Accounting Scandal Updates on October 14, 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 beginning to look more like reform as usual in Washington DC!
Bowing to pressure from the Big 4 CPA firms and from some large corporations, Harvey Pitt (Chairman of the Securities and Exchange Commission) bows to pressure to appoint an oversight chairman who is less likely to induce major reforms in auditing practices.

Harvey Pitt withdrew his earlier support for John H. Biggs, chairman of the teachers' pension fund TIAA-CREF, to chair the new accounting oversight board being created as a results of the Sarbanes-Oxley bill. http://www.accountingweb.com/item/92584 
Mr. Pitt was not initially aware that the big firms were so opposed to John Biggs.

From CFO.com --- http://www.cfo.com/specialreport/0,,344,00.html 


 NEW BUSINESS
A Good Year for Outsiders
Coming: Auditor Cataclysm?
Sussing Out The Second Six

PREVIOUS ACCOUNTING
Internal Auditors: More Power To 'Em
Auditing's New Rules of Engagement
The Fear of All Sums
Study: Auditors Don't Uncover Problems
There's a Monster in Finance
A CFO Blacklist?
Is Auditor Rotation Coming?
Suing Auditors after Bum Deals
Andersen, Justice: No Deal
Clients Give Auditors a Low Grade
Andersen's Woes: The Winners

Coming: Auditor Cataclysm?  
Industry watchers are predicting a massive shake-out in the accounting business over the next few years. This may not be great news for CFOs.
by Joseph Radigan, CFO.com, October 2, 2002 --- http://www.cfo.com/article/1,5309,7802||S||344,00.html 

In the wake of the year's many accounting scandals, CFOs at some publicly traded companies have been seeking auditors from outside the shrinking ranks of the top-tier accounting firms. But finance chiefs may soon find that the ranks of non-Big Four firms is thinning as well -- thanks to the very reforms that are supposed to restore confidence in the auditing profession.

Lee Graul, director of the SEC practice for BDO Seidman in Chicago, says he attended an American Institute of Certified Public Accountants (AICPA) meeting in early August where the participants concluded that their ranks would contract by as much as two thirds in the next few years. Such a consolidation would bring the number of members in the AICPA's SEC Practice Section from 1,200 to around 400.

Graul says the sentiment at the group's August meeting was that the cost of insurance and regulatory compliance will prove too great for the bulk of these audit firms. "The expectation is that the Public Company Accounting Review Board will be much more aggressive than the SEC has been in regulating auditors," Graul says. "You will see firms drummed out of the business."

Even accountancies that don't run afoul of the new oversight board (created by the Sarbanes-Oxley bill) won't want to bother with the heightened cost of compliance. Asserts Graul: "They won't want the cost of insurance."

Observers say auditing firms have yet to feel the true impact of the new wave of accounting laws and regulations. But according to Ray Ball, an accounting professor with the Graduate School of Business at the University of Chicago, complying with the new industry requirements has "raised the cost of being in business."

Ball says that auditors will "need an internal staff to ensure compliance, the cost of which will not be totally proportional to the number of clients a firm has." Small accountancies that can't distribute their fixed costs across a long list of customers will see per-client expenses go up dramatically. Big Four firms, on the other hand, should be able to parse the increased costs over their huge roster of multinational corporates.

"The smaller firms will either drop out of serving public clients or they will merge into larger companies who will incur the costs," Ball predicts.

Regional firms will likely find themselves squeezed on another front as well. The economic downturn could drive a host of smaller, entrepreneur-driven companies out of business. And those are exactly the type of clients that second-tier and regional accountancies cater to.

"Quite honestly, the degree of regulation has really caught people by surprise," notes Dana Hermanson, professor of accounting and director of research at the Corporate Governance Center for Kennesaw State University's Michael J. Coles College of Business (in Kennesaw, Georgia). "This has all been in just the last three months."

Raise High The Roof Beam, Auditor
None of this is real great news for CFOs, who work more closely with independent auditors than any other officer in the executive suite. Hermanson expects that 2003 and 2004 will be a period of tremendous turmoil as many auditors -- and clients -- grasp the impact of the new regulatory regime.

