
company to better position itself for future growth. These efforts include:
expenditures significantly in 2002. We intend 2003 capital expenditures will
be $2.1 billion on an annual basis.
workforce by 17,000, beginning this Friday, which is expected to save $900
million on an annual basis. This downsizing is primarily composed of
discontinued operations, operations & technology functions, attrition and
Selling a series of
non-core businesses, including exiting the wireless resale business, which
alone will save $700 million annually. The company is also exploring the sale
of other wireless assets and certain South American assets. These sales will
reduce losses associated with these operations and allow the company to focus
on its core businesses.
Paying Series D, E
and F preferred stock dividends in common stock rather than cash, deferring
dividends on MCI QUIPS, and discontinuing the MCI tracker dividend, saving
approximately $375 million annually.
discussions with our bank lenders.
Creating a new
position of Chief Service and Quality Officer to keep an eye focused on our
customer services during this restructuring.
“We intend to create
$2 billion a year in cash savings in addition to any cash generated from our
business operations,” said Sidgmore. “By focusing on these steps, I am
convinced WorldCom will emerge a stronger, more competitive player.”
of MCI's most outspoken opponents, never filed a lawsuit against MCI. But last
spring, the company's general counsel, William Barr, said MCI had operated as "a
criminal enterprise," referring to the company's accounting fraud. Mr. Barr also
argued that the company should be liquidated rather than allowed out of
bankruptcy. Mr. Barr couldn't be reached for comment Monday. Commenting on the
settlement, Verizon spokesman Peter Thonis said, "we understand that this is
still under criminal investigation and nothing has changed in that regard." Shawn Young, and Almar Latour, The Wall Street Journal,
February 24, 2004 ---
In Switch, CFO Sullivan Pleads
Agrees to Testify Against Former Boss
After trying for two years to build
a case against Bernard J. Ebbers, the federal government finally charged
the man at the top of WorldCom Inc., amid growing momentum in the
prosecution of the big 1990s corporate scandals.
Mr. Ebbers was indicted Tuesday for
allegedly helping to orchestrate the largest accounting fraud in U.S.
history. The former chairman and chief executive, who had made WorldCom
into one of the biggest stock-market stars of the past decade, was charged
with securities fraud, conspiracy to commit securities fraud and making
false filings to regulators.
After a grueling investigation,
prosecutors finally got their break from an unlikely source: Scott
Sullivan, WorldCom's former chief financial officer. He had vowed to fight
charges against him and was set to go to trial in late March. But instead,
after a recent change of heart, he pleaded guilty Tuesday to three charges
just before Mr. Ebbers's indictment was made public. Mr. Sullivan also
signed an agreement to cooperate in the case against his former boss.
The indictment, which centers
around the two executives' private discussions as they allegedly conspired
to mislead investors, shows that Mr. Sullivan's cooperation already has
yielded big results for prosecutors. "Ebbers and Sullivan agreed to take
steps to conceal WorldCom's true financial condition and operating
performance from the investing public," the indictment stated.
WorldCom, now known as MCI, is one
of the world's largest telecommunications companies, with 20 million
consumer and corporate customers and 54,000 employees. The company's
investors lost more than $180 billion as the accounting fraud reached $11
billion and drove the company into bankruptcy. Ultimately almost 20,000
employees lost their jobs.
Attorney General John Ashcroft
traveled to New York Tuesday to announce the indictment, as years of
prosecutors' efforts in WorldCom and other big corporate fraud cases
finally start to bear fruit. Little progress had been made in the WorldCom
case since five employees pleaded guilty to fraud charges in the summer of
2002. As outrage over the wave of corporate scandals built, prosecutors
struggled with several key puzzle pieces as they sought to assign blame
for the corporate wrongdoing.
They were initially unable to make
cases against Mr. Ebbers and Enron Corp. Chief Executive Jeffrey Skilling.
And Mr. Sullivan and former Enron Chief Financial Officer Andrew Fastow
gave every indication that they were going to vigorously fight the charges
against them. Enron, the Houston-based energy company, filed for
bankruptcy-court protection in 2001.
But in recent weeks a lot has
changed. In January Mr. Fastow pleaded guilty and agreed to cooperate with
prosecutors. Soon afterward the government indicted his former boss, Mr.
Skilling. Meanwhile, highly publicized fraud trials of the top executives
of Tyco International Ltd. and Adelphia Communications Corp. are under way
in New York and prosecutors have continued to make plea agreements in the
cases stemming from the fraud at HealthSouth Corp. Two former HealthSouth
executives agreed to plead guilty Tuesday (see
article). Former HealthSouth Chairman Richard Scrushy was indicted
Mr. Ashcroft in his announcement
Tuesday said that two years of work had paid off with more than 600
indictments and more than 200 convictions of executives. "America's
economic strength depends on ... the accountability of corporate
officials," he said.
Mr. Sullivan, a close confidant of
Mr. Ebbers, pleaded guilty to three counts of securities fraud. He
secretly began cooperating with prosecutors in recent weeks, according to
people close to the situation.
Continued in the article
Contrary to the optimism expressed
above, most analysts are predicting that WorldCom will declare bankruptcy in a
matter of months. Unlike the Enron scandal where accounting deception was
exceedingly complex in very complicated SPE and derivatives accounting schemes,
it appears that WorldCom and its Andersen auditors allowed very elementary and
blatant violations of GAAP to go undetected.
This morning on June 27, 2002, I found
some interesting items in the reported prior-year
SEC 10-K report for WorldCom and its Subsidiaries:
income (in millions)
paid (in millions)
The enormous disparity between income
reported to the public and taxes actually paid on income are consistent with the
following IRS study:
An IRS study
released this week shows a growing gap between figures reported to investors
and figures reported for tax income. With all the scrutiny on accounting
practices these days, the question is being asked - are corporations telling
the truth to the IRS? To investors? To anyone?
Such results highlight the fact that audited GAAP figures reported to
investors have lost credibility. Three problems account for this.
One is that bad audits have become routine such that too many companies either
have to belatedly adjust accounting reports or errors and fraud go undetected.
The second major problem is that the powerful corporate lobby and its friends in
the U.S. Legislature have muscled sickening tax laws and bad GAAP. The third
problem is that in spite of a media show of concern, corporate America still has
a sufficient number of U.S. senators, congressional representatives, and
accounting/auditing standard setters under control such that serious reforms are
repeatedly derailed.Appeals to virtue and ethics just are not going to solve this problem
until compensation and taxation laws and regulations are fundamentally revised
to impede moral hazard.
One example is the case of employee stock options
accounting. Corporate lobbyists muscled the FASB and the SEC into not
booking stock options as expenses for GAAP reporting purposes. However,
America lobbied for enormous tax benefits that are given to
corporations when stock options are exercised (even though these options are
not booked as corporate expenses). Following the Enron scandal, powerful
investors like Warren Buffet and the Chairman of the Federal Reserve Board,
Alan Greenspan, have made strong efforts to book stock options as expenses,
but even more powerful leaders like George Bush have blocked reform on stock
For example, in its Year 2000 annual
report, Cisco Systems reported $2.67 billion in profits, but managed to wipe out
nearly all income taxes with a $2.5 billion benefit from the exercise of
employee stock options (ESOs). In a similar manner, WorldCom reported $585
million in 1999 and $124 million in 2000 tax benefits added to paid-in capital
from exercise of ESOs.
under greed, with stock options and tax shelters for all.
Proposed revision of the U.S. Pledge of Allegiance following a U.S. June 26,
2002 court decision that the present version is unconstitutional.
