Updates on February 25,
Bob Jensen at Trinity University
Updates and issues in the accounting, finance, and business scandals --- http://www.trinity.edu/rjensen/fraud.htm
Scandal Updates --- http://www.trinity.edu/rjensen/fraud.htm#ScandalUpdates
Bob Jensen's Summary of Suggested Reforms --- http://www.trinity.edu/rjensen/FraudProposedReforms.htm
Revenue Accounting Controversies --- http://www.trinity.edu/rjensen/ecommerce/eitf01.htm
Electronic Business Controversies --- http://www.trinity.edu/rjensen/ecommerce/000start.htm
Bob Jensen's Bottom Line Commentary --- http://www.trinity.edu/rjensen/FraudConclusion.htm
The Virginia Tech Overview: What Can We Learn From Enron? --- http://www.trinity.edu/rjensen/fraudVirginia.htm
Fraud References --- http://www.trinity.edu/rjensen/fraud.htm#References
Dealer Tricks: An
This includes a summary of ten unethical tricks of the trade by automobile dealers.
In Congressional hearings on the Enron collapse, Professor Baruch Lev of New York University's Stern School of Business gave the House Committee on Energy and Commerce a short but insightful lesson on the "axis of evil" confronting the accounting profession today. When introducing Professor Lev, Committee Chairman W. J. "Billy" Tauzin said, "If there were a Nobel Prize for Accounting, it would surely have been awarded to Baruch Lev." If his testimony helps lawmakers navigate through this crisis, he may still get that prize. http://www.accountingweb.com/item/71516
IT Braces Against New Enron Aftershock First, companies with accounting woes saw wary investors dump shares. Now, these same firms face a related, and potentially more serious, threat -- class action lawsuits. http://www.newmedia.com/default.asp?articleID=3396
As Questions Mount, Telecoms Get Spinning Global Crossing was one of the first telecommunications firms to become the recipient of regulatory scrutiny following Enron's implosion, but it is not likely to be the last. Trying to head criticism off at the pass, two telecoms are busy spinning their explanations. http://www.newmedia.com/default.asp?articleID=3393
How about improvement of Andersen's verifications of management reports? This is not something new that is needed in the way of auditing standards. It has been a standard ever since the Mckesson & Robbins scandal in 1938. A crisis in public accounting was provided by the celebrated McKesson & Robbins case. McKesson & Robbins, Inc., whose financial statements had been audited by Price Waterhouse & Co., had inflated inventory and receivables by $19 million dollars through falsification of supporting documents. The auditors merely accepted inventory and receivables balances reported by management without bothering to even verify their existence in McKesson & Robbins.
Auditors should verify all major transactions and not confine verifications to inventories and receivables. Does it take an Enron scandal for accounting firms to go beyond inventory and receivables verification?
Why would Andersen sit for over four years without independently verifying what outside equity holders invested in SPEs, especially since the amounts were so vital to financial statements. The fact that Enron put up half of one outsider's equity investment is what triggered the restatement of financial statements and was a key event in the collapse of the company. Why didn't Andersen independently verify what management reported for so many years and then get into a panic when Enron finally disclosed that it lied? Aren't auditors hired to protect investors from management lies?
To me, an auditor's legal defense built upon a contention that management lied to the auditors just does not hold water. Auditors are supposed to independently verify what management provides them, especially on really big-deal items.
All that aside, the actions and possible misdeeds of a few auditors should not cast a shadow over the other (84,000?) professionals in Andersen. Andersen has some of the best professionals in the world and some of the most ethical professionals in the world.
But that does not mean that questions should not be raised about the following:
1. Internal quality controls system-wide that protect the international firm from a bad local audit. For example, why weren't the lead partners on the Enron audit rotated frequently? It would seem that David Duncan was verifying the golf handicaps of Enron top brass more than he was verifying outside investment in SPEs year after year.
2. Why complain about accounting standards so vocally after the horse is out of the barn when Andersen and virtually all other large accounting firms have so actively pressured the FASB and the SEC to not have tougher accounting and auditing standards? See http://www.trinity.edu/rjensen/fraud.htm#Blame
From: E. Scribner [mailto:escribne@NMSU.EDU]
Sent: Monday, February 18, 2002 1:30 PM T
o: AECM@LISTSERV.LOYOLA.EDU Subject:
Re: Arthur Andersen Conference Call
It was refreshing in a way to hear directly from the auditors instead of through the lens of the newspapers and without the pressure of Congressional questioning. Maybe I'm still in denial, but I sense a tone of integrity among the auditors that I don't sense among the prominent Enron officials. I certainly want to believe Andersen, but the call didn't provide enough information to enable a judgment on most points. They still seem to be caught between allegations of duplicity at the worst or negligence at best.
The call didn't alleviate my concern that the magnitude of the Enron fees influenced the Houston office's professional skepticism. There also seemed to be confusion between statements to the effect that auditors don't cause companies to collapse but we've got to make some changes. (The conclusion seemed to be, however, that the only changes needed are to improve the accounting standards for SPE consolidation and to take certain steps, albeit reluctantaly, to satisfy public misperceptions--e.g., that consulting conflicts with independence.) The call stressed that the audit was fine except for one blown judgment call and one side-letter that was concealed by the client; the harsh move of firing the lead auditor stemmed from the shredding activity.
But if one missing side-letter can produce such disastrous results, how can an auditor stay with an engagement that is so vulnerable?
As far as influencing my counseling of students, the call had no effect, as best I can read myself. I've always tried hard to give the students the facts as I know them and let them make their own employment decisions.
Hope this vague answer at least stimulates further comments.
New Mexico State University
Las Cruces, NM, USA
February 19, 2002 Message from Elliot Kamlet [ekamlet@BINGHAMTON.EDU]
I understand that Andersen's position on Enron is that David Duncan, acting as a rogue partner, has probably overlooked what he did not want to see. It was explained to me by a senior New York partner that Andersen is such a good place to work because of the high degree of freedom afforded to individual partners and that would have to change.
Then I read (again) the story of Andersen and Baptist Foundation of Arizona and see a clear case of the partner who was in charge of the Lincoln Savings & Loan audit who then was in charge of the Baptist Foundation of Arizona audit, who should have provided a warning to Andersen. However, according to this story, he informed other partners and lawyers in Chicago and still nothing happened. I think I was more upset by this story than Enron?
See the story at
This is a great opportunity for academics to show Denny Beresford that they are interested in responding to FASB calls for comments. For example, do you think the new EDs go far enough? How can we get airlines to book billions of dollars in leased airplanes on the balance sheet? These EDs do not seem to do the job.
As influential House Energy Committee Chairman Billy Tauzin called for a review of accounting rules "across the country and across corporate boards," the Financial Accounting Standards Board continued its relentless drive to strengthen the standards. On February 15, FASB announced the release of a revised limited version of an exposure draft entitled Rescission of FASB Statements No. 4, 44, and 64 and Technical Corrections-Amendment of FASB Statement No. 13. The new ED proposes an important change in lease accounting. http://www.accountingweb.com/item/72443
As influential House Energy Committee Chairman Billy Tauzin called for a review of accounting rules “across the country and across corporate boards,” the Financial Accounting Standards Board (FASB) continued its relentless drive to strengthen the standards. On February 15, 2002, FASB announced the release of a revised limited version of an exposure draft (ED) entitled Rescission of FASB Statements No. 4, 44, and 64 and Technical Corrections—Amendment of FASB Statement No. 13. The new ED supplements a previous ED dated November 15, 2001 and proposes an important change in lease accounting.
