Bob,
Iwanted to share my latest Special Report, and the third and final
installment in a series on financial regulatory reform. This one looks at
how the accounting industry and the SEC have hobbled America’s audit
watchdog, the PCAOB. It tells the story of one of the more remarkable
revolving door cases in Washington. Former Senior Deloitte partner James
Schnurr was demoted at Deloitte after a string of damning inspections by the
PCAOB, but was then later appointed by Mary Jo White to be SEC Chief
Accountant, responsible for overseeing the PCAOB.
Jensen Comment
Most people in the world think the profession of accountancy is dull. Perhaps
it's not as thrilling as the defense industry or the Mafia or the FBI, but it
does have its source material for novels on intrigue, fraud, and underhanded
dealings.
There are the frauds (at worst) and inept
auditing (at worst) where accounting firms settle for billions of dollars in and
are sometimes even fined (e.g. KPMG's $456 million fine by the IRS) ---
http://www.trinity.edu/rjensen/Fraud001.htm
Hi Elliot,
Audit firms do provide consulting services even though some services were banned
by SOX. The consulting division is supposed to be independently managed and
operated to the extent possible.
The big controversy in this regard is in the UK where authorities are getting
closer to making audit firms sell off consulting divisions or vice versa.
It may not be the superhuman robotic police officer
who patrolled the lawless streets of Detroit in the 1987 sci-fi thriller,
but corporate filers should be every bit as concerned about the Securities
and Exchange Commission’s (“SEC”) new Accounting Quality Model (“AQM”),
labeled not-so-affectionately by some in the financial industry as “RoboCop.”
Broadly speaking, the AQM is an analytical tool which trawls corporate
filings to flag high-risk activity for closer inspection by SEC enforcement
teams. Use of the AQM, in conjunction with statements by recently-confirmed
SEC Chairman Mary Jo White and the introduction of new initiatives announced
July 2, 2013, indicates a renewed commitment by the SEC to seek out
violations of financial reporting regulations. This pledge of substantial
resources means it is more important than ever for corporate filers to
understand SEC enforcement strategies, especially the AQM, in order to
decrease the likelihood that their firm will be the subject of an expensive
SEC audit.
The Crack Down on Fraud in Accounting and
Financial Reporting
In his speech nominating Mary Jo White to take over
as chairman of the SEC, President Obama issued a warning: “You don’t want to
mess with Mary Jo.” That statement now seems particularly true for
corporate filers given the direction of the SEC under her command.
Previously a hallmark of the SEC, cases of accounting and
financial-disclosure fraud made up only 11% of enforcement actions brought
by the Commission in 2012. Since taking over as chairman, Ms. White has
renewed the SEC’s commitment to the detection of fraud in accounting and
financial disclosures.
“I think financial-statement fraud, accounting
fraud has always been important to the SEC,” Ms. White said during a June
interview “It’s certainly an area that I’m interested in and you’re going to
see more targeted resources in that area going forward.” She has backed that
statement up with a substantial commitment of resources. In July, the
commission announced new initiatives which aim to crack down on financial
reporting fraud through the use of technology and analytical capacity,
including the Financial Reporting and Audit Task Force and the Center for
Risk and Quantitative Analytics (“CRQA”). These initiatives will put
financial reports under the microscope through the use of technology-based
tools, the most important of which is RoboCop.
RoboCop: Corporate Profiler
RoboCop’s objective – to identify earnings
management – is not a novel one; rather, it is the model’s proficiency that
should worry filers. Existing models on earnings management detection
generally attempt to estimate discretionary accrual amounts by regressing
total accruals on factors that proxy for non-discretionary accruals. The
remaining undefined amount then serves as an estimate of discretionary
accruals. The fatal flaw in this approach is the inevitable high amount of
“false-positives”, rendering it useless to SEC examiners.
The AQM extends this traditional approach by
including discretionary accrual factors in its regression. This additional
level of analysis further classifies the discretionary accruals as either
risk indicators or risk inducers. Risk indicators are factors that are
directly associated with earnings management while risk inducers indicate
situations where strong incentives for earnings management exist. Based on a
comparison with the filings of companies in the filer’s industry peer group,
the AQM produces a score for each filing, assessing the likelihood that
fraudulent activities are occurring.
While the SEC will be keeping their
factor-composition cards close to the chest, the “builder of RoboCop”, Craig
Lewis, Chief Economist and Director of the Division of Risk, Strategy, and
Financial Innovation (“RSFI”) at the SEC, has offered several clues about
the types of information most likely to catch RoboCop’s attention (Is it
just a coincidence that RoboCop’s movie partner was an Officer Lewis?).
“An accounting policy that could be considered a
risk indicator (and consistently measured) would be an accounting policy
that results in relatively high book earnings, even though firms
simultaneously select alternative tax treatments that minimize taxable
income,” said Mr. Lewis. “Another accounting policy risk indicator might be
a high proportion of transactions structured as ‘off-balance sheet.’”
Frequent conflicts with independent auditors,
changes in auditors, or filing delays could also be risk indicators.
Examples of risk inducers include decreasing market share or lower
profitability margins. This factor-based analysis allows for model
flexibility, meaning examiners are able to add or remove factors to
customize the analysis to their specific needs. The SEC will be able to
continually update the model to account for the moves filers are taking to
conceal their frauds.
Next Generation RoboCop
One of the perceived weaknesses of RoboCop is its
dependence on financial comparisons between filers within an industry peer
group. As Lewis points out, “most firms that are probably engaging in
earnings management or manipulation aren’t doing it in a way that allows
them to stand out from everybody else. They’re actually doing it so they
blend in better with their peer group.”
To account for this, the SEC’s current endeavor is
expanding the model’s capabilities to include a scan of the “Management
Discussion & Analysis” (“MD&A”) sections of annual reports. Through a study
of past fraudulent filings, analysts at RSFI have developed lists of words
and phrasing choices which have been common amongst fraudulent filers in the
past. These lists have been turned into factors and incorporated into the
AQM
“We’re effectively going in and we’re saying: what
are the word choices that filers make that maximize our ability to
differentiate between fraudsters in the past and firms that haven’t had
fraud action brought against them yet?” Mr. Lewis explained during a June
conference in Ireland.
“So what we’re doing is taking the MDNA section,
we’re comparing them to other firms in the same industry group, and we’re
finding that in the past, fraudsters have tended to talk a lot about things
that really don’t matter much and they under-report all the risks that all
the other firms that aren’t having these same issues talk quite a bit
about.”
Firms engaged in fraudulent activity have tended to
overuse particular words and phrasing choices which are associated with
relatively benign activities. They have also tended to under-disclose risks
which are prevalent among a peer group. When a filer has engaged in similar
behavior, RoboCop will flag these types of unusual choices for examiner
review.
How the SEC Uses RoboCop
Although the SEC has cautioned that the AQM is not
the “robot police coming out and busting the fraudsters,” filers would be
wise to understand the power of this tool. RoboCop is a fully automated
system. Within 24 hours from the time a filing is posted to EDGAR, it is
processed by the AQM and the results are stored in a database. The AQM
outputs a risk score which informs SEC auditors of the likelihood that a
filing is fraudulent. The SEC then uses this score to prioritize its
investigations and concentrate review efforts on portions of the report most
likely to contain fraudulent information.
The results of RoboCop’s analysis will likely
become the basis for enforcement scheduling and direction of resources in
the near future. A filing’s risk score will determine whether a filing is
given a quick, unsuspecting review, or whether it is thoroughly dissected by
an SEC exam team, possibly leading to an expensive audit. The SEC has also
said it plans to use the risk scores as a means of corroborating (or
invalidating) the approximately 30,000 tips, complaints, and referrals
submissions it estimates will be received each year through its Electronic
Data Collection Systems or completed forms TCR.
I'm giving thanks for many things this Thanksgiving Day on November 22, 2012,
including our good friends who invited us over to share in their family
Thanksgiving dinner. Among the many things for which I'm grateful, I give thanks
for accounting fraud. Otherwise there were be a whole lot less for me to study
and write about at my Website ---
The accountants who
service publicly traded companies are likely to have something to be
thankful for this year: shareholders are not filing federal securities fraud
lawsuits against them.
Just 10 years
ago, public company accountants were in the cross hairs of shareholders,
regulators and prosecutors. A criminal indictment destroyed
Enron’s auditor, Arthur Andersen. Congress created
a new regulator, the
Public Company Accounting Oversight Board,
to oversee the profession. And in dozens of lawsuits in the years afterward,
shareholders named accountants as co-defendants when alleging accounting
fraud.
But things
have changed. According to NERA Economic Consulting, which tracks
shareholder litigation and reported on the decline in accounting firm
defendants in
its midyear report in July, not one accounting
firm has been named a defendant so far this year. One of the study’s
co-authors, Ron I. Miller, confirmed that the trend has continued at least
through November.
That prompts the
question, why don’t shareholders sue accountants anymore?
“To the extent that
firms have been burned for a lot of money, they have some pretty strong
incentives to try to behave,” Mr. Miller said. “That’s the hopeful side of
the legal system: You hope that if you put in penalties, that those
penalties change people’s actions.”
The less positive
alternative, he added, is that public companies “have gotten better at
hiding it.”
From 2005 to 2009,
according to the NERA report, 12 percent of securities class action cases
included accounting firm co-defendants. The range of federal securities
fraud class action cases filed per year in that period was 132 to 244.
The absence
of accounting firm defendants this year can probably be explained at least
in part by court decisions; the Supreme Court has issued rulings, as in
Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc.
in 2008, making it more difficult to recover damages
from third parties in fraud cases.
So perhaps more
shareholder suits would take aim at accountants, if the plaintiffs believed
that their claims would survive a defendant’s motion to dismiss. And it is
possible that plaintiffs will add accounting firm as defendants to existing
cases in the future, if claimants get information to support such claims.
Over all, fewer
shareholder class action lawsuits are based on allegations of accounting
fraud, as opposed to other types of fraud. The NERA midyear report found
that in the first six months of 2012, about 25 percent of complaints in
securities class action cases included allegations of accounting fraud, down
from nearly 40 percent in all of 2011.
Perhaps the
Sarbanes-Oxley Act, the legislative response to the accounting scandals of
the early 2000s, actually worked, Mr. Miller said.
“There’s been a lot
of complaining about SOX, and certainly the compliance costs are high for
smaller publicly traded companies,” he said, but accounting fraud “is to a
large extent what SOX was intended to stop.”
Public
company accountants still have potential civil liability to worry about,
said Joseph A. Grundfest, a former commissioner of the
Securities and Exchange Commission who teaches at
Stanford Law School. Regulators, he said, are investigating potential
misconduct involving accounting firms.
The Investor
Protection Trust provides independent, objective information to help
consumers make informed investment decisions. Founded in 1993 as part of a
multi-state settlement to resolve charges of misconduct, IPT serves as an
independent source of non-commercial investor education materials. IPT
operates programs under its own auspices and uses grants to underwrite
important initiatives carried out by other organizations.
The accountants who
service publicly traded companies are likely to have something to be
thankful for this year: shareholders are not filing federal securities fraud
lawsuits against them.
Just 10 years
ago, public company accountants were in the cross hairs of shareholders,
regulators and prosecutors. A criminal indictment destroyed
Enron’s auditor, Arthur Andersen. Congress created
a new regulator, the
Public Company Accounting Oversight Board,
to oversee the profession. And in dozens of lawsuits in the years afterward,
shareholders named accountants as co-defendants when alleging accounting
fraud.
But things
have changed. According to NERA Economic Consulting, which tracks
shareholder litigation and reported on the decline in accounting firm
defendants in
its midyear report in July, not
one accounting firm has been named a defendant so far this year. One of the
study’s co-authors, Ron I. Miller, confirmed that the trend has continued at
least through November.
That prompts the
question, why don’t shareholders sue accountants anymore?
“To the extent that
firms have been burned for a lot of money, they have some pretty strong
incentives to try to behave,” Mr. Miller said. “That’s the hopeful side of
the legal system: You hope that if you put in penalties, that those
penalties change people’s actions.”
The less positive
alternative, he added, is that public companies “have gotten better at
hiding it.”
From 2005 to 2009,
according to the NERA report, 12 percent of securities class action cases
included accounting firm co-defendants. The range of federal securities
fraud class action cases filed per year in that period was 132 to 244.
The absence
of accounting firm defendants this year can probably be explained at least
in part by court decisions; the Supreme Court has issued rulings, as in
Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc.
in 2008, making it more difficult to recover
damages from third parties in fraud cases.
So perhaps more
shareholder suits would take aim at accountants, if the plaintiffs believed
that their claims would survive a defendant’s motion to dismiss. And it is
possible that plaintiffs will add accounting firm as defendants to existing
cases in the future, if claimants get information to support such claims.
Over all, fewer
shareholder class action lawsuits are based on allegations of accounting
fraud, as opposed to other types of fraud. The NERA midyear report found
that in the first six months of 2012, about 25 percent of complaints in
securities class action cases included allegations of accounting fraud, down
from nearly 40 percent in all of 2011.
Perhaps the
Sarbanes-Oxley Act, the legislative response to the accounting scandals of
the early 2000s, actually worked, Mr. Miller said.
“There’s been a lot
of complaining about SOX, and certainly the compliance costs are high for
smaller publicly traded companies,” he said, but accounting fraud “is to a
large extent what SOX was intended to stop.”
Public
company accountants still have potential civil liability to worry about,
said Joseph A. Grundfest, a former commissioner of the
Securities and Exchange Commission
who teaches at Stanford Law School.
Regulators, he said, are investigating potential misconduct involving
accounting firms.
I
know of no free Web reference that records all criminal and civil actions
where a Big Four firm is a defendant.
Big Four lawsuits can arise in over 100 nations (recently one of the largest
actions in history was filed in Hong Kong, where the Ernst & Young partner
in charge was actually jailed) ---
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
In
the U.S. there are both state and federal jurisdictions. And there can be
individual or class action lawsuits brought by plaintiffs. One of the better
sources for federal securities class action lawsuits is the Stanford
University Law School Federal Class Action Clearinghouse ---
http://securities.stanford.edu/
But this by no means covers most of the lawsuits against large auditing
firms. In fact, the database has surprisingly few hits for Big Four firms.
Many of the SEC lawsuits are not in this database.
Keep in mind that auditors are usually secondary in lawsuits with their
clients being the primary defendants. Most of the lawsuits are probably
filed in the state where a corporate client is licensed as a corporation,
which gives Delaware a lot of lawsuits.
For the past ten years I’ve tried to keep tidbits on the highly publicized
lawsuits involving large auditing firms ---
http://www.trinity.edu/rjensen/fraud001.htm
Interestingly, auditing firms sometimes win in courts, as recently happened
when Ernst & Young emerged as a winner.
I
don’t have time at the moment, but it would be interesting to see how much
PwC provides in the Comperio database. Since this database is heavily used
by clients, my guess is that Comperio is not a good source for searching
auditor lawsuits.
There are also instances where an auditing firm is a plaintiff, usually
where it is suing a former client.
There can also be criminal cases like the recent case where the managing
partner of PwC in England was charged with stealing money from PwC to pay
for the luxurious tastes of his mistress ---
http://www.trinity.edu/rjensen/fraud001.htm#PwC
"Information regarding litigation is highly sensitive, because of the risk
that the data could be used
unfairly against a firm in litigation. For these reasons, the data presented
in this report were gathered from the six audit firms and aggregated (the
data relate only to claims against the six U.S. firms and do not include
claims in U.S. courts against any non-U.S. firms that are members of the
same networks). To prevent "reverse engineering" of the data to tie specific
facts to a specific lawsuit or firm, the data have been grouped - for
example, aggregating data from several different years. The litigation data
discussed in this report do not include information relating to government
inquiries, investigations, or enforcement actions.31" [Footnote 31 in the
CAQ report states: "2007 litigation data in this report reflect submissions
by five firms of information as of December 20, 2007 and by one firm of
information as of November 30, 2007."]
I try to keep up
as best I can on litigation against the auditors. It's not easy since I am
not an attorney and do not have access to their databases. I depend of the
"kindness of lawyer strangers" to help me often.
It's not easy
since auditors are often one of many defendants in a class action lawsuit ,
for example. Often news reports or other blog posts do not include all the
defendants if auditors are not the focus of the story. Which they are often
not. Which is why my site is useful.
I look at the
lists compiled by Kevin LaCroix on his site DandODiary.com of securities
litigation and class action suits, Francis Pileggi of DelawareLitigation.com
also mentions suits against or by auditors (as in the Deloitte suit against
their own Vice Chairman ) when they make it to Delaware Chancery Court. They
both keep an eye out for me now and it was Frans=cis who alerted me to both
the judgement against Deloitte's Flanagan and the recent "in pari delicto"
case against pwC.
I also use a site
called Justia to look for all other suits against the firms, often focused
on suits in Federal Courts.
http://dockets.justia.com/
Interestingly PwC
does a great job tracking everyone else's 10b-5 litigation - except their
own. You will never see auditor litigation broken out in their report. ---
http://10b5.pwc.com/public/Default.aspx
Bob is right to
say that there's a whole slew of suits, at times very large and important
that are outside of the US, such as the ones in Hong Kong against EY. For
that I count on Google Alerts (and my blog readers) to alert me, sometimes
at odd hours of the night, of new developments.
With hindsight, we
now know that auditors in 2007 should have been looking carefully at bank
books.
They should have
drilled into allowances for loan losses, and they should have been
especially alert for signs that the banks were playing games when they sold
loans. Auditors should have carefully reviewed how the banks were valuing
their mortgage-backed securities and loans that they planned to sell.
It won’t surprise
you to learn that in at least one case, the auditor seems to have done a
pretty poor job.
What may be
surprising is that the Public Company Accounting Oversight Board figured
that out at the time, and was harshly critical of Deloitte & Touche, one of
the Big Four audit firms, for not doing the work to check assumptions in
those areas and for being overly reliant on whatever the bank’s management
said was proper.
Those comments were
made after the board’s inspectors reviewed Deloitte’s audit of a bank’s 2006
results, as part of the annual inspection of the firm. The inspection of 61
Deloitte audits concluded in November 2007.
Had the auditor
taken the criticism to heart, it might have gone back in and checked more
thoroughly.
But it did not.
The bank was not
named in the report, even in the previously confidential part released this
week.
I thought it might
have been Washington Mutual, a Deloitte client that collapsed in September
2008, but Deloitte says that was not the case.
Deloitte, in its
response to the board, stated that at the bank, “the audit procedures
performed, the conclusions reached and the related documentation were
appropriate in the circumstances.”
In other words,
Deloitte concluded the board simply did not understand what it was talking
about.
All that became
public in early 2008, when the censored version of the board’s report became
public. But it was little remarked on at the time. Now we have seen the rest
of the report, and it is even more critical.
The report said its
inspections indicated “a firm culture that allows, or tolerates, audit
approaches that do not consistently emphasize the need for an appropriate
level of critical analysis and collection of objective evidence, and that
rely largely on management representations.”
Deloitte responded
by denying almost everything. It did not like the “second guessing” shown by
the regulators. It said “we strongly take exception” to the observation
about its culture, which it said was simply wrong.
In any case, the
firm concluded, “there were only a limited number of instances,” not nearly
enough to justify questioning Deloitte’s quality controls.
The board
inspectors found problems in 27 of the 61 Deloitte audits.
The Sarbanes-Oxley
law that established the board included provisions to protect the public
images of audit firms. If a board inspection found problems with the quality
control systems, that was to be kept confidential unless the firm did not
move to fix the problems over the following year. Then the release could be
delayed while the firm tried to persuade the board to keep the information
private. If that effort failed, the firm could appeal to the Securities and
Exchange Commission.
Only then could the
report be made public. So in this case, it took 41 months from the issuance
of the report — more than three years — for Deloitte’s clients to learn of
the problem.
The board
also has the authority to file enforcement actions against auditors, but
those, too, are private until the S.E.C. rules on an appeal. It is as if
charges of robbery had to be kept confidential until all appeals had been
completed. There is no way to know if the accounting board has taken action
against anyone. An auditor that the board deems to be in violation of rules
may keep working for years while secret proceedings continue.
Continued in article
Jensen Comment
Norris is not telling us subscribers on the AECM anything we've not already
stated before. But it's important for the world to know more about the warts of
CPA auditors.
My all-time heroes
Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an
exercise in writing fiction: Watch the video! (a bit slow loading) Lynn Turner
is Partnoy's co-author of the white paper "Make Markets Be Markets" "Bring
Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt
Institute, March 2010 ---
http://makemarketsbemarkets.org/modals/report_off.php
Recently I wrote the following tidbit
about audit reform:
If audit reform swaggered into a Luckenbach, Texas saloon, it would be "all
hat and no horse"
The ladies of the night would die laughing at that "itty-bitty thang" that
walked in
And it would need a ladder to peek over the top of the spittoon
How much voting power lies in shareholder hands?
Teaching Case from The Wall Street Journal Accounting Weekly Review on
April 27, 2012
TOPICS: Executive
Compensation, SEC, Securities and Exchange Commission
SUMMARY: At
Citigroup's annual meeting on April 17, 2012, shareholders voted not to
support the company's executive compensation plan. The article is written by
Francesco Guerrera, the WSJ's Money & Investing editor; this piece is an
opinion item and students are asked to identify that fact. The related video
specifically identifies the Citigroup executive pay proposal on which
shareholders voted as bad "corporate governance" both for proposing that top
management be given bonuses based on a low threshold of performance and for
poorly explaining the reason behind that pay. Questions ask the students to
access SEC filings of both the proxy statement filed prior to the annual
meeting and the report of the results of the meeting.
CLASSROOM
APPLICATION: The article is useful in any class covering executive
compensation and SEC disclosure in undergraduate or graduate financial
accounting or auditing classes.
3. (Introductory) Based on the discussion in the article, what was
the most significant outcome of the Citigroup annual meeting?
4. (Advanced) How does the result of this shareholder vote impact
what Citigroup may pay its top executives? In your answer, define the term
"corporate governance."
5. (Introductory) Who is the author of this article? Do you feel
that the author's opinion on this matter is expressed in the article?
Support your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Citigroup Inc.'s C +0.59%
shareholders have spoken but is anybody listening?
The rejection of Citi's
compensation plan at last week's annual investor meeting is more than a
stinging rebuke for its board and management.
Citigroup Inc.'s C +0.59%
shareholders have spoken but is anybody listening?
The rejection of Citi's
compensation plan at last week's annual investor meeting is more than a
stinging rebuke for its board and management.
Citigroup Inc.'s C +0.59%
shareholders have spoken but is anybody listening?
The rejection of Citi's
compensation plan at last week's annual investor meeting is more than a
stinging rebuke for its board and management.
Sure, Mr. Pandit can share
with Uncle Sam the credit for pulling Citi back from the brink.
But Citi's shares are down
more than 88% since he took over. The stock has underperformed not just
healthier banks like J.P. Morgan Chase JPM +1.46% & Co. and Wells Fargo WFC
+1.45% & Co. but also fellow problem child Bank of America Corp. BAC +0.12%
And dividend increases and share buybacks for Citi have been halted by
regulators, leaving shareholders with little to celebrate.
This is no time for
lucrative victory laps.
If the pay bump is to
compensate Mr. Pandit for two lean years, let's remember that the decision
to take $1 in salary was his. And that he received at least $165 million in
2007 when Citigroup bought his hedge fund—only to wind it down 11 months
later amid mediocre returns.
The second argument is that,
with the profit-sharing arrangement, Citigroup's directors sought to provide
Mr. Pandit with "a financial incentive to remain as CEO."
That's what Citi's blog
says. What it really means is that, after years during which some
regulators, directors and shareholders privately questioned Mr. Pandit's
leadership of the company, the board of directors wanted to back him
unequivocally.
That's understandable but if
directors are so confident in his ability, they should set much more
demanding performance targets.
Not once has the board
explained how it arrived at the $12 billion figure or how it has calculated
the profit shares of each executive.
Mr. Parsons and fellow
directors are at fault on this: They should have dealt with shareholders'
concerns long before last week's embarrassing vote. Michael O'Neill, the
banking veteran who replaced Mr. Parsons, will have to pick up the pieces.
Mr. O'Neill, who will also
head the board's compensation committee, should review the performance
targets, discuss them with shareholders and then change them.
My suggestion: Set relative
metrics that compare Citigroup's profits to its peers; have more than one
target, so different levels of performance are compensated differently; and
make sure that the CEO's bonus is tied to more-demanding hurdles than his
underlings.
Years of Creative Accounting by CitiGroup My all-time heroes
Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an
exercise in writing fiction: Watch the video! (a bit slow loading) Lynn Turner
is Partnoy's co-author of the white paper "Make Markets Be Markets" "Bring
Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt
Institute, March 2010 ---
http://makemarketsbemarkets.org/modals/report_off.php
The topic of audit industry reform is hot again.
OK, that’s relative to where you stand on what’s hot. But in the world of
legal and regulatory compliance and auditors the only thing hotter would be
a significant development in the
New York Attorney General’s case against Ernst & Young.
Here in the U.S. the PCAOB has been busy. I’ll
give them – mostly Chairman James Doty and the Investor Advisory Group led
by Board Member Steve Harris – credit for that. The Investor Advisory Group
– rather, the boldest amongst them – recently sent
a letter to the PCAOB to provide comments on the
PCAOB’s June 21, 2011 Concept Release entitled Possible Revisions to
PCAOB Standards Related to Reports on Audited Financial Statements and
Related Amendments to PCAOB Standards.
It is worth noting that a number of other
parties agree that the current form of the auditor’s report fails to
meet the legitimate needs of investors. First, the U.S. Treasury
Advisory Committee on the Auditing Profession (ACAP) called for the
PCAOB to undertake a standard-setting initiative to consider
improvements to the standard audit report. The ACAP members support “…
improving the content of the auditor’s report beyond the current
pass/fail model to include a more relevant discussion about the audit of
the financial statements.”
Second, surveys conducted by the CFA Institute
in 2008 and 2010 indicate that research analysts want auditors to
communicate more information in their reports.
Finally, even leaders of the accounting
profession have acknowledged that the audit report needs to become more
relevant. In testimony before ACAP, Dennis Nally, Chairman of PwC
International stated, “It’s not difficult to imagine a world where the …
trend to fair value measurement — lead one to consider whether it is
necessary to change the content of the auditor’s report to be more
relevant to the capital markets and its various stakeholders.”
Finally, leaders of the accounting profession
have previously stated that changes to the audit report should reflect
investor preferences. In their 2006 White Paper, the CEOs of the six
largest accounting firms stated, “The new (reporting) model should be
driven by the wants of investors and other users of company
information …” (their emphasis).
Before we turn to a discussion of the IAG
investor survey, we believe it is important to underscore the
fundamental but often overlooked fact that the issuer’s investors,
not its audit committee or management team or the company itself, are
the auditor’s client. It is therefore not only appropriate, but
essential, that investors’ views and preferences take center stage as
the PCAOB considers possible changes to the format and content of the
audit report.
In the meantime, I’ve written two articles about
the proposals on auditor regulation before the European Commission.
In Forbes, I told you not to count on
Europe to reform the audit model or auditors, in general.
The audit industry is reportedly under siege in
Europe and on the verge of being broken up, restrained, and rotated
until all the good profit is spun out.
This is neither a foregone conclusion nor
highly likely.
The European Commission’s internal markets
commissioner Michel Barnier is talking tough, but the rhetoric should be
no surprise to those who have been following the European response to
the financial crisis closely…
In American Banker, I focused on the
impact of auditor reforms on financial services. Why is the European
Commission taking such strong action now? Why is the U.S. lagging so far
behind?
The clamor for accountability from the auditors
for financial crisis failures and losses has been much louder, much
stronger, and going on much longer in the U.K. and Europe, than in the
United States. Barnier’s most dramatic proposals are viewed by most
commenters as a reaction to the bank failures. “Auditors play an
essential role in financial markets: financial actors need to be able to
trust their statements,” Barnier told the Financial
Times. “There are weaknesses in the way
the audit sector works today. The crisis highlighted them.”
There’s is a concern on both sides of the
Atlantic over long-standing auditor relationships.
The average auditor tenure for the largest 100
U.S. companies by market cap is 28 years. The U.S. accounting regulator,
the PCAOB, highlighted the auditor tenure trap in its recent Concept
Release on Auditor Independence and Auditor Rotation. According to The
Independent, quoting a recent House of
Lords report, only one of the FTSE 100 index’s members uses a non-Big
Four firm and the average relationship lasts 48 years. Some of the U.S.
bailout recipients — General Motors, AIG, Goldman Sachs, Citigroup — and
crisis failure Lehman had as
long or longer relationships with their
auditors…
It's not often that
a conference session feels like a true-crime show. And yet Angela Morelock,
a forensic accountant with the accounting firm BKD, delivered material like
that and more in a talk here that detailed the bad, the really bad, and the
mind-bogglingly bad in the fraud and embezzlement cases that her firm has
investigated.
Her presentation
was designed to educate administrators, gathered here at the annual meeting
of the National Association of College and University Business Officers,
about common fraud scams and patterns that might indicate something is
wrong.
But before going
into the statistics, she posted on a screen a ditty, scribbled out by, and
found in the office of, a fraud perpetrator in the accounting office of a
pharmacy chain: "Oh, what a tangled web we weave when first we practice to
deceive. But once we've practiced for a while, oh my, how we've improved our
style!"
"Fraud cases, every
single time, are hindsight 20/20," she said. "It's a little bit amazing to
me—the subtle clues, the small things, that we will miss. Tell me how this
hangs in the cubicle of someone in an accounting department for an extended
period of time without someone asking about it."
That was one of the
big takeaways from Ms. Morelock's talk: Fraud perpetrators will leave
lifestyle clues that they are up to no good. In her experience, criminals
tend to follow recognizable patterns. They like to give gifts, and they are
compulsive shoppers. Gambling problems are common among them.
They tend to be
long-term employees, who start small and rationalize their thefts over time.
They can be male or female, but statistics say that the big losses usually
happen with more-educated, high-ranking employees. That is in part because
there are all sorts of checks and controls on the financial transactions
handled by low-level employees, whom some assume to be more prone to fraud
and theft. However, the supervisors of those employees are often not
subjected to the same controls and scrutiny, opening a window for abuse. Ms.
Morelock told of a supervisor at one business who collected the cash drawers
from various clerks, and took one home every day for 10 years, until she had
collected $1.3-million.
And then there are
the things that just don't add up, Ms. Morelock said, and she related
another of her many war stories: A bookkeeper at a church organization went
on vacation, and a diamond certificate in her name arrived at her work,
which set off alarm bells. Right off the bat, Ms. Morelock found that the
employee, who was making $45,000 a year, had purchased a $390,000 house,
which her co-workers knew about.
The employee had
paid for the house in cash, skimmed off of the organization. And she bought
a lot more, like big-screen TV's, video games, and appliances. "These
lifestyle clues are the best early warning signs," Ms. Morelock said.
Schemes Involving Vendors
One common
oversight, where fraud dwells, is where employees choose vendors. "That
power, to be the one who chooses the vendor, is a significant power that we
often don't focus on enough," Ms. Morelock said. "That is where fake
vendors, conflicts of interests, kickback schemes, and straw-vendor schemes
originate."
Here is how a
straw-vendor scheme works, based on another real case: A graphic designer
can pick a printer for his work with an organization. He sets up his friend,
who is not a printer, as the vendor and places printing orders through the
friend. The friend goes out and finds a real printer to handle the actual
printing. The friend gets the job printed and bills the organization at an
inflated price, and the organization pays. Then the graphic designer and his
friend pay the printer's lower cost, and split the profits.
For Ms. Morelock,
the case proves that you can find fraud in the most unlikely corners of an
organization. "Most of us would look a graphic designer and think, What kind
of fraud risk could that person possibly be?" she said. In the case Ms.
Morelock uncovered, the graphic designer and his friend netted $600,000 in
their five-year scam.
Fraud cases in
higher education tend to be lower than in other organizations, she pointed
out, but certain parts of higher education have been more troublesome. "We
have seen a lot of athletic-department scams recently, that go everywhere
from travel expenses and ATM cards to misuse of booster funds," she said.
"Although many organizations consider booster funds to be separate from the
college or university, guess whose name hits the front page of the paper
when there is a problem?" she said. She also alluded to a ticket-scalping
scandal that has plagued the University of Kansas.
Continued in this article
Jensen Comment
Frauds and thefts can take place even
where we least expect ti.
Federal securities class action
lawsuits increased 19 percent in 2008, with almost half involving firms in the
financial services sector according to the annual report prepared by the
Stanford Law School Securities Class Action Clearinghouse in cooperation with
Cornerstone Research ---
http://securities.stanford.edu/scac_press/20080106_YIR08_Press_Release.pdf
Yesterday,
COSO
announcedthe release of a new research study,
Fraudulent Financial Reporting: 1998-2007, that
examines 347 alleged accounting fraud cases identified by a review of U.S.
Securities and Exchange Commission (SEC) Accounting and Auditing Enforcement
Releases (AAER's) issued over a ten-year period ending December 31, 2007.
The COSO Fraud Study updates COSO's previous 10-year
study of fraud and was led by the same core academic research team as COSO's
previous Fraud Study.
COSO's Fraud Study provides an in-depth analysis of the nature, extent and
characteristics of accounting frauds occurring throughout the ten years, and
provides helpful insights regarding new and ongoing issues needing to be
addressed.
COSO is more formally known as The Committee of Sponsoring Organizations of
the Treadway Commission, and the five sponsoring organizations are the
AAA,
AICPA,
FEI, IIA, and
IMA. More
COSO info is available on their website,
www.coso.org.
A major U.S. city
long known as a hotbed of pay-to-play politics infested with clout and
patronage has seen nearly 150 employees, politicians and contractors get
convicted of corruption in the last five decades.
Chicago has
long been distinguished for its pandemic of public corruption, but actual
cumulative figures have never been offered like this. The astounding
information is featured in a
lengthy report published by one of Illinois’s
biggest public universities.
Cook County,
the nation’s second largest, has been a
“dark pool of political corruption” for more than
a century, according to the informative study conducted by the University of
Illinois at Chicago, the city’s largest public college. The report offers a
detailed history of corruption in the Windy City beginning in 1869 when
county commissioners were imprisoned for rigging a contract to paint City
Hall.
It’s downhill from
there, with a plethora of political scandals that include 31 Chicago
alderman convicted of crimes in the last 36 years and more than 140
convicted since 1970. The scams involve bribes, payoffs, padded contracts,
ghost employees and whole sale subversion of the judicial system, according
to the report.
Elected
officials at the highest levels of city, county and state
government—including prominent judges—were the perpetrators and they worked
in various government locales, including the assessor’s office, the county
sheriff, treasurer and the President’s Office of Employment and Training.
The last to fall was renowned
political bully Isaac Carothers, who just a few
weeks ago pleaded guilty to federal bribery and tax charges.
In the last few
years alone several dozen officials have been convicted and more than 30
indicted for taking bribes, shaking down companies for political
contributions and rigging hiring. Among the convictions were fraud,
violating court orders against using politics as a basis for hiring city
workers and the disappearance of 840 truckloads of asphalt earmarked for
city jobs.
A few months
ago the city’s largest newspaper revealed that Chicago aldermen keep a
secret, taxpayer-funded pot of cash (about $1.3
million) to pay family members, campaign workers and political allies for a
variety of questionable jobs. The covert account has been utilized for
decades by Chicago lawmakers but has escaped public scrutiny because it’s
kept under wraps.
Judicial
Watch has extensively investigated Chicago corruption, most recently the
conflicted ties of top White House officials to
the city, including Barack and Michelle Obama as well as top administration
officials like Chief of Staff Rahm Emanual and Senior Advisor David Axelrod.
In November Judicial Watch
sued Chicago Mayor Richard Daley's office to
obtain records related to the president’s failed bid to bring the Olympics
to the city.
Need advice on choosing a textbook for an MBA class
on fraud (to be taken mostly by Master of Accounting students).
I am deciding between Albrecht's Fraud Examination
and Hopwood's Forensic Accounting. I also plan to have students read Cynthia
Cooper's book, Journey of a Corporate Whistleblower.
I will be teaching a three-week version of the
course this summer as a study abroad, but also will be converting it into a
16 week semester-long 3 hour course.
Any suggestions would be helpful -
Thank you,
Eileen
November 3, 2009 reply from Bob Jensen
Hi Eileen,
I'm really not able to give you an opinion on either
choice for a textbook. But before making a decision I always compared the
end-of-chapter material and the solutions manual to accompany that material.
If the publisher did not pay for good end-of-chapter material I always view
the textbook to be a cheap shot. The end-of-chapter material is much harder
to write than the chapter material itself.
I also look for real world cases and illustrations.
Don't forget the wealth of material, some free, at
the site of the Association of Certified Fraud Examiners ---
http://www.acfe.com/
I would most certainly consider using some of this material on homework and
examinations.
Instead of a textbook you might use the ACFE online
self-study materials ($79) ---
Click Here
"A Model Curriculum for Education in Fraud and Forensic Accounting,"
by Mary-Jo Kranacher, Bonnie W. Morris, Timothy A. Pearson, and Richard A.
Riley, Jr., Issues in Accounting Education, November 2008. pp. 505-518
(Not Free) ---
Click Here
There are other articles on fraud and forensic accounting in this November
edition of IAE:
Incorporating Forensic Accounting and Litigation Advisory Services Into
the Classroom Lester E. Heitger and Dan L. Heitger, Issues in Accounting
Education 23(4), 561 (2008) (12 pages)]
West Virginia University: Forensic Accounting and Fraud Investigation (FAFI)
A. Scott Fleming, Timothy A. Pearson, and Richard A. Riley, Jr., Issues
in Accounting Education 23(4), 573 (2008) (8 pages)
The Model Curriculum in Fraud and Forensic Accounting and Economic Crime
Programs at Utica College George E. Curtis, Issues in Accounting
Education 23(4), 581 (2008) (12 pages)
Forensic Accounting and FAU: An Executive Graduate Program George R.
Young, Issues in Accounting Education 23(4), 593 (2008) (7 pages)
The Saint Xavier University Graduate Program in Financial Fraud
Examination and Management William J. Kresse, Issues in Accounting
Education 23(4), 601 (2008) (8 pages)
Also see
"Strain, Differential Association, and Coercion: Insights from the Criminology
Literature on Causes of Accountant's Misconduct," by James J. Donegan and
Michele W. Ganon, Accounting and the Public Interest 8(1), 1 (2008) (20
pages)
Two out of every
three United States corporations paid no federal income taxes from 1998
through 2005, according to a report released Tuesday by the Government
Accountability Office, the investigative arm of Congress.
The study, which is
likely to add to a growing debate among politicians and policy experts over
the contribution of businesses to Treasury coffers, did not identify the
corporations or analyze why they had paid no taxes. It also did not say
whether they had been operating properly within the tax code or illegally
evading it.
The study covers
1.3 million corporations of all sizes, most of them small, with a collective
$2.5 trillion in sales. It includes foreign corporations that do business in
the United States.
Among foreign
corporations, a slightly higher percentage, 68 percent, did not pay taxes
during the period covered — compared with 66 percent for United States
corporations. Even with these numbers, corporate tax receipts have risen
sharply as a percentage of federal revenue in recent years.
The G.A.O. study
was done at the request of two Democratic senators, Carl Levin of Michigan
and Byron L. Dorgan of North Dakota. In recent years, Senator Levin has held
investigations on tax evasion and urged officials and regulators to examine
whether corporations were abusing tax laws by shifting income earned in
higher-tax jurisdictions, like the United States, to overseas subsidiaries
in low-tax jurisdictions.
Senator Levin said
in written remarks on Tuesday that “this report makes clear that too many
corporations are using tax trickery to send their profits overseas and avoid
paying their fair share in the United States.”
But the G.A.O. said
that it did not have enough data to address the role of what some policy
experts say is a crucial factor in profits sent overseas.
That factor, known
as transfer pricing, involves corporations’ charging their overseas
subsidiaries lower prices for goods and services, a common move that lowers
a corporation’s tax bill. A number of corporations are in transfer-pricing
disputes with the Internal Revenue Service.
Either way, the
nearly 1,000 largest United States corporations were more likely than
smaller ones to pay taxes.
In 2005, one in
four large United States corporations paid no taxes on revenue of $1.1
trillion, compared with 66 percent in the overall pool. Large corporations
are those with at least $250 million in assets or annual sales of at least
$50 million.
Joshua Barro, a
staff economist at the Tax Foundation, a conservative research group, said
that the largest corporations represented only 1 percent of the total number
of corporations but more than 90 percent of all corporate assets.
The vast majority
of the large corporations that did not pay taxes had net losses, he said,
and thus no income on which to pay taxes. “The notion that there is a large
pool of untaxed corporate profits is incorrect.”
In 2004, a
G.A.O. study said that 7 in 10 of all foreign corporations doing business in
the United States, or foreign-controlled corporations, paid no taxes from
1996 through 2000, compared with 6 in 10 United States corporations.
This article has been revised to
reflect the following correction:
Correction: August 14, 2008
An article on Wednesday about a Government Accountability Office study
reporting on the percentage of corporations that paid no federal income
taxes from 1998 through 2005 gave an incorrect figure for the estimated tax
liability of the 1.3 million companies covered by the study. It is not $875
billion. The correct amount cannot be calculated because it would be based
on the companies’ paying the standard rate of 35 percent on their net
income, a figure that is not available. (The incorrect figure of $875
billion was based on the companies’ paying the standard rate on their $2.5
trillion in gross sales.)
From Smart Stops of the Web, Journal of accountancy, October
2008 ---
FRAUD /
FORENSIC ACCOUNTING
HAVE FRAUD FEARS?
http://fvs.aicpa.org/Resources/Antifraud+Forensic+Accounting
Search no further than the AICPA’s offering of
antifraud and forensic accounting resources. Click “Tools and Aids”
to download Managing the Business Risk of Fraud: A Practical
Guide, which outlines principles for establishing effective
fraud risk management. The paper was released jointly by the AICPA,
the Association of Certified Fraud Examiners and The Institute of
Internal Auditors (see “Highlights,”
page 16). The site also offers fraud detection and prevention tips,
including an “Indicia of Fraud” checklist and case studies. There’s
also information on the newly created Certified in Financial
Forensics (CFF) credential (see “News
Digest,” Aug. 08, page 30) and upcoming Web seminars.
BE
CRIME SMART www.fbi.gov/whitecollarcrime.htm
Think of the most outrageous
business fraud scheme you’ve ever heard of— you’re likely to find
it, plus hundreds of other white-collar crime cases—at this site
from the FBI. Look under “Don’t Be Cheated” for a fraud awareness
test or click on “Know Your Frauds” for access to the FBI’s analysis
of common fraud schemes, including the prime bank note scheme,
telemarketing fraud and up-and-coming Internet scams. CPAs and
financial professionals can access details on options backdating,
securities scams and investment fraud under “Interesting Cases” or
learn about the FBI’s major programs involving corporate, hedge fund
and bankruptcy fraud.
SURF THE FRAUD NET
www.auditnet.org/fraudnet.htm
Jim Kaplan, a government auditor and author of
The Auditor’s Guide to Internet Resources, 2nd Edition,
hosts this Internet portal for auditors, which provides fraud
policies, procedures, codes of ethics and articles on a range of
topics, including internal auditing, fraud risk mitigation and
preventing embezzlement. The site also features a newsfeed, piping
in daily fraud news from around the world..
Financial
Executives Research Foundation (FERF), the research affiliate of Financial
Executives International (FEI), has announced the release of two important
new pieces of research designed to aid public company management and
corporate boards in the efficient evaluation of their assessment of
reporting issues and internal controls. A new FERF Study, entitled "What's
New in Financial Reporting: Financial Statement Notes from Annual Reports,"
examines disclosures from 2006 annual reports for the 100 largest
publicly-traded companies which used particularly innovative techniques to
clearly address difficult accounting issues. The study identifies and
analyzes recent reporting trends and common practices in financial
statements.
The report illustrates how
companies addressed specific accounting issues recently promulgated by
the Financial Accounting Standards Board (FASB), and by the Securities
and Exchange Commission (SEC), and in doing so, uncovered a number of
trends, which included:
Most of the disclosures
selected appear to have been developed specifically for a company's
own operations and industry standards, rather than "boilerplate"
disclosures.
Four accounting areas
identified with a considerable variation in disclosures. The
examples cited in these areas used innovative techniques to clearly
address difficult accounting issues.
Commitments and
contingencies
Derivatives and
financial instruments
Goodwill and
intangibles
Revenue
recognition
Twenty-five out of
100 filers in the 2006 reporting season reported tangible asset
impairments as a critical accounting policy.
Many companies
report condensed consolidating cash flows statements as part of
their segment disclosures, although not required by SFAS No. 131,
Disclosures about Segments of an Enterprise and Related Information.
To further facilitate
use of this report as a reference tool, all of the financial statement
footnotes gathered for the study are available to members on the
Financial Executives International Web site.
"FERF undertook this study
to provide our members with an illustration of how companies have used
innovative techniques to clearly address difficult accounting concerns,"
said Cheryl Graziano, vice president, research and operations for FERF.
"Recent accounting issues publicized by the FASB and the SEC have had a
direct impact on members of the financial community, and the report shows
that many companies are taking action."
"We hope that all financial
executives can utilize the report as both a quick update to summarize recent
trends in the most annual reporting season, as well as a reference to
address common accounting issues. The convenience of the online database
will provide executives with a readily handy tool when drafting their own
annual reports," said Graziano.
A second piece of research
by FEI, entitled the "FERF Fraud Risk Checklist," provides boards of
directors and management with a series of questions to help in assessing the
potential risk factors associated with fraudulent financial reporting and
the misappropriation of assets. These questions were developed from a number
of key sources on financial fraud and offer executives a single framework in
which to evaluate their company's reporting, while providing a sample
structure for management to use in documenting its thought process and
conclusions.
"Making improvements to
compliance with Sarbanes Oxley is a daily practice for financial executives,
and the first step in efficient evaluation of internal controls is the
proper assessment of potential exposures or risks associated with fraud,"
said Michael Cangemi, president and CEO, Financial Executives International.
"Through conversations with members of the financial community, we learned
that, while this type of risk assessment is a routine skill for auditors,
many members of management are not always familiar with this concept. This
checklist combines knowledge from the leading resources on fraud to help
financial management take a proactive step in evaluating their company's
practices and identifying areas for improvement."
The annual report
study, including the full report and access to the online database, and the
fraud checklist, are available for purchase on the
FEI Web site
I have been writing regular blogs for The
Guardian, a UK national newspaper. The articles are available at
http://commentisfree.guardian.co.uk/prem_sikka/index.html
and offer a critical commentary on
business and accountancy matters. For three days after each article the
website takes readers' comments and colleagues are welcome to add comments,
critical or otherwise. The most recent article appeared on 29 January 2008.
There is now also an extensive database of
corporate and accountancy misdemeanours on the AABA website
(
You might enjoy "The AICPA's Prosecution of Dr. Abraham Briloff: Some
Observations," by Dwight M. Owsen --- http://accounting.rutgers.edu/raw/aaa/pi/newsletr/spring99/item07.htm
I think Briloff was trying to save the profession from what it is now going
through in the wake of the Enron scandal.
The Securities and Exchange Commission has taken
disciplinary action against more than 50 accountants in 2005 and 2006 for
misconduct in scandals big and small. But few have paid a dime to compensate
shareholders for their varying levels of neglect or complicity.
It also turns out that nearly half of them continue
to hold valid state licenses to hang out their shingles as certified public
accountants, based on an examination of public records by The Associated
Press.
So while the SEC has forbidden these CPAs from
preparing, auditing or reviewing financial statements for a public company,
they remain free to perform those very same services for private companies
and other organizations that may be unaware of their professional misdeeds.
Some would say the accounting profession has taken
its fair share of lumps, particularly with the abrupt annihilation of Arthur
Andersen LLP and the jobs of thousands of auditors who had nothing to do
with the firm's Enron Corp. account. Meantime, the big auditing firms are
paying hundreds of millions of dollars in damages - without admitting or
denying wrongdoing - to settle assorted charges of professional malpractice.
Individual penance is another matter, however, and
here the accountants aren't being held so accountable.
Part of the trouble is that there doesn't appear to
be an established system of communication by which the SEC automatically
notifies state accounting regulators of federal disciplinary actions. In
several instances, state accounting boards were unaware a licensee had been
disciplined by the SEC until it was brought to their attention in the
reporting for this column. The SEC says it refers all disciplinary actions
to the relevant state boards, so the cause of any breakdowns in these
communications is unclear.
Another obstacle may be that some state boards do
not have ample resources to tackle the sudden swell of financial scandals.
It's not as if, for example, the Texas State Board of Public Accountancy had
ever before dealt with an accounting fraud as vast as that perpetrated at
Houston-based Enron.
"We don't have the staff on board to manage the
extra workload that the profession has been confronted with over the last
few years," said William Treacy, executive director of the Texas board. "So
we contracted with the attorney general's office to provide extra
prosecutorial power."
Treacy said his office is usually notified of SEC
actions concerning Texas-licensed CPAs, but the process isn't automatic.
With other states, communications from the SEC
appear less certain. If nothing else, many boards rely upon license renewals
to learn about SEC actions, but that only works if the applicants respond
truthfully to questions about whether they've been disciplined by any
federal or state agency. A spokeswoman for Georgia's board said one CPA
recently disciplined by the SEC had renewed his license online without
disclosing it.
Ransom Jones, CPA-Investigator for the Mississippi
State Board of Public Accountancy, said most of his leads come from other
accountants, media reports and annual registrations.
"The SEC doesn't necessarily notify the board,"
said Jones, whose agency revoked the licenses of key players in the scandal
at Mississippi-based WorldCom.
Some state boards appear more vigilant than others
in policing their membership. The boards in California and Ohio have
punished most of their licensees who have been disciplined by the SEC since
the start of 2005.
New York regulators haven't yet penalized any
locals targeted by the SEC in that timeframe, though they have taken action
against two disciplined by the SEC's new Public Company Accounting Oversight
Board. It is conceivable that cases are underway but not yet disclosed, or
that some individuals have been cleared despite the SEC's findings. A
spokesman for the New York State Education Department said all SEC referrals
are probed, but not all forms of misconduct are punishable under local
statute. New rules now under consideration would strengthen those
disciplinary powers, he said.
Meanwhile, although the SEC deserves credit for
de-penciling those CPAs who've breached their duties as gatekeepers of
financial integrity, barely any of those individuals have been asked to make
amends financially.
No doubt, except for those elevated to CEO or CFO,
most accountants are not paid as handsomely as the corporate elite. That
said, partners from top accounting firms are were [sic] paid well enough to
cough up more than the SEC has sought, which in most cases has been zero.
Earlier this year, in what the SEC crowed about as
a landmark settlement, three partners for KPMG LLP agreed to pay a combined
$400,000 in fines regarding a $1.2 billion fraud at Xerox Corp. One of those
fined still holds his license in New York.
"The SEC has never sought serious money from errant
CPAs," said David Nolte of Fulcrum Financial Inquiry LLP. "Unfortunately,
the small fines in the Xerox case set a record of the amount paid, so
everyone else has also gotten off easy."
It's not that the CPAs found culpable in scandals
don't deserve a right to redemption, or just to earn a living. Most of the
bans against practicing before the SEC are temporary, spanning anywhere from
a year to 10 years.
But the presumed deterrent of SEC action is
weakened if federal and state regulators don't work together on a consistent
message so bad actors don't get a free pass at the local level.
The Fraud Detectives
Consultant Network --- http://www.frauddetectives.com/
This is a helpful site, although I
might add that accountants, attorneys, and others can list themselves free at
this site with no filtering with regard to skills and experience.
Turning to business, the board rapidly
approved a series of transactions, according to the minutes and a
report later commissioned by Hollinger. The board awarded a
private company, controlled by Lord Black, $38 million in
"management fees" as part of a move by Lord Black's team
to essentially outsource the company's management to itself. It
agreed to sell two profitable community newspapers to another
private company controlled by Lord Black and Hollinger executives
for $1 apiece. The board also gave Lord Black and his colleagues a
cut of profits from a Hollinger Internet unit.Finally,
the directors gave themselves a raise. The meeting lasted about an
hour and a half, according to the minutes and two directors who
were present. Robert Frank and Elena Cheney --- Click
here to read part of their article
If the Enron bankruptcy proves
anything, it is that there are sinners in all walks of life, and
that the market economy provides mechanisms for rooting out and
punishing systematic liars. Those who clamor for Congress to “do
something” to assure that this kind of thing will never happen
again are delusional if they think Congress has the ability to
legislate away sin or otherwise improve on the market system of
profit and loss. Such delusions are a testament to the
successful brainwashing of generations of public school students
who have been taught to worship the “god” of the state and to
look to it to solve all of life’s problems.
Accounting fraud at Enron is such a big
story because it is so exceptional; only once in a blue moon
does a major corporation destroy itself in this way. In
contrast, “accounting” fraud is an inherent feature of
government.
There is no such thing as real
accounting in government, of course, since there are no
profit-and-loss statements, only budgets. Consequently, there is
no way of ever knowing, in an accounting sense, whether
government is adding value or destroying it. All we know is that
the budget grew by a certain amount, for some ostensible
purpose. And government is constantly lying to the public about
how much of the public’s money is being spent and what it is
being spent on.
As Gene Epstein has reported in
Barron’s, during the Clinton administration, vast sums were
transferred from the Social Security and Federal Highway Trust
Funds to the budget so that Clinton and the Republican Congress
could take “credit” for balancing the budget. Any corporate CEO
who raided his employees’ pension fund and put the money in the
company coffers so that the bottom line would look good and he
could earn himself a fat bonus would end up in prison.
The federal government practices what
it calls “baseline budgeting,” whereby federal agencies announce
that they wish to increase their budgets by, say, 10 percent a
year, and if they only increase them by 5 percent that is called
a 5 percent budget “cut.” There can be no better example of
accounting fraud than calling a budget increase a cut.
The General Accounting Office,
Congressional Budget Office, and other federal agencies also use
“static analysis” when analyzing and reporting to the public on
tax policy changes. That is, they assume that taxation has no
effect whatsoever on economic behavior. So, if we have a $10
trillion economy, and impose a flat 75-percent income tax, these
“authoritative” sources will announce that the IRS expects to
collect $7.5 trillion in revenues, each year, ignoring several
hundred years of economic theory and practice.
Continued in article
Clinton's famously crude remark And I hope that comes through in the
book (see below for references to the book Infectious
Greed). I am very critical of the
tax law changes that created the incentives for companies to pay
executives with stock options, which were made at the beginning
of the Clinton Administration to appease populist
anti-corporation forces among his supporters by appearing to do
something about what, even then, was alleged to be execessive
pay for corporate executives. Not to mention his
Administration's hands-off approach to Wall Street
(when Arthur Levitt headed the SEC).
There's that great story --- perhaps apocoryphal --- that I
recount in the book about Clinton's famously crude remark when
he discovered that voters cared much more about whether the
stocks were going up than his economic program.
Frank Partnoy, Partnoy's Solutions, welling@weeden,
October 21, 2005
Selected works of FRANK PARTNOY
Bob Jensen at Trinity University
1. Who is Frank Partnoy?
Cheryl Dunn requested that I do a review of my
favorites among the “books that have influenced [my] work.”
Immediately the succession of FIASCO books by Frank Partnoy
came to mind. These particular books are not the best among related
books by Wall Street whistle blowers such as Liar's Poker:
Playing the Money Markets by Michael Lewis in 1999 and Monkey
Business: Swinging Through the Wall Street Jungle by John Rolfe
and Peter Troob in 2002. But in1997. Frank Partnoy was the first
writer to open my eyes to the enormous gap between our assumed
efficient and fair capital markets versus the “infectious greed”
(Alan Greenspan’s term) that had overtaken these markets.
Partnoy’s succession of FIASCO books,
like those of Lewis and Rolfe/Troob are reality books written from
the perspective of inside whistle blowers. They are somewhat
repetitive and anecdotal mainly from the perspective of what each
author saw and interpreted.
My favorite among the capital market fraud
books is Frank Partnoy’s latest book Infectious Greed: How Deceit
and Risk Corrupted the Financial Markets (Henry Holt & Company,
Incorporated, 2003, ISBN: 080507510-0- 477 pages). This is the most
scholarly of the books available on business and gatekeeper
degeneracy. Rather than relying mostly upon his own experiences,
this book drawn from Partnoy’s interviews of over 150 capital
markets insiders of one type or another. It is more scholarly
because it demonstrates Partnoy’s evolution of learning about
extremely complex structured financing packages that were the
instruments of crime by banks, investment banks, brokers, and
securities dealers in the most venerable firms in the U.S. and other
parts of the world. The book is brilliant and has a detailed and
helpful index.
What did I learn most from Partnoy?
I learned about the failures and complicity of
what he terms “gatekeepers” whose fiduciary responsibility was to
inoculate against “infectious greed.” These gatekeepers instead
manipulated their professions and their governments to aid and abet
the criminals. On Page 173 of Infectious Greed, he writes
the following:
Page #173
When Republicans captured the House of Representatives in
November 1994--for the first time since the Eisenhower
era--securities-litigation reform was assured. In a January 1995
speech, Levitt outlined the limits on securities regulation that
Congress later would support: limiting the statute-of-limitations
period for filing lawsuits, restricting legal fees paid to lead
plaintiffs, eliminating punitive-damages provisions from securities
lawsuits, requiring plaintiffs to allege more clearly that a
defendant acted with reckless intent, and exempting "forward looking
statements"--essentially, projections about a company's future--from
legal liability.
The Private Securities Litigation Reform
Act of 1995 passed easily, and Congress even overrode the veto of
President Clinton, who either had a fleeting change of heart about
financial markets or decided that trial lawyers were an even more
important
constituency than Wall Street. In any event, Clinton and Levitt
disagreed about the issue, although it wasn't fatal to Levitt, who
would remain SEC chair for another five years.
He later introduces Chapter 7 of Infectious
Greed as follows:
Pages 187-188
The regulatory changes
of 1994-95 sent three messages to corporate CEOs. First, you are
not likely to be punished for "massaging" your firm's accounting
numbers. Prosecutors rarely go after financial fraud and, even when
they do, the typical punishment is a small fine; almost no one goes
to prison. Moreover, even a fraudulent scheme could be recast as
mere earnings management--the practice of smoothing a
company's earnings--which most executives did, and regarded as
perfectly legal.
Second, you should use
new financial instruments--including options, swaps, and other
derivatives--to increase your own pay and to avoid costly
regulation. If complex derivatives are too much for you to
handle--as they were for many CEOs during the years immediately
following the 1994 losses--you should at least pay yourself in stock
options, which don't need to be disclosed as an expense and have a
greater upside than cash bonuses or stock.
Third, you don't need
to worry about whether accountants or securities analysts will tell
investors about any hidden losses or excessive options pay. Now
that Congress and the Supreme Court have insulated accounting firms
and investment banks from liability--with the Central Bank decision
and the Private Securities Litigation Reform Act--they will be much
more willing to look the other way. If you pay them enough in fees,
they might even be willing to help.
Of course, not every
corporate executive heeded these messages. For example, Warren
Buffett argued that managers should ensure that their companies'
share prices were accurate, not try to inflate prices artificially,
and he criticized the use of stock options as compensation. Having
been a major shareholder of Salomon Brothers, Buffett also
criticized accounting and securities firms for conflicts of
interest.
But for every Warren
Buffett, there were many less scrupulous CEOs. This chapter
considers four of them: Walter Forbes of CUC International, Dean
Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass
of Rite Aid. They are not all well-known among investors, but their
stories capture the changes in CEO behavior during the mid-1990s.
Unlike the "rocket scientists" at Bankers Trust, First Boston, and
Salomon Brothers, these four had undistinguished backgrounds and
little training in mathematics or finance. Instead, they were
hardworking, hard-driving men who ran companies that met basic
consumer needs: they sold clothes, barbecue grills, and prescription
medicine, and cleaned up garbage. They certainly didn't buy swaps
linked to LIBOR-squared.
The book Infectious Greed has chapters
on other capital markets and corporate scandals. It is the best
account that I’ve ever read about Bankers Trust the Bankers Trust
scandals, including how one trader named Andy Krieger almost
destroyed the entire money supply of New Zealand. Chapter 10 is
devoted to Enron and follows up on Frank Partnoy’s invited testimony
before the United States Senate Committee on Governmental Affairs,
January 24, 2002 ---
http://www.senate.gov/~gov_affairs/012402partnoy.htm
The controversial writings of Frank Partnoy
have had an enormous impact on my teaching and my research.
Although subsequent writers wrote somewhat more entertaining
exposes, he was the one who first opened my eyes to what goes on
behind the scenes in capital markets and investment banking.
Through his early writings, I discovered that there is an enormous
gap between the efficient financial world that we assume in agency
theory worshipped in academe versus the dark side of modern reality
where you find the cleverest crooks out to steal money from widows
and orphans in sophisticated ways where it is virtually impossible
to get caught. Because I read his 1997 book early on, the ensuing
succession of enormous scandals in finance, accounting, and
corporate governance weren’t really much of a surprise to me.
From his insider perspective he reveals a world
where our most respected firms in banking, market exchanges, and
related financial institutions no longer care anything about
fiduciary responsibility and professionalism in disgusting contrast
to the honorable founders of those same firms motivated to serve
rather than steal.
Young men and women from top universities of
the world abandoned almost all ethical principles while working in
investment banks and other financial institutions in order to become
not only rich but filthy rich at the expense of countless pension
holders and small investors. Partnoy opened my eyes to how easy it
is to get around auditors and corporate boards by creating
structured financial contracts that are incomprehensible and serve
virtually no purpose other than to steal billions upon billions of
dollars.
Most importantly, Frank Partnoy opened my eyes
to the psychology of greed. Greed is rooted in opportunity and
cultural relativism. He graduated from college with a high sense of
right and wrong. But his standards and values sank to the criminal
level of those when he entered the criminal world of investment
banking. The only difference between him and the crooks he worked
with is that he could not quell his conscience while stealing from
widows and orphans.
Frank Partnoy has a rare combination of
scholarship and experience in law, investment banking, and
accounting. He is sometimes criticized for not really understanding
the complexities of some of the deals he described, but he rather
freely admits that he was new to the game of complex deceptions in
international structured financing crime.
2. What really happened at Enron?
I begin with the following document the best thing I ever read
explaining fraud at Enron.
Testimony of Frank Partnoy Professor of Law, University of San Diego
School of Law Hearings before the United States Senate Committee on
Governmental Affairs, January 24, 2002 ---
http://www.senate.gov/~gov_affairs/012402partnoy.htm
The following selected quotations from his
Senate testimony speak for themselves:
Quote:In
other words, OTC derivatives markets, which for the most part did
not exist twenty (or, in some cases, even ten) years ago, now
comprise about 90 percent of the aggregate derivatives market,
with trillions of dollars at risk every day. By those measures,
OTC derivatives markets are bigger than the markets for U.S.
stocks. Enron may have been just an energy company when it was
created in 1985, but by the end it had become a full-blown OTC
derivatives trading firm. Its OTC derivatives-related assets and
liabilities increased more than five-fold during 2000 alone.
Quote: And,
let me repeat, the OTC derivatives markets are largely
unregulated. Enron’s trading operations were not regulated, or
even recently audited, by U.S. securities regulators, and the OTC
derivatives it traded are not deemed securities. OTC derivatives
trading is beyond the purview of organized, regulated exchanges.
Thus, Enron – like many firms that trade OTC derivatives – fell
into a regulatory black hole.
