Enron/Andersen Scandal Updates on June 4, 2002
Bob Jensen at Trinity University

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


It's no wonder that Watson and other energy CEOs are circling the wagons. Each day seems to bring damaging new revelations: bogus energy swaps in which traders at companies like Reliant Resources and CMS Energy passed power back and forth in order to inflate revenues; fishy accounting strategies like Dynegy's complex profit-boosting scheme Project Alpha; and evidence that Enron's traders tried to drive power prices sky-high during the California energy crisis. These and other disclosures have sparked a surge of investigations by the SEC, the Federal Energy Regulatory Commission (FERC), and a host of congressional committees. To make matters worse, the controversy has pushed shares of these companies into a tailspin--Dynegy, for example, has dropped more than 50% in just the past two months. And in late May, embattled CMS Chairman and CEO William McCormick Jr. resigned.
"Is Energy Trading a Big Scam," Fortune, May 27, 2002 --- http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=208135 


Derivatives cannot hedge derivatives for accounting purposes -- now or under FASB 133," Bass said. "Does Dave [Duncan] think his accounting works even under FASB 133? No way."
Carl Bass, Andersen Auditor in 1999 who asked to be removed from Enron's audit review responsibilities --- 
http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm#Bass
 
The main reasons are given in FAS Paragraph 405.  FAS 133 Paragraph 21(2)(c) disallows hedged items to be derivative financial instruments for accounting purposes, because derivative instruments are carried at fair value and cannot therefore be hedged items in fair value hedges.  Also see Paragraphs 405-407.  Paragraph 472 prohibits derivatives from be designated hedged items any type of hedge, including cash flow, fair value, and foreign exchange hedges.  The reason is that derivatives under FAS 133 must be adjusted to fair value with the offset going to current earnings.  This is tantamount to the "equity method" referred to in Paragraph 472.  More importantly from the standpoint of Enron transactions, Paragraphs 230 and 432  prohibit a firm's own equity shares from being hedged items for accounting purposes.  Whenever a firm hedges the value of its own shares, FAS 133 does not allow hedge accounting treatment.  What good is an expert like Carl Bass is the system is designed to ignore his expertise?


From the Prairie Home Companion Archive --- http://prairiehome.org/performances/20020511/gift.shtml#top 

The Sweetest Gift, A Mother's Smile
Saturday, May 11, 2002
Listen: RealAudio Clip | How to Listen


One day a mother went down to Houston
To see an erring but precious son.
He worked for Enron and yet she loved him
It did not matter what he had done.

She did not bring (to him)
Parole or pardon (free)
She brought no lawyer (mouthpiece)
In the corporate style (three piece suit).
It was a halo (bright)
Sent down from heaven (light)
The sweetest gift, a mother's smile.

Her boy had gone into accounting
Though she had prayed he'd be a priest.
He'd formed six off-shore corporations
And the stockholders he royally fleeced.

She did not bring (to him)
Parole or pardon (free),
She brought no silver (brought no gold)
No pomp or style (him to see)
It was a halo (bright)
Sent down from heaven (bright)
The sweetest gift, a mother's smile.

Then she discovered that her own pension
Which was invested in TIAA-CREF
Had taken a big hit from Enron
And she told him, "I hate you, Jeff."

 

 

She did not swing (at him)
A ballpeen hammer (hard)
She did not kick him (his butt)
She did not break (down in tears),
She only said (that she)
A hostile witness (would be)
And that she hoped he would get twenty years.

She spilled her guts out at the trial,
She told the truth, nothing but the truth,
About his avarice and his cruelty
And how he'd treated her in his youth.

He got no pardon (no)
No second chances (not him).
He got twenty (years)
In Leavenworth (Kansas)
He looked so sad (and grim)
As she looked down (at him)
The sweetest gift, a mother's smile.