Together, the two EDs propose to amend four Statements of Financial Accounting Standards (FAS):
FAS No. 4 - Reporting Gains and Losses from Extinguishment of Debt
FAS No. 13 - Accounting for Leases
FAS No. 44 - Accounting for Intangible Assets of Motor Carriers
FAS No. 64 - Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements
Specific proposed changes include the following:
- As described in the first ED, companies will no longer be required to classify gains and losses from the extinguishment of debt as extraordinary items, but they will still be allowed to use this accounting treatment in certain circumstances.
- As described in the new ED, the accounting for certain types of leases will change, (i.e., sale-leaseback transactions and lease modifications with economic effects similar to sale-leaseback transactions).
The reason for two EDs instead of one is because the second has its roots in the comment letters for the first. Commentators suggested changes they felt would improve financial reporting by eliminating inconsistencies in the various standards. FASB agrees in theory. But it also recognizes that some companies might have structured their leases differently, if the proposed accounting changes had been in effect at the time of the transaction. To ensure these substantive changes get a fair hearing, FASB decided to expose them for public comment as part of its “due process.”
Comments on the revised ED are due by March 18, 2002.
One of my students forwarded this link.
"PwC: Sharing the Hot Seat with Andersen? PricewaterhouseCoopers' dual role at Enron and its controversial debt-shielding partnerships has congressional probers asking questions," Business Week Online , February 15, 2002 --- http://businessweek.com/bwdaily/dnflash/feb2002/nf20020215_2956.htm
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 partnerships.
Investigators plan to question the complex valuation calculations that underlie the opinions. Enron ultimately lost hundreds of millions of dollars on the deals. A PwC spokesman says the firm stands by its assessment of the deals' value at the time.
OVERLAP. Perhaps more significantly, Pricewaterhouse was working for one of the Fastow partnerships -- LJM2 Co-Investment -- at the same time it assured Enron that the Houston-based energy company was getting a fair deal in its transactions with LJM2. In effect, PwC was providing tax advice to help LJM2 structure its deal -- the first of the so-called Raptor transactions -- while the accounting firm was also advising Enron on the value of that deal.
Pricewaterhouse acknowledges the overlapping engagements but says its dual role did not violate accounting's ethics standards, which require firms to maintain a degree of objectivity in dealing with clients. The firm says the work was done by two separate teams, which did not share data. PwC's spokesman says LJM2's tax structure wasn't a factor in its opinion on the deal's valuation. And, the spokesman says, each client was informed about the other engagement. That disclosure may mean that the firm's actions were in the clear, says Stephen A. Zeff, professor of accounting at Rice University in Houston.
Lynn Turner, former chief accountant at the Securities & Exchange Commission, still has questions. "The standard [for accountants] is, you've got to be objective," says Turner, who now heads the Center for Quality Financial Reporting at Colorado State University. "The question is whether [Pricewaterhouse] met its obligation to Enron's board and shareholders to be objective when it was helping LJM2 structure the transaction it was reviewing. From a common-sense perspective, does this make sense?"
"NO RECOLLECTION." PwC's contacts on both sides of the LJM2 deal were Fastow and his subordinates. BusinessWeek could not determine whether Enron's board, the ultimate client for the fairness opinion, knew of Pricewaterhouse's dual engagements. But W. Neil Eggleston, the attorney representing Enron's outside directors, says Robert K. Jaedicke, chairman of the board's audit committee, has "no recollection of this conflict being brought to the audit committee or the board."
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 history.
The fairness opinions were necessary because Enron's top financial officers -- most notably Fastow, the managing partner of LJM and LJM2 -- were in charge on both sides of these transactions. Indeed, both of PwC's fairness opinions were addressed to Ben F. Glisan Jr., a Fastow subordinate who became Enron's treasurer in May, 2000. Glisan left Enron in November, 2001, after the company discovered he had invested in the first LJM partnership.
SELLING POINT. Since the deals were not arms-length negotiations between independent parties, Pricewaterhouse was called in to assure Enron's board that the company was getting fair value. Indeed, minutes from a special board meeting on June 28, 1999, show that Fastow used PwC's fairness review as a selling point for the first deal.
That complex transaction was designed to let Enron hedge against a drop in value of its investment in 5.4 million shares of Rhythms NetConnections, an Internet service provider. PwC did not work for LJM at the time it ruled on that deal's fairness for Enron. The firm valued LJM's compensation to Enron at between $164 million and $204 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."
"CRISIS OF CONFIDENCE." Some documents associated with LJM2 identified Pricewaterhouse as the partnership's auditor. A December, 1999, memo prepared by Merrill Lynch to help sell a $200 million private placement of LJM2 partnership interests listed the firm as LJM2's auditor. In fact, KPMG was the auditor. The PwC spokesman says his firm didn't even bid for the LJM2 audit contract. Merrill Lynch declined to comment on the erroneous document.
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.
Roger Collins forwarded this link.
"Enron creditors question cash 'hole'," BBC News, February 15, 2002 --- http://news.bbc.co.uk/hi/english/business/newsid_1822000/1822853.stm
February 15, 2002 Message From Miklos A. Vasarhelyi [miklosv@ANDROMEDA.RUTGERS.EDU]
Would continuous Audit have prevented the Enron mess?
A well performed continuous audit would certainly have much earlier brought to light the Enron operational problems, and across the value chain resource flow analytics identified resource discontinuities. While the facts on Enron are not yet clear, arguably a well performed traditional audit would also have detected many of problems. The key difference would be on the timeliness of the problem detection (much sooner), the nature of the assurance provided (that can be the assurance of processes not necessarily of the eventual financial report), the nature of the assurance process (closer to secondary supervision than of ex-post facto archival review), and the audit technology used ( heavy reliance on inter-process analytics, models of processes, and alarming).
What is the continuous audit (assurance) methodology?
Continuous auditing is a type of auditing which produces audit results simultaneously with, or a short period of time after, the occurrence of relevant events. The need of assurance of the integrity of information processes arises in many situations. The traditional financial audit is an instantiation of this process. This particular form of assurance includes a set of corporate measures represented by GAAP and a 'independent' third party assurer.
The continuous assurance methodology utilizes online information technology to provide potentially many different forms of assurance including a form that expands the "traditional financial audit, and makes it more sensitive to extraordinary transactions as some observed in the Enron case.
What is different between the traditional and the continuous audit?
The continuous audit (assurance) is close to a supervisory process where the analytical methods of traditional audit are extended by the examination of continuous flows of data and a series of models of expected system behavior and consequent data content. Alarms extend the nature and scope of the assurance process bringing it closer to operations with the intrinsic advantages and disadvantages of this process change.
In a continuous audit there is software the continuously monitors company transactions and compares its generic characteristics to their observed / expected characteristics. If significant discrepancies occur, alarms are triggered that must be acknowledged by operational managers, auditors, and top management.
In the Enron case its transactions with SPEs were abnormal in nature and detectable as abnormal. Many of the ratios of Enron's sub-entities would not have been coherent with its competition and would trigger evaluation. An end-to-end flow analysis (and monitoring) of Enron's component value additions would not reconcile and call for audit procedures that looked for non-disclosed entities.
How does continuous assurance relates to continuous reporting?
As continuous assurance depends on continuous flows of transaction data as well as analysis of level variables, a fully deployed assurance system will be an overlay to a continuous measurement system. Continuously measuring financial data flows and account levels entails a continuous reporting system. Most large US corporations today already keep internal reporting on a continuous basis in critical variables such as cash (for treasury management), payables (to take advantage of discounts), inventory and production (for just-in-time), etc.