Worldcom Inc.'s restated
financial reports aren't
even at the printer yet, and
already new questions are
surfacing about whether
investors can trust the
independence of the
company's latest auditor,
KPMG LLP -- and, thus, the
I suspect by now, most of you are aware that after
the world's largest accounting scandal ever, our
Denny Beresford accepted an invitation to join
the Board of Directors at Worldcom. This has been an intense addition to
his day job of being on the accounting faculty at the University of Georgia.
Denny has one of the best, if not the best, reputations for technical skills
and integrity in the profession of accountancy. In the article below, he
is quoted extensively while coming to the defense of the KPMG audit of the
restated financial statements at Worldcom. I might add that Worldcom's
accounting records were a complete mess following Worldcom's deliberate
efforts to deceive the world and Andersen's suspected complicity in the crime.
If Andersen was not in on the conspiracy, then Andersen's Worldcom audit goes
on record as the worst audit in the history of the world. For more on
the Worldcom scandal, go to
Worldcom Inc.'s restated financial reports aren't
even at the printer yet, and already new questions are surfacing about
whether investors can trust the independence of the company's latest
auditor, KPMG LLP -- and, thus, the numbers themselves.
The doubts stem from a brewing series of disputes
between state taxing authorities and WorldCom, now doing business under the
name MCI, over an aggressive KPMG tax-avoidance strategy that the
long-distance company used to reduce its state-tax bills by hundreds of
millions of dollars from 1998 until 2001. MCI, which hopes to exit
bankruptcy-court protection in late February, says it continues to use the
strategy. Under it, MCI treated the "foresight of top management" as an
asset valued at billions of dollars. It licensed this foresight to its
subsidiaries in exchange for royalties that the units deducted as business
expenses on state tax forms.
It turns out, of course, that WorldCom management's
foresight wasn't all that good. Bernie Ebbers, the telecommunications
company's former chief executive, didn't foresee WorldCom morphing into the
largest bankruptcy filing in U.S. history or getting caught overstating
profits by $11 billion. At least 14 states have made known their intention
to sue the company if they can't reach tax settlements, on the grounds that
the asset was bogus and the royalty payments lacked economic substance.
Unlike with federal income taxes, state taxes won't necessarily get wiped
out along with MCI's restatement of companywide profits.
MCI says its board has decided not to sue KPMG --
and that the decision eliminates any concerns about independence, even if
the company winds up paying back taxes, penalties and interest to the
states. MCI officials say a settlement with state authorities is likely, but
that they don't expect the amount involved to be material. KPMG, which
succeeded the now-defunct Arthur Andersen LLP as MCI's auditor in 2002, says
it stands by its tax advice and remains independent. "We're fully familiar
with the facts and circumstances here, and we believe no question can be
raised about our independence," the firm said in a one-sentence statement.
Auditing standards and federal securities rules
long have held that an auditor "should not only be independent in fact; they
should also avoid situations that may lead outsiders to doubt their
independence." Far from resolving the matter, MCI's decision not to sue has
made the controversy messier.
In a report released Monday, MCI's Chapter 11
bankruptcy-court examiner, former U.S. Attorney General Richard Thornburgh,
concluded that KPMG likely rendered negligent and incorrect tax advice to
MCI and that MCI likely would prevail were it to sue to recover past fees
and damages for negligence. KPMG's fees for the tax strategy in question
totaled at least $9.2 million for 1998 and 1999, the examiner's report said.
The report didn't attempt to estimate potential damages.
Actual or threatened litigation against KPMG would
disqualify the accounting firm from acting as MCI's independent auditor
under the federal rules. Deciding not to sue could be equally troubling,
some auditing specialists say, because it creates the appearance that the
board may be placing MCI stakeholders' financial interests below KPMG's. It
also could lead outsiders to wonder whether MCI is cutting KPMG a break to
avoid delaying its emergence from bankruptcy court, and whether that might
subtly encourage KPMG to go easy on the company's books in future years.
"If in fact there were problems with prior-year tax
returns, you have a responsibility to creditors and shareholders to go after
that money," says Charles Mulford, an accounting professor at Georgia
Institute of Technology in Atlanta. "You don't decide not to sue just to be
nice, if you have a legitimate claim, or just to maintain the independence
of your auditors."
In conducting its audits of MCI, KPMG also would be
required to review a variety of tax-related accounts, including any
contingent state-tax liabilities. "How is an auditor, who has told you how
to avoid state taxes and get to a tax number, still independent when it
comes to saying whether the number is right or not?" says Lynn Turner,
former chief accountant at the Securities and Exchange Commission. "I see
little leeway for a conclusion other than the auditors are not independent."
Dennis Beresford, the chairman of MCI's audit
committee and a former chairman of the Financial Accounting Standards Board,
says MCI's board concluded, based on advice from outside attorneys, that the
company doesn't have any claims against KPMG. Therefore, he says, KPMG
shouldn't be disqualified as MCI's auditor. He calls the tax-avoidance
strategy "aggressive." But "like a lot of other tax-planning type issues,
it's not an absolutely black-and-white matter," he says, explaining that "it
was considered to be reasonable and similar to what a lot of other people
were doing to reduce their taxes in legal ways."
Mr. Beresford says he had anticipated that the
decision to keep KPMG as the company's auditor would be controversial. "We
recognized that we're going to be in the spotlight on issues like this," he
says. Ultimately, he says, MCI takes responsibility for whatever tax filings
it made with state authorities over the years and doesn't hold KPMG
He also rejected concerns over whether KPMG would
wind up auditing its own work. "Our financial statements will include
appropriate accounting," he says. He adds that MCI officials have been in
discussions with SEC staff members about KPMG's independence status, but
declines to characterize the SEC's views. According to people familiar with
the talks, SEC staff members have raised concerns about KPMG's independence
but haven't taken a position on the matter.
Mr. Thornburgh's report didn't express a position
on whether KPMG should remain MCI's auditor. Michael Missal, an attorney who
worked on the report at Mr. Thornburgh's law firm, Kirkpatrick & Lockhart
LLP, says: "While we certainly considered the auditor-independence issue, we
did not believe it was part of our mandate to draw any conclusions on it.
That is an issue left for others."
Among the people who could have a say in the matter
is Richard Breeden, the former SEC chairman who is overseeing MCI's affairs.
Mr. Breeden, who was appointed by a federal district judge in 2002 to serve
as MCI's corporate monitor, couldn't be reached for comment Tuesday.
KPMG’s “Unusual Twist”
While KPMG's strategy isn't
uncommon among corporations
with lots of units in
different states, the
accounting firm offered an
unusual twist: Under KPMG's
direction, WorldCom treated
"foresight of top
management" as an intangible
asset akin to patents or
Worldcom Inc.'s restated
financial reports aren't
even at the printer yet, and
already new questions are
surfacing about whether
investors can trust the
independence of the
company's latest auditor,
KPMG LLP -- and, thus, the
I suspect by now, most of you are aware that
after the world's largest accounting scandal ever, our
Denny Beresford accepted an invitation to
join the Board of Directors at Worldcom. This has been an intense
addition to his day job of being on the accounting faculty at the
University of Georgia. Denny has one of the best, if not the best,
reputations for technical skills and integrity in the profession of
accountancy. In the article below, he is quoted extensively while
coming to the defense of the KPMG audit of the restated financial
statements at Worldcom. I might add that Worldcom's accounting
records were a complete mess following Worldcom's deliberate efforts to
deceive the world and Andersen's suspected complicity in the crime.