Quote:
Specifically, Enron used derivatives and special purpose vehicles
to manipulate its financial statements in three ways. First, it
hid speculator losses it suffered on technology stocks. Second,
it hid huge debts incurred to finance unprofitable new businesses,
including retail energy services for new customers. Third, it
inflated the value of other troubled businesses, including its new
ventures in fiber-optic bandwidth. Although Enron was founded as
an energy company, many of these derivatives transactions did not
involve energy at all.
Quote:
Moreover, a thorough inquiry into these dealings also should
include the major financial market “gatekeepers” involved with
Enron: accounting firms, banks, law firms, and credit rating
agencies. Employees of these firms are likely to have knowledge
of these transactions. Moreover, these firms have a
responsibility to come forward with information relevant to these
transactions. They benefit directly and indirectly from the
existence of U.S. securities regulation, which in many instances
both forces companies to use the services of gatekeepers and
protects gatekeepers from liability.
Quote:
Recent cases against accounting firms – including Arthur Andersen
– are eroding that protection, but the other gatekeepers remain
well insulated. Gatekeepers are kept honest – at least in theory
– by the threat of legal liability, which is virtually
non-existent for some gatekeepers. The capital markets would be
more efficient if companies were not required by law to use
particular gatekeepers (which only gives those firms market
power), and if gatekeepers were subject to a credible threat of
liability for their involvement in fraudulent transactions.
Congress should consider expanding the scope of securities fraud
liability by making it clear that these gatekeepers will be liable
for assisting companies in transactions designed to distort the
economic reality of financial statements.
Quote: In a
nutshell, it appears that some Enron employees used dummy accounts
and rigged valuation methodologies to create false profit and loss
entries for the derivatives Enron traded. These false entries
were systematic and occurred over several years, beginning as
early as 1997. They included not only the more esoteric financial
instruments Enron began trading recently – such as fiber-optic
bandwidth and weather derivatives – but also Enron’s very
profitable trading operations in natural gas derivatives.
Quote: The difficult
question is what to do about the gatekeepers. They occupy a
special place in securities regulation, and receive great benefits
as a result. Employees at gatekeeper firms are among the most
highly-paid people in the world. They have access to superior
information and supposedly have greater expertise than average
investors at deciphering that information. Yet, with respect to
Enron, the gatekeepers clearly did not do their job.
3. What are some of Frank Partnoy’s
best-known books?
Frank Partnoy, FIASCO: Blood in the Water on
Wall Street (W. W. Norton & Company, 1997, ISBN 0393046222, 252
pages).
This is the first of a
somewhat repetitive succession of Partnoy’s “FIASCO” books that
influenced my life. The most important revelation from his
insider’s perspective is that the most trusted firms on Wall Street
and financial centers in other major cities in the U.S., that were
once highly professional and trustworthy, excoriated the guts of
integrity leaving a façade behind which crooks less violent than the
Mafia but far more greedy took control in the roaring 1990s.
After selling a
succession of phony derivatives deals while at Morgan Stanley,
Partnoy blew the whistle in this book about a number of his
employer’s shady and outright fraudulent deals sold in rigged
markets using bait and switch tactics. Customers, many of them
pension fund investors for schools and municipal employees, were
duped into complex and enormously risky deals that were billed as
safe as the U.S. Treasury.
His books have
received mixed reviews, but I question some of the integrity of the
reviewers from the investment banking industry who in some instances
tried to whitewash some of the deals described by Partnoy. His
books have received a bit less praise than the book Liars Poker
by Michael Lewis, but critics of Partnoy fail to give credit that
Partnoy’s exposes preceded those of Lewis.
Frank Partnoy, FIASCO: Guns, Booze and
Bloodlust: the Truth About High Finance (Profile Books, 1998,
305 Pages)
Like his earlier
books, some investment bankers and literary dilettantes who reviewed
this book were critical of Partnoy and claimed that he
misrepresented some legitimate structured financings. However, my
reading of the reviewers is that they were trying to lend credence
to highly questionable offshore deals documented by Partnoy. Be
that as it may, it would have helped if Partnoy had been a bit more
explicit in some of his illustrations.
Preface
1. A Better Opportunity
2. The House of Cards
3. Playing Dice
4. A Mexican Bank Fiesta
5. F.I.A.S.C.O.
6. The Queen of RAVs
7. Don't Cry for Me, Argentina
8. The Odd Couple
9. The Tequila Effect
10. MX
11. Sayonara
Frank Partnoy, FIASCO: The Inside Story of a
Wall Street Trader (Penguin, 1999, ISBN 0140278796, 283 pages).
This is a blistering
indictment of the unregulated OTC market for derivative financial
instruments and the devious million and billion dollar deals
conceived by drunken sexual deviates in investment banking. Among
other things, Partnoy describes Morgan Stanley’s annual drunken
skeet-shooting competition.
This is also one of
the best accounts of the “fiasco” caused by Merrill Lynch in which
Orange Counting lost over a billion dollars and was forced into
bankruptcy.
Frank Partnoy, Infectious Greed: How Deceit
and Risk Corrupted the Financial Markets (Henry Holt & Company,
Incorporated, 2003, ISBN: 080507510-0, 477 pages)
Partnoy shows how
corporations gradually increased financial risk and lost control
over overly complex structured financing deals that obscured the
losses and disguised frauds pushed corporate officers and their
boards into successive and ingenious deceptions." Major corporations
such as Enron, Global Crossing, and WorldCom entered into enormous
illegal corporate finance and accounting. Partnoy documents the
spread of this epidemic stage and provides some suggestions for
restraining the disease.
4. What are examples of related books that
are somewhat more entertaining than Partnoy’s early books?
Michael Lewis, Liar's Poker: Playing the
Money Markets (Coronet, 1999, ISBN 0340767006)
Lewis writes in
Partnoy’s earlier whistleblower style with somewhat more intense and
comic portrayals of the major players in describing the double
dealing and break down of integrity on the trading floor of Salomon
Brothers.
John Rolfe and Peter Troob, Monkey Business:
Swinging Through the Wall Street Jungle (Warner Books,
Incorporated, 2002, ISBN: 0446676950, 288 Pages)
This is a hilarious tongue-in-cheek
account by Wharton and Harvard MBAs who thought they were starting
out as stock brokers for $200,000 a year until they realized that
they were on the phones in a bucket shop selling sleazy IPOs to
unsuspecting institutional investors who in turn passed them along
to widows and orphans. They write. "It took us another six
months after that to realize that we were, in fact, selling crappy
public offerings to investors."
There are other
books along a similar vein that may be more revealing and
entertaining than the early books of Frank Partnoy, but he was one
of the first, if not the first, in the roaring 1990s to reveal the
high crime taking place behind the concrete and glass of Wall
Street. He was the first to anticipate many of the scandals that
soon followed. And his testimony before the U.S. Senate is the
best concise account of the crime that transpired at Enron. He
lays the blame clearly at the feet of government officials (read
that Wendy Gramm) who sold the farm when they deregulated the
energy markets and opened the doors to unregulated OTC derivatives
trading in energy. That is when Enron really began bilking the
public.
If the Big Four shrinks to the Big Three, some
clients will continuously employ all three firms. Accounting
Firm 1 hired for audits is not allowed to perform tax services or
information system consulting.Accounting
Firm 2 hired for tax services runs a liability risk if it also designs
the information system feeding the tax information.Accounting Firm 3 hired for information systems consulting is not
allowed to perform audits and probably should not perform tax services.
It will be very confusing unless something is done to distinguish the
external accountants in the client's offices. I suggest color codes.
What will the colors be,
after there are but three?
I wonder if the Big Three will adopt distinct
colors.As I recall Andersen
employees preferred orange shirts when demonstrating outside the Justice
Department (in a pouring rain) around the time Andersen was being tried
for obstruction of justice in the destruction of Enron’s audit files.White has been pretty well taken up by medical services.Black has always been the most popular auditor color --- when I
worked for Ernst, I was required to have a black fedora to match my
black suits.But undertakers
also prefer black.Traders
in the commodity pits wear bright colors.Why can’t accountants do the same?
Seriously, I always thought Andersen's choice of orange was rather
ironic. This is too close to prison-orange for a firm that is trying to
fend off a criminal conviction.
Quotations
At a time when U.S. firms are more reliant than ever
on quality accounting and auditing services, the influential Business Roundtable
is supporting liability caps for auditors. The Roundtable is worried that the
Big Four accounting firms could soon shrink to three or fewer firms if Congress
doesn't act to stem the liabilities the firms face when things go wrong.
"Business Roundtable Supports Auditor Liability Cap," AccountingWeb,
January 18, 2005 --- http://www.accountingweb.com/item/100390
Discontent is rightfully rising over CEO pay versus performance In fact, the boss enjoyed a hefty raise
last year. The chief executives at 179 large companies that had filed
proxies by last Tuesday - and had not changed leaders since last year -
were paid about $9.84 million, on average, up 12 percent from 2003,
according to Pearl Meyer & Partners, the compensation consultants.
Surely, chief executives must have done something spectacular to justify
all that, right? Well, that's not so clear. The link between rising pay
and performance remained muddy - at best. Profits and stock prices are
up, but at many companies they seem to reflect an improving economy
rather than managerial expertise. Regardless, the better numbers set off
sizable incentive payouts for bosses. With investors still smarting from
the bursting of the tech bubble, the swift rebound in executive pay is
touching some nerves. "The disconnect between pay and performance keeps
getting worse," said Christianna Wood, senior investment officer for
global equity at Calpers, the California pension fund. "Investors were
really mad when pay did not come down during the three-year bear market,
and we are not happy now, when companies reward executives when the
stock goes up $2."
Claudia H. Deutsch, "My Big Fat C.E.O. Paycheck," The New York Times,
April 3, 2005 ---
http://www.nytimes.com/2005/04/03/business/yourmoney/03pay.html?
Bob Jensen's threads on corporate fraud are at
http://www.trinity.edu/rjensen/fraud.htm
Bob Jensen's updates on fraud are at
http://www.trinity.edu/rjensen/fraudUpdates.htm
Steve Albrecht (former American Accounting Association President and
Professor of Accounting at Brigham Young University) conducted
interviews when Barry Minkow was still in prison. You can read
Steve's account of the ZZZZ Best Fraud at http://www.swcollege.com/vircomm/stice_survey/sts/sts04.html
Question Why is there so much investment fraud?
Answer What we have is a perfect fraud storm. In
places across the country with an appreciating housing market, low
interest rates, and consumers dissatisfied with Wall Street returns,
you'll find people ripe for [perpetrators]. "Ten Questions for Barry Minkow," CFO Staff, by CFO
Magazine, January 2005, Page 20 --- http://www.cfo.com/article.cfm/3516399/c_3516777?f=magazine_alsoinside
The current head of the Fraud Discovery Institute, Barry Minkow, also
served more than seven years in prison for the infamous ZZZZ Best scam.
Barry Minkow says he plans to be remembered
for more than the ZZZZ Best Co. fraud. The 38-year-old Minkow served
more than seven years in prison for the infamous 1980s scam. But he
hopes that his current efforts as head of the Fraud Discovery
Institute and as pastor of The Community Bible Church in San Diego
will supersede his activities as CEO of the carpet-cleaning company.
This month his new book, Cleaning Up (Nelson Current), debuts.
1. Currently, you are fighting the very
crime you were convicted of. Isn't that ironic?
No one failed worse than I did at such a young age. Sure, you can
adjust the dollar amounts and say it was $10 billion with Bernie
Ebbers at WorldCom, but it doesn't matter. I was CEO of a public
company and I failed. [ZZZZ Best] was a fully reporting public company
with a stock that went from $12 to $80. And at 21, I got a 25-year
sentence and a $26 million restitution order, and that's [since been]
turned into $1 billion in fraud uncoverings.
2. What can other white-collar criminals
glean from your mistakes?
Jeff Skilling's and Andy Fastow's best days are ahead of them...if
they admit they did wrong, do whatever they can to pay back their
victims, and use the same talents they used to defraud people to help
them.
3. When you speak to executives about
fraud, what's your main message?
When I speak to executives, I wear my orange prison jumpsuit. It's
gimmicky... [but] the best way to stop fraud is to talk people out of
perpetrating it in the first place by doing two things: increasing the
perception of detection and increasing the perception of prosecution.
4. Are you surprised that the fraud
techniques you used are still out there?
It doesn't surprise me at all. Long before Enron was touring people on
phony trading floors, ZZZZ Best was touring people on buildings for
restoration jobs that we never did. Now the variation on a theme is
always there, but here's what we do: we lie about what we owe and we
lie about what we earn.
5. On what do you blame the rash of
corporate fraud in recent years?
It's a mentality called right equals forward motion and wrong is
anyone who gets in my way. You see, we used to endorse character and
integrity, but today the business ethic that reigns is achievement.
And whenever you establish the worth of someone based on what they can
do and not on who they are, you have created the environment for
fraud.
6. Are you skeptical of efforts, such as
Sarbanes-Oxley, to legislate ethics?
Let me tell you why this legislation is brilliant. Sarbox hit at a
common denominator of corporate fraud: bypassing systems of internal
controls. I would not have been able to perpetrate the ZZZZ Best fraud
if I had not been able to bypass the system of internal controls. And
you know who are heroes now — the internal auditors and the Public
Company Accounting Oversight Board. Unless you're a perpetrator, you
don't know how good these moves are.
7. Should the sentencing guidelines for
white-collar criminals be overhauled?
Yes, and judges should have more discretion. My judge is the one who
said that I had no conscience. Two years ago, he dismissed my $26
million restitution order, dismissed me from probation three years
early, and told me to go out and fight corporate fraud. [But] I don't
care if anyone goes to jail. The number-one thing white-collar
criminals need to do is give the money back to those hurt the most.
8. When will you be satisfied that you've
repaid your debt to society?
I won't be. Union Bank had a $7 million loan [against ZZZZ Best], and
I have a long way to go. But I haven't missed a payment in nine years.
They've gotten over $100,000 this year alone.
9. Why is there so much investment fraud?
What we have is a perfect fraud storm. In places across the country
with an appreciating housing market, low interest rates, and consumers
dissatisfied with Wall Street returns, you'll find people ripe for
[perpetrators].
10. What do you say to those who doubt
your conversion to the straight and narrow?
There's this great phrase in the Bible: "When the man's ways
please the Lord, he makes even his enemies be at peace with him."
The biggest critics of Barry Minkow should be law enforcement. They
absolutely know if someone is a fake or real. But they've been my
biggest supporters.
Instead of adding more
regulating agencies, I think we should simply make the FBI tougher on
crime and the IRS tougher on cheats
Our Main Financial Regulating
Agency: The SEC Screw Everybody Commission
One of the biggest regulation failures in history is the way the SEC
failed to seriously investigate Bernie Madoff's fund even after being
warned by Wall Street experts across six years before Bernie himself
disclosed that he was running a $65 billion Ponzi fund.
CBS Sixty Minutes on June 14,
2009 ran a rerun that is devastatingly critical of the SEC. If you’ve
not seen it, it may still be available for free (for a short time only)
at
http://www.cbsnews.com/video/watch/?id=5088137n&tag=contentMain;cbsCarousel
The title of the video is “The Man Who Would Be King.”
Between 2002 and 2008 Harry
Markopolos repeatedly told (with indisputable proof) the Securities and
Exchange Commission that Bernie Madoff's investment fund was a fraud.
Markopolos was ignored and, as a result, investors lost more and more
billions of dollars. Steve Kroft reports.
Markoplos makes the SEC look
truly incompetent or outright conspiratorial in fraud.
I'm really surprised that the SEC
survived after Chris Cox messed it up so many things so badly.
As Far as Regulations Go
An
annual report issued by the Competitive Enterprise Institute (CEI) shows
that the U.S. government imposed $1.17 trillion in new regulatory costs
in 2008. That almost equals the $1.2 trillion generated by individual
income taxes, and amounts to $3,849 for every American citizen.
According the 2009 edition of Ten Thousand Commandments: An Annual
Snapshot of the Federal Regulatory State, the government issued 3,830
new rules last year, and The Federal Register, where such rules are
listed, ballooned to a record 79,435 pages. “The costs of federal
regulations too often exceed the benefits, yet these regulations receive
little official scrutiny from Congress,” said CEI Vice President Clyde
Wayne Crews, Jr., who wrote the report. “The U.S. economy lost value in
2008 for the first time since 1990,” Crews said. “Meanwhile, our federal
government imposed a $1.17 trillion ‘hidden tax’ on Americans beyond the
$3 trillion officially budgeted” through the regulations. Adam Brickley,
"Government Implemented Thousands of New Regulations Costing $1.17
Trillion in 2008," CNS News, June 12, 2009 ---
http://www.cnsnews.com/public/content/article.aspx?RsrcID=49487
Jensen Comment
I’m a long-time believer that industries being regulated end up
controlling the regulating agencies. The records of Alan Greenspan (FED)
and the SEC from Arthur Levitt to Chris Cox do absolutely nothing to
change my belief ---
http://www.trinity.edu/rjensen/FraudRotten.htm
How do industries leverage the
regulatory agencies?
The primary control mechanism is to have high paying jobs waiting in
industry for regulators who play ball while they are still employed by
the government. It happens time and time again in the FPC, EPA, FDA,
FAA, FTC, SEC, etc. Because so many people work for the FBI and IRS,
it's a little harder for industry to manage those bureaucrats. Also the
FBI and the IRS tend to focus on the worst of the worst offenders
whereas other agencies often deal with top management of the largest
companies in America.
The link to the
following article was forwarded by Charles Wankel
[wankelc@VERIZON.NET]
"Account for
more than hill of beans," The Bay City Times Via The Saginaw News,
December 16, 2007 ---
Click Here
When Kojo Quartey
went to college to learn accounting 25 years ago, many considered
the job a steady, unexciting career.
But financial
scandals in recent years at Enron, WorldCom and other companies have
transformed the field, says Quartey, dean of Davenport University's
Donald W. Maine School of Business.
''When I was an
accounting student, we were all number crunchers. In this day and
age, it's a much more exciting field,'' he said.
Many accountants
today are seeking specialized training to work as detectives who can
sniff out financial fraud. They call themselves forensic
accountants.
Davenport, a Grand
Rapids-based university with branches at 5300 Bay in Kochville
Township and at 3930 Traxler Court in Bay County's Monitor Township,
has two online offerings in the growing field. One is a new
bachelor's degree in business administration in accounting fraud
investigation and the other is a forensic accounting examiner
certificate available to postgraduates.
Forensic accountants
undergo training to mind the books while keeping an eye out for
crime.
Demand for
accountants who have such training is skyrocketing, Quartey told a
group of Bay and Arenac county high school counselors.
In addition to
traditional accounting, forensic accountants may learn from law
enforcement experts about how to detect fraud, and from
psychologists about how to interview people to detect lying, Quartey
said.
Irene Bembenista
teaches classes at Davenport required for the forensic examiner
certificate.
''It's not just how
to do an audit, but what are some of the clues that would indicate
something more is going on? And ideas about where to further
investigate,'' said Bembenista, Davenport's associate business
school dean.
Bembenista said 10
years ago, people did not generally recognize forensic accounting as
a college career path.
A federal law
enacted in 2002 to reform accounting has brought the investigation
field into its own. It's also created job opportunities because it
requires accountants at public entities to maintain a separation of
duties, Bembenista said.
''Accountants aren't
allowed to do double duties, like taxes and audit the company at the
same time,'' she said.
''And businesses are
very interested in accountants with a fraud (detection) background,
because they are looking out for the well-being of the
organization.''
The starting salary
for an accounting fraud investigator is $48,000 to $60,000 a year,
and certified forensic examiners can earn more than $100,000 a year,
Davenport says compensation studies indicate.
Davenport has
about two dozen students enrolled in the forensic accounting
certificate curriculum, Quartey said. The next term begins in
January, and more information is available on the Internet at
www.davenport.edu
"The Effective Use of Benford's Law to Assist in Detecting Fraud in Accounting Data," by Cindy Durtchsi, William Hillison,
and Carl Pacini,
Journal of Forensic Accounting, Vol. 5, 2004, pp. 17-34
http://www.auditnet.org/articles/JFA-V-1-17-34.pdf
Accounting Teachers About Cooking the
Books Get Caught ... er ... Cooking the Books The media and blogs are conveniently
pinning the Huron debacle on its Andersen roots, and hinting that the
Enron malfeasance bled into Huron.
What I find ironic below is that the
Huron Consulting Group is itself a consulting group on technical
accounting matters, internal controls, financial statement restatements,
accounting fraud, rules compliance, and accounting education. If any
outfit should've known better it was Huron Consulting Group ---
Huron Consulting Group was formed in May
of 2003 in Chicago with a core set of 213 following the implosion of
huge Arthur Andersen headquartered in Chicago. The timing is much more
than mere coincidence since a lot of Andersen professionals were
floating about looking for a new home in Chicago. In the past I've used
the Huron Consulting Group published studies and statistics about
financial statement revisions of other companies. I never anticipated
that Huron Consulting itself would become one of those statistics. I
guess Huron will now have more war stories to tell clients.
An accounting mess
at Huron Consulting Group Inc. that led to the decapitation of top
management and the collapse in its share price puts the survival of
the Chicago-based firm in jeopardy.
Huron’s damaged
reputation imperils its ability to provide credible expert witnesses
during courtroom proceedings growing out of its bread-and-butter
restructuring and disputes and investigations practices. Rivals are
poised to capture marketshare.
“These types of
firms have to be squeaky clean with no exceptions, and this was too
big of an exception,” says Allan Koltin, a Chicago-based accounting
industry consultant. “I respect the changes they made and the speed
(with which) they made them. I’m not sure they can recover from
this.”
Huron executives
declined to comment.
Late Friday, Huron
said it would restate results for the three years ended in 2008 and
for the first quarter of 2009, resulting in a halving of its
profits, to $63 million from $120 million, for the 39-month period.
Revenue projections for 2009 were cut by more than 10%, to a range
of $650 million to $680 million from $730 million to $770 million.
The company said its
hand was forced by its recent discovery that holders of shares in
acquired firms had an agreement among themselves to reallocate a
portion of their earn-out payments to other Huron employees. The
company said it had been unaware of the arrangement.
“The employee
payments were not ‘kickbacks’ to Huron management,” the company
said.
Whatever the
description, the fallout promises to shake Huron to its core. The
company’s stock plunged 70% Monday to about $14 per share, and law
firms were preparing to mount class-action shareholder litigation.
“If the public
doesn’t buy that the house is clean, my guess is some of the senior
talent will start to move very quickly,” says William Brandt,
president and CEO of Chicago-based restructuring firm Development
Specialists Inc. “Client retention is all that matters here.”
Publicly traded
competitors like Navigant Consulting Inc. are unlikely to make bids
for Huron because of the potential for damage to their own stock.
Private enterprises like Mesirow Financial stand as logical
employers as Huron workers jump ship.
“There certainly is
potential out there for clients and employees who may be looking at
different options, but at this point in the process it’s a little
early to tell what impact this will have,” says a Navigant
spokesman.
Huron’s woes led to
the resignation last week of Chairman and CEO Gary Holdren and Chief
Financial Officer Gary Burge, both of whom will stay on with the
firm for a time, and the immediate departure of Chief Accounting
Officer Wayne Lipski.
Mr. Holdren, 59, has
a certain amount of familiarity with turmoil.
He was among
co-founders of Huron in 2002, when their previous employer,
Andersen, folded along with its auditing client Enron Corp. He told
the Chicago Tribune in 2007, “Initially, when we’d call on potential
clients, they’d say, ‘Huron? Who are you? That sounds like Enron,’
or ‘Aren’t you guys supposed to be in jail? Why are you calling us?’
”
This year, it’s been
money issues dogging Huron. In the spring, shareholders twice
rejected proposals to sweeten an employee stock compensation plan.
Mr. Holdren’s total
compensation in 2008 was $6.5 million, according to Securities and
Exchange Commission filings. Mr. Burge received $1.2 million.
A Huron unit in June
sued five former consultants and their new employer, Sonnenschein
Nath & Rosenthal LLP, alleging that the defendants were using trade
secrets to lure Huron clients to the law firm. The defendants denied
the charges. The case is pending in Cook County Circuit Court.
Chief Executive Gary
Holdren and two other top executives are resigning from
Chicago-based management consultancy Huron Consulting Group as the
company announced Friday it is restating financial statements for
three fiscal years.
Holdren’s
resignation as CEO and chairman was effective Monday and he will
leave Huron at the end of August, the company said in a statement.
Chief Financial Officer Gary Burge is being replaced in that post
but will serve as treasurer and stay through the end of the year.
Chief Accounting Officer Wayne Lipski is also leaving the company.
None of the departing executives will be paid severance, Huron said.
Huron will restate
its financial results for 2006, 2007, 2008 and the first quarter of
2009. The accounting missteps relate to four businesses that Huron
acquired between 2005 and 2007.
According to Huron’s
statement and a filing with the Securities and Exchange Commission,
the selling shareholders of the acquired businesses distributed some
of their payments to Huron employees. They also redistributed
portions of their earnings “in amounts that were not consistent with
their ownership percentages” at the time of the acquisition, Huron
said.
A Huron spokeswoman
declined to give the number of shareholders and employees involved,
saying the company was not commenting beyond its statement.
“I am greatly
disappointed and saddened by the need to restate Huron’s earnings,”
Holdren said in the statement. He acknowledged “incorrect”
accounting.
Huron said the
restatement’s total estimated impact on net income and earnings
before interest, taxes, depreciation and amortization for the
periods in question is $57 million.
“Because the issue
arose on my watch, I believe that it is my responsibility and my
obligation to step aside,” said Holdren.
Huron said the
board’s audit committee had recently learned of an agreement between
the selling shareholders to distribute some of their payments to a
company employee. The committee then launched an inquiry into all of
Huron’s prior acquisitions and discovered the involvement of more
Huron employees.
Huron said it is
reviewing its financial reporting procedures and expects to find
“one or more material weaknesses” in the company’s internal
controls. The amended financial statements will be filed “as soon as
practicable,” Huron said.
James Roth, one of
Huron’s founders, is replacing Holdren as CEO. Roth was previously
vice president of Huron’s health and education consulting business,
the company’s largest segment. George Massaro, Huron’s former chief
operating officer who is the board of directors’ vice chairman, will
succeed Holdren as chairman.
James Rojas, another
Huron founder, is now the company’s CFO. Rojas was serving in a
corporate development role. Huron did not announce a replacement for
Lipski, the chief accounting officer.
The company’s shares
sank more than 57 percent in after-hours trading. The stock had
closed Friday at $44.35. Huron said it expects second-quarter
revenues between $164 million and $166 million, up about 15 percent
from the year-earlier quarter.
The company,
founded by former partners at the Andersen accounting firm including
Holdren, also said that it is conducting a separate inquiry into
chargeable hours in response to an inquiry from the SEC.
First, kudos to the Audit Committee (John McCartney, Dubose Ausley and
James Edwards) for unearthing this issue and pursuing it fearlessly to
its terrible end at Huron Consulting.
From The Wall Street Journal Weekly Accounting Review on August 6, 2009
TOPICS: Accounting
Changes and Error Corrections, Advanced Financial Accounting,
Mergers and Acquisitions
SUMMARY: Huron
Consulting Group, Inc., was formed in May 2002 by partners from the
now-defunct Arthur Andersen LLP. "Today, fewer than 10% of the
company's employees came directly from Arthur Andersen." The firm
provides "...financial and legal consulting services, including
forensic-style investigative work...." The firm announced
restatement of earnings for fiscal years 2006, 2007, and 2008 and
the first quarter of 2009 due to inappropriate accounting for
payments made to acquire four businesses between 2005 and 2007. The
payments were made after the acquisitions for earn-outs: additional
amounts of cash payments or stock issuances based on earning
specific financial performance targets over a number of years
following the business combinations. However, portions of these
earn-out payments were redistributed to employees remaining with
Huron after the acquisitions based on specific performance measures
by these employees rather than being based on their relative
ownership interests in the firms prior to acquisition by Huron.
Consequently, those payments are deemed to be compensation expense.
The amounts restated thus reduce net income for the periods of
restatement and reduce future income amounts, but do not affect cash
flows of the firm. Negative shareholder reaction to this
announcement by a firm which provides consulting services in this
area certainly is not surprising.
CLASSROOM APPLICATION: Accounting
for allocation of a purchase price in a business combination is
covered in this article.
QUESTIONS:
1. (Introductory)
In general, how do we account for assets acquired in business
combinations? How are cash payments and stock issued to selling
shareholders accounted for?
2. (Introductory)
What are contingent payments in a business combination? What are the
two main types of contingent payments and what are their accounting
implications?
3. (Introductory)
Which of the above 2 types of contingent payments were employed in
the Huron acquisition agreements for businesses it acquired over the
years 2005 to 2008?
4. (Advanced)
Obtain the SEC 8_k filing by Huron for the restatement announcement,
dated July 31, 2009, and the filing answering subsequent questions
and answers as posted on its web site, dated August 3, 2009
available at
http://www.sec.gov/Archives/edgar/data/1289848/000119312509160844/d8k.htm
and
http://www.sec.gov/Archives/edgar/data/1289848/000128984809000017/exh99-1.htm
respectively. What was the problem which made the original
acquisition accounting improper? What accounting standard
establishes requirements for handling corrections of errors such as
this? In your answer, explain why the company discloses that
investors must not rely on the previously released financial
statements.
5. (Advanced)
Refer specifically to the August 3, 2009, filing obtained above.
What were the ultimate journal entries made to correct these errors?
Explain the components of these entries.
6. (Advanced)
The author of this article writes that this error in reporting and
subsequently required restatement "...suggests [that] a closer
alliance between consulting and accounting isn't such a bad idea."
What is the SEC requirement that divides consulting and accounting?
Do you think this problem with reporting would have arisen had the
firm been allowed to perform both auditing, accounting, and
consulting services to its clients? Support your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Financial downturns often expose accounting problems at companies,
but scandals have been noticeably absent in the recent turmoil. Not
so anymore.
Late Friday, Huron Consulting Group Inc. said it would restate the
last three years of financial results, withdraw its 2009 earnings
guidance and lower its outlook for 2009 revenue. The accounting
snafu, which has decimated the company's shares, was all the more
surprising because Huron traces its roots to Arthur Andersen LLP,
the accounting firm at the heart of the last wave of scandals.
A dose of added irony is that Huron makes its money providing
financial and legal consulting services, including forensic-style
investigative work, and tries to help clients avoid these types of
mistakes.
"One of their businesses is forensic accounting -- they're experts
in this," says Sean Jackson, an analyst at Avondale Partners in
Nashville, Tenn., who dropped his rating to the equivalent of "hold"
from "buy." "Investors are saying, 'These guys had to know what
happened with the accounting, or they should have known.'"
Investors fear the accounting issues, which will reduce net income
by $57 million for the periods in question, might damage the firm's
credibility. Huron's shares fell 70% on Monday, well below the price
of its initial public offering in 2004. On Tuesday, Huron shares
rose four cents to $13.73.
Huron, based in Chicago, was started in May 2002 by refugees from
Arthur Andersen who fled the firm after it was indicted for its role
in the collapse of Enron Corp. At the time, the group said that it
would specialize in bankruptcy and litigation work, as well as
education and health-care consulting, and that it would work with
more than 70 former clients of Arthur Andersen. Arthur Andersen's
guilty verdict was later overturned, but it was too late to save the
firm, which was dismantled. Today, fewer than 10% of the company's
employees came directly from Andersen, according to a Huron
spokeswoman.
Huron on Friday also announced preliminary second-quarter revenue
that was shy of analyst expectations, along with the resignation of
Gary Holdren, its board chairman and chief executive, along with the
resignations of finance chief Gary Burge and chief accounting
officer Wayne Lipski. "No severance expenses are expected to be
incurred by the company as a result of these management changes,"
Huron's regulatory filing said.
After its founding by 25 Andersen partners and more than 200
employees, Huron grew rapidly. It soon had 600 employees and counted
firms like Pfizer, International Business Machines and General
Motors as clients. Growing scrutiny of accounting firms that also
did consulting made Huron's consulting-only business look promising,
and shares soared from below $20 five years ago to nearly $44 before
the news on Friday.
That is when Huron dropped its bombshell -- one that suggests a
closer alliance between consulting and accounting isn't always such
a bad idea. Huron is restating financial statements to correct how
it accounted for certain acquisition-related payments to employees
of four businesses that Huron purchased since 2005.
Huron said the employees shared "earn-outs," or financial rewards
based on the performance of acquired units after the transaction was
completed, with junior employees at the units who weren't involved
in the original sale. They also distributed some of the proceeds
based on performance of employees who remained at Huron, not based
on the ownership interests of those employees in the businesses that
were sold.
The payments were legal. The problem was how Huron accounted for
these payouts. The compensation should have been booked as a noncash
operating expense of the company. Huron said the payments "were not
kickbacks" to Huron management, but rather went to employees of the
acquired businesses.
The method the company used to book the payments served to increase
its profit. The adjustments reduced the company's net income,
earnings per share and other measures, though it didn't affect its
cash flow, assets or liabilities.
Part of investors' concern is that they aren't entirely sure what
happened at Huron. The company's executives aren't speaking with
analysts, some said on Tuesday.
Employees and big producers now might bolt from Huron, Avondale
Partners' Mr. Jackson says.
"It's still unclear what happened, but it's almost irrelevant at
this point," says Tim McHugh, an analyst at William Blair & Co., who
has the equivalent of a "hold" on the stock, down from a "buy" last
week. "The company's brand has been impaired and turnover of key
employees is a significant risk."
First, kudos to the Audit Committee (John McCartney, Dubose Ausley
and James Edwards) for unearthing this issue and pursuing it
fearlessly to its terrible end.
Second, shame on senior management to succumb to greed and not
complying strictly with accounting standards
Third, shame also on the auditor, PricewaterhouseCoopers for failing
to spot this issue, especially in 2008, when the amount of money
kept in goodwill was $31 million, three times the true net income of
Huron of only $10 million
Fourth, shame on Huron itself for providing accounting, internal
audit, internal controls, Sarbanes, and similar advice to its
corporate clients, while following shady accounting practices.
Physician, heal thyself first.
Finally, our sympathies for all the hard working and honest Huron
consultants who had nothing to do with acquisitions or their
accounting, and are likely as mad as anyone that this could happen
to them.
Andersen Partners in the Aftermath of Enron:
Protiviti and Huron in Particular
Some Andersen partners stayed on at the Andersen firm (that is no longer an
auditing firm) and some continued to make their living at Andersen's training
facility in St. Charles, Illinois. In 2005, the U.S. Supreme Court overturned
Andersen's conviction for obstruction of justice ---
http://en.wikipedia.org/wiki/Arthur_Andersen_LLP_v._United_States
The U.S. Supreme Court overturned the conviction of the Arthur Andersen
accounting firm for destroying documents related to its Enron account before the
energy giant's collapse. The ruling is not based upon guilt or innocence. It is
based only on a technicality in the judge's instructions to the jury. The ruling
will not lead to a revival of this once great firm that in the years preceding
its collapse became known for some terrible audits of firms like Waste
Management, Enron, Worldcom and other clients. For details see
http://news.bbc.co.uk/2/hi/business/4596949.stm
Also see
http://accounting.smartpros.com/x48441.xml
Former Andersen partners who formed two consulting firms are not fairing
so well at the moment. But the things at Protivii are a bit more rosy than
things at Huron.
First there's the huge book cooking (creative accounting) scandal at Huron
Consulting that has now sucked in PwC as well ---
Huron Consulting Group was formed in May of 2003 in Chicago with a core
set of 213 following the implosion of huge Arthur Andersen headquartered in
Chicago. The timing is much more than mere coincidence since a lot of Andersen
professionals were floating about looking for a new home in Chicago. In the past
I've used the Huron Consulting Group published studies and statistics about
financial statement revisions of other companies. I never anticipated that Huron
Consulting itself would become one of those statistics. I guess Huron will now
have more war stories to tell clients.
See the module above.
Protiviti was formed largely of Andersen's former internal auditing
consultants and has a history outlined below.
Protiviti, as many will recall, was principally
Andersen’s internal audit service line, and these professionals joined the
multi-billion dollar organization Robert Half International ($RHI) in 2002
to form their own division, separate from the staffing units for which RHI
is better known for – Accountemps, Office Team and Management Resources.
Starting with just over 700 employees in 25 locations, Protiviti has
certainly grown in size and scope, and now is a global business consulting
and internal audit firm providing risk, advisory, and transaction services;
with 2,500 professionals in 62 locations in 17 countries worldwide. The
Protiviti division accounts for 13% of total parent company RHI revenues;
and within Protiviti itself, international operations were 30% of total
Protiviti revenues.
All the senior management at Protiviti continue to be Andersen alumni:
Joseph A. Tarantino, President and Chief Executive
Officer, ex-head of Arthur Andersen’s Financial Services Assurance practice
for metropolitan New York
Carol M. Beaumier, Executive Vice President, Global Industry Programs,
ex-partner in Arthur Andersen’s Regulatory Risk Services practice
Robert B. Hirth Jr., Executive Vice President, Global Internal Audit,
ex-partner with Arthur Andersen
James Pajakowski, Executive Vice President, Global Risk Solutions,
ex-partner with Arthur Andersen
Gary Peterson, Executive Vice President, International Operations,
ex-partner at Arthur Andersen
We haven’t focused on Protiviti for the longest
time, but our attention was brought back after seeing RHI’s full year 2009
results. We were quite surprised to see that despite its size, Protiviti had
a full year 2009 loss. Yes, a loss of $30 million for the entire year on
revenues of $384 million.
To dig deeper into this situation, we had to go
back all the way to 2007, analyze a whole series of quarterly earnings and
read through multiple earnings transcripts (courtesy: SeekingAlpha.com).
An interesting picture emerges from our analysis,
vividly demonstrating the intensity and rapidity of the global slowdown, and
consequent management efforts to cope with business shrinkage.
In 2007, Protiviti had revenues of $552 million,
gross margin of $175 million (32% of revenues), and operating income of $21
million (4% of revenues). In 2008, revenues held reasonably flat at $547
million, but gross margin had decreased by $20 million to $155 million (28%
of revenues), and operating income fell by $14 million, a full 66% to $7
million (1% of revenues). In 2009, the situation had rapidly deteriorated,
with revenues falling 30% to $384 million, gross margin plunging by $75
million to $80 million (21% of revenues), and operating income declining
precipitously by $38 million to a net loss figure of $(31) million (negative
8% of revenues). In a matter of just 24 months, Protiviti’s top line had
eroded by 30% and its operations had gone from a healthy profit to a huge
loss.
A deeper look at the quarterly earnings for two
full years, 2008 and 2009, reveals the full extent of the situation.
In 2007, Protiviti had good operating results, with
3,300 employees, up a whopping 16% from 2006, as management hired talent in
sync with increased demand for its services.
From Q1-2008 to Q3-2008, in the first three
quarters of 2008, revenues continued at the 2007 quarterly run-rate of about
$140 million, but total costs, principally direct compensation costs from
all the increased staff levels were up 4%, increasing from 68% of revenues
in 2007 to 72% of revenues in the first three quarters of 2008. Things were
still on a decent footing at that time, operating income was a few million
dollars profit on the average each quarter, not at 2007 levels, but
certainly not at losses either. The expected increase in 2008 revenues had
not been seen, and the increased cost line continued to pressure Protiviti’s
profits. A review of the Q3-2008 quarterly earnings call shows that
management was cautiously optimistic about Protiviti’s performance and
prospects, and there were initial efforts to bring costs in line with flat
revenues. Given that RHI had not ever managed Protiviti through a downturn,
senior management could not provide decent guidance on revenues for the
upcoming fourth quarter.
Then, with the collapse of Lehman Brothers in
September 2008, the financial crisis became really severe in Q4-2008.
In Q4-2008, Protiviti’s revenues fell to $125
million, $15 million below the run rate seen in the last three quarters, but
Protiviti had already started moving to reducing its cost base. Both direct
costs and SG&A costs were quickly reined in, and the cost base in Q4-2008
was reduced by $12 million in comparison to Q3-2008, to almost offset the
$15 million loss in revenue. Overall, operating income for Q4-2008 decreased
to $1 million from $4 million in Q3-2009.
At the end of 2008, Protiviti had seen flat
revenues to 2007, but a sharp drop in profits. The firm had 3,200 employees,
100 lower than the 3,300 at the end of 2007, through some initial layoffs.
Its likely no-one imagined how 2009 would turn out.
In Q1-2009, Protiviti’s revenue fell to $100
million, $25 million below Q4-2008 (some of this was attributed to
seasonally slow first quarters), but this is when Protiviti really started
to manage its employee base. It took an $8 million extraordinary charge in
the quarter for severance costs, with an intent to manage its employee
compensation costs in line with falling revenues. There was also a
contemporaneous reduction in SG&A, but the quarter still ended with a $11
million operating loss, as total costs in the quarter could not come down
far enough with the rapid decline in revenue.
In Q2-2009, quarterly revenues had fallen another
$10 million to $90 million, however, the cost base also fell by $10 million
from the previous quarter and the operating loss position of $11 million
held steady from the prior quarter. Protiviti took an additional $2 million
employee severance restructuring charge in the quarter. By this time,
management had recognized the severity of the issue and were taking active
steps to manage costs in line with declining revenues. Management said that
US operations had better profitability than international operations, which
were being scrutinized in detail. Also, the division was taking steps to
diversify away purely from Internal Audit and Sarbox type work into IT audit
and co-sourcing to create a larger set of non-correlated service lines.
By Q3-2009, the positive cost impact of the
reductions in staff were showing on the bottom line. Q3-2009 revenues were
$96 million, a good $6 million better than the $90 million in Q2-2009 in
terms of revenue, with the third quarter being sequentially generally better
than the second quarter. Costs in Q3-2009 were also $7 million better than
Q2-2009, with the net result that operating profit increased by $12 million
from Q2-2009 to Q3-2009. Q3-2009 turned in a small operating income of $1
million. Q3-2009 gross margin% matched what were historical levels in the
first half of 2008.
In Q4-2009, the operating situation was quite
similar to Q3-2009, as revenues and costs generally held steady and flat.
Revenue was $96 million, staff utilization improved and operating income was
essentially zero.
Protiviti ended 2009 with $384 million in revenue,
30% lower than 2008, and with an operating loss of $21 million (net of
restructuring charges) compared with $7 million of operating profit in 2008.
The big change in 2009 was the employee base, the year ended with 2,500
employees, 700 employees lower than the end of the previous year. This was a
gut-wrenching 22% reduction in staff, in that 1 out of every 5 professionals
with Protiviti who was working at the end of 2008 was no longer at the firm
in 2009.
As we turn into 2010, management appears much more
bullish about Protiviti’s 2010 prospects and indicated generally that the
division will aim to generate positive operating profit for this year. The
problem seems to lie in Protiviti’s operations outside the US, which are
offsetting a higher level of US profitability, and there seems to be serious
effort to turn that around. It indicates that operating costs levels have
now been sized to a $400 million revenue business; and anecdotal evidence at
Protiviti consultants indicates there is growing confidence that there will
higher levels of business in this year.
Anyone who has passed through this crisis will
recall with clarity how difficult the last quarter of 2008 and the first
half of 2009 really was. This is a case study on Protiviti, but likely
representative of all consulting and accounting firms, who faced and
continue to face a crisis unprecedented in modern times. The decline in
Protiviti (a Big 4 firm spin off) is in line with the decreases in Advisory
service lines at the Big Four firms, however the magnitude of the fall is
much higher at Protiviti, much to its smaller size and smaller footprint in
higher-growth emerging countries of the world.
While we have been able only to tell the story from
the public financials, we do recognize there is a deep human cost, in terms
of lost jobs, continued unemployment, potentially poor morale, and tough
disengagement and working conditions. We invite Protiviti alumni to join the
Big4 LinkedIn group, which has a robust discussion and job board to extend
their network and keep abreast of developments. And if any of our readers
have first-hand or deeper knowledge of this situation, we welcome your
comments.
Another Andersen legacy
partners firm is FRA. it consists of only 6 or so partners
who do SEC/GAAP/IFRS consulting, no audit. Scott Taub of SEC
fame is part of the team, based in Chicago.
http://www.finra.com/scott.html
"Predicting Material
Accounting Misstatements"
Patricia M. Dechow University of California, Berkeley - Haas School of
Business
Weili Ge University of Washington - Michael G. Foster School of Business
Chad R. Larson Washington University, St. Louis
Richard G. Sloan Haas School of Business, UC Berkeley
SSRN, November 16, 2009
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=997483
Abstract:
We examine 2,190 SEC Accounting and Auditing Enforcement Releases (AAERs)
issued between 1982 and 2005. We obtain 676 firms that are alleged
to have misstated their quarterly or annual financial statements. We
examine the characteristics of misstating firms along five
dimensions: accrual quality; financial performance; non-financial
measures; off-balance sheet activities; and market-based measures.
We compare misstating firms to themselves during non-misstatement
years and misstating firms to the broader population of all publicly
listed firms. The results reveal that during misstatement years,
accruals and cash and credit sales are unusually high, while return
on assets and the number of employees are declining. In addition,
misstating firms finance more of their assets through operating
leases and have relatively less PP&E. We find that market pressures
appear to affect incentives to misstate. Misstating firms are
raising new financing, have higher market-to-book ratios, and strong
prior stock price performance. We develop a model to predict
accounting misstatements. The output of this model is a scaled
logistic probability that we term the F-Score, where values greater
than one suggest a greater likelihood of a misstatement.
Accounting Teachers About
Cooking the Books Get Caught ... er ... Cooking the Books The media and blogs are conveniently
pinning the Huron debacle on its Andersen roots, and hinting that the
Enron malfeasance bled into Huron.
What I find ironic below is
that the Huron Consulting Group is itself a consulting group on
technical accounting matters, internal controls, financial statement
restatements, accounting fraud, rules compliance, and accounting
education. If any outfit should've known better it was Huron Consulting
Group ---
http://www.huronconsultinggroup.com/about.aspx
Huron Consulting Group was
formed in May of 2003 in Chicago with a core set of 213 following the
implosion of huge Arthur Andersen headquartered in Chicago. The timing
is much more than mere coincidence since a lot of Andersen professionals
were floating about looking for a new home in Chicago. In the past I've
used the Huron Consulting Group published studies and statistics about
financial statement revisions of other companies. I never anticipated
that Huron Consulting itself would become one of those statistics. I
guess Huron will now have more war stories to tell clients.
An
accounting mess at Huron Consulting Group Inc. that led to the
decapitation of top management and the collapse in its share price
puts the survival of the Chicago-based firm in jeopardy.
Huron’s
damaged reputation imperils its ability to provide credible expert
witnesses during courtroom proceedings growing out of its
bread-and-butter restructuring and disputes and investigations
practices. Rivals are poised to capture marketshare.
“These
types of firms have to be squeaky clean with no exceptions, and this
was too big of an exception,” says Allan Koltin, a Chicago-based
accounting industry consultant. “I respect the changes they made and
the speed (with which) they made them. I’m not sure they can recover
from this.”
Huron
executives declined to comment.
Late
Friday, Huron said it would restate results for the three years
ended in 2008 and for the first quarter of 2009, resulting in a
halving of its profits, to $63 million from $120 million, for the
39-month period. Revenue projections for 2009 were cut by more than
10%, to a range of $650 million to $680 million from $730 million to
$770 million.
The company
said its hand was forced by its recent discovery that holders of
shares in acquired firms had an agreement among themselves to
reallocate a portion of their earn-out payments to other Huron
employees. The company said it had been unaware of the arrangement.
“The
employee payments were not ‘kickbacks’ to Huron management,” the
company said.
Whatever
the description, the fallout promises to shake Huron to its core.
The company’s stock plunged 70% Monday to about $14 per share, and
law firms were preparing to mount class-action shareholder
litigation.
“If the
public doesn’t buy that the house is clean, my guess is some of the
senior talent will start to move very quickly,” says William Brandt,
president and CEO of Chicago-based restructuring firm Development
Specialists Inc. “Client retention is all that matters here.”
Publicly
traded competitors like Navigant Consulting Inc. are unlikely to
make bids for Huron because of the potential for damage to their own
stock. Private enterprises like Mesirow Financial stand as logical
employers as Huron workers jump ship.
“There
certainly is potential out there for clients and employees who may
be looking at different options, but at this point in the process
it’s a little early to tell what impact this will have,” says a
Navigant spokesman.
Huron’s
woes led to the resignation last week of Chairman and CEO Gary
Holdren and Chief Financial Officer Gary Burge, both of whom will
stay on with the firm for a time, and the immediate departure of
Chief Accounting Officer Wayne Lipski.
Mr. Holdren,
59, has a certain amount of familiarity with turmoil.
He was
among co-founders of Huron in 2002, when their previous employer,
Andersen, folded along with its auditing client Enron Corp. He told
the Chicago Tribune in 2007, “Initially, when we’d call on potential
clients, they’d say, ‘Huron? Who are you? That sounds like Enron,’
or ‘Aren’t you guys supposed to be in jail? Why are you calling us?’
”
This year,
it’s been money issues dogging Huron. In the spring, shareholders
twice rejected proposals to sweeten an employee stock compensation
plan.
Mr.
Holdren’s total compensation in 2008 was $6.5 million, according to
Securities and Exchange Commission filings. Mr. Burge received $1.2
million.
A Huron
unit in June sued five former consultants and their new employer,
Sonnenschein Nath & Rosenthal LLP, alleging that the defendants were
using trade secrets to lure Huron clients to the law firm. The
defendants denied the charges. The case is pending in Cook County
Circuit Court.
Chief
Executive Gary Holdren and two other top executives are resigning
from Chicago-based management consultancy Huron Consulting Group as
the company announced Friday it is restating financial statements
for three fiscal years.
Holdren’s
resignation as CEO and chairman was effective Monday and he will
leave Huron at the end of August, the company said in a statement.
Chief Financial Officer Gary Burge is being replaced in that post
but will serve as treasurer and stay through the end of the year.
Chief Accounting Officer Wayne Lipski is also leaving the company.
None of the departing executives will be paid severance, Huron said.
Huron will
restate its financial results for 2006, 2007, 2008 and the first
quarter of 2009. The accounting missteps relate to four businesses
that Huron acquired between 2005 and 2007.
According
to Huron’s statement and a filing with the Securities and Exchange
Commission, the selling shareholders of the acquired businesses
distributed some of their payments to Huron employees. They also
redistributed portions of their earnings “in amounts that were not
consistent with their ownership percentages” at the time of the
acquisition, Huron said.
A Huron
spokeswoman declined to give the number of shareholders and
employees involved, saying the company was not commenting beyond its
statement.
“I am
greatly disappointed and saddened by the need to restate Huron’s
earnings,” Holdren said in the statement. He acknowledged
“incorrect” accounting.
Huron said
the restatement’s total estimated impact on net income and earnings
before interest, taxes, depreciation and amortization for the
periods in question is $57 million.
“Because
the issue arose on my watch, I believe that it is my responsibility
and my obligation to step aside,” said Holdren.
Huron said
the board’s audit committee had recently learned of an agreement
between the selling shareholders to distribute some of their
payments to a company employee. The committee then launched an
inquiry into all of Huron’s prior acquisitions and discovered the
involvement of more Huron employees.
Huron said
it is reviewing its financial reporting procedures and expects to
find “one or more material weaknesses” in the company’s internal
controls. The amended financial statements will be filed “as soon as
practicable,” Huron said.
James Roth,
one of Huron’s founders, is replacing Holdren as CEO. Roth was
previously vice president of Huron’s health and education consulting
business, the company’s largest segment. George Massaro, Huron’s
former chief operating officer who is the board of directors’ vice
chairman, will succeed Holdren as chairman.
James
Rojas, another Huron founder, is now the company’s CFO. Rojas was
serving in a corporate development role. Huron did not announce a
replacement for Lipski, the chief accounting officer.
The
company’s shares sank more than 57 percent in after-hours trading.
The stock had closed Friday at $44.35. Huron said it expects
second-quarter revenues between $164 million and $166 million, up
about 15 percent from the year-earlier quarter.
The
company, founded by former partners at the Andersen accounting firm
including Holdren, also said that it is conducting a separate
inquiry into chargeable hours in response to an inquiry from the
SEC.
In another paper from the
FMAs,
Gupta and Fields
look at whether more short
term debt leads to more "earnings management."
Does short-term debt lead to more "earnings
management"?
Short answer: YES.
Longer answer:
Intuitively the idea behind the paper is that if
a firm has to go back to the capital markets,
they do not want to do so when times are bad. Of
course, sometimes times are bad. In those times,
management may be tempted to "manage" earnings
so that things do not appear as bad as they may
be.
The findings? Sure enough, managers seemingly
manage their firm's earnings more when the firm
has more short term debt.
A few look-ins:
From the Abstract (this is the best summary of
the entire paper):
"...results indicate that (i) firms with
more current debt are more susceptible to
managing earnings, (ii) this relation is
stronger for firms facing debt market
constraints (those without investment grade
debt) and (iii) auditor characteristics such
as auditor quality and tenure help diminish
this relation...."
Which fits intuition. Why?
* The more the constraints, the more incentive
the management has to manage earnings since if
they do not, they may not be able to refinance.
* Auditors would frown upon this behavior and
the stronger the auditor, the less likely it is
that the manager would manage earnings.
How does this "earnings management" manifest
itself? The most common way (although not the
only way) that managers manipulate earnings is
through the use of accruals . Thus, the authors
examine this and find:
"A one standard-deviation increase in
short-term debt (total current liabilities)
increases discretionary accruals by 1.69%
and increase total accruals by 2.28%. Our
evidence supports the idea that debt
maturity significantly impacts the tendency
of firms to manage earnings."
Which is a really interesting finding!
Sharing Site of Note --- http://www.dartmouth.edu/~msimmons/ Thank you Mark Simmons at Dartmouth for sharing internal
auditing and fraud investigation resources.
This site focuses on topics that deal
with Internal
Auditing and Fraud
Investigation with certain links
to other associated and relevant sources. It is dedicated to
sharing information.
Internal
Auditing
is an independent, objective assurance and consulting activity
designed to add value and improve an organization's
operations. It helps an organization accomplish its
objectives by bringing a systematic, disciplined approach to
evaluate and improve the effectiveness of risk management,
control, and governance processes. (Institute of
Internal Auditors)
Fraud
Investigation
consists of the multitude of steps necessary to resolve
allegations of fraud — interviewing witnesses, assembling
evidence, writing reports, and dealing with prosecutors and
the courts. (Association of Certified Fraud Examiners)
Confession season is upon us, but the problem
so far isn't companies owing up to earnings shortfalls. Instead, they're
admitting past financial results were simply wrong.
Unnerved by a sterner accounting culture,
companies have been increasingly reaching back years to ratchet down
reported profits by tens or even hundreds of millions of dollars. Eyeing
the March 15 filing deadline for calendar 2003 annual reports,
Bristol-Myers Squibb (BMY:NYSE) , P.F. Chang's (PFCB:Nasdaq)
, Veritas (VRTS:Nasdaq) and Nortel (NT :Nasdaq) this week
joined a fast-growing string of public companies to say prior financial
reports inflated real business trends.
The number of restated audited annual financial
statements hit a record high of 206 last year, according to
Chicago-based Huron Consulting Group. Observers say 2004 is already
shaping up as a banner year for revisions.
"There are certainly more high-profile
restatements and you're hearing about them more" compared to past years,
said Jeff Brotman, an accounting professor at the University of
Pennsylvania.
For Bristol-Myers Squibb, Nortel and Network
Associates (NET:NYSE) , recent restatements came on top of prior
restatements, much to the irritation of investors. In at least two
cases, the embarrassing double restatements prompted internal shifts;
Nortel put two of its financial executives on leave as part of a
bookkeeping probe. Network Associates fired PricewaterhouseCoopers,
according to various news reports, after the auditor cited "material
weakness" in its internal controls in the company's annual report.
Probably the biggest reason for the wave of
honesty is a host of new corporate governance and accounting rules in
the wake of the corporate reform legislation known as Sarbanes-Oxley,
which went into effect a year and a half ago. Also, accounting firms
have grown far more cautious, cowed by the collapse of auditor Arthur
Andersen in 2002 after massive fraud at its client Enron.
The upshot is that both managers and auditors
are now more likely to err on the side of conservative accounting.
"A lot of things in accounting are judgment
calls, gray areas," said Peter Ehrenberg, chair of the corporate finance
practice group at Lowenstein & Sandler, a Roseland, N.J.-based law firm.
"If there are issues in any given company and we were in 2000, a person
acting in good faith might easily say, 'We can pass on that.' But that
same person looking at the same facts today might say, 'There's too much
risk.'
"Certainly regulators in general are more
credible because they're much less likely to give the benefit of the
doubt in this environment," he added. "The auditors know that and
they're [therefore] less likely to stick their necks out."
Case in point: Last week Gateway (GTW:NYSE)
said longtime auditor PricewaterhouseCoopers won't work for it anymore.
PwC did the books back in 2000 and 2001 -- an era of aggressive
accounting that still haunts Gateway, though it's now under different
management.
From Executive Suite to Cell Block
Tougher law enforcement against corporate
offenders is also fueling more prudent behavior. The long-underfunded
Securities and Exchange Commission, which is now required to review
the financial statements of public companies every three years, has
finally been given more dollars to hire staff. In 2003, the SEC's
workforce was 11% higher than in 2001. This year, the agency's budget
allocation should allow it to expand its payroll an additional 9%, to
nearly 3,600 employees.
On the corporate side, CEOs and CFOs have had
to certify their financial reports since August 2002, also as a result
of Sarbanes-Oxley. "I think Sarbanes-Oxley makes executives ask the hard
questions they should have always asked," said Jeffrey Herrmann, a
securities litigator and partner in the Saddle Brook, N.J.-based law
firm of Cohn Lifland Pearlman Herrmann & Knopf. "Maybe today an
executive says to his accounting firm: 'I'm not going to regret anything
here about how we handled goodwill or reserves, am I? It isn't coming
back to haunt us, is it?' "
Recent government prosecutions against
high-level executives such as Tyco's Dennis Kozlowski,
Worldcom's Bernie Ebbers, and Enron's Andrew Fastow and Jeffrey
Skilling starkly underscore the penalties managers may face for playing
fast-and-loose with accounting.
Meanwhile, auditing firms are starting to
rotate staff, bringing in newcomers to take a fresh look at clients'
accounting. Also, new rules handed down by the Financial Accounting
Standards Board have prompted reassessments of past accounting methods,
which can lead to earnings revisions reaching back five years (the
period for which financial data is included in annual reports).
Another level of checks and balances on
accounting shenanigans arrived last April when the SEC ruled that
corporate audit committees must be composed entirely of members
independent from the company itself. "Audit committees are getting more
active and making sure that when they learn of problems, they're going
to be dealt with," said Curtis Verschoor, an accounting professor at
DePaul University.
In this environment of heightened scrutiny,
however, the notion that a restatement was tantamount to a financial
kiss of death has faded, too.
"We have now seen companies that issued
restatements that have lived to do business another day," said Brotman.
"The stock hasn't crashed; nobody's been fired or gone to jail; they
haven't lost access to the capital markets; there haven't been any more
shareholder lawsuits than there would have already been. If a company
does a restatement early, fully and explains exactly what it is and why,
it's not a lethal injection."
Meanwhile, corporate reform rules are being put
in place that could lead to yet more accounting cleanups down the road.
One provision will make companies find a way for whistleblowers to
confidentially report possible wrongdoings, noted Verschoor.
Still, "the pendulum swings both ways," said
Herrmann. "If the government continues to prosecute people in high-level
positions, maybe that will last for a while. It probably will send a
message and the fear of God will spread. But my guess is that politics
being what it is, somewhere down the line the spotlight will be off and
there will be fewer prosecutions."
A Round-Up of Recent Earnings Restatements Some firms are no stranger to the restatement
dance
Company
Financial Scoop
Number of restatements in past
year
Bristol-Myers Squibb (BMY:NYSE)
Restating fourth-quarter and full-year results for
2003 due to accounting errors. Follows an earlier restatement of
earnings between 1999 and 2002, as of early 2003
Twice
P.F. Chang's China Bistro (PFCB:Nasdaq)
Will delay filing its 10K; plans to restate
earnings for prior years, including for calendar year 2003
Once
Veritas (VRTS:Nasdaq)
Will restate earnings for 2001 through 2003
Once
Nortel (NT:NYSE)
Will restate earnings for 2003 and earlier periods;
Nortel already restated earnings for the past three years in October
2003
Twice
Metris (MXT:NYSE)
Restated its financial results for 1998 through
2002 and for the first three quarters of 2003 following an SEC
inquiry
Once
Quovadx (QVDX:Nasdaq)
Restating results for 2003
Once
WorldCom
Restated pretax profits from 2000 and 2001; this
month former CEO Bernie Ebbers indicted on fraud charges in
accounting scandal that led to 2002 corporate bankruptcy
Once
Service Corp. International (SRV:NYSE)
Restating results for 2000 through 2003
Once
Flowserve (FLS:NYSE)
Restating results for 1999 through 2003
Once
OM Group (OMG:NYSE)
Restating results for 1999 through 2003
Once
IDX Systems (IDXC:Nasdaq)
Restated results for 2003
Once
Network Associates (NET:NYSE)
Restated results for 2003 this month; restated
earnings for periods from 1998 to 2003 after investigations by the
SEC and Justice Department
Twice
Take-Two (TTWO:Nasdaq)
In February, restated results from 1999 to 2003
following investigation by the SEC
Once
Sipex (SIPX:Nasdaq)
In February, restated results from 2003, marking
the second revision of third-quarter '03 results
Twice
Source:
SEC filings, media reports.
March 1, 2004 message from Mike
Groomer
Bob,
Do you have any
idea about who coined the phrase “Cooking the Books? What is the lineage
of these magic words?
Mike
Hi Mike,
The phrase "cooking the books"
appears to have a long history. Several friends on the AECM found some
interesting facts and legends.
However, there may be a little
urban legend in some of this.
I suspect that the phrase may
have origins that will never be determined much like double entry
bookkeeping itself with unknown origins. And I'm not sure were the term
"books" first appeared although I suspect it goes back to when ledgers
were bound into "books."
-----Original
Message-----
From: David Albrecht
Sent: Monday, March 01, 2004 9:56 PM
Subject: Acct 321: Cooking the books
The phrase
"Cooking the Books" has been part of our linguistic heritage for over
two hundred years. Here is a discussion of the origination of the
phrase. Enjoy! Dr. Albrecht
Cooking the books, an old
recipe -
http://www.accountantsworld.com/DesktopDefault.aspx?tabid=2&faid=290
--> "No one knows for sure when all the ingredients in the phrase
'cooking the books' were first put together. Shakespeare was the first
to refer to "books" as a business ledger (King Lear, Act III, Scene iv,
"Keep...thy pen from lenders books"). The American Heritage Dictionary
of Idioms cites 1636 as the first time the word 'cook' was used to mean
falsify (but it didn't also include the word 'books'). Combining 'cook'
and 'books' may be a 20th century innovation. Even the origin of
"cooking the books" is controversial.
A related term
is "cookbooking," as used in Gleim's 'Careers in Accounting: How to
Study for Success.' Per Gleim ". . .cookbooking is copying from the
chapter illustration, step-by-step. Barely more than rote memorization
is required to achieve false success. Do not cookbook!"
According to
http://www.businessballs.com/clichesorigins.htm , the phrase dates
back to the 18th century, to an (unattributed) report that used the
phrase "the books have been cooked." The report dealt with the conduct
of George Hudson and the accounts of the Eastern Counties Railways.
Original
Message-----
From: Groomer, S. Michael [mailto:groomer@indiana.edu]
Sent: Tuesday, March 02, 2004 9:40 AM
To: Jensen, Robert Subject: RE: Acct 321: Cooking the books
Hi Bob,
Yes… very
interesting… See below… Thanks for your efforts.