In addition to continuous measurement of flow variables continuous assurance methodology requires the development of a comprehensive system of models (and standards) that allow for comparisons with continuous data flows. This system of models can be of great value to break down value added in an auditee and to point out non reported entities and discontinuities in value.
What should be different in the audit model to deal with lack of independence? Does continuous assurance resolve this problem?
Environmental standards and controls are necessary for obtaining objectivity and independence both in the traditional as well as in the continuous audit environment. Corrupt managements, economically interested assurors, and lack of objectivity will always happen to a certain degree. Continuous assurance methodologies can be used to force the identification of these events, to allow for multi-party process monitoring, and to bring to light data inconsistencies that arise in bad or corrupt business models.
While the traditional US regulatory model is rather anachronistic using old technology to measure and monitor 21st century corporations, both companies, audit local offices, audit firms, and the government could benefit from monitoring flows and analytics creating a better set of overviews, checks, and balances. An Italian Bank (BIPOP Carire) has used online technology to provide continuously updating reports of its financial health to Italian authorities.
Could the continuous assurance model radically change the scenario government supervision, auditor policing, and detection of audit failure?
Conceivably, companies could be required to provide summary continuous reports along a wide range of flow related variables to the government (or other supervisory authority) to monitor key processes. The government would be positioned as one of the multiple stakeholder of business and reports / model / data flow tailored to its supervisory, legal, and statutory needs.
While there is the illusion that one set of disclosures should satisfy external reporting needs, the modern corporation has many stakeholders with different information needs and objectives. These stakeholders could pay and get separate information structures and specific online assurances that would pay for itself in the form of the reduction of their risks. Real-time covenant monitoring would decrease banking risks, asset impairment monitoring would reduce insurance risk, etc...
Would the continuous assurance process have detected the problems / existence of the related party partnerships that plagued Enron?
Yes. With this particular problem in mind, data flows and models could be developed that would question (and require justification) the large non-repetitive data and resource flows between Enron and the partnerships. These flagged (alarmed transactions) would have to be formally explained by management, and ratified as normal by auditors. Conceivably, a reporting system could be put in place to call to the attention of supervisory authorities these anomalies that would serve as a timely deterrent of some of these problems. A library of validity tests, developed in a continuous audit environment, including tests of related party transactions, overlapping management, double-dipping, conflict of interests , insider trading, trading by managers, can be developed and applied on a consistent basis.
Could laws be enacted to provide more efficient monitoring of publicly held companies?
Clearly, the laws, standards, and practices that currently rule business entity measurement and assurance are anachronistic. They were developed over the last centuries and decades taking in consideration a substantially different type of business entity, control environment, and data processing capabilities. Legislation compliance and monitoring are expensive processes (even after the technological revolution) but can today be performed at much narrower thresholds of error. There is little doubts that much tighter regulation can be devised and implemented. It is up to societal mores to decide on its desirability.
Miklos A. Vasarhelyi
KPMG Professor of AIS
315 Ackerson Hall
180 University Avenue
Newark, NJ 07102
(973) 353 5002
(201) 454 4377 (cell)
The board of directors of SunTrust Banks, Inc. voted this week to end its 60-year-old relationship with Big Five firm Andersen and has agreed to hire PricewaterhouseCoopers to perform the company's audit work in the future. The bank claims its decision had nothing to do with Andersen's recent problems stemming from its controversial Enron audit. SunTrust was Andersen's largest banking client, responsible for more than $3 million in annual fees. http://www.accountingweb.com/item/72155
From Business Week's Online Insider on February 15, 2002
THE BETRAYED INVESTOR In the 1990s, a new class of investors--millions of working Americans pouring cash into stocks and mutual funds--became a powerful economic and political force. They bought into the idea that stocks could only make them richer. Then the market bubble burst--and then came Enron. Now, many feel misled by Wall Street, corporations, accountants, and Washington. The strength of the recovery hinges on winning back investors' confidence.
Available to subscribers: http://www.businessweek.com/premium/content/02_08/b3771001.htm?c=bwinsiderfeb15&n=link60&t=email
Available to all readers (Monday, February 18, 2002): http://www.businessweek.com/magazine/content/02_08/b3771001.htm?c=bwinsiderfeb15&n=link60&t=email
From Accounting Education.com on February 15, 2002 --- http://accountingeducation.com/news/news2543.html
Title: DELOITTE & TOUCHE CEO JIM COPELAND - IDEAS TO ENHANCE FINANCIAL SYSTEM Source: Deloitte Touche Tohmatsu Country: United States of America
Date: 11 February 2002
Contributor: Andrew Priest
Strengthening the American financial system will require a series of careful, specific changes rather than statements and ideas that only address perception, according to James E. Copeland, Jr., Chief Executive Officer of Deloitte & Touche and its global parent Deloitte Touche Tohmatsu.
"We can go for a quick fix and feel better for a while," Mr. Copeland said today in a speech at the National Press Club, "or we can make the tough changes needed to build lasting confidence in our system of financial reporting." He continued, "Public perception determines behavior, but we must remember it is the facts that determine the consequences."
Among the several steps Mr. Copeland proposed in his speech was the creation of an independent oversight board, similar to the National Transportation Safety Board, to investigate instances of business failures and report to the public with a comprehensive explanation of the cause and recommendations to avoid a recurrence. While not a substitute for the governance and disciplinary changes required to enhance accounting and auditing, Mr. Copeland said, such a panel would make a major contribution by methodically analyzing cause and dispassionately spelling out recommendations for improvement. "With that kind of information in place, the public, industry, and policy makers have an authoritative framework for action."
Mr. Copeland outlined issues that he believes must be part of the debate around reforming the profession. First among them, he said, is to make certain that the accounting profession and the SEC develop and maintain a constructive working relationship that he said had deteriorated over the past decade. "The Commission can't do its work without a strong, robust auditing profession, and the profession can't do its job effectively without the power, authority and support of the commission," he said.
"The leaders of our profession and the SEC over that period of time should be embarrassed by our failure to work better together - I know I am," Mr. Copeland said. "We let our lack of trust in each other get in the way of our public responsibility to work together," he added. "The important thing now is to rebuild bridges and reassure investors that the twin watchdogs of the capital markets are on the job and working together," he said.
Additional ideas that Mr. Copeland suggested included the following: Establishment of criminal penalties for providing false information to an auditor.
Adoption by accounting firms of several recommendations of the Public Oversight Board's Panel on Audit Effectiveness.
Use of a set of Key Performance Indicators to help dilute today's obsession with Earning Per Share as a financial measure.
Public reporting on quality-of-earnings discussions held with audit committees and on a range of results that different accounting policies or assumptions would produce.
Report on a range of results that different accounting policies or assumptions would produce. "Until all parties are ready to focus on the real issues and their solutions," Mr. Copeland concluded, "we will not begin to make the kinds of reforms that will actually strengthen the system. We need to spend our time on finding new and better ways to provide better, more accurate, and more relevant financial reporting information to the investing public."
Mr. Copeland also commented on the decision earlier this week by Deloitte to separate Deloitte Consulting. "We reached this decision with great regret," he said, "because we firmly believe the perception of conflict has always been just that, a perception." Mr. Copeland said it was necessary for Deloitte to take the step so that clients were not forced to choose between "the best auditing firm in the world or the best consulting firm in the world." He said it was ironic that Deloitte was forced to take this step because "over the past five years no other Big Five firm has come close to our audit quality record."
