Accounting Scandal Updates and Other Fraud on March 31, 2004
Bob Jensen at Trinity University

 

Updates and issues in the accounting, finance, and business scandals --- http://www.trinity.edu/rjensen/fraud.htm 

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

Resources to prevent and discover fraud from the Association of Fraud Examiners --- http://www.cfenet.com/resources/resources.asp 

Self-study training for a career in fraud examination --- http://marketplace.cfenet.com/products/products.asp 

There are some financial executives who do/did the right thing (e.g., blow the whistle) when confronted with an ethics issue.  There are some nice examples of real executives in real situations in the following article:
"Financial Execs Who do the Right Thing," by Jeffrey Marshall adn Ellen M. Heffes, Financial Executive, November 2003, pp. 32-38 --- http://www.fei.org/mag/articles/11-2003_cover.cfm 

Source for United Kingdom reporting on financial scandals and other news --- http://www.financialdirector.co.uk 

Where are some great resources (hard copy and electronic) for teaching ethics?

"An Inventory of Support Materials for Teaching Ethics in the Post-Enron Era,” by C. William Thomas, Issues in Accounting Education, February 2004, pp. 27-52 --- http://aaahq.org/ic/browse.htm

ABSTRACT: This paper presents a "Post-Enron" annotated bibliography of resources for accounting professors who wish to either design a stand-alone course in accounting ethics or who wish to integrate a significant component of ethics into traditional courses across the curriculum.  Many of the resources listed are recent, but some are classics that have withstood the test of time and still contain valuable information.  The resources listed include texts and reference works, commercial books, academic and professional articles, and electronic resources such as film and Internet websites.  Resources are listed by subject matter, to the extent possible, to permit topical access.  Some observations about course design, curriculum content, and instructional methodology are made as well.

Bob Jensen's threads on resources for accounting educators are at http://www.trinity.edu/rjensen/000aaa/newfaculty.htm#Resources 

Quotations

Scandals Are a Hot Topic in College Courses --- http://www.smartpros.com/x42201.xml 

American investigators have discovered that KPMG marketed a tax shelter to investors that generated more than $1bn (£591m) in unlawful benefits in less than a year.
David Harding, Financial Director --- http://www.financialdirector.co.uk/News/1135558 
For more about KPMG see http://www.trinity.edu/rjensen/fraud.htm#KPMG 

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

There is a "moral high ground" when all the largest accounting firms sold illegal tax shelters to banks like Wachovia and other audit clients like Worldcom. At least they preyed on tax cheats like big corporations or wealthy individuals rather than widows and orphans.  The same moral high ground was claimed at Morgan Stanley when it sold illegal derivative instruments to pension fund managers. The quote is as follows from http://www.derivativesstrategy.com/magazine/archive/1997/1197fea6.asp 

"I sold to cheaters, not widows and orphans. That was the moral high ground if there was a moral high ground in derivatives. I sold to cheaters." 
Frank Partnoy, Morgan Stanley

If you find an offer on eBay for an iPod that's too good to be true, it probably is. EBay is swamped with supposed buyers clubs that promise cheap iPods. Beware: It's a classic pyramid scheme --- http://www.wired.com/news/culture/0,1284,62226,00.html?tw=newsletter_topstories_html 

The open-access method of distributing scientific journals, says John E. Cox, a publishing-industry consultant, "is the most articulate and serious threat to the conventional publishing market that we've seen."
Lila Gutterman, "The Promise and Peril of 'Open Access,'" The Chronicle of Higher Education, January 30, 2004, Page A10.
See The Biggest Academic Rip-off of All Time by Publishing Monopolists --- http://www.trinity.edu/rjensen/fraud033104.htm#MonopolyJournals 

Verizon, one of MCI's most outspoken opponents, never filed a lawsuit against MCI. But last spring, the company's general counsel, William Barr, said MCI had operated as "a criminal enterprise," referring to the company's accounting fraud. Mr. Barr also argued that the company should be liquidated rather than allowed out of bankruptcy. Mr. Barr couldn't be reached for comment Monday. Commenting on the settlement, Verizon spokesman Peter Thonis said, "we understand that this is still under criminal investigation and nothing has changed in that regard."
Shawn Young, and Almar Latour, The Wall Street Journal, February 24, 2004 --- http://online.wsj.com/article/0,,SB107755372450136627,00.html?mod=technology_main_whats_news 
Bob Jensen's threads on the Worldcom/MCI scandals are at http://www.trinity.edu/rjensen/fraud.htm#WorldcomFraud 

But for Freddie Mac, the other pillar of the colossal U.S. mortgage market, Freddie Mac's restatement has only caused headaches and has even raised new questions about the quality of financial reporting.
Patrick Barta, "Restatement by Freddie Mac Puts Fannie on the Spot," The Wall Street Journal, January 12, 2004, Page C1.

The problem is the companies' (Freddie Mac versus Fannie Mae) business and financial statements have become so complex that they are effectively "unanalyzable" says James Bianco, president of Bianco Research, a Chicago-based fixed-income research firm that has been critical of Fannie and Freddie in the past.  He says the same is becoming true of other large financial institutions, particularly those that, like Fannie and Freddie, use large volumes of derivatives, which are investment contracts that can be used by companies to offset risk from interest rate shifts.
Ibid

You buy shares in a company. The government charges one of the company's executives with fraud. Who foots the legal bill? All too often, it's you.
Laurie P. Cohen (See below)

Ethics:  Is there a bright line?
This is a gray zone for tiny and customary ways of doing business in the U.S.
Jenzabar, acompany that sells higher-education software, gave $300 cash cards to college presidents who attended a dinner it held in San Diego.
Andrea L. Foster, The Chronicle of Higher Education, February 13, 2004.

Ethics:  Is there a bright line?
This is a gray zone for huge and customary ways of doing business in the U.S.
So what's a little business deal among friends?  It's trouble, if the friends are college or college-foundation trustees who benefit personally from the decisions they make on behalf of the institutions they serve. 
Julianne Basinger, "Boars Crack Down on Members' Insider Benefits," The Chronicle of Higher Education, February 6. 2004, Page A1.

Ware Enterprises and Investments Inc., which targeted blacks and Christians as well as nearly 20 NFL players, is nothing more than a Ponzi scheme, the Securities and Exchange Commission said Tuesday as it acted to shut down the Orlando-based investment firm. 
AccountingWEB, January 29, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=98643 

Mutual-fund investors sent a record $14 billion in net assets to exchange-traded funds last month as they sought escape from the recent share-trading scandal.
Aaron Lucchetti, The Wall Street Journal, January 23, 2004 --- http://online.wsj.com/article/0,,SB107482213730209735,00.html?mod=mkts_main_news_hs_h 

Democratic Presidential Candidate John Kerry refers to the Mutual Fund Industry as "Organized Crime."
"John Kerry’s 19 Year Record On Investor Issues," American Shareholders' Association ---  http://www.americanshareholders.com/news/asakerryreport03-22-04.pdf  

Mr. Quattrone's rise shows how some who were on the inside during the tech boom piled up huge fortunes in part through special access, unavailable to other investors, to the machinery of that era's frenzied stock market. But now he faces a crunch. The steep yearlong downturn in tech stocks has hurt the profits of his technology group. And in recent weeks, the group he heads has come under scrutiny in connection with a federal probe into whether some investment-bank employees awarded shares of hot IPOs in exchange for unusually high commissions, and whether those commissions amounted to kickbacks.
Susan Pulliam and Randall Smith, The Wall Street Journal, May 3, 2003 --- http://online.wsj.com/article/0,,SB988836228231147483,00.html?mod=2_1040_1 
Bob Jensen's threads on "Rotten to the Core" are at http://www.trinity.edu/rjensen/fraud.htm#Cleland 

As CEO, he helped build Deutsche Bank into a global giant. So why is he now facing ten years in prison?
Janet Guyon, "The Trials of Josef Ackermann", Fortune --- http://www.fortune.com/fortune/ceo/articles/0,15114,574292,00.html 

Dutch police raid 23 apartments and arrest 52 people in one of the largest busts of suspected Nigerian e-mail hucksters. The detainees' identities are not released, but police believe most were, in fact, Nigerian --- http://www.wired.com/news/ebiz/0,1272,62124,00.html?tw=newsletter_topstories_html 
Bob Jensen's threads on the enormous Nigerian and other e-mail frauds are at http://www.trinity.edu/rjensen/FraudReporting.htm 

Mutual Fund Advice
John C. Bogle, the founder of the Vanguard Group, says that a low expense ratio is the single most important factor in evaluating a fund, but that it is not the only one. He also advises people to consider the fund manager's tenure, for example, and the frequency of a fund's trading.
Riva D. Atlas,"Does the Expense Ratio Tell the Whole Story?" The New York Times, February 8, 2004 --- http://www.nytimes.com/2004/02/08/business/yourmoney/08fees.html 

Federal prosecutors are planning to seek a criminal indictment against a former chief executive of Enron. 
http://www.nytimes.com/2004/02/13/business/13CND-ENRO.html?ex=1077710269&ei=1&en=bcf410a8cbba40a7  


International Corruption Surveys and Indices --- http://www.transparency.org/cpi/ 

Ken Lay's secret recipes for legally looting $184,494.426 from the corporation you manage. 

Jeff Skilling and Andy Fastow may spend a few years in Club Fec, but they'll never touch Ken Lay. Here's how you can cook the books using Ken Lay's favorite recipes.

1. Hire financial sharpies (read that Skilling, Fastow, Mark, Belfert, Frevert, Pai, and others) to cook the books so that you can make a fortune on your share holdings and stock options before the bubble bursts. But don't allow them to tell you about the sneaky deals (read that derivatives in SPEs) that you probably couldn't understand in a million years if they tried to explain them --- http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm 

ENRON'S CAST OF CHARACTERS AND THEIR STOCK SALES --- http://www.trinity.edu/rjensen/fraud.htm#StockSales 

2. If word of bad dealings (read that the Watkins memo) crosses your desk, hire an unethical law firm (read that Vinson and Elkins --- http://www.businessweek.com/bwdaily/dnflash/jan2002/nf20020118_8522.htm ) and an accounting firm (read that Andersen --- http://abcnews.go.com/sections/business/DailyNews/enron_020117.html  ) to absolve you of responsibility by allowing you to claim to have passed the buck along to experts.

3. Appoint a Board of Directors made up of greedy whores (male and female) or oblivious fools (read that former professors) who will rubber stamp any of your looting deals so that you can claim that your dealings were "approved" by the Board (otherwise known as how Dennis Kozlowski looted $600 million from Tyco). See http://snipurl.com/EnronBoard 

4. Have your company buy your wife expensive jewelry and clothing and then set her up in a resale shop (read that Jus' Stuff) to lauder the money. See http://www.fool.com/news/take/2002/take020501.htm?source=EDNWFH 

Ken Lay's Wife Sets Up Shop Enron's stock may not be worth much, but the former CEO's bright-yellow pair of metal fighting cocks might be. At least that's what his wife hopes. Linda Lay, wife of ex-chief executive Ken Lay, is opening an antique and secondhand store that will feature some of the Lays' personal property. The boutique will be called Jus' Stuff (possible slogan: "We sold our souls, now we're selling our stuff"), and will hawk artwork, couches, a mahogany bed, a reproduction of an antique desk, and, of course, the fighting cocks. This led us to speculate what else might turn up in the inventory of Jus' Stuff (possible ad campaign: "10% off to people who lost their 401(k)s and can't retire"). So, here are the top items we'd like to see in the storefront window: 

14. Enron stock certificates, framed and matted 

13. Patents for energy-efficient appliances that Enron bought up and locked away 

12. Hotline telephone connected to the Cayman Islands Better Business Bureau 

11. Battery-powered laugh machine that Enron execs used when discussing shareholders 

10. Humble pie, à la mode 

09. A racy home video, starring Linda "Love" Lay 

08. Collections of souvenir silverware from restaurants and souvenir towels from hotels 

07. Actual set of blindfolds worn by Andersen auditors 

06. Posters from Enron's short-lived "Got Gas?" ad campaign 

05. The photos from their vacation in India with the Cheneys 

04. The jester cap and books Ken was given after appearing on some investing radio show 

03. The cabana boy 

02. Graven image of Khutspa, the god of "getting away with it" 

01. Shredded paper -- lots of it

 

Actually the guy you have to admire the most in all of this is Lou Pai. He looted millions from Enron to buy an entire Colorado mountain and neither the SEC nor media reporters ever fishing for him for Lou Pai.

Nothing will every really be solved until white collar crime does not pay so well even when you get caught.

Bob Jensen's threads on the Enron/Andersen scandal are at http://www.trinity.edu/rjensen/fraud.htm 

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

Bob Jensen's threads on scandals at Ernst & Young are at http://www.trinity.edu/rjensen/fraud.htm#Ernst 

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

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

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

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

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

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

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

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

Old and New

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

'Maximum Risk'

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bob Jensen's threads on current scandals in the large auditing firms can be found at http://www.trinity.edu/rjensen/fraud.htm#others 

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

 

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

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

Dear Bob, 

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

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

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

Sorry about the social implications. 

Kind regards, 

Mac Wright

March 27, 2004 reply from Bob Jensen

Hi Mac,

You are correct about the fact that risk-based auditing has led to game playing. Somehow the HealthSouth executives figured out that the risk of getting caught with fraudulent transactions under $6,000 each was nearly zero under their auditor's (E&Y) risk-based model, so they looted the company with transactions under $6,000 each.

I agree with you that some form of risk-based auditing should be utilized.  I think this was the case long before KPMG formalized the concept.  However, in addition the fear of detailed testing of small transactions must still remain high among client employees. Auditors must invest more in unpredictable detailed testing up to a point where the probability of being audited for even small transactions is significant.

Probably the worst-case scenario that virtually eliminated fear of getting caught was Andersen's notoriously defective audits of Worldcom. I'm told (rumor mill) that an Andersen auditor had not even been seen in Worldcom's purchasing department for a number of years. What is the first department an auditor should investigate for fraud?