Best regards,
Mike
cook the books
- falsify business accounts - according to 18th century Brewer, 'cook
the books' originally appeared as the past tense 'the books have been
cooked' in a report (he didn't name the writer unfortunately) referring
to the conduct George Hudson (1700-71), 'the railway king', under whose
chairmanship the accounts of Eastern Counties Railways were falsified.
Brewer says then (1870) that the term specifically describes the
tampering of ledger and other trade books in order to show a balance in
favour of the bankrupt. Brewer also says the allusion is to preparing
meat for the table. These days the term has a wider meaning, extending
to any kind of creative accounting. Historical records bear this out,
and date the first recorded use quite accurately: Hudson made a fortune
speculating in railway shares, and then in 1845, which began the period
1845-47 known as 'railway mania' in Britain, he was exposed as a
fraudster and sent to jail. Other cliche references suggest earlier
usage, even 17th century, but there appears to be no real evidence of
this. There is an argument for Brewer being generally pretty reliable
when it comes to first recorded/published use, because simply he lived
far closer to the date of origin than reference writers of today. If you
read Brewer's Dictionary of Phrase and Fable you'll see it does have an
extremely credible and prudent style. The word 'book' incidentally comes
from old German 'buche' for beech wood, the bark of which was used in
Europe before paper became readily available. The verb 'cook' is from
Latin 'coquere'
This is also why the
financial masters of the universe tend not to write books. If you
have been proved—proved—right, why bother? If you need to tell it,
you can’t truly know it. The story of David Einhorn and Allied
Capital is an example of a moneyman who believed, with absolute
certainty, that he was in the right, who said so, and who then
watched the world fail to react to his irrefutable demonstration of
his own rightness. This drove him so crazy that he did what was, for
a hedge-fund manager, a bizarre thing: he wrote a book about it.
The story
began on May 15, 2002, when Einhorn, who runs a hedge fund called
Greenlight Capital, made a speech for a children’s-cancer charity in
Hackensack, New Jersey. The charity holds an annual fund-raiser at
which investment luminaries give advice on specific shares. Einhorn
was one of eleven speakers that day, but his speech had a twist: he
recommended shorting—betting against—a firm called Allied Capital.
Allied is a “business development company,” which invests in
companies in their early stages. Einhorn found things not to like in
Allied’s accounting practices—in particular, its way of assessing
the value of its investments. The
mark-to-market accounting that Einhorn
favored is based on the price an asset would fetch if it were sold
today, but many of Allied’s investments were in small startups that
had, in effect, no market to which they could be marked. In
Einhorn’s view, Allied’s way of pricing its holdings amounted to
“the you-have-got-to-be-kidding-me method of accounting.” At the
same time, Allied was issuing new
equity, and, according to Einhorn, the
revenue from this could be used to fund the dividend payments that
were keeping Allied’s investors happy.
To Einhorn, this looked like a potential Ponzi scheme.
The next day,
Allied’s stock dipped more than twenty per cent, and a storm of
controversy and counter-accusations began to rage. “Those engaging
in the current misinformation campaign against Allied Capital are
cynically trying to take advantage of the current post-Enron
environment by tarring a great and honest company like Allied
Capital with the broad brush of a Big Lie,” Allied’s C.E.O. said.
Einhorn would be the first to admit that he wanted Allied’s stock to
drop, which might make his motives seem impure to the general
reader, but not to him. The function of hedge funds is, by his
account, to expose faulty companies and make money in the process.
Joseph Schumpeter described capitalism as “creative destruction”:
hedge funds are destructive agents, predators targeting the weak and
infirm. As Einhorn might see it, people like him are especially
necessary because so many others have been asleep at the wheel. His
book about his five-year battle with Allied, “Fooling Some of the
People All of the Time” (Wiley; $29.95), depicts analysts,
financial journalists, and the S.E.C. as being culpably complacent.
The S.E.C. spent three years investigating Allied. It found that
Allied violated accounting guidelines, but noted that the company
had since made improvements. There were no penalties. Einhorn calls
the S.E.C. judgment “the lightest of taps on the wrist with the
softest of feathers.” He deeply minds this, not least because the
complacency of the watchdogs prevents him from being proved right on
a reasonable schedule: if they had seen things his way, Allied’s
stock price would have promptly collapsed and his short selling
would be hugely profitable. As it was, Greenlight shorted Allied at
$26.25, only to spend the next years watching the stock drift
sideways and upward; eventually, in January of 2007, it hit
thirty-three dollars.
All this has a
great deal of resonance now, because, on May 21st of this year, at
the same charity event, Einhorn announced that Greenlight had
shorted another stock, on the ground of the company’s exposure to
financial derivatives based on dangerous subprime loans. The company
was Lehman Brothers. There was little delay in Einhorn’s being
proved right about that one: the toppling company shook the entire
financial system. A global cascade of
bank implosions ensued—Wachovia, Washington Mutual, and the
Icelandic banking system being merely some of the highlights to
date—and a global bailout of the entire system had to be put in
train. The short sellers were proved
right, and also came to be seen as culprits; so was mark-to-market
accounting, since it caused sudden, cataclysmic drops in the book
value of companies whose holdings had become illiquid. It is
therefore the perfect moment for a short-selling advocate of marking
to market to publish his account. One can only speculate whether
Einhorn would have written his book if he had known what was going
to happen next. (One of the things that have happened is that, on
September 30th, Ciena Capital, an Allied portfolio company to whose
fraudulent lending Einhorn dedicates many pages, went into
bankruptcy; this coincided with a collapse in the value of Allied
stock—finally!—to a price of around six dollars a share.) Given the
esteem with which Einhorn’s profession is regarded these days, it’s
a little as if the assassin of Archduke Franz Ferdinand had taken
the outbreak of the First World War as the timely moment to publish
a book advocating bomb-throwing—and the book had turned out to be
unexpectedly persuasive.
If you’re
going to commit financial fraud, you probably don’t want to find
yourself sitting at a table across from David Einhorn, who will know
what you’re up to and share it with the world. Similarly, if you’ve
never played poker and have only ever had a 15 minute tutorial on
the game, you probably should avoid playing with the Greenlight
Capital founder, whose vastly superior skills will demonstrate just
how much you suck. As I like to live on the edge, yesterday in an
undisclosed location, I choose not to heed the wisdom of the latter.
Over several hands, Einhorn and I discussed the new edition of his
2008 book, “Fooling Some Of The People, All Of The Time.”
The
latest version includes an epilogue, and concludes the story of
Allied and Einhorn’s years of trying to get other people to listen
when he said something was up. As we
now know, Allied’s shares collapsed, Greenlight collected $35
million, and the hedge fund made another big (and correct) call on a
bank called Lehman Brothers, whose failure was, according to Einhorn,
“the Allied story all over again,” just on a bigger scale, with more
resounding consequences. Even after
the last crisis, which should have been a wake-up call, Einhorn
doesn’t think we’ve changed much and if anything, the reforms passed
only “encourage poor behavior and will likely foster an even bigger
crisis.” He and I chatted about that exciting event, Quantitative
Easing, Steve Eisman’s illicit pleasure of choice and more, plus
poker tips for people who really, really need them.
Continued in article
How to Pass Price Risk Along to Uncle Sam
Agribusiness Lobby Reaps the Biggest Harvest in Washington DC
A farmer can sell his crop early at a high
price, say, in a futures contract, and still collect a subsidy check
after the harvest from the government if prices are down over all. The
money is not tied to what the farmer actually received for his crop. The
farmer does not even have to sell the crop to get the check, only prove
that the market has dropped below a certain set rate.
"Big Farms Reap Two Harvests With Subsidies a Bumper Crop," by
Timothy Egan, The New York Times, December 26, 2005 --- http://www.nytimes.com/2004/12/26/national/26farm.html?oref=login
The roadside sign welcoming people into this
state reads: "Nebraska, the Good Life." And for farmers
closing out their books at the end of a year when they earned more
money than at any time in the history of American agriculture, it
certainly looks like happy days.
But at a time when big harvests and record
farm income should mean that Champagne corks are popping across the
prairie, the prosperity has brought with it the kind of nervousness
seen in headlines like the one that ran in The Omaha World-Herald in
early December: "Income boom has farmers on edge."
For despite the fact that farm income has
doubled in two years, federal subsidies have also gone up nearly 40
percent over the same period - projected at $15.7 billion this year,
and $130 billion over the last nine years. And that bounty is drawing
fire from people who say that at this moment of farm prosperity, the
nation's subsidy system has never made less sense.
Even those deeply steeped in the system
acknowledge it seems counterintuitive. "I struggle with the same
question: how the hell can you have such high government payments if
farmers had such a great year?" said Keith Collins, the chief
economist for the Agriculture Department.
The answer lies in the quirks of the federal
farm subsidy system as well as in the way savvy farmers sell their
crops. Mr. Collins said farmers use the peculiar world of agriculture
market timing to get both high commodity prices and high subsidies.
"The biggest reason is with record
crops, prices have fallen," he said. "And farmers are taking
advantage of that."
A farmer can sell his crop early at a high
price, say, in a futures contract, and still collect a subsidy check
after the harvest from the government if prices are down over all. The
money is not tied to what the farmer actually received for his crop.
The farmer does not even have to sell the crop to get the check, only
prove that the market has dropped below a certain set rate.
From Smart Stops on the Web, Journal of Accountancy, January
2004, Page 27 ---
Accountability Resources Here www.thecorporatelibrary.com CPAs can read about corporate governance in the real
world in articles such as “Alliance Ousts Two Executives” and “Mutual
Fund Directors Avert Eyes as Consumers Get Stung” at this Web site.
Other resources here include related news items from wire services and
newspapers, details on specific shareholder action campaigns and links
to other corporate governance Web stops. And on the lighter side,
visitors can view a slide show of topical cartoons.
Cartoon 1: Two kids competing on the blackboard. One
writes 2+2=4 and the other kid writes 2+2=40,000. Which kid as
the best prospects for an accounting career?
Cartoon 36: Where the Grasso is greener (Also see Cartoon 37)
Show-and-Tell www.encycogov.com This e-stop, while filled with information on corporate
governance, also features detailed flowcharts and tables on bankruptcy,
information retrieval and monitoring systems, as well as capital,
creditor and ownership structures. Practitioners will find six
definitions of the term corporate governance and a long list of
references to books, papers and periodicals about the topic.
Investors, Do Your Homework www.irrc.org At this Web site CPAs will find the electronic version
of the Investor Responsibility Research Center’s IRRC Social Issues
Reporter, with articles such as “Mutual Funds Seldom Support Social
Proposals.” Advisers also can read proposals from the Shareholder Action
Network and the IRRC’s review of NYSE and Sarbanes-Oxley Act reforms, as
well as use a glossary of industry terms to help explain to their
clients concepts such as acceleration, binding shareholder proposal
and cumulative voting.
SARBANES-OXLEY SITES
Get Information Online www.sarbanes-oxley.com CPAs looking for links to recent developments on the
Sarbanes-Oxley Act of 2002 can come here to review current SEC rules and
regulations with cross-references to specific sections of the act.
Visitors also can find the articles “Congress Eyes Mutual Fund Reform”
and “FBI and AICPA Join Forces to Help CPAs Ferret Out Fraud.”
Tech-minded CPAs will find the list of links to Sarbanes-Oxley
compliance software useful as well.
Direct From the Source www.sec.gov/spotlight/sarbanes-oxley.htm To trace the history of the SEC’s rule-making policies
for the Sarbanes-Oxley Act, CPAs can go right to the source at this Web
site and follow links to press releases pertaining to the commission’s
involvement since the act’s creation. Visitors also can navigate to the
frequently asked questions (FAQ) section about the act from the SEC’s
Division of Corporation Finance.
PCAOB Online www.pcaobus.org The Public Company Accounting Oversight Board e-stop
offers CPAs timely articles such as “Board Approves Registration of 598
Accounting Firms” and the full text of the Sarbanes-Oxley rules. Users
can research proposed standards on accounting support fees and audit
documentation and enforcement. Accounting firms not yet registered with
the PCAOB can do so here and check out the FAQ section about the
registration process.
Where are some great
resources (hard copy and electronic) for teaching ethics?
"An Inventory of Support Materials
for Teaching Ethics in the Post-Enron Era,” by C. William Thomas,
Issues in Accounting Education, February 2004, pp. 27-52 ---
http://aaahq.org/ic/browse.htm
ABSTRACT:
This paper presents a "Post-Enron" annotated bibliography of resources
for accounting professors who wish to either design a stand-alone course
in accounting ethics or who wish to integrate a significant component of
ethics into traditional courses across the curriculum. Many of the
resources listed are recent, but some are classics that have withstood
the test of time and still contain valuable information. The
resources listed include texts and reference works, commercial books,
academic and professional articles, and electronic resources such as
film and Internet websites. Resources are listed by subject
matter, to the extent possible, to permit topical access. Some
observations about course design, curriculum content, and instructional
methodology are made as well.
The former
head of Kmart Corp., who told jurors he was hired to save the
venerable retailer, was found liable Monday for misleading investors
about company finances before a bankruptcy filing in 2002.
The verdict
in the civil fraud trial followed 10 days of testimony in federal
court in Ann Arbor. The case was a fresh look at Charles Conaway's
brief tenure and the desperate scramble to keep Kmart afloat before
one of the largest bankruptcies in retail history.
The
Securities and Exchange Commission accused him of failing to
disclose that the retailer was delaying payments to suppliers to
save cash. The trial centered on a conference call with analysts and
Kmart's quarterly report to regulators, both in November 2001.
"It was a
clean sweep," SEC trial lawyer Alan Lieberman said of the verdict.
"It is
never enough for the numbers to be right. For the average investor,
the numbers being right do not tell the whole story," he said. "They
need to know the material information that management knows. The
foundation of the markets is full and honest disclosure."
The SEC
blamed Conaway for not sharing details in the report's
management-analysis section. He testified that he didn't write it,
didn't read it and relied on his chief financial officer and others.
During a
call with Wall Street analysts, Conaway said sales were poor - and
the stock took a 15 percent hit - but he didn't talk about the
vendor strategy or an ill-timed purchase of $800 million in
merchandise.
He
testified that Kmart had $1 billion in cash and credit when the call
was made and the quarterly report was filed. Conaway said it "never"
crossed his mind that he was withholding critical news.
The jury,
however, found that he acted "with intent to defraud or with
reckless disregard for the truth."
Despite
Conaway's testimony, the jury found that delaying payments to
vendors was a "material liquidity deficiency" affecting Kmart's
finances and should have been publicly reported.
Conaway's
lawyer, Scott Lassar, said they were disappointed with the verdict
and would pursue an appeal.
U.S.
Magistrate Judge Steven Pepe will handle the penalty phase. Conaway,
48, could be fined and banned from serving as an executive or
director at a public company.
He had a
successful career in the drugstore industry when he agreed in 2000
to try to turn around Kmart, which was no match for discount rivals
Wal-Mart Stores Inc. and Target Corp. Conaway was gone less than two
years later.
Kmart
emerged from Chapter 11 bankruptcy as a smaller company and now is
part of Sears Holdings Corp., based in Hoffman Estates, Ill.
The lawsuit
against Conaway and his former CFO, John McDonald Jr., was filed in
2005, three years after the bankruptcy.
Ronald
Kiima, formerly an assistant chief accountant at the SEC, said when
a company fails "there's a lot of `What did you know and when did
you know it?'"
"If
you don't give the sausage-making of what happened during a quarter,
that could be an issue," Kiima said in an interview. "For a CEO to
say he didn't lay eyes on the report is pretty damning."
Continued in article
Jensen Comment
Discount retailer Kmart came under investigation for irregular
accounting practices in 2002. In January an anonymous letter initiated
an internal probe of the company's accounting practices. The Detroit
News obtained a copy of the letter that contains allegations
pointing to senior Kmart officials as purposely violating accounting
principles with the knowledge of the company's
auditors, PricewaterhouseCoopers.
http://www.accountingweb.com/item/82286
Bankrupt retailer Kmart
explained the impact of accounting irregularities and said employees
involved in questionable accounting practices are no longer with the
company.
http://www.accountingweb.com/item/90935
Kmart's CFO Steps up to Accounting Questions
AccountingWEB US - Sep-19-2002 - Bankrupt retailer
Kmart explained the impact of accounting irregularities in a
Form 10-Q filed with the U.S. Securities and Exchange
Commission (SEC) this week. Chief Financial Officer Al Koch
said several employees involved in questionable
accounting practices are no longer with the company.
Speaking to the concerns about vendor allowances recently
raised in anonymous letters from in-house accountants, Mr.
Koch said, "It was not hugely widespread, but neither was it
one or two people."
The
Kmart
whistleblowers who wrote the letters said they were
being asked to record transactions in obvious violation of
generally accepted accounting principles. They also said
"resident auditors from PricewaterhouseCoopers are hesitant
to pursue these issues or even question obvious changes in
revenue and expense patterns."
In
response to the letters, the company admitted it had
erroneously accounted for certain vendor transactions as
up-front consideration, instead of deferring appropriate
amounts and recognizing them over the life of the contract.
It also said it decided to change its accounting method.
Starting with fourth quarter 2001, Kmart's policy is to
recognize a cost recovery from vendors only when a formal
agreement has been obtained and the underlying activity has
been performed.
According to this week's Form 10-Q, early recognition of
vendor allowances resulted in understatement of the
company's fiscal year 2000 net loss by approximately $26
million and overstatement of its fiscal year 2001 net loss
by approximately $78 million, both net of taxes. The 10-Q
also said the company has been looking at historical
patterns of markdowns and markdown reserves and their
relation to earnings.
Kmart is under investigation by the SEC and the Justice
Department. The Federal Bureau of Investigation, which is
handling the investigation for the U.S. Attorney, said its
investigation could result in criminal charges. In the
months before Kmart's bankruptcy filing, top executives took
home approximately $29 million in retention loans and
severance packages. A spokesperson for PwC said the firm is
cooperating with the investigations.
24 Days:
How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed
Faith in Corporate America, by John R. Emshiller and Rebecca Smith (Haper
Collins, 2003, ISBN: 0060520736)
Here's a powerful Enron Scandal book in the words of the lead whistle
blower herself: Power Failure: The Inside Story of the Collapse of
Enron by
Mimi Swartz,
Sherron Watkins
ISBN: 0385507879 Format: Hardcover, 400pp Pub. Date: March 2003
“They’re still trying to hide the weenie,”
thought Sherron Watkins as she read a newspaper clipping about Enron two
weeks before Christmas, 2001. . . It quoted [CFO] Jeff McMahon
addressing the company’s creditors and cautioning them against a rash
judgment....
Chronicling the inner workings of Andersen at
the height of its success, Toffler reveals "the making of an Android," the
peculiar process of employee indoctrination into the Andersen culture; how
Androids - both accountants and consultants--lived the mantra "keep the
client happy"; and how internal infighting and "billing your brains out"
rather than quality work became the all-important goals. Final Accounting
should be required reading in every business school, beginning with the
dean and the faculty that set the tone and culture." - Paul Volker, former
Chairman of the Federal Reserve Board.
The AccountingWeb, March 25, 2003.
Barbara Ley
Toffler is the former Andersen was the partner-in-charge of
Andersen's Ethics & Responsible Business Practices Consulting Services.
Title:
Final Accounting: Ambition, Greed and the Fall of Arthur Andersen Authors: Barbara Ley Toffler, Jennifer Reingold ISBN: 0767913825 Format: Hardcover, 288pp Pub. Date: March 2003 Publisher: Broadway Books
Book
Description A withering exposé of the unethical practices that triggered
the indictment and collapse of the legendary accounting firm.
Arthur
Andersen's conviction on obstruction of justice charges related to the
Enron debacle spelled the abrupt end of the 88-year-old accounting firm.
Until recently, the venerable firm had been regarded as the accounting
profession's conscience. In Final Accounting, Barbara Ley Toffler,
former Andersen partner-in-charge of Andersen's Ethics & Responsible
Business Practices consulting services, reveals that the symptoms of
Andersen's fatal disease were evident long before Enron. Drawing on her
expertise as a social scientist and her experience as an Andersen
insider, Toffler chronicles how a culture of arrogance and greed
infected her company and led to enormous lapses in judgment among her
peers. Final Accounting exposes the slow deterioration of values that
led not only to Enron but also to the earlier financial scandals of
other Andersen clients, including Sunbeam and Waste Management, and
illustrates the practices that paved the way for the accounting fiascos
at WorldCom and other major companies.
Chronicling the
inner workings of Andersen at the height of its success, Toffler reveals
"the making of an Android," the peculiar process of employee
indoctrination into the Andersen culture; how Androids—both accountants
and consultants--lived the mantra "keep the client happy"; and how
internal infighting and "billing your brains out" rather than quality
work became the all-important goals. Toffler was in a position to know
when something was wrong. In her earlier role as ethics consultant, she
worked with over 60 major companies and was an internationally renowned
expert at spotting and correcting ethical lapses. Toffler traces the
roots of Andersen's ethical missteps, and shows the gradual decay of a
once-proud culture.
Uniquely
qualified to discuss the personalities and principles behind one of the
greatest shake-ups in United States history, Toffler delivers a chilling
report with important ramifications for CEOs and individual investors
alike.
From the Back
Cover "The sad demise of the once proud and disciplined firm of Arthur
Andersen is an object lesson in how 'infectious greed' and conflicts of
interest can bring down the best. Final Accounting should be required
reading in every business school, beginning with the dean and the
faculty that set the tone and culture.” -Paul Volker, former Chairman of
the Federal Reserve Board
“This exciting
tale chronicles how greed and competitive frenzy destroyed Arthur
Andersen--a firm long recognized for independence and integrity. It
details a culture that, in the 1990s, led to unethical and anti-social
behavior by executives of many of America's most respected companies.
The lessons of this book are important for everyone, particularly for a
new breed of corporate leaders anxious to restore public confidence.”
-Arthur Levitt, Jr., former chairman of the Securities and Exchange
Commission
“This may be
the most important analysis coming out of the corporate disasters of
2001 and 2002. Barbara Toffler is trained to understand corporate
‘cultures’ and ‘business ethics’ (not an oxymoron). She clearly lays out
how a high performance, manically driven and once most respected
auditing firm was corrupted by the excesses of consulting and an
arrogant culture. One can hope that the leaders of all professional
service firms, and indeed all corporate leaders, will read and reflect
on the meaning of this book.” -John H. Biggs, Former Chairman and Chief
Executive Officer of TIAA CREF
“The book
exposes the pervasive hypocrisy that drives many professional service
firms to put profits above professionalism. Greed and hubris molded
Arthur Andersen into a modern-day corporate junkie ... a monster whose
self-destructive behavior resulted in its own demise." -Tom Rodenhauser,
founder and president of Consulting Information Services, LLC
"An intriguing
tale that adds another important dimension to the now pervasive national
corporate governance conversation. -Charles M. Elson, Edgar S. Woolard,
Jr., Professor of Corporate Governance, University of Delaware
“You could not
ask for a better guide to the fall of Arthur Andersen than an expert on
organizational behavior and business ethics who actually worked there.
Sympathetic but resolutely objective, Toffler was enough of an insider
to see what went on but enough of an outsider to keep her perspective
clear. This is a tragic tale of epic proportions that shows that even
institutions founded on integrity and transparency will lose everything
unless they have internal controls that require everyone in the
organization to work together, challenge unethical practices, and commit
only to profitability that is sustainable over the long term. One way to
begin is by reading this book. –Nell Minow, Editor, The Corporate
Library
About the
Author Formerly the Partner-in-Charge of Ethics and Responsible Business
Practices consulting services for Arthur Andersen, BARBARA LEY TOFFLER
was on the faculty of the Harvard Business School and now teaches at
Columbia University's Business School. She is considered one of the
nation's leading experts on management ethics, and has written
extensively on the subject and has consulted to over sixty Fortune 500
companies. She lives in the New York area. Winner of a Deadline Club
award for Best Business Reporting, JENNIFER REINGOLD has served as
management editor at Business Week and senior writer at Fast Company.
She writes for national publications such as The New York Times, Inc and
Worth and co-authored the Business Week Guide to the Best Business
Schools (McGraw-Hill, 1999).
March 8, 2004
message from neil glass [neil.glass@get2net.dk]
Note that you can download the first chapter of his book for free.
The book may be purchased as an eBook or hard copy.
Dr. Jensen,
I just came across your website and was pleased
to find you talk about some of the frauds and other problems I reveal in
my latest book. If you had a moment, you might be amused to look at my
website only-on-the-net.com where I am trying to attract some attention
to my book Rip-Off: The scandalous inside story of the Management
Consulting Money Machine.
Lessons Learned From
Paul Volker:
The Culture of Greed Sucked the Blood Out of Professionalism
In an effort
to save Andersen's reputation and life, the top executive officer,
Joe Berardino, in Andersen was replaced by the former Chairman of
the Federal Reserve Board, Paul Volcker. This great man,
Volcker, really tried to instantly change the culture of greed that
overtook professionalism in Andersen and other public
accounting firms, but it was too little too late --- at least for
Andersen.
The bottom line:
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 will be shaded.
Paul Volcker (See below)
WASHINGTON, May 17 (Reuters) - Former Federal Reserve Board
Chairman Paul Volcker, who took charge of a rescue team at
embattled accounting firm Andersen (ANDR), said on Friday that
creating "a new Andersen" was no longer possible.
In a
letter to Sen. Paul Sarbanes, Volcker said he supports the
Maryland Democrat's proposals for reforming the U.S. financial
system to prevent future corporate disasters such as the collapse
of Enron Corp. (ENRNQ).
"The
sheer number and magnitude of breakdowns that have increasingly
become the daily fare of the business press pose a clear and
present danger to the effectiveness and efficiency of capital
markets," Volcker said in the letter released to Reuters.
"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
At FEI's
recent financial reporting conference in New York, Paul Volcker
gave the keynote address and declared that the accounting and
auditing profession were in a "state of crisis." Earlier that
morning, over breakfast, he lamented the daily bombardment of
financial reporting failures in the press.
I agree with
his assessment. The causes and contributing factors are numerous,
but one thing is clear: We as financial executives need to do
better, be stronger and take the lead in restoring the credibility
of financial reporting and preserving the capital markets.
If you
didn't already know it and believe it deeply, recent cases prove
the value of a financial management team that is ethical, credible
and clear in its communications. A loss of confidence in that team
can be a fatal blow, not just to the individuals, but to the
company or institution that entrusts its assets to their
stewardship. I think the FEI Code of Ethical Conduct says it best,
and it is worth reprinting the opening section here. The full code
(signed by all FEI members) can be found
here.
. . .
So how did
the profession reach the state Volcker describes as a crisis?
The
market pressure for corporate performance has increased
dramatically over the last 10 years. That pressure has produced
better results for shareholders, but also a higher fatality rate
as management teams pressed too hard at the margin.
The
standard-setters floundered in the issue de jour quagmire,
writing hugely complicated standards that were unintelligible
and irrelevant to the bigger problems.
The
SEC fiddled while the dot-com bubble burst. Deriding and
undermining management teams and the auditors, the past
administration made a joke of financial restatements.
We've
had no vision for the future of financial reporting. Annual
reports, 10Ks and 10Qs are obsolete. Bloomberg and Yahoo!
Finance have replaced the horse-and-buggy vehicles with summary
financial information linked to breaking news.
We've
had no vision for the future of accounting. Today's mixed model
is criticized one day for recognizing unrealized fair value
contractual gains and alternatively for not recognizing the fair
value of financial instruments.
The
auditors dropped their required skeptical attitude and embraced
business partnering philosophies. Adding value and justifying
the audit fees became the mandate. Management teams and audit
committees promoted this, too.
Audit
committees have not kept up with the challenges of the
assignment. True financial reporting experts are needed on these
committees, not the general management expertise required by the
stock exchange rules.
How Tyco's CEO
Enriched Himself by Mark Maremont and Laurie P. Cohen, The
Wall Street Journal The latest story of corporate abuse surrounds the former
Tyco CEO. This story provides a vivid example of the abuses
that are leading many to question current business practices. http://www.msnbc.com/news/790996.asp
A To-Do List for Tyco's CEO by William C. Symonds, BusinessWeek online The new CEO of Tyco has a tough job ahead of him cleaning
up the mess left behind.
http://www.businessweek.com/magazine/content/02_32/b3795050.htm
Implausible Deniability: The SEC Turns Up CEO Heat by Diane Hess, TheStreet.com The SEC's edict requires written statements, under oath,
from senior officers of the 1,000 largest public companies
attesting to the accuracy of their financial statements.
http://www.thestreet.com/markets/taleofthetape/10029865.html
You buy shares in a company. The
government charges one of the company's executives with fraud. Who
foots the legal bill?
All too often, it's you.
Consider the case of a former Rite Aid
Corp. executive. Four days before he was set to go to trial last
June, Frank Bergonzi pleaded guilty to participating in a criminal
conspiracy to defraud Rite Aid while he was the company's chief
financial officer. "I was aggressive and I pressured others to be
aggressive," he told a federal judge in Harrisburg, Pa., at the
time.
Little more than a month later, Mr.
Bergonzi sued his former employer in Delaware Chancery Court,
seeking to force the company to pay more than $5 million in unpaid
legal and accounting fees he racked up in connection with his
defense in criminal and civil proceedings. That was in addition to
the $4 million that Rite Aid had already advanced for Mr.
Bergonzi's defense in civil, administrative and criminal
proceedings.
In October, the Delaware court sided with
Mr. Bergonzi. It ruled that Rite Aid was required to advance Mr.
Bergonzi's defense fees until a "final disposition" of his legal
case. The court interpreted that moment as sentencing, a time that
could be months -- or even years -- away. Mr. Bergonzi has agreed
to testify against former colleagues at coming trials before he is
sentenced for his crimes.
Rite Aid's insurance, in what is known as
a directors-and-officers liability policy, already has been
depleted by a host of class-action suits filed against the company
in the wake of a federal investigation into possible fraud that
began in late 1999. "The shareholders are footing the bill"
because of the "precedent-setting" Delaware ruling, laments Alan
J. Davis, a Philadelphia attorney who unsuccessfully defended Rite
Aid against Mr. Bergonzi.
Rite Aid eventually settled with Mr.
Bergonzi for an amount it won't disclose. While it is entitled to
recover the fees it has paid from Mr. Bergonzi after he is
sentenced, the 58-year-old defendant has testified he has few
remaining assets. "We have no reason to believe he'll repay" Rite
Aid, Mr. Davis says.
Rite Aid has lots of company. In recent
government cases involving Cendant Corp.; WorldCom Inc., now known
as MCI; Enron Corp.; and Qwest Communications International Inc.,
among others, companies are paying the legal costs of former
executives defending themselves against fraud allegations. The
amount of money being paid out isn't known, as companies typically
don't specify defense costs. But it totals hundreds of millions,
or even billions of dollars. A company's average cost of defending
against shareholder suits last year was $2.2 million, according to
Tillinghast-Towers Perrin. "These costs are likely to climb much
higher, due to a lot of claims for more than a billion dollars
each that haven't been settled," says James Swanke, an executive
at the actuarial consulting firm.
Continued in the article
Corporate Accountability: A Toolkit for Social Activists
The Stakeholder Alliance (ala our friend Ralph Estes and
well-meaning social accountant) ---
http://www.stakeholderalliance.org/
WASHINGTON, Feb. 19, 2002 (Knight-Ridder / Tribune News Service) —
Enron Corp.'s collapse was a symptom of a financial recklessness
that spread during the 1990s economic boom as investors and
corporate executives pursued profits at all costs, former Federal
Reserve Chairman Paul Volcker told a Senate committee Thursday.
Volcker
-- chairman of the new oversight panel created by Enron's auditor,
the Andersen accounting firm, to examine its role in the financial
disaster -- told the Senate Banking Committee he hoped the debacle
would accelerate current efforts to achieve international
accounting standards. Such standards could reassure investors
around the world that publicly traded companies met certain
standards regardless of where such companies were based, he said.
"In the
midst of the great prosperity and boom of the 1990s, there has
been a certain erosion of professional, managerial and ethical
standards and safeguards," Volcker said.
"The
pressure on management to meet market expectations, to keep
earnings rising quarter by quarter or year by year, to measure
success by one 'bottom line' has led, consciously or not, to
compromises at the expense of the public interest in full,
accurate and timely financial reporting," he added.
But the
74-year-old economist also blamed the new complexity of corporate
finance for contributing the problem. "The fact is," Volcker said
"the accounting profession has been hard-pressed to keep up with
the growing complexity of business and finance, with its
mind-bending complications of abstruse derivatives, seemingly
endless varieties of securitizations and multiplying,
off-balance-sheet entities. (Continued in the article.)
I've been teaching Intermediate Financial Accounting for several
years. Recently, I've been thinking about having students read a
supplemental book . Given the current upheaval, there are several
possibilities for additional reading. Can anyone make a recommendation?
BTW, these books would make great summer reading.
Dave Albrecht
Benston et. al. (2003). Following the Money:
The Enron Failure and the State of Corporate Disclosure.
Berenson, Alex. (2003). The Number: How the
Drive for Quarterly Earnings Corrupted Wall Street and Corporate
America.
Brewster, Mike. (2003). Unaccountable: How the
Accounting Profession Forfeited an Public Trust.
Brice & Ivins. (2002.) Pipe Dreams: Greed, Ego
and the Death of Enron.
DiPiazza & Eccles. (2002). Building Public
Trust: The Future of Corporate Reporting.
Fox, Loren. (2002). Enron, the Rise and Fall.
Jeter, Lynne W. (2003). Disconnected: Deceit
and Betrayal at WorldCom.
Mills, D. Quinn. (2003). Wheel, Deal and Steal:
Deceptive Accounting, Deceitful CEOs, and Ineffective Reforms.
Financial Shenanigans : How to Detect
Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit
(McGraw-Hill Trade; 2nd edition (March 1, 2002))
How Companies Lie: Why Enron Is Just the Tip of
the Iceberg by Richard J. Schroth, A. Larry Elliott
Quality Financial Reporting by Paul B. W.
Miller, Paul R. Bahnson
Take On the Street: What Wall Street and
Corporate America Don't Want You to Know by Arthur Levitt, Paula Dwyer
(Contributor)
And for fun: Who Moved My Cheese? An Amazing
Way to Deal with Change in Your Work and in Your Life by Spencer, M.D.
Johnson, Kenneth H. Blanchard
Neal J. Hannon, CMA Chair, I.T. Committee,
Institute of Management Accountants Member, XBRL_US Steering Committee
University of Hartford (860) 768-5810 (401) 769-3802 (Home Office)
Book Recommendation from The AccountingWeb on April 25, 2003
The professional service accounting firm is
being threatened by a variety of factors: new technology, intense
competition, consolidation, an inability to incorporate new services
into a business strategy, and the erosion of public trust, just to name
a few. There is relief. And promise. And hope. In The Firm of the
Future: A Guide for Accountants, Lawyers, and Other Professional
Services, confronts the tired, conventional wisdom that continues to
fail its adherents, and present bold, proven strategies for restoring
vitality and dynamism to the professional service firm.
http://www.amazon.com/exec/obidos/ASIN/0471264245/accountingweb
COSO is a voluntary private sector organization
dedicated to improving the quality of financial reporting through
business ethics, effective internal controls, and corporate governance.
COSO was originally formed in 1985 to sponsor the National Commission on
Fraudulent Financial Reporting, an independent private sector initiative
which studied the causal factors that can lead to fraudulent financial
reporting and developed recommendations for public companies and their
independent auditors, for the SEC and other regulators, and for
educational institutions.
The National Commission was jointly sponsored
by the five major financial professional associations in the United
States, the American Accounting Association, the American Institute of
Certified Public Accountants, the Financial Executives Institute, the
Institute of Internal Auditors, and the National Association of
Accountants (now the Institute of Management Accountants). The
Commission was wholly independent of each of the sponsoring
organizations, and contained representatives from industry, public
accounting, investment firms, and the New York Stock Exchange.
The Chairman of the National Commission was
James C. Treadway, Jr., Executive Vice President and General Counsel,
Paine Webber Incorporated and a former Commissioner of the U.S.
Securities and Exchange Commission. (Hence, the popular name "Treadway
Commission"). Currently, the COSO Chairman is John Flaherty, Chairman,
Retired Vice President and General Auditor for PepsiCo Inc.
This is
Levitt's no-holds-barred memoir of his turbulent tenure as chief
overseer of the nation's financial markets. As working Americans poured
billions into stocks and mutual funds, corporate America devised
increasingly opaque strategies for hoarding most of the proceeds. Levitt
reveals their tactics in plain language, then spells out how to
intelligently invest in mutual funds and the stock market. With
integrity and authority, Levitt gives us a bracing primer on the
collapse of the system for overseeing our capital markets, and sage,
essential advice on a discipline we often ignore to our peril - how not
to lose money.
http://www.amazon.com/exec/obidos/ASIN/0375421785/accountingweb
Don Ramsey called my attention
to the following audio interview: For a one-hour audio archive of Diane
Rehm's recent interview with Arthur Levitt, go to this URL:
http://www.wamu.org/ram/2002/r2021015.ram
A free video from Yale University and the AICPA (with an introduction
by Professor Rick Antle and Senior Associate Dean from Yale). This
video can be downloaded to your computer with a single click on a button
at http://www.aicpa.org/video/
It might be noted that Barry Melancon is in the midst of controversy with
ground swell of CPAs and academics demanding his resignation vis-a-vis
continued support he receives from top management of large accounting
firms and business corporations.
A New
Accounting Culture
Address by Barry C. Melancon
President and CEO, American Institute of CPAs
September 4, 2002
Yale Club - New York City
Taped immediately upon completion
Chicago's
Andersen accounting firm must stop auditing publicly traded companies
following the firm's conviction for obstructing justice during the
federal investigation into the downfall of Enron Corp. For decades,
Andersen was a fixture in Chicago's business community and, at one time,
the gold standard of the accounting industry. How did this legendary
firm disappear?
The fall of Andersen
September 1, 2002. This
series was reported by Delroy Alexander, Greg Burns, Robert Manor, Flynn
McRoberts and E.A. Torriero. It was written by McRoberts.
'Merchant or Samurai?'
September 1, 2002. Dick
Measelle, then-chief executive of Andersen's worldwide audit and tax
practice, explores a corporate cultural divide in an April 1995
newsletter essay to Andersen partners.
One New Book on Accounting Professionalism and Public Trust
Building Public Trust: The Future of Corporate Reporting
by Samuel A. DiPiazza, Jr (CEO of PricewaterhouseCoopers (PwC))
and Robert G. Eccies (President of Advisory Capital Partners)
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
Books on Fraud --- Enter the word "fraud" in the search box at
http://www.bn.com/
You might enjoy "The AICPA's Prosecution of Dr. Abraham Briloff: Some
Observations," by Dwight M. Owsen ---
http://accounting.rutgers.edu/raw/aaa/pi/newsletr/spring99/item07.htm
I think Briloff was trying to save the profession from what it is now
going through in the wake of the Enron scandal.
Internal
auditing is an independent, objective assurance and consulting
activity designed to add value and improve an organization's operations.
It helps an organization accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the
effectiveness of risk management, control, and governance
processes. (Institute of Internal Auditors)
Fraud
Investigation consists of the multitude of steps necessary to
resolve allegations of fraud - interviewing witnesses, assembling
evidence, writing reports, and dealing with prosecutors and the courts.
(Association of Certified Fraud Examiners)
This column from Law Library Resource Xchange (LLRX)
(last mentioned in the September 7, 2001 Scout Report) by Kathy Biehl
becomes more interesting with every revelation of misleading corporate
accounting practices. This is a straightforward listing of state
government's efforts to provide easy access to required disclosure
filings of businesses within each state. Each entry is clearly
annotated, describing services offered and any required fees (most
services here are free). The range of information and services varies
considerably from very basic (i.e. "name availability") to complete
access to corporate filings. The noteworthy exception here is tax
filings. Most states do not currently include access to filings with
taxing authorities.
List of
Securities Fraud Class Actions
SORTED BY COMPANY NAME
IMPORTANT
NOTE:
If another district or date than the one for which
you searched appears in the "Court" column, the explanation may be that
the district/date for which you searched is related to this case but is
not singled out as our "First Identified District". This list may be
considered inclusive.
Summary:
According to a Press Release dated December 21, 2001, the complaint
alleges that during the Class Period defendants materially
misrepresented Take-Two's financial results and performance for each of
the quarters of and full year of fiscal 2000, ended October 31, 2000,
and each of the first three quarters of fiscal 2001, ended January 31,
2001, April 30, 2001 and July 31, 2001, respectively, by improperly
recognizing revenue on sales to distributors. On August 24, 2001, the
truth about the Company's financial condition began to emerge when the
effects of defendants' scheme began to negatively impact the Company's
financial results. It was not until December 14, 2001 and December 17,
2001, however,
that the market began to learn that defendants had caused the Company to
improperly recognize revenue for products shipped to distributors, where
the distributors did not have a binding commitment to pay for the
products, in direct contravention of GAAP.
Significantly, defendants' unlawful accounting practices enabled
defendants to portray Take-Two as a financially strong company that was
experiencing dramatic revenue growth, and which was poised for future
success when, in fact, the Company's purported success was the result of
improper accounting practices. On December 14, 2001, following rumors of
a possible restatement of Take-Two's financial results, Take-Two's
common stock fell 31% --$4.72 a share to $10.33 per share. During the
Class Period, Take-Two shares traded as high as $24.50 per share.
Defendants were motivated to misrepresent the Company's financial
results, by among other things, their desire to sell approximately
900,000 shares of Take-Two common stock during the Class Period at
artificially inflated prices for proceeds of over $15 million.
INDUSTRY
CLASSIFICATION: SIC Code: 7372 Sector: Technology Industry: Software &
Programming
NAME OF COMPANY
SUED: Take-Two Interactive Software Inc.
FIRST
IDENTIFIED COMPLAINT IN THE DATABASE Fischbein, et al. v. Take-Two
Interactive Software Inc., et al. COURT: S.D. New York DOCKET NUMBER:
JUDGE NAME: DATE FILED: 12/18/2001 SOURCE: Business Wires CLASS PERIOD
START: 02/24/2000 CLASS PERIOD END: 12/17/2001 TYPE OF COMPLAINT:
Unamended/Unconsolidated PLAINTIFF FIRMS IN THIS OR SIMILAR CASE:
Milberg Weiss Bershad Hynes & Lerach, LLP (New York, NY) One
Pennsylvania Plaza, New York, NY, 10119-1065 (voice) 212.594.5300, (fax)
, Rabin & Peckel LLP 275 Madison Avenue, New York, NY, 10016 (voice)
212.682.1818, (fax) , email@rabinlaw.com Schiffrin & Barroway, LLP 3
Bala Plaza E, Bala Cynwyd, PA, 19004 (voice) 610.667.7706, (fax)
610.667.7056, info@sbclasslaw.com
TOTAL NUMBER OF
PLAINTIFF FIRMS: 3
February 28, 2002 message from
Allen Plyler
Bob,
Take-Two
Interactive just restated their last restatement.
Allen Plyler
Keller Graduate School of Management, Chicago, Illinois.
Important
Database --- From the Scout Report on February 1, 2001
This column
from Law Library Resource Xchange (LLRX) (last mentioned in the
September 7, 2001 Scout Report) by Kathy Biehl becomes more interesting
with every revelation of misleading corporate accounting practices. This
is a straightforward listing of state government's efforts to provide
easy access to required disclosure filings of businesses within each
state. Each entry is clearly annotated, describing services offered and
any required fees (most services here are free). The range of
information and services varies considerably from very basic (i.e. "name
availability") to complete access to corporate filings. The noteworthy
exception here is tax filings. Most states do not currently include
access to filings with taxing authorities.
From The Wall Street Journal
Accounting Educators' Review on May 23, 2002
TITLE: SEC Broadens Investigation
Into Revenue-Boosting Tricks; Fearing Bogus Numbers Are Widespread, Agency
Probes Lucent and Others
REPORTER: Susan Pulliam and Rebecca Blumenstein
DATE: May 16, 2002
PAGE: A1
LINK:
http://online.wsj.com/article/0,,SB1021510491566948760.djm,00.html
TOPICS: Financial Accounting, Financial Statement Analysis
SUMMARY: "Securities and Exchange
Commission officials, concerned about an explosion of transactions that
falsely created the impression of booming business across many industries,
are conducting a sweeping investigation into a host of practices that pump
up revenue."
QUESTIONS:
1.) "Probing revenue promises to be a much broader inquiry than the
earlier investigations of Enron and other companies accused of using
accounting tricks to boost their profits." What is the difference between
inflating profits vs. revenues?
2.) What are the ways in which
accounting information is used (both in general and in ways specifically
cited in this article)? What are the concerns about using accounting
information that has been manipulated to increase revenues? To increase
profits?
3.) Describe the specific
techniques that may be used to inflate revenues that are enumerated in
this article and the related one. Why would a practice of inflating
revenues be of particular concern during the ".com boom"?
4.) "[L90 Inc.] L90 lopped $8.3
million, or just over 10%, off revenue previously reported for 2000 and
2001, while booking the $250,000 [net difference in the amount of wire
transfers that had been used in one of these transactions] as 'other
income' rather than revenue." What is the difference between revenues and
other income? Where might these items be found in a multi-step income
statement? In a single-step income statement?
5.) What are "vendor allowances"?
How might these allowances be used to inflate revenues? Consider the case
of Lucent Technologies described in the article. Might their techniques
also have been used to boost profits?
Reviewed By: Judy Beckman,
University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
From The Wall Street Journal Accounting Educators' Review on
May 27, 2004
TITLE: SEC Gets Tough With Settlement in Lucent Case
REPORTER: Deborah Solomon and Dennis K. Berman
DATE: May 17, 2004
PAGE: A1
LINK: http://online.wsj.com/article/0,,SB108474447102812763,00.html
TOPICS: Criminal Procedure, Financial Accounting, Legal Liability,
Revenue Recognition, Securities and Exchange Commission, Accounting
SUMMARY: After a lengthy investigation into the accounting practices
of Lucent Technologies Inc., the Securities and Exchange Commission is
expected to file civil charges and impose a $25 million fine against the
company. Questions focus on the role of the SEC in financial reporting.
QUESTIONS:
1.) What is the Securities and Exchange Commission (SEC)? When was the
SEC established? Why was the SEC established? Does the SEC have the
responsibility of establishing financial reporting guidelines?
2.) What role does the SEC currently play in the financial reporting
process? What power does the SEC have to sanction companies that violate
financial reporting guidelines?
3.) What is the difference between a civil and a criminal charge?
What is the difference between a class-action suit by investors and a
civil charge by the SEC?
4.) What personal liability do individuals have for improper
accounting? Why does the SEC object to companies indemnifying
individuals for consequences associated with improper accounting?
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
One-time Internet booster Henry
Blodget, who recently left Merrill Lynch, is reportedly one of several
stock analysts being probed for alleged conflicts of interest ---
http://www.wired.com/news/politics/0,1283,48992,00.html
From The Wall Street Journal's
Accounting Educator Reviews on January 24, 2002
SUMMARY: Paul F. Polishan, the
former chief financial officer and senior vice president of Leslie Fay,
was convicted of 18 felony counts for his role in overstating the earnings
of Leslie Fay between 1989 and 1993. Mr. Polishan was sentenced to serve
nine years in prison. Questions deal with accountants' liability and
consequences of fraudulent financial reporting.
QUESTIONS:
1.) In what situations is overstating earnings a crime? What other
penalties could result from overstating earnings? Do you think overstating
earnings should result in a prison sentence? Support your answer.
2.) Were Leslie Fay's financial
statements audited? What responsibility does the auditor bear concerning
the earnings overstatement?
3.) In what situations would an
independent auditor be liable under common law for overstated earnings?
What defenses are available to the auditor?
4.) In what situations would an
independent auditor be liable under civil law for overstated earnings?
What defenses are available to the auditor?
5.) In what situations would an
independent auditor be liable under criminal law for overstated earnings?
What defenses are available to the auditor?
6.) Who is harmed by overstated
earnings? How are each of these groups harmed?
Reviewed By: Judy Beckman,
University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
In
particular, it has raised awareness of “hollow swaps”, where two
telecoms companies exchange identical amounts of network capacity, then
book the purchase cost as capital expense and the sale as revenue.
Although C&W says it does not use hollow swaps, it has recently
admitted to using another controversial accounting method to book the sale
of “indefeasible right of use” (IRU) contracts. C&W booked the
contracts, which give access to its telecoms network, as upfront revenue
even though they were spread over periods of up to 15 years. Such deals
— which were outlawed in 1999 by regulators in America — boosted
C&W’s revenues by £373 million in 2001.
Chris Ayres and Clive Mathieson, London Times Online, March 1, 2002
---
http://www.thetimes.co.uk/article/0,,5-222235,00.html
The Association
of Certified Fraud Examiners is an international, 25,000-member
professional organization dedicated to fighting fraud and white-collar
crime. With offices in North America and chapters around the globe, the
Association is networked to respond to the needs of anti-fraud
professionals everywhere.
In the April 2002 issue of
Journal of Accountancy, Joseph Wells, chairman of the Association of
Certified Fraud Examiners (CFE), reviews the results of a survey by CFE
and discusses the implications for CPAs.
http://www.accountingweb.com/item/77418
In Congressional testimony on
February 14, James G. Castellano, the chairman of the American Institute
of CPAs said the Institute plans to release a draft of a new standard by
the end of February. The objective of the new standard is to help auditors
detect new types of management fraud.
http://www.accountingweb.com/item/72560
A message from Andrew Priest on
February 34. 2002
Yahoo! is
carrying this news story in respect of Tyco International. Apparently
the firm spent $US8 billion in its past three fiscal years on more than
700 acquisitions that were never announced to the public. The story is
at
http://au.news.yahoo.com/020205/2/3vlo.html .
Is this another
Andersen client? :-) Seriously does anyone know who the auditor is on
this one?
Former Tyco
International Chief Financial Officer Mark Swartz, who is serving a
prison sentence for looting the company, has sued for $60 million in
retirement and other money he says he is owed.
The lawsuit, which
was made public on Monday, accuses Tyco of breach of contract and
unjust enrichment for not paying him some $48 million from an
executive retirement agreement, $9 million in reimbursement for New
York taxes, and other money.
"We know of no basis
on which Swartz could recover from the company," Tyco spokesman Paul
Fitzhenry said in an email, although the company had not yet been
served with the complaint.
Swartz was convicted
of grand larceny and securities fraud in 2005, along with former
Chief Executive Dennis Kozlowski. They are each serving sentences of
8-1/3 to 25 years.
In his lawsuit,
filed in New York state Supreme Court, Swartz charges the company
knew the Manhattan District Attorney intended to bring criminal
charges against him when it approved the main contract at issue in
the lawsuit.
"The directors and
management of Tyco approved the subject agreement with actual
knowledge that he was shortly to be indicted," the lawsuit said.
Tyco has a separate
suit against Swartz pending in U.S. District Court in the Southern
District of New York. That case, to fix the amount Swartz must pay
Tyco, is scheduled for trial in September, Fitzhenry said.
Tyco also brought a
similar suit in federal court against Kozlowski. In that case, the
judge dismissed Kozlowski's counterclaims for pay and benefits after
1995. The remaining issues are scheduled for trial in August,
Fitzhenry said.
Swartz was chief
financial officer of the industrial conglomerate from 1995 through
2002. He was indicted in September 2002 and convicted in June 2005.
Besides the prison sentence, he paid $72 million in court-ordered
restitution and fines.
Since September,
Swartz has been assigned to Lincoln Correctional Facility in New
York city, a minimum-security facility where Kozlowski also is
based, according to the state Department of Corrections.
Swartz is on a
furlough schedule where he can leave on Wednesdays and return on
Monday. He is scheduled to appear before the Parole Board in
September 2013.
Kozlowski, whose
purchase of a $6,000 shower curtain made him a symbol of corporate
greed, was denied parole in April.
Continued in article
Bob Jensen's threads on Tyco are at
http://www.trinity.edu/rjensen/Fraud001.htm
Search for Tyco at the above site.
Unlike many companies that failed after their top executives went to
prison, Tyco was and remained financially very sound because of
successful acquisitions engineered by the top executives that went to
prison for criminal activities along the way, including stealing from
the company.
On May 20, 2002 the Securities and Exchange Commission announced
proceedings against Big Five firm Ernst & Young. The case reaches back to
the years before E&Y's consulting practice was sold to Cap Gemini. It
involves alleged independence violations due to product sales and
consulting fees related to PeopleSoft software, while PeopleSoft was an
E&Y audit client.
http://www.accountingweb.com/item/81348
In a ruling Tuesday, Brenda Murray, the chief administrative law
judge at the SEC, granted Ernst & Young's motion for summary judgment
and dismissed the case without prejudice. Ms. Murray agreed with Ernst &
Young that more than one SEC commissioner needed to approve the action
for it to be valid.
From Double Entries on July 5,
2002
In the
first-ever auditor independence case against a foreign audit firm, the
Securities and Exchange Commission has brought a settled enforcement
action against Moret Ernst & Young Accountants (Moret), a Dutch
accounting firm now known as Ernst & Young Accountants. The case arises
from Moret's joint business relationships with an audit client. In
today's order, the SEC censured Moret for engaging in "improper
professional conduct" within the meaning of Rule 102(e) of the SEC's
Rules of Practice, and ordered Moret to comply with certain remedial
undertakings, including the payment of a $400,000 civil penalty. This is
the first time that the SEC has ordered any audit firm to pay a civil
penalty for an auditor independence violation. Moret consented to the
order without admitting or denying the SEC's findings. Full details from
the SEC in our full article.
Just click on through
1.) "The most
visible indicator of improper accounting-and source of new
investigations-is the growing number of restated financial reports."
Based on your knowledge of APB Opinion 23, why is this statement true?
What other sources of information does the SEC use to trigger
investigations?
2.) Why would
the SEC want to "ferret out" questionable accounting practices before
"word of a company's accounting problems has leaked and battered its
stock price"? How does this goal relate to the SEC's responsibilities?
What steps are they undertaking to accomplish this goal?
3.) What is
fraudulent financial reporting (as opposed to an accounting error)? Why
might the current economic circumstances lead to greater incidences of
fraudulent financial reporting?
4.) Read the
summary of a research study entitled "Fraudulent Financial Reporting:
1987-1997: An Analysis of U.S. Public Companies" at the AICPA web site
http://www.aicpa.org/news/p032699b.htm How do the factors
identified in this study provide a basis for helping the SEC to detect
questionable accounting practices earlier than is now the norm?
5.) How are
executives' compensation packages tied to share prices? What are the
benefits of such compensation arrangements? Why do current market
conditions enhance the risk that executives may be willing to undertake
earnings management practices to enhance their own salaries? What market
reactions to earnings announcements exacerbate these incentives to
manage earnings?
AICPA Issues Proposed Standard On
Fraud Detection
On February 28, 2002, the American Institute of CPAs (AICPA) released a
draft of a revised audit standard on Consideration of Fraud in a Financial
Statement Audit. If adopted, this updated standard will replace the
current standard with the same name, (Statement on Auditing Standards No.
82).
http://www.accountingweb.com/item/73718
Risk
Management/Internal Audit
BEYOND TRADITIONAL AUDIT TECHNIQUES Paul E. Lindow and Jill D. Race Instead of just reviewing required controls, internal auditors can
broaden their approach both within and outside the audit process to
identify areas for risk management improvements. Here’s a case study
on how the internal audit group at California Federal Bank redefined its
role to add more value and become key advisers to the company.
Risk Management/Litigation Services
FIVE TIPS TO STEER CLEAR OF THE COURTHOUSE Paul Sweeney As litigation costs continue to mount, businesses want to develop
efficient strategies to identify and monitor vulnerabilities and avoid
lawsuits. CPAs have the expertise to offer clients solutions to several
corporate risk management problems.
From The Wall Street Journal
Accounting Educators' Review on March 7, 2002
SUMMARY: The article implies that a
new auditing standard on fraud actually has been issued, but the actual
document issued was an exposure draft of a proposed standard.
The article begins with the
statement that "the Auditing Standards Board (ASB) of the American
Institute of Certified Public Accountants issued expanded fraud guidance
for U.S. auditors..." Is this statement correct?
2.) In the second paragraph of the
article, the author states, "The guidance comes at a time when
questionable accounting practices have surfaced in the wake of
bankruptcy-law filings by...Enron Corp. and Global Crossing Ltd."
Were these recent scandals the reason behind the new auditing standard
proposal? If not, what were the ASB's reasons for proposing the new
standard? (Hint: again see the actual document at the AICPA's
web site.)
3.) The proposed new standard would
mandate specific requirements to search for fictitious entries and perform
other tests to search for fraud under certain circumstances. Compare
and contrast this proposal to current auditing requirements to search for
fraud.
SMALL GROUP ASSIGNMENT: The proposed
auditing standard requests feedback from respondents to assess each of the
major areas of the new standard (e.g., classification of risk
factors for fraud, identification of revenue recognition as the major area
for risk of fraud, consideration of the risk of management override of
fraud, inquiry of audit committees about fraud, and the attitude of
professional skepticism). Divide the class into small groups and
assign one section to each group to draft a response to the questions
posed in the exposure draft.
Reviewed By: Judy Beckman,
University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
Can Internal Auditors truly be
independent while being employed by the entity and seen as working for the
management to achieve organizational goals? In theory, External Auditors
are more likely to be perceived as independent, but is it not the case
that Internal Auditors appear to have little or no independence?
http://www.accountingweb.com/item/65704
Internal
auditing is an independent, objective assurance and consulting
activity designed to add value and improve an organization's operations.
It helps an organization accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the
effectiveness of risk management, control, and governance
processes. (Institute of Internal Auditors)
Fraud
Investigation consists of the multitude of steps necessary to
resolve allegations of fraud - interviewing witnesses, assembling
evidence, writing reports, and dealing with prosecutors and the courts.
(Association of Certified Fraud Examiners)
Responding to
widespread concerns that investors were not always given reliable
financial information in that time of frantic revenue growth, regional
offices of the S.E.C., the Federal Bureau of Investigation and the
United States attorney's office here are cooperating in a legal
crackdown on accounting violations.
A tough
law-enforcement response to accounting irregularities, of course, is not
new. In the past year, federal investigators have pursued cases of
irregularities at companies like Waste Management (news/quote), Cendant
(news/quote) and Sunbeam. But now the government is turning up the heat
in Silicon Valley, home to a preponderance of questionable accounting,
particularly among software companies, during the Internet boom.
Over the last
four years, nearly one in five accounting restatements — red flags for
potential misconduct — have been by companies in California, according
to a study by Arthur Andersen, the accounting firm. (Arthur Andersen was
itself the recent subject of an S.E.C. civil sanction for the way it
audited the books of Waste Management, the trash-disposal company, and
agreed to a settlement without admitting or denying civil fraud
allegations.) In the same four- year period, the total number of
restatements for all industries has nearly doubled, Arthur Andersen's
report said.
So far in the
technology sector, federal investigators and prosecutors here have set
their sights on relatively small companies, where a high proportion of
problems center on what accountants call improper "revenue
recognition" — the recording of revenue that does not exist. It
could be, for example, from a pending sale that is misclassified as
completed, or a service contract in which money has not yet changed
hands.
The Arthur
Andersen study of accounting restatements from 1997 to 2000 showed that
27 percent of the restatements nationwide had been filed in the software
and computer industries. About 62 percent of the software companies
involved had annual gross revenue of less than $100 million.
The rise of
accounting fraud investigations, specifically related to overstatement
of revenue, reflects a serious white-collar crime trend in the
high-technology sector in recent years, said Leslie B. Caldwell, chief
of the securities fraud section for the United States attorney's office
here.
"The pressure
to do this in the technology industry was intense because the
expectation for growth was so high, and it wasn't sustainable," she
said, without commenting on specific cases.
The inquiry at
Indus International focused on revenue for the third quarter of 1999.
According to the shareholder lawsuits against the company and former
executives, the revenue total included sales derived from "irregular
contracts," money that was not received during the quarter in question.
Last October, Indus International agreed to settle the suits for $4.3
million without admitting or denying wrongdoing.
Previously, Ms.
Caldwell said, her office waited for the S.E.C. to refer cases for
criminal investigation. But now, "we're taking the bull in our own
hands," she said.
"There are
a number of matters under investigation of corporations that cooked
their books to meet Wall Street's expectations — expectations that the
companies themselves created," she added.
Harris Miller,
president of the Information Technology Association of America, a trade
group, said accounting problems in the software industry had arisen
because of what he called vague rules covering sales of licensing
agreements, which resulted in many companies claiming revenue that they
expected to receive.
"The rules for
revenue recognition were a bit cloudy, not just for software companies
but for any company that delivers services over time," Mr. Miller said.
His organization, he said, was not making excuses for executives who
intentionally violated regulations. "Yes, there was pressure to drive
the top line," he said. "But you can never justify misconduct."
Ms. Caldwell's
unit of seven lawyers, responsible for expediting complicated and
paper-intensive securities investigations, was created in February 2000
by Robert S. Mueller, United States attorney for the Northern District
of California, whom President Bush chose to serve as director of the
F.B.I.
Matthew J.
Jacobs, a spokesman for the United States attorney's office here, said
Mr. Mueller had made the prosecution of accounting fraud a major
objective because of its prevalence in both economic booms and declines.
Mr. Mueller was not available for comment, the United States attorney's
office said on Friday.
In its most
prominent case to date, Ms. Caldwell's team obtained indictments last
September against two former executives at McKesson, the pharmaceutical
and medical technology company based here. The defendants were charged
with accounting fraud related to the 1999 merger of McKesson and HBO &
Company, a software company based in Atlanta. Prosecutors said $9
billion in shareholder losses resulted. The defendants pleaded not
guilty to the charges, and the case is in the pretrial phase.
The F.B.I. and
federal prosecutors here are investigating about 50 cases of possible
criminal securities fraud in the district, more than a dozen of them
focusing on companies suspected of accounting fraud.
In addition to
Indus International, at least six small and medium-size software
companies in Northern California are under federal criminal and civil
investigation, according to officials. Among them is Critical Path, a
San Francisco company that sells e-mail messaging technology to other
businesses and reported $135.7 million in sales last year. In February,
after an internal investigation that led to the departure of its chief
executive and two other executives, Critical Path restated revenue for
the third and fourth quarters of 2000, subtracting a total of $19.4
million from what it had claimed. The company's share price plummeted
and class-action suits were filed, contending deception and fraud.
Critical Path has said it is cooperating with investigators.
In another
case, the S.E.C. filed a civil complaint last September in Federal
District Court here against three former executives of the Cylink
Corporation (news/quote), a Santa Clara company that makes cryptographic
software for computer network security, accusing them of violating
accounting rules by recognizing spurious transactions as sales in
quarterly earnings statements. The complaint said Cylink recognized more
than $900,000 in revenue in the second quarter of fiscal 1998 for sales
in which some customers were given a three-month window to cancel their
orders.
"When senior
officers are involved in this kind of conduct we're going to hold them
responsible," Robert L. Mitchell, head of the S.E.C.'s enforcement
office in San Francisco, said when the complaint was issued. "Companies
only act through individuals." The S.E.C. settled a separate
administrative "cease and desist" proceeding with the corporation. In
the civil litigation against three former Cylink executives, each was
accused of securities fraud, circumvention of Cylink's internal controls
and falsification of records.
In July,
according to court records, one of the former Cylink executives, Thomas
Butler, who had been vice president for sales, signed a consent decree,
without admitting or denying the charges, agreeing to pay a $100,000
fine and forfeit a $25,000 bonus he had been awarded by Cylink for his
sales performance. Litigation against the two other defendants is still
pending. Robert Fougner, Cylink's general counsel, said that he and
other company executives could not comment on the case.