Bob Jensen's threads on Suggested Reforms for the accounting profession are at http://www.trinity.edu/rjensen/fraud.htm#SuggestedReforms
As the first step in a comprehensive program of accounting reforms, the Securities and Exchange Commission has announced it intends to release proposed rules for expanded disclosures. Find out how these rules will affect you and your clients. http://www.accountingweb.com/item/72097
Five former chairmen of the Securities and Exchange Commission testified before the Senate Committee on Banking, Housing, and Urban Affairs on February 12, 2002 on the issues that have arisen as a result of the Enron collapse. A key topic was their shared frustration with the process for setting accounting principles. They urged Congress to find a way to free the Financial Accounting Standards Board from the business pressures of constituencies and funding dilemmas. http://www.accountingweb.com/item/72093
STATEMENT OF JAMES G. CASTELLANO
CHAIR, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
FEBRUARY 14, 2002
Testifying before the House Energy and Commerce Committee (Subcommittee on Communications, Trade and Consumer Protection), James G. Castellano, chairman of the American Institute of Certified Public Accountants, today expressed the accounting profession's support for reform - both of the current accounting and auditing system and for enhancement and modernization of the broader financial reporting system.
Thank you, Chairman Stearns, Ranking Minority Member Towns and other distinguished members of the committee for permitting me to testify today on the adequacy of current accounting standards. I am Jim Castellano, Chairman of the Board of the American Institute of Certified Public Accountants. Corporate accountability is of great importance to the continued strength of the American economy and confidence in our capital markets. In order for our capital markets to function effectively and for our economy to allocate resources efficiently, it is essential that business enterprises report accurately and fairly to investors and that investors perceive that they do so. Our economy needs both the fact and appearance of credible financial reporting.
The business collapse of Enron last year has shaken the faith of America, and of the world, in our financial markets. The personal tragedy to Enron’s employees, retirees, and investors goes far beyond the dollars and jobs they have lost. And this tragedy occurred despite the fact that we have the freest, most open, transparent, and dynamic financial market in the world. The accounting profession has also been deeply disturbed by what has occurred. We are proud of our history of serving the public interest by providing assurance to the investors that the financial statements of public companies fairly present, in all material respects, the financial position of these companies'.
The Enron business failure has added additional pressures on our economy and raised questions concerning confidence in our capital markets. Legitimate questions are being asked about corporate ethics and governance, including the role of a company’s board of directors and its audit and finance committees, internal controls, compliance with accounting and audit standards and other SEC reporting requirements, financial reporting transparency, the adequacy of the current financial reporting model, the auditor disciplinary and quality review process, how analysts use available financial information in making buy/sell recommendations to investors, and other issues.
While no one has all the facts and relevant information about the failure, it appears to be the result of many contributing factors, all of which need to be addressed to restore investor confidence in the system. Our profession has zero tolerance for those who do not adhere to the rules. The AICPA and its members are committed to the goal of assuring that investors and creditors have the highest quality of financial information. We will take the necessary steps to restore public confidence in the accounting profession and capital market system, and will work with Congress to develop meaningful public policy reform.
My goal today will be to touch on some of the reforms we have supported and will continue to support for the accounting and auditing system, and to suggest additional reforms which we as CPAs believe will strengthen the financial reporting system.
Capital should be deployed where it can be most productive. At the root of productive capital investment is the availability of timely, reliable and meaningful information. The success of our capital markets depends upon informative, reliable financial reporting – often referred to as "transparency." Three critical conditions must exist for investor information reporting to be meaningful. There must be:
1. Adequate reporting standards that provide full transparency of all meaningful and relevant information to investors;
2. Compliance with those reporting standards, including appropriate auditing;
3. Timely access to, and sufficient user understanding of, the information available.
ADEQUACY OF CURRENT ACCOUNTING STANDARDS AND REPORTING SYSTEM
The current accounting model has historically performed well. But to work for today's economy, it must be modernized. Economic change has moved much more swiftly than accounting for such changes has adapted. Intellectual capital has become the greatest engine for corporate growth. Yet, accounting is still based on hard assets – physical plant and related items for producing goods. Many companies, like those in advertising, produce revenues based almost exclusively from knowledge work. Knowledge work has become the key to all companies’ effectiveness. Even companies producing tangible goods have become highly dependent on intangible sources of revenues and competitive advantage.
Changes in business prospects have made quarterly reports outdated. Timely information has always been prized, but the pace of change in corporate dynamics and earnings capabilities has made it much more important. Corporate diversification, alliances of all sorts, the rate and depth of economic change, and transnational relationships have enormously changed the risks facing modern corporations. The relative absence of up-to-date information with which to assess corporate earning capacity coupled with the pace of change, helps explain the volatility of today’s share prices. Meanwhile, the use of the Internet for economic communications has been exploding. Real-time disclosure of selected financial information – that is, information that can be useful to investors without creating competitive disadvantage to companies – on the Internet is clearly foreseeable. Investors need more frequent corporate financial and non-financial disclosures (i.e. on-line, real-time) to make informed investment decisions.
The accounting profession was first among those convinced the accounting model needed to be modernized. From 1991-1994, a special committee of the American Institute of Certified Public Accountants (AICPA) studied the state of business reporting.1 The committee’s greatest achievement was its research on the needs of investors and creditors. The research showed that investors have many unmet information needs. This evidence was new because investors and creditors do not actively make their information needs known to the accounting community.
The findings on information needs should have been a loud wake-up call to those who depend on the disclosure system or have responsibility for it. Investors and creditors are, figuratively speaking, the customers of financial reporting. More precisely, because corporations seek capital from investors and creditors, investors and creditors are customers of the corporation’s sale of securities. Monetary exchanges do not take place without information, and the better the information about a prospective purchase, the better the purchaser’s chance to make a satisfactory pricing assessment. Putting the same point in terms of investors’ purchases of securities, the better the information they have the lower the risk of poor investment or credit decisions.
The report concluded that investors' needs were not being fully met. It described needs that go far beyond what is required by the current financial reporting model. In fact, to capture the idea of reporting non-financial information, the report adopted the broader term “business reporting.” The report contained an illustrated, comprehensive model of business reporting designed by the Special Committee, as well.
Business reporting is wider than financial statements. It should include non-financial information and presentations outside the financial statements. The Special Committee’s business reporting model was not limited to financial statements, although it at all times includes them, in recognition of their importance to investors and creditors. The “accounting model” has in the past referred only to financial statements, but in the future it will refer as well to business reporting to investors and creditors.
It is very disappointing that the report was produced seven years ago and so little has been done in response. If investors’ needs were not being met seven years ago, they are likely being met even less today. Calls for reform have come from many different sources, including nonaccountants. They include former SEC Commissioner Steven M. H. Wallman, economist Robert E. Litan, and Yale School of Management dean and former Under Secretary of Commerce for International Trade Jeffrey E. Garten. Wallman has written on his own and with Margaret Blair as part of a Brookings Institution project on intangibles. Litan joined Peter Wallison in a project for the AEI-Brookings Joint Center for Regulatory Studies.
Garten recommended that companies be given incentives to provide more information on intangible assets and performance metrics, in a report by a group commissioned by the SEC. Economists recognize the importance of intellectual capital as a source of economic growth, which means a source of revenue. For example, Brad DeLong wrote, "Economic development has become less and less about accumulating more and more physical capital and more and more about the creation and deployment of intellectual capital."2 A 1996 United States General Accounting Office report said: "[T]he current reporting model does not provide information about important business assets. As a result, historical cost-based financial statements are not fully meeting users’ needs."
In the broadest sense, if we are going to modernize the accounting model, we must focus on these things:
· First, a broader "bandwidth" of information, such as was endorsed by the AICPA’s Special Committee;
· Second, different distribution channels, namely, the Internet;
· And third, increased reporting frequency, ultimately, on-line, real-time reporting.