Bob

March 28, 2004 reply from Glen L Gray [vcact00f@CSUN.EDU] 

I know a treasurer of a major company. It used to bug him that the auditors came by every year and take up her staff's time collecting & reconciling bank and investment information. Then a few years ago, they just stopped showing up in the treasury dept. I've always wondered what the auditor's risk model was if suddenly cash and investments were no longer important.

Update March 2004
From The American Assembly --- http://www.hypermediative-dev1.net/index.php 
The Future of the Accounting Profession --- http://snipurl.com/AccountingFuture 

What Went Wrong? 
As the bubble economy encouraged corporate management to adopt increasingly creative accounting practices to deliver the kind of predictable and robust earnings and revenue growth demanded by investors, governance fell by the wayside. All too often, those whose mandate was to act as a gatekeeper were tempted by misguided compensation policies to forfeit their autonomy and independence. The technology stock bubble of the late 1990s – and the puncturing of that bubble in 2000 – coincided with significant failures in corporate governance.

Preface 
On November 13, 2003, fifty-seven men and women, including leaders from the worlds of accounting, finance, law, academia, investment banking, journalism, non-governmental organizations, as well as the current and former regulatory officials from The Federal Reserve Board, the Securities and Exchange Commission (SEC), the General Accounting Office (GAO), the Public Company Accounting Oversight Board (PCAOB), The Financial Accounting Standards Board (FASB), and the International Accounting Standards Board (IASB) gathered at the Lansdowne Resort, Leesburg, Virginia, for the 103rd American Assembly entitled “The Future of the Accounting Profession.” Over the course of the Assembly, the distinguished professionals considered three broad areas of the accounting profession: its present state, its desired future state, and how it might reach that future state. 

This Assembly project was co-directed by Roderick M. Hills, Partner, Hills & Stern, and former Chairman of the SEC, and Russell E. Palmer, CEO, The Palmer Group, former CEO, Touche Ross & Co. Initiated by the co-directors in fall 2000, this project showed an extraordinary prescience of the material events that subsequently unfolded. The project benefited greatly from the advice and active guidance of an eminent steering committee, whose names and affiliations are listed in the appendix of this report.

There are too many conclusions and recommendations to summarize concisely.  Several that caught my eye are as follows:

Accounting firms must seek out job candidates with a strong knowledge of business and finance. We believe that the Big Four.  Accounting firms must seek out job candidates with a strong knowledge of business and finance. We believe that the Big Four

The consolidation of the accounting industry has come at a cost for the profession. With fewer alternatives, companies may have few options to their current auditors. This may be a situation that is difficult to correct, but it is one that demands that regulators seek to maintain public confidence in the surviving Big Four accounting firms, and where auditing firms themselves strive to overcome the limitations created by their market dominance.

To remain a profession, auditors need to address issues ranging from the potential problems or conflicts created by the consolidation of their industry to the need to restore their credibility to attract the ‘best and the brightest’ of college graduates.

Auditing firms must place the appropriate value on the partners who conduct top-quality audits, not solely on those ‘rainmakers’ who bring in the most new business. The goal must be to maintain topnotch auditing standards.

Bob Jensen's Conclusions

The names of the participants are included in the above final report.  Given the tremendous amount of talent and experience of this group, I was disappointed in the rather unimaginative conclusions.  In the end, a song came to mind with the lyrics "Is that all there is?"   

What is wrong with the report it that it is like focusing on medical doctors to correct the exploding problem of diabetes, prostate cancer, and breast cancer in urban society.  Another analogy would be to focus on the police to correct the problem of crime in large U.S. Cities or the Border Patrol to stop the rising tide of illegal immigration in the United States.

The recent flood of scandals in the accounting, tax, and auditing professions were inevitable in the growing sickness of urban society and culture where families more pride in money than in honor and/or the breakdown of family infrastructure altogether.  Honesty begins at home.  If home fails, then honesty  is forced by the sanctions imposed by strict law enforcement such as we find in very few societies other than Singapore.  Law enforcement has not broken down in the United States, which is one of the major factors that makes the U.S. a better place to live than in many other nations.   But many think that we are now fighting a losing battle. 

But law enforcement is broken when it comes to white collar crime in nearly all nations of the world and especially in the United States.  Business leaders violate the laws and push unethical behavior to the edge because these shameful acts pay big time even in the unlikely event they will be caught.  

Conclusions that are lacking in the above report include the following conclusion by Bob Jensen:

Unmentioned Recommendation 1  
The accounting profession must develop a strategy and funding to combat white collar crime and tax evasion where it will do the most good in modern times.  There are many fronts on which this war can be fought, including the following:

Unmentioned Recommendation 2  
Make all persons in society accountable for their resources and life styles.  One means of doing this is doing this is to eliminate cash in all economic affairs.  Every economic transaction should be accompanied by an auditable trail.  A cashless society that is now technologically feasible is one way to start.  The accounting profession should commence to seriously lobby for a cashless society.

I guess what I am really trying to say is that the accounting profession will never solve the problems that are emerging without solving the causes of those underlying problems.  Medical doctors cannot stop the rising tide of diabetes without devoting their professional efforts and resources to changing life styles, food quality, and eating trends in modern society.  Juvenile crime and drug addiction cannot be solved without creating economic incentives to strengthen family values and parental controls.  White collar crime cannot be solved without providing genuine preventative measures aimed at the root causes.

March 5, 2004 reply from Roger Collins [rcollins@CARIBOO.BC.CA] 

Bob, in response to your challenge - under Unmentioned recommendation 1 you say that

the accountancy profession should undertake an expensive lobbying effort to curb the crimes of their clients

Did you mean "expensive" - "extensive" or perhaps both ? :-)

One other thought. White collar crime seems to be so ubiquitous these days that its almost an alternative career path; if you get caught, its Club Fed; when you've done your time, it could well be back to your cosy little niche in the business pantheon. Maybe the powers that be should consider a more creative sentencing regime that separates these crooks from their place in society. I suppose that we won't get the chance to bring back the stocks or the pillory - but instead of 5 years in the (play) pen at taxpayer expense, how about twenty years at the neighbourhood car wash or sewage farm, accompanied by compulsory relocation to one of the "nicer" inner-city neighbourhoods (Watts, say, or Cook county)? As I said, just a thought ... :-)

Roger

March 5, 2004 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU] 

Roger's comments about light sentences for corporate fraud crimes reminded me of a session I attended last week on governance matters. One of the speakers was a retired federal judge. He showed a copy of the sentencing guidelines for various federal crimes and noted that those guidelines provide for potential prison terms for Sarbanes-Oxley type crimes that are longer than for murder. 

Denny Beresford

March 6, 2004 reply from Bob Jensen

Hi Denny,

If the odds are 99-1 that you won’t get caught and 10-1 that you can plea bargain down to no jail time, the expected value of a $1 million heist is pretty high.

After after seeing the light sentences (e.g., Fastow got the "huge" ten years and Waksal got eight years), the new Sarbanes guidelines are a welcome relief.  However, the National Association of Defense Lawyers, a very powerful lobbying group, is still in there fighting against tough sentences and for loopholes.  Spit will most likely freeze in the Mojave Desert the day that any non-violent CEO or CFO gets more than 10 years in Club Fed in spite of the sentencing guidelines.  The Association of Defense Lawyers wrote the following in a lobbying letter --- http://snipurl.com/DefenseLawyers 
Note that a $1 million theft may ultimately get you “41-51” months.

Given that the statutory maximum constraints on the offense levels have been substantially revised by the Congress via Sarbanes-Oxley, the current loss table, supplemented by carefully-tailored specific offense characteristic enhancements (including those in the proposed permanent amendments), will more than adequately punish those offenders who operate at the highest levels of economic crime. Many of the offenses potentially affected by a wholesale revision of the loss table involve criminal statutes and scenarios untouched by the Sarbanes-Oxley amendments. Most of the cases affected by the economic guidelines and loss table involve individual defendants who are low-to-mid-level employees who engage in some unremarkable fraud scheme or involve defendants who are not corporate employees at all. There is no suggestion in either the legislative history or the statutory directive that Sarbanes-Oxley was designed to increase sentences for garden-variety fraud or economic offenses, much less those offenses subject to the application of the loss table that do not involve corporate crime. Nor is there any basis or proof to suggest that the current guidelines are not acting as severe enough penalty for, or deterrent to, criminal conduct. A generalized request to “get tough” on crime, arising in the middle of any wave of media stories about corporate or other types of wrongdoing should not be the grounds for changing sentences or guidelines. Indeed, it is precisely in times of passion and emotion that statutes and rules, including those addressing penalties and sentences, should remain constant so that balances that have been carefully struck over time are not tipped for the excitement of the moment.

. . . 

The incremental increases in offense levels at the higher end of the consolidated theft and fraud table instituted via the ECP significantly exceed those of their previous separate tables. For example, a $1 million loss in year 2000, even with application of the more than minimal planning offense characteristic, would result in a 30-37 month sentencing range; in contrast, the same offender after the implementation of the ECP loss tables is subject to a 41-51 month range, an approximately 25% increase. Thus, the upward trend will accelerate over the next few years as the sentence increases built into the ECP begin to take effect.

There are times in life when the project at hand calls for the "bigger hammer" --- http://www.biggerhammer.net/

Bob Jensen’s threads on white collar crime are at http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

March 5, 2004 reply from Todd Boyle [tboyle@ROSEHILL.NET] 

1. Transaction semantics.

Until accountants agree on unambiguous semantics at the transaction level, there is little hope. Transactions happen between principal parties. Do you call them, parties, persons? or call them by their roles, buyer, seller? This is an example of a few hundred concepts that need accountants' participation and discussion.

Until we get on the same page with descriptive semantics, there is no hope of having an honest set of books, that agrees with the counterparty in exchanges, let alone, honest financial statements. See Bill McCarthy's stuff. http://www.msu.edu/user/mccarth4/ and efforts such as UBL, ebXML, as well as newer work of edifact, and x12.

2. Drilldown.

Stakeholders should be entitled to drill down into the numbers in financial statements of publicly listed corporations, period. We need a freedom of information act (FOIA) but meanwhile accountants might lend a hand, ensuring that what is in the financial statements is more objectively tied to the native transaction semantics that arise between the principals in the transactions, instead of our high-fallutin, abstract summary buckets.

3. Externalities.

A good case can be made that today's transaction records are essentially, incomplete. (I would not be so charitable! ) A seller of goods or services is rewarded for what they deliver, and rewarded for avoiding and minimizing their costs. Only those persons having some physical power or role to get paid, are paid. Costs to the commons are not paid. Costs to future generations or faraway people, are not paid, nor, the harms or costs inflicted on people who do not have recognized title, within our monolithic global title system, to be paid.

When I was in school in the 1970s there was a lot of discussion about social costs and externalities. I think this is an essential element in accounting reform, if financial statements are to be viewed as anything other than sophisticated lies, to protect the interests of the powerful and the privileged.

Accountants maintaining the GAAP framework need to admit the truth: economic substance includes more than the systems of title and commercial law in each jurisdiction.

Can't we contribute, with other professions, towards a conceptual framework for economic substance of commons, like the environment? That alone would be a priceless contribution. Today's decisions, based on incomplete quantitative models, are doing immeasurable harm.

Another candidate for increased work would be measurement of economic costs, of disenfranchised stakeholders in economic processes such as workers. There are other categories of unacknowledged and unrecorded economic advantage.

There is a worldwide anti-globalization movement. Their basic message is that corporations should not move operations wherever protections for labor and the environment are most underdeveloped. The delta between such things as environmental compliance costs, pension and health benefits in different jurisdictions is a rich source of quantitative bases for improved financial statements.

The other broad complaint of anti-globalization concerns income inequality. Here again, accountants are in a position to help, with transparency. Transparency invariably results in greater fairness and freer competition.

In summary let's take a step back from the transactions records, long enough to realize, they are so incomplete as to be essentially, a sophisticated lie. A self-serving fairy tale, accurate to the penny with the quantities agreed by arms-length haggling between the powerful, while excluding material interests of other stakeholders.

When the very numbers in your bank account are a lie, is it any wonder the financial statements of the global 500 corporations are a lie?

Todd Boyle ex-CPA 
Kirkland WA - 425-827-3107 
http://www.ledgerism.net/  , http://refusenik.org 

Bob Jensen’s threads on white collar crime are at http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays

 

Still Rotten to the Core

From the AccountingWEB.com, March 3, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=98815 

FleetBoston Financial Corp. has disclosed that its Fleet Specialist Unit will pay $59.4 million in a settlement with the Securities and Exchange Commission and the New York Stock Exchange. The settlement stems from an investigation of the NYSE’s five largest specialist firms, who were accused of failing to oversee traders who improperly traded ahead of their customers. In a preliminary agreement announced Feb. 17, the specialists agreed to pay a total of $240 million — $155 million in disgorgement of ill-gotten gains plus penalties of about $85 million.

Until FleetBoston Financial made its annual filing Tuesday with the SEC, it was not known how much Fleet Specialist Inc. would pay in restitution and penalties.

The Boston bank holding company said the settlement includes a censure, a cease-and-desist order, and an "undetermined form of undertaking," according to the Wall Street Journal. It also said the settlement wouldn't resolve regulatory charges against individuals.

The agreement involves no admission or denial of wrongdoing and is subject to approval by the SEC and NYSE.

Bob Jensen's threads on other rotten-to-the-core security analysts, investment bankers, mutual funds, and brokers are at http://www.trinity.edu/rjensen/FraudRotten.htm 

Freddie Mac Annual Stockholders' Meeting to Be Webcast 
(or a listen-in conference call via telephone) 

Freddie Mac held its 2004 annual stockholders' meeting on Wednesday, March 31, 2004. The annual meeting will convene at 9 a.m. E.T. at the Hilton McLean Tysons Corner, 7920 Jones Branch Drive, McLean, VA.

Note that this Webcast is like to be contentious and deals with risk that could bring down the entire U.S. economy.  For accounting students and faculty, it should be especially interesting from the standpoint of the importance of accounting rules in valuation and risk analysis of a corporation.