In cases in
which criminal charges are brought against company executives, potential
penalties can be harsh. In addition to fines imposed by the S.E.C., a
conviction of an executive on a criminal securities fraud charge can
result in a prison sentence of up to 10 years and a fine as high as $1
million. Conviction on a lesser charge, like wire fraud or conspiracy,
carries a maximum five- year sentence and $250,000 fine.
Until recently,
the pace of these investigations had been plodding, owing to their
complexity and a shortage of resources. For example, Scorpion
Technologies, a software company that was based in Los Gatos, Calif.,
and is now defunct, was accused of fraudulently claiming as much as $3.6
million of its $12.4 million in reported 1991 revenue. The S.E.C. filed
civil charges and federal prosecutors indicted company executives on
securities fraud charges in 1996. The last of the Scorpion defendants,
John T. Dawson, was indicted in 1999. Last November, he pleaded guilty
to charges that he had helped create offshore companies that masqueraded
as buyers of Scorpion software products. Mr. Dawson's sentencing hearing
is set for Oct. 2.
The Justice
Department has a high threshold for criminal prosecution in these cases,
with a distinction being made between misleading accounting practices
and criminal fraud, Ms. Caldwell said. A suspicious accounting trick, by
itself, cannot be the basis for seeking an indictment without other
facts establishing deliberate fraud, she said.
Some major
technology companies, including Lucent Technologies (news/quote), have
been subject to recent class- action suits contending irregularities in
the way the companies accounted for their growing revenue before their
businesses weakened. The S.E.C. started examining Lucent's books last
November, after the company had disclosed an accounting problem, fired
an employee and filed a restatement lowering its revenue for its fiscal
year 2000 by $679 million.
Lucent,
however, seems an exception. For now, at least, it appears to be the
smaller technology companies that are receiving the most scrutiny.
The Securities and Exchange Commission has filed suit against the
founder and five other former top officers of Waste Management Inc. for
massive fraud. The complaint charges the defendants with inflating profits
to meet earnings targets.
http://www.accountingweb.com/item/76329
Note that Waste Management just announced that it was changing
auditors. The auditor up to now was (guess?) Arthur Andersen.
"Channel stuffing" refers to the practice of building
inventories in distribution channels. On July 11, 2002 Bristol-Myers
Squibb, one of the world's largest pharmaceutical companies, confirmed
that the Securities and Exchange Commission (SEC) has launched an
"informal inquiry" into its sales practices.
http://www.accountingweb.com/item/85930
Channel stuffing was (is?) common in the tobacco industry
where companies load up sales revenues on deliveries that they know they
will have to take back after the freshness dates on packages expire.
More cartons were (are?) sent to customers than can ever be sold before
expiration dates.
Lurking in the shadows behind the public spotlight on
Andersen and Enron has been a criminal case against
BDO Seidman for failing to report that a client had
misappropriated investor funds. Legal steps this week follow a settlement
in April with a goal of removing all criminal charges against the firm.
http://www.accountingweb.com/item/84264/ee2eE47/3825
BDO Seidman snags guilty verdict National CPA firm BDO Seidman LLP has been found
grossly negligent by a Florida jury for failing to find fraud in an audit that
resulted in costing a Portuguese Bank $170 million. The verdict opens up the
opportunity for the bank to pursue punitive damages that could exceed $500
million.
"BDO Seidman snags guilty verdict," AccountingWeb, June 26, 2007 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=103667
PricewaterhouseCoopers accused of lax audits of Gazprom
Welcome to the
first issue of BusinessWeek Online's European Insider. This weekly
newsletter contains highlights of news, analysis, commentary, and
regular columns that cover Europe specifically, as well as other stories
with wide international impact.
Angry investors
are accusing PricewaterhouseCoopers of lax audits of Gazprom. Did the
accounting firm ignore the energy giant's insider dealing and shady
asset transfers?
There are
growing concerns that the nation's economic downturn is compelling
companies to aggressively seek out ways to make their financial
statements look better than they really are.
Just this
year, dozens of companies have been caught in the act. Among them:
--
Xerox Corp. restated earnings after admitting that it did not properly
follow certain accounting rules at a Mexican division.
-- ConAgra Foods Inc. reduced earnings by more than $100 million
after discovering fictitious sales and earnings at one of its
subsidiaries.
-- Kroger Co., the giant supermarket chain, revised down its earnings
for 1998-2000, saying executives at its Ralphs Grocery subsidiary
conspired to hide cash from auditors and senior management.
Accounting
manipulation has become so prevalent that lawmakers in Washington are
considering hearings on the issue, while the Securities and Exchange
Commission has seen a sharp rise in the number of companies under
investigation.
"There is a
big question looming out there: Why is there such a massive
deterioration in accounting practices and can it be stopped?" said
Joseph Carcello, an accounting professor at the University of Tennessee.
Last year there
were 156 financial restatements, up from 150 in 1999 and 91 in 1998. The
restatements in the last three years add up to more than the combined
total for the previous eight years, according to the Financial
Executives International, a Morristown, N.J.-based group representing
senior corporate financial officers.
About $31.2
billion in market value was wiped out following restatements, as
investors sold stock in such companies, according to FEI.
Many companies
claim restatements don't mean they have broken any rules, saying that
accounting standards are open to interpretation. Often courts are left
to decide whether laws were violated. Most problems stem from how
revenue is counted. Corporations can falsely boost sales figures by
recording revenue before delivering products or asking customers to
receive goods before they need them. Sometimes they will claim sales
before the goods are sold at all.
"There is not a
"one-shoe-fits-all" mentality that works in accounting," said Mary Ellen
Carter, assistant professor of accounting at Columbia University's
Graduate School of Business. "Management is in the best position to know
what accounting choices capture their business ... but they also know
what accounting choices don't."
Companies hire
outside auditors to verify their financial statements, mainly to check
if accounting standards are met. Yet accounting firms are known to
overlook irregularities, sometimes in an attempt to hold on to their
audit contracts and more lucrative consulting services for the same
companies.
In June,
accounting titan Arthur Andersen LLP agreed to pay a $7 million civil
fine to settle federal allegations that it issued false and misleading
audit reports for Waste Management Inc. from 1993 to 1996 that inflated
the trash hauler's profits by more than $1 billion. Andersen neither
acknowledged nor denied the allegations.
"There is
supposed to be checks in the system that prevent management from being
able to do such things, but it is clear that the checks have eroded,"
said Michael Lange, a partner in Berman DeValerio Pease Tabacco Burt &
Pucillo, a Boston law firm that handles investor lawsuits. At
Centennial Technologies, top executives fabricated sales of "Flash 98,"
a nonexistent product, to friends of former CEO Emmanuel Pinez. The
company also created false sales records by shipping fruit baskets to
Pinez' friends and recording the shipments as $2 million in revenues.
The maneuvers made it look like Centennial made a profit of $12 million
in 1996, when in reality the company lost $28 million. Based on
the earnings reports, shares of Centennial increased 450 percent in 1996
to $55.50 a share. Faraone managed to get in at $46 a share, but after
the fraud was uncovered in early 1997, the stock plunged to $3.
Last year,
Pinez was convicted in federal court, and sentenced to five years in
prison and a $150 million fine. Other companies -- blue-chips and
startups -- have employed similar schemes. Sunbeam Corp. and its
former CEO Albert Dunlap are accused of creating the illusion of a
speedy turnaround after he arrived at the company in 1996. An SEC
lawsuit filed in May alleges that the company shifted revenues to
inflate losses under the old management and added the sales back to
inflate income under Dunlap. The lawsuit also charges that Sunbeam
offered discounts to customers that stocked up on merchandise months
ahead of schedule, but failed to disclose that such revenue would hurt
future results. Dunlap has denied the allegations.
Xerox, the
troubled business machine maker, restated earnings from 1998 to 2000 in
May after acknowledging that its Mexican subsidiary improperly booked
sales and hid bad debts. Questions over its accounting practices helped
push its stock down more than 60 percent in the last year.
ConAgra, whose
brands include Bumble Bee tuna and Butterball turkeys, said in May that
falsified sales at its United Agri Products Cos. subsidiary would force
it to lower earnings from 1998 to 2000 by about $123 million. The
company and the SEC are informally investigating the accounting
practices.
Last month,
software maker AremisSoft Corp. announced it was cooperating with a SEC
probe into unaccounted-for revenues. The company claimed $7.1 million in
sales to the Bulgarian government last year, but auditors have confirmed
receipt of only $1.7 million.
The SEC has
become increasingly aggressive in its crackdown against alleged
offenders. About 260 investigations now under way, a substantial jump
from years past. Lawmakers are also expressing concern about
accounting fraud. Rep. Richard Baker, R-La., chairman of a House
subcommittee on capital markets, said last month that he may call
hearings on the issue. There's also been a rise in the number of
shareholder lawsuits. A recent study by the audit and consulting firm
PricewaterhouseCoopers found that of the 201 class-action federal and
state lawsuits filed against corporations in 2000, some 53 percent
contained accounting allegations. That's up from less than 40 percent in
1995.
"The spectrum
of lawsuits goes across all industries, and all sizes of business" said
Harvey Kelly, partner in the corporate investigations practice at
PricewaterhouseCoopers. "It shows that no one is immune to these kind of
challenges." Faraone joined a class-action lawsuit against
Centennial, never expecting to see any of his losses returned. A
settlement of the case in 1998 got him 666 shares back, then valued at
about 50 cents each, and he sold them immediately. The company,
however, was bought this year by Solectron Corp. for $108 million.
Centennial stockholders collected $13.79 for every share they owned. If
Faraone had waited, he could have recovered nearly $9,200. He,
however, has no regrets about selling the stock.
"This company
did me wrong in a sneaky way," he said. "I wasn't willing to take any
more chances."
From the CFO Journal's Morning Ledger on July 17,
2020
Good morning. Germany’s
top financial supervisor received detailed warnings about deceptive
financial practices at Wirecard starting
in 2008, but repeatedly failed to investigate the allegations,
raising questions about the country’sability
to enforce securities rulesthat
protect investors.
Documents show the Federal Financial
Supervisory Authority, or BaFin, saw Wirecard’s former CEO as more
trustworthy than his critics because he bought a large chunk of
shares in the company at a key moment. BaFin also decided against
assuming direct oversight of Wirecard, which could have increased
its ability to probe the company. Wirecard recently filed for
insolvency proceedings after it failed to account for $2
billion in funds.
Ernst & Young,
Wirecard’s longtime auditor, in a separate case in China said its
local entity Ernst & Young Hua Ming LLPbears
no responsibility for Luckin
Coffee Inc.’s
2019 financial statements and what it called the company’s
fraudulent misconduct. Earlier this year, Luckin revealed that more
than $300 million of its 2019 sales were fabricated by a group of
employees.
The quality of audits by EY and other
“Big Four” audit firms, including Deloitte, KPMG and PricewaterhouseCoopers,
also is under scrutiny in the U.K. The country’s accounting
regulator said earlier this week audit quality has deteriorated
further.
Are EY's IPO clients "special" or is a lack of ICFR
warnings a key risk indicator?
Why is it that Ernst & Young LLP’s IPO clients appear
to be like the citizens of Lake Wobegon — stronger, better-looking,
and above average?
None of its
2019 IPO clients, including WeWork, disclosed material weaknesses in
internal controls over financial reporting in their S-1s, according
to my reporting on September 4.
However,
more than 20% of the audit clients of all the other Big 4 firms —
Deloitte, KPMG and PwC—include management disclosures of ICFR
weaknesses in their S-1s.
EY’s audit
clients also have a lower percentage of going concern opinions than
average, according to recent research.
Much has
been written about WeWork’s canceled IPO.
Here’s how Professor John
C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia
University Law School and Director of its Center on Corporate
Governance summed it up:
Clearly,
this failure was overdetermined, as many competing causes can
explain it, including: (1) the extraordinary level of self-dealing
that its CEO, Adam Neumann, regularly engaged in; (2) the corporate
governance structure that locked up all voting power and control in
him; (3) a system of non-GAAP metrics that more than raised
eyebrows; (4) an extraordinarily high valuation for a company that,
despite its claims of being a high-tech start-up, was closer to a
simple real estate firm; and (5) the unstable personality of its
founder (who, on a continuum from Elon Musk (brilliant but reckless)
to Martin Shkreli (a felon with pretensions), seems closer to the
latter end).
WeWork’s first S-1 was
filed on August 14, and then two amended S-1s were filed on
September 4th and 13th. It was the one made public on September 4th
that I wrote about,
with my former MarketWatch colleague Ciara Linnane.
Once they
read about them in the S-1, just about everyone but EY, and the SEC,
was concerned about all the related-party transactions and conflicts
of interest WeWork’s CEO Adam Neuman had with the company.
From the CFO Journal's Morning Ledger on October16, 2017
Ernst & Young,
auditor fined for misconduct
Ernst & Young LLP
and a senior statutory auditor have been fined after admitting
misconduct in relation to the audit of financial statements of
Tech Data Ltd., formerly known as Computer 2000 Distribution
Ltd., for the financial year ended Jan. 31, 2012.
Reply from Bob Jensen on November 15,
2015
Hi Tom,
What I find somewhat worrisome in
the article is the following quotation from EY:
EY was not the
auditor of any Madoff entity; we were among the many auditors of
funds that chose to use Madoff as their investment adviser.
While we regret the investors’ losses, no audit of a Madoff-advised
fund could have detected this Ponzi scheme,” Ernst & Young’s Amy
Call Well said in an email.
This raises questions about the
extent to which an auditor must verify third party investment,
insurance, and deposit quality. Consider a hypothetical example.
When EY auditors receive a verification that their client does
indeed have casualty insurance in the amount of $10 million from
Every State Life and Casualty Company to what extent is the auditor
responsible to verify the quality of that insurance beyond verifying
that Every State is indeed licensed in every state to sell life and
casualty insurance and the auditor's reading of the insurance
contract terms? The auditors might even go a step further to
determine that Every State was indeed audited by KPMG. But KPMG is
not likely to share inside working paper information with EY
regarding Every State.
To what extent is EY liable above an
beyond the KPMG audit report on the financial statements of Every
State?
My guess is that EY would not be
liable to FutureSelect Portfolio Management Fund for its Madoff
Losses had the Madoff Fund been properly audited. But the Madoff
Fund was not audited by a NY-licensed auditor where the fund was
headquartered. Perhaps EY is more liable in cases where EY relied on
investment verification that was not properly audited.
I am not an expert on the fine print
of the rules of auditing and never taught auditing. To what extent
are auditors liable to verify the quality of deposits in banks,
receivables from third parties, insurance coverage, etc.? Years ago,
when I was a lowly staff auditor in the Denver Office of EY, I can't
recall that we went beyond verifying that the client's accounts
existed in the correct balances reported by the client.
This touches on something that
always made me uneasy about test checking inventory. One of our
Denver Office audit clients was a piston manufacturer in Pueblo,
Colorado. When we showed up on Sunday mornings to count pistons we
found two types of containers at the end of each production line.
The company said one container had pistons that met quality control
standards. The other container was for rejects. But as an auditor I
could not tell any difference between a good piston and a bad
piston. We simply took the client's word that those pistons it
called satisfactory were indeed satisfactory, including the pistons
that were boxed up and purportedly ready to ship to customers.
Fortunately our client was more honest than a well known
manufacturer of salad oil at the time.
It would really be interesting to
know how this FutureSelect case would have been decided for EY
if the Madoff Fund had been audited by KPMG.
The
Japanese affiliate of Ernst & Young LLC has launched an in-house
investigation (using over 150 investigators) into its audit of
Toshiba Corp in the wake of the electronics maker's $1.2 billion
accounting scandal, a person with knowledge of the matter said.
Ernst &
Young ShinNihon LLC has established a team of about 20 executives to
investigate whether there were any problems with how it conducted
its audits of Toshiba, the person said.
The person
spoke on condition of anonymity. No one could be reached at the
company's offices in Tokyo on Saturday.
Continued in article
Jensen Comment
Audit firms traditionally defend themselves that they're not hired to be fraud
detectors unless the frauds materially affect financial statements. The Toshiba
accounting fraud had a monumental impact on financial statements.
From the CFO Journal's
Morning Ledger on July 15, 2015
Toshiba has detailed a number of cases in which business units
failed to book adequate costs for executing contracts, causing
the company to overstate profit. Toshiba said in June that it
would need to
reduce operating profit for the 2009
through 2013 fiscal years by a total of ¥54.8 billion. People
familiar with the matter said the figure has now ballooned to at
least ¥150 billion ($1.2 billion). Toshiba declined to comment.
During
those years, the company’s combined operating profit totaled
¥1.05 trillion, so even at the higher level, the reduction would
amount to less than 15% of the company’s operating profit over
the five years.
The
government’s audit regulator found deficiencies in 20 audits
conducted by Ernst & Young LLP in the latest annual inspection of
the Big Four accounting firm.
The
deficient audits found by the Public Company Accounting Oversight
Board represent 36% of the 56 reviewed by the board in its 2014
inspection report of Ernst & Young, issued Tuesday. That is an
improvement from last year’s report, in which the board found 28
deficient audits at E&Y out of 57 audits or partial audits surveyed,
a deficiency rate of 49%.
A
deficiency, as defined by the PCAOB, means the audit firm hadn’t
obtained enough evidence to support its approvals of a company’s
financial statements and internal controls. It doesn’t mean the
financial statements are inaccurate or that the problems found
haven’t since been addressed.
In a
statement, E&Y said it is “fully committed to delivering
high-quality audits.” The firm said it believes its audit quality
and that of the profession as a whole are “improving and we are
committed to continuing this process.”
Among the
types of deficiencies the inspectors found in E&Y’s audits were
insufficient testing of controls related to revenue recognition,
problems with testing of controls related to oil and gas properties
and insurance reserves, and a failure to identify that a company had
miscalculated its loss on conversion of its convertible notes.
In two of
the audits surveyed, E&Y revised its opinion of the company’s
internal controls after the inspection to issue a negative opinion,
the PCAOB said.
The PCAOB
didn’t identify the companies involved in each deficient audit, in
accordance with its usual practice.
"The Lehman Brothers Bankruptcy D: The Role of Ernst & Young"
Authors
Rosalind Z. Wiggins Yale University - Yale Program on Financial
Stability
Rosalind L. Bennett FDIC, Division of Insurance and Research
Andrew Metrick Yale School of Management ; National Bureau of
Economic Research (NBER)
Abstract:
For many years prior to its demise, Lehman Brothers employed Ernst &
Young (EY) as the firm’s independent auditors to review its
financial statements and express an opinion as to whether they
fairly represented the company’s financial position. EY was supposed
to try to detect fraud, determine whether a matter should be
publicly disclosed, and communicate certain issues to Lehman’s Board
audit committee. After Lehman filed for bankruptcy, it was
discovered that the firm had employed questionable accounting with
regard to an unorthodox financing transaction, Repo 105, which it
used to make its results appear better than they were. EY was aware
of Lehman’s use of Repo 105, and its failure to disclose its use. EY
also knew that Lehman included in its liquidity pool assets that
were impaired. When questioned, EY insisted that it had done nothing
wrong. However, Anton R. Valukas, the Lehman bankruptcy examiner,
concluded that EY had not fulfilled its duties and that probable
claims existed against EY for malpractice. In this case,
participants will consider the role and effectiveness of independent
auditors in ensuring complete and accurate financial statements and
related public disclosure.
From the CFO Journal's Morning Ledger on April 10, 2015
Noble Group faces fresh attack on its accounting practices
https://mail.google.com/mail/u/1/#inbox/14ca2fd477bbb090
Commodities trader Noble Group Ltd.’s
accounting practices came under attack from short seller
Muddy Waters LLC, the third outfit this year to question
its financial statements. Muddy Waters said Noble “seems to exist
solely to borrow and burn cash,” and alleged its 2011 acquisition of
PT Alhasanie was designed to reduce a quarterly
loss reported that year.
SINGAPORE—U.S. short-seller Muddy Waters
LLC has joined in the criticism being lobbed at
Noble Group Ltd., becoming the third outfit this year to
publicly question the commodities trader’s management and financial
statements.
In a 14-page report dated Wednesday and
published on its website, Muddy Waters said Noble “seems to exist
solely to borrow and burn cash,” and alleged its 2011 acquisition of
Indonesian coal-mining service company PT Alhasanie was designed to
reduce a quarterly loss reported that year, Noble’s first as a
public company.
Noble has repeatedly denied any wrongdoing.
In a statement Thursday, it said it “completely rejects the
allegations” while noting that Muddy Waters had publicly stated that
it has a short position in Noble’s shares. “The company is studying
the report in detail,” it said.
Noble is the second Singapore-listed
commodities trader that Muddy Waters has criticized. In 2012, it
attacked
Olam International
Ltd.’s accounting practices and
investments, which left Muddy Waters facing off with Singapore
state-investment firm Temasek Holding Pte. Ltd. Temasek eventually
helped lead a buyout of Olam.
Muddy Waters had more success with a 2011
attack on Chinese forestry company Sino-Forest Corp., which was
later delisted in Toronto and filed for bankruptcy. Prominent U.S.
hedge-fund manager
John Paulson has said his firm, Paulson &
Co., suffered millions of dollars in losses from a stake in
Sino-Forest.
Noble first came under attack in February
when an anonymous outfit calling itself Iceberg Research claimed
Noble’s balance sheet overvalued its commodities contracts and
associate companies. Hong Kong-based GMT Research has also published
critical reports on Noble, including one this week that questioned
the company’s valuation of Mongolian mining assets.
“Muddy Waters’ entrance into the fray
validates some genuine concerns that exist over Noble’s financial
statements,” GMT founder Gillem Tulloch said Thursday. “We believe
Noble’s financial statements are some of the most curious we’ve seen
in Asia.”
Noble earlier rebutted some of Iceberg
Research’s allegations. In March, it
filed a lawsuit in Hong Kong against Iceberg and
a former Noble employee it said it suspected was behind the reports.
Singapore-listed shares of Noble, which is
headquartered in Hong Kong and trades in commodities such as oil and
coal, fell as much as 9% in Thursday trading. They closed at 0.86
Singapore dollars (63 U.S. cents), down 5.5% for the day and more
than 28% since the Iceberg report was published in mid-February.
In its report, Muddy Waters echoed
Iceberg’s criticism of Noble’s acquisitions.
“When we scratched the surface of [the PT
Alhasanie] transaction, we found numerous red flags and aggressive
actions by Noble,”
Muddy Waters founder Carson Block
wrote.
For instance, the report alleged, the commodities trader paid
$300,000 for PT Alhasanie and immediately booked a gain of more than
$46 million.
TORONTO—Ernst & Young LLP agreed to pay 8
million Canadian dollars ($7.2 million) to settle allegations by
Canada's biggest securities regulator that it didn't adequately
audit the financial statements of Sino-Forest Corp. and another
Chinese company.
The accounting firm admitted no wrongdoing
in the settlement, which came after it and the Ontario Securities
Commission reached a tentative agreement earlier this month.
The E&Y-Sino-Forest case, the
higher-profile of the two cases, was related to the collapse in 2012
of what was then one of the largest publicly traded forest-products
companies in Canada following allegations the company inflated the
value of its timber assets.
The OSC alleged late in 2012 that E&Y
breached provincial securities laws by failing "to perform
sufficient audit work to verify the ownership and existence of
Sino-Forest's most significant assets" in China between 2007 and
2010. It also alleged in 2013 that E&Y didn't follow accounting
rules for its auditing of Zungui Haixi Corp.'s financial statements,
ahead of the Chinese shoe maker's 2009 initial public offering and
subsequent stock listing on the junior Canadian TSX Venture
Exchange.
"We believe that this settlement…is in the
best interests of all parties" and "enables us to put this matter
behind us," a spokeswoman for Ernst & Young said in an email.
The regulator had planned to hold
administrative hearings for both cases, but decided a settlement
agreement was a more efficient way to handle the cases.
The settlement "will avoid two complex and
lengthy hearings dealing with the interpretation and application of
auditing standards in connection with audits of financial statements
of reporting issuers, the exercise of professional judgment and the
conflicting reports of multiple expert witnesses," according to the
settlement agreement.
Continued in article
Question
When can an auditor having sex with the Chief Accounting Officer (CAO)
be an appropriate application of "detail testing?"
Possibility
It may beat statistical sampling and analytical review combined. Maybe
it should not ipso facto get a bad rap. But it does become more
difficult to remain independent.
Yeah it probably should get a bad rap for the same reason teachers
should not assign grades to students with whom they are "sleeping."
Ventas, Inc. (NYSE: VTR) (“Ventas” or
the “Company”) today announced that the Company has dismissed
Ernst & Young (“E&Y”) as its public accounting firm, effective
July 5, 2014, due to E&Y’s determination that it was not
independent solely as a result of an inappropriate personal
relationship between an E&Y partner and Ventas’s former Chief
Accounting Officer and Controller. Ventas also announced that,
following such dismissal, its Audit Committee has engaged KPMG
LLP (“KPMG”) as the Company's independent public accounting
firm.
E&Y has advised the Company that,
solely due to the inappropriate personal relationship, it
determined that it was not independent of the Company during the
periods in question. As a result of such determination, E&Y
stated that it was obligated under applicable law and
professional standards to withdraw (and it has withdrawn) its
audit reports on the Company’s financial statements for the
years ended December 31, 2012 and 2013, and its review of the
Company’s results for the quarter ended March 31, 2014. E&Y’s
decision to withdraw such audit reports and review was made
exclusively due to the personal relationship in question, and
not for any reason related to Ventas’s financial statements, its
accounting practices, the integrity of Ventas’s controls or for
any other reason.
The crony in question, one Robert J. Brehl, has "separated
himself" from his duties as Chief Accounting Officer and Controller.
Continued in article
Added Jensen comment?
Are the working papers on this audit X-rated?
Ernst & Young LLP was accused by
the U.S. of failing to comply with an Internal Revenue Service
request for documents in an investigation of the tax liability of
the billionaire chairman of industrial-bearing maker Schaeffler AG.
The agency had asked for testimony
and “books, records and other data” tied to a probe of Georg F. W.
Schaeffler, the office of
Manhattan U.S. Attorney
Preet Bharara said in a lawsuit filed yesterday.
The company, jointly owned by
Schaeffler and his mother, Maria-Elisabeth Schaeffler, is struggling
to reduce debt from an attempt spearheaded by former Chief Executive
Officer Juergen Geissinger to buy a limited stake in car-component
maker Continental AG that backfired amid the global recession of
2008.
Schaeffler, 49, has a net
worth of $7.8 billion, according to the Bloomberg Billionaires
Index, and he ranks 168th on the index. He owns 80 percent of
Schaeffler, which is based in Herzogenaurach,
Germany, and is the
world’s second-largest maker of automotive, aerospace and industrial
roller bearings.
The probe is tied to Schaeffler’s
personal tax liabilities dating back to 2004, according to a
declaration by Paul Doerr, an IRS agent investigating the case. The
investigation also covers 2005, 2009 and 2010, Doerr said in the
declaration filed in a Manhattan federal court lawsuit brought by
Schaeffler last year against the IRS.
Tax Liability
Doerr said he previously conducted
an investigation into Schaeffler’s tax liabilities for 2007 and
2008.
The agency previously investigated
“the valuation of assets related to the restructuring and
refinancing transactions that occurred in 2009 and 2010, after the
acquisition of Continental AG,” Doerr said.
Francine sked Mark O’Connor, CEO and
Co-founder of Monadnock
Research, to comment on the
Going Concern post
about Ernst & Young’s “Vision 2020″ announcement.
Caleb Newquist at
GoingConcern.com thinks Ernst & Young’s goals are a bit ambitious.
One of our
sources at EY thought so [too] and told us there are a few
key things that would have to happen for the firm to come
even remotely close to achieving it:
1) A rapidly
expanding advisory business
2) More
acquisitions and
3) A lot more
Partners, Principals, and Executive Directors.
Caleb also mentions
the “I” word.
As the advisory
business expands, the more potential there will be for
conflicts with the firm’s audit clients. Since EY and the
rest of the Big 4 want to be known as trusted business
advisors rather than simply auditors or tax preparers, the
advisory business gravy train will continue to be a priority
and circumventing independence will become an ongoing
exercise. We’ve already seen EY
cross the line in this area with
the revelation that it was lobbying on behalf of audit
clients, so it stands to reason they can make make arguments
in other cases for the sake of expanding business lines that
expand their influence can command larger fees while the
audit business gets pushed into the background.
Really, the timing of all this is
perfect for EY because all
the firms are doing it
and they
don’t give a damn if people think they’re less independent.
The advisory businesses have momentum and since independence
is in the eye of the beholder, it’s easy for any firm to
say, “That’s just, like, your opinion, man.”
It’s up to renegade regulators like
Ben Lawsky and private plaintiffs to keep
the consulting side of the audit firms honest.
Here are Mark O’Connor’s comments on Ernst
& Young’s Vision 2020 strategy.
One important aspect of
Ernst & Young’s “Vision 2020” is a
global strategic initiative to reach $50 billion in revenues by
2020. That’s a very aggressive goal, and there are a few
important reasons why that might be both out of reach and bad
for global business.
Lofty goals like EY’s Vision 2020 serve
a promotional purpose to attract top talent, and create the
rationalization for promises of vast internal opportunities to
keep top performers engaged. Beyond that, it allows current “EY”
partners to move from the global advisory leadership sidelines
to join principals at other Big Four firms reaping the rewards
of higher-margin consulting work. But it is on this point that
unintended consequences would likely foreclose any real
possibility that the $50 billion aspect of EY’s 2020 strategic
plan could be executed as currently conceived.
Big Four firms tend move in lock-step
without huge percentage year-over-year gains relative to one
another in any line of business without large M&A transactions –
buying or selling. Unless the firm’s strategy was to lower its
quality or margin expectations in an attempt to go after the
audit business of other Big Four firms and large auditors around
the world, almost all of EY’s proposed growth will need to come
from advisory. Otherwise, such dramatic growth in assurance
would come at the expense of lower margins across a sector that
already has very low margins. Anything far beyond the current
Big Four average audit growth rate of 3.4% is unlikely, so any
EY scenario with $50 billion in revenues by 2020 based primarily
on assurance practice growth has a probability close to zero.”
Given this, virtually all of EY’s
extraordinary growth would need to come from advisory. EY had
around $13.5 billion in non-assurance revenues in fiscal 2012,
so it would need to grow that by around 266% to reach that goal.
That would require an 11. 5% compound annual growth rate (CAGR)
coming out of our “great global recession”, assuming that the
assurance revenues independently grow at a 3.5% annual rate.
EY’s 2012 advisory non-assurance non-tax growth was close to
13%, so in isolation an 11.5% sustained advisory CAGR might seem
aggressive, but reasonable.
Jensen Comment
This time I think Tom is on to something. It would be great if E&Y would
reply to his blog post, but I doubt that this is going to happen. The
usual reply is that external auditors are not paid to detect fraud
unless the fraud is material to the audited financial statement
outcomes. It would seem that the survey results in this instance would
mostly affect financial statements in great gobs.
The Ontario
Superior Court has approved a $117-million class-action settlement
involving Sino-Forest Corp. and its former auditor, Ernst &
Young.
The agreed
deal will see the accounting firm pay toward a fund to compensate
shareholders of the troubled Chinese-Canadian company, which has
been accused of fraudulently overstating its assets.
It’s
believed to be one of the largest settlements involving an auditor
in Canadian history.
The
class-action had alleged that directors, officers, auditors and
underwriters at timber trader misled investors with its accounting.
Several
shareholders had originally objected to the settlement.
The
company was first accused in 2011 of being a Ponzi scheme by Muddy
Waters Research, prompting investigations by the Ontario regulator
and the RCMP.
Was Ernst & Young a
corporate spy?
From the CFO Morning Ledger newsletter on February 19, 2013
Express Scripts
sues E&Y.
Express Scripts has filed a lawsuit against
Ernst & Young
and a former employee for allegedly stealing at least 20,000 pages
containing confidential information and trade secrets, the WSJ’s
Jon Kamp and Michael Rapoport report. Express
Scripts hired E&Y to provide consulting services while combining its
business with Medco Health Solutions. The pharmacy-benefit company
accused E&Y of taking “competitively sensitive cost and pricing
information” and “highly proprietary” documents involving business
and integration strategies, projections and performance metrics. E&Y
confirmed there was a violation of company policies, and that the
individual “at the center of these allegations”–who the Express
Scripts lawsuit said was a Health Care IT Partner named Donald
Gravlin–”is no longer with the firm.” But E&Y also said it will
“vigorously contest the claims” in the lawsuit.
Teaching Case from The Wall
Street Journal Accounting Weekly Review on February 23, 2013
TOPICS: Auditing, Big Four Firms,
Consulting, Ernst & Young, Litigation, Trade Secrets, Accounting
SUMMARY: Pharmacy-benefit giant
Express Scripts Holding Co. has filed a lawsuit against accounting
firm Ernst & Young LLP and a former employee for allegedly stealing
at least 20,000 pages of data containing confidential information
and trade secrets. St. Louis-based Express Scripts hired E&Y to
provide consulting services while combining its business with Medco
Health Solutions. The lawsuit seeks "substantial punitive damages,"
and to stop E&Y from using or disclosing the information at issue.
E&Y confirmed there was a violation of company policies, and that
the individual "at the center of these allegations is no longer with
the firm." But E&Y also said it will "vigorously contest the claims"
in the lawsuit. The accounting firm noted it "immediately took all
necessary steps" to secure the data at issue once it became aware of
the matter, and that it's not aware of any instance where the data
was used inappropriately or transmitted to a third party. Express
Scripts uses PricewaterhouseCoopers for auditing work and Deloitte
for tax accounting.
CLASSROOM APPLICATION: This is an
interesting peak into the Big 4 world. This case shows an accounting
firm's potential for liability for employee actions. It also
mentions that the client, Express Scripts, employs three Big 4
accounting firms for three different types of work provided by those
firms: auditing, tax, and consulting.
QUESTIONS:
1. (Introductory) What are the facts of this lawsuit? Who
is the plaintiff and who are the defendants? What is the issue in
the case?
2. (Advanced) What is a "Big Four" accounting firm? What
firms are in the Big Four? What are all the various services offered
by Big Four accounting firms? How are Big Four firms different from
other accounting firms? How are they similar?
3. (Advanced) How can companies protect themselves from
accountants and consultants stealing confidential information and
using it for other purposes? In what ways can accountants and
accounting firms be sanctioned for such behavior?
4. (Advanced) The article states that Express Scripts uses
three different firms to do auditing work, tax, and consulting. Why
would a company use different CPA firms for different tasks? On the
other hand, why would a company use one firm for several tasks? With
these factors in mind, how should firms market their array of
services?
Reviewed By: Linda Christiansen, Indiana University
Southeast
Pharmacy-benefit giant Express Scripts Holding Co. ESRX -1.14% has
filed a lawsuit against accounting firm Ernst & Young LLP and a
former employee for allegedly stealing at least 20,000 pages of data
containing confidential information and trade secrets.
St.
Louis-based Express Scripts hired E&Y to provide consulting services
while combining its business with Medco Health Solutions. Express
Scripts bought Medco last year to form the largest pharmacy-benefit
manager by prescriptions handled.
These
firms, known as PBMs, managed drug benefits for health plans and
corporate clients, using their buying clout to secure rebates from
drug manufacturers. Express Scripts said in the lawsuit that its
investigation did not show E&Y's actions affecting any patient or
protected health information.
“Express
Scripts hired Ernst to provide consulting services in last year's
Medco deal.”
But Express
Scripts did accuse the big-four accounting giant of taking
"competitively sensitive cost and pricing information" and "highly
proprietary" documents involving business and integration
strategies, projections and performance metrics.
Express
Scripts didn't have a comment on the matter beyond the content of
the court filing, which seeks "substantial punitive damages," and to
stop E&Y from using or disclosing the information at issue. The
lawsuit was filed Thursday in the Circuit Court in St. Louis County,
Mo., and reviewed by Dow Jones Newswires.
E&Y in a
statement Friday confirmed there was a violation of company
policies, and that the individual "at the center of these
allegations"--who the Express Scripts lawsuit said was a Health Care
IT Partner named Donald Gravlin--"is no longer with the firm."
But E&Y
also said it will "vigorously contest the claims" in the lawsuit.
The accounting firm noted it "immediately took all necessary steps"
to secure the data at issue once it became aware of the matter, and
that it's not aware of any instance where the data was used
inappropriately or transmitted to a third party.
According
to Express Scripts' allegations, an investigation launched last
August determined Mr. Gravlin was sending confidential information
from another E&Y employee's Express Scripts email account to an
outside email account. The company accused him of "sneaking into
Express Scripts' headquarters and stealing confidential and
proprietary information" for months.
The PBM
also alleged that E&Y was motivated to facilitate this activity
because it stood to gain from the confidential information, which
could be used to grow and develop additional business both with
Express Scripts and competitors.
The issue of tax
avoidance by corporations is a hot one. In the US and in the UK,
legislators and pundits seeking “tax justice” have changed the
discussion from one of tax breaks that stimulate “jobs and growth”
to one of tax fairness to provide much needed funds for public works
and public commitments in time of economic hardship.
In December
2012, I wrote in the UK publication Accountancy on the
subject of offshore profit shifting by corporations such as
Starbucks, Google, Amazon, and other US multinationals. The UK is
mad as hell and not going to take it anymore. It seems US
multinationals move profits out of the UK via circuitous supply
chain routes leaving no profits, no tax liability and, therefore, no
tax revenue there, for all their hoopla here about success abroad.
Shifting
Multinationals are under
increasing scrutiny for income
shifting and offshoring profits.
Francine McKenna reports
US corporations with activities in
relatively high tax UK avoid tax on
profits by moving income to tax
havens. Loopholes in the US tax code
allow corporations to do this with
impunity. Governments continue to prioritise
a ‘competitive tax environment for
business’ in the hope corporations
will convert profits into economic
growth and jobs. Tax justice and a
fair spread of the deficit reduction
burden have been ignored.
Multinationals
headquartered in the US often reduce
income taxes by shifting profits
offshore. Profit shifting erodes the
corporate tax base and reduces
overall tax revenues. Lower revenues
are squeezing governments all over
the world trying to provide services
during a prolonged period of
economic uncertainty and high
sovereign debt. There are now
significant differences in the tax
burden among corporate taxpayers and
an overall unequal burden on all
taxpayers in the US and in the UK.
Here’s
the PDF of that article from the
December 2012 issue of Accountancy.
So it was
quite a shock for me to learn that, when the debate landed
in the US,
HP paid Ernst & Young, probably
the preeminent tax advisor of the Big Four accounting firms
at least for US multinationals, for testimony before the
Senate Subcommittee on Investigations in September.
Maybe
it doesn’t seem strange to you to see $2 million in “Other”
fees to the auditor show up on the HP proxy. Maybe you
weren’t aware Ernst & Young is already being investigated by
the SEC for independence violations related to tax lobbying.
According to Reuters, Ernst &
Young provided tax lobbying services to audit clients.
The last
time we had a big Big Four independence rules crackdown, it
was 2004. It was Ernst & Young again, sanctioned for its
systems integrator relationship with PeopleSoft, an audit
client. Ernst & Young was suspended from accepting new
public company audit clients for six months.
I bet
you can’t tell me about an SEC or PCAOB enforcement order
for a similar firm-level independence offense since. But
they do occur with some regularity, in my observation. There
was
one in Australia against KPMG that
resulted in an enforcement order. It was suspiciously
similar to what I reported regarding tax services provided
by KPMG to audit client GE. The
KPMG GE issue went away quietly.
And I
reported over the holidays about
PwC’s systems integration relationship with audit client
Thomson Reuters, an inappropriate
business alliance that’s very similar to the PeopleSoft
case. An SEC inquiry of the potential independence was
inadvertently confirmed by PwC, to my editors at Forbes,
when a PwC spokesman complained to them about my recent
reporting. PwC told Forbes editors the SEC had called them
about it even though I had “not given them much time that
morning to respond to the story.” PwC did not request a
retraction or a correction to the story, only a chance to
talk me and Forbes out of it.
That’s not
going to happen.
Here’s what
Ernst & Young did for HP – and Microsoft – in September of
2012. Microsoft was also called by Senator Carl Levin to
testify. Microsoft is a tax lobbying client of Ernst &
Young.
Let’s hope
EY didn’t charge Microsoft for the same appearance.
A U.S.
investor activist group affiliated with large labor unions is asking
Hewlett-Packard Co to replace its auditor, Ernst & Young, over the
technology giant's troubled acquisition of UK software company
Autonomy.
Change to
Win Investment Group (CtW), based in Washington, D.C., also is
seeking a revamp of HP's audit committee, which is responsible for
overseeing Ernst & Young's long-standing relationship as the auditor
that reviews HP's books.
Spokesmen
for HP and Ernst & Young declined to comment.
Labor union
pension funds own large stakes in many U.S. companies and often use
them as platforms to push for changes in how those corporations are
managed. Union pension funds tied to CtW invest more than $200
billion in stocks, including shares in HP, said CtW in a letter to
an HP board member on Thursday.
CtW
questioned why Ernst & Young did not spot problems at Autonomy. "HP
is clearly a company facing serious challenges," CtW said in its
letter. "Unfortunately, the highly conflicted, decade-long
relationship between Ernst & Young and HP cannot provide
shareholders with the reassurance they need."
Auditors
are outside accounting firms retained by corporations to vet their
books regularly and offer an opinion on the validity of financial
results. The four firms that dominate auditing worldwide - Ernst &
Young, KPMG, Deloitte and PricewaterhouseCoopers - are faced with
ever-rising scrutiny of their role in investor losses and accounting
lapses.
The CtW
letter was addressed to Rajiv Gupta, chairman of the corporate
governance committee of HP's board. It was signed by William
Patterson, executive director of CtW Investment Group.
Gupta could
not be reached for comment.
HP,
AUTONOMY CLASH
HP said in
November that it overpaid for Autonomy in 2011. HP accused Autonomy
of serious accounting improprieties. Autonomy has rejected the
allegations and said HP was looking for "scapegoats."
CtW urged
HP to name an independent special master to investigate and report
to shareholders on the Autonomy deal, as well as on an earlier
acquisition of Electronic Data Systems Corp (EDS), which CtW said
was "equally disastrous."
HP has said
it is deferring to U.S. and UK regulators to investigate the
allegations it has made against Autonomy.
HP in
August swung to an $8.9 billion quarterly loss as it swallowed a
write-down linked to its $13.9 billion purchase of EDS. That was
followed in November by an $8.8 billion writedown on Autonomy's
value, which HP blamed largely on improper accounting at the
software company.
Ernst &
Young was not Autonomy's auditor. But according to CtW, the
accounting firm had an opportunity to spot Autonomy's problems when
it reviewed the goodwill, or intangible value, that HP recorded for
its acquisition of Autonomy.
However,
one risk expert said CtW was putting the blame in the wrong place. A
separate due diligence team, not the auditor, was responsible for
determining the value of Autonomy, said Peter Bible, chief risk
officer at EisnerAmper, an accounting and consulting firm.
"The
auditors didn't buy the company, HP did. And the people inside HP
ought to be the ones held accountable for the purchase price that
was paid," Bible said.
CtW
questioned whether Ernst & Young was independent enough to audit HP
because of the large amount of non-audit services Ernst provided to
HP, including tax consulting and lobbying.
Washington
Council, a tax lobbying firm acquired by Ernst in 2000, lobbied for
HP from 2000 to 2004, CtW said.
AUDITING,
LOBBYING EYED
Government
lobbying records and U.S. Securities and Exchange Commission filings
show that Ernst & Young was HP's auditor while Washington Council
was registered as a lobbyist for HP.
Reuters
reported last week that the SEC was investigating whether Ernst
violated auditor rules by letting its lobbying unit perform work for
some major audit clients.
Ernst has
said all of its services for audit clients undergo considerable
scrutiny to be sure they are within the rules.
U.S.
independence rules bar auditors from serving in an "advocacy role"
for audit clients. The goal of this rule is to ensure that auditors
are objective regarding companies they audit so that they can serve
as watchdogs for investors.
It is not
clear what type of lobbying activities would be barred under the
prohibition against advocacy.
The 2002
Sarbanes-Oxley Act restricted the type of non-audit services that
audit firms can provide, but broad exceptions were granted for tax
consulting services.
CtW said
that HP was out of step with its peers in using Ernst for
significant services other than audit work. The other fees paid to
Ernst are much higher than those paid by Dell Inc and Apple Inc to
their audit firms, CtW said.
The
Securities and Exchange Commission is investigating whether auditing
company Ernst & Young violated auditor rules by letting its lobbying
unit perform work for several major audit clients, people familiar
with the matter told Reuters.
The SEC
inquiry began shortly after Reuters reported in March 2012 that
Washington Council Ernst & Young, the E&Y unit, was registered as a
lobbyist for several corporate audit clients including Amgen Inc,
CVS Caremark Corp and Verizon Communications Inc [ID:nL2E8DL649],
according to one of the sources.
The SEC's
enforcement division and its Office of the Chief Accountant are
looking in to the issue, according to the two sources, who spoke in
recent days and who could not be named because the investigation is
not public.
It is
unclear how far along the probe is, or whether it could result in
the SEC filing civil charges against Ernst & Young, one of the
world's largest audit and accounting firms.
An SEC
spokesman declined to comment.
Ernst &
Young spokeswoman Amy Call Well declined to comment on whether the
company was being investigated. "All of our services for audit
clients undergo considerable scrutiny to confirm they are consistent
with applicable rules," she said.
U.S.
independence rules bar auditors from serving in an "advocacy role"
for audit clients. The goal is to allow auditors to maintain some
degree of objectivity regarding the companies they audit, based on
the idea that auditors are watchdogs for investors and should not be
promoting management's interests.
The SEC's
rule does not definitively say whether lobbying could compromise an
auditor's independence. It is more focused on barring legal
advocacy, such as expert witness testimony.
In
interviews last year, former SEC Chief Accountant Jim Kroeker told
Reuters that certain lobbying activities could potentially be
covered under the general prohibition on advocacy. Kroeker is now an
executive at Deloitte, a rival of Ernst & Young.
'ABUNDANTLY
CLEAR' LINE
Harvard
Business School Professor Max Bazerman said on Monday that it was
"abundantly clear" that a firm that is lobbying for a company is no
longer capable of independently auditing that company.
Ernst &
Young has previously said it complied with independence rules. It
also said that it did not act in an advocacy role and that the work
performed by its lobbying unit was limited to tax issues.
Tax
consulting is a permissible activity under auditor independence
rules if it does not involve public advocacy.
About two
months after publication of the Reuters story, federal records
showed Washington Council Ernst & Young was no longer registered as
a lobbyist for Amgen, CVS Caremark or Verizon Communications.
A spokesman
for Amgen did not immediately respond to calls seeking comment.
Verizon and CVS spokesmen declined to comment.
Ernst &
Young also terminated a lobbying relationship with a fourth company,
Nomura Holdings Inc, which also used an E&Y affiliate for auditing
services.
Obtaining an independent view on the books is the main reason
companies are required to hire outside auditors, said Richard
Kaplan, law professor at the University of Illinois.
A senior
partner closed an investigation into a £100,000 “bribe” despite
colleagues suspecting the money had been paid to a judge overseeing
a multi-million-pound tax case the company was fighting.
The
allegations were disclosed by former E&Y partner and whistle-blower
Cathal Lyons, who is suing the accountant for $6m for breach of
contract.
He claims
medical insurance he was relying on to treat injuries sustained in a
car accident was withdrawn after he raised the issue of the alleged
bribe with the accountant’s global head office in London.
Mr Lyons
was a partner with E&Y’s Russian practice when the alleged
wrongdoing came to light. It was originally investigated by James
Mandel, E&Y’s general counsel in Moscow. In a witness statement
supplied in support of Mr Lyons’s case, Mr Mandel said he suspected
the payment may have been corrupt and wrote a report to that effect.
“I had the
suspicion that this payment was not a proper payment for legal fees,
but was an illegal payment possibly made to facilitate a positive
outcome of a tax case,” he claimed in his witness statement.
He
suspected that the €120,000 payment via a Russian law firm was made
to influence a 390m rouble (£8.4m) court case brought by Russian tax
authorities investigating a tax avoidance scheme E&Y was using to
pay its Russian partners. E&Y was later cleared of liability in the
case.
The
accountant has admitted there was an investigation into allegations
of bribery, but said the case was closed by Herve Labaude, a senior
partner, in January 2010.
Mr Lyons
claims that after he reported his concerns about the case to E&Y’s
global head office, his medical insurance was withdrawn and he was
dismissed.
In his writ
he says the dismissal flowed from “personal animosity against him
rising from a discussion in late 2010 between the claimant and Maz
Krupski [E&Y’s director of global tax and statutory] regarding
alleged corruption by the practice.”
Mr Lyons relied on his medical insurance to cover the
cost of treatment flowing from a serious car accident he suffered in
2006. The accident left him with permanent disabilities and partial
amputation. It is estimated medical cover in his current condition
would cost $300,000 per year. He is suing for 20 years’ cover, or
$6m.
Jensen Comments
The courts have been very kind to large auditing firms that allowed
clients to grossly underestimate bad debt reserves and failed to detect
(or at least report) insider frauds and going concern questions for
nearly 2,000 clients that went bankrupt after 2007. This particular
IndyMac case judge was also not a bit sympathetic with the SEC's case in
general.
One
telltale sign of a
bull market
is that investors don't care as much about dodgy corporate
accounting practices. A case in point: the public reaction -- or
lack thereof -- to a financial restatement disclosed late yesterday
afternoon by Williams Cos., the natural-gas producer.
Williams
didn't issue a press release about the
restatement. As far as I can tell, there have been no news reports
about the company's accounting errors, which Williams divulged in a
filing with the Securities and Exchange
Commission. They aren't a small matter, though.
As a result
of the restatement, Williams said its shareholder equity fell $497
million, or 28 percent, to $1.3 billion as of Dec. 31. Additionally,
the company said it had "identified a material weakness in internal
control over financial reporting," which is never a good sign. Net
income wasn't affected.
Shares of
Williams were trading for $33.65 this afternoon, down 73 cents,
after setting a 52-week high yesterday. The stock is up 88 percent
since Oct. 4.
Williams,
which is audited by Ernst & Young, said the restatement was
necessary to correct errors in deferred tax liabilities related to
its investment in Williams Partners LP, a publicly traded master
limited partnership in which it owns a 68 percent stake. A Williams
spokesman, Jeff Pounds, declined to comment when asked why the
company didn't issue a press release flagging the restatement.
The answer
seems obvious, though: The company didn't want anyone to write about
it. Oh well.
Ernst &
Young LLP agreed to pay $2 million to settle allegations by the
government's auditing regulator that the firm wasn't skeptical
enough in assessing how a client, Medicis Pharmaceutical Corp.,
accounted for a reserve covering product returns.
The Public
Company Accounting Oversight Board also sanctioned four current or
former partners of the Big Four accounting firm, including two whom
it barred from the public-accounting field. Ernst & Young and the
four partners settled the allegations without admitting or denying
the board's findings.
The $2
million fine is the largest monetary penalty imposed to date by the
board, which inspects accounting firms and writes and enforces the
rules governing the auditing of public companies.
The board
said Ernst & Young and its partners didn't properly evaluate
Medicis's sales-returns reserve for the years 2005 through 2007. The
firm accepted the company's practice of imposing the reserve for
product returns based on the cost of replacing the product, instead
of at gross sales price, when the auditors knew or should have known
that wasn't supported by the audit evidence, the board said.
Medicis
later revised its accounting for the reserve and restated its
financial statements as a result.
SUMMARY: The article covers an interview with Ernst
& Young CEO James Turley. He comments on the change in the
accounting profession from being self-regulated to highly regulated,
E&Y's performance in regulatory reviews, the performance of the
accounting profession following the financial crisis stemming from
the burst housing bubble, and the situation E&Y faces through its
client Olympus which has admitted to presenting fraudulent financial
statements.
CLASSROOM APPLICATION: The article is useful in
auditing classes or other classes covering ethics and prevention of
fraudulent financial reporting.
QUESTIONS:
1. (Introductory) What are the accounting "industry's woes"
indicated in the title of this article? Base your answer on the
article, the related article, and other knowledge you have.
2. (Introductory) Who regulates the accounting profession?
Describe the process of regulatory review of the accounting and
auditing profession as you understand it. What have been the recent
findings from those reviews at E&Y?
3. (Advanced) The interviewer asks whether "...accounting
firms are scapegoats when clients get into trouble for irresponsible
financial practices." Why do you think accounting firms could be
considered "scapegoats" in these situations?
4. (Advanced) Consider Mr. Turley's response to the
question above. Why do auditors have a responsibility to "lift
confidence in financial reporting"?
5. (Advanced) In the related video, Mr. Turley states that
few companies had to restate financial statements following the
financial crises in contrast to the time period around the Enron
collapse and resulting crisis. When are companies required to
restate financial statements? How does this fact indicate that the
accounting profession has functioned well within the time frame of
the financial crisis following the burst housing bubble?
SMALL GROUP ASSIGNMENT:
E&Y CEO James Turley states that during the 35 years he has worked
in accounting, the profession has gone from being self-regulated to
being highly regulated. Prepare a timeline of that progress in the
accounting profession. Properly cite your sources for this
information. (Hint: begin at the web site of the Public Company
Accounting Oversight Board (PCAOB) on the web at
http://pcaobus.org/About/Pages/default.aspx)
Reviewed By: Judy Beckman, University of Rhode Island
Ernst & Young LLP
and its fellow auditors have spent some uncomfortable time in the
spotlight.
The company has been
under scrutiny since October for its role in the $1.7 billion
accounting scandal at Olympus Corp. A panel appointed by Olympus
cleared Ernst & Young and KPMG Azsa LLC of any wrongdoing last week,
but Japanese regulators continue to investigate the matter.
Meanwhile, a U.S.
watchdog said in December it found deficiencies in one-fifth of the
audits it inspected at Ernst & Young as part of a broader inspection
that found flaws at all the Big Four audit firms. The privately held
company is also still fighting a 2010 lawsuit filed by the New York
attorney general's office alleging it helped Lehman Brothers
Holdings Inc. hide its financial woes before the bank's 2008
collapse.
Chairman and Chief
Executive James Turley remains optimistic about Ernst & Young's
global prospects. Last year, Mr. Turley steered the firm toward
growth across its tax, assurance and advisory services, with strong
results in Brazil, India, Africa and China. Global revenues for the
privately owned partnership rose to $22.9 billion for the 2011
fiscal year ending last June, from $21.3 billion a year earlier.
It is a bittersweet
end to a decade-long run for Mr. Turley, who plans to retire in June
2013 after joining the company 35 years ago as a fresh graduate of
Rice University. He will be succeeded by Mark Weinberger, who runs
Ernst & Young's global tax practice.
The 56-year-old CEO
recently talked to The Wall Street Journal about the responsibility
of accounting firms and what should be done to regulate the
profession. Edited excerpts:
WSJ: Has the nature
of the accounting profession changed in the last few years?
Mr. Turley: I've
been in the profession some 35 years now, and it's changed a lot
during those times, from capital market requirements, to the
responsibility we have to investors, to how we work with independent
audit committees. When I started, this was a self-regulated
profession. Today, we're highly regulated.
WSJ: In December,
the government's auditing-oversight board said it found 13
deficiencies in 63 audits at Ernst & Young, and identified flaws at
all Big Four firms. Was this a matter of oversight?
Mr. Turley: This was
a matter of execution. It's a matter of us now analyzing the root
causes of [flawed audits] and figuring out how we continue to
improve our performance in delivery of audits. It's a matter we take
extraordinarily seriously and work closely with our regulator in
this country, the PCAOB [Public Company Accounting Oversight Board],
to continue to improve.
WSJ: Ernst & Young's
Japanese arm, Ernst & Young ShinNihon LLC, is still being
investigated over its role as an auditor in the Olympus accounting
scandal. What's the latest?
Mr. Turley: I can't
say much about a matter that's in the process of being analyzed. But
you should understand that in this two-decades-long issue at
Olympus, we arrived on the scene about a year ago. So we came in
pretty late in the game.
WSJ: Ernst & Young
has been caught up in a string of litigation involving clients
including HealthSouth and Lehman Brothers. How do you maintain
stability?
Mr. Turley: We're in
a very litigious world, and inevitably, when a company of any type
fails or has any problems, one of the Big Four accounting firms
typically has been delivering that work. So we, like all our
competitors, have matters of litigation. Our people understand that.
WSJ: Do you think
accounting firms are scapegoats when clients get into trouble for
irresponsible financial practices?
Mr. Turley: We have
a responsibility to do everything we can to lift confidence in
financial reporting. That doesn't mean we get it right every time.
But in any kind of a crisis, like the world has gone through,
they're trying to point fingers. We all wish—we in this profession,
we in society—we could have seen around the corner and seen that
housing prices were going to tumble, liquidity challenges were going
to come. Unfortunately, no one saw that, and we couldn't see around
the corner any better than anyone else.
WSJ: What else can
be done to improve the quality and transparency of accounting?
Mr. Turley: More
trend information, more qualitative information, more key
performance indicators from companies. Right now, we're essentially
asked to give an on-off switch on how we feel about a set of
financial statements. Are there different ways to communicate with
investors that would be more informative?
WSJ: Ernst & Young
is now in more than 140 countries. In which markets do you see the
most promise and growth?
Mr. Turley: Last
year or so, our fastest-growing market was Brazil. We continue to
see great growth in both China and Southeast Asia. India and Eastern
Europe, especially Russia, continue to perform very well. We're
seeing strong growth in actually all of our businesses now, and in
most of our geographies. Europe is the most challenged, because of
the aftermath of the ongoing crisis that you read about every day.
WSJ: What do you
plan to do after you retire?
Mr. Turley: I
haven't any idea at this point. Most people I talk with who are
retired would say don't make any decisions too fast.
The allegation is
made in a High Court case brought against the Big Four accountant by
former employee Cathal Lyons. The ex-E&Y partner claims he was
dismissed from the company and had hundreds of thousands of pounds
worth of medical cover withdrawn after he reported the alleged
corruption to the practice’s director of global tax.
Mr Lyons’ claim in
the High Court relates to his employment by E&Y’s Russian practice.
In 2006 he suffered
a serious road accident resulting in permanent disabilities and
partial amputation. Despite suffering serious medical complications
Mr Lyons continued to work for Ernst & Young, albeit in a reduced
capacity, until he claims he was dismissed in 2010.
Following his
dismissal, the medical insurance cover provided by Ernst & Young was
withdrawn. Mr Lyons claims this was in direct breach of an agreement
he had reached with E&Y that he would be covered by the medical
insurance for life.
His dismissal and
the subsequent removal of his medical insurance were a direct result
of him reporting his concerns about corruption, he claims.
Remember The New Yorker Cartoon
with the CEO saying to the Chief Accounting Officer:
"The only thing that can save us now Digby is an accounting miracle."
So, in a move to
provide some constructive advice, we offer Mr. Stevens a few simple
suggestions. First, do not merely mouth “transparency” as some sort
of mantra, but embrace financial reporting transparency, believe it,
live it, and report transactions and events as if your economic life
depended on it. That means no more gross/net revenue games, no more
peculiar or low quality gains, as investment gains can be, and no
more disclosures about inventory management systems when there is no
inventory account on the balance sheet.
SUMMARY: Groupon, Inc reported its second quarter
earnings after the close of the market on Monday, August 13, 2012.
This article, written in advance of that earnings announcement,
cautions investors "to dig deeply into the results....Last fall, Groupon started...to sell discounted products, in addition to its
core daily deals for restaurants, spas, and [other] such
[services]....Notable is how the accounting treatment of this
business inflates net revenue growth...[When] Groupon takes the
products into inventory [as in 75% of the first-quarter Groupon
Goods deals, the company] accounts for sales on a gross basis, not a
net basis....As Groupon Goods accounts for more net revenue growth,
it could be masking weakness in the core daily deals business." The
related article discusses the actual quarterly results that were
reported and the video also was prepared after the quarterly filing.
CLASSROOM APPLICATION: The article may be used to
introduce topics in revenue recognition, particularly between sales
of goods as a principal and offering services as an agent.
QUESTIONS:
1. (Introductory) From your own knowledge and use of the
service or from another source, describe Groupon's business model.
Cite any sources you use other than your own knowledge of the
business.
2. (Introductory) What new business has Groupon recently
launched?
3. (Introductory) As described in the article, compare the
accounting treatment for Groupon's newly launched business with its
original one.
4. (Advanced) In your opinion, should this difference in
accounting treatment exist? Support your answer.
5. (Advanced) Why does the author conclude that "Groupon is
making it tough [for investors and other financial statement users]
to understand its business"?
6. (Introductory) Refer to the related article. What
results shown in the actual financial statement filing are related
to the issues discussed in the main article?
7. (Introductory) Refer to the related video prepared after
the quarterly financial statement filing. According to the
interviewee--Mr. George Stahl, Dow Jones Newswires Deputy Managing
Editor--what is "confusing" about the company's revenue?
Reviewed By: Judy Beckman, University of Rhode Island
Not every dollar of Groupon's GRPN -6.40%
revenue is created equal anymore. Will investors get a full
explanation when the Internet coupon company reports second-quarter
earnings Monday?
Groupon reported a surprising acceleration
in its North American business in the first quarter, with net
revenue rising 33% from the previous quarter. That was up from the
fourth quarter's 11% increase. That improvement, said Chief
Executive Andrew Mason, was due to technology that targets customers
with coupons they are more likely to buy. That may give investors
comfort, because it suggests Groupon isn't relying just on a huge
marketing budget to drive growth. Trouble is, it doesn't appear to
be the whole story. Related Reading
Groupon Staff Feel the Heat Ahead of
Groupon Earnings, Investors Bet on a Big Move
Investors will want to dig deeply into the
results, which are expected to show net revenue increased 2% quarter
over quarter to $573 million and earnings stayed flat at minus two
cents a share. Last fall, Groupon started a business called Groupon
Goods to sell discounted products, in addition to its core daily
deals for restaurants, spas and such. That business took off in the
first quarter, driving roughly 10% of North American gross billings,
data provider Yipit says. Notable is how the accounting treatment of
this business inflates net revenue growth overall. About 75% of
first-quarter Groupon Goods deals were so-called first party deals,
Yipit estimates. For these, Groupon takes the products into
inventory and accounts for sales on a gross basis, not a net basis.
That contrasts with regular Internet
coupons in which net revenue reflects only Groupon's share of what a
customer pays, typically about 40%. Analyst Ken Sena of Evercore
Partners estimates that Groupon Goods accounted for a bit more than
half of first-quarter net revenue growth. As Groupon Goods accounts
for more net revenue growth, it could be masking weakness in the
core daily deals business. Yipit data suggest Groupon's North
American gross billings declined 2% in the second quarter from the
first. Considering Europe's slowdown, Groupon's international
business—about 60% of the total— may have slowed even more.
SUMMARY: As described by Colin Barr in the related
video, "One month after they came out with their fourth quarter
numbers, '[Groupon] said--guess what-- "Oh, those were wrong..." The
company reissued is report for the quarter and year ended December
31, 2011 because they had not booked a sufficient reserve for
customer refunds. In the first quarter of 2012, customer refunds
under the company's policy exceeded the amount that management had
expected because the company faces higher refund rates when selling
Groupons for higher priced goods.
CLASSROOM APPLICATION: The article is useful in a
financial reporting class to cover corrections of errors,
restatements, accruals for contingent liabilities, and the
difference between earnings and cash flows. The article conveys a
sense of the need for confidence in financial reporting in order for
investors and others to have confidence in management's abilities.