If Andersen was not in on the conspiracy, then Andersen's Worldcom audit
goes on record as the worst audit in the history of the world. For
more on the Worldcom scandal, go to
Worldcom Inc.'s restated financial reports
aren't even at the printer yet, and already new questions are
surfacing about whether investors can trust the independence of the
company's latest auditor, KPMG LLP -- and, thus, the numbers
The doubts stem from a brewing series of
disputes between state taxing authorities and WorldCom, now doing
business under the name MCI, over an aggressive KPMG tax-avoidance
strategy that the long-distance company used to reduce its state-tax
bills by hundreds of millions of dollars from 1998 until 2001. MCI,
which hopes to exit bankruptcy-court protection in late February, says
it continues to use the strategy. Under it, MCI treated the "foresight
of top management" as an asset valued at billions of dollars. It
licensed this foresight to its subsidiaries in exchange for royalties
that the units deducted as business expenses on state tax forms.
It turns out, of course, that WorldCom
management's foresight wasn't all that good. Bernie Ebbers, the
telecommunications company's former chief executive, didn't foresee
WorldCom morphing into the largest bankruptcy filing in U.S. history
or getting caught overstating profits by $11 billion. At least 14
states have made known their intention to sue the company if they
can't reach tax settlements, on the grounds that the asset was bogus
and the royalty payments lacked economic substance. Unlike with
federal income taxes, state taxes won't necessarily get wiped out
along with MCI's restatement of companywide profits.
MCI says its board has decided not to sue
KPMG -- and that the decision eliminates any concerns about
independence, even if the company winds up paying back taxes,
penalties and interest to the states. MCI officials say a settlement
with state authorities is likely, but that they don't expect the
amount involved to be material. KPMG, which succeeded the now-defunct
Arthur Andersen LLP as MCI's auditor in 2002, says it stands by its
tax advice and remains independent. "We're fully familiar with the
facts and circumstances here, and we believe no question can be raised
about our independence," the firm said in a one-sentence statement.
Auditing standards and federal securities
rules long have held that an auditor "should not only be independent
in fact; they should also avoid situations that may lead outsiders to
doubt their independence." Far from resolving the matter, MCI's
decision not to sue has made the controversy messier.
In a report released Monday, MCI's Chapter 11
bankruptcy-court examiner, former U.S. Attorney General Richard
Thornburgh, concluded that KPMG likely rendered negligent and
incorrect tax advice to MCI and that MCI likely would prevail were it
to sue to recover past fees and damages for negligence. KPMG's fees
for the tax strategy in question totaled at least $9.2 million for
1998 and 1999, the examiner's report said. The report didn't attempt
to estimate potential damages.
Actual or threatened litigation against KPMG
would disqualify the accounting firm from acting as MCI's independent
auditor under the federal rules. Deciding not to sue could be equally
troubling, some auditing specialists say, because it creates the
appearance that the board may be placing MCI stakeholders' financial
interests below KPMG's. It also could lead outsiders to wonder whether
MCI is cutting KPMG a break to avoid delaying its emergence from
bankruptcy court, and whether that might subtly encourage KPMG to go
easy on the company's books in future years.
"If in fact there were problems with
prior-year tax returns, you have a responsibility to creditors and
shareholders to go after that money," says Charles Mulford, an
accounting professor at Georgia Institute of Technology in Atlanta.
"You don't decide not to sue just to be nice, if you have a legitimate
claim, or just to maintain the independence of your auditors."
In conducting its audits of MCI, KPMG also
would be required to review a variety of tax-related accounts,
including any contingent state-tax liabilities. "How is an auditor,
who has told you how to avoid state taxes and get to a tax number,
still independent when it comes to saying whether the number is right
or not?" says Lynn Turner, former chief accountant at the Securities
and Exchange Commission. "I see little leeway for a conclusion other
than the auditors are not independent."
Dennis Beresford, the chairman of MCI's audit
committee and a former chairman of the Financial Accounting Standards
Board, says MCI's board concluded, based on advice from outside
attorneys, that the company doesn't have any claims against KPMG.
Therefore, he says, KPMG shouldn't be disqualified as MCI's auditor.
He calls the tax-avoidance strategy "aggressive." But "like a lot of
other tax-planning type issues, it's not an absolutely black-and-white
matter," he says, explaining that "it was considered to be reasonable
and similar to what a lot of other people were doing to reduce their
taxes in legal ways."
Mr. Beresford says he had anticipated that
the decision to keep KPMG as the company's auditor would be
controversial. "We recognized that we're going to be in the spotlight
on issues like this," he says. Ultimately, he says, MCI takes
responsibility for whatever tax filings it made with state authorities
over the years and doesn't hold KPMG responsible.
He also rejected concerns over whether KPMG
would wind up auditing its own work. "Our financial statements will
include appropriate accounting," he says. He adds that MCI officials
have been in discussions with SEC staff members about KPMG's
independence status, but declines to characterize the SEC's views.
According to people familiar with the talks, SEC staff members have
raised concerns about KPMG's independence but haven't taken a position
on the matter.
Mr. Thornburgh's report didn't express a
position on whether KPMG should remain MCI's auditor. Michael Missal,
an attorney who worked on the report at Mr. Thornburgh's law firm,
Kirkpatrick & Lockhart LLP, says: "While we certainly considered the
auditor-independence issue, we did not believe it was part of our
mandate to draw any conclusions on it. That is an issue left for
Among the people who could have a say in the
matter is Richard Breeden, the former SEC chairman who is overseeing
MCI's affairs. Mr. Breeden, who was appointed by a federal district
judge in 2002 to serve as MCI's corporate monitor, couldn't be reached
for comment Tuesday.
KPMG’s “Unusual Twist”
While KPMG's strategy isn't
uncommon among corporations
with lots of units in
different states, the
accounting firm offered an
unusual twist: Under KPMG's
direction, WorldCom treated
"foresight of top
management" as an intangible
asset akin to patents or
The potential claims against KPMG represent the most pressing issue for
MCI. The report didn't have an exact tally of state taxes that may have been
avoided, but some estimates range from $100 million to $350 million. Fourteen
states likely will file a claim against the company if they don't reach
settlement, said a person familiar with the matter.
The examiner in MCI's Chapter 11 bankruptcy case
issued a report critical of a "highly aggressive" tax strategy KPMG LLP
recommended to MCI to avoid paying hundreds of millions of dollars in state
income taxes, concluding that MCI has grounds to sue KPMG -- its current
MCI quickly said the company would not sue KPMG.
But officials from the 14 states already exploring how to collect back taxes
from MCI could use the report to fuel their claims against the telecom
company or the accounting firm. KPMG already is under fire by the U.S.
Internal Revenue Service for pushing questionable tax shelters to wealthy
In a statement, KPMG said the tax strategy used by
MCI is commonly used by other companies and called the examiner's
conclusions "simply wrong." MCI, the former WorldCom, still uses the
The 542-page document is the final report by
Richard Thornburgh, who was appointed by the U.S. Bankruptcy Court to
investigate legal claims against former employees and advisers involved in
the largest accounting fraud in U.S. history. It reserves special ire for
securities firm Salomon Smith Barney, which the report says doled out more
than 950,000 shares from 22 initial and secondary public offerings to
ex-Chief Executive Bernard Ebbers for a profit of $12.8 million. The shares,
the report said, "were intended to and did influence Mr. Ebbers to award"
more than $100 million in investment-banking fees to Salomon, a unit of
Citigroup Inc. that is now known as Citigroup Global Markets Inc.