Recordings of the meeting were broadcast afterwards for those who could not listen in on the original Webcast --- http://www.freddiemac.com/news/archives/investors/2004/annualstockwebcast_032504.html 

McLean, VA – Freddie Mac (NYSE:FRE) will hold its next annual stockholders' meeting on March 31, 2004. The annual meeting will convene at 9 a.m. E.T. at the Hilton McLean Tysons Corner, 7920 Jones Branch Drive, McLean, VA.

The annual meeting can be heard in listen-only mode live via Freddie Mac's Investor Relations website 
( http://www.freddiemac.com/investors/webcasts ).The meeting also can be heard in listen-only mode via conference call. The dial-in numbers for the call are:

A recording of the annual meeting will be available continuously beginning at approximately 4 p.m. E.T. Wednesday, March 31 until midnight Wednesday, April 14. To access the recording, call (800) 475-6701 in the United States, or (320) 365-3844 from international locations. The access code for the recording is: 723715.

Freddie Mac is a stockholder-owned company established by Congress in 1970 to support homeownership and rental housing. Freddie Mac fulfills its mission by purchasing residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage-related securities and debt instruments in the capital markets. Over the years, Freddie Mac has opened doors for one in six homebuyers in America.

Freddie Mac's earnings releases and other financial disclosures are available on the Investors' page of the company's website at www.freddiemac.com.

 

Alan Greenspan claims that the financial risk of Freddie Mac could bring down the entire economy.  The Year 2002 financial statements of Freddie Mac were delayed by nearly one year due to errors in the Year 2000 and 2002 annual reports that resulted in revised reports that took almost a year to restate by PwC after being certified in error by Andersen.  The top executives of Freddie Mac were fired due to suspected book cooking in the accounting statements.

The errors largely center around failure to follow FAS 133 rules for accounting for derivative financial statements and hedging activities, with particular problems centered around inappropriate use of hedge accounting for macro hedges.  You can read more about the saga at http://www.trinity.edu/rjensen/caseans/000index.htm#FreddieMac 

The original and revised sets of financial statements can be downloaded and compared from links at http://www.freddiemac.com/investors/ 

"Greenspan Says Congress Should Limit Fannie, Freddie," by Dawn Kopecki and Josepth Rebello, The Wall Street Journal, February 24, 2004 --- http://online.wsj.com/article/0,,SB107763512493737729,00.html?mod=home_whats_news_us 

Mortgage giants Fannie Mae and Freddie Mac could pose a threat to the financial system, according to Federal Reserve Chairman Alan Greenspan.

Mr. Greenspan called on Congress Tuesday to impose stringent restrictions on the ability of Fannie Mae and Freddie Mac to issue debt and purchase assets, saying the growth of the institutions poses a risk to the safety of the U.S. financial system.

"The Federal Reserve is concerned about the growth and the scale of the [government-sponsored enterprises'] mortgage portfolios, which concentrate interest and prepayment risks at these two institutions," Mr. Greenspan said in written testimony to the Senate Banking Committee. Although he said he didn't think a crisis was imminent, "preventative actions are required sooner rather than later."

"GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and non-mortgages, that they hold," he added in the written testimony.

"Fannie Mae Scolded for Relying On Obsolete Accounting System," by John D. McKinnon and James R. Hagerty, The Wall Street Journal, February 26, 2004 --- http://online.wsj.com/article/0,,SB107774602918839236,00.html?mod=home_whats_news_us 

Federal financial regulators said that Fannie Mae relies on 70 outmoded manual accounting systems that could lead to more problems similar to October's $1.1 billion error.

In a letter to the company Tuesday, the Office of Federal Housing Enterprise Oversight said the mortgage giant's use of so many manual systems, as opposed to fully automated and integrated ones, raises concern. The agency told Fannie Mae officials to submit a remediation plan within 30 days.

The letter marks the latest rebuke by regulators against Fannie Mae and its mortgage-market sibling, Freddie Mac. Last year, Ofheo imposed a $125 million penalty on Freddie Mac after the federally sponsored company was forced to restate its accounting by almost $5 billion. Chief among Freddie Mac's sins was deliberate manipulation of its books by executives, but investigators also found sloppy accounting methods, including overreliance on manual systems.

Manual accounting systems typically refer to computer programs that are separate from the main accounting program, and allow for manual overrides. They are a concern to regulators because they create more room for human error, and thus require more review and controls, sapping resources from other accounting duties.

In July, soon after Freddie's problems came to light, Fannie Chairman Franklin Raines held a news conference to distance his company from the mess at Freddie Mac, where employees were sifting through years of old transactions while also reviewing and sometimes reversing longstanding accounting policies.

At the time, Mr. Raines said that unlike Freddie, Fannie had strong internal accounting controls. Last October, though, Fannie Mae had to correct a $1.1 billion accounting mistake that it briefly made in its financial reports. The error stemmed from a manual system that was being used to account for part of the company's derivatives business. Now the Ofheo letter suggests that the company has many more such manual systems. Fannie also faces a full-scale review by Ofheo of its accounting policies.

In response, a Fannie Mae spokesman, Chuck Greener, said the company is "a leader in the use of technology in financial services," and added that "virtually every financial institution in America" has similar manual systems, also known as end-user systems. Mr. Greener said the company is "very comfortable we will be able to respond to Ofheo's request fully."

In written testimony prepared for a Senate Banking Committee hearing Wednesday, Mr. Raines said: "We have effective controls in place to protect against mistakes, and we have effective protections in place in the rare chance that something dramatic does happen."

The committee is preparing legislation that would tighten regulation of Fannie, Freddie Mac and the Federal Home Loan Bank System.

A day earlier, Federal Reserve Chairman Alan Greenspan told the same committee that Fannie and Freddie pose "very serious" risks to the U.S. financial system because of the large amounts of mortgage loans they hold on their books, and the large amounts of federally subsidized debt they use to buy them up. Mr. Greenspan suggested explicit curbs on their debt. But Mr. Raines asserted that Fannie does a better job of hedging against risk than do banks. Both he and Richard F. Syron, Freddie's chairman and chief executive, urged Congress to avoid putting undue constraints on their growth.

Continued in the article

Bob Jensen's threads on accounting problems in the Freddie and Fannie family are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Message from FERF on February 24, 2004

Fraud Checklists

Another FEI member responsible for a Sarbanes-Oxley 404 engagement recently inquired about a "checklist that can be used at the process level to help identify the types of fraud concerns related to a specific process."

FERF researchers found the following references:

An Appendix to Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit (SAS 99), provides examples of fraud risk factors. The appendix is available at the AICPA website at: http://www.aicpa.org/antifraud/business_industry_govt/assessing_organization_vulnerability/identify_assess_risk/38.htm

The Association of Certified Fraud Examiners provides a fraud prevention checkup that can be used to assist in determining an "entity's vulnerability to fraud." http://www.cfenet.com/pdfs/FrdPrevCheckUp.pdf

In January 2003, the Institute of Internal Auditors conducted a survey on red flags used to detect fraud. Though the survey is closed, the text can be used as a checklist. http://www.gain2.org/redflags.htm

Somewhat related to the issue of fraud, Mutual Interest published an article about SAS 99 and fraud: http://www.auditnet.org/articles/SAS%2099%20Friend%20or%20Foe.PDF

FERF also wrote an article on fraud detection that will be published in the March/April 2004 issue of FE Magazine that will soon be available at http://www.fei.org/mag/.

Bob Jensen's main fraud links are at http://www.trinity.edu/rjensen/fraud.htm

SOX = Sarbox = Sarbanes-Oxley Act of 2002

"A World of Trouble:  Even with an extended deadline for Sarbox compliance, questions about offshoring have companies on edge," by Craig Schneider, CFO Magazine, Spring 2004 Special Edition, pp. 41-44 --- http://www.cfo.com/article/1,5309,12609||M|846,00.html 

Beware a false sense of security: Even though the SEC has pushed back the deadline for compliance with Section 404 of the Sarbanes-Oxley Act of 2002, a little-known and perhaps largely outdated auditing standard for outsourcers could hamstring companies that are rushing to send their business processes offshore.

The standard in question is Statement on Auditing Standards No. 70, "Reports on the Processing of Transactions by Service Organizations." Set up by the American Institute of Certified Public Accountants in 1993, SAS 70 spells out how an external auditor should assess the internal controls of an outsourcing service provider and issue an attestation report to outside parties or to a client.

Auditors and other critics of the standard say SAS 70 is in need of a major overhaul, especially considering the November deadline for Section 404 compliance facing many public companies (see "Just What Does Section 404 Entail?").

Finance would seem to have more at stake than other corporate functions in clarifying the situation, since transferring financial tasks overseas can put material transactions in the hands of outsourcers. That will give finance folks pause regardless of how many cost-cutting sermons they've sat through. Stan Lepeak, a vice president at research firm Meta Group Inc., believes that incompatibilities between SAS 70 and Sarbox will "dampen outsourcing, at least in the short run, until outsourcers can show that they have both the adequate controls in place [and] evidence to prove that."

Tom Eubanks, global leader for finance and accounting outsourcing with IBM Business Consulting Services, isn't so sure. "At first blush," he says, "one might think, 'Why would you outsource in a world where Sarbox is in place...and the magnifying glass is on the finance function?'" But Eubanks turns that around and says that "companies are looking at outsourcing as a valid way to address some [Sarbanes-Oxley] issues."

All in the Timing Under SAS 70, an outsourcing-service provider undergoes an annual audit, performed either by its own independent auditor or by the auditors of its outsourcing clients. There are two types of service-auditor reports. Type I includes the service auditor's opinion on the fairness of the presentation of the provider's description of its controls and how well they're designed to meet specified control objectives. Type II reports, generally preferred for their greater depth, include the same data as Type I as well as the auditor's opinion on the effectiveness of the controls during the period under review.

Even a Type II report, however, doesn't guarantee airtight compliance with Sarbox. For one thing, the timing of the audit–if it's performed by the service provider's auditor–might be out of sync with the client's reporting period. If the audit is performed in June and the client's fiscal year ends December 31, for instance, there's a six-month gap in the attestation of the outsourcer's internal controls. If the controls slip up during the second half of the year, the accuracy and reliability of the client's own year-end attestation could be compromised–and fair game for a Securities and Exchange Commission inquiry.

One response to the timing issue is to request that the service provider undergo SAS 70 audits on a quarterly basis or "fill in the gaps" with updates throughout the year. Smaller service providers might bridle at the added cost during contract negotiations–but after all, it's the client's attestation that's on the line.

Another concern centers on just how much of the service provider's audit will be revealed. A service provider is required to inform its clients only about any failures of SAS 70 tests; there's no requirement to spell out the exact substance or scope of the audit. Thus, for instance, a client's own external auditor would be unable to tell the client whether a test that unearthed two failures probed 40 processes, or only 4. That could lead to some poor assessments of service-provider controls. "We will be dealing completely in the dark as far as the population of that test," says Lynn Edelson, systems and process assurance leader for PricewaterhouseCoopers. "I think that was one of the biggest flaws in SAS 70 in light of Sarbanes-Oxley."

Continued in the article.

Bob Jensen's threads on proposed reforms in general are at http://www.trinity.edu/rjensen/FraudProposedReforms.htm 

March 3, 2004 message from Davidson, Dee (Dawn) [dgd@MARSHALL.USC.EDU]

This article was in RiskCenter today as a reprint from CIO magazine.  http://www.riskcenter.com/story.php?id=8214

RiskCenter is a free membership newsletter, but if anyone wants the full text, I can send it. 

March 3: Sarbox Risk - A Funny Thing Happened on the Way to Compliance

Location: New York
Author: Ben Worthen
Date: Wednesday, March 3, 2004

Congress responds to public outrage by passing legislation. Hence, the Sarbanes-Oxley Act, forged in the flames of the WorldCom, Tyco and Enron scandals. The act was intended to protect investors from executive fraud by requiring stricter standards for—and more oversight of—corporate accounting. As written, it's far-reaching—covering everything from who can sit on a board of directors to penalties for mistreating corporate whistle-blowers. And complying with it is potentially very expensive and time-consuming. When President George Bush signed the act into law in July 2002, corporate executives held their breath, waiting to see how the Securities and Exchange Commission would interpret it. (The law itself isn't as important as how the SEC chooses to apply and enforce it.) When the SEC proposed a strict interpretation three months later, they gulped. But when the SEC issued its final rule on the most important section of the law last June, they exhaled.

What You Thought (And What We Reported) No Longer Applies

A year ago, everyone was afraid of Sarbanes-Oxley. It looked as if companies were going to have to spend millions automating everything from ledger balancing to revenue accounting. Compliance promised to become a new cottage industry for software vendors. Now, it appears none of that need happen. Somewhere between the time the law left the president's desk in July 2002 and the SEC 's issuance of its final rule in June 2003, Sarbanes-Oxley, or Sarbox, or Sox, as it is variously and colloquially known, lost some of its teeth.

Of course, it can still bite. Companies will be forced to document their processes and change some of them. And compliance will still carry a price tag. But thanks to the final rule, CIOs will not have to confront the challenges and expenses of automation.

"You have to have adequate controls—not automated controls," says Joseph W. Hearington Jr., corporate director for internal auditing at Universal, a $2.6 billion tobacco company. "We have a combination of automated and manual, and that works for us. Our challenge isn't to reinvent the wheel, but to make sure we can prove that what we have works."

This is very different from what everyone thought—and from what the vendors and the technology press have been (and in some cases still are) saying and reporting. As recently as this past fall, articles continued to tell CIOs that technology is necessary to achieve Sarbanes-Oxley compliance and that their IT departments were directly in the line of federal fire. Even CIO ran an article last May warning companies that they were underestimating the role that their IT systems would play in Sarbanes-Oxley compliance.

The section of the Sarbanes-Oxley Act responsible for this furor is 404, which requires that both CEOs and CFOs test and attest to the effectiveness of their companies' internal controls. While the October 2002 SEC proposed rule did not elaborate on how effective "effective" needed to be, it made it perfectly clear how seriously it took Section 404 by interpreting internal controls in the broadest way possible. The proposal targeted "the company's entire system of internal controls, rather than just its internal accounting controls."