Also mentioned in the article is the firm's auditor, Ernst & Young,
stating that this event clearly represents a material weakness in
internal control.
QUESTIONS:
1. (Introductory) Based on the information in the article
and the related video, what problem is Groupon now having to
correct?
3. (Advanced) Why does first quarter 2012 activity result
in accounting changes to fourth quarter 2011 results of operations?
4. (Advanced) What accounting standards require reissuing
Groupon's financial statements as the company has done under these
circumstances? What disclosures must be made in these circumstances?
Provide references to authoritative accounting standards for these
requirements.
5. (Advanced) As noted in the press release, there was no
change to the company's previously reported operating cash flows.
Why not?
6. (Introductory) What sense is portrayed in the article
and the video about Groupon's operations and the maturity of its
leadership in handling a public company? How does this viewpoint
stem from the accounting problems that they have faced in the first
quarter of operating as a public company?
7. (Advanced) How has the company's stock price reacted to
this announcement?
8. (Advanced) (Refer to the related article) What is a
material weakness in internal control?
9. (Advanced) (Refer to the related article) Do you think
that Groupon's auditor Ernst & Young needed to perform any systems
testing to make the statement about internal control that was quoted
in the article? Explain your answer.
Reviewed By: Judy Beckman, University of Rhode Island
The Securities and Exchange Commission is
examining Groupon Inc.'s GRPN -2.48% revision of its first set of
financial results as a public company, according to a person
familiar with the situation.
The regulator's probe into the popular
online-coupon company is at a preliminary stage and the SEC hasn't
yet decided whether to launch a formal investigation into the
matter, the person said.
The SEC decision to examine the
circumstances surrounding Groupon's surprise revision is the
start-up's latest run-in with the regulator. Groupon twice revised
its finances before its November IPO. An SEC spokesperson declined
to comment, as did a spokesman for Groupon.
Groupon shares plunged Monday, ending the
day down nearly 17% at $15.27, far below its $20 IPO price. The
selloff came despite damage control efforts by Groupon's top two
executives, Chief Executive Andrew Mason and finance chief Jason
Child.
The Chicago company also closed ranks
around Mr. Child, even as accounting experts and investors
criticized his performance. People familiar with the situation said
Mr. Child, who joined Groupon from Amazon.com Inc. in December 2010,
continues to have the support of Mr. Mason and others at the
company.
Groupon said Friday it was revising its
results for the fourth quarter after discovering executives had
failed to set aside enough money for customer refunds. The company
had reported a loss of $37 million for its fourth quarter. The
accounting changes reduced the company's revenue for the quarter by
$14.3 million and widened its loss by $22.6 million.
The revision came after an unsettling
discovery in late February. That's when Groupon's chief accounting
officer told Messrs. Mason and Child that many customers had
returned their coupons in January, said a person familiar with the
matter. Read More
Heard: Disclosure Could Aid Groupon Therapy
Deal Journal: Analysts Question Groupon Model After Groupon, Critics
Wary of JOBS Act Groupon Forced to Revise Results 3/31/12
What's worse: the four-year-old company
didn't have enough money set aside in its reserves to cover those
refunds, according to this person.
The duo questioned whether this meant
people weren't interested in buying daily deals anymore, according
to this person: "It made [the executives] think there's got to be
something [they] don't understand. A business just doesn't go
sideways and go in another direction overnight." Related Video
Groupon shares slid Monday as several Wall
Street analysts questioned the stability of the company's business
following a revision of its fourth-quarter results, Dan Gallagher
reports on digits. Photo: AP.
Ultimately both men got comfortable after
an internal analysis found only certain types of coupons were being
returned, this person said.
The moment of crisis illustrates how deep
the growing pains are at Groupon as it comes to grips with its
status as a newly public Web company. In addition to revising its
quarterly results, the company on Friday revealed a "material
weakness in its internal controls." Insight from CFO Journal
Investor Outreach Having Big Effect on
Say-on-Pay Results Lufthansa Convertibles Monetize JetBlue Stake
Multiemployer Pension Plans May Be in Hot Water
According to people familiar with the
situation, Groupon expects to address the material weakness by the
time it reports its first-quarter earnings on May 14.
Groupon has also hired a second accounting
firm, KPMG, in addition to its current accountant Ernst & Young.
KPMG's role is to make Groupon compliant with Sarbanes-Oxley,
federal regulations around accounting and disclosures of public
companies. In addition, Groupon plans to hire more accounting and
finance staff, said a person familiar with the matter.
The revision threw open the question of
"whether there is any real corporate governance at Groupon
whatsoever," wrote professors Anthony Catanach of Villanova
University and Ed Ketz of Penn State University on their Grumpy Old
Accountants blog.
Others fingered Groupon's fast growth—its
revenue was $1.62 billion last year, up from $14.5 million in
2009—as the culprit for its recent mishaps. Groupon previously had
to change its accounting twice before its IPO in response to SEC
concerns.
"I view this as growing pains," said one
Groupon investor who declined to be named. "This is like a high
school kid who is a five-foot sophomore and becomes seven feet by
the time he's a senior."
At the heart of Groupon's most recent
problem is something known as the "Groupon Promise" which allows
customers to return one of its coupons. The company has no plans to
change its policy, said a person familiar with the matter, since it
uses it to compete with rivals like LivingSocial Inc.
But that policy led to a meeting in late
February between Mr. Child and his chief accounting officer Joe Del
Preto, just a few weeks after Groupon had reported its first
earnings report as a public company.
For the month of January, Mr. Del Preto
told Mr. Child the number of refunds had exceeded all previous
models Groupon had built to predict its customers' behavior, said a
person familiar with the matter.
SUMMARY: As described by Colin Barr in the related
video, "One month after they came out with their fourth quarter
numbers, '[Groupon] said--guess what-- "Oh, those were wrong..." The
company reissued is report for the quarter and year ended December
31, 2011 because they had not booked a sufficient reserve for
customer refunds. In the first quarter of 2012, customer refunds
under the company's policy exceeded the amount that management had
expected because the company faces higher refund rates when selling
Groupons for higher priced goods.
CLASSROOM APPLICATION: The article is useful in a
financial reporting class to cover corrections of errors,
restatements, accruals for contingent liabilities, and the
difference between earnings and cash flows. The article conveys a
sense of the need for confidence in financial reporting in order for
investors and others to have confidence in management's abilities.
Also mentioned in the article is the firm's auditor, Ernst & Young,
stating that this event clearly represents a material weakness in
internal control.
QUESTIONS:
1. (Introductory) Based on the information in the article
and the related video, what problem is Groupon now having to
correct?
3. (Advanced) Why does first quarter 2012 activity result
in accounting changes to fourth quarter 2011 results of operations?
4. (Advanced) What accounting standards require reissuing
Groupon's financial statements as the company has done under these
circumstances? What disclosures must be made in these circumstances?
Provide references to authoritative accounting standards for these
requirements.
5. (Advanced) As noted in the press release, there was no
change to the company's previously reported operating cash flows.
Why not?
6. (Introductory) What sense is portrayed in the article
and the video about Groupon's operations and the maturity of its
leadership in handling a public company? How does this viewpoint
stem from the accounting problems that they have faced in the first
quarter of operating as a public company?
7. (Advanced) How has the company's stock price reacted to
this announcement?
8. (Advanced) (Refer to the related article) What is a
material weakness in internal control?
9. (Advanced) (Refer to the related article) Do you think
that Groupon's auditor Ernst & Young needed to perform any systems
testing to make the statement about internal control that was quoted
in the article? Explain your answer.
Reviewed By: Judy Beckman, University of Rhode Island
The Securities and Exchange Commission is
examining Groupon Inc.'s GRPN -2.48% revision of its first set of
financial results as a public company, according to a person
familiar with the situation.
The regulator's probe into the popular
online-coupon company is at a preliminary stage and the SEC hasn't
yet decided whether to launch a formal investigation into the
matter, the person said.
The SEC decision to examine the
circumstances surrounding Groupon's surprise revision is the
start-up's latest run-in with the regulator. Groupon twice revised
its finances before its November IPO. An SEC spokesperson declined
to comment, as did a spokesman for Groupon.
Groupon shares plunged Monday, ending the
day down nearly 17% at $15.27, far below its $20 IPO price. The
selloff came despite damage control efforts by Groupon's top two
executives, Chief Executive Andrew Mason and finance chief Jason
Child.
The Chicago company also closed ranks
around Mr. Child, even as accounting experts and investors
criticized his performance. People familiar with the situation said
Mr. Child, who joined Groupon from Amazon.com Inc. in December 2010,
continues to have the support of Mr. Mason and others at the
company.
Groupon said Friday it was revising its
results for the fourth quarter after discovering executives had
failed to set aside enough money for customer refunds. The company
had reported a loss of $37 million for its fourth quarter. The
accounting changes reduced the company's revenue for the quarter by
$14.3 million and widened its loss by $22.6 million.
The revision came after an unsettling
discovery in late February. That's when Groupon's chief accounting
officer told Messrs. Mason and Child that many customers had
returned their coupons in January, said a person familiar with the
matter. Read More
Heard: Disclosure Could Aid Groupon Therapy
Deal Journal: Analysts Question Groupon Model After Groupon, Critics
Wary of JOBS Act Groupon Forced to Revise Results 3/31/12
What's worse: the four-year-old company
didn't have enough money set aside in its reserves to cover those
refunds, according to this person.
The duo questioned whether this meant
people weren't interested in buying daily deals anymore, according
to this person: "It made [the executives] think there's got to be
something [they] don't understand. A business just doesn't go
sideways and go in another direction overnight." Related Video
Groupon shares slid Monday as several Wall
Street analysts questioned the stability of the company's business
following a revision of its fourth-quarter results, Dan Gallagher
reports on digits. Photo: AP.
Ultimately both men got comfortable after
an internal analysis found only certain types of coupons were being
returned, this person said.
The moment of crisis illustrates how deep
the growing pains are at Groupon as it comes to grips with its
status as a newly public Web company. In addition to revising its
quarterly results, the company on Friday revealed a "material
weakness in its internal controls." Insight from CFO Journal
Investor Outreach Having Big Effect on
Say-on-Pay Results Lufthansa Convertibles Monetize JetBlue Stake
Multiemployer Pension Plans May Be in Hot Water
According to people familiar with the
situation, Groupon expects to address the material weakness by the
time it reports its first-quarter earnings on May 14.
Groupon has also hired a second accounting
firm, KPMG, in addition to its current accountant Ernst & Young.
KPMG's role is to make Groupon compliant with Sarbanes-Oxley,
federal regulations around accounting and disclosures of public
companies. In addition, Groupon plans to hire more accounting and
finance staff, said a person familiar with the matter.
The revision threw open the question of
"whether there is any real corporate governance at Groupon
whatsoever," wrote professors Anthony Catanach of Villanova
University and Ed Ketz of Penn State University on their Grumpy Old
Accountants blog.
Others fingered Groupon's fast growth—its
revenue was $1.62 billion last year, up from $14.5 million in
2009—as the culprit for its recent mishaps. Groupon previously had
to change its accounting twice before its IPO in response to SEC
concerns.
"I view this as growing pains," said one
Groupon investor who declined to be named. "This is like a high
school kid who is a five-foot sophomore and becomes seven feet by
the time he's a senior."
At the heart of Groupon's most recent
problem is something known as the "Groupon Promise" which allows
customers to return one of its coupons. The company has no plans to
change its policy, said a person familiar with the matter, since it
uses it to compete with rivals like LivingSocial Inc.
But that policy led to a meeting in late
February between Mr. Child and his chief accounting officer Joe Del
Preto, just a few weeks after Groupon had reported its first
earnings report as a public company.
For the month of January, Mr. Del Preto
told Mr. Child the number of refunds had exceeded all previous
models Groupon had built to predict its customers' behavior, said a
person familiar with the matter.
Continued in article
From The Wall Street Journal Accounting Weekly Review in
February 4, 2012
SUMMARY: The article quotes excerpts from Groupon,
Inc. CEO Andrew Mason's comments in an interview with the WSJ. The
related video shows Mr. Mason's responses to written questions
flashed on screen. Accounting topics addressed in the interview are
two topics with which the SEC was concerned during the company's IPO
process: (1) the company's use of "Adjusted Consolidated Segment
Operating Income, which showed the company's revenue minus certain
marketing costs" and (2) Mr. Mason's writing of a memo about the
firm to employees which was then leaked to the press during a quiet
period imposed by SEC just prior to the IPO. The stock is now
trading at $21.49 as of the date of this writing, slightly above the
$20/share IPO price.
CLASSROOM APPLICATION: The article is useful in
discussing segment reporting requirements, handling of marketing
costs, and the overall IPO process.
QUESTIONS:
1. (Introductory) What two accounting and financial
reporting issues impacted Groupon during its process of becoming a
publicly traded company?
2. (Introductory) What is Groupon CEO Andrew Mason's
assessment of having used an unusual accounting metric in the
company's first filing for its initial public offering (IPO)?
3. (Advanced) Refer to the related article. What was the
unusual accounting metric? How is this metric justified in Mr.
Mason's current interview with TWSJ?
4. (Advanced) Consider the requirements for segment
reporting. How may operating income as reported by business segment
differ from total consolidated operating income presented on the
income statement? State your source for accounting requirements that
allow this treatment.
5. (Introductory) What is an S-1 registration statement and
what is a "quiet period"? How and why did Mr. Mason violate this
requirement for a quiet period?
Reviewed By: Judy Beckman, University of Rhode Island
Groupon
Inc. Chief Executive Andrew Mason wants to prove his company is
worth the fuss after its roller-coaster ride to an initial public
offering last year.
The
31-year-old founder took his Chicago-based daily deals site public
in November at a valuation of $13 billion, well below the $15
billion to $20 billion price tag Groupon once thought it could
command. The IPO also brought on questions about another bubble in
the Internet sector and the viability of the daily-deals business
model.
Critics
pointed out that Groupon was unprofitable and was spending heavily
to acquire new subscribers amid a flood of competition from
daily-deal clones. The company also raised eyebrows at the
Securities and Exchange Commission over an unusual accounting metric
called Adjusted Consolidated Segment Operating Income, which showed
the company's revenue minus certain marketing costs.
Groupon's
stock soared 31% above its $20 IPO price on its first day of
trading, but withered in following weeks. Shares closed at $19.63,
down 2.1%, in 4 p.m. trading Monday. The company is set to report
its first quarterly results as a public company next week.
Mr. Mason,
who sometimes posts online videos of himself in his underwear doing
yoga or dancing, sat down for a recent interview in his Chicago
office to discuss challenges facing the company and his ability to
handle them. Edited excerpts:
WSJ: Do you
think you're mature enough to be the CEO of a multi-billion dollar
company?
Mr. Mason:
I got the company this far. To the degree I was weird, I was weird
before we were a public company and managed to get it worth whatever
it's worth. I'm going to continue doing my thing and work my butt
off to add value for shareholders and as long as they and the board
see fit to keep me in this role, I feel enormously privileged to
serve.
WSJ:
Groupon has been criticized by analysts and investors for not being
profitable. How important is profitability?
Mr. Mason:
We believe that the most important thing for us to be focused on is
growing the business, building something that our consumers and our
merchant partners love. And when you focus on those inputs, revenue
and profitability is the output and it follows naturally.
WSJ: Some
critics say the daily deal model is too easy to replicate.
Mr. Mason:
There's proof. There are over 2,000 direct clones of the Groupon
business model. However, there's an equal amount of proof that the
barriers to success are enormous. In spite of all those competitors,
only a handful are remotely relevant.
WSJ: Why?
Mr. Mason:
People overlook the operational complexity. We have 10,000 employees
across 46 countries. We have thousands of salespeople talking to
tens of thousands of merchants every single day. It's not an easy
thing to build.
WSJ: You
had a rough IPO. What was the hardest part?
Mr. Mason:
After filing the S-1, we entered a quiet period that greatly
restricted our ability to have a conversation with the public. It
was frustrating to not be able to directly address many of the
concerns that people raised about the business.
WSJ:
Including discussing "Adjusted Consolidated Segment Operating
Income?" You were accused by critics of trying to hide your high
marketing costs from investors.
Mr. Mason:
Groupon spends money on marketing in a way that's different from
traditional Internet and e-commerce companies. Our marketing spend
is designed to drive subscribers to our daily mailing list. A
traditional e-commerce company is driving transactions. Our own
proprietary advertising network can continually advertise to our
customers at virtually no additional cost. There's an upfront
investment that we know pays off over the long-term.
WSJ: Was it
a mistake to include that metric?
Mr. Mason:
In retrospect, I think it was naive, and I wouldn't have included
it. The list of companies that have added their own financial
metrics is not a savory group. It created a distraction that wasn't
worth the benefit.
WSJ: The
SEC also took issue with a memo you wrote to employees during the
quiet period that was leaked to the press.
Mr. Mason:
I wrote the memo because 23-year-olds were coming into my office and
asking how they should respond to their parents when they ask if
Groupon is about to go bankrupt. The risks of not communicating to
my employees were greater than the risks of doing otherwise.
If I knew
it was going to leak, I would have been less bizarre, and I wouldn't
have made a joke about my now-wife. She was upset. (He joked that
his then-girlfriend asked him why he never said anything nice about
her.)
WSJ:
Groupon's stock price is trading below its IPO price of $20. Why?
Mr. Mason:
Luckily there are people smarter than me in this world that know the
answers to those kinds of questions. I leave that to the financial
community.
Last week
was Groupon’s big week, although not in a good way. What happened?
Well, the premier source of daily deal dish got knocked down a few
more pegs after announcing a revision to 4th quarter earnings and
the announcement by management that there was a material weakness in
internal controls over financial reporting that was causing their
disclosure controls to be ineffective. Groupon went public just a
few months ago, last November, and the annual report was the
company’s first filing as a public company.
Here’s one of the few journalists who got the details right,
Jonathan Weil of Bloomberg, explaining
why, in this case, the news was especially bad:
Didn’t
Groupon know before its initial public offering that its
controls were weak? A company spokesman, Paul Taaffe, declined
to comment. Let’s assume for the moment, though, that its
executives did know. Even then, they wouldn’t have had to tell
investors beforehand.
That’s
because there is no requirement to disclose a control weakness
in a company’s IPO prospectus. Groupon would have had no
obligation to disclose the problem until it filed its first
quarterly or annual report as a public company — which is what
it did. Sandbagging IPO investors in this manner is perfectly
legal, it turns out.
The
reason lies with a gaping hole in the Sarbanes-Oxley Act, which
Congress passed in 2002 in response to the accounting scandals
at Enron Corp. and WorldCom Inc. That statute had two main
sections related to companies’ internal controls, which are the
systems and processes that companies are supposed to have in
place to ensure the information they report is accurate. Those
provisions apply only to companies that are public already, not
ones that have registered for IPOs.
One
section, called 302, requires public companies’ top executives
to evaluate each quarter whether their disclosure controls and
procedures are effective. The other section, known as 404, is
better known. It requires public companies in their annual
reports to include assessments by management and outside
auditors about the effectiveness of their internal controls over
financial reporting. Congress left it to the Securities and
Exchange Commission to write the rules implementing those
provisions.
Here’s
where it gets tricky. Groupon reported the weakness in its
financial-reporting controls through a Section 302 disclosure,
not a Section 404 report. In other words, the problem was
serious enough that it amounted to a shortcoming in the
company’s overall disclosure controls.
Groupon
won’t have to comply with Section 404’s requirements until its
second annual report, due next year, under an exemption the SEC
passed in 2006 for newly public companies. Likewise,
Groupon’s auditor, Ernst & Young LLP, to date has expressed no
opinion on the company’s internal controls in its audit reports.
From the
momentGroupon announced the revision on March 30,
there were two important facts that almost all major media financial
journalists got wrong:
1) The
announcement of lower revenue and lower income for the fourth
quarter was a revision of an earnings release, not a
restatement. Groupon never filed a 10Q so there was no
SEC filing to restate. Fessing up to the right numbers in the annual
report was the first time the company was bound to report those
numbers and, at that time, they corrected previously announced
earnings for the 4th Quarter.
2)
Management made the assessment of the material weakness in internal
controls over financial reporting that caused disclosure controls to
be ineffective, not auditor Ernst & Young.
Ernst & Young deserves no credit for the announcement, nor any
blame, just yet, for the fact that the weaknesses had to be finally
admitted. There is no transparency regarding the auditor’s agreement
or disagreement previously with Groupon, any public documentation of
their discussions or any reason to believe Ernst & Young either
encouraged or discouraged Groupon to get their act together sooner.
And the same can be said
for financial reporting as practiced by internet companies given
their “new business models” that require “new accounting.” Internet
company financial statements seem to mean different things to
different people, not unlike a piece of artwork. Unfortunately,
some of this accounting “artwork” is junk, as we have recently
reported in the case of Groupon (First
10K: April Fool’s!). At times like this
beauty rests in the I of the artist.
How can
management and directors and auditors see one thing, when the
complete opposite reflects reality? And why do internet IPOs seem
particularly vulnerable? Well, we think the problem is with the
accounting “standards” (and we use that term loosely) that apply to
these companies. As we stated in an earlier post:
Internet company accounting is suspect given all the unsupported
assertions and assumptions that must be made to comply with
generally accepted accounting principles…
Think about
it. The internet company balance sheet is generally dominated by
intangible assets whose values are based on assumptions that are
works of art themselves. And then there’s revenue recognition in
these companies with management making all kinds of assumptions
about primary obligors, selling price hierarchies, and virtual
sales. Yes, what makes internet company accounting “special” is
that so many of the applicable accounting rules require major
assumptions, many of which could be better characterized as “giant
leaps of faith.” Clearly, the accounting rules used for internet
companies should not be called “standards,” as their many judgments
make any meaningful comparison an impossibility! Enough
pontificating…
Given
Groupon’s recent accounting struggles we thought it might be
interesting to see if there were any other internet company
accounting issues lurking within today’s “hot” internet companies.
So, we looked at the most recent 10K filings of Demand Media,
Facebook, Groupon, Linked In, and Zynga, focusing primarily on
revenue and expense recognition, “unusual” accounting issues, and of
course some of our favorites: intangible assets, cash flows, and
non-GAAP financial metrics. Here is what we found.
Revenue
Two of the
five companies (Demand Media and Facebook) generate a significant
amount of their revenue from advertising. The way these companies
record revenue appears to be relatively straight-forward.
Generally, ad revenue is recognized either when the ad content is
delivered, or for click-based ads, when a user clicks on an ad.
Nothing very interesting or complicated here.
Linked In,
on the other hand, has a much more subjective revenue recognition
method for its hiring and marketing solutions. Most of the
Company’s contractual arrangements include multiple
deliverables, i.e., several products packaged together
which Linked In swears can’t be pulled apart to record revenue
separately. Gee, if the Company’s cost accounting system keeps
track of product and service costs separately, why can’t revenue be
estimated separately? Interesting question, huh? Anyway,
Linked In uses convoluted GAAP criteria to record revenue, the
relative selling price method, based on a selling price hierarchy.
In short, management decides what revenue will be based on vendor
specific evidence, third party evidence, or management’s best
estimate of selling price, in that order of priority. Which one do
you thing management likely favors?
Then,
there’s our poster child for bad internet company accounting,
Groupon. As you may recall, the Company was busted by the SEC for
improper revenue recognition last September. See “Groupon
Finally Restates Its Numbers.” Basically,
Groupon ignored accounting guidance (that’s a much better word than
“standard”) in Emerging Issues Task Force (EITF) 99-19, as well as
SEC Staff Accounting Bulletin 101 (question 10), and recorded the
gross amounts it received on Groupon sales as
revenues. Since being forced to restate its financial statements,
the Company now records revenue at the net amount
retained from the sale of Groupons (gross collections less an agreed
upon percentage of the purchase price due to the featured merchant
excluding any applicable taxes), since it is acting as the
merchant’s agent in the transaction.
It should
be noted that Demand Media also faces the “gross vs. net”
revenue issue discussed in EITF 99-19. For revenue sharing
arrangements in which the Company is considered the primary obligor,
it reports revenue on a gross basis. But for those situations where
it distributes its content on third-party websites and the customer
acts as the primary obligor, it records revenue on a net basis.
And
last, but not least, there is Zynga with its consumable or durable
virtual goods! For the sale of consumable virtual
goods (goods consumed by player game actions), revenue is recognized
as the goods are consumed. On the other hand, revenue from the sale
of durable virtual goods (goods accessible to a player over an
extended period of time) is recognized ratably over the estimated
average playing period of paying players for the applicable game.
Confused yet? Basically, we have to rely on Zynga to provide us
with a best estimate of the lives of both consumable and virtual
goods to book revenue. As we indicated in “Zynga’s
First 10K: Zestful Zephyrs,” by
merely changing the game’s rules, the Company can change what it
books as revenue! This is all too arbitrary. Are we really
surprised?
So, when it
comes to recording revenue, it appears that booking advertising
income is relatively easy, compared to the management estimates
needed for multiple deliverables (Linked In) and virtual good sales
(Zynga), or deciding who the “primary obligor” is (Demand Media and
Groupon). We would not be surprised if some internet companies
don’t intentionally complicate their product offerings to make
revenue recognition a function of management guesstimates!
Cost Capitalization
Given that
several of these companies are struggling to achieve or maintain
profitability, it is not surprising that they would try to record as
an asset what really is an expense. And sure enough, we find
several instances of this. For example, Demand Media capitalizes
many different types of costs including content costs, registration
and acquisition costs for undeveloped websites and internally
developed software, as well as intangible assets acquired in
acquisitions. How significant is this? Over 72 percent of the
Company’s $590.1 million in total assets are intangible in nature!
Now that takes cost capitalization to a new height…we’d probably try
that too if we were losing as much money every year as they are
(2011’s net loss was $18.5 million).
Linked In
also plays this “game,” but with a new twist. The Company does do
something quite interesting…it defers expensing $13.6 million in
commissions already paid on non-cancelable subscription contracts,
presumably to match the commission costs with the related revenue
streams. Why stop there? Couldn’t you make the same argument for a
whole host of other expenses as well? Maybe they did, but Deloitte
didn’t buy it.
Groupon and
Zynga also have played a slightly different version of the cost
capitalization game, by recording tax assets that presumably will
lower future tax liabilities. In recording these tax
assets, the companies reduce income tax expense in the income
statement, thus improving the bottom line. The only problem is that
a company must have future taxable income in order to use
these alleged tax assets! Well, if the companies did this to
mitigate their operating losses, the game has ended for Zynga, and
soon will end for Groupon.
In 2011
Zynga recorded a $113.4 million allowance against its deferred tax
assets, almost fully reserving these assets, and effectively wiping
them off the books. This suggests that the Company may have had a
reality check as to its future prospects, given that it no longer
projects a future that includes profitability, more specifically
taxable income.
As
for Groupon, we highlighted this same tax issue earlier in
Groupon’s First 10K: Looking Under the Hood.
In 2011, the Company increased its valuation
reserve for deferred tax assets by $72.3 million reducing reported
deferred tax assets to $65.3 million. Although Groupon gave no
reason for the increased reserve, it likely was forced to record it
for the same reason as Zynga, i.e., little likelihood of generating
taxable income in the foreseeable future against which deferred tax
assets could be used. So, who would have thought…the income tax
note might actually shed some light on what a company really thinks
its profit forecast is (as opposed to the press release)!
Other Accounting Issues
Our
internet company reviews also turned up a couple of interesting
points, which give us insight into managements’ attitude toward
financial reporting transparency…and believe it or not, Groupon is
NOT involved!
The
first involves cash, naturally, and how Demand Media “defines”
cash. You may recall that we first reported on the increasing trend
of companies to manipulate reported cash balances in “What’s
Up With Cash Balances?” And, yes, Demand
Media is overstating its balance sheet cash by including accounts
receivable as cash even though it has yet to receive the monies.
Here is what the Company’s accounting policy note says:
Continued in article
Jensen Comment
In the 1990s tech boom, startup companies in particular were not making
any profits and had cash shortage problems. These companies tried to
shift the focus to revenues and devised all sort of (mostly fraudulent)
schemes to record non-cash revenue. The EITF worked overtime trying to
plug the dikes against new revenue reporting schemes ---
http://www.trinity.edu/rjensen/ecommerce/eitf01.htm
TOPICS: business combinations, Financial Analysis,
Goodwill, Impairment
SUMMARY: Groupon filed its initial public offering (IPO) on
Friday, November 4, 2011, selling only a total of 6.4% of the
company's total shares. The IPO proceeds brought in $805 million,
the third smallest total for all IPOs since 1995, only larger than
the IPOs of Vonage Holdings and Orbitz in total proceeds. In terms
of the percent of outstanding shares sold, only Palm has sold a
smaller percentage in that same time frame. Quoting from the related
article, "Silicon Valley and Wall Street took Groupon's stock market
debut as a sign that investors are still willing to make risky bets
on fast-growing but unprofitable young Internet companies....Groupon
shares rose from their IPO price of $20 by 40% in early trading, and
ended at the 4 p.m. market close at $26.11, up 31%. The closing
price valued Groupon at $16.6 billion...."
CLASSROOM APPLICATION: Questions focus on measuring the
implied fair value of an entire business from the value of only a
portion. The concept is used in accounting for business combinations
and in goodwill impairment testing.
QUESTIONS:
1. (Introductory) Summarize the Groupon initial public
offering (IPO). How many shares were sold? At what price?
2. (Introductory) Describe the market activity of the stock
on its first day of trading. How does that activity show that
"investors are...willing to make risky bets on...young Internet
companies"?
3. (Advanced) How has the Groupon stock fared to the date
you write your answer to this question?
4. (Advanced) Define the term "implied fair value". How did
sale of only 6.3% of the shares outstanding translate into an
overall firm valuation of $12.8 billion? Show your calculation.
5. (Advanced) Given the range of trading reported in the
article and your answer to question 3 above, what is the range of
total firm value shown during this short time of public trading of
Groupon stock? Again, show your calculations. How does the small
percentage of shares contribute to the size of this range?
Reviewed By: Judy Beckman, University of Rhode Island
Even by dot-com
standards, Groupon's initial public offering is puny in terms of the
number of shares it actually sold to the public. According to
Dealogic, dating back to 1995 just three U.S. tech companies floated
a smaller percentage of their shares in their IPOs. Palm sold 4.7%
of its shares in a $1 billion offering; Portal Software sold 6.2% in
a tiny $64 million offering, and Ciena sold 6.2% in a $132 million
offering. Then comes Groupon, which sold 6.3% this week as part of
its $805 million offering.
That is well below
the median of 21% for the 50 largest technology IPOs dating back to
1995, according to Dealogic.
Groupon's limited
float strategy isn't new. Two of this year's other big Internet
IPOs, LinkedIn and Pandora Media also sold a limited number of
shares, just 9.4% of the total outstanding for both companies. Those
deals were also led by Morgan Stanley.
Considering doubts
about Groupon's business model, in order to ensure a strong first
day's trading, the underwriters not only limited the free-float, but
they also scaled back their original valuation target.
At Friday's close of
trading, Groupon shares were at $26.11 apiece, 31% above the IPO
price. That puts Groupon's market capitalization at about $17
billion, or roughly eight times next year's likely revenue. That is
steep, considering that the daily-deals Internet company is still
unprofitable and that growth appears to be slowing quickly.
SUMMARY: Groupon finally completed its IPO on Friday,
November 4, 2011, and interest in the company is therefore naturally
high. Competitors to Groupon attempt to obtain market share from the
newly public company by offering quicker payment terms to the small
business which provide the merchant benefits offered by Groupon.
Small businesses need their working capital as fast as possible and
therefore some complain about the Groupon terms. Groupon argues that
its terms are designed to ensure that merchant suppliers cannot use
Groupon for a quick infusion of cash just prior to closing
operations.
CLASSROOM APPLICATION: Questions ask students to analyze
Groupon's financial statements-particularly its working capital
components-to assess the issues with the company's payment terms.
QUESTIONS:
1. (Introductory) What are Groupon's payment terms? How do
those terms help Groupon's customers, the buyers of its electronic
coupons?
2. (Introductory) How do Groupon's payment terms help
Groupon's own financial position and operating results? In your
answer, define the financial concepts of cash flow and working
capital mentioned in the article.
3. (Advanced) Groupon issued its initial public offering of
stock (IPO) on Friday, November 4, 2011. Access the S-1 registration
statement filed with the SEC for this offering on June 2, 2011. It
is available on the SEC web site at
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm
Click on the link to the Table of Contents, then on Index to
Consolidated Financial Statements, then on Consolidated Balance
Sheets. As of December 31, 2010, how much working capital did the
company have? Did this amount improve through the quarter ended
March 31, 2011?
4. (Advanced) Given your measurement of Groupon's working
capital, how easy do you think it would be for Groupon to address
its competition by changing its payment terms? Support your answer.
5. (Advanced) Continue working with the Groupon audited
consolidated financial statements as of December 31, 2010 and the
unaudited quarterly statements. What items comprise Groupon's
Accounts Receivable? How collectible are these amounts?
6. (Advanced) What items comprise Groupon's Accounts
Payable, accrued Merchants Payable, and Accrued Expenses? Given your
knowledge of Groupon's payment terms, can you identify how soon each
of these payments must be made?
7. (Advanced) Consider how you would schedule a detailed
estimate of the timing of Groupon's cash flows for the three current
liabilities discussed above.
Reviewed By: Judy Beckman, University of Rhode Island
Rivals of Groupon
Inc. are threatening the daily deal site leader by offering quicker
payment to merchants, possibly jeopardizing a key part of Groupon's
business model.
Groupon keeps itself
in cash by collecting money immediately when it sells its daily
coupons to consumers while extending payments to the merchants over
60 days. For instance, a hair salon might run a deal offering $100
of services for just $50 on Groupon's website, which then keeps as
much as half of the total collected and sends the remainder to the
salon in three installments about 25 to 30 days apart.
"The payment timing
is so erratic you can't count on any of that money helping to pay
your bills," says Mark Grohman, owner of Meridian Restaurant in
Winston-Salem, N.C.
After running three
Groupon promotions this year and last, Mr. Grohman says he won't use
the service again in part because it puts too big a strain on his
cash flow. "With smaller margins in restaurants, you need that
capital in the bank as fast as possible," he says.
Heissam Jebailey,
co-owner of two Menchie's frozen-yogurt franchises in Winter Park,
Fla., says he also has begun to view Groupon's installment payments
as too slow.
Enlarge Image
SBGROUPON SBGROUPON
"You want to get
paid in full as quickly as possible," says Mr. Jebailey, who has run
deals with both Groupon and its rival LivingSocial Inc. offering
customers $10 of frozen yogurt for $5. He says both promotions were
successful but that he'd only use Groupon again if the service
promises to pay faster. "We're the ones that have to cover the cost
of goods for giving away everything at half price," he says. "I will
not do another deal with Groupon unless they agree to my terms."
Groupon executives
have no plans to change payments terms, said a person familiar with
the matter. Because Groupon has a backlog of 49,000 merchants in
line to offer a deal with the site, executives feel confident that
they don't need to make any changes to payment terms, said another
person.
While Groupon pays
merchants in installments of 33% over a period of 60 days,
LivingSocial and Amazon.com Inc.'s Amazon Local pay merchants their
full share in 15 days. Google Inc.'s Google Offers promises 80% of
the merchant's cut within four days, and the remainder over 90 days.
Groupon pays in
installments for a reason, according to a person familiar with the
matter: It has seen some merchants try to use Groupon to get a quick
infusion of cash before going out of business, leaving customers
with vouchers that can't be redeemed.
The Chicago-based
start-up has a policy of offering refunds to customers who aren't
satisfied, and as a result it is cautious about doing deals with
merchants who may not carry through on their end, says the person
familiar with the matter.
Groupon also says it
pays merchants before they provide services to customers and will
accelerate payments if merchants experience unusually fast consumer
redemption.
"We believe
Groupon's payment terms are fair to merchants and important to
protect consumers," says Julie Mossler, director of communications
for Groupon.
It also is in
Groupon's best interest to stretch out payments to its customers for
as long as possible, says John Hanson, a certified public accountant
and executive director at Artifice Forensic Financial Services LLC
in Washington, D.C. "It makes their cash position look stronger on
their books."
Steady cash flow has
helped fuel the valuation of Groupon, which first sold shares to the
public last week. Groupon's stock was down nearly 4% Wednesday,
bringing its share price of $23.98 closer to the company's IPO price
of $20 a share. Based on the 5.5% of shares that trade, the company
has a valuation of about $15 billion. But its working-capital
deficit has ballooned to $301.1 million as of Sept. 30, and the
amount it owes its merchants is also way up.
Groupon's "accrued
merchant payable" balance increased to $465.6 million as of Sept.
30, from $4.3 million at year-end 2009, its filings say. This
merchant payable balance exceeded Groupon's cash and contributed to
the company's working capital deficit, according to the company's
filing.
Offering merchants
faster payment terms could hurt its cash flow and force it to raise
funds to cover its day-to-day cash needs, Groupon said in a recent
securities filing. In international markets, the company pays
merchants only once a coupon has been redeemed.
Every one-day
reduction in Groupon's merchant payables represents a risk of about
$14 million in free cash flow, according to estimates by Herman
Leung, a Susquehanna analyst. "It's a key driver of cash flow
dollars and a key assumption in the Groupon model," he says of the
60-day payment period. "It's highly sensitive."
To be sure,
Groupon has faced waves of competition for more than a year, and
many of those challengers already have come and gone.
Continued in article
Teaching cases on the accounting
scandals at Groupon (especially overstatement of revenues) and its
auditor (Ernst & Young) ---
See Below
What’s all the hoopla about Groupon’s latest “revision” to its
financial reports and lack of internal controls? Why is everyone
acting so surprised? You should have known something was up when
the Groupon’s 10K was so long in coming after earnings were
originally released on February 8th. Moreover, we warned
you all in
“Trust No One, Particularly Not Groupon’s Accountants,”
that this day would soon come. Remember this?
It is absolutely ludicrous to think that
Groupon is anywhere close to having an effective set of internal
controls over financial reporting having done 17 acquisitions in a
little over a year. When a company expands to 45 countries, grows
merchants from 212 to 78,466, and expands its employee base from 37
to 9,625 in only two years, there is little doubt that internal
controls are not working somewhere. Any M&A expert will agree. And
don’t forget that Groupon admitted to having an inexperienced
accounting and reporting staff.
We just
can’t resist: TOLD YOU SO! We just wonder what took E&Y so long to
figure this out…after all, as Groupon’s auditors, they get to see
the Company’s books and records, and we don’t. Maybe it’s just a
case of not being able to see the forest for all of the trees.
That’s not very comforting is it?
And could
it be any more appropriate that this latest “revision” release comes
so close to April Fool’s Day?
For those
of you that have real lives and may have missed it, here’s what
happened:
On February 8, 2012, Groupon issued a press release reporting
revenues of $506.5 million, free cash flows of $155.1 million,
and operating profits of $15.0 million (among other things). See
the
Company’s 8K filed on this date for
more details.
Then, this past Friday after the markets’ close, the Company
announced a “revision” to its original earnings press release.
2011 revenues and operating profits were both revised downward,
revenues down to $492.2 million and operating profits flipping
to a loss of $15 million. See
Groupon’s 8K filed on March 30, 2012 for more details.
But the biggest
“surprise,” or confirmation of trouble, can be found in Item 9A
of the
Company’s 2011 10K, also filed on
March 30, where Groupon admits to having a material weakness in
internal control over financial reporting. The following
Company admissions are particularly damning:
We did
not maintain financial close process and procedures that were
adequately designed, documented and executed to support the accurate
and timely reporting of our financial results.
We did
not maintain effective controls to provide reasonable assurance that
accounts were complete and accurate and agreed to detailed support,
and that account reconciliations were properly performed, reviewed
and approved.
We did
not have adequate policies and procedures in place to ensure the
timely, effective review of estimates, assumptions and related
reconciliations and analyses, including those related to customer
refund reserves. As noted previously, our original estimate
disclosed on February 8 of the reserve for customer refunds proved
to be inadequate after we performed additional analysis.
So, what
should all this mean for investors and market regulators? Well,
first of all, the Groupon’s earnings revision which was prompted by
an increased reserve requirement for customer refunds, highlights
the subjectivity and uncertainty associated with any accounting
assumptions (or judgments) made by relatively “new” companies,
operating in “new” industries, with inexperienced management:
yes, internet companies! In short, internet company
accounting is suspect given all the unsupported assertions and
assumptions that must be made to comply with generally accepted
accounting principles, not to mention the likely internal control
weakness issue.
Next,
we question whether there is any real corporate governance at
Groupon whatsoever. Usually, when material weaknesses surface,
heads roll…not at Groupon! Instead, the board of directors rewarded
the Company’s chief financial officer with a salary increase and
bonus. According to a
Groupon 8K filed on March 19, 2012:
Mr.
Child’s base salary was increased from $350,000 to $380,000 per
year. This increase will be effective on April 1, 2012…Mr. Child’s
annual bonus guarantee of $350,000 will remain in place for 2012,
and he will receive half of the guaranteed bonus in June 2012. The
remainder of the guarantee plus any additional bonus earned under
the plan will be paid in the first quarter of 2013.
Absolutely
unbelievable! Not only does the guy who is responsible for the
aforementioned system of internal control bust get to keep his job,
but he gets a raise and a bonus! Need we say more?
Finally, do
you really believe that this material weakness in internal control
(and related refund issue) mysteriously appeared in the fourth
quarter of 2011? Of course not, but by assigning it to the fourth
quarter of 2011, Groupon and E&Y can avoid the embarrassment of
admitting that the financial statements included in the Company’s
IPO filing were incorrect. This is probably not a bad strategy from
their perspective given the impending securities litigation that is
now lurking.
Today
(October 21) Groupon issued
amendment Number 6 to its S-1 filing. The
most interesting data are on page 9 of the report, which we repeat
below.
What stands
out to us is that stockholders’ equity on September 30 is negative—the
firm has become technically insolvent!
Our prediction that Groupon has a high probability of failure
remains intact.
Continued in article
Jensen Comment
This illustrates that on occasion insolvent firms may have value
depending upon the net value of all the things that don't get posted to
the balance sheet under GAAP. Common examples include contingency
assets/liabilities that are not yet booked, intangibles such as the
value of employees, and a boatload of other items that accountants just
cannot measure with enough confidence and stability to put into the
general ledger.
One of the best examples is the
early years of Amazon.com that every year incurred relatively large
losses in the income statement but managed to continue to sell equity
shares because investors sniffed out huge value in the air surrounding
the net assets.
Groupon of course is another
matter, Catenach and Ketz, the grumps, have never liked the stench
surrounding the air over Groupon as if it was a pile of something that
smells very bad.
Trust No one, Particularly Not
Groupon's Accountants and Auditors (Ernst & Young)
From The Wall Street Journal Weekly
Accounting Review on September 30, 2011
SUMMARY: This article presents financial reporting and
auditing issues stemming from the Groupon planned IPO. Groupon
originally filed for an initial public offering in June 2011. At the
time, the filing contained a measure Adjusted Consolidated Segment
Operating Income that is a non-GAAP measure of performance. The SEC
at the time required the company to change its filing to use
GAAP-based measures of performance. The SEC has continued to
scrutinize the Groupon financial statements and has required the
company to report revenue based only on the net receipts to the
company from sales of its coupons after sharing proceeds with the
businesses for which it makes the coupon offers.
CLASSROOM APPLICATION: The article is useful in financial
accounting and auditing classes. Instructors of financial accounting
classes may use the article to discuss reporting of the change in
measuring revenues and related costs. Instructors of auditing
classes may use the article to discuss non-standard audit reports.
Links to SEC filings are included in the questions. The video is
long; discussion of Groupon's issues stops at 5:30.
QUESTIONS:
1. (Introductory) According to the article, what accounting
and disclosure issues have delayed the initial public offering of
shares of Groupon, Inc.? What overall economic and financial factors
are also affecting this timing?
2. (Introductory) What was the problem with Groupon CEO
Andrew Mason's letter to Groupon employees? Do you think Mr. Mason
intended for this letter to be made public outside of Groupon?
Should he have reasonably expected that to happen?
3. (Advanced) What accounting change forced restatement of
the financial statements included in the Groupon IPO filing
documents? You may access information about this restatement
directly at the live link included in the online version of the
article.
http://online.wsj.com/public/resources/documents/grouponrestatement20110923.pdf
4. (Introductory) According to the article, by how much was
revenue reduced due to this accounting change?
5. (Introductory) Access the full filing of the IPO
documents on the SEC's web site at
http://sec.gov/Archives/edgar/data/1490281/000104746911008207/a2205238zs-1a.htm
Proceed to the Consolidated Statements of Operations on page F-5.
How are these comparative statements presented to alert readers
about the revenue measurement issue?
6. (Advanced) Move back to examine the consolidated balance
sheets on page F-4. Do you think this accounting change for revenue
measurement affected net income as previously reported? Support your
answer.
7. (Advanced) Proceed to footnote 2 on p. F-8. Does the
disclosure confirm your answer? Summarize the overall impact of
these accounting changes as described in this footnote.
8. (Advanced) What type of audit report has been issued on
the Groupon financial statements in this IPO filing? Explain the
wording and dating of the report that is required to fulfill
requirements resulting from the circumstances of these financial
statements.
Reviewed By: Judy Beckman, University of Rhode Island
SUMMARY: This article focuses on financial statement
analysis of the Groupon IPO filing documents including some
references to cost measures. "Forget the snappy 'adjusted
consolidated segment operating income.' That profit measure...was
rightly rejected by regulators. It is the complete absence of
details on subscriber churn that is more problematic. How often are
folks unsubscribing from Groupon's daily emails?...The issue is
important since...the cost of adding new subscribers has increased
quickly."
CLASSROOM APPLICATION: The article may be used in a
financial statement analysis or managerial accounting class.
QUESTIONS:
1. (Introductory) What is the overall concern about
Groupon's business condition that is expressed in this article?
2. (Advanced) The author states that the cost of adding new
subscribers has increased. How was this cost determined? How does
this calculation make the cost assessment comparable from one period
to the next?
3. (Advanced) What does Groupon CEO Andrew Mason say about
the company's cost of acquiring customers? What income statement
expense item shows this cost? How does the increasing unit cost
discussed in answer to question 2 above bring the CEO's assertion
into question?
4. (Advanced) In general, how does the author of this
assess the quality of the filing by Groupon for its initial public
offering? Why should that assessment impact the thoughts of an
investor considering buying the Groupon stock when it is offered?
Reviewed By: Judy Beckman, University of Rhode Island
"Trust No one, Particularly Not
Groupon's Accountants," by Anthony H. Catanach Jr. and J. Edward
Ketz, Grumpy Old Accountants Blog, August 24, 2011 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/
"Is Groupon "Cooking Its Books?"
by Grumpy Old Accountants Anthony H. Catanach Jr. and J. Edward Ketz,
SmartPros, September 2011 ---
http://accounting.smartpros.com/x72233.xml
Teaching Case
When Rosie Scenario waved goodbye "Adjusted Consolidated Segment
Operating Income"
From The Wall Street Journal Weekly
Accounting Review on August 19, 2011
SUMMARY: In filing its prospectus for its initial public
offering (IPO), Groupon has removed from its documents "...an
unconventional accounting measurement that had attracted scrutiny
from securities regulators [adjusted consolidated segment operating
income]. The unusual measure, which the e-commerce had invented,
paints a more robust picture of its performance. Removal of the
measure was in response to pressure from the Securities and Exchange
Commission...."
CLASSROOM APPLICATION: The article is useful to introduce
segment reporting and the weaknesses of the required management
reporting approach.
QUESTIONS:
1. (Introductory) What is Groupon's business model? How
does it generate revenues? What are its costs? Hint, to answer this
question you may access the Groupon, Inc. Form S-1 Registration
Statement filed on June 2, 011 available on the SEC web site at
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm
2. (Advanced) Summarize the reporting that must be provided
for any business's operating segments. In your answer, provide a
reference to authoritative accounting literature.
3. (Advanced) Why must the amounts disclosed by operating
segments be reconciled to consolidated totals shown on the primary
financial statements for an entire company?
4. (Advanced) Access the Groupon, Inc. Form S-1
Registration Statement filed on June 2, 011 and proceed to the
company's financial statements, available on the SEC web site at
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm#dm79801_selected_consolidated_financial_and_other_data
Alternatively, proceed from the registration statement, then click
on Table of Contents, then Selected Consolidated Financial and Other
Data. Explain what Groupon calls "adjusted consolidated segment
operating income" (ACSOI). What operating segments does Groupon,
Inc., show?
5. (Introductory) Why is Groupon's "ACSOI" considered to be
a "non-GAAP financial measure"?
6. (Advanced) How is it possible that this measure of
operating performance could be considered to comply with U.S. GAAP
requirements? Base your answer on your understanding of the need to
reconcile amounts disclosed by operating segments to the company's
consolidated totals. If it is accessible to you, the second related
article in CFO Journal may help answer this question.
Reviewed By: Judy Beckman, University of Rhode Island
Groupon Inc. removed
from its initial public offering documents an unconventional
accounting measurement that had attracted scrutiny from securities
regulators.
The unusual measure,
which the e-commerce had invented, paints a more robust picture of
its performance. Removal of the measure was in response to pressure
from the Securities and Exchange Commission, a person familiar with
the matter said.
In revised documents
filed Wednesday with the SEC, the company removed the controversial
measure, which had been highlighted in the first three pages of its
previous filing. But Groupon's chief executive defended the term
Wednesday. [GROUPON] Getty Images
Groupon,
headquarters above, expects to raise about $750 million.
Groupon had
highlighted something it called "adjusted consolidated segment
operating income", or ACSOI. The measurement, which doesn't include
subscriber-acquisitions expenses such as marketing costs, doesn't
conform to generally accepted accounting principles.
Investors and
analysts have said ACSOI draws attention away from Groupon's
marketing spending, which is causing big net losses.
The company also
disclosed Wednesday that its loss more than doubled in the second
quarter from a year ago, even as revenue increased more than ten
times.
By leaving ACSOI out
of its income statements, the company hopes to avoid further
scrutiny from the SEC, the person familiar with the matter said. The
commission declined comment.
Groupon in June
reported ACSOI of $60.6 million for last year and $81.6 million for
the first quarter of 2011. Under generally accepted accounting
principles, the company generated operating losses of $420.3 million
and $117.1 million during those periods.
Wednesday's filing
included a letter from Groupon Chief Executive Andrew Mason
defending ACSOI. The company excludes marketing expenses related to
subscriber acquisition because "they are an up-front investment to
acquire new subscribers that we expect to end when this period of
rapid expansion in our subscriber base concludes and we determine
that the returns on such investment are no longer attractive," the
letter said.
There was no mention
of when that expansion will end, but the person familiar with the
matter said the company reevaluates the figures weekly.
Groupon said it
spent $345.1 million on online marketing initiatives to acquire
subscribers in the first half and that it expects "to continue to
expend significant amounts to acquire additional subscribers."
The latest SEC
filing also contains new financial data. Groupon on Wednesday
reported second-quarter revenue of $878 million, up 36% from the
first quarter. While the company's growth is still rapid, the pace
has slowed. Groupon's revenue jumped 63% in the first quarter from
the fourth.
The company's
second-quarter loss was $102.7 million, flat sequentially and wider
than the year-earlier loss of $35.9 million.
Groupon expects to
raise about $750 million in a mid-September IPO that could value the
company at $20 billion.
The path to going
public hasn't been easy. The company had to file an amendment to its
original SEC filing after a Groupon executive told Bloomberg News
the company would be "wildly profitable" just three days after its
IPO filing. Speaking publicly about the financial projections of a
company that has filed to go public is barred by SEC regulations.
Groupon said the comments weren't intended for publication.
Teaching Case on How to Overstate Revenues
Auditor Ernst & Young is also named in the $7 billion lawsuit
Jensen Comment
I don't know what it is about The Wall Street Journal, but it is
very common for me to be forced to go elsewhere to find the names of the
audit firms included in client lawsuits. It's like the WSJ tries to
protect audit firms.
From The Wall Street Journal Accounting Weekly Review on
September 2, 2011
SUMMARY: Sino-Forest Corp. is traded on the Toronto
Stock Exchange (TSX) with the symbol TRE. The exchange suspended
trading in the company's shares for 15 days beginning Friday, August
26. TSX also ordered the chief executive and other key managing
executives to resign on Friday, though that order was then delayed
to allow for a hearing first. The current article indicates the
executives "resigned voluntarily" over the weekend of August 27 to
28 after "Canadian regulators said the company may have committed
fraud." These proceedings began based on "allegations...published by
short seller Muddy Waters LLC" (see the related article). This
short-selling analyst alleged the company may have overstated
revenues and timber holdings; the Ontario Securities Commission also
said that the company "'appears to have engaged in significant
non-arm's length transactions which may have been contrary to
Ontario securities laws and the public interest.'"
CLASSROOM APPLICATION: The article is second in
this week's coverage of accounting and auditing issues at Chinese
companies traded on North American exchanges. This case involves
accounting for revenues and natural resources-timber reserves-and
highlights potential issues from non-arm's-length transactions
conducted through subsidiaries. Questions on accounting and auditing
these areas are posed, but the auditing questions may be deleted for
instructors wishing to focus on only the accounting-related issues.
QUESTIONS:
1. (Introductory) What steps has Sino-Forest undertaken in
response to allegations that the company may have committed fraud?
List all that you find described in the main and related articles.
2. (Introductory) What areas of accounting are specifically
of concern at Sino-Forest Corp.?
3. (Advanced) Name some audit steps that are designed to
detect potential accounting problems in these areas of specific
concern at Sino-Forest. In your answer, state the audit objectives
you would try to achieve by conducting these tests and identify
whether they are transaction-related audit objectives or
balance-related audit objectives.
4. (Advanced) If Sino-Forest and its management have
committed fraud as alleged by analysts and Canadian regulators, are
these audit steps that you list above designed to detect this fraud
with absolute certainty? Explain your answer.
5. (Advanced) What is a "non-arm's-length transaction"?
What is a subsidiary? What potential accounting measurement concerns
arise if Sino-Forest has undertaken this type of transaction? Why
does conducting the actions through a subsidiary potentially
exacerbate these accounting measurement concerns?
6. (Advanced) Name some audit steps that are designed to
detect these potential accounting measurement problems stemming from
non-arm's-length transactions. In your answer, state the audit
objectives you would try to achieve by conducting these tests and
identify whether they are transaction-related audit objectives or
balance-related audit objectives.
Reviewed By: Judy Beckman, University of Rhode Island
HONG
KONG—Sino-Forest Corp. said its chairman and chief executive
resigned and three employees have been temporarily suspended, after
Canadian regulators said the company may have committed fraud.
The
forestry company said Sunday that Allen Chan voluntarily stepped
down as chairman and CEO pending completion of the company's review
of fraud allegations published two months ago by short seller Muddy
Waters LLC.
Mr. Chan
will assume the title of founding chairman emeritus of the
Chinese-operated company, shares of which are listed in Toronto. He
wasn't available for comment.
William
Ardell, lead director and chairman of Sino-Forest's independent
committee conducting the investigation, will succeed Mr. Chan as
chairman. Sino-Forest Vice Chairman Judson Martin, an executive
director, will become chief executive. Mr. Martin also is chief
executive of Sino-Forest's Greenheart Group Ltd. unit, shares of
which are listed in Hong Kong.
Sino-Forest
said Mr. Chan would continue to assist the company's internal
investigation and that he had planned to resign before the Ontario
Securities Commission on Friday ordered a 15-day trading halt for
the company's shares.
The
commission issued the order after saying regulators had found that
the company may have "misrepresented some of its revenue and/or
exaggerated some of its timber holdings." The commission said the
company, through its subsidiaries, also "appears to have engaged in
significant non-arm's-length transactions which may have been
contrary to Ontario securities laws and the public interest."
The
commission on Friday ordered executives to resign but revoked the
order the same day, saying it would require a hearing.
Sino-Forest's stock is down 72% for the year. The shares took a
beating in June when Muddy Waters published its allegations of
questionable accounting. The shares closed Thursday at 4.81 Canadian
dollars (US$4.90), down 5.7%.
The lawsuit
seeks money for those who bought Sino-Forest shares on the stock
market and through the company's public offering.
The
claim names several Sino-Forest executives, including former CEO
Allen Chan, auditor
Ernst & Young, and financial
institutions that acted as underwriters for the company's 2009
prospectus offering. They include TD Securities, Dundee Securities,
RBC Securities, Scotia Capital, and CIBC World Markets.
The lead
plaintiffs in the suit are the Labourers' Pension Fund of Central
and Eastern Canada and the International Union of Operating
Engineers Local 793 pension plan.
If the suit
is granted class-action status, any judgements or settlements would
be available to all members of the class.
The
allegations against Sino-Forest have not been proven in court.
TOPICS: Audit Firms, Audit Quality, Auditing,
PCAOB, Public Accounting, Public Accounting Firms
SUMMARY: The Public Company Accounting Oversight
Board (PCAOB) barred two former Ernst & Young LLP employees, Peter
C. O'Toole and Darrin G. Estella, "...from auditing public
companies, alleging they provided misleading documents to inspectors
who were evaluating the accounting firm's work... [The men also have
been barred] from associating with public accounting firms for at
least three years and at least two years, respectively."
CLASSROOM APPLICATION: The article is useful to
cover ethics, the function of the PCAOB, and the reputational
foundation for the public accounting profession-typical topics in an
opening chapter of an auditing text.
QUESTIONS:
1. (Advanced) What is the Public Company Accounting
Oversight Board (PCAOB)? What are the organization's
responsibilities?
2. (Introductory) According to the PCAOB, what did Peter C.
O'Toole and Darrin G. Estella do to some audit workpapers?
3. (Advanced) What options for action are available to the
PCAOB when finding something such as Messrs. O'Toole and Estella
did? What actions did the PCAOB take and what has been the result?
4. (Advanced) An attorney for Mr. O'Toole "...noted that
the PCAOB didn't allege any deficiencies in the audit, nor...[that]
the men were trying to hid any audit failure or lie about the work
that was actually done...." Then how has the announcement of these
men's actions by the PCAOB harmed the accounting and auditing
profession?
5. (Advanced) Do you think what Messrs. O'Toole and Estella
did was ethically acceptable? Support your answer.
SMALL GROUP ASSIGNMENT:
Question for small group discussion: Suppose you are asked by a
superior to introduce an audit workpaper or alter an audit workpaper
after completing an audit engagement. What would you do? What impact
will your decision have on your immediate future? On your potential
long term future?
Reviewed By: Judy Beckman, University of Rhode Island
The government's
audit overseer barred two former Ernst & Young LLP employees from
auditing public companies, alleging they provided misleading
documents to inspectors who were evaluating the accounting firm's
work.
The Public Company
Accounting Oversight Board barred Peter C. O'Toole and Darrin G.
Estella, a former partner and former senior manager in E&Y's Boston
office, from associating with public accounting firms for at least
three years and at least two years, respectively. Mr. O'Toole also
was fined $50,000.
The PCAOB said Mr.
O'Toole's three-year bar was the longest it had ever imposed on a
partner of a Big Four accounting firm. The two men agreed to
settlements with the PCAOB but didn't admit or deny the board's
findings. Mr. O'Toole and Mr. Estella may apply to remove their bars
after three and two years, respectively.
The PCAOB said that
shortly before its inspectors were to scrutinize an E&Y audit of an
unidentified company in 2010 as part of its regular inspections of
the firm, Mr. O'Toole and Mr. Estella created, backdated and placed
in the audit file a document concerning the valuation of one of the
audit client's investments, the most important issue in the audit.
Mr. O'Toole also allegedly authorized other members of the audit
team to alter other working papers in advance of the inspection. The
changes weren't disclosed to the PCAOB, the board said.
Ernst & Young said
in a statement that it had "separated" both men from the firm after
it determined that its policy prohibiting supplementing or changing
audit documents had been violated. E&Y said it cooperated fully with
the PCAOB's investigation, and that Mr. O'Toole's and Mr. Estella's
conduct had no impact on the client's financial statements or on
E&Y's audit conclusions.
The U.S.
Supreme Court on Monday declined to hear an appeal brought by an AOL
Inc. investor alleging that Ernst & Young LLP approved tainted
financial statements related to Time Warner Inc.'s merger with AOL.
In
rejecting the petition for certiorari, the high court dashed AOL
investor Dominic Amorosa and co-petitioner attorney Christopher
Gray’s claims that the Second Circuit failed to properly apply the
Securities Litigation Uniform Standards Act of 1998 when it
dismissed the fraud suit in February.
The
decision brings an end to 2003 suit claiming that Ernst & Young, the
independent auditor for AOL, Time Warner and the merged company,
engaged in fraud and abetted the companies' fraud when it issued
audited financial statements approving the companies' allegedly
faulty accounting.
"My client
and I believe that the certiorari petition raised significant and
unsettled questions of law concerning an 'opt-out' securities
plaintiff’s right to pursue individual claims under the Securities
Exchange Act and state law," petitioner Christopher Gray said.
"While we are disappointed with the denial of certioriari, obviously
not every case can be heard by the U.S. Supreme Court on the merits
and we look forward to moving on to other matters."
The Second
Circuit found that Amorosa had failed to state a claim for loss
causation because none of the events he identified as corrective
disclosures addressed AOL’s accounting practices or in any way
implicated Ernst & Young’s June 1999 audit opinion.
The
petitioners argued that the high court previously established that a
corrective disclosure explicitly reflecting the alleged false
statement is not required state such a claim.
Amorosa and
Gray also challenged the Second Circuit's finding in its Feb. 2
dismissal that SLUSA preempted Amorosa's state law claims.
SLUSA
defines cases that are to be considered preempted as covered class
actions — cases that seek damages for more than 50 people and that
are joined, consolidated or otherwise proceed as a single action —
but it does not preempt state law claims in individual securities
lawsuits like Amorosa's, the petitioners argued.
A federal appeals court Thursday
reinstated a class-action lawsuit filed by Broadcom Corp. investors
against Ernst & Young, saying the auditors should have known about
an option-backdating scheme at the Irvine tech company.
A lower-court judge had dismissed
the case against Ernst & Young after concluding the plaintiffs
hadn’t shown that the auditors knew that the value of Broadcom’s
stock was probably inflated by the company’s manipulation of its
financial statements.
Thursday’s ruling by the U.S. 9th
Circuit Court of Appeals in San Francisco reversed that dismissal
and scolded Ernst & Young for not acting to stop the $2.2-billion
backdating scheme.
Ernst & Young "apparently accepted
management at its word, never received requested documentation and
issued an unqualified opinion on the accuracy of Broadcom’s
financial statements," the 9th Circuit panel ruled in overturning
the lawsuit’s dismissal by U.S. District Judge Manuel L. Real in Los
Angeles.
Ernst & Young’s audit "amounted to
no audit at all," the appeals court said.
A spokesman for Ernst & Young
declined to comment on the ruling, saying the firm was still
reviewing it.
Continued in article
Recall that Lehman opted to record sales of poisoned securities in a
questionable arms length sale to former employees in what was literally
a situation where 100% of the sold securities would be returned at 5% or
8% higher prices.
As Lehman auditors, Ernst & Young is now contending in a lawsuit that
they had no choice to account for these as sales under
FAS 140
even though that accounting was deceptive for investors and hid
financial risks.
The Lehman Bankruptcy Judge stomped down heavily upon Ernst & Young.
Links to this report and other media quotations regarding the
repo
sales disgrace can be found at
http://www.trinity.edu/rjensen/Fraud001.htm#Ernst
A lawsuit against Ernst & Young was brought by the Attorney General of
New York and is not pending in court. The SEC ducked this one like a
miserable coward.
