Accounting Scandal Updates on July 10, 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 

      My larger point is that we cannot count on changes in corporate governance to substitute for needed reforms of the accounting and auditing disciplines. After all, boards of directors are, and should be, collegial bodies typically closely attuned to, and sympathetic with, the chief executive officer. They are necessarily heavily dependent on management for information. Their independence and experience is invaluable, particularly on strategic issues and organizational questions. But their attitudes and aptitudes are not those of skeptical auditor, acting at arm’s length in the interest of the investment community. 
     We have today an all too rare opportunity for significant and lasting reforms. The stage is set for an international effort to bring accounting standards up to date. The need for internal change in accounting firms to focus on their auditing responsibilities is better recognized. A legislative process is well underway. 
     The market itself, visible in its own erratic performance, is calling for action.
Paul Volcker (See Below)

"FINALLY, A TIME FOR AUDITING REFORM" 
REMARKS BY PAUL A. VOLCKER  
AT THE CONFERENCE ON CREDIBLE FINANCIAL DISCLOSURES 
KELLOGG SCHOOL OF MANAGEMENT 
NORTHWESTERN UNIVERSITY 
EVANSTON, ILLINOIS 
JUNE 25, 2002
http://www.fei.org/download/Volker_Kellogg_Speech_6-25-02.pdf 

How ironic that we are meeting near Arthur Andersen Hall with the leadership of the Leonard Spacek Professor of Accounting. From all I have learned, the Andersen firm in general, and Leonard Spacek in particular, once represented the best in auditing. Literally emerging from the Northwestern faculty, Arthur Andersen represented rigor and discipline, focused on the central mission of attesting to the fairness and accuracy of the financial reports of its clients. 

The sad demise of that once great firm is, I think we must now all realize, not an idiosyncratic, one-off, event. The Enron affair is plainly symptomatic of a larger, systemic problem. The state of the accounting and auditing systems which we have so confidently set out as a standard for all the world is, in fact, deeply troubled.

The concerns extend far beyond the profession of auditing itself. There are important questions of corporate governance, which you will address in this conference, but which I can touch upon only tangentially in my comments. More fundamentally, I think we are seeing the bitter fruit of broader erosion of standards of business and market conduct related to the financial boom and bubble of the 1990’s. 

From one angle, we in the United States have been in a remarkable era of creative destruction, in one sense rough and tumble capitalism at its best bringing about productivity-transforming innovation in electronic technology and molecular biology. Optimistic visions of a new economic era set the stage for an explosion in financial values. The creation of paper wealth exceeded, so far as I can determine, anything before in human history in relative and absolute terms. 

Encouraged by ever imaginative investment bankers yearning for extraordinary fees, companies were bought and sold with great abandon at values largely accounted for as “intangible” or “good will”. Some of the best mathematical minds of the new generation turned to the sophisticated new profession of financial engineering, designing ever more complicated financial instruments. The rationale was risk management and exploiting market imperfections. But more and more it has become a game of circumventing accounting conventions and IRS regulations. 

Inadvertently or not, the result has been to load balance sheets and income statements with hard to understand and analyze numbers, or worse yet, to take risks off the balance sheet entirely. In the process, too often the rising stock market valuations were interpreted as evidence of special wisdom or competence, justifying executive compensation packages way beyond any earlier norms and relationships. 

It was an environment in which incentives for business management to keep reported revenues and earnings growing to meet expectations were amplified. What is now clear, is that insidiously, almost subconsciously, too many companies yielded to the temptation to stretch accounting rules to achieve that result.

I state all that to emphasize the pressures placed on the auditors in their basic function of attesting to financial statements. Moreover, accounting firms themselves were caught up in the environment – - to generate revenues, to participate in the new economy, to stretch their range of services. More and more they saw their future in consulting, where, in the spirit of the time, they felt their partners could “better leverage” their talent and raise their income. 