One smallish change: the cost of audits will go through the roof. "Audits may cost 40 percent more in 2002 than they did in 2001," Hermanson forecasts.

That very large spike in the cost of filing audited annual and quarterly reports may convince managers at small, privately owned companies to avoid the public markets entirely. Likewise, it might sway executives at some small-cap public companies to take their businesses private.

The dustup in the audit industry itself will be equally dramatic --particularly for smaller accounting partnerships. Says Hermanson: "You'll see some firms from the audit side that may conclude, 'Hey, we only have two audit clients. Let's get out of the business.'" Some of those firms may simply resort to providing ancillary accounting services, tax work, and compensation and benefits consulting.

In addition to a pending spike in overhead costs and shrinkage in the number of clients, some of the procedural changes under the Sarbanes-Oxley Act will also take their toll. Charles Elson, director of the Center for Corporate Governance at the University of Delaware, notes that "the rotation of partners required under Sarbanes-Oxley is going to force some consolidation."

Continued at http://www.cfo.com/article/1,5309,7802||S||344,00.html 

"Smart Stops on the Web," Journal of Accountancy, October 2002, Page 23 --- http://www.aicpa.org/pubs/jofa/oct2002/news_web.htm 

“Accountability, Integrity, Reliability” --- www.gao.gov  
The GAO home page offers the profession a lengthy list of downloadable resources including the report, “FDIC Information Security: Improvements Made But Weaknesses Remain,” and publications on accounting and financial management. Visitors to the site can access FraudNET to “facilitate reporting of allegations of fraud, waste, abuse, or mismanagement of federal funds.”

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

Linda Specht at Trinity University forwarded this ethics Website that may be of considerable interest --- http://www.ethicsweb.ca/codes/ 

Accounting for Employee Stock Options

FASB Exposure Draft on Employee Stock Options --- http://www.fei.org/download/FASB10_2.pdf 

FASB Issues Exposure Draft on Accounting for Stock Options, 
Amends Transition and Disclosure Provisions Norwalk, CT, 
October 4, 2002

The FASB has issued an Exposure Draft, Accounting for Stock-Based Compensation—Transition and Disclosure, that would amend FASB Statement No. 123, Accounting for Stock-Based Compensation. The purpose of the proposed amendment is twofold: 

•To enable companies that choose to adopt the preferable fair value based method to report the full effect of employee stock options in their financial statements immediately upon adoption. 

•To make available to investors better and more frequent disclosure about the cost of employee stock options. 

The proposed changes would provide three methods of transition for companies that voluntarily adopt the fair value method of recording expenses relating to employee stock options. In addition, the FASB proposes clearer and more prominent disclosures about the cost of stock-based employee compensation and an increase in the frequency of those disclosures to include publication in quarterly financial statements. Currently, companies are not required to present stock option disclosures in interim financial statements. 

The FASB plans to issue the amendment to Statement 123 by the end of this year and its provisions would be effective immediately upon issuance. The proposed disclosures to be provided in annual financial statements would be required for fiscal years ending after December 15, 2002. The proposed disclosures to be provided in interim financial information would be required as of the first interim period of the first fiscal year beginning after December 15, 2002, with earlier application encouraged. 

A copy of the Exposure Draft is available on the FASB’s website at www.fasb.org . The comment period concludes on November 4, 2002.

FASB News Release on October 1, 2002

NEWS RELEASE 10/01/02

FASB Issues Statement No. 147, Acquisitions of Certain Financial Institutions

Norwalk, CT, October 1, 2002—Today the FASB issued FASB Statement No. 147, Acquisitions of Certain Financial Institutions. That Statement, which provides guidance on the accounting for the acquisition of a financial institution, applies to all acquisitions except those between two or more mutual enterprises (the Board has a separate project on its agenda that will provide guidance on the accounting for transactions between mutual enterprises).

The provisions of Statement 147 reflect the following important conclusions reached by the Board:

Copies of Statement 147 may be obtained through the FASB’s Order Department by calling 800-748-0659 or by placing an order on-line.