Ernst & Young
AccountingLink
29 April 2011
To the Point:
Repo
accounting amendments finalized
The Financial
Accounting Standards Board (FASB)
today amended its guidance on accounting for repurchase
agreements. The amendments simplify the accounting by
eliminating the requirement that the
transferor demonstrate it has adequate collateral to
fund substantially all the cost of purchasing replacement
assets. As a result, more arrangements could be accounted
for as secured borrowings rather than sales.
The attached To the Point summarizes what you need to
know about the new guidance. It is
also available online.
It's about time!
When I suggested this in a meeting and later in an email message a
couple of years ago a FASB board member gave me the brush off.
The FASB announced yesterday that it will
take a look at repo accounting. Again. As we don’t expect much
improvement, we wonder why it bothers.
Michael Rapoport of The Wall Street Journal
reports, “The Financial Accounting Standards Board agreed Wednesday
to look at further revisions to how companies must account for their
use of repurchase agreements, or ‘repos,’ a form of financing for
securities-trading firms, following a previous revision last year.
In particular, the board will look at ‘repos to maturity,’ a
potentially risky variant that contributed to MF Global’s collapse
last year.”
The Lehman Brothers collapse led to some
small, insignificant changes in the repo rules. With the
collapse of MF Global, the board thinks it
desirable to consider some incremental but insignificant
amendments. As last year’s revision was impotent, we expect more of
the same from any revision this year.
What the board should have done a decade or
two ago was to focus on the economic substance of the transaction,
and the substance of a repurchase agreement is that it is a secured
borrowing. Pure and simple. Thus, all repurchase agreements should
be accounted for as secured borrowings.
The FASB’s statement yesterday says more
about it than it does repo accounting. The board is incredibly slow
and, with old age, is slowing down even further. The board is
reactive instead of proactive; apparently, it cannot think about an
issue unless there is some type of financial crisis. The board
cannot think simple; instead, it seems to complexify whatever issue
is at hand. Finally, the board seems beholden to banks and has been
for some time. It appears to carry water for bankers, whether the
topic is special purpose entities, derivatives, fair value
accounting, or repurchase agreements.
Forget
reforming repo accounting. Let’s reform FASB instead. (so say
Catanach and Ketz)
Jensen Comment
Question
Where did the missing MF Global $1+ billion end up?
PricewaterhouseCoopers
LLP agreed to pay $65 million to settle class-action litigation over
failed brokerage MF Global Holdings Ltd., a case in which investors
claimed PwC botched its audits of the firm before it collapsed into
bankruptcy in 2011. The lawsuit had said MF Global used customer
funds to meet the increased liquidity demands of the firm's bets on
European sovereign debt. MF Global didn't have sufficient internal
controls to deal with that, a deficiency that PwC ignored.
CLASSROOM APPLICATION:
This
is a good article to use in an auditing class to show how costly
audit errors or omissions can be.
QUESTIONS:
1. (Introductory) What are the facts of the lawsuit
discussed in the article? Who are the plaintiffs and who is the
defendant?
2. (Advanced) What did the plaintiffs allege in the
lawsuit? What was PwC's involvement in MF Global Holdings' business
or bankruptcy? Why would PwC have any liability exposure in this
situation?
3. (Advanced) What were the terms of the settlement? Why
did PwC settle the case? Was this a good decision?
4. (Advanced) What could accounting firms do to prevent or
to reduce the chances of these situations occurring?
Reviewed By: Linda Christiansen, Indiana University Southeast
PricewaterhouseCoopers LLP agreed Friday to
pay $65 million to settle class-action litigation over failed
brokerage MF Global Holdings Ltd., a case in which investors claimed
PwC botched its audits of the firm before it collapsed into
bankruptcy in 2011.
MF Global shareholders had contended that
PwC’s audits gave MF Global a clean bill of health even though the
accounting firm knew or should have known that the firm’s financial
statements were erroneous and its internal controls weren’t
effective.
PwC denied any wrongdoing. In a statement
Friday, the firm said it is “pleased to resolve this matter and
avoid the cost and distraction of prolonged securities litigation.”
The firm “stands behind its audit work and its opinions on MF
Global’s financial statements,” PwC said.
The settlement, which is subject to court
approval, was reached after the two sides went through a mediation
process presided over by a former federal judge, according to court
documents. The proceeds will be distributed among investors in MF
Global securities.
MF Global filed for bankruptcy in October
2011 after customers balked at the firm’s big, risky bets on
European sovereign debt. About $1.6 billion in customer funds were
found to be missing, though customers have been reimbursed. The firm
has agreed to pay $200 million in civil fines. Jon S. Corzine, MF
Global’s former chairman and chief executive and a former New Jersey
governor, still faces civil charges from the Commodity Futures
Trading Commission for failure to supervise.
The lawsuit had said MF Global used
customer funds to meet the increased liquidity demands of the firm’s
bets on European sovereign debt. MF Global didn’t have sufficient
internal controls to deal with that, a deficiency that PwC ignored,
according to the lawsuit.
Continued in article
"Who Is The PwC Partner Responsible For MF Global? Someone With A
Lot of Baggage," by Francine McKenna, re:TheAuditors, June
14, 2013 ---
Click Here
Investigators seem no closer to the answer
than they were when the New York brokerage firm filed for bankruptcy
exactly a year ago Wednesday, owing thousands of farmers and
ranchers, hedge funds and other investors an estimated $1.6 billion.
Their money was supposed to be stashed safely at MF Global, but
company officials used much of it for margin calls and other
obligations.
The last, best hope for a breakthrough in
the probe is Edith O'Brien, the former assistant treasurer at MF
Global. Working in the company's Chicago office, she was the go-to
person for emergency money transfers as MF Global flailed for its
life.
"She really kept the place running," says
Matthew Gopin, MF Global's former head of internal audit for North
America, referring to her everyday duties approving money transfers.
One transfer in particular has drawn
outsize attention.
Ms. O'Brien hasn't budged from her refusal
to cooperate with investigators unless she is shielded from
prosecution, and in March she cited her constitutional right against
self-incrimination in refusing to testify before a congressional
panel.
Earlier this year, her lawyers told the
government what she would testify to in exchange for an immunity
deal. Those talks didn't go anywhere, and prosecutors subsequently
signaled that she isn't a target of the criminal probe, according to
a person involved in the case. She still could face civil charges
from regulators.
It isn't clear if Ms. O'Brien knew that the
transfers she approved in MF Global's final days violated U.S. rules
on the use of customer funds or deepened a deficit in customer
accounts. In some cases, Ms. O'Brien has told friends, she relied on
calculations prepared by other MF Global employees that turned out
to be wrong. In others, employees bungled transactions that she
approved.
Friends say she has been worried about
becoming the "fall guy" in the probe, especially since former MF
Global Chief Executive Jon S. Corzine told lawmakers in December
that she assured him the $175 million transfer was proper.
In private conversations, Ms. O'Brien has
bristled at and disagreed with Mr. Corzine's comments. "They may
have thought they had a chump, but they've got the wrong chump," she
told several friends while drinking Chardonnay at a bar in Chicago,
according to someone who was there.
One email from Ms. O'Brien reviewed by the
Journal shows her informing Mr. Corzine of an MF Global account the
money came from, as opposed to providing explicit assurances that
the transfer was proper. The email didn't note, however, that the
funds originated from a customer account.
Mr. Corzine declined to comment. Bankruptcy
lawyers winding down the company have since found money to cover
most of the estimated $1.6 billion customers couldn't get.
Continued in article
MF Global Was Another Repo Scandal
"FASB WILL TAKE ANOTHER LOOK AT REPO ACCOUNTING," by Anthony H.
Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants, March 22, 2012
---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/585
The FASB subsequently decided that most repos are to be booked as
secured borrowings rather than repo sales.
Last defendant standing. Not an
enviable place for EY in the case, In re Lehman Brothers
Securities and Erisa Litigation.
Everyone else had folded their
tent, paid the price to cross this dog off the list. Lehman
underwriters agreed in 2011 to a $426.2 million settlement. UBS, one
of the underwriters, held out and settled last August for another
$120 million. Even before the UBS and EY settlements,
Bernstein Litowitz Berger & Grossmann, attorneys for the plaintiffs,
claimed the combined
recovery of $516,218,000 is the third largest recovery to date in a
case arising from the financial crisis.
The $99 million EY will pay is
more than Lehman’s officers and directors, who settled for $90
million. That’s a big deal considering the executives typically say,
“The auditors said it was ok,” and the auditors say, “Management
duped us.” But it’s not that much considering that EY agreed to pay
C$117 million ($117.6 million) last December to settle claims in a
Canadian class action suit against Sino-Forest Corp, a Chinese
reverse merger fraud. That settlement is the largest by an auditor
in Canadian history, according to the the law firms.
And it’s not as much as some
thought EY would pay for Lehman. In fact, many thought Lehman would
finish off EY for good.
“The Examiner concludes that
sufficient evidence exists to support colorable claims against
Ernst & Young LLP (“Ernst & Young”) for professional malpractice
arising from Ernst & Young’s failure to follow professional
standards of care with respect to communications with Lehman’s
Audit Committee, investigation of a whistleblower claim, and
audits and reviews of Lehman’s public filings.”
That may not sound like a
mortal threat against Ernst & Young. But the damages here could
be enormous. A successful lawsuit against E&Y could result in a
court finding that the failure to properly advise the audit
committee prevented Lehman from taking genuine steps to
substantially reduce its leverage, which may have saved the firm
from bankruptcy. Which is to say, E&Y could find itself blamed
for all the losses to Lehman
shareholders. That
would be a stretch—such a claim would be speculative—but it
still should be scaring the heck out of the partners.
When the bankruptcy examiner’s
report on Enron came out, the language about Arthur Andersen was
quite mild. It merely noted there was “sufficient evidence from
which a fact-finder could conclude that Andersen: (1) committed
professional negligence in the rendering of accounting services
to Enron…” It went on to note that Andersen likely had a strong
defense against liability since so many Enron executives were
implicated.
“Enron brought down Arthur Andersen,”
Felix Salmon notes. “Will Lehman do the same for E&Y?”
In July of 2011, New
York Federal Court Judge Lewis Kaplan decided
to allow substantially all of the
allegations against Lehman executives and at least one of the
allegations against Ernst & Young to move forward to discovery and
trial. One month later Lehman Brothers executives, including its
former chief executive Richard S. Fuld Jr., agreed to pay $90
million to settle. Insurance proceeds paid for their settlement.
What was the
remaining allegation
against Ernst & Young? That the auditor had reason to know Lehman’s
2Q 2008 financial statements could be materially misstated because
of the extensive use of Repo 105 transactions.
New York prosecutors are poised to
file civil fraud charges against Ernst & Young for its alleged role
in the collapse of Lehman Brothers, saying the Big Four accounting
firm stood by while the investment bank misled investors about its
financial health, people familiar with the matter said.
State Attorney General Andrew
Cuomo is close to filing the case, which would mark the first time a
major accounting firm was targeted for its role in the financial
crisis. The suit stems from transactions Lehman allegedly carried
out to make its risk appear lower than it actually was.
Lehman Brothers was long one of
Ernst & Young's biggest clients, and the accounting firm earned
approximately $100 million in fees for its auditing work from 2001
through 2008, say people familiar with the matter.
The suit, led by Mr. Cuomo, New
York's governor-elect, could come as early as this week. It is part
of a broader investigation into whether some banks misled investors
by removing debt from their balance sheets before they reported
their financial results to mask their true levels of risk-taking, a
person familiar with the case said. The state may seek to impose
fines and other penalties.
Mr. Cuomo's office has sought
documents and information from several firms, including Bank of
America Corp., which earlier this year disclosed six transactions
that were wrongly classified. Jerry Dubrowski, a Bank of America
spokesman, said the bank's practice is to cooperate with any inquiry
from regulators.
It is possible that Ernst & Young
will try to settle before any suit is filed. The firm declined to
comment. A spokesman for the Lehman Brothers estate also declined to
comment.
The transactions in question,
known as "window dressing," involve repurchase agreements, or repos,
a form of short-term borrowing that allows banks to take bigger
trading risks. Some banks have systematically lowered their repo
debt at the ends of fiscal quarters, making it appear they were less
risk-burdened than they actually were most of the time.
Lehman Brothers dubbed
transactions of this type "Repo 105." The maneuver came to light in
March, when the bankruptcy examiner investigating the firm's
collapse more than two years ago found that it moved some $50
billion in assets off its balance sheet. Lehman labeled those
transactions as securities sales instead of loans, which led
investors to believe the firm was financially healthier than it
really was.
The bankruptcy examiner's report
and the attorney general's investigation found that Lehman Brothers
carried out the Repo 105 transactions on a quarterly basis in 2007
and 2008 without telling investors. Mr. Cuomo's investigation found
that Repo 105 transactions started as far back as 2001, said the
person familiar with the probe.
The attorney general's
investigation, which began after the bankruptcy examiner's report,
found that Ernst & Young specifically approved of Lehman's use of
Repo 105 transactions and provided the investment bank with a
complete audit opinion from 2001 through 2007, said the person.
Mr. Cuomo's office has also been
investigating suspected window-dressing transactions at other banks,
said the person, and is probing whether they similarly misled
investors.
An analysis earlier this year by
The Wall Street Journal found that other banks were reducing their
level of debt at quarter-end.
The attorney general's office has
sought documents and information from several firms, including Bank
of America Corp., which earlier this year disclosed six transactions
that were wrongly classified. The Journal's analysis found that Bank
of America was among the most active banks in reducing its debt at
reporting time.
The state's investigations into
other firms' window dressing are less advanced than its Ernst &
Young probe, said a person familiar with the probes.
Other regulators have said they
are looking into window dressing as well. The Securities and
Exchange Commission's investigation into Lehman's collapse is
focusing on Repo 105 transactions, said people familiar with the
matter. It has proposed new types of disclosures to help investors
identify when banks are window dressing. But the SEC has said it
hasn't found any widespread inappropriate practices in that area.
Britain's Financial Reporting
Council, which oversees corporate reporting rules, is also
investigating Ernst & Young's role in the Lehman collapse.
The Lehman bankruptcy examiner's
report also stated that there may be evidence to support negligence
and malpractice claims against Ernst & Young regarding Lehman's
audits and its lack of response to a whistle-blower at Lehman who
raised red flags about the repo trades.
The whistle-blower was Matthew
Lee, a Lehman Brothers senior vice president. He had complained to
his boss, and eventually wrote a letter in May 2008 to senior Lehman
executives expressing concern that the Repo 105 transactions
violated Lehman's ethics code by misleading investors and regulators
about the true value of the firm's assets. Days later, Mr. Lee was
ousted from the firm.
According to the Lehman bankruptcy
examiner's report, Ernst & Young auditors saw the letter, and later
interviewed Mr. Lee after he was let go from Lehman. Ernst & Young
previously said in a statement that Lehman management determined Mr.
Lee's "allegations were unfounded." Mr. Lee couldn't be reached for
comment.
Andrew Cuomo, New York’s attorney general,
filed a civil complaint again Ernst & Young claiming that the
accounting firm helped Lehman Brothers mislead investors by using
transactions called Repo 105s (aka Cooking The Books). Anyone who
thinks that E&Y and the state of New York are going to make it to a
courtroom to settle this in front of a jury has got to be kidding.
Last time I checked, there were four major accounting firms (The Big
4) and there have been numerous calls that a fifth is needed to take
the place of the ill-fated Arthur Andersen. A guilty verdict for
E&Y would mean we would have “The Big 3” (look how well that number
worked out for the automotive industry). A settlement is imminent.
We have all seen this type of theater play
out before. A prosecutor calls out a company for some “massive
wrongdoing” then settles within a year for a new record dollar
figure (Goldman Sachs, Bank of America, AIG, etc.). This filing by
Cuomo simply gets the negotiations started with E&Y. But are these
types of settlements effective?
Corporate Counsel’s
Sue Reisinger did an in-depth piece as to
whether these large settlements work in deterring future bad
behavior. Her conclusion…THEY DON’T. A look at BP alone provides
plenty of evidence of this. Back in 2005, a BP facility was cited
for over 300 safety violations at a plant that had an explosion
killing 15 and injuring 270. To correct this bad behavior, BP got a
$21 million fine as a deterrent. This past April that same BP
facility released thousands of pounds of cancer-causing chemicals
into the air for 40 days…another fine. Then the BP oil spill in the
Gulf of Mexico, killing 11 and impacting lives all along America’s
Gulf Coast. So how do you punish the company to correct the
behavior? My son was even perplexed when we bought gas at the local
BP station, “should we purchase gas elsewhere to protest the oil
spill or purchase it here to help pay for the cleanup?” I didn’t
have an answer, but I do know this, put someone in jail that was
responsible and these questions go away.
So what should be done? Start locking
people up and here’s why:
1) We need people as examples, not
companies. Shareholders are shouldering most of the financial
penalty, not the individuals responsible.
2) Prison is effective punishment.
While I will argue that prison sentences for some are too long, the
experience does get your mind right. White-Collar recidivism is
negligible for a reason….the punishment works.
3) Hold People Accountable. I would
rather see the CEO of a company go to jail saying he was sorry, than
see one more commercial about how sorry the company is about the
wrong they did (a la BP).
4) Arresting one person will lead you to
the real person responsible. Once someone is arrested they will
start talking, and so on, and so on.
The corporate veil has a place in business
but it should not protect those that are guilty of crimes…and it
seems to me that more than a few bad guys have gotten away. Civil
litigation has become too easy for both the prosecutors and the
defense, so let’s up the game and put some butts on the line. I’m
speaking from experience, prison hurts, is a great deterrent and
will go a long way to clean things up in corporate wrongdoing.
Ernst & Young chalked up one small victory
in
New York State Supreme Court this week
over claims by the New York Attorney General that the firm committed
fraud leading to the failure of Lehman Brothers in 2008. Justice
Jeffrey Oing said the New York Attorney General cannot claim $150
million in fees that Ernst & Young earned from Lehman Brothers
Holdings from 2001-2008, when the firm filed bankruptcy.
Attorney David Ellenhorn of the NYAG
claimed the fees represented “disgorgement” of “ill gotten gains”
since the Attorney General says Ernst & Young repeatedly committed
“fraudulent acts” as auditor of Lehman Brothers all those years.
When Ellenhorn tried to explain this to the judge, Oing told
Ellenhorn he had the wrong remedy.
Not good when you have to explain too much
to the judge.
Fortunately for the New York Attorney
General, the fees disgorgement strategy is Plan B. (It’s literally
“Letter B” in the list of remedies the
NYAG seeks for Ernst & Young’s alleged fraudulent acts.) The New
York Attorney General can still pursue its request that Ernst &
Young “pay restitution, disgorgement and damages caused, directly or
indirectly, by the fraudulent and deceptive acts and repeated
fraudulent acts and persistent illegality complained of herein plus
applicable pre-judgment interest.”
In the lawsuit filed against accounting firm Ernst & Young,
Andrew Cuomo brought four claims, three of them under New York’s
Martin Act, one of the most powerful prosecutorial tools in the
country. Technically speaking, the Martin Act allows New York’s
top law enforcer to go after wrongdoing connected to the sale or
purchase of securities. Nothing too noteworthy there.
But what is noteworthy is the power the act confers upon its
user. It enables him to subpoena any document from anyone doing
business in New York and, if he so desires, keep an
investigation entirely secret. People subpoenaed in Martin Act
cases aren’t afforded a right to counsel or the right against
self-incrimination. “Combined, the act’s powers exceed those
given any regulator in any other state,” wrote Nicholas Thompson
in this
2004 Legal Affairs article.
And we haven’t even gotten to the kicker. Courts in civil Martin
Act cases have held that “fraud” under the Martin Act “includes
all deceitful practices contrary to the plain rules of common
honesty and all acts tending to deceive or mislead the public,
whether or not the product of scienter or intent to defraud.” In
other words, in order to prove a Martin Act violation, the
attorney general is not required to prove that the defendant
intended to defraud anyone, only that a defrauding act was
committed…
Mr. Ellenhorn, however, is all, “We’ll
never make it…”, like
Glum in Gulliver’s Travels. He worried
aloud to the judge,
according to Reuters, that the private
class action litigation still facing Ernst & Young over Lehman will
beat him to the punch in claiming compensation for investor losses.
The remaining allegation in the class
action litigation against Ernst & Young? That Ernst & Young had
reason to know that Lehman’s 2Q 2008 financial statements could be
materially misstated because of the extensive use of Repo 105
transactions.
Ellenhorn is worried because the NYAG’s
remaining remedy is for investors’ damages. Investors, however, have
their own ongoing lawsuits against Ernst & Young to recover the same
damages. If the investors are successful first in their lawsuits,
the state cannot pursue a double recovery for the same damages.
Ernst & Young claimed victory at the time
of Judge Kaplan’s decision, too. To me, however, the threat of a
trial is formidable. It’s costing Ernst & Young a lot of time and
money to address.
Jensen Comment
I don't much care whether Lehman and Ernst abided by the letter of FAS
140 rules. To me there's an overriding auditing principle that says if a
contract is designed to both follow the letter of the law under GAAP and
to deceive investors, creditors, and regulators then exception should be
taken to deliberate attempts by the client to deceive.
From all I know about Lehman's Repo 105/108 contracts the primary
intent was deception.
When confronted with a choice of protecting the client versus
protecting investors, I think the auditors in this case dredged up a
rather obscure section of GAAP to protect the client and deceive the
investors. It's like dredging up some statute written in 1798 justifying
whipping your wife with a leather strap.
Ketz Me If You Can (and it was Tom Selling who coined "Betz from Ketz")
"NY v. Ernst & Young (Part II): Who Cares Whether Lehman Bros.
Followed GAAP?" by J. Edward Ketz, SmartPros, February 2011 ---
http://accounting.smartpros.com/x71245.xml
The major result of this case is that the
courts do not rely exclusively on whether the external auditors
attest to an entity’s application of generally accepted accounting
principles. Instead, the standard is fairness. This is the proper
outcome, for managers cannot be allowed to loot corporations and
cover it up with transactions that abide by generally accepted
accounting rules (also known as cleverly rigged accounting ploys or
CRAP).
A. A. Sommer, former commissioner at the
SEC put this case into perspective as follows:
Judge Friendly … said in effect that the
first law for accountants was not compliance with generally accepted
accounting principles, but rather full and fair disclosure, fair
presentation, and if the principles did not produce this brand of
disclosure, accountants could not hide behind the principles but had
to go beyond them and make whatever additional disclosures were
necessary for full disclosure. In a word, “present fairly” was a
concept separate from “generally accepted accounting principles,”
and the latter did not necessarily result in the former.
While the FASB and the SEC and the
accounting firms have shied away from the concept of “fairness,” the
courts have embraced it. Interestingly, the courts ended up in a
place quite similar to that in Statement of Financial Concepts No.1
The court said that corporate managers should report assets and
liabilities and stockholders’ equity and revenues and expenses as
fairly as possible and then to communicate these results fairly to
the firm’s investors and potential investors.
Notice the similarities between the cases.
Both Lehman Brothers and Continental Vending wanted to manage their
financial leverage. They both accomplished this by reducing assets
and liabilities by some number; while keeping the equity the same,
the leverage ratios shrunk materially. Both Lehman Brothers and
Continental Vending relied on GAAP to obtain the desired hiding of
liabilities. And both Lehman Brothers and Continental Vending
supplied deficient, uninformative disclosures on these transactions.
E&Y finds itself in a position similar to
Lybrand, Ross Brothers, and Montgomery. It appears that E&Y will
defend itself based on accounting rules, just as Lybrand, Ross
Brothers, and Montgomery said it followed GAAP. The ultimate
question is whether the judge of jury will find this sufficient. Is
it a reasonable defense to follow the rules or is a professional
auditor responsible for attesting that the financial statements as a
whole fairly present the financial position and the results of
operations?
Over at Bloomberg,
Jonathan Weil (who has the tendency to let
the dust settle before chiming in) takes Ernst & Young to task for
their lack of willingness to take responsibility for the Lehman
Brothers bankruptcy and digs up a bunch of old bodies in the
process.
E&Y had established itself as a repeat
offender long before Governor-Elect Cuomo filed his suit. In
recent years we’ve seen four former E&Y partners sentenced to
prison for selling illegal tax shelters, while other
partners have been
disciplined by the SEC for blessing
fraudulent financial statements at a variety of
companies, including
Cendant Corp. and
Bally Total Fitness Holding Corp.
In the Bally case, E&Y last year paid
an $8.5 million fine, without admitting or denying the SEC’s
professional-misconduct claims. The SEC also has imposed
sanctions against E&Y three times since 2004 for violating its
auditor-independence rules.
After that friendly reminder (which
certainly makes some people wince), JW takes a look at the
E&Y’s response to the suit,
specifically
the part where they more or less say that Cuomo is off his rocker,
“There is no factual or legal basis for a claim to be brought
against an auditor in this context where the accounting for the
underlying transaction is in accordance with the Generally Accepted
Accounting Principles (GAAP).”
Weil says E&Y is missing the point
entirely:
That isn’t an accurate depiction of the
claims Cuomo brought, though. Cuomo’s suit unambiguously took
the position that Lehman violated GAAP. What’s more, it’s not
credible for E&Y to say that Lehman didn’t. (An E&Y spokesman,
Charles Perkins, said he “can’t comment beyond our statement.”)
In the footnotes to its audited
financial statements, Lehman said it accounted for all its
repurchase agreements as financings. This was false, because
Lehman accounted for its Repo 105 transactions as sales, a point
the Valukas report chronicled in exhaustive detail.
The question is, of course, if this all
adds up to fraud on E&Y’s part. Cuomo says it does. Weil says that
E&Y needs to come up with a better story.
Colin Barr, on the other hand, writes that
E&Y could easily turn the tables:
The Ernst & Young statement suggests
the firm will argue that it can’t be prosecuted under the Martin
Act because Lehman, not E&Y, was the outfit actually producing
the financial reports, and because it was Lehman, not E&Y, that
was peddling billions of dollars of securities just months
before its implosion.
In this view, E&Y was just a gatekeeper
hired to vouch for Lehman’s books, something it will claim it
did well within the confines of the law. This strikes lawyers
who are familiar with the law as an eminently reasonable
approach, if not exactly a surefire recipe for success.
“If I were Ernst & Young, I would
assert I was not a primary actor,” said Margaret Bancroft, a
partner at Dechert LLP and author of a 2004 memo that explained
the Martin Act soon after Spitzer began brandishing it against
Wall Street. “You can say that with more than a straight face.”
“Just gatekeepers,” and not “fraudsters,”
is obviously the preferred view but the catch is, E&Y would be
admitting that they are really shitty gatekeepers.
A lawsuit contending that Lehman Brothers
Holdings Inc.'s former officials, underwriters and auditors are
responsible for investor losses should go forward for the most part,
a federal judge ruled Wednesday.
The investors who filed the lawsuit have
"adequately alleged" that the former Lehman executives, including
ex-Chief Executive Richard Fuld and ex-finance chief Erin Callan,
and other defendants misled them about Lehman's financial health,
leverage, risk management and exposure to dicey mortgage and
real-estate assets, ruled Judge Lewis A. Kaplan of the U.S. District
Court in Manhattan.
The investors—pension funds, companies and
individuals who bought $31 billion in Lehman debt and stock—say the
defendants made misleading statements and omissions that caused them
losses when Lehman collapsed into bankruptcy in 2008. Specifically,
they contend, Lehman's use of "Repo 105" transactions—repurchase
agreements that allowed Lehman to lower its leverage
temporarily—falsely allowed the bank to present itself as
financially stronger than it really was. The plaintiffs are seeking
class-action status for the suit.
Judge Kaplan rejected the defendants'
attempt to dismiss the entire case, but he threw out some claims,
particularly some of those against Ernst & Young LLP, Lehman's
independent auditor. The judge did allow a claim to continue
alleging that E&Y made misstatements in July 2008 about Lehman's
compliance with accounting rules when in fact E&Y was aware of the
bank's use of Repo 105s, which "cast into doubt" whether its balance
sheet was consistent with generally accepted accounting principles.
Steve Singer, an attorney for the
plaintiffs, said he was pleased with the ruling. The "vast majority"
of the case will go forward, he said, including the core
allegations, and all of the defendants remain in the case.
Michael Chepiga, an attorney for
Christopher O'Meara and Joseph Gregory, two former Lehman executives
who are defendants, said the judge's ruling was "a long, complicated
opinion with a lot of issues. We're studying it closely."
Ernst & Young said in a statement that it
was "pleased that Judge Kaplan's ruling dismisses most of the claims
against us in this matter, and we strongly believe that we will
ultimately prevail on the remaining claim." Adam Wasserman, an
attorney for Lehman's independent directors, said he was "confident"
that the evidence "will demonstrate that the independent directors
acted diligently and appropriately."
Robert Cleary, an attorney for Ms. Callan,
declined to comment. A spokeswoman for UBS AG, one of Lehman's
underwriters, also declined to comment. Attorneys for other
defendants, including Mr. Fuld, couldn't be reached. Lehman itself
isn't a defendant in the case.
A 2010 report by a bankruptcy-court
examiner, exposing Lehman's use of Repo 105s, raised questions about
whether its executives and auditors should face any regulatory
action or other sanctions. To date, however, the only case that has
been brought is a civil fraud lawsuit by the New York attorney
general's office against Ernst & Young, which has denied any
wrongdoing.
In other Lehman developments Wednesday:
• The U.K.'s Supreme Court ruled in
investors' favor against units of Lehman and Bank of New York
Mellon Corp. in a battle over complex derivatives transactions.
The ruling upholds a "flip clause" in credit derivatives
contracts that allowed the investors to move ahead of Lehman to
grab assets backing the derivatives deals. The ruling clashes
with a U.S. court ruling that the flip clauses violate U.S.
bankruptcy law.
Continued in article
It's good news that most the charges against E&Y were dropped by
Judge Kaplan.
Here's the part of the Kaplan's finding that Ernst & Young doesn't:
like.
Moving on to the discussion of the
allegations against Ernst & Young. We found this section (pages
67-77) especially interesting. Kaplan dismisses the majority of the
specific allegations against the auditors but writes that one
particular incident means that the case against them cannot be
thrown out. Here’s the section where Kaplan judges that the
plaintiffs fail to present convincing evidence of false or
misleading material statements…
Plaintiffs’ allegations respecting “red
flags” therefore bear not only on whether 303 E&Y violated the
pertinent GAAS requirements, but also on whether it did so with
the requisite state of mind. For the reasons discussed above,
the true sale opinion and netting grid were not red flags, the
disregard of which could be called highly reckless. And while
E&Y’s alleged failure to follow up on the Lee interview arguably
would have been a departure from GAAS, the only subsequent E&Y
statement at issue is the report on the interim financials in
the 2Q08, which contained no statement of a GAAS-compliant
audit. Accordingly, the TAC fails to allege that E&Y made any
false or misleading statements with respect to GAAS compliance
either in the 2007 10-K or in any of the subsequent 10-Q’s, much
less that it did so with scienter.
… but he stops to ask another question on
Repo 105:
In other words, have plaintiffs
sufficiently alleged that E&Y knew enough about Lehman’s use of
Repo 105s to “window-dress” its period-end balance sheets to
permit a finding that E&Y had no reasonable basis for believing
that those balance sheets fairly presented the financial
condition of Lehman?
The answer: yes, in one case.
Plaintiffs rely for this purpose on
precisely the same alleged red flags discussed previously in
connection with E&Y’s GAAS opinion – the “true sale” opinion,
the netting grid, and the Lee interview. The first two are no
stronger in this context than in that. The Lee
interview, however, is a different matter.
The “Lee interview” pertains to warnings
allegedly made by
Matthew Lee, Lehman’s SVP for Global
Balance Sheet and Legal Entity Accounting, that Ernst & Young were
told of a $50bn repo 105 move in June 2008 but did not pass on the
full information to Lehman’s board. Thus, it failed to fulfill GAAP
requirements as part of its Q2 2008 auditing.
Here’s Kaplan again:
The TAC alleges that Lee told E&Y in
June 2008 “that Lehman moved $50 billion of inventory off its
balance sheet at quarter-end through Repo 105 transactions and
that these assets returned to the balance sheet about a week
later.” Assuming that is so, E&Y arguably was on 308 notice by
June 2008 that Lehman had used Repo 105s to portray its net
leverage more favorably than its financial position warranted, a
circumstance that could well have resulted in the published
balance sheet for that quarter being inconsistent with GAAP’s
overall requirement of fair presentation. Accordingly,
the TAC adequately alleges that E&Y misrepresented in the 2Q08
that it was “not aware of any material modifications that should
be made to the consolidated financial statements referred to
above for them to be in conformity with U.S. generally accepted
accounting principles” notwithstanding Lee’s disclosure to it.
It’ll be interesting to see whether this
drives the parties to a settlement — and how it affects the civil
fraud case brought by former Attorney General (now Governor) Cuomo.
Continued in article
From the CFO Journal's Morning Ledger on September 12, 2013
Where is Dick
Fuld now?
Almost five years ago, Lehman
Brothers went into the largest bankruptcy in U.S. history,
the fission bomb trigger to the thermonuclear event we now call the
financial crisis. Since then, many former Lehman executives have
found employment on Wall Street. Not so former CEO Dick Fuld, a
character so outsize—even for a Wall Street filled with such
types—that peers called him “the Gorilla” for his “brutish manner
and aggressiveness.” Post-Lehman, Mr. Fuld might as well be called
“the Dodo” because he has disappeared from his native habitat, the
big money Wall Street scene. Mr. Fuld has sold off real-estate
properties and art from his wife’s collection to pay for lawsuits
filed by those organizations that lost heavily when Lehman’s $40
billion real-estate business went bust. True, he has pitched deals
to Blackstoneand BlackRock, among others, but to no success Wall
Street insiders tell Businessweek’s Joshua Green.
Mr. Fuld and his wife are now major investors
in a tiny Phoenix-based chemical company that grew out a holding
company for a San Francisco strip club. “His real problem is that
he’s forever associated with the Lehman bankruptcy, and anyone who
hires him, or even speaks up for him, risks having this connection
rub off on them,” writes Green. “Fuld has become Wall Street’s
Hester Prynne, forever branded.”
Jensen Comment
If the SEC had any guts this gorilla should be looking out through bars.
Bob Jensen's threads on Dick Fuld's wrong doings aided and abetted
by a Big Four auditing firm are at
http://www.trinity.edu/rjensen/Fraud001.htm#Ernst Scroll down to the Lehman Bros. fraudulent reporting.
Attorneys from Houston’s Ahmad, Zavitsanos
& Anaipakos are representing a group of investors in a lawsuit filed
against hedge fund auditors Ernst & Young after the group lost more
than $17 million following the collapse of a Plano, Texas-based
hedge fund that promised low-risk investments.
The lawsuit focuses on two funds sold by
Plano’s Parkcentral Global and was filed on behalf of Houston
financial consultant Gus H. Comiskey and four Tucson, Ariz.-based
entities, including the Thomas R. Brown Family Private Foundation.
The now-defunct Parkcentral Global was operated by affiliates of
billionaire and former presidential candidate H. Ross Perot before
closing its doors after losing a total of more than $2.6 billion.
“Our clients were told that an investment
in Parkcentral was designed to preserve capital. Instead, they lost
every penny in record time. E&Y was supposed to be auditing
Parkcentral, but the audited financial statements never once warned
Parkcentral’s investors of their impending doom,” says attorney
Demetrios Anaipakos, who will try the case with Amir H. Alavi.
We attempted to reach Jacqueline Higgins
late yesterday at her office number in Boston, however we discovered
that when we were transferred to her extension we simply bounced
back to reception, who needless to say, was very confused about that
phenomenon. After attempting to page Ms. Higgins, only then did the
receptionist learn and then relay to us that Ms. Higgins was no
longer with the firm.
We checked with Ernst & Young spokesman
Charlie Perkins on this development and he confirmed that Ms.
Higgins “will be leaving the firm at the end of the year.”
And lest there still be any confusion due
to the carefully worded E&Y statement, the partner and senior
manager in question have been dismissed from the firm.
We’ll keep you updated if we hear more from
inside at the firm or if further action is taken by the PCAOB.
For nearly two decades I've updated a Web document called "The Dark
Side" in which I post things that worry me about advances in education
and communication technology ---
http://www.trinity.edu/rjensen/000aaa/theworry.htm
Business Week now has a very
long cover story that fits right into "The Dark Side." I don't consider
myself a prude or a religious nut. But this trend in networking most
certainly discourages me about how technology sometimes eats away at
morality and good name of technology. This is yet another dark side
tidbit on the evils of technology that goes along with ID theft, malware
spreading, Internet frauds, porn, plagiarism, malicious hacking, and the
like. I was a bit surprised to find this article in Business Week
rather than Newsweek or Time Magazine.
.
The infidelity economy may be "alive, well, and profitable." But so is
porn!
Those of you teaching about
advances in social networking should also cover the emerging dark sides
of social networking.
After
hearing an ad on Howard Stern's radio show or seeing a schlocky
commercial on late-night TV, you might find yourself on
AshleyMadison.com—the premier "dating" website for aspiring
adulterers. Type in the URL, and as the page loads a gauzy violet
backdrop appears with a fuzzy image of a half-dressed couple going
at it beyond a hotel doorway. "Join FREE & change your life today.
Guaranteed!"
Setting up
a profile costs nothing and takes about 12 seconds. First you check
off your availability status: "attached male seeking females,"
"attached female seeking males," or, even though the concept of the
site is that all users are in relationships and therefore equally
invested in secrecy, "single female seeking males." Next you're
asked for location, date of birth, height and weight, and whether
you're looking for something "short term," "long term," "Cyber
affair/Erotic Chat," "Whatever Excites Me," and so on. If you're
like me, you choose a handle based on the cupcake you most recently
ate—"redvelvet2"—and then shave a few years and pounds off your
numbers.
Once you
provide an e-mail address that your spouse would presumably never
have access to, you're thrust into Ashley Madison's low-tech pink
and purple interface. And then, if you're a woman, the onslaught
begins.
Continued in article
February 12, 2011 reply from
Francine McKenna
Bob,
Maybe you
forgot it was that terrible Ashley Madison.com site, the one
that advertises on CNBC and wanted to advertise on the Superbowl
that lured the poor Ernst & Young partner into a debauched life
of inside trading and illicit love triangles.
In the fall of 2004, a
fortysomething investment banker named Donna Murdoch logged into
Ashley Madison, the discreet dating website married people visit
"when divorce is not an option," and introduced herself to James
Gansman, a partner at Ernst & Young in New York. The two struck
up a relationship, meeting occasionally in hotels in Philly, New
York, and California, and talking on the phone about their
lives: James told Donna about how he was kicking ass at work,
Donna told James about how she was struggling with her subprime
mortgage.
Eventually the two settled
into a comfortable day-to-day routine in their respective
offices in New York and Philadelphia, staring at the same
Yahoo Finance screen.
Sweet. Bill and Melinda
Gates used to do kind of the same thing when they were
long-distance dating. They'd see the same movies in different
places and then talk about them on the phone. We just though
we'd mention that, because that's the kind of information we
have trapped inside our brains, and we hope that by releasing it
we can make room for other things. Anyway, Donna and James's
relationship did not go the way of Bill and Melinda's.
Eventually, their
conversations about business grew more specific.
Mr. Gansman led Ms. Murdoch
in a guessing game about which deals he was working on, she
said. "The game was that I wouldn't be looking and he would
give me hints: The market cap of two billion or market cap
of 400 billion, and here's what they do, and he'd read it to
me, and ultimately make sure I guessed," Ms. Murdoch
testified. Before long, the guessing game fell away. Mr.
Gansman told her more directly about upcoming deals of Ernst
clients, she said.
She made $400, 000 off the
deal, and the SEC noticed. He made nothing, and now he's going
to jail. The end.
The
forensic practices at the Big 4 are WAY ahead of the accounting
academia in using the technology to cover the dark side of social
networking in e-discovery. We in the accounting academia have been
too busy regressing to take note.
I know of
at least two who used it extensively in fraud examination as far
back as 2008. They demonstrated its use to me while I was designing
our fraud examination course.
New York
prosecutors are poised to file civil fraud charges against Ernst &
Young for its alleged role in the collapse of Lehman Brothers,
saying the Big Four accounting firm stood by while the investment
bank misled investors about its financial health, people familiar
with the matter said.
State
Attorney General Andrew Cuomo is close to filing the case, which
would mark the first time a major accounting firm was targeted for
its role in the financial crisis. The suit stems from transactions
Lehman allegedly carried out to make its risk appear lower than it
actually was.
Lehman
Brothers was long one of Ernst & Young's biggest clients, and the
accounting firm earned approximately $100 million in fees for its
auditing work from 2001 through 2008, say people familiar with the
matter.
The suit,
led by Mr. Cuomo, New York's governor-elect, could come as early as
this week. It is part of a broader investigation into whether some
banks misled investors by removing debt from their balance sheets
before they reported their financial results to mask their true
levels of risk-taking, a person familiar with the case said. The
state may seek to impose fines and other penalties.
Mr. Cuomo's
office has sought documents and information from several firms,
including Bank of America Corp., which earlier this year disclosed
six transactions that were wrongly classified. Jerry Dubrowski, a
Bank of America spokesman, said the bank's practice is to cooperate
with any inquiry from regulators.
It is
possible that Ernst & Young will try to settle before any suit is
filed. The firm declined to comment. A spokesman for the Lehman
Brothers estate also declined to comment.
The
transactions in question, known as "window dressing," involve
repurchase agreements, or repos, a form of short-term borrowing that
allows banks to take bigger trading risks. Some banks have
systematically lowered their repo debt at the ends of fiscal
quarters, making it appear they were less risk-burdened than they
actually were most of the time.
Lehman
Brothers dubbed transactions of this type "Repo 105." The maneuver
came to light in March, when the bankruptcy examiner investigating
the firm's collapse more than two years ago found that it moved some
$50 billion in assets off its balance sheet. Lehman labeled those
transactions as securities sales instead of loans, which led
investors to believe the firm was financially healthier than it
really was.
The
bankruptcy examiner's report and the attorney general's
investigation found that Lehman Brothers carried out the Repo 105
transactions on a quarterly basis in 2007 and 2008 without telling
investors. Mr. Cuomo's investigation found that Repo 105
transactions started as far back as 2001, said the person familiar
with the probe.
The
attorney general's investigation, which began after the bankruptcy
examiner's report, found that Ernst & Young specifically approved of
Lehman's use of Repo 105 transactions and provided the investment
bank with a complete audit opinion from 2001 through 2007, said the
person.
Mr. Cuomo's
office has also been investigating suspected window-dressing
transactions at other banks, said the person, and is probing whether
they similarly misled investors.
An analysis
earlier this year by The Wall Street Journal found that other banks
were reducing their level of debt at quarter-end.
The
attorney general's office has sought documents and information from
several firms, including Bank of America Corp., which earlier this
year disclosed six transactions that were wrongly classified. The
Journal's analysis found that Bank of America was among the most
active banks in reducing its debt at reporting time.
The state's
investigations into other firms' window dressing are less advanced
than its Ernst & Young probe, said a person familiar with the
probes.
Other
regulators have said they are looking into window dressing as well.
The Securities and Exchange Commission's investigation into Lehman's
collapse is focusing on Repo 105 transactions, said people familiar
with the matter. It has proposed new types of disclosures to help
investors identify when banks are window dressing. But the SEC has
said it hasn't found any widespread inappropriate practices in that
area.
Britain's
Financial Reporting Council, which oversees corporate reporting
rules, is also investigating Ernst & Young's role in the Lehman
collapse.
The Lehman
bankruptcy examiner's report also stated that there may be evidence
to support negligence and malpractice claims against Ernst & Young
regarding Lehman's audits and its lack of response to a
whistle-blower at Lehman who raised red flags about the repo trades.
The
whistle-blower was Matthew Lee, a Lehman Brothers senior vice
president. He had complained to his boss, and eventually wrote a
letter in May 2008 to senior Lehman executives expressing concern
that the Repo 105 transactions violated Lehman's ethics code by
misleading investors and regulators about the true value of the
firm's assets. Days later, Mr. Lee was ousted from the firm.
According
to the Lehman bankruptcy examiner's report, Ernst & Young auditors
saw the letter, and later interviewed Mr. Lee after he was let go
from Lehman. Ernst & Young previously said in a statement that
Lehman management determined Mr. Lee's "allegations were unfounded."
Mr. Lee couldn't be reached for comment.
The bottom line is that it was bad enough that E&Y
approved Lehman’s deceptive repo accounting. But their ex post
continued defense, at the highest level in the firm, of this deception
is destroying the credibility of E&Y.
What is being destroyed is our faith that the large auditing firms place
their public responsibility ahead of the deceptive dictates of their
auditing clients.
E&Y is trying to shift the blame for bad repo accounting
onto the FASB. But this won’t fly because the FASB has no jurisdiction
elsewhere in the world. In particular, E&Y is using an FAS 140 defense
in the U.K. where FAS 140 has no jurisdiction.
-----Original Message-----
From: Jensen, Robert [mailto:rjensen@trinity.edu]
Sent: Thursday, April 08, 2010 9:18 AM
To: Jim Fuehrmeyer
Subject: RE: AT&T $1 billion write-down, Repo 105 and other dumb
questions
Yes, but can the FAS 140 defense
be used in the British Courts when British investors sue the failed
London office of Lehman and the London office of E&Y?
I assumed that branch investment
banks in England are subject to UK accounting/auditing standards. Or can
investment banks avoid local accounting/auditing standards by having
headquarters in other nations?
Bob Jensen
-----Original Message-----
From: Jim Fuehrmeyer [mailto:jfuehrme@nd.edu]
Sent: Thursday, April 08, 2010 11:51 AM
To: Jensen, Robert
Subject: RE: AT&T $1 billion write-down, Repo 105 and other dumb
questions
I guess
that depends on what their basis is for suing. I'm not a lawyer, of
course. I expect the local Lehman office filed statutory reports in the
UK, whether they were regulated or not, and those would have been done
using IFRS. The Repo 105 would not qualify as a sale under IFRS - the
fixed price repurchase arrangement would take care of that (IFRS No.
39R, AG40) - so I expect this would have shown as a secured borrowing on
those financials. I'm quite sure UK companies file financial
statements, even wholly-owned subsidiaries of US companies. Assuming the
Lehman entities did that, the financials may even be available to the
public/press and someone's likely already pouring over them. So it's
not clear to me that a UK plaintiff would be relying on the US GAAP
financials nor is it clear to me what damages there are in the UK
related to the Lehman subsidiaries. The plaintiffs I guess would be
creditors, lenders and so on, and you're correct, they would not have
been using the consolidated Lehman 10K as a basis for their credit
decisions if they had local financials to go on - and I bet that would
be the case here.
The
requirement to file local financials is typical all around the world -
except in the US of course. A US subsidiary of a foreign company doesn't
have to do separate financials. And that's among the reasons the big US
multinationals want to be on IFRS. Their subsidiaries all around the
world already have to prepare local, statutory financials and most
places are now using IFRS so they have to convert all those subs to US
GAAP for purposes of reporting here. They could actually save a lot of
time and effort if the US piece went to IFRS.
Jim
In particular, he’s not been informed of the Wharton
(University of Pennsylvania) challenge to the way Lehman accounted for
repo sales: Best Explanation to
Date:
"Lehman's Demise and Repo 105: No Accounting for Deception,"
Knowledge@Wharton, March 31, 2010 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2464
The collapse of Lehman Brothers in September
2008 is widely seen as the trigger for the financial crisis, spreading
panic that brought lending to a halt. Now a 2,200-page report says that
prior to the collapse -- the largest bankruptcy in U.S. history -- the
investment bank's executives went to extraordinary lengths to conceal
the risks they had taken. A new term describing how Lehman converted
securities and other assets into cash has entered the financial
vocabulary: "Repo 105."
While Lehman's huge indebtedness and other
mistakes have been well documented, the $30 million study by Anton
Valukas, assigned by the bankruptcy court, contains a number of
surprises and new insights, several Wharton faculty members say.
Among the report's most disturbing
revelations, according to Wharton finance professor
Richard J. Herring, is the picture of
Lehman's accountants at Ernst & Young. "Their main role was to help the
firm misrepresent its actual position to the public," Herring says,
noting that reforms after the Enron collapse of 2001 have apparently
failed to make accountants the watchdogs they should be.
"It was clearly a dodge.... to circumvent the
rules, to try to move things off the balance sheet," says Wharton
accounting professor professor Brian J. Bushee,
referring to Lehman's Repo 105 transactions. "Usually, in these kinds of
situations I try to find some silver lining for the company, to say that
there are some legitimate reasons to do this.... But it clearly was to
get assets off the balance sheet."
The use of outside entities to remove risks
from a company's books is common and can be perfectly legal. And, as
Wharton finance professor
Jeremy J. Siegelpoints out, "window
dressing" to make the books look better for a quarterly or annual report
is a widespread practice that also can be perfectly legal. Companies,
for example, often rush to lay off workers or get rid of poor-performing
units or investments, so they won't mar the next financial report.
"That's been going on for 50 years," Siegel says. Bushee notes, however,
that Lehman's maneuvers were more extreme than any he has seen since the
Enron collapse.
Wharton finance professor professor
Franklin Allensuggests that the other
firms participating in Lehman's Repo 105 transactions must have known
the whole purpose was to deceive. "I thought Repo 105 was absolutely
remarkable – that Ernst & Young signed off on that. All of this was
simply an artifice, to deceive people." According to Siegel, the report
confirms earlier evidence that Lehman's chief problem was excessive
borrowing, or over-leverage. He argues that it strengthens the case for
tougher restrictions on borrowing.
A Twist on a Standard Financing
Method
In his report, Valukas, chairman of the law
firm Jenner & Block, says that Lehman disregarded its own risk controls
"on a regular basis," even as troubles in the real estate and credit
markets put the firm in an increasingly perilous situation. The report
slams Ernst & Young for failing to alert the board of directors, despite
a warning of accounting irregularities from a Lehman vice president. The
auditing firm has denied doing anything wrong, blaming Lehman's problems
on market conditions.
Much of Lehman's problem involved huge
holdings of securities based on subprime mortgages and other risky debt.
As the market for these securities deteriorated in 2008, Lehman began to
suffer huge losses and a plunging stock price. Ratings firms downgraded
many of its holdings, and other firms like JPMorgan Chase and Citigroup
demanded more collateral on loans, making it harder for Lehman to
borrow. The firm filed for bankruptcy on September 15, 2008.
Prior to the bankruptcy, Lehman worked hard
to make its financial condition look better than it was, the Valukas
report says. A key step was to move $50 billion of assets off its books
to conceal its heavy borrowing, or leverage. The Repo 105 maneuver used
to accomplish that was a twist on a standard financing method known as a
repurchase agreement. Lehman first used Repo 105 in 2001 and became
dependent on it in the months before the bankruptcy.
Repos, as they are called, are used to
convert securities and other assets into cash needed for a firm's
various activities, such as trading. "There are a number of different
kinds, but the basic idea is you sell the security to somebody and they
give you cash, and then you agree to repurchase it the next day at a
fixed price," Allen says.
In a standard repo transaction, a firm like
Lehman sells assets to another firm, agreeing to buy them back at a
slightly higher price after a short period, sometimes just overnight.
Essentially, this is a short-term loan using the assets as collateral.
Because the term is so brief, there is little risk the collateral will
lose value. The lender – the firm purchasing the assets – therefore
demands a very low interest rate. With a sequence of repo transactions,
a firm can borrow more cheaply than it could with one long-term
agreement that would put the lender at greater risk.
Under standard accounting rules, ordinary
repo transactions are considered loans, and the assets remain on the
firm's books, Bushee says. But Lehman found a way around the
negotiations so it could count the transaction as a sale that removed
the assets from its books, often just before the end of the quarterly
financial reporting period, according to the Valukas report. The move
temporarily made the firm's debt levels appear lower than they really
were. About $39 billion was removed from the balance sheet at the end of
the fourth quarter of 2007, $49 billion at the end of the first quarter
of 2008 and $50 billion at the end of the next quarter, according to the
report.
Bushee says Repo 105 has its roots in a rule
called FAS 140, approved by the Financial Accounting Standards Board in
2000. It modified earlier rules that allow companies to "securitize"
debts such as mortgages, bundling them into packages and selling
bond-like shares to investors. "This is the rule that basically created
the securitization industry," he notes.
FAS 140 allowed the pooled securities to be
moved off the issuing firm's balance sheet, protecting investors who
bought the securities in case the issuer ran into trouble later. The
issuer's creditors, for example, cannot go after these securities if the
issuer goes bankrupt, he says.
Because repurchase agreements were really
loans, not sales, they did not fit the rule's intent, Bushee states. So
the rule contained a provision saying the assets involved would remain
on the firm's books so long as the firm agreed to buy them back for a
price between 98% and 102% of what it had received for them. If the
repurchase price fell outside that narrow band, the transaction would be
counted as a sale, not a loan, and the securities would not be reported
on the firm's balance sheet until they were bought back.
This provided the opening for Lehman. By
agreeing to buy the assets back for 105% of their sales price, the firm
could book them as a sale and remove them from the books. But the move
was misleading, as Lehman also entered into a forward contract giving it
the right to buy the assets back, Bushee says. The forward contract
would be on Lehman's books, but at a value near zero. "It's very similar
to what Enron did with their transactions. It's called
'round-tripping.'" Enron, the huge Houston energy company, went bankrupt
in 2001 in one of the best-known examples of accounting deception.
Lehman's use of Repo 105 was clearly intended
to deceive, the Vakulas report concludes. One executive email cited in
the report described the program as just "window dressing." But the
company, which had international operations, managed to get a legal
opinion from a British law firm saying the technique was legal.
Bamboozled
The Financial Accounting Standards Board
moved last year to close the loophole that Lehman is accused of using,
Bushee says. A new rule, FAS 166, replaces the 98%-102% test with one
designed to get at the intent behind a repurchase agreement. The new
rule, just taking effect now, looks at whether a transaction truly
involves a transfer of risk and reward. If it does not, the agreement is
deemed a loan and the assets stay on the borrower's balance sheet.
The Vakulas report has led some experts to
renew calls for reforms in accounting firms, a topic that has not been
front-and-center in recent debates over financial regulation. Herring
argues that as long as accounting firms are paid by the companies they
audit, there will be an incentive to dress up the client's appearance.
"There is really a structural problem in the attitude of accountants."
He says it may be worthwhile to consider a solution, proposed by some of
the industry's critics, to tax firms to pay for auditing and have the
Securities and Exchange Commission assign the work and pay for it.
The Valukas report also shows the need for
better risk-management assessments by firm's boards of directors,
Herring says. "Every time they reached a line, there should have been a
risk-management committee on the board that at least knew about it."
Lehman's ability to get a favorable legal opinion in England when it
could not in the U.S. underscores the need for a "consistent set" of
international accounting rules, he adds.
Siegel argues that the report also confirms
that credit-rating agencies like Moody's and Standard & Poor's must bear
a large share of the blame for troubles at Lehman and other firms. By
granting triple-A ratings to risky securities backed by mortgages and
other assets, the ratings agencies made it easy for the firms to satisfy
government capital requirements, he says. In effect, the raters enabled
the excessive leverage that proved a disaster when those securities'
prices fell to pennies on the dollar. Regulators "were being bamboozled,
counting as safe capital investments that were nowhere near safe."
Some financial industry critics argue that
big firms like Lehman be broken up to eliminate the problem of companies
being deemed "too big to fail." But Siegel believes stricter capital
requirements are a better solution, because capping the size of U.S.
firms would cripple their ability to compete with mega-firms overseas.
While the report sheds light on Lehman's
inner workings as the crisis brewed, it has not settled the debate over
whether the government was right to let Lehman go under. Many experts
believe bankruptcy is the appropriate outcome for firms that take on too
much risk. But in this case, many feel Lehman was so big that its
collapse threw markets into turmoil, making the crisis worse than it
would have been if the government had propped Lehman up, as it did with
a number of other firms.
Allen says regulators made the right call in
letting Lehman fail, given what they knew at the time. But with
hindsight he's not so sure it was the best decision. "I don't think
anybody anticipated that it would cause this tremendous stress in the
financial system, which then caused this tremendous recession in the
world economy."
Allen, Siegel and Herring say regulators need
a better system for an orderly dismantling of big financial firms that
run into trouble, much as the Federal Deposit Insurance Corp. does with
ordinary banks. The financial reform bill introduced in the Senate by
Democrat Christopher J. Dodd provides for that. "I think the Dodd bill
has a resolution mechanism that would allow the firm to go bust without
causing the kind of disruption that we had," Allen says. "So, hopefully,
next time it can be done better. But whether anyone will have the
courage to do that, I'm not sure."
The facts of life continue to give discomfort
to the FASB. When Anton Valukas criticized Lehman Brothers, there was
plenty of disparagement left over for the FASB and the SEC. After all,
when ambiguity exists in financial accounting rules, we shouldn't be
surprised when managers take advantage of these ambiguities.
That’s, of course, assuming there are
ambiguities. Given that Lehman’s transactions have no business purpose
and were designed merely to deceive the investment community, maybe
ambiguity is not the issue to debate.
FAS 140 dealt with accounting for the
transfer of financial resources. Essentially, the board said that such a
transaction should be treated in either of two ways. If the transfer
shifted control of the resource to another entity, then one should
account for the transaction as a sale. The cash is recorded, the
financial resource is taken off the books, and a gain or loss is
recorded. If the transfer does not shift control of the resource to
another entity, then one should account for the transaction as a secured
borrowing. The cash is recorded, but the firm also records a liability.
No gain or loss is recorded; and the financial resource stays on the
books.
(As an aside, I find it frustrating that
virtually all reporters misstate the accounting issue. Consider this
sentence as an example. “The transactions allowed Lehman to temporarily
remove some $50 billion in assets from its balance sheet, presenting a
stronger financial picture than existed.” If they would only use some
common sense. If one applies for a mortgage on a house he or she is
buying, do you think the bank will be impressed if they show less
assets?)
FAS 140 goes on to spell out some criteria
for assessing whether control has been transferred. Paragraph 9 spells
out these criteria:
“The transferor has surrendered control over
transferred assets if and only if all of the following conditions are
met:
a. The transferred assets have been isolated
from the transferor—put presumptively beyond the reach of the transferor
and its creditors, even in bankruptcy or other receivership (paragraphs
27 and 28).
b. Each transferee (or, if the transferee is
a qualifying SPE (paragraph 35), each holder of its beneficial
interests) has the right to pledge or exchange the assets (or beneficial
interests) it received, and no condition both constrains the transferee
(or holder) from taking advantage of its right to pledge or exchange and
provides more than a trivial benefit to the transferor (paragraphs
29−34).
c. The transferor does not maintain effective
control over the transferred assets through either (1) an agreement that
both entitles and obligates the transferor to repurchase or redeem them
before their maturity (paragraphs 47−49) or (2) the ability to
unilaterally cause the holder to return specific assets, other than
through a cleanup call (paragraphs 50−54).”
For me, the third condition nixes the
sale-accounting executed by Lehman. The asset was coming back to the
firm, so it should have employed the accounting for a secured borrowing.
But, Lehman Brothers treated these
transactions as sales and Ernst & Young agreed. Did E&Y screw up or did
its partners believe there was enough ambiguity in the rules to allow
managers to choose gain accounting? Either FAS 140 is ambiguous or it is
not. If so, we need to tighten the rules considerably, as I discuss
below. If not, then society needs to hold some Lehman managers and some
E&Y partners accountable.
I wonder whether the FASB could save its face
and its political hide if it just simplified the accounting. It could
require business enterprises to record the transaction as a secured
borrowing in all cases where the financial asset returns to the firm and
in all cases where there is even the possibility of its return.
The SEC could help as well. It should require
all firms who account for a transfer of a financial asset as a sale and
then receives it back, in part or repackaged in any way, to issue an
8-K. Managers would have to display for the entire world to see any and
all phony sales of financial assets, and they would have to explain why
they did not account for the transaction as a secured borrowing.
Last, let us note that the problem would be
compounded exponentially if principles-based accounting were in place in
the U.S. How could anybody fault Lehman Brothers in a regime of
principles-based accounting? The managers could always retort that they
were following the me-first principle.
Ketz Me If You Can
Here's Professor Ketz's Bombshell We've All Been Waiting For: And to
Think I Was Shocked by Repo 105s Until Ed Wrote This
The bankruptcy report by Anton Valukas has
created quite a stir. Given that we all knew about the demise of Lehman
Brothers, what was the surprise? Ok, he wrote about some fast and loose
accounting tricks, which are dubbed Repo 105 transactions. So what?
What I find fascinating about managers at
Lehman’s is not so much what they did, but that the public is
shocked—shocked!—at another accounting game. As if these behaviors were
going to stop!
On what basis would the public believe that
corporate accounting had become the truth, the whole truth, and nothing
but the truth? Maybe they thought that Sarbanes-Oxley was the golden
legislation that solved all our problems. But, as most of the act was
incremental changes over previous dictates, that conclusion has
exaggerated and continues to exaggerate the reality.
Besides, legislation today will never focus
on the real issues of creating incentives for managers to walk the
straight and narrow, generating disincentives for those who walk astray,
and making sure these things are enforced. In today’s partisanship, what
happens depends on who is in office. If it is the Republicans, they’ll
talk about ethics and close their eyes. If it is the Democrats, they
will ignore current violations and pass new legislation as they continue
to build the Great Socialistic Society. And neither party enforces the
law, unless you count the SEC’s fining of shareholders as enforcement.
With fewer accounting tricks, as documented
by USA Today, maybe the public felt that the tide had turned. Maybe it
had, but the cycle continues. Managers find accounting chicanery easier
to carry out at some times than others. Never mistake a lull in
accounting tricks as their cessation. It is merely a rest before a
return to lies, damned lies, and accounting.
Perhaps people felt that the auditors were
ferreting out fraud. While the auditors at least have to worry about
potential lawsuits, that apparently does not mean that they are always
skeptical of management’s actions, even with a credible whistleblower.
Audits in the U.S. are better than audits in other countries, but there
is still room for improvement. Let’s not think that the auditors are
always vigilant.
Maybe with stock market prices going up after
an extended downturn, folks started believing that the economy was
resurging. I cannot share that optimism for we have so many asset
bubbles yet to burst. Even if it were true, increasing stock market
prices just accent the perverse incentives in our economy, as corporate
managers and directors attempt to maximize their own wealth through
share-based compensation, and accounting is merely a tool to accomplish
their goals.
No, I don’t see much reason for accounting
frauds to cease. I laugh when I watch television programs, listen to
radio broadcasts, and read news accounts and op-ed pieces that lash out
at the rascals that dominated Lehman Brothers. What are these people
thinking? Why is anybody shocked?
The heart is deceitful above all things and
desperately wicked—who can understand it? Clearly, not those who are
shocked at the revelations by Valukas.
The bottom line is that it was bad enough that E&Y
approved Lehman’s deceptive repo accounting. But their ex post
continued defense, at the highest level in the firm, of this deception
is destroying the credibility of E&Y.
What is being destroyed is our faith that the large auditing firms place
their public responsibility ahead of the deceptive dictates of their
auditing clients.
Two FTSE
100 audits required “significant improvement”, according to an
annual review of the UK’s largest eight audit firms, released today.
Auditors
have also been accused of altering documents before handing them to
regulators and putting cost savings ahead of quality, in the review
by the Audit Inspection Unit (AIU).
The report
raised a number of concerns following its inspection of 109 audits
from AIM and the FTSE 350.