Most experts applied the same thoroughness to the rest of the section, including that tricky word effective. The only way to guarantee that a control is 100 percent effective, said the prevailing wisdom, was to remove the possibility of human error. A conservative reading of the SEC 's proposal, says Irwin Kishner, chairman of the corporate law department at Herrick, Feinstein, a firm whose clients include Bridgestone/Firestone and Hollinger International, would have outlawed the manual processes that bridged the gaps between automated systems—for example, reconciling financial data from multiple systems in a spreadsheet. Automating each of these processes would have cost companies millions and kept CIOs busy for years.

The reaction from affected companies (which was just about every company) was understandably negative, and what followed was a serious outbreak of politics.

How Sarbanes-Oxley Was Defanged

The first shot came from the White House. Just days before the SEC 's Section 404 proposal was released in October 2002, administration officials leaked word that President Bush wanted to cut the SEC 's budget more than $200 million, from the $776 million authorized in the Sarbanes-Oxley Act to $568 million. "You see a lot of rhetoric about trying to clean something up," says Larry Noble, executive director of the Center for Responsive Politics, a nonpartisan political watchdog group. "But when the rubber hits the road, they don't want to see any changes." According to the Center, seven of the the top 10 contributors to President Bush's current reelection campaign are financial services companies, precisely the constituency that would be most immediately and negatively affected by rigorous enforcement. "Their first choice is to derail a bill," Noble says. "But when an industry realizes that isn't going to happen, they try to water down the regulation."

Meanwhile, the SEC , as is its practice whenever it proposes a new rule, was soliciting feedback from companies and concerned individuals, and the responses to Section 404 resembled hate mail. In a representative comment, Eli Lilly's chief auditor said that the proposed rule would substantially increase costs while doing nothing to improve shareholder value. At a conference last May, John Gibson, president and CEO of Halliburton Energy Services—a major subsidiary of Halliburton, an enterprise with close and widely publicized ties to the administration (Vice President Dick Cheney was Halliburton's former chairman and CEO)—called Sarbanes-Oxley "the most ridiculous thing I've seen."

The SEC got the message, making what one official called "significant changes" in its final rule. Most notably, the final rule does away with the aforementioned broad interpretation of internal controls and replaces it with "internal controls over financial reporting." While this change may seem minor, Kishner says that its impact is major. "Financial controls are just a subset of internal controls," he says. "It is a less aggressive interpretation [of the law]."

With this less aggressive interpretation, the punctilious reading that would have rendered manual processes illegal no longer applied. Both the proposed and the final versions of the SEC rule require companies to identify weak points in their internal control processes and take steps to mitigate the risks those weaknesses create. But rather than making it necessary for companies to fix control weaknesses through automation, the new rule neither requires nor regulates how companies do it, says Deborah Birnbach, who specializes in technology-related litigation at Testa, Hurwitz & Thibeault. The lawyers, analysts, auditors and corporate executives consulted for this article all agree that complying with the rule requiring that internal financial controls be effective can entail nothing more than having someone run around double-checking manual work. "You don't have to spend millions of dollars to make things foolproof," says Birnbach.

That means it's left up to the enterprise to decide whether it wants to make a significant investment in technology that will automate its manual processes (which are still found in most every company) or make a smaller investment in additional people to run around and do the double-checking. And because no one is sure how the SEC will enforce the current rule or whether future changes will make the Sarbanes-Oxley Act tighter or looser, many companies are choosing the latter route. If they're wrong, there still will be time to buy and implement automation technology. If they're right, a small cost in human resources now will allow them to make IT investments on their own time line, not the government's.

 (more in article)

dee davidson
Leventhal School of Accounting
Marshall School of Business
University of Southern California
213.740.5018
dgd@marshall.usc.edu

"How the U.S. Accounting Profession Got Where It Is Today:  Part II," by Stephen A. Zeff, Accounting Horizons, Volume 17, No. 4, December 2003, Page 280.

Conclusion

    A series of defining events and decisions have brought the accounting profession to where it is today:

    At the same time as audit partners were given these perverse incentives by their firm's top management, their clients were becoming ever more driven by their own set of perverse incentives: bonuses based on earnings, and stock options with values linked to the price of the company's stock (and therefore, it was believed, to earnings).  To maximize their mounting compensation, CEOs began to take every advantage of the subjective judgments implicit in accounting choices, thus placing immense pressure on audit engagement partners--themselves under pressure to keep clients content--to accede to accounting practices arguably beyond the realm of acceptability.

    The magnitude and range of consulting services rendered by the big firms in recent times has played an important part in this drama.  The dramatic growth in these services has fueled the increasingly widespread perception of auditors' lack of independence from their clients.  In my view, however, the root cause of the questionable decisions attributable to audit firms in recent years has been the purely financial incentives given to audit partners by their firms, exacerbated by other aspects of the firms' reward system, such as promotions and other such intangible benefits conferred on a partner for maintaining good relations with clients.  That reward system for audit partners can be changed only by the leadership in their firms.

"Conservatism in Accounting Part II:  Evidence and Research Opportunities," by Ross L. Watts, Accounting Horizons, Volume 17, No. 4, December 2003, Page Page 287.

SYNOPSIS: This paper is Part II in a two-part series on conservatism in accounting.  Part I examined alternative explanations for conservatism in accounting and their implications for accounting regulators (SEC and FASB).  Part II summarizes the empirical evidence on the existence of conservatism, conservatism's increase over time, and conservatism's alternative explanations.  It also discusses opportunities for future research on conservatism.

   The empirical literature uses a variety of conservatism measures in time-series and cross-sectional tests of contracting, shareholder litigation, taxation, and accounting regulation explanations for conservatism.  The tests' results suggest the importance of all four explanations.  Two non-conservatism explanations--earnings management and the abandonment option--cannot individually or jointly explain the observed systematic understatement of net assets that is the hallmark of conservatism.

   Researchers should note that accounting's effects on managerial behavior play a central role in the evolution of both accounting and financial reporting.  Assessing the relevance of an accounting method to financial statement users' decisions requires assessing managers' abilities to use that method to manipulate accounting numbers and commit fraud.  The evidence on conservatism suggests asymmetric verifiability is critical to constraining manipulation and fraud.

"The Impact and Valuation of Off-Balance-Sheet Activities Concealed by Equity Method Accounting," by Mark P. Bauman, Accounting Horizons, Volume 17, No. 4, December 2003, Page 303.

SYNOPSIS: This paper reports the results of a study of the financial reporting effects of off-balance-sheet activities concealed by the equity method of accounting.  The study examines footnote disclosures relating to equity method investees, offers suggestions for improving the usefulness of those disclosures, and estimates the valuation effects of information in the disclosures.  An important empirical finding is that the market places significant negative values on investor-guaranteed off-balance-sheet obligations.

Most Companies Get an "F" in Fraud Prevention http://www.accountingweb.com/item/98709 

Enron had a code of conduct. Enron had a hotline. And in the end, Enron had fraud. Today, companies operate with a false sense of security because they either don't have a fraud prevention program or the program they have is a legal, yet ineffective "fig leaf." "One key to fraud prevention is to create an atmosphere where employees feel confident in reporting wrongdoing without being victimized, even if executives appear to be involved," explains Toby Bishop, president & CEO of the Association of Certified Fraud Examiners (ACFE), the largest anti-fraud association in the world. "If companies don't have effective fraud prevention programs, they are at risk of failure," says Bishop.

Years ago, working as a consultant, Bishop tested the effectiveness of an existing fraud prevention program for a major utility company. Management thought their program was working and wanted confirmation. Bishop's firm surveyed a statistical sample of employees to assess their feelings about management's commitment only to discover that employees in one division did not believe management wanted to "do the right thing," says Bishop.

"If employees perceive their company's fraud controls to be weak or if they think management is only giving lip service to ethical behavior, fraud is inevitable," Bishop warns.

In 2002 fraud prevention was one of the goals addressed in the Sarbanes-Oxley Act (SOX), legislation that affects how public organizations and accounting firms deal with corporate governance, financial reporting and public accounting. The effect of SOX has been far reaching, leading to voluntary changes in private companies and mandatory changes in public companies. But is it preventing fraud? "It may not be as effective as people expected," Bishop answers.

Over the past 18 months Bishop has taught several thousand participants how to use the ACFE's Fraud Prevention Check-Up, a tool that identifies major gaps in organizations' fraud prevention processes. None of the participants thought their organization would pass the test, which means they are at significant risk of fraud.

Bishop says while Sarbanes-Oxley invokes a basic framework for internal controls, including anti-fraud controls, additional specifics are needed to address controls to prevent fraud. "There is a definite gap in the standards used to establish fraud prevention controls, if companies use them at all."

Bob Jensen's threads on whistle blowing are at http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing 

Hackers Hall of Fame --- http://tlc.discovery.com/convergence/hackers/bio/bio.html 

See complete coverage of corporate-scandal trials, including an interactive graphic tracking who's in prison, who's on trial and who's under investigation --- http://online.wsj.com/page/0,,2_1040,00.html 

The open-access method of distributing scientific journals, says John E. Cox, a publishing-industry consultant, "is the most articulate and serious threat to the conventional publishing market that we've seen."
Lila Gutterman, "The Promise and Peril of 'Open Access,'" The Chronicle of Higher Education, January 30, 2004, Page A10.

Members of the Academy Unite:  Create Change Right Now

The biggest academic rip-off of all time is coming to your academic society, if it's not already there, and it will affect your ability to transfer knowledge to your students.  I want to thank Diane Graves from the Trinity University Library and other presenters on February 6 who opened my eyes wider to the magnitude of this pending disaster.  Decades ago the large journal publishers did the world a favor by disseminating highly specialized research that did not have a large subscription market.  But times have changed in this networked age where the need for hard copy printing of specialized journals is no longer needed.

Giant commercial publishers (especially in Europe) of academic journals have been buying up small journal publishing firms to where the only thing left for them to buy up is the publishing of journals in your academic society.  I will refer to these buy-out  publishers as the Greedy Monopolists.  

For example, my main academic society is the American Accounting Association (AAA).  The AAA publishes a variety of research, professional, and educational journals that I find very informative to me and my students.  They are reasonably priced in hard copy and in electronic versions --- http://accounting.rutgers.edu/raw/aaa/pubs.htm 

What is really great for education is that the AAA will allow instructors to provide free copies or selected articles to each student in a course.  This is common in other academic societies and is extremely important.  The Greedy Monopolists will put an end to this!

What the Greedy Monopolists are doing in their latest strategy to rip off academe is to approach an academic society like the AAA and negotiate a takeover of the society's publishing and copyrights of its various journals.  They are offering enormous purchase prices that appear to be manna from heaven to societies that struggle to break even on publishing costs.  But there is a hitch.  As soon as the Greedy Monopolists take over, the prices of the subscriptions soar upwards of four, five, or more times present subscription rates.  And you can forget that clause that says you can distribute multiple copies of articles for free to your students.

Librarians of colleges and universities have seen this rip-off by Greedy Monopolists coming for years and have had to deal with the soaring subscription rates for academic journals.  The are fighting back on a number in a number of ways:

 

One of the key main new approaches is called Create Change Right Now --- http://www.createchange.org/home.html 

Scholarly communication exists for the benefit of the world’s research and teaching community. Authors want to share new findings with all their colleagues, while researchers, students, and other readers want access to all of the relevant literature.

However, the traditional system of scholarly communication is not working. Libraries and their institutions worldwide can no longer keep up with the increasing volume and cost of scholarly resources. Authors communicate with only those of their peers lucky enough to be at an institution that can afford to purchase or license access to their work. Readers only have access to a fraction of the relevant literature, potentially missing vital papers in their fields.

Involvement by the academic community is critical in ensuring that efforts to reclaim scholarly communication for scholars and researchers succeed. Together we can develop a new system that meets your needs and those of future scholars and students. It's time to create change!

Please download the revised Create Change brochure at http://www.createchange.org/resources/brochure.html 

Faculty should read the following from http://www.createchange.org/faculty/intro/aboutcc.html 

CREATE CHANGE is a response to the serious crisis in scholarly communication. A number of factors, chiefly the dramatic increases in journal costs and the increasing commercialization of scholarly publishing, have decreased scholars' access to essential research resources all over the world.

CREATE CHANGE seeks to address the crisis in scholarly communication by helping scholars regain control of the scholarly communication system-- a system that should exist chiefly for them, their students, and their colleagues in the worldwide scholarly community, not primarily for the benefit of publishing businesses and their shareholders.

CREATE CHANGE has as its core goal to make scholarly research as accessible as possible to scholars all over the world, to their students, and to others who might derive value from it. We believe this goal can be achieved by the following strategies:

CREATE CHANGE promotes information exchange, discussion, and action. Specifically, the program aims to accomplish the following:

CREATE CHANGE is sponsored by the Association of Research Libraries, the Association of College and Research Libraries (a division of the American Library Association), and SPARC (the Scholarly Publishing and Academic Resources Coalition). Funding for this project has been provided by the three organizations and the Gladys Krieble Delmas Foundation.

 

The most important things faculty from around the world can do are the following:

Forwarded by Amy Dunbar on February 9, 2004

From 2/09/2004 Chronicle of Higher Education.

Editorial Board of Scientific Journal Quits, Accusing Elsevier of Price-Gouging

The Board of Directors of a scholarly journal popular with computer scientists and mathematicians has resigned en masse, accusing its distributor, Elsevier, of making the publication too expensive for many college libraries to afford.

In a statement issued to readers, members of the board of the Journal of Algorithms announced that they would now devote their attention to a new journal, to be called Transactions on Algorithms. The new journal will be published by the Association for Computer Machinery, which distributes a number of similar periodicals.

There is no timetable for the debut of the new publication, but the departing directors said they hope to make it available at a much lower price than what Elsevier charged for the Journal of Algorithms. In 2003, a yearlong subscription to the monthly journal cost $700 -- an increase of more than $100 since Elsevier started publishing it, in 2001.

