Accounting Scandal Updates on February 28, 2003
Bob Jensen at Trinity University

Bob Jensen's main document on the Enron scandal and other accounting frauds is at http://www.trinity.edu/rjensen/fraud.htm 

Bob Jensen's SPE threads are at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm  

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory.htm  

Bob Jensen's Summary of Suggested Reforms --- http://www.trinity.edu/rjensen/FraudProposedReforms.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 Facts and Prevention Tips from SmartPros --- http://www.smartpros.com/x36701.xml 
Bob Jensen's tips are at http://www.trinity.edu/rjensen/fraud.htm#ThingsToKnow 

Many of the scandals are documented at http://www.trinity.edu/rjensen/fraud.htm 

Domenic Martino, CEO of the Australian arm of Deloitte Touche Tohmatsu, resigned last week in the wake of publicity surrounding his role as director of failed telco company New Tel. http://www.accountingweb.com/item/97080 

Former EDS Executive Accuses Company of Inflating Results
The Wall Street Journal, January 31, 2003 --- 
http://online.wsj.com/article/0,,SB1044055325641025584,00.html?mod=technology_main_whats_news 

It is claimed that in the 1870s the whole boom town of Palisade, Nevada, known as one of the most violent towns west of Chicago, was in on a huge spoof. To build up its Wild West image, when a train pulled in, the townspeople usually staged public shoot-outs or bank robberies. (Beef blood from the local slaughterhouse added to the effect.) Everyone in town played a role at one time or another, and no one let out the truth. As a result, Palisade became famous; but after the iron-ore raid to Eureka was abandoned in 1876, the town faded away. As long as the hoax lasted, however, there was not one real-life crime recorded in Palisade.
Source: Fakes, Frauds, and Other Malarkey, by Kathryn Lindskoog, Hope Publishing House, 1993. (Forwarded by Kate Head)

The 8th Ernst & Young Global Fraud Survey, "Fraud: The Unmanaged Risk," based on a survey of 400 CEOs in more than 30 countries, reveals that, despite attempts to improve corporate governance in the wake of recent financial scandals, more than half of the companies interviewed had suffered a significant fraud in the last two years. Moreover, some 85% of the worst frauds were by insiders on the payroll. When asked what keeps them up at night, participants were significantly more concerned about asset misappropriation than any other kind of fraud. --- http://www.ey.com/global/download.nsf/South_Africa/Jan03_8th_Global_Fraud_Survey/$file/8th%20Global%20Survey.pdf 

Ernst & Young breathed a sigh of relief this week as a judge threw out two out of three of the claims made against it in a negligence case brought against the Big Four firm by Equitable Life. Had it been successful, the suit could have cost the accounting firm $4.5 billion in damages. http://www.accountingweb.com/item/97126 

A lawsuit initiated in 1994 ended this week with Big Four auditor Deloitte & Touche agreeing to pay $23 million to the State of Kentucky's Department of Insurance on behalf of Kentucky Central Life Insurance Company. http://www.accountingweb.com/item/97178 

Two former Kmart Corp. vice presidents were indicted on securities fraud and other charges. The executives, whose names weren't immediately released, also were charged with conspiracy and making false statements to the Securities and Exchange Commission. The retailer has been under investigation for executive dealings before it filed for bankruptcy protection 13 months ago.  http://www.business2.com/articles/mag/0,1640,47023,00.html 

FOR MORE INFORMATION, see: http://online.wsj.com/article/0,,SB1046278928738020503,00.html

Most of Wall Street's payments of $1.5 billion to settle alleged stock-research abuses will be tax-deductible for the companies.
Gregory Zuckerman, The Wall Street Journal, February 13, 2003 --- http://online.wsj.com/article/0,,SB1045105237868602943,00.html?mod=todays%5Fus%5Fmoneyfront%5Fhs 

The SEC is considering making two rivals of Merck's Medco unit use a Medco accounting technique that some critics say is aggressive.
The Wall Street Journal, February 20, 2003 --- http://online.wsj.com/article/0,,SB1045704096963121463,00.html?mod=todays%5Fus%5Fmoneyfront%5Fhs 
Read about earlier revenue accounting scandals at Merck --- http://www.trinity.edu/rjensen/ecommerce/eitf01.htm#Merck 