 


May 30, 2001 message from Phil Livingson, President of Financial Executives International (FEI)

There is a lot going on in the financial reporting arena, not much of it good, frankly. The Senate Banking Committee postponed its action on their Enron accounting and governance reforms. The passage of an actual bill is very much in doubt at this point. The accounting firms continue to get pounded with audit failures, with Adelphia apparently the latest problem. The leaders of the Final Four accounting firms have been too quiet and need to speak up. Serious reform of their audit quality processes is demanded by the marketplace. I keep hearing from CFOs on this score. Industry uses audited financial statements more than anyone - for operating our companies, dealing with vendors and in M&A.

The marketplace is demanding higher-quality audits and the Final Four need to focus on revising their procedures to produce the needed assurance. I've said over and over again, it starts with us, financial management on the front line, but the auditors play a huge role, too. They have to catch most of the bad apples, and they need to address the situation fast. The silence is further damaging the system.

I am on the way to the USC financial reporting conference to give the lunch address. I'll try to issue an update of the action there soon. Am also speaking to the state boards of accountancy next week and looking forward to that opportunity at this challenging time.


The media may be calling him the "wishy-washiest watchdog since Scooby-Doo," but Securities and Exchange Commission Chairman Harvey Pitt is talking tough about reforming accounting standards. If he follows through on this tough talk, the Financial Accounting Standards Board may be in for big changes. http://www.accountingweb.com/item/82149 


Concerning the Self-Regulation Record of State Boards of Accountancy:  Don't Kick Them Really Hard Until They Are Already Dying
Andersen's failure to comply with professional standards was not the result of the actions on one 'rogue' partner or 'out-of-control' office, but resulted from Andersen's organizational structure and corporate climate that created a lack of independence, integrity and objectivity.
Texas State Board of Public Accountancy, May 24, 2002
"Texas Acts to Punish Arthur Andersen," San Antonio Express News, May 24, 2002, Page 1.
At the time of this news article, the Texas State Board announced that it was recommending revoking Arthur Andersen LLP's accounitn license in Texas and seeking $1,000,000 in fines and penalties.
Bob Jensen's threads on the Enron/Andersen scandals are at http://www.trinity.edu/rjensen/fraud.htm 


Concerning the Self-Regulation Record of the National Association of Securities Dealers:  Build a Shield Around the Bad Guys
"We tell all our clients now, as a matter of policy, 'Do not complain to NASD enforcement,' " says Pat Sadler, a lawyer in Georgia who serves on the NASD's national arbitration and mediation committee. He adds, "Our cooperation with the NASD cannot help our customer. It can only hurt them."
USA Today,
May 24, 2002, Editorial Page
Bob Jensen's "Rotten to the Core" threads are at http://www.trinity.edu/rjensen/fraud.htm#Cleland 


On May 16, the European Union issued long-awaited guidelines on auditor independence in an effort to avoid an Enron-type incident. Among other things, the guidelines recommend that accounting firms rotate audit partners after seven years with the same client and partners wait two years before joining a company they have audited. The recommendations are not binding. Each country is free to adopt stricter requirements. http://www.accountingweb.com/item/81093 


The U.S. Department of Justice and Big Five firm Andersen continued their courtroom tactics this week. Andersen has been charged with one count of obstruction of justice stemming from the firm's destruction of documents relating to its Enron audit. These stories recap the week's events:

Duncan Notes Sealed, Andersen Lawyer Takes the Fifth http://www.accountingweb.com/item/80552 

Duncan Takes the Stand; Judge Makes Potentially Reversible Decision http://www.accountingweb.com/item/80723 

Testimony Continues for Andersen's Duncan http://www.accountingweb.com/item/80842 

Prosecution Admonishes Attorney Hardin's Tactics http://www.accountingweb.com/item/76343 

Duncan Provides Controversial Testimony http://www.accountingweb.com/item/81067 


The U.S. Department of Justice and Big Five firm Andersen have completed Week Three of their trial in Houston while Andersen's clients continue to stream out the door. Andersen has been charged with one count of obstruction of justice stemming from the firm's destruction of documents relating to its Enron audit. These stories recap the week's events:

Snowball Grows: 90 Public Companies Leave Andersen This Week http://www.accountingweb.com/item/81201 

Fireworks at Andersen Trial End in Judge Storming Off Bench http://www.accountingweb.com/item/81244 

Andersen Jury Watches Video Encouraging Document Destruction http://www.accountingweb.com/item/81298 

Andersen Endures More Shake-Ups and Another Week in Court http://www.accountingweb.com/item/81674 


May 31, 2002 message from Rachel McCarthy

ANDERSEN PARTNERS MAY LOSE OUT ON 1 MILLION EACH AS A RESULT OF JOB LOSSES

The UK partners of disgraced auditing firm Andersen are set to lose 1 million in order to fund the 1660 redundancies it has been forced to make. The money is said to be coming directly from both the partners pay packet and equity within the firm.

http://www.aia.org.uk/news/fullstory_index.cfm?fuseaction=detail&storyid=929


From CPAnet on May 29, 2002

C P A N e w s - M a y 2 0 0 2 ==========================================================

Ernst & Young Violated Auditor Independence

http://www.cpanet.com/up/s0205.asp?ID=0567

Andersen staffer says phrase was a hint to shred

http://www.cpanet.com/up/s0205.asp?ID=0568

Andersen employee recounts shredding

http://www.cpanet.com/up/s0205.asp?ID=0569

Andersen loses last big client

http://www.cpanet.com/up/s0205.asp?ID=0570

Fired auditor saved some Enron memos

http://www.cpanet.com/up/s0205.asp?ID=0571

Volcker says "new Andersen" no longer possible

http://www.cpanet.com/up/s0205.asp?ID=0572

Independence Bowl?

http://www.cpanet.com/up/s0205.asp?ID=0573

Defined Benefits, Loose Accounting

http://www.cpanet.com/up/s0205.asp?ID=0574

 


As other major accounting firms begin acquiring pieces of Andersen's U.S. practice, the insurers of those firms, fearing increased exposure, are reportedly refusing to provide liability coverage. http://www.accountingweb.com/item/80399 


Many Andersen employees are moving to Ernst & Young --- http://www.smartpros.com/x34199.xml 

A group of 25 partners and 250 staff has left the remains of Big Five firm Andersen to start a new company, Huron Consulting Group. The group reached an agreement with Andersen earlier this month, making a cash settlement to release the partners from employment and non-compete agreements. http://www.accountingweb.com/item/81634 


Nearly 2,000 professionals, including nearly 200 partners, all members of Andersen's U.S. tax practice, reportedly will join Big Five rival Deloitte & Touche immediately. In addition, members of the Big Five are picking up several other Andersen offices around the country. http://www.accountingweb.com/item/80551 


From The Wall Street Journal Accounting Educators' Reviews on May 16, 2002

TITLE: Duncan Says Fear of Lawsuits Drove Shredding 
REPORTER: Jonathan Weil and Alexei Barrionuevo 
DATE: May 15, 2002 
PAGE: C1 LINK: 
http://online.wsj.com/article/0,,SB1021402543607965400.djm,00.html  
TOPICS: Auditing, Auditor Independence, Auditor/Client Disagreements, Consulting, Disclosure Requirements, Financial Accounting

SUMMARY: The article details the testimony of David Duncan, the Houston office's lead partner on the Enron account, for the Justice Department in its trial against Arthur Andersen; further details are available through on-line links. The first related article emphasizes the personal qualities that have led Mr. Duncan to his current straights.

QUESTIONS: 
1.) The article describes how, during his testimony for the prosecution, Mr. Duncan was asked whether he believes that Enron's disclosures of related party transactions were sufficient. Describe Mr. Duncan's answer to that question. How does that answer show "glimpses of aggressiveness," as it is described in the article?

2.) What is the intent of disclosures about related-party transactions? Where are these disclosure requirements found in the professional literature? Based on Mr. Duncan's answer to the above-described question, do you think it likely that Enron's disclosures upheld the principle underlying this accounting standard?