In an October letter to the directors, who functioned as the editorial board, Donald E. Knuth, an editor of the journal and emeritus professor of computer science at Stanford University, argued that the publication could reach a broad base of academic libraries only if it switched to a cheaper commercial publisher or a nonprofit one.

Zvi Galil, another editor of the journal and dean of the school of engineering and applied science at Columbia University, said that Elsevier had increased the subscription rates unnecessarily, because production costs for the journal had not risen recently. "Basically, we do all the work," Mr. Galil said, "and the company makes all the profit."

In a statement of its own, Elsevier attributed the board's resignation to "an unresolved dispute concerning the commercial aspects of scientific publishing." Company representatives declined to comment further.

Continued in the article.

FTC: Nearly one in eight U.S. adults fell victim to identity theft in the last five year.
Report says thieves cost $53 billion last year --- http://www.cnn.com/2003/TECH/ptech/09/04/id.crime/index.html 

Bob Jensen's threads on identity theft are at http://www.trinity.edu/rjensen/FraudReporting.htm#IdentityTheft 

New Fraud Links

From "Smart Stops on the Web," Journal of Accountancy, January 2004, Page 31 --- http://www.aicpa.org/pubs/jofa/feb2004/news_web.htm 

 
FRAUD SITES

Online Education for Managers
www.bettermanagement.com
CPAs and business managers can brush up on the basics of fraud as well as learn detection and prevention strategies from articles and case studies at this Web site. Titles include “Business Intelligence in the Financial Services Industry.” Fraud investigators can explore the library section to read related content on money laundering, regulatory compliance and risk management and also “solve business problems” with anti-money-laundering and financial services solutions.

Fraud or Frivolity?
www.stockfraudlawyersnetwork.com
CPAs acting as financial consultants will want to visit this e-stop to find out about broker misconduct and what distinguishes a securities fraud case from a frivolous claim. Users also can locate a securities fraud lawyer in their area and get a free consultation.

Fraud Is…
alextalksbusiness.com
Alex Kwechansky, public speaker and author of the book Never Underestimate Who Can Cheat You, gives users a better understanding of fraud in publicly and privately owned companies and how to spot and, hopefully, thwart it at this Web site. The section Dirty Deeds defines different fraud concepts including embezzlement, insider trading and skimming, while the section Here’s the Point outlines some of fraud’s early warning signs.

Insure Against Fraud
www.insurancefraud.org
CPAs looking to advise clients on insurance fraud will find legislative news, the Fraud Case of the Month and the Fraud Hall of Shame at this Web site, first listed as a Smart Stop in April 2002 in response to fraudulent 9/11 claims. Visitors to the Coalition Against Insurance Fraud’s Web stop also can receive a free sample of Insurance Fraud Weekly ePort.

Worth Revisiting
www.ifccfbi.gov
The Internet Fraud Complaint Center (IFCC) Web site, another Smart Stop worthy of more than one mention and first listed in the November 2001 JofA, now offers users IFCC Warnings, which address credit card and identity theft, employment scams and Internet auction fraud. The section Internet Fraud Preventive Measures offers tips on recognizing and preventing online fraud.

Bob Jensen's threads and links are at http://www.trinity.edu/rjensen/FraudReporting.htm 

The bill says: "Three practices — soft dollar arrangements, revenue sharing, and directed brokerage — ought not clutter any mutual fund prospectus.

"Tough Senate Bill Would End Three Mutual Fund Practices," AccountingWeb, February 11, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=98699 

Three U.S. senators on Monday unveiled the Mutual Fund Reform Act of 2004 (MFRA), which would ban three questionable, but legal, practices that bill sponsors say hurt investors and create conflicts of interest. The bill, sponsored by Sens. Peter Fitzgerald, R-Ill., Carl Levin, D-Mich., and Susan Collins, R-Maine, is considered the toughest to date on the $7.4 trillion mutual fund industry, United Press International reported.

The bill says: "Three practices — soft dollar arrangements, revenue sharing, and directed brokerage — ought not clutter any mutual fund prospectus. And neither funds nor fund advisers should be spending time and money crafting elaborate disclosures and justifications of ultimately indefensible practices. By simply prohibiting these practices, MFRA vastly simplifies the disclosure regime, and benefits all stakeholders."

The MFRA is one of four bills that have been introduced in the Senate in the past few months. The House passed its own mutual fund bill in November.

The bill also calls for a method of identifying anonymous investors who use intermediaries to conduct transactions in omnibus accounts. The bill says that funds need to be able to trace individual investors who violate fund trading rules.

Market timing and late trading practices have also been under fire in the mutual fund industry scandal, and the MFRA seeks a no-excuses 4 p.m. trading deadline. More than 20 mutual fund companies are under investigation for allegedly allowing improper trading.

The bill also targets what is known as the 12b-1 law, which allows brokers to charge investors annually for advertising and marketing costs. Over time these "distribution fees," have morphed into "disguised loads," the bill states.

"What happens when fund advisers use their own profits — instead of tapping directly into investors' money — for distribution expenses? Distribution expenses become very reasonable," the bill says.

Other proposed changes include: requiring funds to disclose all costs in an understandable way, making it easier to replace fund directors, protecting whistleblowers, mandating that the SEC approve any new costs the industry wants to impose, and starting several studies on other preventative measures.

On Monday, the day the bill was introduced, Franklin Resources, the biggest publicly traded U.S. mutual fund manager, said the SEC plans to pursue charges against the company and two executives over trading practices.

The trial of three former Adelphia executives may showcase lavish lifestyles and spending sprees, but the complex accounting issues will likely overshadow personal intrigue.  The auditing firm in the hot seat is Deloitte and Touche.  For logs of other Deloitte and Touche scandals, to to http://www.trinity.edu/rjensen/fraud.htm#Deloitte 

"Adelphia Trial Is Scheduled To Start Monday," by Christine Nuzum, The Wall Street Journal, February 20, 2004 --- 

The trial of former Adelphia Communications Corp. executives John Rigas and his two sons is about to begin. While it may showcase lavish lifestyles and spending sprees, the complex accounting issues will likely overshadow personal intrigue.

The government has accused the Rigases, along with former Adelphia executive Michael Mulcahey, of looting hundreds of millions of dollars from the cable company, defrauding investors and misleading regulators. All four have pleaded not guilty.

Jury selection for the trial of the Adelphia executives is scheduled to begin Monday. Adelphia was formerly based in Coudersport, Pa., but now is based in the Denver suburb of Greenwood Village under new management; the firm may even change its name.

At the trial, which is expected to last three months, the government may depict Manhattan apartments, a golf course and private jets as perks that Adelphia bankrolled. However, those details will likely take second stage to how debt is documented on company balance sheets and on accounting practices unique to the cable industry.

Central to the case: a loan to the Rigas family that was guaranteed by Adelphia, and allegations that the company inflated its subscriber base and the portion of its cable network that had been upgraded.

In arguing a pretrial motion Thursday morning, Assistant U.S. Attorney Christopher Clark said he intends to present jurors with copious documents. Attorneys also said to expect electronic displays.

Continued in the article

North Carolina is investigating whether accounting firm Deloitte & Touche gave companies advice designed to help them avoid paying unemployment taxes. The North Carolina Employment Security Commission issued subpoenas on Thursday (March 25, 2004) requesting Deloitte to produce records, correspondence, sales brochures and other items pertaining to the firm's unemployment insurance tax planning practices. http://www.accountingweb.com/item/98916 


They Just Don't Get It

Chartered Jets, a Wedding At Versailles and Fast Cars To Help Forget Bad Times.
As financial companies start to pay out big bonuses for 2003, lavish spending by Wall Streeters is showing signs of a comeback. Chartered jets and hot wheels head a list of indulgences sparked by the recent bull market.
Gregory Zuckerman and Cassell Bryan-Low, "With the Market Up, Wall Street High Life Bounces Back, Too," The Wall Street Journal, February 4, 2004 --- http://online.wsj.com/article/0,,SB107584886617919763,00.html?mod=home%5Fpage%5Fone%5Fus 

"Salary Is the Least of It," Fortune, April 28, 2003, Page 59

While shocking in one sense, these developments are not wholly surprising.  For several decades now, CEO pay has been governed by the Law of Unintended Compensation, which holds that any attempt to reduce compensation has the perverse result of increasing it.

You get the idea.  Regulation is a spur to innovation, and in the pay arena innovation always means "more."  As executive-pay critic Graef Crystal once put it, "The more troughs a pig feeds from, the fatter it gets."

"How Hazards for Investors Get Tolerated Year After Year." by Susan Pulliam, Susanne Craig, and Randal Smith, The Wall Street Journal, February 6, 2004 --- http://online.wsj.com/article/0,,SB107602114582722242,00.html?mod=home%5Fpage%5Fone%5Fus

Corporate Board Minutes Are Altered; Judgments In Arbitration Go Unpaid

Tainted Wall Street research. IPO chicanery. Mutual-fund trading abuses. Corrupt corporate accounting.

Investors have been hit with a wide array of scandals over the past two years, tarnishing the reputations of some of the nation's largest corporations and financial institutions. The facts have varied, but the scandals share a common thread: bad behavior that had been tolerated for years, often with regulators and industry insiders looking the other way.

Savvy investors long knew that some research analysts were overly bullish in recommending shares of their firm's banking clients. But regulators ignored complaints until Eliot Spitzer, the New York attorney general, launched a probe leading to a $1.4 billion settlement with 10 top securities firms last year. Ditto for Wall Street firms that doled out hot initial public offerings of stock to corporate executives to get their companies' financing business -- and in the process, shut out the little guy.

It also was no big secret that corporate boards rubber-stamped management decisions, stomping shareholders in the process. Abuses were left unchecked until a rash of accounting scandals led to sweeping reforms in 2002 that redefined the duties of directors.

There are many more such "open secrets": practices that raise eyebrows but persist on Wall Street and in corporate boardrooms. Here are three open secrets -- regarding corporate-board minutes, payment of arbitration awards and pricing of municipal bonds -- that exemplify the hazards to investors.

Altered Minutes

One reason it has been so difficult to determine what top management and directors knew about -- and did to cause -- the business disasters of the late 1990s is the distortion of corporate-board minutes. All too often, these critical records are altered or left incomplete. When fraud comes to light, investigators struggle to assign blame, making it harder for investors to recoup losses and less likely that misbehavior will be deterred in the future.

"The attitude is that it's OK to lie by omission in board minutes," says Charles Niemeier, a member of the Public Company Accounting Oversight Board. "It's the way it gets done, and the problem is that we have become accepting of this." The oversight board was set up under the Sarbanes-Oxley Act, legislation Congress passed in 2002 to improve corporate accountability. While the act addressed financial statements and public filings, lawmakers didn't look closely at problems concerning internal corporate documents.

Name a corporate blowup, and there is usually an example of board minutes being altered or left incomplete. At Enron Corp., investigators traced the board's knowledge of one dubious off-balance-sheet vehicle only through handwritten notes taken by the corporate secretary during a board meeting in May 2000. The information from the scribbled notes suggested that at least some Enron directors knew the arrangement was an accounting maneuver, rather than something aimed at substantive economic activity. But the formal board minutes from that meeting contained no reference to the directors' knowledge on this point.

There aren't hard rules on how thorough board minutes should be. As a result, some corporate lawyers routinely use bare-bones minutes as a shield to protect companies from liability.

"There is a huge gulf between the two schools of thought on board minutes," says Rodgin Cohen, a partner at the New York law firm of Sullivan & Cromwell. "One is that they should be a full recording. The other is that they should be limited. Most lawyers would suggest that they should be quite limited," he says. "It's like anything: The more words you put down, the greater exposure you have." Mr. Cohen says that he advocates more extensive minutes.

Amy Goodman, a lawyer at Gibson, Dunn & Crutcher who specializes in corporate-governance issues, says that after the recent wave of scandals, many corporate attorneys and their clients are re-evaluating whether they need to include more detail in minutes "to be able to show that directors have acted with due care and in good faith."

In the WorldCom Inc. fiasco, a court-appointed bankruptcy examiner has found that the company created "fictionalized" board minutes in connection with its announcement in November 2000 of plans to create a so-called tracking stock that would correspond to the performance of its consumer business. The long-distance telephone company, now known as MCI, said at the time that the board had approved this move.

In fact, the board hadn't given its approval, the bankruptcy examiner, Richard Thornburgh, a former U.S. attorney general, concluded. The board had held only a "minimal" discussion of the idea during a brief "informational" meeting on Oct. 31, 2000, Mr. Thornburgh's report said. WorldCom management decided to transform records from the October meeting into minutes of a formal board meeting, complete with references to a discussion about the tracking stock that hadn't really taken place, the report found.

One WorldCom lawyer said during the examiner's investigation that transforming the Oct. 31 meeting into a "real meeting was 'wrong' and made the transaction 'look nefarious' when that was not the case," the report said. The examiner faulted former senior WorldCom executives for the decision, although board members and WorldCom lawyers also bear responsibility, the report said.

The practice highlighted the lack of oversight by WorldCom's board, which contributed to the company's downfall and made it into a "poster child" for poor corporate governance, Mr. Thornburgh has said.

Bradford Burns, an MCI spokesman, says the company has instituted reforms "to ensure what happened in the past will never happen again."

Unpaid Judgments

On those occasions when investors catch their brokers cheating and win an arbitration award -- no small feat -- the customer still sometimes ends up losing.

IN PLAIN SIGHT

Here are three 'open secrets' known to regulators and financial-industry insiders but still harmful to investors

• Corporate-board minutes are often manipulated, with important facts changed or left out. That makes it difficult, once fraud is discovered, to determine what directors and top managers knew and what they did.

• Arbitration awards to investors who have been cheated often go unpaid, as, for example, when suspect brokerage firms simply shut down. Wall Street has opposed certain changes that would ease the problem, such as requiring brokerage firms to have increased capital and more liability insurance.

• Municipal bonds are difficult for individual investors to price because of a lack of information, often resulting in their paying too much. There have been improvements lately, but bond dealers are opposing certain additional reforms that would give investors real-time bond data.