I have a mental image of the role of an auditor. He’s a kind of umpire or referee, mandated to keep financial reporting within the established rules. Like all umpires, it’s not a popular or particularly well paid role relative to the stars of the game. The natural constituency, the investing public, like the fans at a ball park, is not consistently supportive when their individual interests are at stake. Matters of judgment are involved, and perfection in every decision can’t be expected. But when the “players”, with teams of lawyers and investment bankers, are in alliance to keep reported profits, and not so incidentally the value of fees and stock options on track, the pressures multiply. And if the auditing firm, the umpire, is itself conflicted, judgments almost inevitably

Continued at http://www.fei.org/download/Volker_Kellogg_Speech_6-25-02.pdf  

"Accounting Abuses and Proposed Countermeasures" Scott Sprinzen, New York (1) 212-438-7812, Standard & Poor's, July 2, 2002 --- http://www.standardandpoors.com/ 

The epidemic of accounting abuses by U.S. corporations has severely undermined analysts' and investors' confidence in the veracity of financial reports. Numerous companies have been found to have significantly overstated their revenues, earnings, cash flow, or assets, or to have understated their liabilities. Lax corporate boards and outside auditors have evidently helped give rise to this phenomenon. Certain out-of-date accounting standards, gaps in the standards, or even the complexity of standards have also played a role, as has the intense pressure on managements to "make the numbers" and meet Wall Street's growth and earnings expectations.

Responding to the current crisis, the U.S. Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) are now pursuing various initiatives to restore confidence in financial reporting and disclosure. Standard & Poor's expects that much of the resulting information will benefit its analytic process and surveillance. The current initiatives, however, are likely to provide only a partial solution, and heightened attention to accounting-related matters--and skepticism by analysts--will continue to be appropriate.

Accounting Abuses The greatest concentration of abuses has been in revenue reporting. Such improprieties have accounted for the dominant share of the restatements mandated by the SEC in the past few years. Notable recent examples include the following: Some energy marketers have admitted to engaging in phantom, or "round trip," trades in electricity contracts. These are essentially back-to-back swaps with no business purpose except to artificially bolster apparent trading volume and revenue. Similarly, in the telecom sector, Global Crossing Ltd. and Qwest Communications International Inc. are reportedly being investigated by the SEC for back-to-back swaps of fiber-optic capacity. In the pharmaceuticals sector, Allergan Inc. and Elan Corp. PLC have entered into transactions in which they formed joint ventures (JV) with third parties, made cash investments into the JV entity, but then got back some or all of the cash in the form of fees for performing R&D, these fees having been reported as revenue. Manufacturers of telecom equipment such as Lucent Technologies Inc. have made highly aggressive use of vendor financing in which, on sales to financially shaky buyers, profits are reported up front, with the financing being provided by the seller. Lucent's vendor notes receivables reached $8.4 billion at year-end 1999. Among its biggest vendor-financing deals was a $2 billion, five-year pact signed in 1998 with Winstar Communications Inc.: Winstar filed for bankruptcy in 2001. Also, companies have increasingly made use of large, one-time, "big bath" restructuring charges or have regularly booked smaller restructuring charges--hoping these would be disregarded by analysts and investors--to accelerate the recognition of operating expenses with the objective of bolstering subsequent reported earnings. Among the many companies that Forbes magazine has termed "serial chargers" are Allied Waste Industries Inc., Cisco Systems Inc., Compaq Computer Corp., E.I. DuPont de Nemours & Co., Fortune Brands Inc., Tenet Healthcare Corp., and Waste Management Inc.

Moreover, notwithstanding the generally poor pension investment portfolio returns of the past two years, most companies have clung to seemingly aggressive long-range–return assumptions (i.e., 9.5% to 10.0% per year), enabling some of them to continue reporting material non-cash pension credits. For certain companies, including Ethyl Corp., United States Steel Corp., Weirton Steel Corp., Verizon Communications Inc., GenCorp Inc., Northrop Grumman Corp., and Allegheny Technologies Inc., pension credits represent a substantial portion of their total reported earnings.