3.) One accounting issue on which Arthur Andersen partners disagreed with Enron officials that isdiscussed in the article is a $1.2 billion error in shareholders' equity that inflated the company's assets. How could Mr. Duncan first have "rationalized" this item as immaterial? What is the definition of materiality? Where in the professional literature is this definition found?

4.) How did the Andersen partners' opinion of the materiality of the $1.2 billion error change in light of press scrutiny about the issue? Are these views consistent with a professional view of materiality?

5.) The Justice Department is basing its case on the argument that the firm of Arthur Andersen, taken as a whole, obstructed justice by authorizing shredding of documents associated with the Enron account that the firm knew would be of interest in an SEC investigation. Mr. Duncan pleaded guilty to knowingly obstructing justice in ordering that the documents be shredded. How could one argue that justice was not obstructed, given that the document shredding did occur? How could one argue that the firm of Arthur Andersen as a whole was not involved in such obstruction of justice, even if it did occur?

6.) Mr. Duncan said he faced relentless pressure from Enron officials to accept questionable accounting and reporting practices. The first related article describes relationships between Mr. Duncan and Enron officials that seem to violate the independence requirement for auditors. Cite these examples. How do you think these independence violations influenced Mr. Duncan's thinking about accouting and reporting issues?

7.) How does that fact that audit clients pay for their independent auditor's services further complicate those independence issues, especially in the case of large companies? How does the fact that audit firms also provide consulting services to these large clients further complicate these issues?

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

--- RELATED ARTICLES --- 
TITLE: How a Bright Star at Andersen Fell Along with Enron; Like his Firm, David Duncan Basked in Glow of Client on a Decade-Long Roll; 'All the Ammo I Can Get' 
REPORTER: Anita Raghavan 
PAGE: A1 
ISSUE: May 15, 2002 
LINK: http://online.wsj.com/article/0,,SB1021425497254672480.djm,00.html 

TITLE: Andersen Ex-Party Pleads Guilty, In a Significant Blow to the Firm; Dramatic Move by David Duncan Gives Prosecutors Weapon to Pursue Charges 
REPORTER: John R. Wilke, Jonathan Weil and Alexei Barrionuevo 
ISSUE: Apr 10, 2002 
LINK: http://online.wsj.com/article/0,,SB1018365232603680560.djm,00.html 


From The Wall Street Journal Accounting Educators' Reviews on May 16, 2002

TITLE: Trade Disclosures Shake Faith in Damaged Energy Market 
REPORTER: Mitchell Benson, Chip Cummins and Jathon Sapsford 
DATE: May 13, 2002 
PAGE: A1 
LINK: http://online.wsj.com/article/0,,SB1021057944808091680.djm,00.html  
TOPICS: Accounting, Accounting Fraud, Accounting Irregularities, Creative Accounting, Disclosure, Earnings Management, Electricity Markets, Fair Value Accounting, Financial Accounting, Fraudulent Financial Reporting, Regulation

SUMMARY: Power producers are alleged to have recorded bogus energy trades in an effort to increase reported growth. Questions focus on motives for recording the bogus trades and related accounting issues.

QUESTIONS: 
1.) Describe the bogus energy trading that is occurring in the energy market. List three reasons that companies engage in these trades.

2.) How do bogus energy trades affect the financial statements? Be sure to consider both the sale of energy and the purchase of energy.

3.) When is the energy scheduled to be provided in the energy exchanges sales? When can revenues be recognized under Generally Accepted Accounting Principles? Why are the companies involved in the exchange recognizing revenue before the service is provided?

4.) What is mark-to-market accounting? If the value of energy changes, how would adjusting the value of energy contracts to market value affect the financial statements?