The root problem is the mismatch between widespread agreement that users’ information needs are not being met and the lack of consensus on how best to meet those needs. Efforts to modernize business reporting must be accelerated, but where should they start?
Reform should address unreported intangibles, off balance sheet activity, non-financial performance indicators, forward-looking information, enterprise opportunity and risk, and more timely reporting. These could become time-consuming projects. However, we support the following list of near term reforms.
NEAR TERM REFORMS:
The FASB should issue standards-level guidance on the location, form, and content of non-financial information that would supplement the historical financial statements. In particular, the FASB should address non-financial performance indicators, unrecorded intangible assets, and forward-looking information. The FASB should determine whether such supplementary reporting should be required, based on experience with voluntary reporting or any other relevant factors it chooses to bring to bear.
As part of the its standards-level guidance, the FASB should make explicit that for purposes of its mandate, disclosures that supplement the financial statements can be desirable to meet users’ needs, even if the disclosures go beyond what some believe is necessary to understand the financial statements. The broader criterion of information useful for making investment and credit decisions should apply. In addition, in the same guidance, the Board should make more explicit the tension between the desirability of comparability and of relevance in business reporting, making clear that users’ needs can at times be satisfied best by relevant information that is not comparable across a population of companies.
The FASB, working with the SEC, should begin a project to consider revising the frequency of reporting based upon the needs of users utilizing the capabilities of modern accounting software and telecommunications.
The accounting profession stands ready to sponsor projects to help the FASB and the SEC complete the projects recommended above in the shortest reasonable timeframe.
These recommendations to the FASB are compatible with its adoption of its project on intangibles.5 The project would establish standards for disclosures about intangible assets not recognized as assets in the financial statements. The proposed project follows the publication of a study by the FASB staff which identified four possible intangibles projects.6 We strongly support the FASB’s adoption of the proposed agenda item. Although the project will entail some difficult subjects, it should be put on a fast track.
Support for reform should not be limited to standard setters, regulators, and those whose oversight can take on formal qualities. All interested parties – including but not limited to the accounting profession, the investment community, registrants, creditors, and the financial industry – should be actively and constructively engaged. They should be united by the common goal of improving the national welfare by empowering investors with better information and thereby spurring growth-creating capital allocation.
For example, we recommend reforms in the following areas:
OFF BALANCE SHEET DISCLOSURES:
We encourage FASB to reprioritize its project agenda and move quickly on its consolidation project to address off-balance sheet disclosure transparency issues. Existing accounting rules for special purpose entities should be reviewed for possible accounting abuses and new types of financing vehicles.
REPORTS ON EFFECTIVENESS OF INTERNAL CONTROLS:
In the near term, company management should be required to make an analysis and assertion as to the effectiveness of the company’s internal control apparatus. The auditor should be required to attest to and report separately on the effectiveness of the management assertion. Management and auditor’s reports on internal controls could make a positive and cost effective contribution to the assurance system and will improve investor confidence in the integrity and reliability of financial statements issued by those who access the capital market. In the wake of the savings and loan collapse, congress placed similar requirements on depository institutions and their auditors.
DISCLOSURES BY COMPANY MANAGEMENT:
The FASB working with the SEC should require expanded disclosure of stock options received by the company management.
Currently, company insiders do not have to disclose stock sales on the open market until the month after the transaction at the earliest. We believe it would make more sense to require disclosure of the intent to sell shares PRIOR to the transaction. In addition to the SEC, all other interested parties such as employees, shareholders, retirees, and pension fund managers should be notified.
We encourage the SEC to initiate additional rulemaking action to enhance disclosures in public company filings related to other management disclosure issues. The AICPA recently endorsed a petition to the SEC calling for more disclosure in a company’s proxy statement about a company’s liquidity, off-balance sheet entities, related party transactions and hedging contracts.
We are encouraged by the SEC’s desire to make rapid progress on business-reporting reform and its desire to achieve timely and more informative filings that can help better inform investors without harm to the SEC’s investor-protection mission. It should consider carefully the relevant recommendations of the ABA Committee on Federal Regulation of Securities 7 and revisit the proposals made in 1996 by the SEC’s own Advisory Committee on the Capital Formation and Regulatory Processes. The Congress should support these efforts.
MANAGEMENT DISCUSSION AND ANALYSIS OF OPERATIONS:
As auditors, we also stand ready to provide additional assurances over management’s discussion and analysis (“MD&A”). Our responsibility, under a traditional audit, is to read the MD&A and consider whether such information is materially inconsistent with the financial information presented in the audited financial statements. We are not required to render a report on our findings; rather we are only required to inform management of our findings if we believe the information is materially inconsistent. Because as a profession we believed that audit committees and boards of directors may want additional assurances relative to MD&A, we introduced, in June 2001, a new audit level service to examine the MD&A. This service, which is separate from our traditional audit, examines MD&A for the purpose of expressing an opinion as to whether:
a) The presentation includes, in all material respects, the required elements of the rules and regulations adopted by the SEC.
b) The historical financial amounts have been accurately derived, in all material respects, from the entity’s financial statements.
c) The underlying information, determinations, estimates, and assumptions of the entity provide a reasonable basis for the disclosures contained therein.
While the demand for this additional voluntary examination has been slow to develop, we hope that more audit committees and board members will avail themselves of this added assurance.
We also need new audit strategies and technologies. In an ideal world, companies would be producing the new disclosures with the desired frequency over the Internet; auditors would be providing contemporaneous assurance that the information was reliable; investors would benefit from better decision making information; productive corporations would benefit from a lower cost of capital; and the economy would be growing with more stability and promise, even than now.
To accomplish this result, not only must the reporting model change but also the focus of auditing must change. Steps toward this new direction have already begun. Auditors in this new world would be reporting on information systems. They would be focusing heavily on preventive controls and providing assurance that information systems were operating effectively and sufficiently to produce reliable information. The transition is also going to demand personnel of the highest caliber. But there will still be pitfalls even in this scenario. While new disclosures could be produced, and the auditors could provide assurance over the systems producing the disclosures, there is still the threat of management overriding the systems and preparing fraudulent and untruthful disclosures. That is why our profession, even before these recent Enron events, has been working on improving auditing standards and guidance to help auditors better detect fraud. Two of the more noted proposed changes, among others, are explicit procedures addressing the risk of management override of controls and required procedures to evaluate the business rationale for significant unusual transactions. A draft of this new standard, intended to elicit public comments, will be issued by month's end with the expectation of issuing a final standard by the end of the year.
In addition to these changes, we are also looking at the following reforms:
We are reviewing the adequacy of professional auditing standards regarding all issues emanating from Enron, including audit procedures from related party transactions, special purpose entities, hedging contracts, internal controls established by the finance or audit committees, and working paper and record retention, and others. We will work with the SEC, FASB and Members of Congress on these recommendations.
We believe it should be illegal to lie to your auditor in the same way for example, that it is a illegal to lie to a prosecutor. We would support legislation or regulations that would accomplish that.
The AICPA, is committed to working diligently with Congress and the SEC to develop a new regulatory model that improves and goes beyond the current self-regulatory processes. While the current self-regulatory model provides for significant public oversight over the existing peer review process, there is no public oversight over discipline. This new model would affect all firms doing SEC audits. We will diligently work to improve the profession's peer review and disciplinary process as it relates to auditors of SEC registrants. We strongly support moving from public oversight to public participation and increasing the transparency, effectiveness, and timeliness of the process. We will work with the Congress and the SEC to strengthen regulation of the profession as they implement a system that incorporates active public participation to enhance discipline and quality monitoring.