Although the statement of cash flows is much less susceptible to accounting manipulations than the income statement, recent developments have shown that it is far from sacrosanct. Thus, WorldCom Inc. has just admitted that it improperly reported $3.8 billion of expenses as capital expenditures within the past five quarters, thereby bolstering reported net cash flow from operating activities.

Along with the trend of overstating their financial performance, some companies have seemingly put renewed emphasis on innovative means of concealing debt:

Companies--including Enron Corp.--have employed share trusts in which assets are "sold" to off–balance-sheet, special-purpose entities (SPEs), but in which the transaction's funding is supported by the seller in some manner such that the seller effectively retains the economic risks associated with the assets. Companies reportedly have entered into prepaid transactions under which they receive payment up front from a financial counterparty for future delivery of some commodity and reporting the transaction as deferred revenue rather than debt, even though interest expense is imputed in the terms of the transaction. There is no intent to make physical deliveries to satisfy the commitment; rather, the goods are ultimately sold back to the seller. Companies have entered into synthetic leases, which are structured to qualify as operating leases for financial reporting purposes, and finance leases for taxation purposes. Analytically, they are viewed by Standard & Poor's as a debt equivalent, just as are conventional operating leases. The insidious aspect is that they are not just off–balance-sheet, but are largely "off-footnote": Because the initial term of the lease is kept artificially short (for tax purposes), and in some cases the lease is nominally cancelable, the disclosed minimum future lease commitments understate the extent of the true economic liability. Finally, companies have entered into borrowing, derivatives, and operating agreements that include credit triggers--such as rating triggers, financial covenants, or material-adverse-change clauses--which can greatly magnify the consequences of erosion in credit quality, but which have often been poorly disclosed (see "Identifying Ratings Triggers and Other Contingent Calls on Liquidity, Part 2," published on May 15, 2002). Countermeasures by the Rule Setters In recent months, the SEC has greatly increased the number of investigations (formal and informal) it is pursuing regarding accounting-related matters. This has led to a large number of restatements by companies and, in several high-profile cases, the levying of fines. The SEC has taken some steps that could lead to enhanced disclosures. Of these, Standard & Poor's views the following SEC proposals as particularly promising from an analytic perspective:

A rule that would require companies to make disclosures about critical accounting policies and the effect on reported financial performance if the company were to assume that certain key estimates were changed; Accelerated and more comprehensive disclosure of insider company equity transactions, plus "loans of money to a director or executive officer made or guaranteed by the company or an affiliate of the company." Presumably, such a requirement would have revealed the abuses at Adelphia Communications Corp., where the founder and controlling owner, and members of his family, borrowed under a credit facility shared with--and guaranteed by--the company, using the proceeds in part to acquire shares of the company; Companies accelerate filing their quarterly and annual reports: 10K's would have to be filed within 60 days of the end of the fiscal year, rather than the current 90 days, and 10Q's would have to be filed within 30 days of the end of the quarter, rather than the current 45 days. The only downside could be the increased potential for errors as companies rush to meet the tighter deadlines; and Expansion of the list of events that require a company to file an 8K, and an acceleration of the deadline--to two business days from five to 15 days--for filing such a report. Separately, the SEC has offered as guidance, in "Management's Discussion and Analysis of Financial Condition and Results of Operation" section of the financial statement, that companies consider including:

Provisions in financial guarantees or commitments, debt or lease agreements, or other arrangements that could trigger a requirement for an early payment, additional collateral support, changes in terms, acceleration of maturity, or the creation of or an additional financial obligation. Such provisions could include adverse changes in the registrant's credit rating, financial ratios, earnings, cash flows, or stock price, or changes in the value of underlying, linked, or indexed assets; Circumstances that could affect the registrant's ability to continue to engage in transactions that have been integral to historical operations or are financially or operationally essential, or that could render that activity commercially impracticable, such as the inability to maintain a specified investment-grade credit rating, level of earnings or earnings per share, financial ratios, or collateral. The SEC also stated that companies should consider the need to "provide disclosures concerning transactions, arrangements, and other relationships with unconsolidated, structured-finance or special-purpose entities or with other persons that are reasonably likely to materially affect liquidity or the availability requirements for capital resources."