Stock analysts will now have to certify the truthfulness of their research reports, under a recent unanimous ruling by federal regulators. http://www.accountingweb.com/item/97116 

Demand for Public Accountants Is Rising, Experts Say --- http://www.smartpros.com/x37056.xml 

STARTING SALARIES FOR ACCOUNTING GRADS UP ON LAST YEAR --- http://accountingeducation.com/news/news3788.html 

Updated IRS listing of tax scams and consumer alerts --- http://www.irs.gov/newsroom/article/0,,id=98269,00.html 

Tax Scams/Consumer Alerts

Tax Scams The IRS urges you not to fall victim to tax scams. Remember that if it sounds too good to be true, it probably is. If you suspect a tax scam, you can report suspected tax fraud activity by calling 1-800-829-0433. Some of the common scams the IRS sees include: The "Dirty Dozen" -- 12 Common Scams (IR-2003-18) Schemes Promoting Use of Disabled Access Credit (IR-2002-17) Home-Based Business Tax Avoidance Schemes (IR-2002-13) Slavery Reparation Scams (IR-2002-08) For more details on other scams, visit the IRS Criminal Investigation's Tax Fraud Alerts.   Identity and Financial Theft Scam Be on the alert for a scam that uses phony bank correspondence and IRS forms to trick unwary bank customers into disclosing their personal and financial information to the scam promoters. The information is used to steal the customer's identity and bank account deposits, run up charges on credit cards, apply for loans, services or benefits in the customer's name, file fraudulent tax returns and more. The phony IRS forms used in this scam may be labeled W-9095, W-8BEN or W-8888. News release IR-2002-55 has more details. Report instances of this fraud to the Treasury Inspector General for Tax Administration at 1-800-366-4484. The Comptroller of the Currency issued Alerts 2002-3 and 2002-6, warning of this identity theft scam and including copies of phony bank correspondence and the phony W-9095. These are on the 2002 Alerts page of the Comptroller's Web site.

Bob Jensen's main site for fraud detection and prevention (including tax fraud and identity theft) is at http://www.trinity.edu/rjensen/fraud.htm 

The U.S. Government's Central Website for Identity Theft Information --- http://www.consumer.gov/idtheft/ 

Coming Up on Dateline from NBC

Also, how do you know if your water is safe to drink? In a hidden camera investigation, ”Dateline NBC” found that some salesmen will scare you into believing you need an expensive filter. You could spend thousands of dollars on a water filter, but do you really need to? Lea Thompson investigates.

One thing that bothered me recently was a television solicitation to send money to purchase slaves in Africa.  There are indeed modern day slaves.  However, doesn't buying slaves from evil owners merely make business better for dealing in slaves?  There must be a better way to help without making it a growing business.

Independence Rules

Corporate Reform: The New SEC Auditor Independence Rules (from Ernst & Young) --- 

http://www.ey.com/global/download.nsf/US/Corporate_Reform_SEC_Auditor_Independence_Rules/$file/CorporateReformSECAuditorIndependenceRules.pdf 

Enron Update - Tax Schemes Even The IRS Doesn't Understand
Last week, the U.S. Senate's Joint Committee on Taxation published a three-volume, 2,700 page report describing what the committee had learned of the tax shelters used by Enron Corporation to reduce and in some cases avoid paying U.S. corporate income tax. http://www.accountingweb.com/item/97152 

The SEC leadership is often on the side of the crooks!
SEC Staff Wants to End 'Short Seller Wars' --- http://www.smartpros.com/x37167.xml 

Feb. 21, 2003 (FinancialWire) — The Financial Times is reporting that the SEC staff had wanted to propose "sweeping changes" to rules governing "short selling," but was rebuffed by Chairman Harvey Pitt. Naming three NYSE companies that have claimed manipulation -- Allied Capital, MBIA and mortgage lender Federal Agricultural Mortgage Corp. "Farmer Mac" -- FT says the staff plans to take its case before new SEC Chief William Donaldson as early as next week.

Also, Wednesday's entry of InternetStudios, Inc. into the fray now brings the number of companies associated with short selling, mostly of the naked variety, to a whopping 57 varieties.

FT's reporter John Labate said that "regulators around the world are under pressure to tighten rules on short-selling, in which traders bet a stock price will fall, amid concern that it is used by professional traders to manipulate share prices, particularly of smaller companies."