We will not oppose prohibitions on auditors of public companies from providing financial systems design and implementation and internal audit outsourcing. We believe such prohibitions will help to restore the public's confidence in the financial reporting system.
Preparing For the Future
Now: But there is another way of viewing this scenario. The disclosures could be produced, and auditors could find themselves inadequately prepared to provide assurance to investors about the information’s reliability. The transition to new reporting and auditing models is going to demand not only new audit approaches but personnel of the highest caliber. With this in mind, the profession has been working actively in the following areas:
Continuous auditing or continuous assurance involves reporting on short time frames and can pertain to either reporting on the effectiveness of a system producing data or more frequent reporting on the data itself. An AICPA task force has concluded that the enabling technologies, if not the tools, required to provide continuous assurance services, are, for the most part, currently available. Their actual implementation will evolve with progressive adoption of the concept and the emergence of appropriate specialized software tools. Work is needed, however, to better understand the market potential for continuous assurance. A clearer insight is needed into both users’ needs as well as decision-makers’ perceptions of the value of this service. A marketing study of user needs would help assess the types of key performance indicators, system reliability issues, and financial and non-financial information that would benefit users. Depending on corporate platforms and established monitoring processes used for other purposes the costs of providing continuous auditing or assurance will vary. Therefore, further research is also needed to better understand how the potential purchasers of these services, such as management, boards and institutional investors, perceive the value of continuous assurance relative to the current model of periodic assurance.
Extensible Business Reporting Language is a freely available internet-based language for business reporting. It is a framework that provides the business community a standards based method to prepare, publish, reliably extract and automatically exchange business reports of companies and the information they contain. Whatever new reporting standards are considered appropriate, it is likely to be richer in disclosure than what we have today and will need XBRL to facilitate.
SysTrust is an assurance level service that independently verifies the reliability of a particular system (including a financial reporting system) against a framework of standards that address security, availability and integrity. Providing a freely available benchmark for what makes a system reliable, SysTrust is designed to provide assurance to boards of directors, corporate management, and investors that the systems that support a business or a particular activity are reliable.
Performance Measures and Value Measurement.
The Value Measurement and Reporting Collaborative (VMRC) is the culmination of years of discussion about the need to change the reporting model. Numerous reports, white papers and books have cited the need for better information to be disclosed by publicly traded companies, not merely more information. Over the past year, the AICPA has been approached by a number of organizations that claim to have the solution to the need for better disclosure. While some companies are already taking steps to report information that investors want, currently these efforts are isolated and may not be comparable between companies. Rather than work with one organization, the AICPA and the Canadian Institute of Chartered Accountants are establishing the VMRC as a means to allow the various stakeholders to work together to determine the best methodology for reporting. Current suggestions include, but are not limited to, reporting of non-financial measures, intangible assets or a combined discounted cash flow and risk analyses. Specifically, the collaborative will:
· Understand the needs of the user community/stakeholder groups;
· Determine what is currently taking place in the field;
· Undertake an in-depth review of 7 or 8 alternative approaches to value measurement and reporting;
Further, this new framework, which will work in conjunction with the current model, will move the current reporting forward not in an incremental step, but in the revolutionary change that is needed today.
The AICPA has embarked on a new student marketing and recruitment plan, designed to attract more students - and the best students - to the accounting profession. This five-year, $25 million initiative is targeted toward late high school and college students, and is interactive in its approach, using web-based business simulations and games, college TV networks and other technology-based techniques to reach this important generation of young people. The campaign will help students understand the important role that CPAs play in all facets of the business world, and the important responsibilities CPAs have in helping businesses and individuals succeed.
In conclusion, I maintain that Congress and others should carefully consider these reforms as they are essential to restore investor confidence in the financial reporting system. I can assure you that the CPA profession wants, as I know you do, to assure that
this future comes about for the benefit of shareholders, consumers, and indeed, all American citizens.
Thank you for this opportunity to express our views.
Bob Jensen's summary of these and other proposed accountancy and auditing reforms in the wake of the Enron scandal can be found at http://www.trinity.edu/rjensen/fraud.htm#SuggestedReforms
Grant Thornton's Five-Point Plan to Restore Public Trust --- http://www.gt.com/publictrust/default.asp
Grant Thornton has asked the other major US accounting firms to embrace our five-point plan to restore public trust. Our plan emphasizes that leaders of those firms must set a tone that once again places the firms’ professional responsibilities ahead of all other business considerations.
As the leading global firm dedicated to serving the needs of middle-market companies, Grant Thornton is aware of the competitive pressures for firm growth. However, Grant Thornton’s most valued principle is an uncompromising commitment to professional excellence. Growth should never be at the expense of public trust. We are concerned about the impact of the Enron debacle on all SEC registrants and the entire accounting profession.
Harvey Pitt, Chairman of the SEC, working with the AICPA, has proposed new measures to regulate the profession, by establishing a new autonomous board to address (1) disciplinary actions and (2) monitoring. Five major firms have announced they would stop providing internal audit and certain technology consulting services to their publicly held audit clients.
While we applaud the SEC and AICPA’s action and the announcement by the five firms, these measures alone are not enough to restore public trust in our profession and do not address all the issues. Undoubtedly, the accounting profession buried its head in the sand and pretended for far too long that no conflicts of interest exist when auditors provide certain consulting services to publicly held audit clients. However, the profession must address the failure by some in the top management of the accounting firms to set a tone that puts professional responsibilities ahead of all other business considerations and an accounting framework that is rules based as opposed to principles based. As a starting point to address all the issues, we urge those parties who are involved in serving the public interest -- auditors, directors and regulators -- to embrace our five-point plan.
The audit service is designed to improve the quality of information for decision makers. Indeed, assurance services, which encompass auditing, are defined as those professional services that improve the quality of information, or its context, for decision makers. This definition provides the framework for those services, including advisory and tax services, which an auditor can provide without creating the appearance of a conflict of interest.
We offer the following five recommendations to send a strong message to the global financial community that the accounting profession is serious about the integrity of the audit process and restoring public trust. Others have brought forward well-intentioned solutions that unfortunately, are not in the public interest. Legislative intervention is not the right solution. The accounting profession needs to provide strong leadership, but cannot do so effectively until it addresses all the issues.
- The actions of the management of the major firms must make it clear that nothing is more important than their professional responsibility. The policies of those firms, including reward systems, must reflect an uncompromising commitment to professional excellence. In addition, all the major firms must collectively agree to limit the nature and extent of services provided to publicly held clients. Such agreement should extend beyond yesterday’s announcement by specifying that the firms will only provide assurance, advisory and tax services to their publicly held audit clients. For example, certain consulting services such as outsourcing should be prohibited. We must change our business models significantly in response to the demands from the public. To do otherwise ignores a fundamental precept: that businesses set priorities based on those drivers that have the greatest impact on earnings. Assurance, advisory, and tax services must once again be the business drivers and focus for the auditors of SEC registrants.
- Audit committees must do a better job of protecting shareholder interests. They must challenge management and the auditors on the treatment of significant accounting issues. They must be diligent in determining that their auditing firms are free of conflicts of interest. Audit committees must ensure that the auditor’s primary responsibility is to the shareholders and that the auditor’s relationship with management is clearly subordinate to such responsibility. The audit committee plays a critical role in this regard. The regulators need to take the steps necessary to reinforce the audit committee’s need to be truly independent of management. Audit committees must be vigilant in performing their duties to ensure that the appropriate auditor-client relationship is maintained and that management is challenged on all significant transactions, including the underlying business purpose of those transactions.