The report
also found some cases where partners signed audit reports before the
audit was complete and one instance when an auditor tried to alter
an internal file after the AIU requested it. Auditors had also
changed internal materiality thresholds, which effectively reduced
their workload, and had also not applied enough scepticism to
internal asset valuations.
“In
particular, in certain cases, it was unclear from the audit files
whether the audit teams had obtained an adequate understanding of
the basis upon which the prices used had been determined,” the
report stated.
The release
follows a joint Financial Services Authority/ FRC report, released
this month, which found auditors displayed a “worrying lack of
scepticism” when auditing banks valuation models.
The AIU
report also reported that auditors were sending work to
company-owned offshore service centres to reduce costs - a practice
it believes, sent the wrong message to partners.
Paul
George, director of the Professional Oversight Board which carried
out the inspections, said auditors needed to change their behaviour,
and show more scepticism when inspecting management judgments.
“We
continue to find a rump of audits which don’t meet the standards we
expect. To eliminate this will require not just changes to policies
and procedures but also behavioural changes to ensure there is
sufficient challenge to management,” he said.
“Developments in auditing have not kept pace with developments in
financial reporting,” George added.
Liz Murrall,
director of corporate reporting at the Investment Management
Association (IMA), said investors are worried about audit quality,
when auditors themselves are under commercial stress.
“In
particular, investors are concerned in the current economic climate
that fee pressure on audit firms could impact audit quality,” she
said.
PwC’s head
of audit, Richard Sexton, said audit quality was the “foundation” of
the firm’s practice, while also conceding the need for reform. “The
integrity of our people and their behaviours are also vital
components of a quality audit… Process alone will never be the
answer,” he said.
Oliver Tant,
UK head of audit at KPMG, said he is “acutely aware” of the need for
auditors to be sceptical. “We are not complacent, however, and look
forward to a wider debate across the profession on the issue,” he
said.
The AIU
will release reports on individual audit firms in September.
The
PCAOB has issued its annual report on Ernst & Young having given the
firm the third degree at its national office and 30 of its 80 U.S.
offices. It inspected 58 audits performed by the firm but exactly
who is, of course, a big secret (unless
you tell us).
There were
five “Issuers” that were listed in the report and some form of the
word “fail” was used 25 times (that includes the footnotes).
[Issuer A] The Firm failed to adequately test the issuer’s loan
loss reserves related to certain loans held for investment.
Specifically, the Firm failed to reconcile certain values used
in the issuer’s models with industry data, failed to test the
recovery rates used in the issuer’s calculation, and failed to
test the qualitative components of the reserves.
Damn those
loan loss reserves!
[Issuer
C] The Firm failed to perform sufficient procedures to test the
issuer’s allowance for loan losses (“ALL”). The issuer
determined the general portion of its ALL estimate, which
represented a significant portion of the ALL, using certain
factors such as loan grades. Data for this calculation were
obtained from information technology systems that reside at a
third-party service organization. The Firm relied on these
systems, but it failed to test the information-technology
general controls (“ITGCs”) over certain of these systems, and it
failed to test certain of the application controls over these
systems. Further, the Firm’s testing of the controls over the
assignment and monitoring of loan grades was insufficient, as
the Firm failed to assess the competence of the individuals
performing the control on which it relied.
This loan
thing appears to be a trend…
[Issuer
D] The Firm failed to sufficiently test the costing of
work-in-process and finished goods inventory. Specifically, the
Firm’s tests of controls over the costing of such inventory were
limited to verifying that management reviewed and approved the
cost allocation factors, without evaluating the review process
that provided the basis for management’s approval.
Hopefully
that doesn’t blow back on an A1.
Anyway, you
get the picture. The whole report is below for your reading
pleasure. E&Y’s got its $0.02 in, however it was short and was
mostly concerned about the firm’s right to keep its response to Part
II (the non-public part)…non-public:
We are
enclosing our response letter to the Public Company Accounting
Oversight Board regarding Part I of the draft Report on 2009
Inspection of Ernst & Young LLP (the “Report”). We also are
enclosing our initial response to Part II of the draft Report.
We note
that Section 104(g)(2) of the Sarbanes-Oxley Act requires that
“no portions of the inspection report that deal with criticisms
of or potential defects in the quality control systems of the
firm under inspection shall be made public if those criticisms
or defects are addressed by the firm, to the satisfaction of the
Board, not later than 12 months after the date of the inspection
report.” Based on this statutory provision, we understand that
our comments on Part ii will be kept non-public as long as Part
ii of the Report itself is non-public.
In
addition, we are requesting confidential treatment of this
transmittal letter.
So this
doesn’t mean much other than E&Y would prefer that no one know how
it managed to tell the PCAOB to fuck right off as nicely as it
could.
An
executive assistant at the giant accounting firm Ernst & Young has
been sentenced to more than two years in federal prison for a $1.7
million embezzlement scheme that helped finance a posh San Francisco
home, two BMWs, jewelry and stays at luxury resorts, authorities
said Wednesday.
Lily
Aspillera, 65, of San Francisco was ordered Tuesday by U.S. District
Judge Susan Illston to serve 30 months behind bars for mail fraud
and tax evasion.
"Like so
many who commit fraud, over time she increased the amount of money
she embezzled, apparently emboldened by not getting caught,"
Assistant U.S. Attorney Doug Sprague wrote in a sentencing
memorandum.
Defense
attorney Donald Bergerson wrote in court papers that his client "has
been punished by her own conscience as much as she can be punished
by any term of imprisonment."
From 2002
to 2008, Aspillera wrote more than $1 million in checks that were
drawn from the accounts of one of Ernst & Young's clients and made
them payable to herself and to "cash."
She also
wrote checks drawn on the client's accounts payable to two of the
client's employees for amounts greater than they were due and then
had those employees cash the checks and give the excess cash back to
her, federal prosecutors said.
Aspillera
used the ill-gotten gains for stays at luxury resorts, golf trips
and the purchase of two BMWs and jewelry worth more than $200,000.
She also used $180,000 for a down payment on a $1.1 million home in
San Francisco's St. Francis Wood neighborhood
Aspillera
must repay the $1.7 million as well as back taxes of $644,843.
Noted
University of Toronto Accounting professor, Dr Gordon Richardson,
has filed an expert witness report in a pending class action suit
against the Canadian Imperial Bank of commerce, saying that the bank
substantially overstated its profits in 2007 and 2008 by basing its
estimates of risk on indefensible assumptions. The lawsuit is
expected to go to court in March, 2011. A write-up on the submission
is at
http://business.financialpost.com/2010/08/10/subprime-suit-challenges-cibc-accounting/
Dr Richardson recommended that the bank
restate its income.
Canadian
Imperial Bank of Commerce breached Canadian accounting standards by
failing to properly disclose its exposure to subprime mortgages,
according to expert testimony filed in Canada’s biggest lawsuit to
stem from the credit crisis.
Gordon
Richardson, the KPMG professor of accounting at the Rotman School of
Management in Toronto and a PhD, writes in his 65-page review of the
bank’s subprime disclosure that “CIBC failed to comply with GAAP
disclosure requirements … and the information provided to pertaining
credit risk was, prior to December 6, 2007, wholly misleading to the
market in general and to class members who invested in CIBC.”
The lawsuit
covers the period of May 31, 2007 to Feb. 28, 2008, a tumultuous
period in the capital markets when credit started freezing up and
investment firms scrambled to understand their exposure to subprime
investments.
Mr.
Richardson said, “CIBC substantially overstated its income for the
last three quarters of fiscal 2007 and the first quarter of 2008 and
income for these periods should be restated in order to comply with
GAAP.” The overstatement resulted from “indefensible assumptions”
related to its hedge fund exposure.
A second
expert witness report from a noted securities valuation firm in the
United States pegs CIBC investor losses at a maximum of
$6.6-billion. The filings are made in preparation for the mammoth
class-action suit, which is expected to come before the Ontario
Superior Court for certification in March 2011.
CIBC
spokesman Rob McLeod said, “CIBC denies these allegations and plans
to vigorously defend this action. CIBC is confident that, at all
times, its conduct was appropriate and that its disclosure met
applicable requirements.” The bank is expected to file its response
by the end of August.
Joel Rochon,
who is representing Thornhill, Ont., investor Howard Green in the
lawsuit, which was filed on July 22, 2008, declined to comment on
the expert testimony reports.
The lawsuit
claims CIBC misrepresented the bank’s exposure to subprime
investments and failed to implement appropriate risk-management
controls related to billions of dollars in investments in
collateralized debt obligations and U.S. subprime mortgages.
A similar
investor lawsuit in the United States covering CIBC disclosures
between May 2007 to May 2008 was dismissed in March. Judge William
Pauley of the Manhattan Federal Court wrote, “CIBC, like so many
other institutions, could not have been expected to anticipate the
crisis with the accuracy [the] plaintiff enjoys in hindsight.”
However,
the laws between the two countries differ and CIBC is being sued in
Canada under a new section of the Ontario Securities Act, which
makes it easier for investors to sue corporations for
misrepresentations. An investor class action against Imax Corp. over
disclosure about the status of theatre construction was certified by
an Ontario judge in February.
Mr.
Richardson’s extensive report examined CIBC’s exposure to various
tranches of subprime residential mortgage-backed securities and
collateralized debt obligations tied to subprime mortgages,
including its hedged and unhedged position.
He makes
some damning conclusions.
“In a
nutshell, investors needed to be told by no later than April 30,
2007 that CIBC’s maximum exposure to credit risk was $11.4-billion.
Instead CIBC misled its shareholders by remaining silent and by
misstating and minimizing its exposure.” He writes that it wasn’t
until Dec. 6, 2007 that the bank “stunned the investment community”
and revealed the $11.4-billion exposure.
He said
based on the TABX and ABX indices, which tracked the value of credit
default swaps tied to subprime mortgage bonds, the bank should have
realized that its main $3.5-billion hedge with counterparty ACA
Financial was in trouble. “CIBC had to have known that its hedge of
$3.5-billion with ACA had collapsed by April 30, 2007 and by no
later than July 2007.”
He said
that should have resulted in fair value writedowns of $769-million,
$2.38-billion and $3.82-billion for the second and third quarters of
fiscal 2007 versus the $273-million and $747-million hit the bank
declared.
He examined
two other hedges involving XL Capital and FGIC Corp. and concluded
that “CIBC should have recorded cumulative U.S. subprime fair value
write downs between $6.54-billion and $6.95-billion by the end of
the first [fiscal] quarter of 2008, rather than the $4.14-billion
cumulative U.S. subprime write own it did take…. ”
While the
CIBC suit is one of the few pieces of subprime litigation in Canada,
in the United States there have been more than 400 lawsuits filed in
federal courts related to the credit crisis, according to NERA
Economic consulting, which tracks such suits.
Elaine
Buckberg, a senior vice-president at NERA in New York, said her firm
has identified 74 cases relating to collateral debt obligations, 10
of which were filed in 2010 and the others filed between 2007 and
2009. Overall, U.S. credit crisis lawsuits have resulted in
US$2.1-billion in settlements involving a number of parties.
Mortgage lender Countrywide Financial Corp. agreed to pay
US$600-million to shareholders who accused it of misleading
investors about its lending practices. Mortgage loan originator New
Century Financial settled with investors for $125-million. Merrill
Lynch settled its subprime litigation for $475-million. Charles
Schwab paid out $225-million over allegations of misrepresentation
related to one of its mutual funds.
It
isn’t the first investor class action CIBC has been at the centre
of. In 2005, it settled a claim by Enron Corp. shareholders for
US$2.4-billion.
Ernst
& Young LLP, Chartered Accountants, Toronto, Ontario, is the external
auditor who prepared the Independent Auditors’ Reports to Shareholders -
Report on Financial Statements and Report on Internal Control over
Financial Reporting. Ernst & Young LLP is independent with respect to
CIBC within the meaning of the Rules of Professional Conduct of the
Institute of Chartered Accountants of Ontario, United States federal
securities laws - 13 - and the rules and regulations thereunder,
including the independence rules adopted by the United States Securities
and Exchange Commission pursuant to the Sarbanes-Oxley Act of 2002; and
applicable independence requirements of the Public Company Accounting
Oversight Board (United States).
Annual Information Form, Canadian Imperial Bank of Commerce, December 4,
2008 ---
http://www.cibc.com/ca/pdf/investor/2008-annual-info-form-en.pdf
I filed this under "Things That Wrankle
Tax Professor Amy Dunbar at the University of Connecticut"
"Supreme Court Declines to Hear Textron Work Product Privilege Case,"
Journal of Accountancy, June 2006 ---
http://www.journalofaccountancy.com/Web/20102952.htm
Here’s my two cents worth on Textron.
The Supreme Court’s denial of cert implies that the IRS and perhaps
other claimants do not have to worry about work product privilege
with respect to workpapers created in the ordinary course of doing
business. I find that case troubling because it may mean that any
reserve workpapers could now be open to litigants in general. I
don’t have any trouble with IRS having access to the workpapers
because I am not convinced that the tax assessment process should be
considered an adversarial process, which is what the work product
privilege was meant to protect. However, “FAS 5” contingencies, now
fondly known as ASC Topic 450 contingencies, are typically
adversarial, and should be protected under work product privilege.
If anyone can tell me why my concern is misplace I would love to
hear your reasoning.
The court noted: “In
some instances the spreadsheet entries estimated the probability of
IRS success at 100 percent.”
A
100% reserve???? How common is this? I think the IRS should find
out. The proposed Form 1120 Schedule UTB won’t help with this
because the actual reserves do not have to be disclosed, only the
maximum liability associated with the tax position.
I love the following quote:
“Textron apparently thinks it is "unfair" for the government to
have access to its spreadsheets, but tax collection is not a
game. Underpaying taxes threatens the essential public interest
in revenue collection. If a blueprint to Textron's possible
improper deductions can be found in Textron's files, it is
properly available to the government unless privileged.
Virtually all discovery against a party aims at securing
information that may assist an opponent in uncovering the truth.
Unprivileged IRS information is equally subject to discovery.”
Obviously the tax division of the
auditing firm didn’t recommend these transactions because PCAOB Rule
3522 requires recommended tax products to have a more likely than
not probability of success.
“A
registered public accounting firm is not independent of its
audit client if the firm, or any affiliate of the firm, during
the audit and professional engagement period, provides any
non-audit service to the audit client related to marketing,
planning, or opining in favor of the tax treatment of, …
a
transaction that was initially recommended, directly or
indirectly, by the registered public accounting firm and a
significant purpose of which is tax avoidance, unless the
proposed tax treatment is at least more likely than not to be
allowable under applicable tax laws.”
I doubt the tax division signed the
return either in view of preparer penalties, but I think that the
very large corporations typically file their own returns, so
preparer penalties are not a deterrent, but I may be wrong about my
assumption.
A 100% reserve for a position will exist
any time a position doesn’t meet the more-likely-than not test under
FIN 48, but Textron was pre-FIN 48.
And
in a win of sorts for now for EY, their client Textron won
a ruling that
allows them to withhold their tax accrual workpapers from the IRS.
The ruling is important because it speaks to the protection of
attorney-client privilege when the work product in question has been
shown to a company’s external auditors. From the blog, ataxingmatter,
a short explanation of why the court’s decision was wrong:
“During an audit of the company covering its 1998-2001 tax
years, the IRS requested Textron’s tax accrual workpapers, but
the company refused to provide them, claiming that they are
protected by various privileges, including the work-product
privilege, even though they were at the least “dual purpose
documents”. The First Circuit upheld the privilege, and even
concluded that the company had not waived the protection by
showing the internal workpapers to its outside auditor, Ernst &
Young, calling the auditor-client relationship a “cooperative
not adversarial relationship” that was unlikely to lead to
litigation.
Even
so, the court acknowledged that E&Y’s own workpapers, which
likely incorporate and even reveal Textron’s analyses, may be
discoverable on remand, under the Arthur Young Supreme Court
opinion. The court’s determination that the company’s internal
tax accrual workpapers may not be summonsed is manifestly
inconsistent with the court’s conclusion that the outside
auditor’s workpapers incorporating the same analysis may be.”
Auditors, in the course of performing their audit, require free and
open access to documents and to executives in order to do a
complete, thorough, and professional job. We have seen similar
issues raised when discussing changes
and additional disclosures under FAS 5. Auditors
understand the delicate balance and, although fully understanding of
their responsibilities to push for full disclosure, are not
willing to push when they believe more disclosure is contrary to
their client’s (read corporate executives’) best interest even if
additional disclosure may be in the best interest of investors and
shareholders.
So, a
ruling here that allows attorney-client privilege for their
clients while still allowing the auditors to have access to the
information is good for the auditors. Their clients can not use the
excuse of losing this protection to keep important information from
them.
So,
here’s the conundrum:
1)
Audit workpapers are not protected.
2)
Clients will remain skittish about sharing information with
auditors that they want to remain protected under work-product
doctrine or the broader attorney-client privilege.
3)Auditors themselves are not comfortable with broader, more
detailed legal contingency disclosures, for example, and have
said so with regard to expanded disclosure under FAS 5.
Result:
Auditors
will see less and less of what is relevant to audit “in accordance
with applicable auditing standards and supported by appropriate
audit evidence.”
Please don't forward this email with my name, but I thought
you may find the info below of interest, you may (or may not) want
to cut/paste info below to share with others; if you do share it, please
don't attribute the comments to me,
it can just be
someone who prefers to be anonymous). Thank you!
www.repo105.com strikes me as possibly being a spam site, maybe
even authored by someone overseas, due to some misspellings on their
site including "Bernie Maddof" and "Dick Chaney."
Moreover, it looks like the site may have been set up to get
attention of people looking for info on "Repo 105" but drives them
to their own business which apparently is selling FX or gold
trading, e.g. this para. on their website:
"Financial markets may well roil in the
throws of this latest revelation, especially if the practice is
shown to be widespread
From
XXXXX
Jensen Comment
An evolving site that might one day be quite good for Repo 105
information might be
http://en.wikipedia.org/wiki/Repo_105
Currently I think my links below will be more useful on this
accounting controversy.
In
the last day or so the SEC staff has sent the letter below to the
CFO of 20 or so very large financial institutions including
insurance companies.
Denny
Beresford
Sample Letter Sent to Public Companies Asking for Information
Related to Repurchase Agreements, Securities Lending Transactions,
or Other Transactions Involving the Transfer of Financial Assets
In
March 2010, the Division of Corporation Finance sent the following
illustrative letter to certain public companies requesting
information about repurchase agreements, securities lending
transactions, or other transactions involving the transfer of
financial assets with an obligation to repurchase the transferred
assets.
March 2010
Name Chief Financial Officer XYZ Company Address
Dear Chief Financial Officer:
We are currently reviewing your Form 10-K for fiscal year ended
______. In our effort to better understand the decisions you
made in determining the accounting for certain of your
repurchase agreements, securities lending transactions, or other
transactions involving the transfer of financial assets with an
obligation to repurchase the transferred assets, we ask that you
provide us with information relating to those decisions and your
disclosure.
With regard to your repurchase agreements, please tell us
whether you account for any of those agreements as sales for
accounting purposes in your financial statements. If you do, we
ask that you:
*
Quantify the amount of repurchase agreements qualifying for
sales accounting at each quarterly balance sheet date for each
of the past three years. * Quantify the average quarterly
balance of repurchase agreements qualifying for sales accounting
for each of the past three years. * Describe _all_ the
differences in transaction terms that result in certain of your
repurchase agreements qualifying as sales versus collateralized
financings. * Provide a detailed analysis supporting your use of
sales accounting for your repurchase agreements. * Describe the
business reasons for structuring the repurchase agreements as
sales transactions versus collateralized financings. To the
extent the amounts accounted for as sales transactions have
varied over the past three years, discuss the reasons for
quarterly changes in the amounts qualifying for sales
accounting. * Describe how your use of sales accounting for
certain of your repurchase agreements impacts any ratios or
metrics you use publicly, provide to analysts and credit rating
agencies, disclose in your filings with the SEC, or provide to
other regulatory agencies. * Tell us whether the repurchase
agreements qualifying for sales accounting are concentrated with
certain counterparties and/or concentrated within certain
countries. If you have any such concentrations, please discuss
the reasons for them. * Tell us whether you have changed your
original accounting on any repurchase agreements during the last
three years. If you have, explain specifically how you
determined the original accounting as either a sales transaction
or as a collateralized financing transaction noting the specific
facts and circumstances leading to this determination. Describe
the factors, events or changes which resulted in your changing
your accounting and describe how the change impacted your
financial statements.
For those repurchase agreements you account for as
collateralized financings, please quantify the average quarterly
balance for each of the past three years. In addition, quantify
the period end balance for each of those quarters and the
maximum balance at any month-end. Explain the causes and
business reasons for significant variances among these amounts.
In addition, please tell us:
*
Whether you have any securities lending transactions that you
account for as sales pursuant to the guidance in ASC 860-10. If
you do, quantify the amount of these transactions at each
quarterly balance sheet date for each of the past three years.
Provide a detailed analysis supporting your decision to account
for these securities lending transactions as sales. * Whether
you have any other transactions involving the transfer of
financial assets with an obligation to repurchase the
transferred assets, similar to repurchase or securities lending
transactions that you account for as sales pursuant to the
guidance in ASC 860. If you do, describe the key terms and
nature of these transactions and quantify the amount of the
transactions at each quarterly balance sheet date for the past
three years. * Whether you have offset financial assets and
financial liabilities in the balance sheet where a right of
setoff — the general principle for offsetting — does not exist.
If you have offset financial assets and financial liabilities in
the balance sheet where a right of setoff does not exist, please
identify those circumstances, explain the basis for your
presentation policy, and quantify the gross amount of the
financial assets and financial liabilities that are offset in
the balance sheet. For example, please tell us whether you have
offset securities owned (long positions) with securities sold,
but not yet purchased (short positions), along with any basis
for your presentation policy and the related gross amounts that
are offset.
Finally, if you accounted for repurchase agreements, securities
lending transactions, or other transactions involving the
transfer of financial assets with an obligation to repurchase
the transferred assets as sales and did not provide disclosure
of those transactions in your Management’s Discussion and
Analysis, please advise us of the basis for your conclusion that
disclosure was not necessary and describe the process you
undertook to reach that conclusion. We refer you to paragraphs
(a)(1) and (a)(4) of Item 303 of Regulation S-K.
As noted above, we seek to better understand the basis for your
decisions and your disclosure. Please provide us with a written
response to these questions within ten business days from the
date of this letter or tell us when you will respond. Upon our
review of your response to these questions, we may have
additional comments that we will provide to you with any other
comments we may have on your Form 10-K.
Far
from going unnoticed, Lehman's Repo 105 transactions are destined to
take a prominent place in the annals of accounting scandals — somewhere
between Enron's infamous special-purpose entities and AIG's
booby-trapped credit default swaps.
"SEC to CFOs: More Repo Disclosure: In its latest "Dear CFO"
letter, the SEC is seeking more information on why some repurchase
agreements are being booked as sales" by Marie Leone, CFO.com,
March 31, 2010 ---
http://www.cfo.com/article.cfm/14487561/c_14487542?f=home_todayinfinance
The
Securities and Exchange Commission is asking public-company CFOs for
additional information about repurchase agreements, or repos, the
transactions that Lehman Brothers used to make its balance sheet
look healthier before the investment bank collapsed into bankruptcy.
The SEC
wants companies to help the regulator "better understand" the
accounting treatment used to record repos, and to provide details
about how management determines whether to record repos as a sale or
a collateralized financing. The commission would like to know, for
example, how many repos qualified for sales accounting treatment
each quarter for the past three years, whether those sales were
concentrated with certain counterparties or countries, the business
reason for structuring such transactions as sales, and whether a
company has changed its original accounting treatment for any of the
repos.
Issued in
March in the form of a "Dear CFO" letter, the SEC's request for
additional information seems "granular and broad at the same time,"
says Wallace Enman, a vice president and senior accounting analyst
with Moody's Investor Services. He says that if companies were to
use the letter as a guide, they would create "relatively robust"
disclosures about repos. A sample letter was posted on the SEC's
Website on Monday.
While SEC
comment letters are usually directed at a single company, Dear CFO
letters cover issues that affect a large swath of companies. But the
repo letter "is not a typical Dear CFO letter where we provide
companies with our views on accounting and disclosure matters they
should consider," says SEC spokesman John Nester. "In this case, we
are seeking very specific information from companies about
repurchase agreements and similar transactions."
Nester says
that based on company responses, the SEC could ask issuers to amend
their filings or modify disclosures in future filings. But so far
the commission has not concluded that any company has failed to
comply with generally accepted accounting principles, violated any
SEC rules, or failed to provide appropriate disclosures.
This isn't
the first time the SEC has questioned companies about the way they
apply asset-transfer accounting rules. Since 2004, the SEC has
exchanged 171 comment letters with 93 different companies about
whether agreements to transfer financial assets are treated as a
sale or a temporary transaction under U.S. GAAP, according to
research firm Audit Analytics.
For his
part, Enman says the questions are the SEC's way of making sure that
Lehman's so-called Repo 105 technique doesn't go unnoticed. Indeed,
in an interview with CNBC this week, SEC Chairman Mary Schapiro said
the commission is looking at all the issues surrounding Repo 105,
both at Lehman and other financial institutions. "We want to make
sure their accounting and disclosures are accurate when it comes to
characterizing repurchases," said Schapiro.
One for
the Books
Far from
going unnoticed, Lehman's Repo 105 transactions are destined to take
a prominent place in the annals of accounting scandals — somewhere
between Enron's infamous special-purpose entities and AIG's
booby-trapped credit default swaps.
Earlier
this month, Anton Valukas, the court-appointed examiner in the
Lehman bankruptcy case, released a 2,200-page report on the collapse
of the investment bank, devoting more than 300 pages to Repo 105.
While the report did not find that Lehman violated asset-transfer
accounting rules, it said that the investment bank was not as
forthcoming as it should have been in its financial-statement
disclosures.
Valukas
faulted Lehman for not revealing enough to investors about the
purpose of Repo 105 transactions and how they affected the bank's
leverage ratios. However, internal Lehman e-mail messages made
public in the report quoted Lehman executives as describing the
repos as balance-sheet "window dressing" and an "accounting
gimmick."
In general,
repos are used to buy and sell groups of securities, usually
Treasury securities, in short-term transactions, typically
overnight. The securities are put up as collateral by a borrower and
in exchange, the borrower receives cash from counterparties that
charge interest. Since the securities are treated as collateral and
the agreement stipulates that the borrower has an obligation to pay
back the cash in short order, the transaction is considered a
financing for accounting purposes, and the transaction remains on
the balance sheet.
In the case
of Repo 105, however, Lehman overcollateralized the transactions by
pledging $105 million for $100 million in cash. As a result, the
investment bank — with the blessing of a legal opinion from UK law
firm Linklaters — categorized Repo 105 as a sale for accounting
purposes. The sales accounting treatment enabled Lehman to remove
the securities from its balance sheet and use the cash from the
"sale" to pay down other debt and improve its overall leverage
ratios.
Lehman
repeated the transaction again and again, including at the end of
the last three quarters the bank was solvent. According to the
Valukas report, "Lehman employed off-balance sheet devices . . . to
temporarily remove securities inventory from its balance sheet,
usually for a period of seven to ten days, and to create a
materially misleading picture of the firm's financial condition in
late 2007 and 2008." Then, a few days into the new quarter, Lehman
would borrow funds to repay the repo borrowing plus interest,
repurchase the securities, and restore the assets to its balance
sheet.
The
Financial Accounting Standards Board moved last year to close the
loophole that Lehman is accused of using, Bushee says. A new rule, FAS
166, replaces the 98%-102% test with one designed to get at the intent
behind a repurchase agreement. The new rule, just taking effect now,
looks at whether a transaction truly involves a transfer of risk and
reward. If it does not, the agreement is deemed a loan and the assets
stay on the borrower's balance sheet.
The
collapse of Lehman Brothers in September 2008 is widely seen as the
trigger for the financial crisis, spreading panic that brought
lending to a halt. Now a 2,200-page report says that prior to the
collapse -- the largest bankruptcy in U.S. history -- the investment
bank's executives went to extraordinary lengths to conceal the risks
they had taken. A new term describing how Lehman converted
securities and other assets into cash has entered the financial
vocabulary: "Repo 105."
While
Lehman's huge indebtedness and other mistakes have been well
documented, the $30 million study by Anton Valukas, assigned by the
bankruptcy court, contains a number of surprises and new insights,
several Wharton faculty members say.
Among
the report's most disturbing revelations, according to Wharton
finance professor
Richard J. Herring, is the picture of
Lehman's accountants at Ernst & Young. "Their main role was to help
the firm misrepresent its actual position to the public," Herring
says, noting that reforms after the Enron collapse of 2001 have
apparently failed to make accountants the watchdogs they should be.
"It
was clearly a dodge.... to circumvent the rules, to try to move
things off the balance sheet," says Wharton accounting professor
professor
Brian J. Bushee,
referring to Lehman's Repo 105 transactions. "Usually, in these
kinds of situations I try to find some silver lining for the
company, to say that there are some legitimate reasons to do
this.... But it clearly was to get assets off the balance sheet."
The
use of outside entities to remove risks from a company's books is
common and can be perfectly legal. And, as Wharton finance professor
Jeremy J. Siegel points out, "window
dressing" to make the books look better for a quarterly or annual
report is a widespread practice that also can be perfectly legal.
Companies, for example, often rush to lay off workers or get rid of
poor-performing units or investments, so they won't mar the next
financial report. "That's been going on for 50 years," Siegel says.
Bushee notes, however, that Lehman's maneuvers were more extreme
than any he has seen since the Enron collapse.
Wharton finance professor professor
Franklin Allen suggests that the other
firms participating in Lehman's Repo 105 transactions must have
known the whole purpose was to deceive. "I thought Repo 105 was
absolutely remarkable – that Ernst & Young signed off on that. All
of this was simply an artifice, to deceive people." According to
Siegel, the report confirms earlier evidence that Lehman's chief
problem was excessive borrowing, or over-leverage. He argues that it
strengthens the case for tougher restrictions on borrowing.
A
Twist on a Standard Financing Method
In his
report, Valukas, chairman of the law firm Jenner & Block, says that
Lehman disregarded its own risk controls "on a regular basis," even
as troubles in the real estate and credit markets put the firm in an
increasingly perilous situation. The report slams Ernst & Young for
failing to alert the board of directors, despite a warning of
accounting irregularities from a Lehman vice president. The auditing
firm has denied doing anything wrong, blaming Lehman's problems on
market conditions.
Much of
Lehman's problem involved huge holdings of securities based on
subprime mortgages and other risky debt. As the market for these
securities deteriorated in 2008, Lehman began to suffer huge losses
and a plunging stock price. Ratings firms downgraded many of its
holdings, and other firms like JPMorgan Chase and Citigroup demanded
more collateral on loans, making it harder for Lehman to borrow. The
firm filed for bankruptcy on September 15, 2008.
Prior to
the bankruptcy, Lehman worked hard to make its financial condition
look better than it was, the Valukas report says. A key step was to
move $50 billion of assets off its books to conceal its heavy
borrowing, or leverage. The Repo 105 maneuver used to accomplish
that was a twist on a standard financing method known as a
repurchase agreement. Lehman first used Repo 105 in 2001 and became
dependent on it in the months before the bankruptcy.
Repos, as
they are called, are used to convert securities and other assets
into cash needed for a firm's various activities, such as trading.
"There are a number of different kinds, but the basic idea is you
sell the security to somebody and they give you cash, and then you
agree to repurchase it the next day at a fixed price," Allen says.
In a
standard repo transaction, a firm like Lehman sells assets to
another firm, agreeing to buy them back at a slightly higher price
after a short period, sometimes just overnight. Essentially, this is
a short-term loan using the assets as collateral. Because the term
is so brief, there is little risk the collateral will lose value.
The lender – the firm purchasing the assets – therefore demands a
very low interest rate. With a sequence of repo transactions, a firm
can borrow more cheaply than it could with one long-term agreement
that would put the lender at greater risk.
Under
standard accounting rules, ordinary repo transactions are considered
loans, and the assets remain on the firm's books, Bushee says. But
Lehman found a way around the negotiations so it could count the
transaction as a sale that removed the assets from its books, often
just before the end of the quarterly financial reporting period,
according to the Valukas report. The move temporarily made the
firm's debt levels appear lower than they really were. About $39
billion was removed from the balance sheet at the end of the fourth
quarter of 2007, $49 billion at the end of the first quarter of 2008
and $50 billion at the end of the next quarter, according to the
report.
Bushee says
Repo 105 has its roots in a rule called FAS 140, approved by the
Financial Accounting Standards Board in 2000. It modified earlier
rules that allow companies to "securitize" debts such as mortgages,
bundling them into packages and selling bond-like shares to
investors. "This is the rule that basically created the
securitization industry," he notes.
FAS 140
allowed the pooled securities to be moved off the issuing firm's
balance sheet, protecting investors who bought the securities in
case the issuer ran into trouble later. The issuer's creditors, for
example, cannot go after these securities if the issuer goes
bankrupt, he says.
Because
repurchase agreements were really loans, not sales, they did not fit
the rule's intent, Bushee states. So the rule contained a provision
saying the assets involved would remain on the firm's books so long
as the firm agreed to buy them back for a price between 98% and 102%
of what it had received for them. If the repurchase price fell
outside that narrow band, the transaction would be counted as a
sale, not a loan, and the securities would not be reported on the
firm's balance sheet until they were bought back.
This
provided the opening for Lehman. By agreeing to buy the assets back
for 105% of their sales price, the firm could book them as a sale
and remove them from the books. But the move was misleading, as
Lehman also entered into a forward contract giving it the right to
buy the assets back, Bushee says. The forward contract would be on
Lehman's books, but at a value near zero. "It's very similar to what
Enron did with their transactions. It's called 'round-tripping.'"
Enron, the huge Houston energy company, went bankrupt in 2001 in one
of the best-known examples of accounting deception.
Lehman's
use of Repo 105 was clearly intended to deceive, the Vakulas report
concludes. One executive email cited in the report described the
program as just "window dressing." But the company, which had
international operations, managed to get a legal opinion from a
British law firm saying the technique was legal.
Bamboozled
The
Financial Accounting Standards Board moved last year to close the
loophole that Lehman is accused of using, Bushee says. A new rule,
FAS 166, replaces the 98%-102% test with one designed to get at the
intent behind a repurchase agreement. The new rule, just taking
effect now, looks at whether a transaction truly involves a transfer
of risk and reward. If it does not, the agreement is deemed a loan
and the assets stay on the borrower's balance sheet.
The Vakulas
report has led some experts to renew calls for reforms in accounting
firms, a topic that has not been front-and-center in recent debates
over financial regulation. Herring argues that as long as accounting
firms are paid by the companies they audit, there will be an
incentive to dress up the client's appearance. "There is really a
structural problem in the attitude of accountants." He says it may
be worthwhile to consider a solution, proposed by some of the
industry's critics, to tax firms to pay for auditing and have the
Securities and Exchange Commission assign the work and pay for it.
The Valukas
report also shows the need for better risk-management assessments by
firm's boards of directors, Herring says. "Every time they reached a
line, there should have been a risk-management committee on the
board that at least knew about it." Lehman's ability to get a
favorable legal opinion in England when it could not in the U.S.
underscores the need for a "consistent set" of international
accounting rules, he adds.
Siegel
argues that the report also confirms that credit-rating agencies
like Moody's and Standard & Poor's must bear a large share of the
blame for troubles at Lehman and other firms. By granting triple-A
ratings to risky securities backed by mortgages and other assets,
the ratings agencies made it easy for the firms to satisfy
government capital requirements, he says. In effect, the raters
enabled the excessive leverage that proved a disaster when those
securities' prices fell to pennies on the dollar. Regulators "were
being bamboozled, counting as safe capital investments that were
nowhere near safe."
Some
financial industry critics argue that big firms like Lehman be
broken up to eliminate the problem of companies being deemed "too
big to fail." But Siegel believes stricter capital requirements are
a better solution, because capping the size of U.S. firms would
cripple their ability to compete with mega-firms overseas.
While the
report sheds light on Lehman's inner workings as the crisis brewed,
it has not settled the debate over whether the government was right
to let Lehman go under. Many experts believe bankruptcy is the
appropriate outcome for firms that take on too much risk. But in
this case, many feel Lehman was so big that its collapse threw
markets into turmoil, making the crisis worse than it would have
been if the government had propped Lehman up, as it did with a
number of other firms.
Allen says
regulators made the right call in letting Lehman fail, given what
they knew at the time. But with hindsight he's not so sure it was
the best decision. "I don't think anybody anticipated that it would
cause this tremendous stress in the financial system, which then
caused this tremendous recession in the world economy."
Allen,
Siegel and Herring say regulators need a better system for an
orderly dismantling of big financial firms that run into trouble,
much as the Federal Deposit Insurance Corp. does with ordinary
banks. The financial reform bill introduced in the Senate by
Democrat Christopher J. Dodd provides for that. "I think the Dodd
bill has a resolution mechanism that would allow the firm to go bust
without causing the kind of disruption that we had," Allen says.
"So, hopefully, next time it can be done better. But whether anyone
will have the courage to do that, I'm not sure."
-----Original Message-----
From: Jensen, Robert [mailto:rjensen@trinity.edu]
Sent: Thursday, April 08, 2010 9:18 AM
To: Jim Fuehrmeyer
Subject: RE: AT&T $1 billion write-down, Repo 105 and other dumb
questions
Yes,
but can the FAS 140 defense be used in the British Courts when
British investors sue the failed London office of Lehman and the
London office of E&Y?
I
assumed that branch investment banks in England are subject to UK
accounting/auditing standards. Or can investment banks avoid local
accounting/auditing standards by having headquarters in other
nations?
Bob
Jensen
-----Original Message-----
From: Jim Fuehrmeyer [mailto:jfuehrme@nd.edu]
Sent: Thursday, April 08, 2010 11:51 AM
To: Jensen, Robert
Subject: RE: AT&T $1 billion write-down, Repo 105 and other dumb
questions
I guess that
depends on what their basis is for suing. I'm not a lawyer, of
course. I expect the local Lehman office filed statutory reports in
the UK, whether they were regulated or not, and those would have
been done using IFRS. The Repo 105 would not qualify as a sale
under IFRS - the fixed price repurchase arrangement would take care
of that (IFRS No. 39R, AG40) - so I expect this would have shown as
a secured borrowing on those financials. I'm quite sure UK
companies file financial statements, even wholly-owned subsidiaries
of US companies. Assuming the Lehman entities did that, the
financials may even be available to the public/press and someone's
likely already pouring over them. So it's not clear to me that a UK
plaintiff would be relying on the US GAAP financials nor is it clear
to me what damages there are in the UK related to the Lehman
subsidiaries. The plaintiffs I guess would be creditors, lenders
and so on, and you're correct, they would not have been using the
consolidated Lehman 10K as a basis for their credit decisions if
they had local financials to go on - and I bet that would be the
case here.
The
requirement to file local financials is typical all around the world
- except in the US of course. A US subsidiary of a foreign company
doesn't have to do separate financials. And that's among the
reasons the big US multinationals want to be on IFRS. Their
subsidiaries all around the world already have to prepare local,
statutory financials and most places are now using IFRS so they have
to convert all those subs to US GAAP for purposes of reporting here.
They could actually save a lot of time and effort if the US piece
went to IFRS.
“Gentlemen, not one of you could have done this on your own.
This was a team effort.” Casey Stengel after the Mets 40-120
season.
Why didn’t
the Big 4 audit firms warn that these obscenely over leveraged
institutions threatened our financial future? Why didn’t the
auditors question, push back, or raise objections to illegal and
unethical disclosure gaps? Every one of the failed or bailed out
financial institutions carried non-qualified, clean audit opinions
in their wallets when they cashed the taxpayers’ check.
Lehman
Brothers. Bear Stearns. Washington Mutual. AIG. Countrywide. New
Century. Citigroup. Merrill Lynch. GE Capital. GMAC. Fannie Mae.
Freddie Mac.
The largest
four global audit firms – Deloitte, Ernst & Young, KPMG and
PricewaterhouseCoopers – have combined revenues of almost $100
billion dollars and employ hundreds of thousands of people. There’s
no hard proof they’re completely corrupt, but they’ve proven
themselves to be demonstrably self-interested and no longer
singularly focused on their public duty to shareholders.
Something
is rotten with the accounting industry.
America’s
public accountants – in particular, the Big 4 audit firms – aren’t
protecting investors. And no one is holding them accountable.
The crisis
that culminated in the near-collapse of the global financial system
is still the subject of Congressional hearings.
Last
month the
Lehman Bankruptcy Examiner’s report told
us that there’s “sufficient evidence exists to support colorable
claims against Ernst & Young LLP for professional malpractice
arising from [their] failure to
follow professional standards of care.”
This weekthe Securities and
Exchange Commission charged Goldman Sachs and one of its vice
presidents with fraud for misleading investors by “misstating and
omitting key facts about a financial product tied to subprime
mortgages.”
That
financial product was a structured collateralized debt obligation (CDO)
that hinged on the performance of subprime residential
mortgage-backed securities (RMBS). Goldman Sachs, according to the
SEC, failed to disclose vital information about the CDO to
investors. In particular, John Paulson’s hedge fund, a Goldman
client, played a leading role in the
portfolio
selection process and the hedge fund took a short position against
the CDO, without disclosure to Goldman’s other clients.
In one of
the most egregious cases of auditor complacence during the financial
crisis, Pricewaterhouse Coopers LLP (PwC), the firm that audits both
AIG and Goldman Sachs, sat on the sidelines for almost two years
while their clients disputed the value of credit default swaps
(CDS).
There’s been no public explanation of how PwC presided over the
dispute between AIG and Goldman—a dispute
eventually pushed AIG to accept a bailout – without doing something
decisive to help resolve it. This long-running “difference of
opinion” between two of its most important global clients was
arguably material to at least one of them. Why didn’t PwC force a
resolution sooner based on consistent application of accounting
standards?
PwC was
paid a combined $230 million by the two firms for 2008 and remains
the “independent” auditor to both companies.
Gatekeepers? Or foxes in the hen house?
The
auditor’s role is to be a gatekeeper. A watchdog. An advocate for
shareholders. This is their public duty.
This public
trust is subsidized by a government-sponsored franchise. All
companies listed on major stock exchanges must
have an audit opinion. Audit firms are meant to be shareholders’
first line of defense, and they are hired by and report to the
independent Audit Committee of the Board of Directors.
And yet the
same audit firms that stood by and watched Bear Stearns and Lehman
Brothers fail – Deloitte and Ernst &Young – are recipients of
lucrative government contracts to audit or monitor the taxpayers’
investment in the bailed out firms. Deloitte, the Bear Stearns and
Merrill Lynch auditor, works for the US Federal Reserve system.
Ernst & Young, Lehman’s auditor, is working for the US Treasury on
the original $700 billion TARP program and with the Fed on the AIG
bailout.
Who
are we kidding?
America’s auditors serve themselves. Focused on “client service” not
shareholder advocacy, they’ve remained above the financial crisis
finger-pointing fray. Call it skillful lobbying or
targeted political contributions… Either
way, regulators and legislators have been afraid of getting on the
auditors’ bad side.
Investment
banks, mortgage originators, commercial banks, and ratings agencies
have all been questioned about their role in the crisis. And the Big
4 public accounting firms work for all of them.
But
when accused of negligence, malpractice or complicity, the audit
firms frequently claim to have been duped. Do you believe them? The
industry is an oligopoly. That’s a $10 word for what happens when a
market
or
industry is dominated by a small number of
sellers who discuss their strategies in order to achieve common
objectives.
The
Sarbanes Oxley Act of 2002 (SOx) was enacted after the Enron debacle
to restore confidence in the audit profession. Instead, accounting
firms reaped huge financial rewards while enforcing SOx, until the
tremendous cost to America’s businesses forced regulators to lighten
up and the auditors to stand down.
But SOx had
another insidious byproduct: the misplaced belief that after Arthur
Andersen’s implosion, the remaining four global public accounting
firms were too important, and too few, to fail.
This fear
of auditor failure precludes any regulatory or legislative actions
that might precipitate the loss of another large accounting firm.
What do you get when there’s no timely or significant regulatory
consequence to repeated auditor malpractice and incompetence? Moral
hazard. “Too few to fail” has been as detrimental to capital markets
as the notion that some financial institutions are too big to fail.
Shareholders are harmed and investors lose confidence.
Every one
of the audit firms is a defendant in lawsuits for institutions that
failed, were taken over, or bailed out, in addition to several $1
billion plus malpractice, fraud and Madoff-related lawsuits. Any one
of these “catastrophic” matters could threaten their viability.
However, regulators and the worldwide business community are
ignoring this threat or, worse yet, promoting liability caps.
Limiting liability only exacerbates moral hazard.
Can a
crisis caused by “catastrophic” disruption in audit service delivery
be any worse than the one they never warned us about? Why not face
fears head on and start re-writing the audit blank check –
ineffective audit opinions – before the plaintiffs’ bar does it for
us?
Deloitte’s audits “were so deficient that the audit amounted to
no audit at all,” the [Bear Stearns investors] plaintiffs argued
in court papers.
That’s
Reuters describing the rationale behind
the decision of US District Judge Robert Sweet on January 23, 2011
to allow a case against fallen investment bank Bear Stearns and its
outside auditor, Deloitte, to go forward.
The
decision for a group of plaintiffs, including the State of Michigan
Retirement system, and their attorneys is indeed sweet. Subprime
suits have been hampered by the argument they are trying to punish
the case of “classic fraud by hindsight”. Bankers did a great job
during and after the crisis of describing the events that occurred
as “black swan” events,
forces of nature that could not have been
identified in advance.
This
decision is even more significant because it provides a successful
template for including claims against the auditors for financial
crisis failures when warranted. In
Ernst & Ernst v. Hochfelder, the
Supreme Court held that actions under Section 10(b) of the Exchange
Act and Rule 10b-5 require an allegation of “`scienter’—intent to
deceive, manipulate, or defraud.” The “scienter” requirement,
necessary to sustain allegations against the auditors in a
securities claim under Section 10(b), is notoriously difficult to
meet.
If
there’s anything of substance in a claim against auditors the case
usually settles before the facts are made public. New Century
Trustee v. KPMG is an early crisis mortgage originator case,
cited several times in this decision. However, those facts will
never be heard in open court. In spite of – or perhaps because of –
very particular examples of reckless behavior by the auditor
documented by the bankruptcy examiner,
the case was settled.
The
Ernst & Ernst v. Hochfelder decision left open the question of
“whether, in some circumstances, reckless behavior is sufficient for
civil liability under § 10(b) and Rule 10b-5.” However, since
Ernst, most courts have concluded that recklessness can satisfy
the requirement of “scienter” in a securities fraud action against
an accountant.
“Recklessness” in a securities fraud action against an accountant is
defined as, “highly unreasonable [conduct], involving not merely
simple, or even inexcusable negligence, but an extreme departure
from the standards of ordinary care, and which presents a danger of
misleading buyers or sellers that is either known to the defendant
or is so obvious that the actor must have been aware of it.”
The FASB has published on
its web site a letter from Chairman Herz to the House Financial
Services Committee regarding Lehman's accounting for repurchase
agreements. I've attached the pdf file here, or you can go to the
FASB web site and follow the news link.
Paul
The letter is shown below.
April 19, 2010
The Honorable Barney Frank, Chairman
The Honorable Spencer T. Bachus III, Ranking Minority Member
House Financial Services Committee
2129 Rayburn House Office Building
Washington, DC 20515
Re: Discussion of Selected Accounting
Guidance Relevant to Lehman Accounting Practices
Dear Chairman Frank and Ranking Minority
Member Bachus:
Thank you for the opportunity to submit
an explanation of the accounting standards and relevant guidance
relating to repurchase agreements for your April 20, 2010 hearing
"Public Policy Issues Raised by the Report of the Lehman Bankruptcy
Examiner." In order to focus my response on the most relevant financial
accounting guidance, I have referred to certain matters discussed in the
report of the Lehman Bankruptcy Examiner.1
Additionally, I have
also provided a brief discussion of the relevant accounting guidance
relating to consolidation of special-purpose entities, which I believe
may be helpful to the Members of the Committee as they deliberate the
public policy issues relating to Lehman’s bankruptcy.
1 Report of Anton R. Valukas,
Examiner, United States Bankruptcy Court Southern District of New York,
In re Lehman Brothers Holdings Inc., et al., Debtors, March 11, 2010.
The FASB does not have regulatory or
enforcement powers. However, whenever there are reports of significant
accounting or financial reporting issues, we monitor developments
closely to assess whether standard-setting actions by us may be needed.
In some cases, a misreporting is due to outright fraud and/or violation
of our standards, in which case accounting standard-setting action is
not necessarily the remedy. Other cases reveal weaknesses in current
standards or inappropriate structuring to circumvent the standards, in
which case revision of the standards may be appropriate. In some cases,
there are elements of both.
At this point in time, while we have
read the report of the Lehman Bankruptcy Examiner, press accounts, and
other reports, we do not have sufficient information to assess whether
Lehman complied with or violated particular standards relating to
accounting for repurchase agreements or consolidation of special-purpose
entities. Furthermore, we do not know whether other major financial
institutions may have engaged in accounting and reporting practices
similar to those apparently employed by Lehman.
2
In that regard, we work closely with the
SEC. We understand that the SEC staff is in the process of obtaining
information directly from a number of financial institutions relating to
their practices in these areas. As they obtain and evaluate that
information, we will continue to work closely with them to discuss and
consider whether any standard-setting actions by us may be warranted.
However, in the meantime, this letter
and its attachments summarize the current accounting and reporting
standards relating to repurchase agreements and consolidation of
special-purpose entities, including some of the recent changes the FASB
has put in place.
Accounting and Reporting Standards for Repurchase Agreements
In a typical repurchase (repo)
transaction, a bank transfers securities to a counterparty in exchange
for cash with a simultaneous agreement for the counterparty to return
the same or equivalent securities for a fixed price at a later date,
usually a few days or weeks.
Accounting standards prescribe when a
company can and cannot recognize a sale of a financial asset based on
whether it has surrendered control over the asset. In this context, two
of the criteria key in determining whether a sale has occurred are:
(a) The transferred financial assets
must be
legally
isolated from the company that transferred the assets. In other
words, Lehman or its creditors would not be able to reclaim the
transferred securities during the term of the repo, even in the event of
Lehman’s bankruptcy.2
(b) The company that transferred the assets does not maintain
effective control over those assets. Specific tests relate to
whether the company has maintained effective control, which are
described below.
2 The Audit Issues Task Force
Working Group of the AICPA issued an Auditing Interpretation, "The Use
of Legal Interpretations As Evidential Matter to Support Management’s
Assertion That a Transfer of Financial Assets Has Met the Isolation
Criterion in Paragraph 9(a) of Statement of Financial Accounting
Standards No. 140," to assist auditors in their analysis. I have
separately provided a copy to the Committee staff.
If both of these criteria are met (among
other criteria), the repo would be accounted for as a sale. If either of
these criteria is not met, the repo would be accounted for as a secured
borrowing. As a general matter, most standard repo transactions fail one
or both of these criteria and, therefore, are accounted for as
financings.
In the case of repos, one of the
relevant tests for assessing effective control relates to the amount of
cash collateral that has been provided, relative to the value of the
securities transferred. The rationale behind this condition is that the
counterparty has promised to return the securities, but even if it
defaults, the arrangement provides for sufficient cash collateral at all
times, so that the company could buy replacement securities in the
market.
My understanding of Lehman’s Repo 105
and 108 transactions is based on what I have read in the Examiner’s
report, press accounts, and other reports. Lehman apparently engaged in
structured transactions, known within Lehman as "Repo 105" and "Repo
108" transaction.
to temporarily remove securities
inventory from its balance sheet, usually for a period of seven to ten
days. Lehman reported its Repo 105 and Repo 108 transfers as sales
rather than secured borrowings. The cash received in the transfers was
used to pay down liabilities.
Lehman reported its Repo 105 and Repo
108 transactions as sales rather than secured borrowings, apparently by
attempting to structure the transactions so as to try to support the
following conclusions:
(a) That the transferred securities had
been legally isolated from Lehman (based on a true sale opinion from a
U.K. law firm), and
(b) That the collateralization in the
transactions did not provide Lehman with effective control over the
transferred securities.
Based on the Examiner’s report, Lehman’s
Repo 105 and Repo 108 transactions were structurally similar to ordinary
repo transactions. The transactions were conducted with the same
collateral and with substantially the same counterparties.
3
3 Report of Anton R. Valukas,
Examiner, United States Bankruptcy Court Southern District of New York,
In re Lehman Brothers Holdings Inc., et al., Debtors, March 11, 2010,
v3, pg. 746.
Additionally, the following two points
may be relevant to the analysis of Lehman’s accounting for Repo 105 and
Repo 108 transactions.
First, the assessment of legal isolation
may have only considered whether the securities were isolated from a
U.K. subsidiary, as opposed to the consolidated U.S. entity. We
understand that, at least in some cases, the securities were first
transferred from a U.S.-based entity to a U.K. subsidiary, and were then
repoed with a counterparty in the U.K. Attorneys have told us that there
are significant legal differences in how repo transactions are viewed in
the event of the insolvency of a repo seller under U.S. and English
laws. In the United States, case law related to repurchase transactions
has been varied enough that most attorneys generally would not provide a
true sale opinion. In England, there is apparently significantly less
uncertainty about how a transfer related to a repo would be viewed by a
court of law in the event of the insolvency of the repo seller
(transferor). Under English law, a transfer in which the documents
clearly demonstrate a seller intends to transfer outright to the buyer
his entire proprietary interest in an asset apparently would be
considered a true sale.
We understand that the opinion prepared
by the English law firm may have limited applicability and pertains only
to the portion of the transaction executed by the U.K. subsidiary with
the repo counterparty. It is not clear that claims could not be pressed
in another jurisdiction such as the U.S., since the securities were
registered in the U.S. and it is not clear whether the transfer from
Lehman to its U.K. subsidiary would be deemed to be a true sale under
U.S. law. It is also not clear that the transfers would have resulted in
isolation (including in bankruptcy) of the transferred assets from the
consolidated Lehman entity, not just the U.K. subsidiary, and thus any
legal analysis would likely need to address all relevant jurisdictions
including U.K. and U.S. law.
4
Second, with respect to the level of
collateralization in the arrangement, Lehman apparently took a discount
on the face value of the transferred assets (known as a "haircut")
offered to the counterparty. Instead of transferring approximately $100
worth of securities for every $100 of cash received, Lehman transferred
$105 worth of debt securities or $108 of equity securities for every
$100 in cash received (hence, the names Repo 105 and Repo 108). It
appears that Lehman structured the transactions in an attempt to support
a conclusion that there was inadequate cash collateral to ensure the
repurchase of the securities in the event of a default by the
counterparty, and, on that basis, Lehman determined that sale accounting
was appropriate. Under sale accounting, Lehman
(a) Removed the transferred securities
from its balance sheet,
(b) Recognized the cash received, and
(c) Recognized the difference ($105 or
$108 securities derecognized less $100 cash received) as a forward
purchase commitment.
When developing the guidance for
determining whether a company maintains effective control over
transferred assets, the FASB noted that repo transactions have
attributes of both sales and secured borrowings. On one hand, having a
forward purchase contract—a right and obligation to buy an asset—is not
the same as owning the asset. On the other hand, the contemporaneous
transfer and repurchase commitment entered into in a repo transaction
raises questions about whether control actually has been relinquished.
To differentiate between the two, the FASB developed criteria for
determining whether a company maintains effective control over
securities transferred in a repo transaction.
As noted above, one of those criteria
requires a company to obtain adequate cash or collateral during the
contract term to be able to purchase replacement securities from others
if the counterparty defaults on its obligation to return the transferred
securities ("collateral maintenance requirement"). The accounting
guidance provides the following example of a collateral maintenance
requirement that does maintain effective control:
Arrangements to repurchase securities
typically with as much as 98–102% collateralization, valued daily and
adjusted up or down frequently for changes in market prices, and with
clear powers to use that collateral quickly in the event of the
counterparty’s default, typically fall clearly within that guideline.
The accounting guidance emphasizes the
need for understanding the terms of a repo agreement and applying
judgment in other situations to determine whether a company maintains
effective control over the transferred securities. That example was not
intended to, nor does it, create a "bright-line" for making that
determination. Rather, the example describes typical collateral
arrangements in repurchase agreements involving marketable securities
indicating that these typical arrangements clearly result in the
transferor maintaining effective control over the transferred
securities.
The accounting guidance for repos has
been in place since 1997 and has not been changed significantly over the
years.
5
When there are material structured or unusual transactions,
disclosure is also very important. The Examiner’s report indicates that
Lehman’s disclosure was incorrect and misleading. According to the
Examiner’s report, Lehman disclosed that it accounted for all repos as
secured borrowings.
Accounting and Reporting Standards for Consolidation of
Special-Purpose Entities
A recent press account indicates that
Lehman used a small company run by former Lehman employees apparently to
shift investments off its books.
4
Based on that press
account, it is not possible to determine whether that company was an
operating business or a special-purpose entity (SPE). Although the press
account does not describe whether and how the presence of related
parties may have affected Lehman’s consolidation analysis, consolidation
accounting standards require consideration of related parties and
de-facto agents in the consolidation analysis. In addition, accounting
standards require companies to disclose significant related party
transactions and de-facto agent arrangements.
4 Article in New York Times on
April 13, 2010, titled Lehman Channeled Risks Through "Alter Ego"
Firm.
The financial crisis revealed that
accounting standards governing which entity must recognize and report
interests in SPEs were inadequate to protect against "surprise" risks to
institutions that had treated these entities as "off balance sheet."
Before the recent changes to the accounting standards on consolidation
described below, certain entities were exempt from consolidation
requirements. Those exemptions assumed that some SPEs (including
mortgage trusts) could function on "autopilot," in which no entity was
deemed to be in control of such SPEs. This assumption has not been borne
out in the recent period of severe stress in the mortgage market.
Consolidation requirements before the recent changes had a simple
concept that a company should consolidate an SPE if it has the majority
of risks and/or rewards of that entity. However, the implementation of
this concept was effected through complex mathematical calculations that
often excluded the effect of key risks such as liquidity risk. With the
benefit of hindsight, it seems that judgments were made based on overly
optimistic forecasts of returns and risk, enabling companies to avoid
consolidating entities in which they retained significant continuing
risks and obligations. While there were numerous required disclosures
under generally accepted accounting principles and SEC rules, many
financial companies failed to clearly disclose retained risks,
obligations, and involvements with SPEs.
Also, with the benefit of hindsight, it
appears that arrangements were structured to achieve the desired
outcomes of removing financial assets and obligations from balance
sheets and reporting lower ongoing risk and leverage. From an investor’s
viewpoint, this obfuscated important risks and obligations.
To address this, the FASB, at the
request of the SEC, completed targeted projects that resulted in
removing the exemption for certain entities from consolidation
requirements (FAS 166 on transfer of financial assets) and in tightening
the requirements governing when such entities should be consolidated (FAS
167 on consolidation of variable interest entities). In addition, the
FASB enhanced disclosure requirements to improve disclosure of a
company’s
6 The
enhanced disclosure requirements became effective in December 2008.
April 21, 2010 reply from Bob
Jensen
Hi Paul,
One thing
the FASB letter fails to demonstrate is how Lehman’s Repo sales
could possibly serve any economic purpose other than to deceive,
especially sales that only took place just prior to balance sheet
reporting dates.
The letter
reads like an attempt to get E&Y off the hook, although one
paragraph of the FASB’s letter must be disturbing to the auditors
about failures to disclose:
“When there are material structured or unusual transactions,
disclosure is also very important. The Examiner’s report
indicates that Lehman’s disclosure was incorrect and misleading.
According to the Examiner’s report, Lehman disclosed that it
accounted for all repos as secured borrowings.”
Page 5 of the FASB letter
Another
disturbing paragraph of the FASB letter reads as follows:
“A recent press account indicates that Lehman used a small
company run by former Lehman employees apparently to shift
investments off its books. Based on that press account, it is
not possible to determine whether that company was an operating
business or a special-purpose entity (SPE). Although the press
account does not describe whether and how the presence of
related parties may have affected Lehman’s consolidation
analysis, consolidation accounting standards require
consideration of related parties and de-facto agents in the
consolidation analysis. In addition, accounting standards
require companies to disclose significant related party
transactions and de-facto agent arrangements.”
Page 5 of the FASB letter.
It seems to
me there is also something that the standard setters have to change.
If it is virtually certain that nearly all of the Repo sales are
coming back (e.g., because terms of the sales returns are
exceedingly attractive), the it should be explicit that either the
sales are not to be reported as sales or if they were reported as
sales then full disclosure is required as to the price, timing, and
likelihood of the repossessions.
There is
such a thing as the letter of the law and the spirit of the law. In
my viewpoint, the Lehman Repos were only intended to deceive
investors and regulators. The smoking gun here is the timing of the
repo sales around the balance sheet dates. It would be far less
suspicious if most of the Repos sales took place after the balance
sheet dates.
If
the FASB does not add more explicit disclosure requirements to Repo
sales transactions then we’ve got a sorry FASB that needs to be
replaced by the IASB. Also the FASB's accounting requirements for
SPEs, SPVs, VIEs, or whatever you want to call them are still
convoluted and explosive ---
http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm
Bob Jensen
Lehman's Ghost Has
Been Named "Debt Masking"
The initials DM, however, stand for "Deception
Manipulation"
The
Securities and Exchange Commission is considering new rules that
would prevent financial firms from masking the risks they take by
temporarily lowering their debt levels before quarterly reports to
the public are due.
SEC
Chairwoman Mary Schapiro's disclosure, at a hearing of the House
Committee on Financial Services, came two weeks after The Wall
Street Journal reported that 18 large banks had consistently lowered
one type of debt at the end of each of the past five quarters,
reducing it on average by 42% from quarterly peaks.
That
practice, if done intentionally to deceive, already violates SEC
guidelines, an official said. But now, the SEC is weighing requiring
stricter disclosure and a clearer rationale from firms about their
quarter-end borrowing activities. The agency may also extend these
rules to all companies, not just banks.
Excessive
borrowing by banks is widely considered to be one of the causes of
the financial crisis, leading to bank runs in 2008 on firms
including Bear Stearns Cos. and Lehman Brothers. Since then, banks
have grown more sensitive about showing high levels of debt and
risk, worried that their stocks and credit ratings could be
punished.
Tuesday's
hearing focused on a recent report by a bankruptcy examiner that
found that Lehman Brothers, through transactions the firm dubbed
"Repo 105s," had hidden its true debt levels before its collapse by
treating certain loans as sales, thus reducing its end-of-quarter
debt levels.
Rep.
Gregory W. Meeks (D., N.Y.) asked Ms. Schapiro about The Journal's
findings regarding banks' end-of-quarter debt reductions. "It
appears investment banks are temporarily lowering risk when they
have to report results, [then] they're leveraging up with additional
risk right after," Mr. Meeks said. "So my question is: Is that still
being tolerated today by regulators, especially in light of what
took place with reference to Lehman?"
Ms.
Schapiro said the commission is gathering detailed information from
large banks, "so that we don't just have them dress up the balance
sheet for quarter end and then have dramatic increases during the
course of the quarter."
She added:
"We are considering whether...we need new rules to prevent sort of
the masking of debt or liquidity at quarter end, as we saw Lehman do
with the Repo 105 transaction."
Under
current rules, bank holding companies are required to disclose their
average debt balances in their annual reports. The SEC is
considering extending this disclosure requirement to all companies,
an SEC official said. The SEC is also mulling whether those figures
should be made public to shareholders every quarter rather than just
once a year, the official said.