In the 1996 initial public offering of McLeodUSA
Inc., Mr. Ebbers received 200,000 shares, the third-largest allocation of
any investor and behind only two large mutual-fund companies. Despite claims
by Citigroup in congressional hearings that Mr. Ebbers was one of its "best
customers," the report said he had scant personal dealings with the firm
before the IPO shares were awarded.
Mr. Thornburgh said MCI has grounds to sue both
Citigroup and Mr. Ebbers for damages for breach of fiduciary duty and good
faith. The company's former directors bear some responsibility for granting
Mr. Ebbers more than $400 million in personal loans, the report said,
singling out the former two-person compensation committee. Mr. Thornburgh
added that claims are possible against MCI's former auditor, Arthur Andersen
LLP, and Scott Sullivan, MCI's former chief financial officer and the
alleged mastermind of the accounting fraud. His criminal trial was postponed
Monday to April 7 from Feb. 4.
Reid Weingarten, an attorney for Mr.
Ebbers, said, "There is nothing new to these allegations. And it's a lot
easier to make allegations in a report than it is to prove them in court."
Patrick Dorton, a spokesman for Andersen, said, "The focus should be on MCI
management, who defrauded investors and the auditors at every turn."
Citigroup spokeswoman Leah Johnson said, "The services that Citigroup
provided to WorldCom and its executives were executed in good faith." She
added that Citigroup now separates research from investment banking and
doesn't allocate IPO shares to executives of public companies, saying
Citigroup continues to believe its congressional testimony describing Mr.
Ebbers as a "best customer." An attorney for Mr. Sullivan couldn't be
reached for comment.
The potential claims against KPMG
represent the most pressing issue for MCI. The report didn't have an exact
tally of state taxes that may have been avoided, but some estimates range
from $100 million to $350 million. Fourteen states likely will file a claim
against the company if they don't reach settlement, said a person familiar
with the matter.
While KPMG's strategy isn't uncommon
among corporations with lots of units in different states, the accounting
firm offered an unusual twist: Under KPMG's direction, WorldCom treated
"foresight of top management" as an intangible asset akin to patents or
trademarks. Just as patents might be licensed, WorldCom licensed its
management's insights to its units, which then paid royalties to the parent,
deducting such payments as normal business expenses on state income-tax
returns. This lowered state taxes substantially, as the royalties totaled
more than $20 billion between 1998 to 2001. The report says that neither
KPMG nor WorldCom could adequately explain to the bankruptcy examiner why
"management foresight" should be treated as an intangible asset.
Dennis Beresford, the
chairman of MCI's audit
committee and a former
chairman of the
Standards Board, says
MCI's board concluded,
based on advice from
outside attorneys, that
the company doesn't have
any claims against KPMG.
Therefore, he says, KPMG
disqualified as MCI's
auditor. He calls the
"aggressive." But "like
a lot of other
issues, it's not an
he says, explaining that
"it was considered to be
reasonable and similar
to what a lot of other
people were doing to
reduce their taxes in
After reading the report
filed by the bankruptcy
examiner, I question the
label "aggressive." The
tax savings resulted from
the "transfer" of
intangibles to Mississippi
and DC subsidiaries; the
subs charged royalties to
the other members of the
WorldCom group; the other
members deducted the
state tax, BUT Mississippi
and DC do not tax royalty
income. Thus, a state tax
deduction was generated,
but no state taxable
income. The primary asset
KPMG did not mention this
intangible in its tax
ruling requests to either
Mississippi or DC, burying
it in "certain intangible
assets, such as trade
names, trade marks and
The examiner argues that
"management foresight" is
not a Sec. 482 intangible
asset because it could not
be licensed. His
conclusion is supported by
Merck & Co, Inc. v. U.S.,
24 Cl. Ct. 73 (1991).
Even if it was an
intangible asset, there is
an economic substance
argument: "the magnitude
of the royalties charged
was breathtaking (p. 33)."
The total of $20 billion
in royalties paid in
consolidated net income
during that period. The
royalties were payments
for the other group
members' ability to
generate "excess profits"
because of "management
Beresford's argument that
this tax-planning strategy
was similar to what other
people were doing simply
points out that market for
tax shelters was active in
the state area, as well as
the federal area. The
examiner in a footnote 27
states that the examiner
"does not view these
Royalty Programs to be tax
shelters in the sense of
being mass marketed to an
array of KPMG customers.
Rather, the Examiner's
investigation suggest that
the Royalty Programs were
part of the overall
provided by KPMG to
WorldCom and prepresented
tailored tax advice
provided to WorldCom only
in the context of those
restructurings." I find
this conclusion to be at
odds with the examiner's
discussion of KPMG's
reluctance to cooperate
and "a lack of full
cooperation by the Company
and KPMG. Requests for
interviews were processed
slowly and documents were
produced in piecemeal
fashion." Although the
examiner concluded that he
ultimately interviewed the
key persons and that he
information to support his
conclusions, I question
whether he had sufficient
information to determine
that KPMG wasn't marketing
this strategy to other
clients. Indeed, KPMG
apparently called this
strategy a "plain vanilla"
strategy to WorldCom,
which implies to me that
KPMG considered this
off-the-shelf tax advice.
worry that if we don't
call a spade a spade, the
sheltering activity will
continue at the state
level. Despite record
state deficits, the states
appear to be unwilling to
enact any laws that could
cause a corporation to
avoid doing business in
that state. In the "race
to the bottom" for
corporate revenues, the
states are trying to outdo
each other in offering
corporations. The fact
that additional sheltering
is going on at the state
level, over and above the
federal level, is evident
from the fact that state
tax bases are relatively
lower than the federal
base (Fox and Luna, NTJ
2002). Fox and Luna
ascribe the deterioration
to a combination of
explicit state actions and
tax avoidance/evasion by
buinesses. They discuss
Geoffrey, Inc v. South
Carolina Tax Commission
(1993), which involves the
same strategy of placing
intangibles in a state
that doesn't tax royalty
Thus, the strategy advised
by KPMG may well have been
plain vanilla, but the
fact remains that
management foresight is
not an intangible that can
generate royalties. That
is where I think KPMG
overstepped the bounds of
arms-length company would
have paid royalties to
WorldCom for its
SUMMARY: The financial reporting difficulties at Worldcom Inc. continue as
the independence of KPMG LLP is questioned. Questions focus on auditor
1.) What is auditor independence? Be sure to include a discussion of
independence-in-fact and independence-in-appearance in your discussion.
2.) Why is auditor independence important? Should all professionals (e.g.
doctors and lawyers) be independent? Support your answer.
3.) Can accounting firms provide tax services to audit clients without
compromising independence? Support your answer.
4.) Does the relationship between KPMG and MCI constitute a violation of
independence-in-fact? Does the relationship between KPMG and MCI constitute a
violation of independence-in-appearance? Support your answers with
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
Note from Bob Jensen
Especially note Amy Dunbar’s excellent analysis (above) followed by a
troubling reply by Chair of MCI’s Audit Committee, Denny Beresford.I say “troubling,” because all analysts and academics have to work with
are the media reports, interviews with people closest to the situation, and
reports released by MCI and/or government files made public. Sometimes we have to wait for the full story to unfold in court
I have always been troubled by quick judgments that auditors cannot be
independent when auditing financial reports when other professionals in the
firm have provided consulting and tax services. I don’t think this is the real problem of independence in most
instances. The real problem lies in the
dependence of the audit firm (especially a local office) on the enormous audit
fees from a giant corporation like Worldcom/MCI.The risk of losing those fees overshadows virtually every other threat
to auditor independence.