"Banks must end research links, regulator says," by Joshua Chaffin, Financial Times, October 9 2002 --- http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1033848813904&p=1012571727088 

Complete separation of investment banking and research is necessary to stamp out conflicts of interest on Wall Street, said William Galvin, the Massachusetts Secretary of State.

"I don't think you can have a single firm that does research and investment banking," he told the Financial Times on Tuesday.

Mr Galvin has become an important voice among regulators because his state has one of the largest securities fraud divisions, and has taken a leading role with its investigation of Credit Suisse First Boston.

His comments stake out an extreme position in the debate over how to reform a securities industry where analysts have been compromised by investment banking considerations.

He and other state and federal securities regulators are currently discussing a series of reforms with Wall Street banks that could set the stage for a "global" settlement of the competing investigations.

Some banks have advocated a strengthening of the firewall separating investment bankers from analysts, while others have proposed shifting research departments into a subsidiary of the parent financial company. Both would fall short of the total separation favoured by Mr Galvin.

Mr Galvin said on Tuesday that the CSFB probe was intensifying. "It seems the further we go into this, the deeper it gets," he said.

Mr Galvin has turned up e-mail evidence suggesting the firm's research coverage was linked to investment banking fees. "It seems it was company policy to relate what was going to be said about a company [by research analysts] to investment banking," Mr Galvin said.

His investigators are planning to question Frank Quattrone, the head of CSFB's technology investment bank, which was a leading underwriter of "hot" IPOs in the late 1990s. CSFB has since changed this policy.

Massachusetts has already referred evidence to New York attorney-general Eliot Spitzer and asked him to consider criminal charges against the firm.

"Greed-mart Attention, Kmart investors. The company may be bankrupt, but its top brass have been raking it in," by Nelson D. Schwartz, Fortune, October 14, 2002, pp. 139-150 --- http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=209652 

If you didn't know any better, you'd almost feel sorry for James Adamson, CEO of beleaguered, bankrupt Kmart. Despite laying off 22,000 employees and closing hundreds of stores so far this year, the retailer continues to hemorrhage cash as sales keep plunging. Three separate government probes are looking into millions in loans and bonuses handed out by Adamson's predecessor. The investigations were spurred by an explosive series of anonymous letters from inside headquarters that tell of bogus accounting and other shenanigans just before Kmart filed for Chapter 11 in early 2002. And with the crucial holiday season fast approaching, creditors are growing frustrated, raising doubts about Adamson's future at the company, not to mention the fate of Kmart's 220,000 remaining employees.

Shuttling between meetings with employees at headquarters in Troy, Mich., and sit-downs with lawyers and creditors in New York City, Adamson has publicly struck a Trumanesque stance, taking full responsibility for the chain's fate and vowing to do whatever it takes to turn Kmart around. "If this company doesn't succeed, it's on my watch," he told a Detroit newspaper this summer. "I'll take the hit."

Actually he won't. Because despite the pitch-perfect PR, the reality is that even if Kmart goes down, Adamson will still walk away with a shopping cart full of cash. He has already received $2.5 million-the company calls it an "inducement payment"-just for coming aboard as CEO, and his annual salary totals $1.5 million. Then there are the perks guaranteed in his contract-weekly private plane service between his residences in Detroit, New York, and Florida; a car and driver in Michigan and New York; and temporary accommodations at the swanky Townsend Hotel near Kmart headquarters. A standard room there costs $320 a night.

Even if Adamson were the right person to fix the company, such perquisites might seem over the top, especially since most of Kmart's laid-off employees didn't get a dime in severance. But what's especially galling to critics is that Adamson has been a member of Kmart's board of directors since 1996--yup, the same board that okayed those tens of millions in bonuses and loans to other top executives even as Kmart slid toward the precipice. And that's not all: Adamson also headed up the board's audit committee in 2000 and 2001, which happens to be the period now being examined by the SEC and the local U.S. Attorney's office for accounting irregularities.

Meanwhile, the company has set up its own internal "stewardship review" to probe the payouts to ex-execs and alleged accounting hanky-panky. That puts Adamson in the incredibly awkward, deeply conflicted position of heading up Kmart even as his own role in its collapse is being scrutinized by underlings. The retailer had hoped to wrap up the internal investigation by Labor Day but now says its goal is to finish by year-end. Already Kmart has restated 2001's results because of an accounting error that masked $500 million in additional losses.