- The SEC must amend its rules for proxy disclosures of auditor’s fees to require separate disclosure of fees for (1) assurance and advisory services, i.e., those services that meet the definition for assurance services, (2) tax services and (3) all other services. The current proxy rules for disclosure of the fees paid to the auditors, which resulted from a compromise, are misleading because services that do not give rise to a conflict of interest are inappropriately combined with services that can and, in some instances, have created conflicts of interest.
- We urge the use of a principles based approach for all standards setting areas: accounting, auditing and independence. In addition, the auditing standards should be expanded to incorporate a forensic approach. A year ago, the previous administration at the SEC fueled a public debate that effectively killed the Independence Standards Board and its proposed principles based independence framework. Those same individuals conveniently continue to ignore that this framework, properly constructed and implemented, would have addressed some of the very issues that we are trying to solve today. The current rulebook approach for all standards setting fosters a culture of "if the rulebook does not specifically forbid it, it must be okay," where there is more concern about the form of transactions than their substance. A principles based framework for setting standards provides greater assurance to the public that management, auditors and those responsible for corporate governance will do the right thing.
- We believe that Grant Thornton has an excellent auditing methodology and we are willing to share our best practices with others. We assume that others feel the same about their methodology. Accordingly, we urge the AICPA to coordinate a review of the audit methodologies of the major accounting firms. The best practices of these firms should be shared with the entire accounting profession. This unprecedented sharing of best practices by the major firms would serve the public interest by ensuring that all audits of SEC registrants follow the best practices of the leaders of the profession.
The global accounting profession is at a crossroads. In order to regain public confidence, strong leadership is required. Grant Thornton urges the other major US firms to support this five-point plan to restore the public trust and confidence in the accounting profession, which has historically served so ably to make the US capital markets the strongest in the world.
Bob Jensen's summary of these and other proposed accountancy and auditing reforms in the wake of the Enron scandal can be found at http://www.trinity.edu/rjensen/fraud.htm#SuggestedReforms
Under pressure to set accounting standards for the kinds of special purpose entities that kept debt off Enron's balance sheet, the Financial Accounting Standards Board, in February 2002, has tentatively decided on an approach and directed its staff to begin writing an exposure draft. http://www.accountingweb.com/item/72237
Bob Jensen's threads on SPEs can be found at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm
In a landmark vote, Disney shareholders voted to reject the proposal that would have prohibited the company from using the same firm to provide auditing and consulting services. In spite of the shareholder vote giving the company the right to seek auditing and consulting services from the same firm, Disney Chairman and Chief Executive Michael Eisner announced company plans to separate audit and consulting services among outside providers. http://www.accountingweb.com/item/72840
Bob Jensen's threads on suggested reforms in accounting firms are at http://www.trinity.edu/rjensen/fraud.htm#SuggestedReforms
Stephen Cutler, director of the Division of Enforcement of the Securities and Exchange Commission, said the SEC is asking Congress for more power to punish corporate wrongdoers. The SEC is asking for added authority to impose penalties on officers and directors through administrative cases that do not require federal court proceedings. http://www.accountingweb.com/item/72446
Questions about accounting at IBM resulted in analysts expressing worries about the value of Big Blue's stock, and the resulting ripple sent the Dow Jones industrial average down 1.6 percent on Tuesday. IBM share prices dropped to below $100 on Tuesday after a report in Friday's New York Times raised the issue of how the earnings on a $300 million gain were reported to shareholders. http://www.accountingweb.com/item/72700
Questions about accounting at IBM resulted in analysts expressing worries about the value of Big Blue's stock, and the resulting ripple sent the Dow Jones industrial average down 1.6 percent on Tuesday. IBM share prices dropped to below $100 on Tuesday after a report in Friday's New York Times raised the issue of how the earnings on a $300 million gain were reported to shareholders. IBM stock has lost more than 8% in two days.
According to The New York Times, IBM booked the $300 million gain on the sale of an optical unit in December. The New York Times stated that IBM should have accounted for the sale as a one time gain. Instead, the paper reported, IBM referred to the company's fourth-quarter profits in a recent conference call, indicating profits had grown due to increased productivity and higher sales of certain products.
IBM claims the company disclosed the sale adequately in two press releases in December. "IBM's accounting is conservative and fully compliant with all regulatory standards," said Carol Makovich, a company spokeswoman.
A Wall Street investment firm, Prudential Securities, questioned the firm's complex accounting procedures and suggested that such complexities would weigh on IBM's share price. Prudential analyst, Kimberly Alexy, said that long-standing concerns about IBM's earnings "engineering" would hurt the stock in the coming year.
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.
From: William Mister [mailto:bmister@LAMAR.COLOSTATE.EDU]
Sent: Tuesday, February 19, 2002 11:05 PM
Subject: Re: Andersen again
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?
William G. (Bill) Mister
I thought you might be interested in the latter portion of a former student's current resume. She is about to graduate from the Harvard Business School and is looking for a job. I had a similar student, Gabe Knapp, who was a major auditor for Andersen and had a great deal of responsibility for auditing derivative financial instruments before going to the HBS. He graduated last May from Harvard and is now big time with Microsoft.
Now consider the last part of a woman's resume who is just finishing up at Harvard. Will her work experience, prior to going to Harvard, help or hurt her in the job market?
My main purpose in sharing part of her resume is to show you how complicated the derivatives and structured financing operations in large corporations can become. In so many ways I have to sympathize with the auditing firms that lament over having a tiger by the tail when trying to account for these derivatives and in trying to apply the tangled web of FAS 133/138 requirements. I teach FAS 133/138, and I give thanks every night that I'm not the auditor on the line when having to audit deals that were being set up as described below. Would you want to have been in the shoes of the auditor trying to follow this young woman (fresh out of college) around Enron's global world? I say "no way!"
trinity university san antonio, tx Bachelor of Science degree in Business Administration. Dean’s List. Vice-president: Black Student Union. Captain: Varsity volleyball team, All-Region and All-Conference Athletic Awards, Academic All-Region Award.
ENRON ENERGY SERVICES LONDON, ENGLAND Senior Analyst - Outsourcing Developed standard pricing models for the UK’s newly formed energy outsourcing group. Initiated customer contact. Collaborated on key facets of new business development including deal structuring and contract negotiation. Constructed valuation models that estimated savings derived from superior management of assets. Assessed clients’ needs and incorporated their requirements and commodity price forecasts into models. Led effort to develop database of customers’ historic utility bill information with IT. Determined format most useful for quick, replicable pricing procedure given thousands of data points and customer specific requests. Analyzed London’s commercial real estate market extensively as due diligence for potential deal worth $20MM. Evaluated additional outsourcing deals for a brewery, a supermarket chain, and a hotel chain. Ranked #2 analyst of 200+ analysts in eastern hemisphere end of year performance evaluation.
enron middle east houston, tx Analyst - Project Finance Member of project finance team tasked with securing financing for $150MM power plant in Gaza, the first to exclusively serve Palestine. Developed skills in financial modeling, negotiating loan documents, and equity and debt structuring. Spent substantial amount of time working in Palestine. Performed sensitivity analyses and evaluated financing alternatives in an effort to mitigate risks associated with project done in a developing part of the world. Managed relationships between potential lenders, Palestinian partners, lawyers, auditors and team members with concerns regarding financial projections. Consolidated all financial analyses for the prospectus. Contributed to successful $19.8MM IPO on Palestine Securities Exchange. Served as an appointed member of Analyst Advisory Board, a seven-person committee that worked with Enron’s Office of the Chairman to facilitate communication and address analyst concerns.
enron north america houston, tx Analyst - Risk Management Provided daily support to derivatives trader. Administered natural gas risk management book worth $100MM. Facilitated communication between financial and physical traders and book administrators. Explained complex trade structures and described impact on individual books. Reorganized risk book to minimize delays in trade confirmation and forward curve dissemination. Resolved trade disputes with outside counterparties. Forecasted position and P&L movements based on market variables. Calculated P&L and created daily position reports. Booked and confirmed trades.