Although I think Amy’s analysis is brilliant in
analyzing the corporate race to the bottom in tax reporting and the assistance
large accounting firms provided in winning the race to the bottom, I don’t
think the threat that KPMG’s controversial tax consulting jeopardized auditor
independence nearly as much as the huge fixed cost KPMG invested in taking
over a complete mess that Andersen left at the giant Worldcom/MCI. It will take KPMG years to recoup that fixed cost, and I’m certain
KPMG will do everything in its power to not lose the client.On the other hand, the Worldcom/MCI audit is now the focal point of
world attention, and I’m virtually certain that KPMG is not about to put its
worldwide reputation for integrity in auditing in harms way by performing a
controversial audit of Worldcom/MCI at this juncture. KPMG has enough problems resulting from prior legal and SEC pending
actions to add this one to the firm’s enormous legal woes at this point in
I agree with the 15% rule Mac, but much depends upon whether you are
talking about the local office of a large accounting firm versus the global
firm itself. My best example is the local office of Andersen in Houston.
Enron's auditing revenue in that Andersen office was about $25 million.
Although $25 million was a very small proportion of Andersen's global auditing
revenue, it was so much in the local office at Houston that the Houston
professionals doing the audit under David Duncan were transformed into a much
older "profession of the world" in fear of losing that $25 million.
Also there is something different about consulting revenue vis-à-vis
auditing revenue. The local office in charge of an audit may not even know
many of the consultants on the job since many of an accounting firm's
consultants, especially in information systems, come from offices other than
the office in charge of the audit.
Years ago (I refuse to say how many) I was a lowly staff auditor for E&Y on
an audit of Gates Rubber Company in Denver. We stumbled upon a team of E&Y
data processing consultants from E&Y in the Gates' plant. Our partner in
charge of the Gates audit did not even know there were E&Y consultants from
Cleveland who were hired (I think subcontracted by IBM) to solve an data
processing problem that arose.
From: MacEwan Wright, Victoria University Sent: Friday, January 30, 2004
Subject: Re: Case Questions on Independence of Auditor for MCI
Given that, on average, consulting fees used to
represent around 50% of fees from a client, the consulting aspect tended to
reinforce the fee dependency. The old ethical rule in Australia that 15% of
all fees could come from one client was probably too large. A 15% drop in
revenue would severely cramp the style of a big practice. Regards,
"WorldCom to Write Down $79.8 Billion of Good Will," by Simon Romero, The
New York Times, March 14, 2003
WorldCom, the long-distance carrier that is mired
in the nation's largest bankruptcy filing, said yesterday that it was
writing down $79.8 billion of its good will and other assets. The move is an
acknowledgment that many areas of the company's vast telecommunications
network are essentially worthless. The company said in a statement that all
existing good will, valued at $45 billion, would be written down. WorldCom
also said it would reduce the value of $44.8 billion of equipment and other
intangible assets to about $10 billion. WorldCom had previously signaled
that it was considering the write-downs, but the immensity of the values
involved surprised some analysts. WorldCom's write-downs are second only to
those of AOL Time Warner, which recently wrote down nearly $100 billion of
I finished reading
Disconnected: Deceit and Betrayal at WorldCom, by Lynne W. Jeter
Here is my review
of the book submitted to Amazon.
Why to buy this
book: This book will bring you up to speed on WorldCom.
What this book
does: (1) gives a fact-based history of Worldcom from start (1984) to just
past the end (December, 2002), (2) identifies and discusses key figures in
the rise and fall, (3) introduces the foibles of Ebbers, (3) describes the
clash of corporate culture following of MCI acquisition (4) describes
accounting coverup in broad terms (5) suggests five reasons for the fall:
denial of Sprint takeover, inability to integrate and manage MCI, costly
excess capacity entering the business slowdown of 2000-2003, revenue loss as
a result of long-distance competition, Ebbers inadequacies.
What this book does
not: (1) provide acceptable levels of detail in the acquisitions, (2) give
enough detail for the strengths and weaknesses of key figures, (3) provide
sufficient detail about the accounting cover up, (4) thoroughly analyze each
of the reasons the reasons for the fall.
The author is
somewhat confused by accounting terms, and perhaps about what the accounting
After reading this
book, you will be ready for (and need to read) the next books that come out
on WorldComm. At least, I want to know more about it.
Having panned the
book, I still would recommend it to my students.
Bowling Green State University
Worldcom will go down in history as one of the worst audits in the history
of the world. It was a far worse audit by Andersen than the Andersen
audit of Enron.
Worldcom is not the most exciting
research study, because the fraud was so simple. It is, however, an
interesting study of how bad audits were becoming as audit firms commenced to
succumb to client pressures, especially very large clients like Worldcom.
The main GAAP violations at Worldcom
concerned booking of expenses as assets --- over $3 billion overstated. The
company also violated revenue recognition rules in GAAP. Many of the GAAP
violations are summarized in the recent class action lawsuit against Worldcom
NATURE OF THE
This is a class
action on behalf of a class (the "Class") of all persons who purchased or
otherwise acquired the securities of WorldCom Corporation between February
10, 2000 and November 1, 2000 (the "Class Period), seeking to pursue
remedies under the Securities Exchange Act of 1934 ("1934 Act").
During the Class
Period, defendants, including WorldCom, its Chief Executive Officer, Bernard
Ebbers and its Chief Financial Officer, Scott Sullivan, issued a series of
false statements to the investing public. During the Class Period, WorldCom
reported seemingly unstoppable growth in revenue and profitability despite
unprecedented competition in the telecommunications industry, transforming
WorldCom into the second largest long-distance carrier in the United States,
second only to industry giant AT&T. Indeed, WorldCom, headed by Ebbers and
Sullivan, acquired billions of dollars worth of companies in the span of a
few years - - including the then largest merger ever, the 1998 MCI merger.
Throughout the Class Period, defendants represented that the massive MCI
merger was an enormous success - contributing heavily to synergies, revenues
As defendants knew,
due to industry-wide pressure, there was simply no way to continue the
significant revenue and earnings growth the market had come to demand from
WorldCom absent further consolidation. To that end, Ebbers in October, 1999
announced WorldCom’s largest merger ever, a deal to merge with number three
in the industry, Sprint Telecommunications. The Sprint Merger was crucial to
WorldCom for several reasons: (1) due to increased competition, WorldCom’s
revenue growth was slowing dramatically due to regular forced contract
renegotiations as a result of lower prices for long-distance and
telecommunications services; (2) WorldCom’s account receivable situation was
out of control, with hundreds of millions of receivables going uncollected
but remaining on its books for long periods of time; and (3) WorldCom did
not have a significant presence in the wireless business, and needed
Sprint’s wireless division to allow the Company to compete with major
telecommunications providers such as AT&T who did have wireless operations.
The Sprint Merger would not only provide a conduit of increased revenue by
which defendants could mask WorldCom’s deteriorating financial condition,
but also provided a means to hide the enormous amount of uncollectible
accounts receivables through integration-related charges.