 

Fabien Basabe says that in the late 1990s, his brokerage firm recklessly traded away nearly $500,000 of his money. The 65-year-old Miami restaurateur filed an arbitration claim with the National Association of Securities Dealers, as many investors do when they clash with their brokers. In 2002, after a two-year fight, a state court in Florida confirmed an NASD arbitration-panel award ordering J.W. Barclay & Co. to pay Mr. Basabe more than $550,000, plus $150,000 in punitive damages.

The problem was that the small New Jersey securities firm had closed its doors in early 2001, after it lost the initial round of arbitration. Mr. Basabe has yet to see any money. "I went through all of it for nothing," he says.

In the first quarter of 2003, the NASD imposed $99 million in damage awards against brokerage firms and brokers nationwide. What the NASD doesn't trumpet is that investors haven't been able to collect $30 million -- or almost one-third -- of that amount during that period, the most recent for which numbers are available. For 2001, the most recent full year for which figures are available, 55% of the $100 million in arbitration awards went uncollected.

The NASD can suspend the license of a broker or securities firm that refuses to pay up. But many firms and brokers just walk away rather than pay. Because of his disaster with Barclay & Co. (no relation to the big British bank Barclays PLC), Mr. Basabe says he lost his Italian restaurant, I Paparazzi, in the Breakwater Hotel in South Beach.

In 1987, the Supreme Court ruled that securities firms may require customers to waive their right to sue in court as a condition of opening a brokerage account. Since then, arbitration generally has become the sole forum for customers to seek redress from Wall Street firms. And Wall Street has resisted some steps that could protect investors when firms fail to pay.

In 2000, the General Accounting Office, the investigative arm of Congress, issued a report calling for improvements in arbitration-award payouts. The NASD has responded by installing a system that tracks unpaid awards and requiring firms to certify they have paid, among other steps.

But securities firms have successfully lobbied against two other potentially effective reforms. One would increase capital requirements, so that firms would have cash on hand to pay awards. The other would require firms to carry more liability insurance to cover awards. The Securities and Exchange Commission, which oversees the NASD and has jurisdiction on these issues, has reinforced this resistance in its own comments to the GAO.

In reports released in 2000 and last year, the GAO recounted arguments made by the SEC that increasing capital requirements could force many brokerage firms out of business and potentially penalize responsible firms. The SEC also has argued that stiffer insurance requirements could raise investor costs. Securities-industry executives have told the GAO that carrying more insurance to cover arbitration awards "could raise costs on broker-dealers industrywide and ultimately on investors."

An SEC spokesman says the agency "continues to explore ideas about how to improve investor recovery of losses from firms that go out of business."

Investors' inability to collect arbitration awards has broader ripple effects: "A lot of lawyers won't even touch these cases because they know they have no hope of collecting money," says Mark Raymond, Mr. Basabe's attorney.

The NASD arbitration panel found that the Barclays broker who handled Mr. Basabe's account, Anton Brill, engaged in "intentional misconduct" when he made unauthorized trades. Mr. Brill now works at another securities firm in Florida. He has yet to pay the $6,000 in punitive damages levied against him, or any of the remainder of the arbitration award, for which he is jointly liable.

In an interview, Mr. Brill said the case took place "a long time ago," adding that the matter is "still under negotiation." He declined to elaborate. After receiving questions about the case from The Wall Street Journal, an NASD spokeswoman said that the association had begun proceedings to suspend Mr. Brill's license.

Murky Municipals

In October 2002, John Macko bought $15,000 of municipal bonds issued by a trust organized by the government of Puerto Rico. The 57-year-old lawyer in Geneseo, N.Y., discovered after the fact that he had paid $25 to $44 more per $1,000 bond than brokers paid for the same type of bond during the same trading day. This information wasn't available to him at the time he made his purchases. The muni-bond market, Mr. Macko says, "is very opaque."

State and local governments issue municipal bonds to raise money for public projects. The bonds typically are exempt from federal taxes, and most are seen as relatively safe investments. Munis trade on an open market, but there isn't a place small investors such as Mr. Macko can go to figure out whether they are getting a fair price. (In contrast, stock prices are reported minute-to-minute by exchanges, and mutual-fund prices are set once a day. Treasury bonds and many corporate bonds are priced throughout the day with a short delay.)

Bond dealers, with their superior knowledge of the market, can make a legitimate profit on the difference between what they buy bonds for and their sales prices. But dealers have gone a step further: opposing full online dissemination of real-time muni-bond prices that would help small investors. The dealers say that because many munis trade infrequently, it's difficult to determine precise prices. Immediate disclosure of some prices, they add, might increase volatility in the market and cause some dealers to stop trading certain bonds.

Without fresh data on bond trading, individuals can fall prey to brokers who tack on excessive "markups." An example: Last May, the NASD alleged that Lee F. Murphy, a former broker at Morgan Keegan & Co., charged too much in 35 bond sales, including deals in 2001 for bonds sold by St. James Parish, La., to raise money for solid-waste disposal. Mr. Murphy obtained markups from investors ranging from 4.07% to 7.18%. There aren't specific limits on markups, but the industry rule of thumb is that margins should be well below 5%, unless there are exceptional circumstances, such as the strong possibility that a municipality will default.

In the case involving the Morgan Keegan broker, the bonds "were readily available in the marketplace, and Murphy offered no special services justifying an increased markup," the NASD alleged. Mr. Murphy, who settled the administrative charges without admitting or denying wrongdoing, was suspended for 15 days and fined $6,000.

Thomas Snyder, a managing director at Morgan Keegan, says the trades were part of a unique situation in which Mr. Murphy didn't have full information about a volatile, unrated bond. Morgan Keegan officials add that the firm hadn't been sanctioned and that it canceled the trades in question and reimbursed investors. Mr. Murphy wasn't available at the New Orleans office of his current employer, Sterne, Agee & Leach Inc.

Investors in theory can shop around, as they would for a car. But as a practical matter, most individuals buy municipal bonds through their regular broker and don't do much comparing. Securities laws hold brokers to a higher standard of protecting customers' interests than is applied to merchants such as car dealers.

Individual investors -- who directly own an estimated $670 billion of the $1.9 trillion in outstanding munis -- are better off than they were just a year ago. That's when the Municipal Securities Rulemaking Board expanded the amount of muni-bond data available on a Web site called Investinginbonds.com. The MSRB, a congressionally created self-regulatory body, provides the price, size and time of each trade -- but typically with a delay of up to 24 hours. The board plans to report same-day trade data for many bonds beginning next year.

But Wall Street is resisting. Brokers are lobbying the MSRB to delay the release of real-time data for some larger trades and lower-quality bonds so that the impact of the disclosures can be examined. These brokers point to the argument about increasing volatility, which, they say, could heighten the risk of trading losses for both dealers and investors.

Regulatory actions such as the NASD's move against Mr. Murphy have been relatively infrequent, but that may be changing. The SEC and the NASD have launched separate probes of bond pricing, focusing on whether brokers have choreographed transactions among themselves that drive muni prices up or down, to the detriment of customers.

"OVERCOMPENSATING In Fraud Cases Guilt Can Be Skin Deep," by Alex Berenson, The New York Times, February 29, 2004 ---  http://www.nytimes.com/2004/02/29/weekinreview/29bere.html 

The new wave of corporate fraud trials was supposed to be about systemic problems with the way American companies are run. The trials were supposed to be about the collapse of accounting standards and the way huge stock option grants can corrupt executives.

Instead prosecutors have spent a lot of courtroom time talking about perks and obstruction of justice - about floral arrangements and hotel bills run up by the indicted executives, as well as whether they lied to prosecutors or federal investigators.

In the trial of L. Dennis Kozlowski, the former chairman of Tyco International who is accused of looting his company, prosecutors have repeatedly presented evidence of perks received by the defendant, even when the benefits seem only tangentially related to the charges at hand.

The trial of John J. Rigas, the founder of Adelphia Communications, and his sons Timothy and Michael, which began last week, appears set to follow a similar tack. Prosecutors are preparing to present evidence about safari vacations and a $13 million golf course allegedly paid for out of corporate funds.

Meanwhile, federal prosecutors investigating Computer Associates, the Long Island software giant, have focused on alleged lies that executives told to prosecutors, not the accounting chicanery that Computer Associates allegedly used to inflate its profits.

Prosecutors have good tactical reasons for making these trials more about executive greed or obstruction of justice than about accounting or securities fraud, securities lawyers say. White-collar crime cases are often difficult to prove, as prosecutors learned again Friday when the judge in the Martha Stewart case dismissed a securities fraud charge against Ms. Stewart that was at the core of the indictment against her.

So prosecutors look for every possible way to simplify the cases for jurors - and to make defendants look bad.

Evidence of defendants' lavish lifestyles is often used to provide a motive for fraud. Jurors sometimes wonder why an executive making tens of millions of dollars would cheat to make even more. Evidence of habitual gluttony helps provide the answer.

"You're trying to make the case that this individual is greedy, should not be viewed as credible, is only out for himself,'' said Joel Seligman, dean of the Washington University School of Law. "It does have a kind of relevance.''

But prosecutors have other reasons for introducing evidence of extravagant spending. Because the details of the fraud charges can be so difficult to understand, jurors' decisions may ultimately turn on their personal impressions of the indicted executives.

"It's a lot more interesting to show the tape of Jimmy Buffett playing in the background and people walking around nude and drunk than to show the dry accounting evidence,'' said James Cox, a professor of corporate and securities law at Duke University, in reference to a videotape played by prosecutors in the Tyco trial about a birthday party for Mr. Kozlowski's wife, Karen. Tyco paid $1 million, about half the cost, for the party.

"The trial is partly about what the rules are, but a lot about what the defendant is,'' Mr. Cox said.

Continued in the article

"Adding Insult to Injury: Firms Pay Wrongdoers' Legal Fees," by Laurie P. Cohen, The Wall Street Journal, February 17, 2004 --- http://online.wsj.com/article/0,,SB107697515164830882,00.html?mod=home%5Fwhats%5Fnews%5Fus 

You buy shares in a company. The government charges one of the company's executives with fraud. Who foots the legal bill?

All too often, it's you.

Consider the case of a former Rite Aid Corp. executive. Four days before he was set to go to trial last June, Frank Bergonzi pleaded guilty to participating in a criminal conspiracy to defraud Rite Aid while he was the company's chief financial officer. "I was aggressive and I pressured others to be aggressive," he told a federal judge in Harrisburg, Pa., at the time.

Little more than a month later, Mr. Bergonzi sued his former employer in Delaware Chancery Court, seeking to force the company to pay more than $5 million in unpaid legal and accounting fees he racked up in connection with his defense in criminal and civil proceedings. That was in addition to the $4 million that Rite Aid had already advanced for Mr. Bergonzi's defense in civil, administrative and criminal proceedings.

In October, the Delaware court sided with Mr. Bergonzi. It ruled that Rite Aid was required to advance Mr. Bergonzi's defense fees until a "final disposition" of his legal case. The court interpreted that moment as sentencing, a time that could be months -- or even years -- away. Mr. Bergonzi has agreed to testify against former colleagues at coming trials before he is sentenced for his crimes.

Rite Aid's insurance, in what is known as a directors-and-officers liability policy, already has been depleted by a host of class-action suits filed against the company in the wake of a federal investigation into possible fraud that began in late 1999. "The shareholders are footing the bill" because of the "precedent-setting" Delaware ruling, laments Alan J. Davis, a Philadelphia attorney who unsuccessfully defended Rite Aid against Mr. Bergonzi.

Rite Aid eventually settled with Mr. Bergonzi for an amount it won't disclose. While it is entitled to recover the fees it has paid from Mr. Bergonzi after he is sentenced, the 58-year-old defendant has testified he has few remaining assets. "We have no reason to believe he'll repay" Rite Aid, Mr. Davis says.

Rite Aid has lots of company. In recent government cases involving Cendant Corp.; WorldCom Inc., now known as MCI; Enron Corp.; and Qwest Communications International Inc., among others, companies are paying the legal costs of former executives defending themselves against fraud allegations. The amount of money being paid out isn't known, as companies typically don't specify defense costs. But it totals hundreds of millions, or even billions of dollars. A company's average cost of defending against shareholder suits last year was $2.2 million, according to Tillinghast-Towers Perrin. "These costs are likely to climb much higher, due to a lot of claims for more than a billion dollars each that haven't been settled," says James Swanke, an executive at the actuarial consulting firm.

Continued in the article

Bob Jensen's Threads
Outrageous Executive and Director Compensation Schemes That Reward Failure and Fraud --- http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation 

From The Wall Street Journal Accounting Educators' Review  on February 13, 2004

TITLE: Companies Complain About Cost Of Corporate Governance Rules
REPORTER: Deborah Solomon and Cassell Bryan-Low
DATE: Feb 10, 2004
PAGE: A1
LINK: http://online.wsj.com/article/0,,SB107636732884524922,00.html 
TOPICS: Accounting, Accounting Law, Assurance Services, Audit Quality, Auditing, Auditing Services, Internal Controls, Regulation, Sarbanes-Oxley Act

SUMMARY: Companies are beginning to implement internal control systems to
comply with the requirements of the Sarbanes-Oxley Act (SOX). A primary
purpose of the SOX was to improve investor confidence in financial reporting;
however, companies are reporting that the cost of compliance is excessive.

QUESTIONS: 
1.) What is the purpose of a system of internal controls as it relates to financial reporting? Prior to the Sarbanes-Oxley Act what was the auditor's responsibilities for internal controls? Compare and contrast management's needs for internal control and the auditor's responsibility for assessing internal control?

2.) What is cost-benefit analysis? Does the Sarbanes-Oxley Act change the importance of cost-benefit analysis in designing and implementing internal controls? Briefly describe potential costs and benefits of internal control.

3.) Discuss the advantages and disadvantages of the additional internal control requirements imposed by the Sarbanes-Oxley Act?

4.) Estimate the percentage of first-year internal control related costs as a percentage of revenues. Does it appear that the Sarbanes-Oxley Act has more impact on any particular size of company? Support your answer.