Such disclosure could significantly enhance Standard & Poor's ability to maintain surveillance of credit triggers, but the SEC has instructed companies to consider disclosing only circumstances "that could materially affect liquidity if such circumstances are reasonably likely to occur." This, of course, is subject to interpretation.

The FASB, too, has launched a number of initiatives to address shortcomings in financial reporting. Broadly, these initiatives are also welcomed by Standard & Poor's. Most notably, the FASB is developing an "Exposure Draft" that would provide rules for determining when an entity (termed the "primary beneficiary") should consolidate an SPE that functions to support the activities of the primary beneficiary. With this initiative, the FASB's aim is to require the consolidation of SPEs that "lack sufficient independent economic substance." The FASB is clearly targeting the type of abusive schemes employed by Enron.

Nevertheless, preliminary indications are that the FASB is seeking to require consolidation of a number of types of "plain vanilla" securitizations, including collateralized debt obligations and multiseller commercial-paper conduits. On one hand, this could be seen as a non-event from a ratings perspective: Analytically, most securitized assets and related debt are added back to the balance sheet anyway because the corporate sponsor typically remains in a first-loss position and given the concerns regarding moral recourse, i.e., the reality that companies feel they must bail out a troubled securitization although there is no legal requirement for them to do so. (See "Substance, Not Form, of Securitizations Drives Standard & Poor's Leverage Analysis," published on April 18, 2002.)

On the other hand, Standard & Poor's would need to be alert to the potential practical ramifications of such accounting changes. For example, some companies might be in violation of financial covenants upon the consolidation of securitizations. Moreover, there is the risk of a chill being sent through segments of the asset-backed securities market on which certain companies are highly dependent.

In addition, the FASB has issued an exposure draft of a proposed interpretation of guarantees ("Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," May 2002). This exposure draft essentially reiterates existing rules, compliance with which has been lax, requiring the guarantor to make the following disclosures, "...even if it is probable that the guarantor will not need to make any payments under the guarantee":

The nature of the guarantee, including how the guarantee arose and the events or circumstances that would, under the guarantee, require the guarantor to perform; The maximum potential amount of loss under the guarantee; and The nature of any recourse provisions or collateral that would enable the guarantor to recover amounts paid under the guarantee. The FASB is also undertaking an ambitious project that would consist of a comprehensive review of standards governing revenue recognition. Given its sweeping nature, such a project could take several years to complete.

Standard & Poor's Responds In the wake of recent developments, Standard & Poor's, in its credit review process, is placing significantly heightened emphasis on the assessment of accounting quality and information risk. Standard & Poor's also plans to incorporate expanded commentary on accounting-related factors into its industry- and company-specific research reports. In addition, Standard & Poor's intends to take a more active role in commenting on proposed changes in accounting standards and financial disclosure regulations. Last month, Standard & Poor's called for more discipline and standardization in the reporting of core earnings (see "Standard & Poor's to Change System for Evaluating Corporate Earnings," published on May 14, 2002, and "Core Earnings and Ratings Analysis," published on June 4, 2002).

Moreover, to be fully responsive to market needs, Standard & Poor's intends to hold regular discussions with key constituents to consider ways in which its debt-rating policies and research could enhance investor recognition and understanding of accounting quality. To this end, Standard & Poor's sponsored an accounting forum on June 17 and plans to sponsor other such programs

How did accountants miss such massive financial time bombs as Xerox, WorldCom and Enron? A new study by two accounting professors says the answer could be that they were looking in the wrong place for catching executive fraud.

""Auditors' Methods Make It Hard To Uncover Fraud by Executives," by Ken Brown, The Wall Street Journal, July 8, 2002, Page C1 --- http://online.wsj.com/article/0,,SB1026077052109691000,00.html?mod=todays%5Fus%5Fmoneyfront%5Fhs 

Nearly $2 billion in revenue disappears at Xerox Corp. More than $3.8 billion in expenses are wiped out at WorldCom Inc. And $1.2 billion in shareholder equity is vaporized at Enron Corp. A reasonable person might ask how the accountants missed such massive financial time bombs.