What's extraordinary about Kmart is not merely that its top brass rewarded themselves so lavishly while their company foundered. As anyone with even fleeting familiarity with WorldCom, Enron, and Tyco can tell you, executives at other companies have been known to do that too. Instead, the story here is that Kmart execs are still living large and getting paid handsomely, even though Kmart is deep in bankruptcy and could face liquidation. By contrast, the CEO of bankrupt US Air, David Siegel, recently took a 20% pay cut, reducing his salary to $600,000, and refused a $750,000 bonus guaranteed under his contract. "Kmart boggles the mind," says Patrick McGurn, special counsel for Institutional Shareholder Services, which advises big investors on issues like corporate governance and CEO pay. "At least Tyco still has some value for shareholders. You can't say that for Kmart. It's really a pay-for-failure situation. Since the company's in bankruptcy, the shares are likely to end up being worthless." A better way to compensate executives trying to lead their firm out of Chapter 11, experts say, is to tie their pay to how much lenders, bondholders, vendors, and other creditors actually receive when their company emerges from bankruptcy.

Continued at  http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=209652 

Bogle and Siegel (from The Wharton School) on the Stock Market and Corporate Reform --- http://knowledge.wharton.upenn.edu/whatshot.cfm 

What will it take to restore public trust in corporate America? And what kind of stock market returns can today’s depressed investors expect over the next decade? Ask John C. Bogle, retired founder of The Vanguard Group, and you get the impression it will take a lot of work to get even the most modest results.

It’s going to require major reform of executive compensation practices, corporate governance and accounting rules to get the public to trust public companies again, according to Bogle. But that doesn’t mean stocks will pick up where they left off two years ago. Stock investors will have to adjust to much lower returns than they enjoyed in the 1990s – perhaps an annual average of just 6-9%.

“There are just a few bad apples out there,” he said, referring to high-profile financial scandals. “But I believe the barrel is bad – the barrel with the apples is bad … I believe the corporate system, the financial system, generally is bad – is corrupt.”

Bogle, 72, has never been known for mincing his words.

In 1974, he founded Vanguard and served as chairman through 1997 and senior chairman through 1999, when he retired. Vanguard, the second largest mutual fund company, behind Fidelity, is best known for its extremely low management fees and index funds tied to indicators such as the Standard & Poor’s 500. Bogle’s view, which has been well supported by research over the past two decades, is that high trading costs, taxes and fees eat so deeply into the gains of actively managed funds that those funds rarely succeed in beating low-cost index funds. This view, and Bogle’s eagerness to express it to any audience, has long made Bogle the fund industry’s biggest gadfly.

Though retired from Vanguard, Bogle has hardly moved to the sidelines. In 2000 he founded the Bogle Financial Markets Research Center on Vanguard’s Valley Forge, PA campus. He has a busy speaking schedule, and is currently a member of The Conference Board’s Commission on Public Trust and Private Enterprise, formed this year to address issues arising from recent corporate scandals. Among the commission’s 12 high-profile members are Intel chairman Andrew S. Grove, former SEC chairman Arthur Levitt Jr. and former Fed chairman Paul A. Volcker.

On Sept. 17, the commission released the first of three planned reports on executive compensation, corporate governance and accounting. The first installment pinned much of the problem on the excessive use of qualified stock options, which give executives incentives to manipulate financial statements to boost stock prices. To discourage this, the commission recommended rule changes to require that options be carried as expenses. This would encourage companies to instead use performance-based options, which are already expensed.

The commission also said corporate directors’ compensation committees should hire their own executive compensation consultants rather than use consultants hired by CEOs. Finally, it said senior executives should be required to disclose in advance their plans to sell company stock; currently, those disclosures can come as long as 40 days after a sale.

“The light being shined on executive compensation – that was a good place to begin,” Bogle noted. “We want to get a much better link between how the executives do and the performance of their company, if you will, rather than the performance of the stock.”

Stock price, he said, “is not a good measure of executive performance at all,” adding that executives concerned about short-term price gains too often avoid making decisions that can improve their companies’ long-term health.