Throughout 1999 and
the first two quarters of 2000, the Company reported strong sales and
growth, and became an investor favorite, reaching $62 per share in late
1999. WorldCom was followed by numerous analysts who favorably commented on
the Company and its potential, especially in light of the highly anticipated
Sprint Merger. Behind the positive numbers, however, there were significant
problems growing at WorldCom which threatened the Company’s ability to
numerous former employees, the Company resorted to a myriad of improper
revenue recognition and sales practices in order to report favorable
financial results in line with analysts’ estimates despite the significant,
and worsening financial decline WorldCom was then experiencing. Defendants’
fraud involved : (a) failing to take necessary write-offs in order to avoid
a charge to earnings (¶¶58-72); (b) intentionally misrepresenting rates to
customers (¶¶74-81); (c) switching customers' long distance service to
WorldCom without customer approval (¶¶82-83); (d) recognizing revenue from
accounts which had been canceled by customers (¶¶84-87); (e)
"double-billing" (¶¶91-92); (f) back-dating contracts to recognize
additional revenue at the end of a fiscal quarter (¶97); (g) failing to
properly account for contracts which had been renegotiated or discounted
(¶¶93-96, 98-99); and (h) deliberately understating expenses. (¶¶88-90).
Further, despite defendants' frequent statements regarding WorldCom's
increased network expansion3 capabilities, the Company was experiencing
substantial difficulties performing "build-outs", or network expansions, a
failure which limited the Company's growth.
In addition, the
number of uncollectible receivables skyrocketed during the Class Period, in
part because those receivables represented phony sales that never should
have been booked, and in part because defendants allowed over half a billion
of worthless accounts receivable to remain on WorldCom's books in order to
delay a charge against earnings required by Generally Accepted Accounting
Principles ("GAAP"). Defendants knew about the increasing amount of
uncollectible accounts by virtue of a monthly written report which detailed
all accounts deemed uncollectible by virtue of prolonged litigation,
bankruptcy or other circumstances. Indeed, defendants received detailed
monthly packages regarding accounts receivables and their status, which
included lengthy case histories, litigation summaries, a description of the
most recent action taken by the Legal Department, and updates. Ebbers
himself received these reports because he was the individual at WorldCom
responsible for authorizing writeoffs in excess of $25 million - - accounts
for which his express approval was required.
implicitly encouraged the widespread improper revenue recognition tactics
employed by WorldCom employees, as well as the failures to properly reserve
for and account for uncollectible accounts, for several reasons. First,
defendants were desperate to complete the Sprint Merger. As defendants knew,
Sprint shareholders were scheduled to vote on the pending merger on April
28, 2000, and it was essential that WorldCom appear to be a financially
strong company in order for the vote to pass. Therefore, defendants reported
phenomenal financial results for the first quarter on April 27, 2000 - one
day before the Sprint shareholder vote on the merger.
Once Sprint and
WorldCom shareholders approved the Merger, defendants kept up their barrage
of false statements to avoid attracting negative attention while federal
regulators considered the deal, and to ensure the deal was completed on the
most favorable terms possible. Defendants intended to use WorldCom stock as
currency to merge with Sprint, and the higher the price of WorldCom stock,
the cheaper the purchase. It was also crucial to inflate the price of
WorldCom stock in order to complete public offerings of debt in May and
June, 2000 - for nearly $6 billion - to be used as to pay existing debt and
free up additional borrowing capacity in order to pay for the costs of
Defendant also had
personal reasons to misrepresent WorldCom’s financial results. If the Sprint
Merger was completed, Ebbers felt the stock would "go through the roof"and
he stood to gain hundreds of millions of dollars in profits as a result of
his considerable WorldCom holdings, including soon-to-vest stock options.
Ebbers was also strongly motivated to inflate WorldCom’s stock price to
avoid a forced sale of his stock which he bought through a loan years
before. In fact, in order to meet margin calls when the price of WorldCom
stock declined, Ebbers regularly received multi-million dollar personal
loans from the Company at the expense of WorldCom shareholders. Similarly,
Sullivan, keenly aware of the Company’s accounting fraud because of his
position as the Company’s top financial officer, divested himself of nearly
$10 million worth of WorldCom stock on August 1, 2000. John Sidgemore, the
Company’s Chief Technology Officer and a WorldCom Director, aware of the
lack of new products being produced by the Company, sold over $12 million
worth of WorldCom stock in May, 2000.
On July 13, 2000,
defendants were forced to reveal that the Sprint Merger had been rejected by
federal regulators. As a result, defendants scrambled to put together
another deal which could conceal the problems at WorldCom. On September 5,
2000, defendants announced an intent to merge with Intermedia
Communications, Inc. ("Intermedia") an Internet-services company which
included its subsidiary, Digex, a company that manages web sites for
business. This acquisition too would be completed using WorldCom stock as
currency, so it was essential for the stock price to remain artificially
inflated to complete the deal on favorable terms. The Intermedia deal,
however, ran into unexpected hurdles and delays, and was the subject of
lawsuits filed in Delaware Chancery Court by Digex shareholders, seeking to
block the deal, and alleging the deal was financially unfair to Digex
shareholders given WorldCom's worsening financial condition. As a result of
the focusing of a spotlight on WorldCom's true financial status, defendants
could no longer hide WorldCom's problems. On October 26, 2000, defendants
revealed that the Company was forced to write down $405 million of
uncollectible receivables due to bankruptcies of certain wholesale
customers. The $405 million was stated in after-tax terms to deflect
attention from the even higher whopping pre-tax write off of $685 million.
The stock dropped from over $25 to slightly over $21 on October 26, 2000, on
trading volumes of nearly 70 million shares.
On November 1,
2000, defendants dropped the other shoe, announcing a massive restructuring
which would create a separate tracking stock for MCI - - a concession that
the integration of MCI and WorldCom had not worked and was not profitable
for investors. Defendants also revealed that the Company had been
experiencing dramatic declines in growth and profitability. Fourth quarter
2000 earnings would be between $0.34 and $0.37 share - a far cry from the
$0.49 analysts and investors expected, and which defendants said was an
estimate they were comfortable with "from top to bottom." In addition,
rather than earning $2.13 per share in 2001, defendants expected only
between $1.55 and $1.65. The stock dropped over 20% in one day in response,
sinking to a new 52 week low of $18.63 on November 1, 2000.
During a November
1, 2000 conference call, Defendant Ebbers revealed that he had "let
investors down." He also admitted that, contrary to his repeated Class
Period statements detailing the Company’s successful acquisition strategy
which included purchasing billions of dollars worth of assets from
telecommunications and Internet companies, some of the acquired assets
"should have been disposed of sooner."
WorldCom stock has
never recovered, and traded at slightly over $18 per share in May, 2001. As
a result, WorldCom investors who purchased securities during the Class
Period, have lost billions. The following chart indicates the impact of
defendants' false statements on the market for WorldCom securities:
One thing you might look into is the
extortion that various CEOs, including Ebbers at Worldcom, forced upon large
investment banks. These CEOs threatened to withdraw the business of their
large companies if the investment banks did not give them new shares in
various IPOs of other companies. In other words, this extortion did not
directly involve a company like Worldcom, but Bernie Ebbers extorted $11
million from Salamon, Smith, Barney by threatening to withdraw Worldcom's
business with the investment bank. See
Top current and
former WorldCom executives scored millions of dollars from hot initial
public offerings made available to them by Salomon Smith Barney and its
predecessor companies, records released on Friday by the U.S. House
Financial Services Committee showed. Bernie Ebbers, the former chief
executive of WorldCom, made some $11.1 million from 21 IPOs, including $4.56
million off the sale of Metromedia Fiber Network shares and almost $2
million from rival Qwest Communications International shares, according to
"This is an example
of how insiders were able to game the system at the expense of the average
investor," Rep. Michael Oxley, R-Ohio, chairman of the committee, said in a
statement. "It raises policy questions about the fairness of the process
that brings new listings to the markets."
released the documents within moments of receiving the information it had
subpoenaed from Salomon Smith Barney, a unit of Citigroup, as it
investigates whether the company offered IPO shares to win investment
In the late 1990s
through early 2000, technology IPOs were almost guaranteed to soar in the
open market, meaning those investors who were able to buy shares at the
offering prices would likely haul in large, risk-free gains.
hundreds of millions in fees from telecommunications deals over the years. A
memo turned over to the committee by Salomon showed that star
telecommunications analyst Jack Grubman, who recently left the firm, was
sent a memo about which executives got shares in two IPOs.