The answer could be that they were looking in the wrong place

A new study by two accounting professors questions the methods used by the major auditing firms to study the books of their clients. The professors say those methods make it almost impossible for auditors to catch a client's highest-level executives cooking the books, even as most major accounting blowups, including those at Xerox, WorldCom and Enron, involve a company's top brass.

The study, by Steve Sutton of the University of Connecticut in Storrs, Conn., and Charles Cullinan of Bryant College in Smithfield, R.I., argues that over the past two decades auditors have gradually focused more on how companies generate their financial data -- the computerized bookkeeping programs and internal controls that are supposed to act as a check on the system -- than on the numbers themselves. That is in contrast to the older style of auditing, under which accountants dug deeply into corporate accounts, looking at thousands of transactions to determine if the bookkeeping was correct.

The flaw in this changed approach: While the computer programs and internal controls that the auditors now rely on do a great job preventing low-level employees from swiping the petty cash, they can be circumvented by top executives, the folks who shift millions or billions rather than thousands of dollars.

Relying on the controls rather than looking at the specific accounts "does reduce your likelihood of detecting fraud, which we already weren't very good at," says Mr. Sutton, who believes auditors should be doing more work on the nitty-gritty of a company's operations. "I think we may have swung too far and we have to go back and look more at the transactions and the balances," he says. "And, I think, post-Enron, people are doing this somewhat anyhow." But doing a more thorough job of examining companies' books means that accounting firms will have to charge more for their audits, he maintains.

The shift in the way accountants audit their clients' books can be traced to two developments dating from the early 1980s. First, companies increasingly turned to computers to manage their finances. Second, intense competition caused the fees for auditing to fall as much as 50% from the mid-'80s to the mid-'90s. That forced auditors to cut costs themselves, and they did it by cutting back on the labor-intensive process of sifting through dozens, or even hundreds, of corporate accounts. "The way they've looked to become more efficient is to put more reliance on internal controls, which allow you to do less work on account balances and transactions," Mr. Sutton says.

The paper, "Defrauding the Public Interest: A Critical Examination of Reengineered Audit Processes and the Likelihood of Detecting Fraud," was published in the most recent issue of Critical Perspectives on Accounting, an academic journal that tends to find shortcomings of the major accounting firms. The professors' work is based on an analysis of enforcement actions by the Securities and Exchange Commission between 1987 and 1999. The data show that, of the 276 frauds that took place during that time, the company's chief executive was involved about 70% of the time. Interestingly, the researchers also found that the incidence of fraud in the last two years of the study period increased to 36.5 frauds per year from about 20 annually in the study's first 10 years. In those last two years, senior executives other than the CEO were involved in 19% of the frauds.

Robert Bricker, an accounting professor at Case Western Reserve University in Cleveland, who had no involvement with the paper, agrees that auditors' reliance on internal controls is a weakness in the system. "If internal controls exist, they can be circumvented" by top executives seeking to manipulate the books, he says.

And increasing the level of internal controls in an effort to catch such executives is unlikely to work, the paper's authors say. First, it gets increasingly expensive to boost controls as you move up the executive ranks. And no matter how many locks you put on the door, someone has got to have the keys, and that person is likely to be the chief executive or chief financial officer.

In the WorldCom case, auditor Arthur Andersen LLP missed the telecommunications company's plot to boost earnings by improperly treating $3.8 billion in operating expenses as capital expenditures, which would be depreciated over time rather than immediately expensed. By looking at the individual transactions, some auditors say, Andersen might have spotted the ruse. WorldCom fired its chief financial officer after an internal auditor discovered the errors.