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

--- RELATED ARTICLE --- 
TITLE: Reliant Acknowledges Bogus Deals 
REPORTER: Mitchel Benson 
PAGE: A3 
ISSUE: May 14, 2002 
LINK: http://online.wsj.com/article/0,,SB1021303914798801040.djm,00.html 


From Double Entries on May 16, 2002

GUIDANCE ON AUDITORS' QUALITY-CONTROL SYSTEMS
The SEC Practice Section (SECPS) of the American Institute of Certified Public Accountants (AICPA) has issued a practice aid entitled Assessing the Effect on a Firm's System of Quality Control Due to a Significant Increase in New Clients and/or Experienced Personnel. The practice aid provides accounting firms that are members of the SECPS with guidance on how to assess the potential effect that increased levels of (1) new clients and/or (2) experienced hires may have on a firm's quality-control system. The practice aid responds to current conditions, specifically the significant number of auditor changes that have taken place over the past several months. Click through to http://accountingeducation.com/news/news2892.html for further details


Ultimate Insult: a 'Nay' from Andersen --- http://www.smartpros.com/x34073.xml 

May 15, 2002 (FT World Media Abstracts via Comtex) Arthur Andersen LLP recently raised doubts about some of its clients' chances of continuing as going concerns. These clients include PSC Inc., Metawave Communications Corp., Navidec Inc., Marex Inc., Razorfish Inc. and Learn2Corp


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

TITLE: Pitt Faces New Questions on CEO Meetings 
REPORTER: Michael Schroeder and James Bandler 
DATE: May 20, 2002 
PAGE: C1 
LINK: http://online.wsj.com/article/0,,SB1021754792877672440.djm,00.html  
TOPICS: Accounting, Auditing, Regulation, Securities and Exchange Commission

SUMMARY: Harvey Pitt, Chairman of the Securities and Exchange Commission (SEC), is being scrutinized for meeting with executives of companies being investigated by the SEC. Questions focus on the role of the SEC and the implications of the meetings held by Mr. Pitt.

QUESTIONS: 
1.) What is the role of the SEC in accounting standard setting and accounting regulation? Why does the SEC have this power?

2.) Why is Mr. Pitt being criticized? Do you think Mr. Pitt's behavior was inappropriate? Support your answer.

3.) Describe Mr. Pitt's professional activities before becoming Chairman of the SEC. According to government ethics rules, for how long should Mr. Pitt not participate in matters related to companies that he represented prior to his appointment at the SEC? What do you perceive as the purpose of this rule? Do you think that this rule is necessary? Do you think that this rule accomplishes its intended purpose(s)? Support your answers.

4.) Given the credibility issues facing the accounting profession, is it important the the public have confidence in the SEC? Support your answer. If the public loses confidence in the SEC, what are potential implications for accounting?

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


Perhaps I am being a bit too cynical about the message below, but here we have Senator Phil Gramm in charge of repairing the system that he, along with his wife Wendy, helped destroy. If you recall, Wendy led the charge in government to deregulate energy markets, allowing Enron to become the leading energy trader forming deals to extort the State of California, India, and others. As a reward, she received hefty grants from Enron and was on the Enron Board of Directors when the company imploded. You can read more about Wendy Gramm at http://www.trinity.edu/rjensen/fraud.htm#bribes 

Apart from all of this, the following proposal below is being actively supported by the FEI. Senator John Corzine (D-NJ) is expected to offer two corporate governance amendments that would require a financial officer to sign an annual code of ethics and to require that audit committees have at least one "financial expert." Yawn!

My question is whether "one financial expert" is sufficient on an audit committee, especially an audit committee having to deal with extremely complex transactions such as derivative financial instruments, SPEs, global financing transactions, etc? What's wrong requiring all audit committee members be accounting and finance experts with demonstrated expertise on the complex transactions of the client?

It would seem that when the smoke dies down on the Enron mess, the U.S. government (including the SEC) is going to bow to powerful corporate lobbyists and leave us with a system that is still broke in terms of clients pressuring auditors and security analysts, investment bankers pressuring brokers, and all the other rotten parts of the system. Audit committees will continue to be hoaxes whose members are hand-picked puppets of client CEOs. The Enron failed audit committee had more than one "financial expert." Purportedly, none of them understood anything about SPEs and accounting for derivative financial instruments.