Among the proposals could be "rules forcing traders to borrow stock to cover their short positions. Under current rules, traders can take out 'naked' short positions over an unlimited number of shares, putting huge downward pressure on an illiquid stock.

FT said regulators are less concerned about short-selling in the most liquid stocks and may even consider loosening the rules for large companies; and that officials want a consistent set of rules across all US markets. For example, it said, traders are forbidden from shorting a stock quoted on the New York Stock Exchange when the price is falling but Nasdaq stocks operate under a separate rule that does not apply to small stocks in the over-the-counter market.

The staff said it has been lobbied by politicians who complain that small companies and shareholders in their constituencies are being hurt -- perhaps unlawfully. A rule proposal by Georgetown University Associate Professor James J. Angell, presented to the CEO Council last fall, is at http://www.investrend.com/default.asp?level=137 

Continued in the article.

February 19, 2003 message from Tom Hood

-----Original Message----- 
From: Tom Hood [mailto:Tom@macpa.org]  
Sent: Wednesday, February 19, 2003 4:30 PM 
To: Jensen, Robert 
Subject: Content for your website : Summary of Suggested Reforms Importance: High

Bob,

I have attached a copy of our whitepaper entitled The Road to Reform: Protecting the Public Interest, Strengthening the Profession, which was released by us in September, 2002. It was produced by a "blue ribbon" panel of experts from our membership and included Big Four firms, national, regional and local firms; two public company CFOs, two private company CFOs, the Maryland Chamber of Commerce, educators, and a government accounting expert. Our task force also had a member of the Auditing Standards Executive Committee of the AICPA, member of the PCPS Executive Committee of the AICPA, and GASB expert. We reviewed thousands of pages of proposals in crafting our response. We were the first State CPA Society to approach this issue from a comprehensive reform perspective. In fact, our membership demanded that we (the MACPA) do something about the deteriorating situation and show some leadership and this was our response.

I have also included a pdf file of our PowerPoint which was used to expose this to our membership via a Webcast townhall meeting. It ultimately has received significant acceptance. You are free to post on your website and distribute. I would love to hear you comments as well.

I only wish more educators kept up with the massive issues facing this Profession like you do - keep up the great work!!!

<<Road to Reform.pdf>> <<MACPA Webcast.pdf>> Here is a link to our "reform" website that we are using to inform Maryland CPAs

http://www.macpa.org/headlines/2002/Reform/ 

Thanks,

Tom Hood, CPA 
Executive Director 
Maryland Association of CPAs (800) 782-2036

Note that the link to the white paper mentioned below is http://www.macpa.org/headlines/2002/Reform/white_paper.pdf 

The link to the slides is at http://www.macpa.org/headlines/2002/Reform/slides.pdf 

Bob Jensen's summary of proposed reforms is at http://www.trinity.edu/rjensen/FraudProposedReforms.htm 

"Tax-Shelter Sellers Lie Low For Now, Wait Out a Storm," by Cassel Bryan-Low and John D. McKinnon, The Wall Street Journal, February 14, 2003, Page C1 --- http://online.wsj.com/article/0,,SB1045188334874902183,00.html?mod=todays%5Fus%5Fmoneyfront%5Fhs 

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 different bosses.

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 rebounds.

For now, though, some traditional corporate clients and wealthy individuals are getting nervous about using aggressive tax-avoidance plans. The IRS cracked down last year to try to force several big accounting firms -- KPMG, BDO Seidman LLP and Arthur Andersen LLP, among others -- to hand over documents about the tax shelters their corporate clients were using. The 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 reputation.

Some large accounting firms once earned as much as $100 million or more in revenue annually from their shelter-consulting business at the market's peak around 2000. Now, the revenues are in sharp decline, partners at Big Four firms say. In some cases, business from wealthy individuals has dropped about 75% from a few years ago. Business from corporate clients has suffered less, because accounting firms have been able to persuade customers to buy customized, more costly, advice.

Ernst & Young LLP says a group there that had sold tax strategies for wealthy individuals has been shut. E&Y does continue to sell tax strategies to corporate clients, but, a spokesman says: "We don't offer off-the-shelf strategies that don't have a business purpose."

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.