The issue of how audits are done has been a source of concern at the SEC for some time. In a 1998 letter to the American Institute of Certified Public Accountants, a big trade association for the accounting industry, former SEC Chief Accountant Lynn Turner said, "The recent combination of changes in the audit process and high-profile financial frauds have raised questions about the efficacy of the audit process."

Continued at  http://online.wsj.com/article/0,,SB1026077052109691000,00.html?mod=todays%5Fus%5Fmoneyfront%5Fhs 

Building Public Trust: The Future of Corporate Reporting, by Samuel A. DiPiazza and Robert G. Eccles 
Format: Hardcover, 1st ed., 192pp.
ISBN: 0471261513
Publisher: Wiley, John & Sons, Incorporated
Pub. Date: June  2002
http://search.barnesandnoble.com/booksearch/isbnInquiry.asp?userid=16UOF6F2PF&isbn=0471261513  

From the Publisher 
There is a crisis in corporate reporting: the Enron bankruptcy; the shattering of a prestigious global accounting firm; criminal and civil litigation against management, financial institutions, and law firms; stock market volatility caused by repeated restatements and uneasy investors–add to this angry U.S. congressional hearings, pressure on and by the Securities and Exchange Commission, and talk of new rules and new regulatory bodies. The impact is global. There are no walls or oceans around this crisis: it affects the entire world’s capital markets, investors, and economies.

Why has this happened? What must we do? What insights and innovations will prevent future financial disasters? The worlds of finance and investment need answers. The investing public demands them.

In this important new book, written as these events have unfolded, the CEO of PricewaterhouseCoopers and a former Harvard Business School professor put before us their recommendations for addressing the crisis. Take the journey with them, from pioneering concepts to pioneering technology. Their views build on a decade of research, analysis, and dialogue with business leaders assembled by a team of the profession’s finest thinkers.

The time is ripe for change. What is needed is an entirely new level of clarity and relevance. To this end, DiPiazza and Eccles propose a Three-Tier model of corporate transparency that draws from the best thinking and practices worldwide. And there is a technology enabler that can help us get there: the authors show that this twenty-first-century style of reporting is a perfect fit for new Internet/XBRL technology.

This is the book we were waiting for. The blueprint for the future of corporate reporting is in these pages. Committed to quality, clarity, and relevance in corporate reporting, now and in the future, PricewaterhouseCoopers shares its thinking in a time of crisis and renewal.

Building Public Trust: The Future of Corporate Reporting continues and deepens thinking first presented in another book from PricewaterhouseCoopers and John Wiley & Sons: The ValueReporting Revolution: Moving Beyond the Earnings Game, by Robert G. Eccles, Robert H. Herz, E. Mary Keegan, and David M. H. Phillips.

About the Authors: Samuel A. DiPiazza Jr. is the CEO of PricewaterhouseCoopers, the global professional services firm with some 150,000 employees, operating in virtually every country worldwide. Mr. DiPiazza has enjoyed a long career with PricewaterhouseCoopers, which he joined in 1973. He most recently served as Senior Partner and Chairman of the U.S. firm with executive responsibility for U.S. operations.

Robert G. Eccles is founder and president of Advisory Capital Partners, Inc. (ACP), and a Senior Fellow of PricewaterhouseCoopers. Since 1993, ACP has provided strategic, financial, and organizational advisory services to both large companies and fast-growing small and medium-sized ones. Prior to founding ACP, Dr. Eccles was a full professor at Harvard Business School, where he was a faculty member for fourteen years, receiving tenure in 1989.