My guess is the alleged major villain, Enron's CEO Andy Fastow, would have willingly signed the proposed Code of Ethics in the midst of setting up thousands of offshore SPEs to inflate profits and hide Enron debt.

Don't look for huge reforms in the U.S. How many more monumental scandals like Enron, Andersen, and Merrill Lynch will it take before significant progress is made?

It's sad that about the only thing having a significant impact on the accounting systems is the fear of civil litigation. This is heavy price to pay since most of the settlements are siphoned off by the lawyers.

The FEI message below is well intended, but it is addressed to power centers who have repeatedly demonstrated their willingness to preserve the corruption within the economy.

I close with a quote from my forthcoming June 4 edition of New Bookmarks:

"Derivatives cannot hedge derivatives for accounting purposes -- now or under FASB 133," Bass said. "Does Dave [Duncan] think his accounting works even under FASB 133? No way." Carl Bass, Andersen Auditor in 1999 who asked to be removed from Enron's audit review responsibilities ---  http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm#Bass    
What good is an expert like Carl Bass is the system is designed to ignore his expertise?

For other quotations that will make you sick, go to http://www.trinity.edu/rjensen/fraud060402.htm 

Robert (Bob) Jensen Jesse H. Jones Distinguished Professor of Business Trinity University San Antonio, TX 78212-7200 Email: rjensen@trinity.edu Homepage: http://www.trinity.edu/rjensen

-----Original Message----- 
From: Hinchman, Grace [mailto:GHinchman@FEIDC.org]  
Sent: None 
To: rjensen@trinity.edu  
Subject: Enron-Reform Legislation Mark-up

Dear FEI Member:

You are receiving this message because you are represented in the Senate by Senator Phil Gramm, who is a member of the Senate Banking Committee. When Congress returns from the Memorial Day recess on June 3rd, the Banking Committee will begin to mark-up its Enron-reform legislation. At that mark-up, Senator John Corzine (D-NJ) is expected to offer two corporate governance amendments that would require a financial officer to sign an annual code of ethics and to require that audit committees have at least one "financial expert."

FEI supports the Corzine corporate governance amendments and it is important that Senator Gramm also supports these amendments during committee mark-up.

That is why I strongly urge you to fax the following to Senator Gramm at (202) 228-2856. Additionally, if you have a personal relationship with the Senator, we urge you to call him and request that he support the amendments in question.

Finally, if you choose to contact the Senator, please let me know by faxing a copy of your letter to me at (202) 626-6555. Thank you for your help!

Grace L. Hinchman Senior Vice President Public Affairs
May 29, 2002

The Honorable Senator Phil Gramm 370 Russell Senate Office Building Washington, DC 20510

Dear Senator Gramm:

As a member of Financial Executives International and an employee of [XXXXXXXXXX] company in [City] Texas, I urge you to support the two corporate governance amendments that will be offered by Senator Corzine at the upcoming Banking Committee mark-up that would require a financial officer to sign an annual code of ethics and to require that audit committees have at least one "financial expert."

[Please provide information about your company, i.e. number of employees and nature of business.]

Financial Executives International, the leading advocate for the views of corporate financial management, is a professional association of 15,000 CFOs, treasurers and controllers. FEI enhances member professional development through peer networking, career management services, conferences, publications, and special reports and research. More information can be found on the web site at www.fei.org.

First, I strongly urge you to support Senator Corzine's amendment that would require the SEC to make all senior financial officers, accounting officers, controllers, treasurers and chief investor relations officers annually sign a strict code of ethics and that they deliver it to their board or the board's designated committee. For many years, members of FEI have signed such a code, thus committing to its principles. Regardless of whether they are members of FEI, all finance professionals should adhere to a code of ethical conduct containing all the elements of the FEI Code of Ethics. The Code states, for example, that financial arrangements involving actual or apparent conflicts of interest should be avoided. Further, we expect that best practice in this area will be that all finance, accounting, tax and investor relations personnel annually sign such a code. I urge you to use the power of your committee to adopt this important code of ethics requirement.