5.) Do the internal control requirements of the Sarbanes-Oxley Act impose an unnecessary burden on public companies? Support your answer.

6.) Describe the difference between changes in income that are related to additional control and reporting requirements and changes in income that are related to changes in accounting for a specific economic event.

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

"Halliburton: Few Critics on the Street," by Andrew Park, Business Week, February 20, 2004 --- http://www.businessweek.com/bwdaily/dnflash/feb2004/nf20040220_2355_db014.htm 

First came complaints about Halliburton's no-bid contract to help rebuild Iraq's oil industry, worth more than $2 billion. Then came claims from the Defense Dept. that Halliburton may have overcharged it by $61 million for delivering fuel to Iraq.

A wider audit found Halliburton also may have overcharged for food service for U.S. troops. Halliburton denies wrongdoing, but it's no longer operating the fuel-delivery contract, and this month it suspended bills for food service worth some $174.5 million pending an investigation.

It doesn't end there: Halliburton also recently admitted that two employees took $6.3 million worth of kickbacks in connection with work in Iraq, which it immediately repaid. And it's involved in a Justice Dept. probe of bribery allegations related to a natural gas plant being built in Nigeria.

"WHAT WE KNOW." 
The negative attention has gotten so bad that Halliburton just launched a new TV commercial featuring CEO David Lesar that it hopes will rebut the attacks, which it calls politically motivated. "We're serving the troops because of what we know, not who we know," Lesar says twice during the ad.

Investors are likely to stick with Halliburton unless the problems continue to mount, says Stephen Gengaro, an analyst with Jeffries & Co. "Any of the numbers we've seen are, in the grand scheme of things, not all that meaningful," he says.

Ironically, the arm of Halliburton generating most of the heat, its engineering and construction subsidiary Kellogg Brown & Root, is the one that it might be better off without. While KBR has landed more than $5 billion in contracts in Iraq, helping Halliburton boost revenues 63% during the fourth quarter, its 2.2% profit margin badly trails the company's 5.5% average.

Continued in the article

We may have to wave goodbye to streaming media.

"Colleges That Transmit Sound and Video Online Reluctantly Discuss Strategy for Answering Patent Claim, by Scott Carlson, The Chronicle of Higher Education, February 6, 2004, Page A27.

Colleges, along with pornography distributors and mainstream businesses, are struggling for ways to refute claims by Acacia Research Corporation, which says it owns patents on the streaming technology that allows Web users to transmit and play sound and video.  In letters to companies and to many colleges, Acacia is seeking licensing deals that would pay it 2 percent of the gross revenue the recipients derive from such online media.

Acacia has had some successes recently.  It was just granted another patent for streaming technology in Europe.  It signed up a hotel pay-per-view company and, in a coup, a pornography company that had been part of a small group of adult-entertainment sites fighting the patent claims in court.

Acacia has also started sending letters to major corporations.  General Dynamics, the billion-dollar aerospace-and-defense contractor, signed a licensing deal in late December.

Meanwhile, colleges are reluctantly trying to decide whether to band together to challenge Acacia's claims.  Among higher-education providers, only 24/7 University, a for-profit distance-learning company based in Dallas, is known to have agreed to a deal.

Robert A Berman, senior vice president for business development at Acacia, said colleges had "panicked" and "assumed that we're asking for more than we're really asking for."

Acacia, he said, is seeking royalties from colleges only on revenues from their distance-learning courses.  The company is willing to waive royalties on revenue from other classes that use streaming technology.  "We're talking about licenses in the $5,000-to-$10,000-a-year range--at least for now," he said.

Acacia officials won't say how many colleges, or which ones, they have written to.  Institutions of all sizes have received the letters, but it is unclear what criteria the company used in choosing them.

'BUSINESS DECISION'

24/7 University struck an agreement with Acacia early this month.  Delwin Hinkle, chief executive officer of the university, called the deal "simply a business decision."

"They tell you that they have $55-million in the bank and that they are willing to spend that to enforce their patents," he said.  "We looked at it and said it's just another tweak to our cost structure, and we don't have the money, the time, or the inclination to mess with them."

Mr. Hinkle said he had tried to contact major universities to discuss a collective defense but never got a response.  He did not consider joining in the pornography companies' litigation.  "You're known by the company you keep," he said.  "No disrespect to their business, but I'm a Baptist deacon, and I can't hang with those boys."

E. Michael (Spike) Goldberg, chief executive of HomegrownVideo.com, is leading the pornographers' fight against Acacia.  He has been frustrated by higher education's unwillingness to work with him or join his case.

 Continued in the article.

February 12, 2004 message from David R. Fordham [fordhadr@JMU.EDU]

Bob,

In the IT circles, my experience has been that Acacia has the same reputation as a shirtless, tattooed, multi-pierced skinhead who walks up to your car at a stoplight, splashes Coke on your windshield, wipes it off with a paper towel and demands $5 for cleaning your car.

According to what I've heard at a lot of IT conferences, Acacia is a firm of sleazebag lawyers whose only claim to business legitimacy is the buying of semi-worthless patents which are vague enough to be stretched and convoluted and contorted to cover some activity that the general population is already engaged in (such as breathing, eating, etc.) and then doing a lot of research to find a hapless victim who is too clueless or too poor to afford a decent lawyer to find knowledgable expert witnesses so the Acacia team can snow-job a clueless jury into believing that the vague patent has been infringed. Then, Acacia uses their "success" to scare (e.g., legal extortion?) a lot of other clueless companies into settling for "licensing fees", which they then hold up in other court cases as "legitimizing" their claim to the vague patent covering the activity. They only take an interest in activities which have become such an integral part of society as to cause great hardship if they cease, since Acacia's goal is not to stop patent infringement as much as it is to extort licensing fees from others who are doing all the work.

Acacia's streaming video claim is based on a patent issued to an individual in 1992 for transmitting music electronically. But MP3 (the Motion Picture Experts Group Audio Level 3) file format was invented in 1989 and released to the public in 1991. The Acacia claim is that any file which can be used to reconstruct any music or video image is covered by their patent and cannot be transmitted electronically (e.g., like a CD player playing in your living room while you are talking to your grandma on the phone!) unless Acacia receives royalties. In other words, if you sing a jingle on your digital answering machine, you are violating the same Acacia patent which Acacia is using to sue college and universities.

From the scuttlebutt at IT conferences, Acacia's only business is filing lawsuits. They do not invent anything, they don't manufacture anything, they only file lawsuits and collect royalties and fees.

I don't have any first-hand knowledge of any of this, but I have heard many times of their questionable business practices at conferences, and several of my student groups over the last few years have done some research and reported on this phenomenon. One of them described Acacia's relationship to the IT industry as the "Nigerian Treasure Scam" is to the banking industry.

Although Acacia may have some institutions cowed, I'm not sure based on what I've read, that it is much more than a paper tiger that was able to snow-job some juries. (Having served on five juries, I have positively no confidence in a jury to make a good decision on something like this, and the judges of my experience are only marginally better!) I know our legal people here have turned up their nose at Acacia's "success", and aren't the least bit worried.

Check out: http://www.streamingmedia.com/patent/

My reference to "Acacia's Flying Circus" was a reference to Monte Python's antics, shenanigans, and sheer ludicrousness, engaging in activities which are so bizarre as to be almost beyond belief. (The dead parrot sketch, for example -- involving the Acacia pet store, and their customer, the very first gullible jury they snowed.)

David R. Fordham
PBGH Faculty Fellow
James Madison University

Absurd Salaries Being Paid to Head Start's Administrators, But Not The Teachers

February 9, 2004 message from Denise Nitterhouse [dnitterhouse@mba1977.hbs.edu] 

Didn't know if you saw this, thought you'd find it interesting from both the "San Antonio" & "Internet Accountability" perspectives.

Denise Nitterhouse 

-----Original Message----- 
From: NonProfit and Voluntary Action Discussion Group [mailto:ARNOVA-L@LISTSERV.WVU.EDU]  
On Behalf Of Dan Prives Sent: Sunday, February 08, 2004 8:37 PM To: ARNOVA-L@LISTSERV.WVU.EDU  
Subject: Newspaper offers spreadsheet analysis of exec salaries

Some terrific reporting from San Antonio about salaries paid to executives and teachers in the Head Start program. [Link below]

The web sidebar to the article actually includes an downloadable Excel spreadsheet that compares the salaries of the top 100 Head Start contractors. This was accomplished by cross referencing data from the on-line Federal Single-Audit database ( http://harvester.census.gov/sac/ ) with the Form 990 information on Guidestar.

That's what I call reporting -- Internet accountability in action!

The article itself raises some very serious questions about the limits of our present thinking about fair compensation. I believe that Head Start programs are typical of many nonprofits, where the working staff is inadequately compensated, while the execs receive wages "comparable" to the for-profit sector. Especially as for-profit exec salaries have left the planet, this uneven approach to "fair" wages leaves a lot to be desired.

Regards, Dan Prives "Infrastructure consulting for nonprofits $5 million to $50 million" Baltimore, Maryland

Head Start wage gap debate rages

By John Tedesco San Antonio Express-News

http://news.mysanantonio.com/story.cfm?xla=saen&xlb=180&xlc=1122379 

 

Boo to Merrill Lynch

Merrill Lynch was a major player in the infamous Orange County fraud when selling derivative financial instruments.  You can read more about this at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 

It constantly amazes me how often the name Merrill Lynch crops up in news accounts of both outright frauds and concerns over ethics.  The latest account is typical.  A senior vice president at Merrill Lynch testified that the firm received a lead role in a $2.1 billion bond offering for Tyco shortly after hiring a stock analyst favored by Tyco executives for his bullish coverage.

"Merrill Manager Offers Testimony About Tyco Deal," by Colleen Debaise, The Wall Street Journal, February 3, 2004 --- http://online.wsj.com/article/0,,SB107574602208418145,00.html?mod=mkts_main_news_hs_h 

A senior vice president at Merrill Lynch & Co. testified that the firm received a lead role in a $2.1 billion bond offering for Tyco International Ltd. shortly after hiring Phua Young, a stock analyst favored by Tyco executives for his bullish coverage.

The suggestion of a "quid pro quo" was raised as jurors in the trial of Tyco's former top executives were shown an August 1999 e-mail message from Sam Chapin, the senior vice president, to Merrill's then-chairman David Komansky.

In the e-mail, Mr. Chapin wrote that then-Tyco Chief Executive L. Dennis Kozlowski "wanted to recognize the commitment that you and I had made to him to address our equity-research coverage of Tyco."

Mr. Chapin also said in the e-mail, "To demonstrate the impact this hire has on our relationship, Dennis Kozlowski called me on Phua's first day of work to award us the lead management of a $2.1 billion bond offering."

Mr. Kozlowski and Mark H. Swartz, Tyco's former chief financial officer, are on trial in New York State Supreme Court on charges they improperly used Tyco funds to enrich themselves and others.

Prosecutors seemed to use Mr. Chapin's testimony to bolster charges that the former executives committed securities fraud by misleading investors, in part by getting Merrill to hire Tyco's favored analyst. Testimony last month showed that Mr. Kozlowski curried favor with the analyst by hiring a private detective agency to perform a background check on Mr. Young's fiancee, at the cost of $20,000 in Tyco funds.

The behind-the-scenes story of Mr. Young's hiring also appears to be another example of the cozy relationship during the Bubble Era between corporate executives and the supposedly-independent analysts at investment banks.

Mr. Chapin, a 20-year Merrill investment banker, testified that he spoke to Messrs. Kozlowski and Swartz about stock research when he became Merrill's "relationship manager" for Tyco in 1999.

The executives complained about coverage from Jeanne Terrile, the Merrill analyst then covering Tyco. "They did not believe that she fully understood their strategy for growth and development," he said.

In contrast, Mr. Young, then at Lehman Brothers, had a high stock rating on Tyco. When Mr. Chapin spoke to Mr. Kozlowski about hiring Mr. Young for Merrill, the Tyco chief described Mr. Young as a "hard-working analyst [who] did a very good job of covering Tyco," Mr. Chapin testified.

After that conversation, Mr. Chapin said he interviewed Mr. Young even though Merrill's equity-research group was leading the effort to recruit stock analysts. Mr. Chapin said it wasn't unusual for the research group to ask investment bankers to provide feedback on prospective hires.

Shortly afterward, Merrill hired Mr. Young to cover Tyco, and moved Ms. Terrile into a different job. Mr. Chapin testified that he then received a phone call from Mr. Kozlowski with the news about the $2.1 billion bond offering.

At Merrill, Mr. Young continued to be a Tyco cheerleader even as the conglomerate's stock came under siege. The analyst, who once referred to himself in an e-mail as a "loyal Tyco employee," was eventually fined by regulators for issuing exaggerated claims and dismissed by Merrill in 2002. He has denied the accusations and has filed an arbitration claim against Merrill.

Kozlowski attorney Stephen Kaufman sought to play down any improprieties, pointing out that Mr. Young had won a top rating from Institutional Investor at the time Merrill hired him. He asked Mr. Chapin if that designation was the equivalent of winning an Oscar, but Judge Michael Obus wouldn't allow the question.

Continued in the article.

"Stewart Trial Hears Key Witness," by Matthew Rose and Kara Scannell, The Wall Street Journal, February 4, 2004 --- 

"Oh my God, get Martha on the phone."

The government's star witness against Martha Stewart testified Tuesday that that is how his former boss at Merrill Lynch & Co. reacted when informed that ImClone Systems Inc.'s chief executive and members of his family were trying to dump their shares of the biotechnology firm in late 2001.

"You have to tell her what's going on," Douglas Faneuil quoted his former boss, broker Peter Bacanovic, as saying in a subsequent call. Mr. Faneuil said he asked if he was allowed to do that.

"Of course. You must. You've got to. That's the whole point," Mr. Faneuil said Mr. Bacanovic responded.

Continued in the article

If you want to read more about ethics failures at Merrill Lynch, just search for the word Merrill at http://www.trinity.edu/rjensen/FraudRotten.htm 

President Bush makes a cameo appearance in a sickening video at a time when he was still Governor of Texas .  I do not want to imply that I am against the re-election of George W. Bush.  But I do want this video to ring in everybody’s ears just to show how sick corporate accounting became (and I think many top accountants and corporate executives still don’t get it).