Mentor in Big Brothers Big Sisters. Teacher’s aid at dual-language elementary school. MS 150 Ride volunteer.
Conversant in Spanish. Extensive travel throughout Europe, Asia, and Middle East. HBS Volleyball Club member.
Among all your points, I agree with Point 3 the most. In fact, I added Systemic Problem 10 at http://www.trinity.edu/rjensen/fraudConclusion.htm
With respect to profit motive, I am basically in agreement with Milton Friedman concerning the legitimacy of the profit motive as long as you stay within the bounds of the law and professional ethics. When I was an auditor with Ernst & Ernst (that dates me), prestige in accounting firms was considered a necessary condition for profit. Auditors were expected to behave, look, and perform their jobs with extreme dignity. I got home from my first audit because I was wearing a blue blazer instead a a dark suit.
In those days, we really felt like we were auditing "truth." Contracts were relatively simple and transactions were generally pretty easy to track and verify. Now the auditor finds a short path leading to a computer that is then connected in a mysterious way to 22,837 computers in scores of nations around the globe. The transactions are unbelievably complex, and the contract terms are written in a language that almost nobody can understand. Financing does not fall into simple debt and equity categories, payment obligations are structured in cascaded derivatives.
Probably the most serious problem over the years is that clients just got bigger and bigger with mergers, acquisitions, and partnering agreements. In my days, bank audits were relatively simple. Now a bank is a financial institution selling derivatives, selling stock, selling insurance, partnering in real estate deals and other joint ventures in China, and on and on and on. It would not surprise me if banks started death care services alongside their wills and trust services such that Grandma could set up her wills, trust, and cremation services in one simple visit to her bank.
The problem of audit complexity is greatly magnified by the problem of size of the client. Accounting firms have a lot of fixed cost invested in hiring, training, and developing knowledge bases to assist employees around the world. What does a Big 5 firm invest daily in a knowledge base covering accounting, auditing, and tax topics in multiple countries and in multiple languages? What does this firm invest each day scouting for news events to alert employees and clients on happenings around the world? All that fixed cost has to be recovered somewhere.
In my auditing days, the knowledge bases were mostly in shelves of books that were kept in the office "library." Today, the knowledge bases reside in enormous databases that costs millions and millions of dollars to develop and maintain.
Everything got big, Big, BIg, bIG, and then BIGGGG! To pay for BIGGGG, audit firms began to depend on their BIGGGG clients to recover fixed costs and to make a profit (although the growth profits from auditing became minor relative to the growth in profits from consultancy).
This growing dependency on fewer and fewer BIGGGGG clients destroyed the independence of auditors. In wasn't the consultancy nearly as much as it was the size of the audit client. For example, in my days banks were mostly locally-owned, and if they had branches, the branches could not extend beyond the boundary of a given state like Texas, Iowa, Minnesota, Colorado, etc. Now Bank of America is everywhere in the world, especially after its merger with Nations Bank. How can any auditing firm that has Bank of American afford to walk away from such a client if an intractable auditing dispute arises?
The dependence on big clients maimed the integrity of the system. Lynn Turner suggests that large clients be rotated every five years between firms that are qualified to perform the audits. I think this is unrealistic. The fixed cost of setting up to do the Bank of America audit takes millions and millions of dollars in hiring, training, and modifying knowledge bases. When the audit baton is passed after five years, what happens in the firm giving up such an enormous audit? What happens in the firm whose turn it is to "rent" the Bank of America audit or the GE audit or the Microsoft audit for the next five years?
Auditing firms gave up their prestige when their clients became aware that their auditors were little more than puppies yapping at their accounts receivables and senior partners who, at the drop of a hat, could round out a foursome on the links of Scotland on any given Saturday.
There are no easy solutions, and most of what I read is either enormously expensive surgery (cutting out the consultancy) that won't save the patient or cosmetic surgery (e.g., setting up a new oversight board) that cannot possibly have the resources, talent, and energy to save the patient. I think we should do like the insurance companies have done to try to set up realistic claim services to save the patient and at the same time minimize the civil lawsuits
See at http://www.trinity.edu/rjensen/fraudConclusion.htm
From: George Lan [mailto:glan@UWINDSOR.CA]
Sent: Wednesday, February 20, 2002 11:45 AM
Subject: Re: Andersen again
Hi Bob, I agree that the move "from prestige to profits" is having adverse effects but was wondering whether there are changes as well:
1. The Guy Noir radio sketch of a few postings ago was hilarious -- I did recall a passage where the accountant mentioned that "we are more welcoming today" or something along that line.
2. In the old days, the accounting firms were making lots of money and there were less competition and so they could afford to be genteel, selective and "discriminative." ( e.g. the old boys club).
3. In the old days, things were generally just simpler to audit.
4. In the old days, scandals are kept as secretive as possible; today they are probed by the media and other parties and broadcast all over the world. Today, the parties affected also have more recourse than in the good old days.
Overall, the positives (let's call them credits) to the profession may balance the negatives (debits).
University of Windsor
Updates following the Enron Scandal
Bob Jensen's Threads on Accounting Fraud, Forensic Accounting, Securities Fraud, and White Collar Crime
Bob Jensen's Commentary on the Above Messages From the CEO of Andersen
(The Most Difficult Message That I Have Perhaps Ever Written!)
My paper on "Damages" at http://www.trinity.edu/rjensen/damages.htm
Suggested Reforms (Including those of Warren Buffet and the Andersen Accounting Firm)
Bottom-Line Commentary of Bob Jensen: Systemic Problems That Won't Go Away
For those of you who are still confused about special purpose entities (SPEs) and how they are used and/or abused, I added a section called "DIRTY NUMBERS Off Balance Sheet--And Out Of Control" in a module near the top of http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm
I think the above short module provides a nice summary of use and abuse.
And that's the way it was on February 25, 2002 with a little help from my friends.
Bob Jensen's main document on the Enron scandal and other accounting frauds is at http://www.trinity.edu/rjensen/fraud.htm
March 2000, Forbes named AccountantsWorld.com as the Best Website on the
Web --- http://accountantsworld.com/.
Some top accountancy links --- http://accountantsworld.com/category.asp?id=Accounting
For accounting news, I prefer AccountingWeb at http://www.accountingweb.com/
Another leading accounting site is AccountingEducation.com at http://www.accountingeducation.com/
Paul Pacter maintains the best international accounting standards and news Website at http://www.iasplus.com/
How stuff works --- http://www.howstuffworks.com/
Jensen's video helpers for MS Excel, MS Access, and other helper videos are at http://www.cs.trinity.edu/~rjensen/video/
Accompanying documentation can be found at http://www.trinity.edu/rjensen/default1.htm and http://www.trinity.edu/rjensen/HelpersVideos.htm
Robert E. Jensen (Bob) http://www.trinity.edu/rjensen
Jesse H. Jones Distinguished Professor of Business Administration
Trinity University, San Antonio, TX 78212-7200
Voice: 210-999-7347 Fax: 210-999-8134 Email: firstname.lastname@example.org