The Wall Street Journal on June 28, 2002

A new Xerox audit found that the company improperly accelerated far more revenue during the past five years than the SEC estimated in an April settlement, according to people familiar with the matter. The total amount of improperly recorded revenue from 1997 through 2001 could be more than $6 billion... In an indication of how seriously the SEC views the Xerox case, the agency earlier this year notified a number of former executives of Xerox and KPMG that it was considering filing civil charges against them in connection with the accounting abuses. Among those receiving the so-called Wells notices -- which give potential defendants an opportunity to make a case against being charged -- were former Xerox Chairman Paul A. Allaire, Former Chief Executive G. Richard Thoman and former Chief Financial Officer Barry Romeril. Two senior KPMG partners who had been in charge of the Xerox account, Michael Conway and Ronald Safran, also received the noti

From The Wall Street Journal Accounting Educators' Reviews on June 20, 2002

TITLE: And, Now the Question is: Where's the Next Enron? 
REPORTER: Cassell Bryan-Low and Ken Brown 
DATE: Jun 18, 2002 PAGE: C1 LINK: http://online.wsj.com/article/0,,SB1024356537931110920.djm,00.html  
TOPICS: off balance sheet financing, Related-party transactions, loan guarantees, Accounting, Fair Value Accounting, Financial Accounting Standards Board, Regulation, Securities and Exchange Commission

SUMMARY: In the wake of the Enron accounting debacle, investors are concerned that another Enron-like situation could occur. The article describes steps taken to improve the quality of financial reporting.

QUESTIONS: 

1.) Why is it important that investors and other financial statement users have confidence in financial reporting?

2.) What is a related-party transaction? What accounting issues are associated with related-party transactions? What changes in disclosing and accounting for related party transactions are proposed? Discuss the strengths and weaknesses of the proposed changes.

3.) What is off-balance sheet financing? How was Enron able to avoid reporting liabilities on its balance sheet? What changes concerning special-purpose entities are proposed? Will the proposed changes prevent future Enron-like situations? Support your answer.

4.) When are companies required to report loan guarantees as liabilities? What changes are proposed? Do you agree with the proposed changes? Support your answer.

5.) What is mark to market accounting? How did mark to market accounting contribute to the Enron debacle? Discuss the advantages and disadvantages of proposed changes related to mark to market accounting.

6.) What are pro forma earnings? How can pro forma earnings be used to mislead investors? What changes in the presentation of pro forma earnings are proposed? Will the proposed changes protect investors?

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

Controversies over revenue reporting are discussed at http://www.trinity.edu/rjensen/ecommerce/eitf01.htm 

Controversies concerning fair value reporting and intangibles are reviewed at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm 

From The Wall Street Journal Accounting Educators' Reviews on June 27, 2002

TITLE: Critics Take Aim at SEC's Plan for Auditor-Oversight Board 
REPORTER: Michael Schroeder 
DATE: Jun 20, 2002 
PAGE: A2 
LINK: http://online.wsj.com/article/0,,SB1024522864582377080.djm,00.html  
TOPICS: Auditing, Securities and Exchange Commission, Standard Setting

SUMMARY: The SEC and Congress have both outlined plans for a new auditing oversight Board in the wake of the Enron scandal and the plethora of earnings restatements currently undermining confidence in the U.S. financial reporting system.

QUESTIONS: 

1.) Summarize the structure of the SEC's plans to improve auditing oversight. Contrast this plan with the bill passed by the Senate Banking Committee, as described in the related article.

2.) Describe the political backing held by each of the plans discussed under question 1 above. What further steps must the Senate Banking Committee's legislation pass through in order to become law? Are you concerned about regulating the accounting profession through our political system? Support your answer.

3.) What are the main concerns held by critics of the SEC plan? What are some of the arguments in favor of the SEC plan?

4.) SEC Chairman Harvey Pitt says that the agency "plans to unilaterally set up such a board by year's end." Why do you think he said this, despite the plan's criticisms? What will happen if Congress completes legislation that specifically devises a board, such as the plan that has passed the Senate Banking Committee?