A lawyer for the
firm was said to have not found any evidence of a "quid pro quo," in which
it received investment banking business in exchange for the IPO allocations.
"We believe the
allocations at issue fit well within the range of discretion that regulators
have traditionally accorded securities firms in deciding how to allocate IPO
shares," Jane Sherburne, the Salomon lawyer, said in a letter to the
investigation comes after WorldCom admitted in June and July to a whopping
$7.68 billion in accounting errors dating back to 1999, and the No. 2 U.S.
long-distance telephone and Internet data mover was forced to file for
bankruptcy protection in July.
WorldCom's former chairman, made $3.5 million by selling 170,000 shares of
Qwest on Aug. 27, 1997, two months after he acquired the shares in the
company's IPO, according to the documents. Former WorldCom Director Walter
Scott made $2.4 million in his sale of 250,000 shares less than a month
after Qwest went public.
Ironically, the man
at the center of the WorldCom controversy, Scott Sullivan, who was fired for
his role in the accounting debacle, lost $13,059 in the nine IPOs he
His biggest losses
came from the sale of Rhythms NetConnections, losing $144,450 when he sold
his 7,000 shares in May 2001, two years after the company went public but
less than three months before Rhythms filed for bankruptcy.
Ebbers, Sullivan and WorldCom were not immediately available for comment.
Association of Securities Dealers last month proposed new rules to stop
investment banks from allocating IPO shares to favored clients, but the
rules would require approval from the Securities and Exchange Commission.
From: Janko Hahn [mailto:email@example.com]
Sent: Friday, October 18, 2002 4:04 AM
To: Jensen, Robert Subject: Questions about Worldcom
I´m writing a
thesis paper round about 15 pages about the manipulation at Enron and
Worldcom here at the office of Professor Coenenberg. Last semester, you have
been here in Augsburg, so I had a look at your homepage and it was a great
help for me about Enron (I think, the main points to mention are SPE´s and
But I´m still not
shure what to write about worldcom: in different articles I can read about
failures in the books, but nothing specific I can present.
So I have three
questions, perhaps you can help me:
1. what have been
the main points of manipulations at Worldcom? Where in the Gaap standards
can I refer to?
2. why are the
credits to the CEO Ebbers so important? Of course, they are really big and
Ebbers won´t be able to pay them back, but this is no manipulation? So why
do all the newspapers focus on this point?
3. Are these
manipulations at Enron and Wordlcom really illegal? Of course, they are bad
in the meaning of the standards, no prudence, and so on, but is this
illegal? Or is it illegal, beacause they did not show the debts / revenues
in the correct matter and so lied to the investors?
Thanks for your
help Professor Jensen,
with best regards,
Kennedystr. 16 82178 Puchheim
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
Meet 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 Webcast (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.
Walter Pavlo on February 24, 2004
I 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 appreciate them.
I 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
I 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
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 feedback.
125 Second Avenue, #24 New York, NY 10003
Phone: (201) 362-1208
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
It was a pleasure to
speak with you and I hope to correspond with you more in the future.
125 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 speaker)
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 division.
As 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 Islands.
In 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.
Mr. 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:
On 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 San
year for the Institute of Internal
.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 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
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
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
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 business.
Steve Samek, Country Managing Partner, United States, on Andersen's
Independence and Ethical Standards CD-Rom, 1999.
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
"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
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’
"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 vital."
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 Tulane
August 3, 2003 excerpt from a
speech by Art Wyatt (See the link below that Tracey provides)
The 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.
The 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?
The 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
As 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
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 online at
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
more stolid posture on such matters in
earlier years. "How the U.S. Accounting Profession Got Where It Is Today: Part I,"
by Stephen A. Zeff, Accounting Horizons,
September 2003, pp. 189-205.
Note from Bob Jensen
Steve's main points are
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
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
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
accommodation and compromise
on questionable accounting
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
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
. Journalists have not
changed nearly so much as
the journalism environment
in the age of technology and
civil strife around the
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
swaps), newer types of
off balance sheet ploys
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
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 reality.
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
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
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
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?
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
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
especially the outstanding
Read part of the eulogy
for Arthur Andersen,
delivered on January 13,
1947 the Rev. Dr. Duncan
E. Littlefair ---
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 at
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
accounting in theory is
neat, because the
integrity is more
necessary to survival of
the profession than in
other professions that
sell more than integrity.
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
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
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!
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 be punished.
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
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 Bookmarks.
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
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
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
consulting). Andersen also
of mass produced services,
contributed to the
severing from the
"profession" of the notion
(that is being so
romantically bandied about
in this discussion) of the
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
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
If, as you say, accounting
is about integrity
(accounting education is
first of all a moral one?)
what might be the
supplanting the "golden
era of accounting"
discourse (that of
Andersen, Ernst, Haskins,
etc) with one glorifying
the imaginary world of
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
textbooks today are little
more than dumbed down
finance and microeconomics
The rationales we provide
for why we do what we do
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
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
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
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
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
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
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
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 consider "accounting".
Perhaps the term CPA should be renamed "Certified
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 the profession.
E.g., let's use the term "accounting profession" to
really mean the "accounting" profession, and not just the "auditing"
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
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 statements diligently.
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 illustrates.
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
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
"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 documents.
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
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 SEC.
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 violations.
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
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
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 staged?
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.
Video Ordering Details
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 Contextual Ethics
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 trusted.
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
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 the future?
Does your breach of integrity potentially
harm trust and faith in the system and its reputation?
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.
Why should 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 misdeeds?
Message from Steven Bachrach (Department of
Chemistry at Trinity University)
The Sunday 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
A few examples:
Nykesha 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
Gordie Howe skates for 47
seconds in a minor league hockey game to set the "record" for being the first
athlete to compete in 6 decades.
Denny McLain grooves 3 pitches
to Mickey Mantle so that Mantle can hit a home run, passing Jimmie Foxx into
3rd place all time.
Our own 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.
One begins 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,
This story (from the Chicago Tribune)
may be of possible interest in the discussion on "independence".
-------------------- Superior's auditor also
Ernst & Young's dual role at bank called a conflict
By Melissa Allison Tribune staff reporter
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
"It was a direct conflict," said Gaston Gianni,
inspector general for the Federal Deposit Insurance Corp., in testimony to
the Senate Banking Committee Thursday.
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 & Young.
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
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 eventually
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 changes.
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 panelists Thursday.
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, 2002
From: Paul Williams [mailto:williamsp@COMFS1.COM.NCSU.EDU]
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,
Elliot Kamlet wrote:
> If Andersen doesn't quit it, we accountants will go from professionals
> clowns. I'm ready to sue them for their impact on the profession of
> I am a member! >
Reply from Bob Jensen on January 11,
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 and Enron.
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 over?
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
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 and Enron.
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 accountancy.
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 the AECM.
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 town.)
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 message below.
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.
I 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 are at
I 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 ---
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 history.
I 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.
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.
I 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
My 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 leaders.
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.
I 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.
In 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
For 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
I 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 already studied.