Second, in 1999, the Blue Ribbon Panel on Audit Committee Effectiveness called for all audit committee members to be financially literate and for each committee to have at least one financial expert. I strongly support Senator Corzine's corporate governance amendment dealing with audit committee financial experts. Financial experts should at a minimum possess an understanding of Generally Accepted Accounting Principles (GAAP) and audits of financial statements prepared under those principles; experience in the preparation and/or the auditing of financial statements of a company of similar size, scope and complexity as the company on whose board the committee member serves; and experience in the internal governance and procedure of audit committees.

As you and your colleagues debate changes to financial reporting and corporate governance rules, I sincerely hope that you will take my thoughts into consideration and adopt the Corzine amendments.

Sincerely,


May 29, 2002 Reply from William Mister

Bob, well said. I only disagree with your statement that the FEI is "well intended."

Note, Wendy Gramm was also on the Enron Audit Committee.

It appears we will either end up with no bills out of Congress -- they will die in Conference, or worse the Corzine or Oxley Bill will get passed. Both are steps backwards.

It appears all that campaign contribution money was well spent.

William G. (Bill) Mister 
Colorado State University 
970-491-6256 Office direct 
970-491-5102 Accounting Department 
970-491-2676 Fax 

William.Mister@colostate.edu
 


May 29 reply from Kobelsky, Kevin [kobelsky@MARSHALL.USC.EDU

Bob, 
You wrote: 
*****************************************************
"My question is whether "one financial expert" is sufficient on an audit committee, especially an audit committee having to deal with extremely complex transactions such as derivative financial instruments, SPEs, global financing transactions, etc? What's wrong requiring all audit committee members be accounting and finance experts with demonstrated expertise on the complex transactions of the client?
*****************************************************

In short, it's inadequate, but not for reasons that we usually recognize.

The deeper question you are addressing is what organizational mechanisms can be put in place to control devilishly (pun intended) complex settings and their related accounting treatments. I am presenting on this very topic this afternoon to the executive of the SEC/Financial Reporting Institute here at USC. Here are a few thoughts I'll be sharing with them:

Our existing governance structures are not geared towards addressing truly complex issues, but rather assumes that a 'correct' accounting treatment can be unambiguously determined prior to issuance of the statements. In the US, this means being conversant with hundreds of FASB pronouncements and other documents (e.g. EITF) (many of which contain errors as your web site has ably demonstrated) and being able to anticipate all the possible outcomes that might arise from new instruments developed by 'rocket scientist' financial engineers. Right. The underlying assumption of this approach is that if we just had enough standards, THEN we would have a definitive set of GAAP.

I submit that this approach is fundamentally flawed and has significant consequences for the role of the audit committee.

First, on many 'old' issues (e.g. consolidation, stock options) many argue that existing reporting is incomplete or misleading, thus establishing pronouncements doesn't in itself reduce risk (e.g. many of Enron's Raptor transactions WERE in compliance with the 3% rule). Second, financial engineers will continue to devise countless new financial and organizational arrangements, the implications of which are unclear. FASB and the EITF will always be several standards behind. As Enron demonstrates, the number of people who have expertise in these areas is severely limited. Why was it that Carl Bass stood alone? Certainly in part because he was 'the' expert in the area. Even in Andersen, one of the top 5 accounting organizations in the world at the time, the number of such specialists was extremely limited. By definition, this will always be the case for 'bleeding edge' issues.

Current conceptions of management and audit committee responsibilities call for the audit committee to ask the auditors if management's representations are in accordance with GAAP. This assumes we live in a simple world where GAAP is unambiguous. In more modern settings, especially on leading edge issues the client has substantial leeway, and the auditor has little room to substantively disagree. Some committees ask if the auditor would do anything differently if they were doing the accounting and think the response is meaningful. Hardly. What does it mean for the auditor to say "We accept the treatment, but we don't like it"? Such an expression of misgivings is schizophrenic and could come back to haunt the auditor later in court and sooner with management.