I'm surprised that the Democratic contenders, especially John Edwards, have not been replaying parts of this video in campaign appearances.  John Edwards has been especially critical of the closeness of Enron's former top executives with the White House and the U.S. Congress.


The video shot at Rich Kinder's retirement party at Enron features CEO Jeff Skilling proposing Hypothetical Future Value (HPV) accounting with in retrospect is too true to be funny during the subsequent melt down of Enron.

The people in this video are playing themselves and you can actually see CEO Jeff Skilling, Chief Accounting Officer Richard Causey, and others proposing cooking the books.  You can download my rendering of a Windows Media Player version of the video from http://www.cs.trinity.edu/~rjensen/video/windowsmedia/enron3.wmv 
You may have to turn the audio up full blast in Windows Media Player to hear the music and dialog.

"Feds Want To See Enron Videotape President Bush Also Takes Part In Skit," Click2Houston.com, December 16, 2002 --- http://www.click2houston.com/money/1840050/detail.html 

Skits and jokes by a few former Enron Corp. executives at a party six years ago were funny then, but now border on bad taste in light of the events of the past year.

VIDEO Feds Want To See Controversial Enron Videotape Watch Clips From Enron Retirement Tape INTERACTIVES The End Of Enron What's The Future Of Enron? 

A videotape of a January 1997 going-away party for former Enron President Rich Kinder features nearly half an hour of absurd skits, songs and testimonials by company executives and prominent Houstonians, the Houston Chronicle reported in its Monday editions.

The collection is all meant in good fun, but some of the comments are ironic in the current climate of corporate scandal.

In one skit, former Administrative Executive Peggy Menchaca played the part of Kinder as he received a budget report from then-President Jeff Skilling, who played himself, and Financial Planning Executive Tod Lindholm.

When the pretend Kinder expressed doubt that Skilling could pull off 600 percent revenue growth for the coming year, Skilling revealed how it could be done.

"We're going to move from mark-to-market accounting to something I call HFV, or hypothetical future value accounting," Skilling joked as he read from a script. "If we do that, we can add a kazillion dollars to the bottom line."

Richard Causey, the former chief accounting officer who was embroiled in many of the business deals named in the indictments of other Enron executives, made an unfortunate joke later on the tape.

"I've been on the job for a week managing earnings, and it's easier than I thought it would be," Causey said, referring to a practice that is frowned upon by securities regulators. "I can't even count fast enough with the earnings rolling in."

Joe Sutton and Rebecca Mark, the two executives credited with leading Enron on an international buying spree, did a painfully awkward rap for Kinder, while former Enron Broadband Services President Ken Rice recounted a basketball game where employees from Enron Capital & Trade beat Kinder's Enron Corp. team, 98-50.

"I know you never forget a number, Rich," Rice said.

President George W. Bush, who then was governor of Texas, also took part in the skit, as did his father.

At the party, the younger Bush pleaded with Kinder: "Don't leave Texas. You're too good a man."

The governor's father also offered a send-off to Kinder, thanking him for helping his son reach the governor's mansion.

"You have been fantastic to the Bush family," the elder Bush said. "I don't think anybody did more than you did to support George."

Federal investigators told News2Houston Tuesday that they want to take a closer look at the tape.

Investigators with the House committee on government reform are in the process of obtaining a copy of the tape, according to News2Houston.

Former federal prosecutor Phil Hilder said that what was a joke could become evidence for federal investigators.

"There's matters on there that a prosecutor may want to introduce as evidence should it become relevant," Hilder said.

Former employees were shocked to see the tape.

"It's too close to the truth, very close to the truth," said Debra Johnson, a former Enron employee. "I think there's some inside truth to the jokes that they portrayed."

 

At Long Last Fastow and His Wife are Headed for Prison, Albeit a Club Fed Prison
Bob Jensen's threads on the history of the Enron accounting scandals can be found at http://www.trinity.edu/rjensen/fraud.htm 
The weekly updates on these and other accounting scandals are linked at 
Scandal Updates --- http://www.trinity.edu/rjensen/fraud.htm#ScandalUpdates  

 

"Enron's Fastow Is Set to Plead Guilty," by John Emshwiller, The Wall Street Journal, January 14, 2004 ---  http://online.wsj.com/article/0,,SB107404282423783100,00.html?mod=home_whats_news_us 

Enron Corp.'s former chief financial officer, Andrew Fastow, is expected to plead guilty to criminal charges Wednesday, marking the highest level executive to be netted by the federal government's extensive investigation of the fallen energy company.

Mr. Fastow's cooperation with prosecutors could provide investigators a big boost in their continuing efforts to uncover how involved in the Enron scandal were the company's top executives, including former Chief Executives Kenneth Lay and Jeffrey Skilling. Mr. Fastow's wife, Lea, is also expected to plead guilty to a criminal charge to settle a related case against her.

Under the agreement with the Justice Department, Mr. Fastow would plead guilty to criminal counts in return for a 10-year sentence and a pledge to cooperate with the government's Enron probe, said a person familiar with the matter. The plea would resolve the nearly 100-count indictment pending against Mr. Fastow for fraud and other crimes allegedly committed in connection with his work as a top Enron executive.

Mr. Fastow was a key figure who helped create and operate a group of off-balance-sheet entities that investigators contend were central to allowing Enron to improperly create hundreds of millions of dollars of income and hide like amounts of debt. The disclosure of some of those financial dealings in late 2001 led to a collapse in investor confidence that forced Enron to seek bankruptcy-law protection.

As part of his plea negotiations, Mr. Fastow has been providing information about some of the other former Enron officials, say people familiar with the matter. One such person said that Mr. Fastow likely would be able to provide more information about Mr. Skilling than Mr. Lay. Within Enron, Mr. Fastow was considered by many to be something of a protégé of Mr. Skilling. Both Mr. Skilling and Mr. Lay have denied wrongdoing during their tenures at Enron.

Continued in the article.

As the FASB and SEC struggle to join the International Accounting Standards Board (IASB) in requiring the expensing of stock options when vested (which I think is the best accounting alternative), the large and powerful technology industry lobby is swinging its weight around the halls of Congress to get its own way.

"Expensing of Stock Options Isn't the Answer, Readers Say," The Wall Street Journal, March 26, 2005 --- http://online.wsj.com/article/0,,SB107964329516259426,00.html?mod=technology%5Ffeatured%5Fstories%5Fhs 

Lee Gomes said in Monday's column that tech executives opposed to stock-option expensing would get an F from their old business school professors. While I still believe as much, I must concede they would get A's from their college writing teachers, as I received a number of vigorously-argued critiques of the accounting rule change I was supporting. Many readers agreed with the column, but since I compared opponents of stock option expensing to Chicken Little, it's only fair to turn this forum over to them.

* * *

Craig R. Barrett
Chief Executive Officer
Intel Corp.
In today's article you go to great pains to point out that we should have accurate reporting (honest accounting) of earnings and use this as a main thesis in defending the expensing of stock options. You (and others) are quick to point out that options are an expense and should be counted as such. The only problem is that after many, many years of trying, FASB and others have been unable to come up with anything that approximates an accurate expensing method. Just go and see how accurate the expensing that Coke used for their options tuned out to be in retrospect. Or how about the billions of dollars of expense that companies like Cisco Systems Inc. and Intel Corp. would have to take for options that might never be exercised?

You quickly bypass this trivial issue with the tired excuse that the rest of our accounting methodology is inaccurate, so why worry? If our accounting is so inaccurate, why not urge FASB to get back to the real basics of the problem (cash accounting)? What about Sarbanes-Oxley, supporting inaccurate reporting of corporate results as just the natural result of poor guidelines from FASB.

As a CEO I find this trivialization of accounting almost as insulting as your insinuation that the supporters of stock options "would have earned F's from their old business school professors." I would like your side in this argument to address these issues:

• FASB's proposed accounting for options is just plain inaccurate, and everyone knows it. Why will a single, inaccurate number be better than the several pages of detailed option data we currently provide, if our goal is to provide clear and transparent accounting to shareholders?
 
• Why isn't the current dilution of earnings per share the best possible information to be provided to shareholders? After all, shareholders will approve all option programs and options are really just a dilution of ownership.
 
• Many accountants feel that options are not a true expense, despite FASB's view. Why is this not considered?
 
• And yes, we do raise the jobs issue as part of the debate. The Chinese Communists are promoting the use of options, and not for competitors of Coke or other companies who expense options but whose options are typically given to only the top few employees, but for high tech companies like Intel and Cisco. You can ignore this aspect if you choose, but I doubt those who do have run a company in high tech and competed with the rest of the world.
 
• My predictions if expensing wins:
 
• Companies will return to pro forma accounting to give an accurate representation of their financials -- this will marginalize FASB.
 
• Trial lawyers will have a field day with the inaccurate methods used to account for option expensing -- how can they possibly ignore the billions of dollars of inaccurate expenses taken when stock prices don't follow expected trends? CEOs knew or should have known that their choice of option expensing algorithms were inaccurate.
 
• U.S. companies will reduce their use of options, to their competitive disadvantage compared with companies in emerging economies. (We are competing in the future with Asian companies, not the Europe of the IASB.)
 

Your argument ignores these details. We may yet lose the battle on expensing, but trivializing our motives really misses the point.

Frank Huerta
San Carlos, Calif.

I think that incentive options help fuel Silicon Valley, especially in a start-up. However, the difficulty that I see with expensing the options is the value you assess for the expense.

I am one of those students that took options and futures in business school at Stanford and have actually gone through the mechanics of pricing options via the Black-Scholes and binomial models (two of the methods being proposed to value options). The key components in these models are the stock price, strike price, interest rates, time to expiration, dividend, and volatility. Of these, the volatility is the one unknown and requires approximation (typically the computer models use a log-normal distribution of stock prices of PAST performance for this predictor of future volatility, a reasonable estimator that may not always be accurate).

This volatility estimator creates one problem. The option pricing models generates a number that may be used for accounting purposes, but is that the right price? Rather, is it a market clearing price? Options are traded every day for public companies for a price based on supply and demand and the other factors mentioned above. The market determines the volatility by looking at the past, but also the future of the business and its environment and that adjusts the price. The volatility that is derived from the price of exchange traded options is known as the "implied volatility." So, really, the market "creates" the volatility, not the model.

Now for public company options, it might make sense to expense the price of the employee options based on the market price of the exchange-traded options. But this assumes that the employee options match the exchange-traded options in type (American or European), strike price and time to expiration, but that is rare since most employee options are long term (expiration dates of 10 years) and exchange-traded options are usually less than one year, although LEAPS go out a few years typically. So do the pricing methods proposed represent the "true" value of the options in the absence of a market clearing price? Likely not.

In addition to the volatility question, the restrictions imposed on corporate employee option holding and trading impact the "true" value of these options as defined by Black-Scholes or the binomial method. Issues such as: 1) vesting period or "cliffs" (an employee has to hold the option for a set amount of time before he/she can exercise it); 2) trading windows or only certain times or in which the options can be exercised; 3) employee options can be exercised only if they are in the money; and perhaps most importantly 4) the inability to trade the employee option in a market, all create a deviation from the conventional pricing methods for options.

An option has value right up until it expires. Thus, the day the employee is given an option (usually at the money), it has value. This is the value that should be expensed by the company in the period it is incurred. But what is the value? Black-Scholes and binomial pricing do not account for a "lock up" period, and the employee cannot take advantage of that value because he must wait the period of the cliff (say a year), wait for a trading window to open outside of a quiet period, and hope that the option is in the money. Nor can he/she sell the option along the way to capture its value. Even if the employee option is underwater after the cliff, it still has value according to the option pricing models, but the option holder cannot take advantage of this and thus the market is not efficient -- a stipulation of the models.

A good discussion of this topic is on this Web site. Hull and White wrote one of the classic text books on options. In this report (Adobe Acrobat required), they discuss the problems with determining the correct value of employee options and try to come up with a model for pricing them (of which I would need to study more to be convinced, but it is not what the FASB is proposing).

The point is that if companies are going to expense the value of employee options, then they need a better method than what has been proposed to assign and capture the "true" value of those instruments. Otherwise, the numbers will be wrong, and I don't want a new item mucking up income statements and balance sheets any more than they already are. Hull and White and others propose new models, but how do we know if the numbers will be right (volatility assumptions, etc.)?

An interesting idea would be to allow a market to develop for employee options (you may need more supply but I'm sure investment banks could make more money). Then the "true" price can be determined for that derivative instrument and that value can be expensed in or close to the period it is incurred. Companies may have problems with aligning employees with long term incentives since you may have people that receive an option on the first day of employment and then sell them into the market for the money, but there are ways around this.

Martin Mobley
LL.M. Candidate
Georgetown University Law Center

I'm glad you didn't let the facts get in the way of a good story -- it's more entertaining that way. Given its inclusion in The Wall Street Journal, however, I would have expected your editorial to more than just occasionally delve into reality. As it is, your column on stock options expensing is sensational and misguided (at best).

You begin by telling high-tech executives not to worry about expensing options because Coke did it and "Not only has the sky not fallen, not much else bad has happened." What in the world does Coke have to do with the high-tech industry? Coke and the soft drink industry, which have been around for a combined one billion years, are nothing like high-tech companies and the high-tech industry. Neither is Coke's use of stock options, which in 2002 Coke expected would equate to about one cent per share.

You go on to say that "Silicon Valley managers are busy making arguments that would have earned them F's from their old business-school professors." A bold assertion from someone who never once -- in an article suggesting that those who expense options are less than honest -- even bothers to explain why stock options should be expensed. Your references to "bad accounting," lines "being peddled" by companies, and the perverse nature of "rejecting honest accounting" are uninformative. They do, however, seem to be the type of "stock option horror stories" you compare to the monsters that kids believe are under their beds at night.

Although the "point" doesn't appear to have been made, why don't I take a crack at the "counter-point,"