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 WSJ link:
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 ago
In addition to acting
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.
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 say.
It 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.
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.
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
"It 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
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."
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.
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 York.
Mr. 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 publicly.
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
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 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 money.
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 highest were:
illegal to have liabilities off the balance sheet.
accountants from providing both auditing and consulting to the same
This response seems
somewhat surprising in view of two other findings:
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?
TITLE: "Auditor Independence and Earnings
Richard M. Frankel MIT Sloan School of Business 50 Memorial Drive,
E52.325g Cambridge, MA 02459-1261 (617) 253-7084 firstname.lastname@example.org
Marilyn F. Johnson Michigan State University Eli Broad Graduate School
of Management N270 Business College Complex East Lansing, MI
48824-1122 (517) 432-0152 email@example.com
Karen K. Nelson Stanford University Graduate School of Business
Stanford, CA 94305-5015 (650) 723-0106 firstname.lastname@example.org DATE: August 2001 LINK:http://gobi.stanford.edu/ResearchPapers/Library/RP1696.pdf
Academics have found that the provision of
consulting services to audit clients can have a serious effect on a
firm's perceived independence.
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.
(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 consultancy services.
This 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 client.
The study used data collected from over 4,000
proxies filed between February 5, 2001 and June 15, 2001.
It 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 management.
"Firms with 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."
New SEC 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.
"In addition, firms may reduce the
purchase of non-audit services from their auditor to avoid the
appearance of independence problems."
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.
And our 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
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
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
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.
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 Wired to the Top Brass (with reference to his promise to rat on his
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 admit it.
Andersen audits got
Sure seemed enough,
When Waste Management audits ignored smelly stuff.
When Victoria Secret audits
turned into doubt.
Now the latest criminal
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 Tissue audits.
Mr. 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
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, 2003).
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 --- http://www.smartpros.com/x40231.xml
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
"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
"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?"
Enron employees carrying all
Arthur Andersen took another beating Thursday night, but this time it was at a
minor league baseball game instead of in a Texas courtroom.
The 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
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."
The 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.
In addition, the 90
people with either "Arthur" or "Andersen" in their names
who attended were given free admission. Two people named Arthur Andersen were
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?'" he said.
Recognition of 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
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
The 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
In 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
HFV, 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
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."
George Bush also offers a send-off to Kinder, thanking him for helping his son
reach the Governor's Mansion.
"You have been
fantastic to the Bush family," he says. "I don't think anybody did
more than you did to support George."
Note: Jim 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.
UPSKILLING: To develop new skills,
generally technical ones -- often by reskilling (retraining).
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
Things are not looking good for Martha Stewart.
Her stock was down 23 percent yesterday. Wow, that dropped quicker than Dick
Cheney after a double-cheeseburger.
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
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
"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 1995.
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.’"
Business Ethics [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
A take-off from the movies "A Few Good
Men" (Some phrases are in the original script and some are
Tom Cruise: "Did you order the shredding?"
Jack Nicholson: "You want answers?"
Tom Cruise: "I think I'm entitled."
Jack Nicholson: "You want answers!!"
Tom Cruise: "I want the truth!"
Jack Nicholson: "You can't handle the
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 entitled to!!"
Tom Cruise: "Did you order the
Jack Nicholson: "You're damn right I did!"
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 --- http://www.indenture.ac/
A 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).
The 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.
The soft-spoken boy
looked up and meekly whispered, "Help me!"
I realized! that
absolutely no one could have heard that poor boy cry for help. So I grabbed
his other hundred and ran to my car.
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 the money."
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
I liked the one below about Teaching Accounting in
the 1970s. It is so True!
Also forwarded by Dick Haar
Teaching Accounting in 1950:
A logger sells a truckload of lumber
His cost of production is 4/5 of the
What is his profit?
Teaching Accounting in 1960:
A logger sells a truckload of lumber
His cost of production is 4/5 of the
price, or $80.
What is his profit?
Teaching 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?
Teaching Accounting in 1980:
A logger sells a truckload of lumber
His cost of production is $80 and his
profit is $20.
Your assignment: Underline the number
Teaching Accounting in 1990:
By cutting down beautiful forest trees,
the logger makes $20.
What do you think of this way of making
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 answers.
Teaching Match in 2000:
A logger sells a truckload of lumber
His cost of production is $120.
How does Arthur
Andersen determine that his profit margin is $60?
In an Enron tort litigation trial, the
defense attorney was cross-examining a pathologist.
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
Forwarded by George Lan
1. Enronitis : A company suffering from accounting concerns
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
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,
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 banned.
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.
Enron Venture Capitalism
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
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).
In 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 could understand.
You have two cows.
You sell one and buy a bull.
Your herd multiplies and you hire cowhands to help
out on the ranch. You sell cattle.
The economy grows and eventually you can pass the
business on and your cowhands can retire on the profits.
ENRON VENTURE CAPITALISM:
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
The annual report says the company owns eight cows,
with an option on one more.
Now do you see why a company with $62 billion in
assets is declaring bankruptcy?
"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
(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 --- http://www.trinity.edu/rjensen/history.htm#AndersenHistory
(There are some humorous and some sobering parts of this article by Ken Ringle
that Don Ramsey pointed out to me.)
We are neither hunters nor
gatherers. We are accountants..
New Yorker Cartoon
It's up to you now
Miller. The only thing that can save us is an accounting breakthrough.
New Yorker Cartoon
Money is life's report
New Yorker Cartoon
Millions is craft.
Billions is art.
New Yorker Cartoon
My 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
You 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
Try as 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 ---
Possibilities include "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
Richard C. Sansing Associate Professor of Business
Administration Tuck School of Business at Dartmouth 100 Tuck Hall Hanover, NH
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." http://www.accountingweb.com/item/69042
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. http://www.accountingweb.com/item/69888
Arthur Andersen: The Enron Scandal's Other Big
By Holly Bailey
During the 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
Andersen was 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
But that's 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.
While 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 1989.
Among the 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.
Before the 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.
It's unclear 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.
Click here 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
This 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
The 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 U.S. history.
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.
The 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
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.
The 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 fraud.
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,
One 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 saying.
Quote 03 Last 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.
Quote 04 Some 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 the fee.
In 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 lawsuit.
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
Quote 05 Few cases illustrate the potential conflicts in the
accounting business as vividly as the one involving Arthur Andersen and Waste
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 prescription drugs.
"I 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.
In 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
An 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
An 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 auditing.
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 settlement.
"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 confidence."
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.
In 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 internal audits.
The 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
An Ernst & Young spokesman said the firm was
confident it upheld a tradition "of integrity, objectivity and
trust." Grendi declined comment.
A 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.
In theory, the system has several complementary
layers of review. In practice, it is undermined by a lack of resources,
coordination and will.
The 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 found.
The 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
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 public disclosure.
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
The 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.
"We 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
"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.
As 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 prosecutions.
"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 public scrutiny.
The 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.
The 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.
In 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.
The 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 business risks."
It 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 commerce.
I 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.
In 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
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 function.
In 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.
But 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.
In 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 business.
In 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
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 clients.
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
The 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 enterprise.
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.
One 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.
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."
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.
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.
His 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
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.
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 Enron'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.
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.
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. http://www.accountingweb.com/item/69876
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.
Buffett Three years ago the Berkshire Hathaway
CEO proposed three questions any audit
committee should ask auditors:
If 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.
If the auditor were an investor, would he
have received the information essential to
understanding the company's financial
performance during the reporting
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.
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. http://www.theiia.org/ecm/newsletters.cfm?doc_id=739
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