According to Bogle, treating all forms of options as expenses would encourage the use of performance based options. One type is profitable for the executive only if he meets certain revenue goals or satisfies other elements of a long-term corporate plan. Others might have strike prices well above the market price on the date the options are granted. Or the options might be exercisable only if the stock beats a market or industry average.

The reduced emphasis on dividends, Bogle pointed out, is partly attributable to the heavy use of qualified options. Dividends are of no value to an executive who holds options rather than actual shares. Consequently, it’s in his interest to see earnings reinvested in the company or used to buy back shares – techniques meant to boost share prices. A number of experts have argued recently that if companies were given incentives to distribute more of their profits as dividends, it would be more difficult to fudge financial reports. When a dividend check is sent, there must be cash on hand to back it.

Continued at  http://knowledge.wharton.upenn.edu/whatshot.cfm  

AICPA President and CEO Barry C. Melancon outlines his plans to rejuvenate the accounting culture, specifying initiatives the Institute will undertake to rebuild public trust in the financial markets and in the profession itself --- http://www.aicpa.org/pubs/jofa/oct2002/melancon.htm 

WE MUST RESTORE OUR MOST PRICELESS ASSET:
OUR REPUTATION
All of us who are privileged to be leaders of our profession have the responsibility of preserving a legacy of honor and integrity for future generations of CPAs. We owe it to all who preceded us and all who will follow us. We can afford no tolerance for those who strayed from the commitment to put the public interest first. We must do better and we will.

What is needed is not just reform of the accounting laws, it is a rejuvenated accounting culture, both internally in corporate finance offices and externally in audit firms. The culture must build upon the profession’s traditional values, such as rigorous commitment to integrity, a passion for getting it right, a commitment to rules—not just to their letter, but their spirit, and zero tolerance for those who break them.

These values are the commitment of all of the 350,000 CPAs who are members of the AICPA across this country. We are determined to restore the image of the accounting profession and rebuild the legacy we will pass on to the next generation of accountants. We’re committed to the same goals that Congress envisioned when it passed the Sarbanes-Oxley Act and that the president articulated when he signed it.

We are committed to rebuilding confidence in the financial markets and their institutions. We’re committed to dramatically reducing the risk that future investors will fall prey to the kind of financial malfeasance that characterized Enron and WorldCom. And we are committed to something else as well: restoring pride in our profession. For us, it’s personal.

The revelations of financial abuse were a traumatic blow to everyone in the accounting profession. It has been painful to the nearly half of our members who are corporate employees, who serve as the financial conscience for thousands of corporations in America. It has been painful to the vast body of CPAs in public practice, CPAs who are not by and large involved in auditing publicly traded companies, but who concentrate on providing good advice and quality services to individuals and small businesses. Let’s not forget that small businesses make up roughly half of our economy. They are America’s engine of economic growth and job creation and they depend upon their CPAs for expertise and trusted advice. In a business world that seems to grow more complex every day, small business people need to turn to a trusted adviser to put complicated issues in context. CPAs fulfill that role.

The corporate scandals have also been painful to auditors who provide independent, objective judgments to public companies and insist on full disclosure to investors; that includes nearly a thousand audit firms.

The business scandals have been painful to members of our profession because it is made up of honest people. But hundreds of thousands of good apples do not excuse the behavior of a few bad ones. Make no mistake about it, our profession was part of the problem. And it came to embody the public’s perception of the problem.

THE PROFESSION IS INVOLVED
 But no matter how small a minority caused the problems, all of us in the accounting profession are working to solve them. To begin with, we were “present at the creation” of many of the reform ideas that were recently embraced by law. We helped develop the proposal for a board to oversee auditors of public companies, an idea that evolved into the Public Company Accounting Oversight Board. We called for a requirement that auditors be hired by the board’s audit committee, not management. We agreed with a prohibition on those who audit public companies from consulting in two key areas: financial systems design and implementation, and internal audit outsourcing. And we created a public-interest test against which all reforms could be measured:

But we’ve looked beyond legislation. We’ve engaged in a long and serious process of introspection at the AICPA over what went wrong and what must be done to make it right.