Continued at http://online.wsj.com/article/0,,SB1045188334874902183,00.html?mod=todays%5Fus%5Fmoneyfront%5Fhs 

Bob Jensen's threads on stock compensation controversies are at  http://www.trinity.edu/rjensen/theory/sfas123/jensen01.htm 

Jensen Note:  Accounting educators might ask their students why performance looked better.  
Hint:  See the article and see one of Bob Jensen's former examinations at 
http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/Exam02VersionA.htm 

It's Still The Pitts (Obviously)
Reactions to the new auditor independence rules vary widely. Large accounting firms seem generally pleased. But consumer activists are openly scolding the SEC for watering down the rules. http://www.accountingweb.com/item/97078 

Also see http://www.consumerfed.org/auditreformeval.pdf 

Last week Ernst & Young weighed in on the issue of expensing stock options and in the process upset its high-technology clients. The Big Four accounting firm reversed its previous opinion, notifying the Fed

The Financial Accounting Standards Board (FASB) that it now believes employee stock options should be expensed. http://www.accountingweb.com/item/97167 

Some E&Y Clients Are Not Happy About This Reversal
Last week Ernst & Young weighed in on the issue of expensing stock options and in the process upset its high-technology clients. The Big Four accounting firm reversed its previous opinion, notifying the Federal Accounting Standards Board (FASB) that it now believes employee stock options should be expensed. http://www.accountingweb.com/item/97167 

I think the tax shelter marketing of the large CPA firms is probably the most depressing auditing scandal since the fall of Enron.  The article below by Jeremy Kahn makes me want to see my doctor about a prescription for Prozac.  What is worse is that on the way out, the large CPA firms biggest friend ever at the SEC, Harvey Pitt, decided to continue to officially allow this type of consulting bias to continue as his one last act of favoritism on his way out of town.  See http://www.consumerfed.org/auditreformeval.pdf 

To date, only PwC has promised to stop mass-marketing these aggressive tax shelters.  But the horse is out of the barn for all the big firms in terms of billions of dollars of litigation coming down the pike.  This is an illustration of how the entire culture of auditing changed in the large firms just as Paul Volker complained about following his doomed effort to save Andersen --- http://www.fei.org/download/Volker_Kellogg_Speech_6-25-02.pdf 
I think that dealing in tax shelters is not wrong per se.  But it’s a conflict of interest when the auditors deal in them for audit clients.  Where is Abe Briloff when we need him the most to focus auditors back on investors --- http://accounting.rutgers.edu/raw/aaa/pi/newsletr/spring99/item07.htm 

The last thing the Big Four needed was yet another scandal. But they've got one--this time over tax shelters. 
"Do Accountants Have a Future?" by Jeremy Kahn, Fortune, March 3, 2003, pp. 115-116 --- http://www.fortune.com/fortune/articles/0,15114,423588,00.html 

On a snowy Friday in February, dozens of men and women shuffled through Arthur Andersen's spacious Midtown Manhattan office. The place hadn't seen this much activity in months. But it wasn't a sign that the once-proud accounting firm decimated by the Enron scandal was suddenly springing back to life. The visitors hadn't come for help in setting up off-balance-sheet partnerships. No, the firm was selling its furniture and artwork--and the people roaming the halls were hunting for bargains.

A year ago Andersen was still a thriving business, with 28,000 workers in the U.S. and $9 billion in annual revenues. Today it exists--barely--employing fewer than 500 people. Scores of them spend their time traveling from office to office, auctioning stuff off. Meanwhile, with the accounting industry leaping from one crisis to another--the latest one concerns the marketing of suspect tax shelters--investors wonder whether the same fate awaits the remaining Big Four firms.

Accounting firms lobbied successfully last year to block proposals that would have severely limited the type of work they can perform for public companies. There was no conflict of interest between auditing and tax advice, they argued. The latest debacle suggests otherwise. And with each new scandal, the profession hurtles closer to a future it wants desperately to avoid, one in which public accounting firms perform audits and nothing else. To escape that outcome, the Big Four will have to convince regulators that they are serious about changing the way they do business.

Nor is that their only problem. Shocked by Enron's abuse of corporate tax shelters, Congress is taking steps to outlaw such structures. In addition, all the firms face a wave of litigation from wealthy clients who bought into complex individual tax shelters marketed in the 1990s. The IRS is cracking down and pressing investors who used shelters to pay back taxes, interest, and penalties. The clients in turn are suing their accountants for fraud and malpractice. Some have filed civil racketeering claims, which will allow them to collect triple damages if they win. The issue burst on to front pages earlier this month when the board of Sprint ousted CEO William Esrey and president Ronald LeMay over tax shelters they had bought from the firm's auditor, Ernst & Young. (E&Y says it stands by the tax advice it provided the deposed executives.)