We need to move to a system of governance which explicitly recognizes that GAAP is provisional and especially with respect to risk, can't be given yes/no answers, a point that Joseph Berardino made in his Feb. 5 testimony to the House of Representatives.

No member of an Audit Committee (except perhaps yourself, ;-)) could reasonably claim to be an expert on all the accounting treatments a firm might encounter, so a static expertise-based requirement is impractical.

I suggest a process-based approach. Audit committees must work with management and auditors to identify the most complex business transactions and accounting treatments and then gain expertise on these transactions (i.e. discuss their assumptions and alternative treatments). Committee members should be encouraged to get independent advice on these transactions, their accounting treatment and the risks involved.

Once the audit committee becomes aware of the risks involved with transactions and accounting, they must ensure these are adequately communicated to investors. Certainly if transactions are confusing to informed insiders like the Audit Committee, they will be even more so to external investors. In this regards, disclosure requirements geared towards the 'man in the street' are appropriate. Note that the income effects of Enron's transactions WERE disclosed, though not in a way anyone but one of a handful of experts could understand.

Until we explicitly recognize that there will *always* be transactions that outstrip FASB and a typical Audit Committee, we're doomed to repeat these disasters. Thus, the rapid rise in complexity over the last 30 years is a development the profession hasn't yet addressed. Attributing repeated failures to exclusively to vested interests is natural but, I think, premature. Vested interests always exist, but their power varies with the processes they interact with.

Best regards,

Kevin

Kevin Kobelsky PhD CA
CISA Assistant Professor Leventhal School of Accounting, 
Marshall School of Business 
University of Southern California 
Accounting Building 125 Los Angeles, CA 90089-0441 
Voice: (213) 740-0657 Fax: (213) 747-2815


May 30 Reply from Bob Jensen

Hi Kevin,

Thank you for your long and informative reply.

I hope that you don't mind that I added your reply to

You wrote the following: 
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Vested interests always exist, but their power varies with the processes they interact with. 
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I have become very cynical about the U.S. Congress and Senate and legislatures in the state capitols around the nation. It seems to me that our lawmakers wring their hands with hidden glee under the table when there are disasters like Enron and Merrill Lynch. Among legislators, disaster is viewed as opportunity.

They hold Congressional and Senate hearings that become top news stories. But what they are really intending is to shake the money trees that bear more fruit in times of disaster. Our most powerful lawmakers are resounding brass, blowing their horns, pounding their fists, and making fire dances around the money trees, but the intent is never really to badly hurt the vested interests. Legislators merely want to pick more fruit from these shaking trees.

Unfortunately, the "vested interests" have to pay dearly because they "interact with" really powerful Congressional and Senate Committees that could unleash fury if the money trees do not bear enough fruit.

Bob Jensen


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

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

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

Bob Jensen's threads on the state of accountancy can be found at http://www.trinity.edu/rjensen/FraudConclusion.htm




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

 

In March 2000, Forbes named AccountantsWorld.com as the Best Website on the Web --- http://accountantsworld.com/.
Some top accountancy links --- http://accountantsworld.com/category.asp?id=Accounting

 

For accounting news, I prefer AccountingWeb at http://www.accountingweb.com/ 

 

Another leading accounting site is AccountingEducation.com at http://www.accountingeducation.com/ 

 

Paul Pacter maintains the best international accounting standards and news Website at http://www.iasplus.com/

How stuff works --- http://www.howstuffworks.com/ 

 

Bob Jensen's video helpers for MS Excel, MS Access, and other helper videos are at http://www.cs.trinity.edu/~rjensen/video/ 
Accompanying documentation can be found at http://www.trinity.edu/rjensen/default1.htm and http://www.trinity.edu/rjensen/HelpersVideos.htm 

 

Professor Robert E. Jensen (Bob) http://www.trinity.edu/rjensen
Jesse H. Jones Distinguished Professor of Business Administration
Trinity University, San Antonio, TX 78212-7200
Voice: 210-999-7347 Fax: 210-999-8134  Email:  rjensen@trinity.edu