WHAT WENT WRONG?
 For executives of Enron, WorldCom and yes, for some auditors, part of the problem was simple greed or arrogance. Part of the problem was the pressure of a market in which the difference of a penny or two in earnings per share could lead to the difference of a billion or two in market cap. Part of the problem was a failure of some auditors to step up to their own responsibility. And part of it is the financial reporting model itself: The proper treatment of many issues is not clear, such as off-balance-sheet activity. Financial statements are not written in plain English and disclosure is periodic, even though the Internet allows it to be provided in real time.

Part of the problem is a GAAP model with too many rules that leaves too little room for principle-based judgment. And even where GAAP does allow for such judgment, far too many preparers don’t exercise it, opting for a form of “connect the dots” accounting that doesn’t necessarily draw a full and complete picture of a company.

Part of the problem is the fact that institutional investors and other market professionals have not traditionally provided feedback to the AICPA’s standard-setting process. In retrospect, we could and should have done more to solicit it. Now, we must demand it.

Clearly, part of the problem was some inherent weaknesses in disciplinary and monitoring processes for the profession. And part of it is the threat—real or perceived—of auditor dependency on fees from major clients.

Part of the problem is an inclination among many auditors to assume good intent. Most of those who make up the leadership of corporate America are honest, with the interests of their shareholders foremost in mind. But an auditor must carry a standard of professional skepticism into each and every audit. As President Reagan said of arms negotiations with the Soviets: “Trust, but verify.” That’s our obligation to shareholders.

These are explanations, but they are not excuses. They remind us that there is no one simple answer to the question of what went wrong. And there will be no one simple answer to the question of what must we do to make it right. The accounting profession must start with a basic commitment—a commitment that has governed the AICPA and its members since the organization was founded over a century ago.

Let me illustrate that commitment with a story about an auditor named Al Bows, who this summer was the subject of a profile in The Wall Street Journal. He went to work for an audit firm in the depths of the Depression. Public companies had just been mandated to have their financial statements certified. There were no nationally recognized standards in place, no history to draw upon. Bows took pride in helping to reform capitalism. He took pride in something else, too: his integrity. One day he discovered that the CEO of one of his client companies was secretly running a competing business on the side to siphon off profits. The client controlled a major account for Bows. But Bows told him to cut out the con game or he’d turn him in. The client was angry, but he stopped cheating his shareholders. Al Bows possessed a characteristic crucial to the profession: He had the guts to say no, even when he had a lot to lose.

WHAT INVESTORS DESERVE—AUDITORS WHO SAY “NO”
 Let there be no doubt: Hundreds of thousands of members of the CPA profession say “no” every day. “No” means protecting the public interest by rejecting unsound corporate accounting practices. “No” means reducing the risk of deceit and fraud. “No” means ensuring that audited statements are not just accurate, but illuminating. “No” means questioning and challenging management. When justified, it means rejecting management’s accounting decisions. Saying “no” means saying “yes” to protecting the public interest. Only if auditors are fully prepared to say “no” will investors be fully prepared to say “yes.”

“No” is not always easy to say. But obscured by the recent focus on our profession is the fact that auditors say it every day. These stories rarely come to light because an auditor prevails on clients to do the right thing. Every day, an auditor is telling a corporate executive what must be disclosed, why an item can’t be treated in a certain manner or why a certain activity must be shown on the balance sheet.

Every year, members of the AICPA collectively conduct almost 17,000 audits of public companies that are unblemished by restatements or allegations of impropriety. That doesn’t even include hundreds of thousands of audits of privately held companies and government and not-for-profit institutions that exemplify the highest standards of integrity.

That’s the true spirit of the accounting profession, a spirit we must marshal in pursuit of a fair investment climate. We must strive for zero audit defects, knowing full well that a combination of factors will prevent us from ever achieving perfection. But when a failure occurs, we must be unrelenting in ensuring that its weaknesses are not repeated.

The president and Congress have taken a significant step. The accounting profession is determined to carry the cause forward. We realize that no single initiative will rebuild investor confidence, that no single magic bullet will put fraud or malfeasance to rest.

Months