Although the extent of the industry's potential liability from failed tax schemes isn't yet known, it is likely to run into the billions. The Justice Department is also suing--on behalf of the IRS--KPMG and another firm, BDO Seidman, for withholding documents related to their promotion of tax shelters. PricewaterhouseCoopers has already paid $1 million to settle an IRS examination of its tax shelter business.

As if all that weren't enough, the Big Four are still fighting lawsuits from shareholders angry about earnings restatements at companies they audited. One firm, KPMG, is especially vulnerable. On Jan. 29 the SEC filed a civil fraud complaint against the firm for allowing Xerox to inflate its revenues by $3 billion between 1997 and 2000. (KPMG says it "did the right thing" at Xerox and calls the SEC complaint an "injustice.")

As usual, the accountants have only themselves to blame. Their lax attitudes toward aggressive corporate accounting and their decision to market risky tax strategies have the same root cause: greed, coupled with a peculiar inferiority complex. Accountants have always wanted to be more than mere bean counters. In the 1990s they invested heavily in consulting, investment banking, and even legal services. The big firms seemed almost embarrassed by their "legacy role" as guardians of the public's trust in financial reporting. There was more sex appeal--and money--elsewhere.

To increase revenues, accounting firms began using their audits as loss leaders for selling more lucrative consulting work. They also discovered a gold mine in tax shelters. In 1991 the American Institute of Certified Public Accountants changed its code of professional conduct to allow accountants to charge performance-based contingency fees, as opposed to traditional hourly rates. The change set off a race to invent and market tax strategies, for which accountants would ask clients to pay 10% to 40% of the amount they saved in taxes. Tax experts say many of the schemes the accounting firms were selling crossed the line. "They were based on a literal interpretation of the law, but what was being accomplished was clearly violating the spirit of the law," says Robert Willens, a Lehman Brothers accounting expert who has reviewed dozens of tax shelters.

Throughout much of the 1990s the IRS lacked the resources to combat proliferating tax-shelter sales. The schemes were too complex for the IRS to understand--unless someone tipped it off--and the accounting firms made prospective clients sign nondisclosure agreements. By the end of the Clinton administration, however, the Treasury started cracking down. The IRS forced accounting firms to turn over information about how they marketed shelters--including client lists. The agency offered amnesty programs to encourage individuals using suspect structures to come forward. And when it uncovered an abusive tax strategy, it issued notices banning it and recommended penalties. "At one point they were issuing notices almost weekly," Willens says.

Now accounting firms are in hot water with both the IRS and their former clients. "It's not like they screwed people who can't come after them," says Blair Fensterstock, a lawyer who is suing E&Y for $1 billion on behalf of four executives who bought a shelter idea now being challenged by the IRS. Several suits have been filed against the other firms as well.

The industry also faces the prospect of further regulation. New moves are afoot to shutter the shelter business. For example, in regulations issued in late January the SEC told corporate audit committees to "strictly scrutinize" tax services their auditors were providing. Several Congressional Democrats have written the SEC asking it to go even further and ban the auditors from performing tax work.

A host of corporate-governance experts criticize accounting firms for using their position as auditors to sell tax advice to individual executives. Sometimes firms have made more money selling such advice than they did auditing an entire company. That was true at Sprint, where in 2000 Esrey and LeMay paid E&Y $5.8 million--3% of their investment in tax shelters the accounting firm recommended--while Sprint paid E&Y just $2.5 million for the audit and another $2.6 million for services related to it. "Should the accounting firm advising the company also advise the executives? Probably not," says shareholder activist Nell Minow. The new Public Company Accounting Oversight Board will probably examine the subject when it starts work in April.

Another issue is contingent fees. In 2000 the SEC prohibited accounting firms from taking a cut of clients' tax savings when selling advice to companies they audit. But many think the government should ban their use in all cases. To preempt the regulators, the AICPA may urge the IRS to bolster disclosure of any tax strategy sold under a confidentiality agreement or a contingency arrangement.

Some individual accounting firms are doing more--getting out of the shelter game altogether. Even before its legal settlement with the IRS, PwC had stopped mass-marketing tax