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: Democrats Attack SEC Proposal on Audit Oversight as Too Weak 
REPORTER: Michael Schroeder 
PAGE: A4 ISSUE: Jun 21, 2002 
LINK: http://online.wsj.com/article/0,,SB1024610170723082360.djm,00.html 

On July 1, 2002, the Financial Accounting Standards Board released a draft of its proposed rules for consolidation of special purpose entities (SPEs), including the types that kept debt off Enron's balance sheet. http://www.smartpros.com/x34591.xml  

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

After the Andersen verdict was announced, lawmakers and regulators redoubled their efforts to establish a rigorous oversight process for independent auditors, and other reformists joined together in a parallel track for management under the auspices of the Conference Board. http://www.accountingweb.com/item/83935

Merck recorded $12.4 billion in revenue from its Medco pharmacy-benefits unit over the past three years that the subsidiary never collected, an SEC filing says.  See Page A1 of The Wall Street Journal, July 8, 2002 --- http://online.wsj.com/article/0,,SB1026084613164978760,00.html?mod=home_whats_news_us 
The audit firm is Pricewaterhouse Coopers.

Drug giant Merck & Co. recorded $12.4 billion in revenue from the company's pharmacy-benefits unit over the past three years that the subsidiary never actually collected, according to a filing with the Securities and Exchange Commission.

Merck's Medco unit, which manages pharmacy-benefit programs for employers and health insurers, included as part of its revenue the co-payments collected by pharmacies from patients, even though Medco doesn't receive those funds. Between 1999 and 2001, co-payments represented nearly 10% of Merck's overall reported revenue.

Merck first disclosed the accounting treatment in an April SEC filing as it prepared to sell 20% of Medco in an initial public offering. But it wasn't until a subsequent SEC filing on Friday that the company said exactly how much revenue was involved.

Merck, based in Whitehouse Station, N.J., says its revenue-recognition policy conforms to generally accepted accounting principles. The company says the accounting treatment has no effect on its net income, because it subtracts the same amount as an expense. Medco is the country's second-largest pharmacy-benefits manager, with 65 million members. Medco reported revenue last year of $29.69 billion, or 59% of Merck's $50.69 billion in revenue.

"For a company such as Merck to reflect as revenues in its financial statements billions of dollars of co-payments a customer makes directly to another company, the pharmacy, which the pharmacy collects and never remits to Merck, just does not reflect the economics of what is occurring," said Lynn Turner, a former chief accountant at the SEC who is now an accounting professor and director of the Center for Quality Financial Reporting at Colorado State University in Fort Collins. "If that is what the SEC accepts, then investors are in trouble and our financial reporting indeed needs improving," he said.

Medco's accounting practice echoes a recent case involving Edison Schools Inc., a commercial operator of public schools, which was booking as revenue funds that school districts paid directly for teacher salaries and other costs. The SEC in May found that Edison "failed to disclose that a substantial portion of its reported revenues consist of payments that never reach Edison." Although Edison's accounting practice, which didn't affect net income, conformed to generally accepted accounting principles, the SEC said that "technical compliance with GAAP" doesn't insulate a company from enforcement action if it makes filings "that mischaracterize its business or omit significant information." The SEC ordered Edison to add a director of internal audit to its management team. The agency said that Edison would exclude most of those payments from its reported revenue in the future.

There isn't any indication that regulators have an issue with Medco's or Merck's accounting. The SEC hasn't asserted that inclusion of co-payments in revenues are inappropriate or not in accordance with GAAP, according to a Merck official. SEC officials couldn't be reached to comment late Sunday.

A pharmacy-benefits manager such as Medco uses the combined buying power of millions of people in its plans to extract discounts and rebates from drug makers and pharmacies. These companies then pass on some of the savings to clients -- employers and health-insurance companies -- looking to save money on prescription drug costs.

Revenue in Question

Medco's revenue in question is the co-payment -- $10 to $15 is typical in the industry -- paid by consumers with a prescription drug card to their retail pharmacy to cover their portion of the cost of a drug under an insurance plan. The pharmacy keeps the entire amount of the co-payment.

Merck contends that it has legal liabilities for the co-payment under certain circumstances, such as if it transmits electronically to the pharmacist incorrect information about how much co-payment the pharmacist should collect. But in its SEC filing, the company said it doesn't face a "credit risk," which would force it to reimburse pharmacies if a customer skipped out on making the co-payment.

The disclosure from Merck comes amid heightened scrutiny over many companies' accounting policies after several