Currently,
companies are required every quarter to discuss their readily
available cash, or liquidity, as well as any important changes to it
and any efforts they're undertaking to address liquidity problems.
If a company used a transaction at the end of the quarter to
temporarily reduce debt or increase liquidity in a significant way,
the SEC official said, the company would be required under current
rules to disclose that.
The SEC
official said the goal of any new rules would be to give
shareholders a better sense of financial institutions' actual debt
levels. The official said the agency is concerned companies are
misleading investors if what they are disclosing at the period end
doesn't reflect what the true activity was during the period. The
official said they are considering whether to shed more light on the
intra-period levels, for example, by requiring companies to disclose
what the high debt level was during the period. The SEC is analyzing
responses to the letters before formally proposing new rules.
The Journal
story focused on weekly disclosures filed with the New York Federal
Reserve Bank by 18 major banks that are known as "primary dealers"
because they trade directly with the central bank. The reports
detail money the banks have lent and borrowed on the repurchase, or
"repo," market, where short-term loans are made in exchange for
collateral such as treasury bonds and mortgage-backed securities.
The list of primary dealers includes the U.S. brokerage units of
J.P. Morgan Chase & Co., Citigroup Inc., Goldman Sachs Group Inc.,
Morgan Stanley and Bank of America Corp. Because the weekly figures
released by the Fed reflect aggregate repo borrowing by all the
banks, it is impossible to determine the behavior of any one bank.
Some banks
privately confirm that they lower their borrowing activities at
quarter end, but others deny doing so. Several pointed to their SEC
filings, which disclose average asset levels and end-of-period asset
levels during the course of a year. Those figures, the firms say,
tell investors that risk and indebtedness vary during a given
quarter.
The latest
New York Fed data show that in the first week of this year's second
quarter, the 18 banks had together raised their net borrowings on
the repo market by 8% from the total that was reported on March 31.
In a
statement, a Goldman representative denied that the firm's
risk-taking in the repo market was masked, adding that "normal
fluctuations in the size of our balance sheet...are fully disclosed
in our quarterly and annual SEC filings."
J.P. Morgan
said that in five out of the past six quarters, repo financing
levels at its U.S. brokerage firm—which accounts for about 15% of
its total assets—either rose or stayed flat at the end of the
quarter.
A Morgan
Stanley spokeswoman said: "Over the past five quarters, our
quarter-end repo balances are virtually identical to our average
quarterly balances."
Citigroup
and Bank of America declined to comment.
A
spokeswoman for the New York Fed cautioned that the repo data
"reflects only a portion of a firm's total assets and liabilities"
and noted that the Fed requires additional reporting of firm-wide
figures.
Some on
Wall Street reacted strongly to the end-of-quarter declines in repo
financing revealed by the Fed data. "The fact that window-dressing
produces distorted financial data (both for individual firms and for
the system as a whole) is unhealthy," wrote Lou Crandall, chief
economist at research firm Wrightson ICAP LLC, in a note reviewing
the Fed data last week.
Bob: The FASB seems to be making
much more of an effort recently to emphasize and practice
'neutrality' in standard setting. The proposed new conceptual
framework features the neutrality principle more centrally, and does
not feature traditional sources of bias (such as conservatism and
matching). I think that the letter is consistent with this
philosophy.
At a recent speaking engagement,
Bob Herz underscored more than once your point about the respective
roles of the SEC vs. the FASB. Bob stated that the SEC is the
regulator, their role being to oversee and control certain business
practices and reporting. The FASB is not a regulator - it is the
accounting standard-setter - and its role is not, under law and the
neutrality principle, to oversee and control business practices; its
role is limited to setting standards for reporting. As a result,
they discuss standard setting in terms of achieving transparency and
disclosure for investors, and not to achieve business
practice-related ends per se.
Paul
April 22, 2010 reply from Bob Jensen
Hi Paul,
FAS 133, for example, was
neither a neutral nor an unbiased standard. It greatly impacted the
use of derivative financial instruments for both financial
speculation as well as hedging purposes.
Perhaps the neutrality goal is
to have zero consequences, but it’s literally impossible in many
instances to require better disclosures, changed principles for
principles-based standards, and even bright lines for booking
without having economic consequences and impacts on behavior.
If you change the basis of
keeping score or of calling fouls, it’s inevitable that the way the
game is played will change. Think of what changing long shots from
two to three points per basket did for basketball. Think of what
penalties, sometimes very severe penalties, for driving helmet shots
did for tackling and blocking behavior in football.
Denny Beresford noted that
economic consequences are often inevitable in a great article years
ago about neutrality (that relates neutrality more to bias than to
consequences). I might contend that even bias is permitted when it
is in favor of the users of financial statements. I think this is
what Denny contends as well.
Neutrality is the quality
that distinguishes technical decision-making from political
decision-making. Neutrality is defined in FASB Concepts Statement 2
as the absence of bias that is intended to attain a predetermined
result. Professor Paul B. W. Miller, who has held fellowships at
both the FASB and the SEC, has written a paper titled:
"Neutrality--The Forgotten Concept in Accounting Standards Setting."
It is an excellent paper, but I take exception to his title. The
FASB has not forgotten neutrality, even though some of its
constituents may appear to have. Neutrality is written into our
mission statement as a primary consideration. And the neutrality
concept dominates every Board meeting discussion, every informal
conversation, and every memorandum that is written at the FASB. As I
have indicated, not even those who have a mandate to consider public
policy matters have a firm grasp on the macroeconomic or the social
consequences of their actions. The FASB has no mandate to consider
public policy matters. It has said repeatedly that it is not
qualified to adjudicate such matters and therefore does not seek
such a mandate. Decisions on such matters properly reside in the
United States Congress and with public agencies.
The only mandate the FASB
has, or wants, is to formulate unbiased standards that advance the
art of financial reporting for the benefit of investors, creditors,
and all other users of financial information. This means standards
that result in information on which economic decisions can be based
with a reasonable degree of confidence.
A fear of information
Unfortunately, there is
sometimes a fear that reliable, relevant financial information may
bring about damaging consequences.
But damaging to whom? Our democracy is based on free dissemination
of reliable information. Yes, at times that kind of information has
had temporarily damaging consequences for certain parties. But on
balance, considering all interests, and the future as well as the
present, society has concluded in favor of freedom of information.
Why should we fear it in financial reporting?
Jensen Comment
In my viewpoint the FASB can change the repo sales rules for more
transparency regarding “debt masking” disclosures by arguing that
debt masking secrecy is unnecessarily deceptive for investors and
creditors and regulators. I can’t imagine that the FASB would
justify not changing FAS 140 in grounds of neutrality after having
been witness to Lehman’s deceptive use of FAS 140 (according to the
Bank Examiner’s report). FAS 140 could be changed by simply
requiring more disclosures on circumstances surrounding relatively
large repo sales transactions, disclosures that explain the terms of
the buy-back contracts and the likelihood of having to buy them
back. This should be no more complicated than estimating loan losses
and bad debt reserves.
In some ways a repo sales
contract is like a written option where the writer of the option has
no control over when and if the buyer of the option will exercise
the option. However, repo sales contracts do not meet the technical
definition of derivatives, because the notional is entirely at risk
whereas in option contracts the risk is usually only a fraction of
the total notional. But we still require booking of written options
and maintaining them at fair value even though control has been
passed to the buyer of the options and not the seller of the
options.
In FAS 140 and in the recent Herz letter on Lehman’s Repo 105 accounting, it seems to me that the
FASB is overplaying a “control” argument that is inconsistent with
FAS 133 treatment of written options not allowed to have hedge
accounting. Control is not the issue in FAS 133. What is the issue
of the booking and disclosure of financial risk of derivative
financial instruments.
Financial risk disclosures
should nearly always dominate FASB reasoning even if neutrality is
at stake. This should apply to repo sales contracts as well as
derivative financial instruments.
FAS 133, for example, was
neither a neutral nor an unbiased standard. It greatly impacted the
use of derivative financial instruments for both financial
speculation as well as hedging purposes.
Bob Jensen
Hi Pat,
Never say never. Auditors can
certainly uncover intent, and often they can do so by asking. If the
client refuses to answer, then that is certainly an incentive to probe
deeper into the audit questions.
Auditors are responsible to fully
understand the transactions and circumstances affecting those
transactions.
In many instances, the client
mentions intent to the auditors hoping that the auditors can devise a
way to meet that intent in the accounting rules. I’ve no idea if the CFO
of Lehman, a former E&Y audit partner, spelled out the leverage problem
faced by Lehman and requested ideas from Lehman’s auditors. But this
would not necessarily be an unusual request.
In any case it is highly unlikely
that E&Y auditors did not fully understand the real reasons behind the
Repo 105 transactions and the timing of those transactions (even if some
of those transactions arose in quarterly review periods rather than full
audit periods).
It’s a huge stretch to assume that
E&Y auditors did not fully understand intent of the Repo 105
transactions.
And ignorance is generally a poor
defense in court no matter what the circumstances, especially when the
defendants are professional experts in such matters.
Begin Quote (about how top
financial executives at Lehman were former E=&Y auditors of Lehman) That kind of comfort
and confidence in your client and their technical competence comes from
a long, lucrative relationship. But it must have been more than that.
It could not have possibly come from confidence in the CFO suite, given
its revolving door and the lack of accounting interest and aptitude in
later years.
No.
Ernst and Young’s confidence in Lehman’s CFO leadership was rooted in
fraternity. Both Christopher O’Meara and
David Goldfarb,
his predecessor who was CFO from 2000 to 2004, are Ernst and Young
alumni. Prior to joining Lehman Brothers in 1994, Mr. O’Meara worked as
a senior manager in Ernst & Young’s Financial Services practice. Prior
to joining Lehman Brothers in 1993, Mr. Goldfarb served as the Senior
Partner of the Ernst & Young’s Financial Services practice, where he
worked from 1979 to 1993.
Mr. Goldfarb, the former EY Senior Partner, was the
Lehman CFO who created the Repo 105 transactions.
End
Quote
Frank Partnoy and Lynn Turner contend that Wall Street
bank accounting is an exercise in writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be
Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy,
Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!
Dave's pictorial is very cute. But a better example would be to show
Barbie reducing her weight from 32 to 1 leverage to about 30.5 to 1
leverage. Of course, that wouldn't have looked very dramatic just like the
Repo 105 transaction had hardly any impact on Lehman's leverage.
Denny Beresford
April 24, 2010 reply from Bob Jensen
That’s a very good point Denny! I do appreciate the
details on how little Lehman got prettier at closing time from “32 to 1
leverage to about 30.5 to 1.”
But your message begs the question: If diet pills
(Repos 105 transactions) were virtually worthless for losing weight
(improving leverage attractiveness at closing time), why take these
potentially dangerous pills in the first place?
And why do so only at quarterly “closing times”?
Of course we might recall the Mickey Gilley’s song
lyrics
"Don't the Girls All Get Prettier at
Closing Time?"
http://www.youtube.com/watch?v=j6ltTzLMgJQ
But that might be extending the concept of bookkeeping’s “closing time”
diet pills a bit too far.
And now would probably not be a good time to also recall that “it’s never
over ‘til the fat lady sings.”
Perhaps you can give us more perspective on why
Lehman's CFO purportedly invented Repo 105 contracts if he knew in advance
that the benefits to leverage attractiveness were not significant at closing
times. Seems like a whole lot trouble and risk in accounting if nobody will
ever notice the weight loss at closing time.
I repeat my argument criticizing the FASB’s “control
reasoning” in the FAS 140 standards. The major justification for allowing a
repo contract to be booked as a sale seems to be that the buyer rather than
the seller "controls" when and if the purchased items are returned to
the seller (which was a virtual certainty in Lehman’s case since the rate of
return as very high to the temporary owner of the securities for a matter of
days.)
The FASB reasons inconsistently with respect to "control."
FAS 133 requires booking and maintaining written options at fair value even
though the seller of the option loses control. It’s the buyer of the option,
especially an American option, who determines if and when the option is
exercised. The buyer has less control in a European option contract, but
American options are vastly more popular in the United States.
When Chrysler sells a SUV’s power train, the
buyer over his/her entire lifetime has control over if and when the
power train is returned. Of course in this case, tradition in accounting
allows the initial sale to be booked as a sale. But accounting rules also
require that warranty reserves be booked with realistic estimates as to the
cost a percentage of the power train parts that will have to be replaced
over the expected lifetimes of all buyers. Of course in the case of
Chrysler, the government has set up a multi-billion warranty fund for
replacing Chrysler power trains or entire cars if Chrysler should eventually
tank. Taxpayers should be grateful that Hank Paulson did not set up a
similar government warranty fund for Lehman’s Repo 105 returns.
It would seem that in FAS 140 the FASB should’ve
required some type of accounting for the financial risk of a seller having
to repossess the contracted item. In the case of Lehman’s Repo 105 contracts
it was 99.99999% certain the “sold” securities would be returned in a matter
of days.
The FASB apparently did not anticipate that FAS 140
would be used to “mask debt” at closing times, and it would seem that the
FASB should now act quickly in the interest of investors to devise some rule
for greater transparency of repo contract sales. Perhaps something like
warranty reserves will suffice. Or perhaps, merely FASB-mandated repo sales
disclosures will suffice where the company must disclose the contracted
return price, the contracted return period, and the estimated amounts that
will be paid out for the repossessions.
I realize that the matching concept reasoning is no
longer politically acceptable. However, AC Littleton would’ve argued that
the $5 cost in the $105 might be better matched to the sales revenues if the
cost is to be incurred a few days after the sale. Keep in mind that if
Lehman called the $5 an interest expense, the Repo 105 contracts would
violate usury laws in most of our 50 states (South Dakota being an
exception).
Once again Denny, I do appreciate the details on how
little Lehman got prettier at closing time from “32 to 1 leverage to about
30.5 to 1.” And the resolution of issues raised in the Lehman Bankruptcy
Examiner’s Report won’t end until “the fat lady sings.”
I agree with Bob’s assessment of the
lack of effectiveness of the control criteria as being the
appropriate criteria for recognition or derecognition of assets. As
Walter Schuetze once remarked to me, “legal form is economic
substance.” In this context, changes in legal ownership of the
securities should determine how a repo is accounted for—“effective
control” is an even more dubious concept than “control.”
However, I disagree with Bob on two
other points.
First, in accounting for the $5 in the
Lehman repo 105, you need to consider it together with the initial
fair value of the forward contract to repurchase the transferred
securities. I would imagine that if you fair valued the asset
component separately from the liability component of the forward
contract, they would not be equal.
Second, as Shayam Sunder wrote, “unlike
a uniform system of weights and measures, the conduct of business
changes in response to the accounting rules applied.” The FASB has
a responsibility to anticipate abuses, and Congress should ask
whether the FASB can do a better job in anticipating abuses of
complex, rules-based standards with highly subjective criteria. I
am not ready to conclude that the FASB should be resolved of
responsibility for these abuses without looking at their due
diligence records.
I think you
misinterpreted my point. My point is that the term “forward
contract” implies that the contract is a derivative. Since Lehman’s
Repo 105 contract is not a derivative, it must be called something
else. That’s all I meant.
With respect to
your proposed solution, I would have to study more on the issue of
repo contracts in practice. In particular, how frequently are these
contracts used in situations where repossession is only a very
remote possibility? It would be great if somebody who mines big
databases could provide more information upon how other companies
use repo contracts, what accounting disclosures are provided about
such contracts, etc. It would be helpful to know more about why the
FASB embedded repo sales in FAS 140. Surely some industry groups
were lobbying the FASB and making arguments for allowing repo
contracts to be accounted for as sales.
I think Lehman’s
purported “debt masking” using the Lehman Repo 105 invention is an
outlier among possible repo contracts and may not even be a
good example of the more common types of repo contracts. Lehman’s
Repo 105 contracts have a fixed return price and a very short (maybe
two weeks?) return horizon. What about repo contracts with longer
time horizons such as five or ten years? What about repo contracts
where the returns vary under some type of time amortization? What
about repo contracts that depend upon some contingency event with
regard to the return and/or the price paid for the repossession?
It may very well
be that some repo contracts can be structured as derivative
financial instruments scoped into FAS 133. For example, repossession
could possibly be contracted as a written option based upon some
underlying.
If I were to
approach rewriting a standard for repo contracts I would first of
all state that whenever the contracts fall under some other standard
such as FAS 133, that those other standards dictate the accounting
treatment. For repo contracts not covered by other standards, then I
would break them down into those with a fixed return price, those
with a fixed amortized price, and those with variable and uncertain
return prices. Then I would have to give more thought on how
investors might best be served under the various types of
repossession contract alternatives. It may well be that when
repossession has a low probability (similar to the case for bad
debts and warranties), then perhaps what should be done is to
currently expense the present value of expected future losses much
like is done with warranty reserve accounting.
I don’t think
Lehman’s Repo 105 contracts should even be called sales if and when
the FASB revises FAS 140. It is inconsistent with the entire history
of accounting to book the “sale” of an item as a sale if it’s
certain to be returned in a matter of days. When Sears sells a dress
that’s returned in two days, the original sale was booked as a sale,
but the probability of the dress being returned is relatively low.
This is not the same as if all dresses sold are certain to be
returned.
Perhaps a fixed or
amortized price repo contract in many instances contract is better
accounted for as a lease. However, I hesitate to call Lehman’s Repo
105 contracts leases since the “lessee” really is not getting an
item with any utility other than the anticipated return price. The
item itself need not even be moved from storage between when the
lease period begins and ends. That begins to look more like a “bill
and hold” transaction. Perhaps Lehman’s Repo 105 contracts should be
accounted for as “bill and holds” ---
http://www.trinity.edu/rjensen/ecommerce/eitf01.htm#BillAndHold
In any case, I
hope the FASB is re-studying the entire realm of repo contracts
found in practice. Then I hope that repo contracts that are
tantamount to debt masking are no longer accounted for under present
FAS 140 rules.
One person wrote
that the Lehman Repo 105 is nothing other than channel stuffing. I
might be inclined to agree if what Lehman really intended was to
push up sales ---
http://www.trinity.edu/rjensen/ecommerce/eitf01.htm#ChannelStuffing
However, I don’t think the motive in Lehman’s case was to inflate
sales. Rather the purpose seems to be more balance sheet related in
an effort to mask debt.
Perhaps the best
alternative standard in this particular case really is a
principles-based standard rather than a bright line standard. The
principle would be for the accounting to be fully transparent with
respect to the intent of the “seller” of the item and on the other
side of the coin the “buyer” of the item. Perhaps repo contracts are
just too varied in practice to embrace in a single standard other
than maybe a principles-based standard. There should be a proviso,
however, that if the contract really is a derivative or a lease or
insurance or whatever, the accounting should conform to the standard
that is written for that particular type of contract.
I think any
reasonable criteria for ownership and control was not met in the
Lehman Repo 105 situation. Why? Lehman continued to collect the
coupon on the underlying securities per the bankruptcy examiner's
report. There were major machinations required on both the Lehman
side and the counterparty's side to present one thing for financial
reporting purposes and to ignore the reality that the securities
were most likely still recorded on the Lehman subsidiary investment
accounting systems. Otherwise, how to match up the coupon with a
CUSIP? It's enough to make me dizzy. Any objective regulator or
watchdog/gatekeeper as the auditors should be should have cringed
and called a fake on the sale treatment.
If you are a regular reader of this site, you
may remember the first time I warned you about the poor disclosure
practices surrounding repurchase risk. It was all the way back in March
of 2007 and I was referring to the lack of disclosures surrounding New
Century Financial. I warned you again seven months ago that another KPMG
client, Wachovia/Wells Fargo, has the same disclosure issues with regard
to repurchase risk. The latest announcements of potentially material
losses due to forced repurchases of mortgages from Fannie Mae (Deloitte)
and Freddie Mac (PwC) were made by JP Morgan and Bank of America – both
audited by PwC. Maybe ya’ll should kick the tires a little more on
Citibank’s big comeback
The facts
of life continue to give discomfort to the FASB. When Anton Valukas
criticized Lehman Brothers, there was plenty of disparagement left
over for the FASB and the SEC. After all, when ambiguity exists in
financial accounting rules, we shouldn't be surprised when managers
take advantage of these ambiguities.
That’s, of
course, assuming there are ambiguities. Given that Lehman’s
transactions have no business purpose and were designed merely to
deceive the investment community, maybe ambiguity is not the issue
to debate.
FAS 140
dealt with accounting for the transfer of financial resources.
Essentially, the board said that such a transaction should be
treated in either of two ways. If the transfer shifted control of
the resource to another entity, then one should account for the
transaction as a sale. The cash is recorded, the financial resource
is taken off the books, and a gain or loss is recorded. If the
transfer does not shift control of the resource to another entity,
then one should account for the transaction as a secured borrowing.
The cash is recorded, but the firm also records a liability. No gain
or loss is recorded; and the financial resource stays on the books.
(As an
aside, I find it frustrating that virtually all reporters misstate
the accounting issue. Consider this sentence as an example. “The
transactions allowed Lehman to temporarily remove some $50 billion
in assets from its balance sheet, presenting a stronger financial
picture than existed.” If they would only use some common sense. If
one applies for a mortgage on a house he or she is buying, do you
think the bank will be impressed if they show less assets?)
FAS 140
goes on to spell out some criteria for assessing whether control has
been transferred. Paragraph 9 spells out these criteria:
“The
transferor has surrendered control over transferred assets if and
only if all of the following conditions are met:
a. The
transferred assets have been isolated from the transferor—put
presumptively beyond the reach of the transferor and its creditors,
even in bankruptcy or other receivership (paragraphs 27 and 28).
b. Each
transferee (or, if the transferee is a qualifying SPE (paragraph
35), each holder of its beneficial interests) has the right to
pledge or exchange the assets (or beneficial interests) it received,
and no condition both constrains the transferee (or holder) from
taking advantage of its right to pledge or exchange and provides
more than a trivial benefit to the transferor (paragraphs 29−34).
c. The
transferor does not maintain effective control over the transferred
assets through either (1) an agreement that both entitles and
obligates the transferor to repurchase or redeem them before their
maturity (paragraphs 47−49) or (2) the ability to unilaterally cause
the holder to return specific assets, other than through a cleanup
call (paragraphs 50−54).”
For me, the
third condition nixes the sale-accounting executed by Lehman. The
asset was coming back to the firm, so it should have employed the
accounting for a secured borrowing.
But, Lehman
Brothers treated these transactions as sales and Ernst & Young
agreed. Did E&Y screw up or did its partners believe there was
enough ambiguity in the rules to allow managers to choose gain
accounting? Either FAS 140 is ambiguous or it is not. If so, we need
to tighten the rules considerably, as I discuss below. If not, then
society needs to hold some Lehman managers and some E&Y partners
accountable.
I wonder
whether the FASB could save its face and its political hide if it
just simplified the accounting. It could require business
enterprises to record the transaction as a secured borrowing in all
cases where the financial asset returns to the firm and in all cases
where there is even the possibility of its return.
The SEC
could help as well. It should require all firms who account for a
transfer of a financial asset as a sale and then receives it back,
in part or repackaged in any way, to issue an 8-K. Managers would
have to display for the entire world to see any and all phony sales
of financial assets, and they would have to explain why they did not
account for the transaction as a secured borrowing.
Last,
let us note that the problem would be compounded exponentially if
principles-based accounting were in place in the U.S. How could
anybody fault Lehman Brothers in a regime of principles-based
accounting? The managers could always retort that they were
following the me-first principle.
Ketz Me If You Can
Here's Professor Ketz's Bombshell We've All Been Waiting For: And
to Think I Was Shocked by Repo 105s Until Ed Wrote This
The
bankruptcy report by Anton Valukas has created quite a stir. Given
that we all knew about the demise of Lehman Brothers, what was the
surprise? Ok, he wrote about some fast and loose accounting tricks,
which are dubbed Repo 105 transactions. So what?
What I find
fascinating about managers at Lehman’s is not so much what they did,
but that the public is shocked—shocked!—at another accounting game.
As if these behaviors were going to stop!
On what
basis would the public believe that corporate accounting had become
the truth, the whole truth, and nothing but the truth? Maybe they
thought that Sarbanes-Oxley was the golden legislation that solved
all our problems. But, as most of the act was incremental changes
over previous dictates, that conclusion has exaggerated and
continues to exaggerate the reality.
Besides,
legislation today will never focus on the real issues of creating
incentives for managers to walk the straight and narrow, generating
disincentives for those who walk astray, and making sure these
things are enforced. In today’s partisanship, what happens depends
on who is in office. If it is the Republicans, they’ll talk about
ethics and close their eyes. If it is the Democrats, they will
ignore current violations and pass new legislation as they continue
to build the Great Socialistic Society. And neither party enforces
the law, unless you count the SEC’s fining of shareholders as
enforcement.
With fewer
accounting tricks, as documented by USA Today, maybe the public felt
that the tide had turned. Maybe it had, but the cycle continues.
Managers find accounting chicanery easier to carry out at some times
than others. Never mistake a lull in accounting tricks as their
cessation. It is merely a rest before a return to lies, damned lies,
and accounting.
Perhaps
people felt that the auditors were ferreting out fraud. While the
auditors at least have to worry about potential lawsuits, that
apparently does not mean that they are always skeptical of
management’s actions, even with a credible whistleblower. Audits in
the U.S. are better than audits in other countries, but there is
still room for improvement. Let’s not think that the auditors are
always vigilant.
Maybe with
stock market prices going up after an extended downturn, folks
started believing that the economy was resurging. I cannot share
that optimism for we have so many asset bubbles yet to burst. Even
if it were true, increasing stock market prices just accent the
perverse incentives in our economy, as corporate managers and
directors attempt to maximize their own wealth through share-based
compensation, and accounting is merely a tool to accomplish their
goals.
No, I don’t
see much reason for accounting frauds to cease. I laugh when I watch
television programs, listen to radio broadcasts, and read news
accounts and op-ed pieces that lash out at the rascals that
dominated Lehman Brothers. What are these people thinking? Why is
anybody shocked?
The
heart is deceitful above all things and desperately wicked—who can
understand it? Clearly, not those who are shocked at the revelations
by Valukas.
Round
trip loans. Director-approved balance sheet manipulation.
Window-dressing of accounts at period-end.
“The regulator said auditing firms needed to pay “particular
attention” to guidance that it had previously issued on
monitoring transactions taking place around year-end, as well as
the procedures expected to be followed by auditors…These
standards and guidance notes require auditors to scrutinize
“material” short-term deposits that are re-lent on broadly
similar terms, and loan repayments that are received shortly
before year-end and then subsequently re-advanced within a short
timeframe.
The
guidance notes emphasized that the auditors needed experience
and judgment to identify the implications of such transactions,
and assess whether they constituted attempts to engage in the
so-called “window-dressing” of accounts.”
If
that sounds like
Lehman Brothers, it’s because the kinds of
tricks and techniques used in that case, such as Repo 105, are
neither new nor unique.
The
PCAOB, the US regulator of public
accounting firms, tried to remind the firms at the end of December
2008 of their responsibilities in the “current economic
environment.”
In
an audit of internal control over financial reporting, the
auditor also should evaluate whether the company’s controls
sufficiently address the identified risks of material
misstatement due to fraud and controls intended to address the
risk of management override of controls. Controls that might
address these risks include:
Controls over significant, unusual transactions,
particularly those that result in late or unusual journal
entries;
Controls over journal entries and adjustments made in
the period-end financial reporting process;
Controls over related party transactions;
Controls related to significant management estimates;
and
Controls that mitigate incentives for, and pressures on,
management to falsify or inappropriately manage financial
results.
Repurchase
agreements recorded as loans are legal “round trip” financing tools,
often used to both improve liquidity as well as shuffle assets and
liabilities at period end to suit management’s objectives.
When disguised as “sales” without proper disclosure
and splashed like mud over and over in the
face of a skeptical attorney like
Anton Valukas,
Repo 105 transactions they gain high-class
call-girl-type notoriety that’s undeserved given their common whore
characteristics.
A
round-trip loan was used by
Refco executives to hide uncollectible
receivables. Three of their executives, as well as an outside
counsel, went to jail for that fraud.
In 2005,
Time-Warner paid a $300 million penalty, agreed to an anti-fraud
injunction and an order to comply with prior cease-and-desist order
and agreed to restate its financial results and engage independent
examiner. Their CFO, Controller and Deputy Controller also consented
to a cease-and-desist order.
“Beginning in mid-2000, stock prices of Internet-related
businesses declined precipitously as, among other things, sales
of online advertising declined and the rate of growth of new
online subscriptions started to flatten. Beginning at this time,
and extending through 2002, the company
employed fraudulent round-trip transactions that boosted its
online advertising revenue to mask the fact that it also
experienced a business slow-down. The round-trip transactions
ranged in complexity and sophistication, but in each instance
the company effectively funded its own online advertising
revenue by giving the counterparties the means to pay for
advertising that they would not otherwise have purchased.
To conceal the true nature of the transactions, the company
typically structured and documented round-trips as if they were
two or more separate, bona fide transactions, conducted at arm’s
length and reflecting each party’s independent business
purpose…”
Questions
How is bright-line-rule Repo accounting in 2008 like the
bright-line-rule “1% Solution” of a
decade earlier?
How can you "PUT" away your cares about clear-cut (bright
line) rules of accounting?
Answers
See how AOL did it in conspiracy with Goldman Sachs
With the AOL-Time Warner deal due to close in just three
months, Bertelsmann needed to reduce its AOL Europe holding -- pronto.
But the obvious buyer, AOL, didn't want to own more than 50% or more of
the venture, either. Going above half might trigger a U.S. accounting
rule that would force AOL to consolidate all the struggling unit's
losses on its books when AOL was already grappling with deteriorating ad
revenues and a declining stock price. Enter Goldman Sachs Group Inc. (GS
) Business Week has learned that the premier Wall Street bank agreed to
buy 1% of AOL Europe -- half a percent from each parent -- for $215
million. AOL Europe, in return, agreed to a "put" contract promising
Goldman that it could sell back the 1% by a specific date and at a set
price. That simple transaction solved Bertelsmann's EU problem without
trapping AOL in an accounting conundrum -- a perfect solution.
Goldman's 1% Solution
In 2000, it cut a questionable deal that smoothed the AOL-Time Warner
merger. Will the SEC take action?
In more ways than one, the news from the European Union
was bad. It was October, 2000, and the EU's executive arm, the European
Commission, had just jolted America Online Inc. with a ruling that its
pending acquisition of Time Warner Inc. (TWX
) could harm competition in Europe's media markets, especially the
emerging online music business. The EC was concerned that AOL was a
50-50 partner with German media giant Bertelsmann in one of Europe's
biggest Internet service providers, AOL Europe. Now the EC was ordering
Bertelsmann to give up control over AOL Europe.
With the AOL-Time Warner deal due to close
in just three months, Bertelsmann needed to reduce its AOL Europe
holding -- pronto. But the obvious buyer, AOL, didn't want to own more
than 50% or more of the venture, either. Going above half might trigger
a U.S. accounting rule that would force AOL to consolidate all the
struggling unit's losses on its books when AOL was already grappling
with deteriorating ad revenues and a declining stock price.
Enter Goldman Sachs Group Inc. (GS )
Business Week has learned that the premier Wall Street bank agreed
to buy 1% of AOL Europe -- half a percent from each parent -- for $215
million. AOL Europe, in return, agreed to a "put" contract promising
Goldman that it could sell back the 1% by a specific date and at a set
price. That simple transaction solved Bertelsmann's EU problem without
trapping AOL in an accounting conundrum -- a perfect solution.
LEGAL HEADACHES
Or so it seemed at the time. But the deal
also may have violated U.S. securities laws. The Securities A: Exchange
Commission and the Justice Dept. have construed some deals involving
promises to buy back assets at a specific time and price as
share-parking arrangements designed to mislead investors. The former
chief executive of AOL Europe says the Goldman deal may have kept up to
$200 million in 2000 losses off of the combined AOL-Time Warner
financials -- enough, he says, that Time Warner might have tried to
change the terms of the $120 billion merger, since AOL wouldn't have
looked as healthy. But as the deal moved toward consummation, the
Goldman arrangement was never disclosed in public documents to AOL or
Time Warner shareholders.
The AOL Europe transaction threatens to
create problems for Goldman Sachs. But it could also prolong the legal
headaches of Time Warner Inc., as the AOL-Time Warner combine is now
called. For the past two years, Time Warner has been in heated
negotiations with the SEC over AOL's accounting for advertising revenues
(BW -- June 7). Just as the SEC is wrapping up that case -- it could
warn Time Warner as early as this summer that it intends to bring civil
fraud charges -- the Goldman transaction raises troubling new questions
about AOL's financial dealings prior to the merger.
The SEC has not brought charges over the 1%
solution, and an SEC spokesman would not comment on whether the agency
is probing the deal. Time Warner spokeswoman Tricia Primrose Wallace
says the company will not comment on any part of the Goldman
arrangement. A lawyer for Stephen M. Case, AOL's chairman and CEO at the
time of the deal, referred questions to Time Warner. Thomas Middelhoff,
who was Bertelsmann's chairman at the time of the deal and negotiated
the AOL Europe joint venture with Case in 1995, says through a spokesman
that the sale of a 0.5% stake was "purely a financial technique" handled
by others. And Lucas van Praag, a Goldman Sachs spokesman, says: "We
handled this entirely appropriately. We don't believe there is anything
untoward here."
The University of California has joined with Amalgamated
Bank to file a lawsuit against AOL Time Warner Inc., claiming their
stakes have lost more than $500 million in value because the media
company allegedly lied about its financial condition.
The University of California, which dropped out of a federal
class-action suit against AOL earlier this month, filed the complaint
Monday in the Superior Court of California in Los Angeles. The
university and co-plaintiff Amalgamated Bank, a New York institution
that manages funds for several dozen union pension funds, are being
represented by Milberg Weiss Bershad Hynes & Lerach.
The plaintiffs allege that AOL Time Warner materially misrepresented its
revenue and subscriber growth after the merger of AOL and Time Warner in
January 2001. In two separate restatements in October and March, AOL
slashed nearly $600 million from previously reported revenue over the
past two years.
The University of California and Amalgamated allege that AOL's
admissions so far have been "too conservative," and that the company may
have overstated results by almost $1 billion.
In a March 28 filing with the Securities and Exchange Commission, AOL
Time Warner said it faces 30 shareholder lawsuits that have been
centralized in the U.S. District Court for the Southern District of New
York. The company said in the filing it intends to defend itself
"vigorously." The lawsuit filed by the University of California and
Amalgamated names several current and former AOL Time Warner executives,
as well as financial-services giants Citigroup and Morgan Stanley.
Citigroup is the parent of Salomon Smith Barney, now called Smith
Barney, which with Morgan Stanley allegedly reaped $135 million in
advisory fees from the AOL and Time Warner merger.
Defendants include Stephen Case, who resigned as chairman in January;
former Chief Executive Gerald Levin, who left the company in May;
current Chairman and Chief Executive Richard Parsons; and Ted Turner,
who recently stepped down as vice chairman.
The lawsuit claims they and more than two dozen other insiders sold off
$779 million in stock just after the merger closed but before the
accounting revelations that would cause the stock price to plummet.
The suit also
names AOL's auditor, Ernst & Young.
The University of California claims it lost $450 million in the value of
its AOL Time Warner shares, which were converted from more than 11.3
million Time Warner shares in the merger. At the end of 2002, the value
of the university's portfolio was at $49.9 billion.
“Gentlemen, not
one of you could have done this on your own. This was a team
effort.” Casey Stengel after the Mets 40-120 season.
Why didn’t the Big 4
audit firms warn that these obscenely over leveraged institutions
threatened our financial future? Why didn’t the auditors question,
push back, or raise objections to illegal and unethical disclosure
gaps? Every one of the failed or bailed out financial institutions
carried non-qualified, clean audit opinions in their wallets when
they cashed the taxpayers’ check.
Lehman Brothers.
Bear Stearns. Washington Mutual. AIG. Countrywide. New Century.
Citigroup. Merrill Lynch. GE Capital. GMAC. Fannie Mae. Freddie Mac.
The largest four
global audit firms – Deloitte, Ernst & Young, KPMG and
PricewaterhouseCoopers – have combined revenues of almost $100
billion dollars and employ hundreds of thousands of people. There’s
no hard proof they’re completely corrupt, but they’ve proven
themselves to be demonstrably self-interested and no longer
singularly focused on their public duty to shareholders.
Something is rotten
with the accounting industry.
America’s public
accountants – in particular, the Big 4 audit firms – aren’t
protecting investors. And no one is holding them accountable.
The crisis that
culminated in the near-collapse of the global financial system is
still the subject of Congressional hearings.
Last month the
Lehman Bankruptcy Examiner’s report told
us that there’s “sufficient evidence exists to support colorable
claims against Ernst & Young LLP for professional malpractice
arising from [their] failure to
follow professional standards of care.”
This weekthe Securities and
Exchange Commission charged Goldman Sachs and one of its vice
presidents with fraud for misleading investors by “misstating and
omitting key facts about a financial product tied to subprime
mortgages.”
That financial
product was a structured collateralized debt obligation (CDO) that
hinged on the performance of subprime residential mortgage-backed
securities (RMBS). Goldman Sachs, according to the SEC, failed to
disclose vital information about the CDO to investors. In
particular, John Paulson’s hedge fund, a Goldman client, played a
leading role in the
portfolio
selection process and the hedge fund took a short position against
the CDO, without disclosure to Goldman’s other clients.
In one of the most
egregious cases of auditor complacence during the financial crisis,
Pricewaterhouse Coopers LLP (PwC), the firm that audits both AIG and
Goldman Sachs, sat on the sidelines for almost two years while their
clients disputed the value of credit default swaps (CDS).
There’s been
no public explanation of how PwC presided over the
dispute between AIG and Goldman—a dispute
eventually pushed AIG to accept a bailout – without doing something
decisive to help resolve it. This long-running “difference of
opinion” between two of its most important global clients was
arguably material to at least one of them. Why didn’t PwC force a
resolution sooner based on consistent application of accounting
standards?
PwC was paid a
combined $230 million by the two firms for 2008 and remains the
“independent” auditor to both companies.
Gatekeepers?
Or foxes in the hen house?
The auditor’s role
is to be a gatekeeper. A watchdog. An advocate for shareholders.
This is their public duty.
This public trust is
subsidized by a government-sponsored franchise. All companies listed
on major stock exchanges must have an
audit opinion. Audit firms are meant to be shareholders’ first line
of defense, and they are hired by and report to the independent
Audit Committee of the Board of Directors.
And yet the same
audit firms that stood by and watched Bear Stearns and Lehman
Brothers fail – Deloitte and Ernst &Young – are recipients of
lucrative government contracts to audit or monitor the taxpayers’
investment in the bailed out firms. Deloitte, the Bear Stearns and
Merrill Lynch auditor, works for the US Federal Reserve system.
Ernst & Young, Lehman’s auditor, is working for the US Treasury on
the original $700 billion TARP program and with the Fed on the AIG
bailout.
Who are we
kidding?
America’s
auditors serve themselves. Focused on “client service” not
shareholder advocacy, they’ve remained above the financial crisis
finger-pointing fray. Call it skillful lobbying or
targeted political contributions… Either
way, regulators and legislators have been afraid of getting on the
auditors’ bad side.
Investment banks,
mortgage originators, commercial banks, and ratings agencies have
all been questioned about their role in the crisis. And the Big 4
public accounting firms work for all of them.
But when
accused of negligence, malpractice or complicity, the audit firms
frequently claim to have been duped. Do you believe them? The
industry is an oligopoly. That’s a $10 word for what happens when a
market
or
industry is dominated by a small number of
sellers who discuss their strategies in order to achieve common
objectives.
The Sarbanes Oxley
Act of 2002 (SOx) was enacted after the Enron debacle to restore
confidence in the audit profession. Instead, accounting firms reaped
huge financial rewards while enforcing SOx, until the tremendous
cost to America’s businesses forced regulators to lighten up and the
auditors to stand down.
But SOx had another
insidious byproduct: the misplaced belief that after Arthur
Andersen’s implosion, the remaining four global public accounting
firms were too important, and too few, to fail.
This fear of auditor
failure precludes any regulatory or legislative actions that might
precipitate the loss of another large accounting firm. What do you
get when there’s no timely or significant regulatory consequence to
repeated auditor malpractice and incompetence? Moral hazard. “Too
few to fail” has been as detrimental to capital markets as the
notion that some financial institutions are too big to fail.
Shareholders are harmed and investors lose confidence.
Every one of the
audit firms is a defendant in lawsuits for institutions that failed,
were taken over, or bailed out, in addition to several $1 billion
plus malpractice, fraud and Madoff-related lawsuits. Any one of
these “catastrophic” matters could threaten their viability.
However, regulators and the worldwide business community are
ignoring this threat or, worse yet, promoting liability caps.
Limiting liability only exacerbates moral hazard.
Can a crisis caused
by “catastrophic” disruption in audit service delivery be any worse
than the one they never warned us about? Why not face fears head on
and start re-writing the audit blank check – ineffective audit
opinions – before the plaintiffs’ bar does it for us?
Making unattractive assets disappear from corporate
balance sheets was one of the great magical tricks performed by
accountants over the last few decades.
Whoosh went assets into off-balance-sheet vehicles
that seemed to be owned by no one. Zip went assets into
securitizations that turned mortgage loans for poor credit risks
into complicated pieces of paper that somehow earned AAA ratings.
As impressive as those accomplishments were, they did
not make the assets vanish altogether. If you dug deep enough, you
could find the structured investment vehicle or the underlying
assets of that strange securitization.
Now there is another possibility in the world of
accounting magic. Did accountants find a way to make some assets
disappear altogether? Was it possible for everybody with an interest
in them to disclaim ownership?
Until recently, it never would have
occurred to me that companies would want to do that — particularly
if the assets in question were perfectly respectable ones. But now
that we have learnedLehman
Brothersdid
it, the question arises of how far the practice went.
Lehman’s reasons for doing it were simple: to mislead
investors into thinking the company was not overleveraged. Were
other firms doing that? Are they still? Lehman thought not, but no
one really knows.
Now theSecurities
and Exchange Commissionis
demanding that other firms disclose whether they did the same. If it
finds they did, the commission ought to go further and examine
whether there were conspiracies to make the assets vanish, thus
making Wall Street appear to be less leveraged than it was.
Lehman’s practices, outlined in a
bankruptcy examiner’sreportreleased
last month, showed the creative use of accounting for repos.
Don’t let your eyes glaze over. I’ll try to keep it
simple.
A repo is simply a “sale” of a
financial asset to someone else, with an agreement to repurchase it
at a fixed price and date. That amounts to borrowing secured by the
asset, often aTreasurybond,
with the added security that the lender has the bond, and so can
sell it quickly if need be.
Normally, such transactions are accounted for as
loans, as they should be. They are often the cheapest way for a
brokerage firm to borrow money.
I had taken for granted that repos
were always accounted for as loans, but it turns out there was a
loophole. TheFinancial
Accounting Standards Boardhad
accepted that under some conditions a repo could be treated as a
sale. One condition: if the securities securing the transaction were
worth significantly more than the loan, that could be a sale.
In the examples the board provided, it concluded that
securing the loan with assets worth 102 percent of the amount
borrowed did not produce a sale, but that 110 percent would push the
deal over the line. In between was a gray area.
Lehman appears to have concluded that 105 percent was
enough if the assets being borrowed against were bonds. If they were
equities, it set the bar at 108 percent.
By doing such sales repos at the end of each quarter,
and reversing them a few days later, the firm could seem to have
less debt than it really did.
It started the practice in 2001 but really
accelerated it in 2007 and early 2008, when investors belatedly
discovered there were risks to high leverage ratios. At the end of
2007, the bankruptcy examiner concluded, Lehman’s real leverage
ratio was 17.8 — meaning it had $17.80 in assets for every dollar of
equity. It reported a ratio of 16.1.
By the end of June 2008 — Lehman’s last public
balance sheet — it was hiding $50 billion of debt that way, enabling
it to appear to be reducing its leverage far more than it was. When
investors asked how it was doing that, Lehman officials chose not to
explain what was actually happening.
Lehman’s collapse is history, but after it was
allowed to collapse other firms were rescued. We don’t know whether
those firms used the same tricks, although we do know that Lehman
thought they were not doing so.
Thequestionssent
to financial companies by the S.E.C. this week should provide
answers to that question. Companies that classified repos as sales
are going to have to provide specifics and explain exactly why the
accounting was justified. The reports will go back three years, so
we can see history as well as current practices.
It would be nice if the commission found that other
firms did not choose to hide borrowing this way.
But if that is not what is found, then the commission
should dig deeper into actual transactions. It should find out how
the firm on the other side of each repo accounted for it.
There are at least two abuses that might have
happened.
The first would stem from differing reporting
periods. One firm could hide debt with another when its quarter
ended. Then, when the other firm’s quarter ended, that firm could
hide debt with the first firm.
The second method would reflect the fact that two
companies involved in a transaction do not have to use the same
accounting. Lehman could treat the repo as a sale, but the other
firm could call it a financing. Presto: Nobody reports owning the
assets in question.
That could even be legal. The second firm could
conclude that an asset-to-loan ratio of 105 percent was not high
enough to qualify for sales treatment, while the first firm thought
105 percent was high enough.
But legal or not, it would be misleading.
Wall Street leverage remains an important issue. The
S.E.C. should discover if it was, or is, being concealed, and then
get to the bottom of how that was done.
Floyd Norris comments on
finance and economics in his blog at nytimes.com/norris.
The Financial Accounting Standards Board moved last
year to close the loophole that Lehman is accused of using, Bushee says. A new
rule, FAS 166, replaces the 98%-102% test with one designed to get at the intent
behind a repurchase agreement. The new rule, just taking effect now, looks at
whether a transaction truly involves a transfer of risk and reward. If it does
not, the agreement is deemed a loan and the assets stay on the borrower's
balance sheet.
"Lehman's Demise and Repo 105: No Accounting for Deception,"
Knowledge@Wharton, March 31, 2010 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2464
It was like
a hidden passage on Wall Street, a secret channel that enabled
billions of dollars to flow through Lehman Brothers.
In the
years before its collapse, Lehman used a small company — its “alter
ego,” in the words of a former Lehman trader — to shift investments
off its books.
The firm,
called Hudson Castle, played a crucial, behind-the-scenes role at
Lehman, according to an internal Lehman document and interviews with
former employees. The relationship raises new questions about the
extent to which Lehman obscured its financial condition before it
plunged into bankruptcy.
While
Hudson Castle appeared to be an independent business, it was deeply
entwined with Lehman. For years, its board was controlled by Lehman,
which owned a quarter of the firm. It was also stocked with former
Lehman employees.
None of
this was disclosed by Lehman, however.
Entities
like Hudson Castle are part of a vast financial system that operates
in the shadows of Wall Street, largely beyond the reach of banking
regulators. These entities enable banks to exchange investments for
cash to finance their operations and, at times, make their finances
look stronger than they are.
Critics say
that such deals helped Lehman and other banks temporarily transfer
their exposure to the risky investments tied to subprime mortgages
and commercial real estate. Even now, a year and a half after
Lehman’s collapse, major banks still undertake such transactions
with businesses whose names, like Hudson Castle’s, are rarely
mentioned outside of footnotes in financial statements, if at all.
The
Securities and Exchange Commission is examining various creative
borrowing tactics used by some 20 financial companies. A
Congressional panel investigating the financial crisis also plans to
examine such deals at a hearing in May to focus on Lehman and Bear
Stearns, according to two people knowledgeable about the panel’s
plans.
Most of
these deals are legal. But certain Lehman transactions crossed the
line, according to the account of the bank’s demise prepared by an
examiner of the bank. Hudson Castle was not mentioned in that
report, released last month, which concluded that some of Lehman’s
bookkeeping was “materially misleading.” The report did not say that
Hudson was involved in the misleading accounting.
At several
points, Lehman did transactions greater than $1 billion with Hudson
vehicles, but it is unclear how much money was involved since 2001.
Still,
accounting experts say the shadow financial system needs some
sunlight.
“How can
anyone — regulators, investors or anyone — understand what’s in
these financial statements if they have to dig 15 layers deep to
find these kinds of interlocking relationships and these kinds of
transactions?” said Francine McKenna, an accounting consultant who
has examined the financial crisis on her blog, re: The Auditors.
“Everybody’s talking about preventing the next crisis, but they
can’t prevent the next crisis if they don’t understand all these
incestuous relationships.”
The story
of Lehman and Hudson Castle begins in 2001, when the housing bubble
was just starting to inflate. That year, Lehman spent $7 million to
buy into a small financial company, IBEX Capital Markets, which
later became Hudson Castle.
From the
start, Hudson Castle lived in Lehman’s shadow. According to a 2001
memorandum given to The New York Times, as well as interviews with
seven former employees at Lehman and Hudson Castle, Lehman exerted
an unusual level of control over the firm. Lehman, the memorandum
said, would serve “as the internal and external ‘gatekeeper’ for all
business activities conducted by the firm.”
The deal
was proposed by Kyle Miller, who worked at Lehman. In the
memorandum, Mr. Miller wrote that Lehman’s investment in Hudson
Castle would give the bank and its clients access to financing while
preventing “headline risk” if any of its deals went south. It would
also reduce Lehman’s “moral obligation” to support its off-balance
sheet vehicles, he wrote. The arrangement would maximize Lehman’s
control over Hudson Castle “without jeopardizing the off-balance
sheet accounting treatment.”
Mr. Miller
became president of Hudson Castle and brought several Lehman
employees with him. Through a Hudson Castle spokesman, Mr. Miller
declined a request for an interview.
The
spokesman did not dispute the 2001 memorandum but said the
relationship with Lehman had evolved. After 2004, “all funding
decisions at Hudson Castle were solely made by the management team
and neither the board of directors nor Lehman Brothers participated
in or influenced those decisions in any way,” he said, adding that
Lehman was only a tenth of Hudson’s revenue.
Still,
Lehman never told its shareholders about the arrangement. Nor did
Moody’s choose to mention it in its credit ratings reports on Hudson
Castle’s vehicles. Former Lehman workers, who spoke on the condition
that they not be named because of confidentiality agreements with
the bank, offered conflicting accounts of the bank’s relationship
with Hudson Castle.
One said
Lehman bought into Hudson Castle to compete with the big commercial
banks like Citigroup, which had a greater ability to lend to
corporate clients. “There were no bad intentions around any of this
stuff,” this person said.
But another
former employee said he was leery of the arrangement from the start.
“Lehman wanted to have a company it controlled, but to the outside
world be able to act like it was arm’s length,” this person said.
Typically,
companies are required to disclose only material investments or
purchases of public companies. Hudson Castle was neither.
Nonetheless, Hudson Castle was central to some Lehman deals up until
the bank collapsed.
“This
should have been disclosed, given how critical this relationship
was,” said Elizabeth Nowicki, a professor at Boston University and a
former lawyer at the S.E.C. “Part of the problems with all these
bank failures is there were a lot of secondary actors — there were
lawyers, accountants, and here you have a secondary company that was
helping conceal the true state of Lehman.”
First of all I might note that
an article in The Economist supports what I've been saying all
along ---
that Lehman's Repo 105 contracts supported by their auditors had only
one purpose --- to deceive the public
"Beancounters in a bind Banks’ professional advisers come under
scrutiny," The Economist, March 20, 2010, Page 81 ---
http://www.economist.com/business-finance/displaystory.cfm?story_id=15721559
Some of its
counterparty banks get a slap on the wrist for changing the terms of
their collateral demands, for instance. But the strongest criticism
of those who interacted with the flailing firm is reserved for
Lehman’s auditor, Ernst & Young (E&Y), for failing to “question and
challenge improper or inadequate disclosures”. The main “accounting
gimmick” hidden from investors, but apparently known to the auditor,
was called Repo 105. This technique helped the firm flatter its
numbers by temporarily moving assets off its balance-sheet at the
end of each quarter. Lawyers are also in the spotlight: unable to
find an American law firm to approve the transaction as a “true
sale” of assets, Lehman got the nod from Linklaters in London. Both
E&Y and Linklaters deny any wrongdoing.
Although Repo 105 appears to have been in line with American
accounting standards, its effect was to deceive.
The technique allowed Lehman to reduce its reported leverage
substantially and thus avoid ruinous ratings downgrades as it fought
for survival. Investors would like to think that auditors consider
not just the letter of the rules but their spirit, too. The examiner
concluded that there was enough evidence to support a case for
malpractice against E&Y.
Continued in article"
From The Wall Street Journal
Accounting Weekly Review on March 26, 2010
Note that Ernst & Young is disputing some portions of the Examiner's
Report with regard to the whitleblower
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
TOPICS: Bankruptcy,
Business Ethics, Code of Ethics, Ethics, Financial Statement Fraud,
Fraud, Internal Controls, Management Fraud, whistleblower
SUMMARY: Matthew
Lee, a Lehman Brothers Holdings Inc. senior vice president, warned
in a May 2008 letter that he believed "senior management" may have
violated Lehman's internal code of ethics by misleading investors
and regulators about the true value of the firm's assets. Mr. Lee's
complaints echo those of many investors and analysts at the time,
who questioned whether Lehman was delaying write-downs to avoid
potentially crippling losses. Mr. Lee, a 14-year veteran who headed
the firm's global balance-sheet and legal-entity accounting, said
Lehman had "tens of billions of dollars of unsubstantiated balances,
which may or may not be 'bad,' or non-performing assets." "I believe
the manner in which the Firm is reporting [certain] assets is
potentially misleading to the public and various governmental
agencies," Mr. Lee wrote.
CLASSROOM APPLICATION: The
Lehman bankruptcy court's report offers us a current-events case
study in financial statement fraud, as well as whistleblowing law
and companies' codes of ethics. This article also connects our
course material with law and ethics, showing students that the
things they are learning in various classes in the business school
are connected. Educated business students need to see the
connections and overlap that occurs.
QUESTIONS:
1. (Introductory)
What warnings did Mr. Lee include in his letter to Lehman officers?
What were his concerns? What evidence did he offer?
2. (Advanced)
What happened to Mr. Lee after he verbally complained? After he
submitted his letter? What has happened to Lehman Brothers since
then? Were Mr. Lee's concerns accurate or were they incorrect
accusations?
3. (Introductory)
What was "Repo 105"? Why did Lehman implement this plan? What are
the problems with this plan? Point to specific rules in GAAP that
Lehman violated with this plan. How should those transaction have
been booked according to GAAP?
4. (Advanced)
What is a whistleblower? What is the value of whistleblowing to the
accounting profession and to society? What are the risks involved
for employees who decide to whistleblow? What do you think
whistleblowing laws should include? Why?
5. (Introductory)
What was the ultimate resolution between Mr. Lee and Lehman
Brothers? Which terms of the agreement are known? Why do you think
Lehman made this decision? How would this settlement be booked?
6. (Advanced)
How could this situation have been prevented? What could Lehman
management have done when they heard Mr. Lee's complaints? Could the
situation have been remedied at that point? Why or why not? Who was
ultimately responsible for Lehman's problems and the treatment of
Mr. Lee?
Reviewed By: Linda Christiansen, Indiana University
Southeast
Matthew
Lee, a Lehman Brothers Holdings Inc. senior vice president, warned
in a May 2008 letter that he believed "senior management" may have
violated Lehman's internal code of ethics by misleading investors
and regulators about the true value of the firm's assets.
View Full
Image
Photo by
Catherine Lee Matthew Lee's complaints echo those of investors and
analysts at the time, who questioned whether Lehman was delaying
write-downs to avoid potentially crippling losses.
Mr. Lee
addressed his letter to then-Chief Financial Officer Erin Callan and
Chief Risk Officer Chris O'Meara, among others, only days before he
was ousted from the firm. Portions of the letter were excerpted in
the U.S. Bankruptcy Court examiner's report on Lehman released last
week. A full version of the letter was reviewed Friday by The Wall
Street Journal. Ms. Callan didn't return a phone call seeking
comment.
Mr. Lee's
complaints echo those of many investors and analysts at the time,
who questioned whether Lehman was delaying write-downs to avoid
potentially crippling losses. Mr. Lee, a 14-year veteran who headed
the firm's global balance-sheet and legal-entity accounting, said
Lehman had "tens of billions of dollars of unsubstantiated balances,
which may or may not be 'bad,' or non-performing assets."
"I believe
the manner in which the Firm is reporting [certain] assets is
potentially misleading to the public and various governmental
agencies," Mr. Lee wrote.
On Friday,
Senate Banking Committee Chairman Christopher Dodd (D., Conn.) asked
the Justice Department to investigate alleged accounting
manipulations that took place at Lehman and that were detailed in
the 2,200-page examiner's report.
More
What
Central Figures at Lehman Knew The Lehman Whistleblower's Letter In
the May 18, 2008, letter, Mr. Lee specifically criticized the
accounting controls in Lehman's Mumbai office. "There is a very real
possibility of a potential misstatement of material facts being
efficiently distributed by that office," Mr. Lee wrote.
At the
time, one India investment was drawing scrutiny from Lehman critics,
including David Einhorn of hedge fund Greenlight Capital Inc. Mr.
Einhorn questioned why the Wall Street firm had written up the value
of a power plant there, known as KSK Energy Ventures, during the
first quarter of 2008. In a speech to investors on May 21, Mr.
Einhorn, who was betting that Lehman's stock would decline, said the
firm had booked a $400 million to $600 million gain in the first
quarter by writing up the value of KSK Energy.
Lehman said
in the spring of 2008 that it booked the gains because an investor
had invested in the venture at a higher valuation than Lehman's
investment. In his May 21 speech, Mr. Einhorn said Lehman later said
that it valued KSK based on its "expected" pre-IPO financing, as
well as other factors.
Mr. Lee's
lawyer, Erwin Shustak, of San Diego, said his client had complained
orally for several months to his boss, Martin Kelly, Lehman's former
global financial controller, about many of the same issues he raised
"formally" in his letter. Mr. Kelly declined to comment, through a
Barclays PLC spokesman, where he now works. According to the
examiner's report, Mr. Kelly had raised concerns to top executives
about the firm's accounting tactic, known as "Repo 105," which
temporarily moved billions of dollars off its balance sheet,
according to the examiner's report. The Lehman bankruptcy estate
declined to comment.
Mr. Shustak
said his client was demoted about two months before he wrote the
letter, which was drafted with help from the attorney. Mr. Lee was
terminated a few days after he wrote the letter.
Lehman's
auditors, Ernst & Young LLP, referred to the document as a
"whistleblower letter" that was "pretty ugly," according to the
examiner's report. In a statement, Ernst & Young said Lehman
management determined that Mr. Lee's "allegations were unfounded."
"Mr. Lee
believes he has been the victim of retaliation for bringing what he
believed, in good faith, to have been ethical and securities law
violations by Lehman to Lehman's managements' attention," Mr.
Shustak wrote in a letter to Jack Johnson, a former member of the
general counsel's staff, that was reviewed by The Wall Street
Journal.
After being
terminated in May, Mr. Lee was asked to return to Lehman on June 12
to be interviewed by Ernst & Young auditors about his complaints,
his lawyer said. That is when Mr. Lee brought up his concerns about
Lehman's use of Repo 105.
Mr. Shustak
also wrote that Mr. Lee, who is now 56 years old, was considering
filing a discrimination complaint because he was the "victim of age
discrimination in what appears to be a company wide decision to
replace more senior, higher paid employees, such as Mr. Lee, all
over the age of forty years of age, with younger, less experienced
and less expensive employees."
The letter
added: "At time same time, Mr. Lee would prefer to resolve his
dispute with Lehman amicably."
Mr.
Lee and Lehman ultimately negotiated a severance agreement, which
his lawyer said precluded him from filing a lawsuit or a
whistle-blower complaint under the Sarbanes-Oxley Act.
Former employees of Big Four
firms (alumni) have a blog that is generally upbeat and tends not to be
critical of their former employers
However, with respect to the impact of the Lehman Bankruptcy Examiners
Report, this Big Four Blog is unusually critical of Ernst and Young and
predicts a very tough time for E&Y in the aftermath.
The
next few days will reveal how the regulators, erstwhile shareholders of
Lehman and other stakeholders will move against E&Y. Valukas’ statement
that there is sufficient evidence to show that E&Y was negligent is
enough to spur a whole host of law suits. E&Y is in a very tough spot
now, and while it may escape an imploding collapse like Andersen, the
long tail of Lehman is sure to create a strong whiplash with painful
monetary, reputational and punitive "Ernst and Young Found Negligent in Lehman Report, Tough
Consequences," The Big Four Blog, March 17, 2010 ---
http://bigfouralumni.blogspot.com/2010/03/ernst-and-young-found-negligent-in.html
There’s
been so much press on the recently released report on the
spectacular failure of Lehman Brothers by Anton Valukas, so we’ll
just focus on the key elements which involve Lehman’s auditor Ernst
& Young.
Valukas is
highly critical of E&Y’s work, claiming that they did not perform
the due diligence needed by audit firms, the ultimate watchdog of
investors’ interests. He believes there is a case of negligence and
professional malpractice against the firm. Though in a very limited
sense Lehman perhaps followed standard accounting principles, and
this is the basis on which E&Y signed off on their annual and
quarterly filings, they wrongly categorized a repo as a sale to
knowingly report a lower leverage ratio, they exceeded internal
limits on the infamous Repo 105, and they found a loophole in the
British system to execute these transactions, and keep them off the
public eye.
Lehman was
clearly at fault and grossly fraudulent in hiding this from
investors, and then obfuscating answers to clear questions from
analysts. Is Ernst and Young equally culpable?
E&Y should
have been more rigorous in pursuing this issue, knowing that it was
material, being misrepresented and highly abused. With full
knowledge of its usage, and then signing off on SEC documents is
definitely negligent.
E&Y is now
being investigated by the FRC in the UK and very likely in due
course by the SEC. The Saudi government has already cancelled E&Y’s
security license in the kingdom. The law suits are yet to hit the
wires, but they are coming. The key is whether a criminal indictment
of the firm is likely, recall that this is what brought down
Andersen. Dealing with civil suits is only a matter of money, but a
criminal charge is going to send clients away in droves. The
critical question is whether the industry can withstand the loss of
a $20 billion accounting giant, the consequences of a Big Three are
quite hard to imagine.
E&Y was
recently hit with a $8.5 million fine by the SEC for its involvement
with Bally Fitness, and in that settlement E&Y agreed to tighten
internal procedures and refrain from audit abuse. So the SEC is
unlikely to look favorably on this.
The next
few days will reveal how the regulators, erstwhile shareholders of
Lehman and other stakeholders will move against E&Y. Valukas’
statement that there is sufficient evidence to show that E&Y was
negligent is enough to spur a whole host of law suits.
E&Y
is in a very tough spot now, and while it may escape an imploding
collapse like Andersen, the long tail of Lehman is sure to create a
strong whiplash with painful monetary, reputational and punitive
consequences.
The messages below are in
reverse order as to the time received on April 7m 2010
From:
THE Internet Accounting List/Forum for CPAs [mailto:CPAS-L@LISTSERV.LOYOLA.EDU]
On Behalf Of Jensen, Robert Sent: Wednesday, April 07, 2010 10:43 AM To: CPAS-L@LISTSERV.LOYOLA.EDU Subject: Re: AT&T $1 billion write-down, Repo 105 and other dumb
questions
Hi Jim,
I agree. But then why does do auditors
contend that financial statements have greater transparency because
of the many additions to standards and interpretations?
The Repo 105 deception seems like one of
the simpler cosmetic that could’ve been made more transparent with a
rather simple footnote indicating the sales amount, the repurchase
amount, and the probability of repurchase under the buy-back
contracts. That was probably more transparency than Lehman wanted at
the time.
Bob
Jensen
From:
THE Internet Accounting List/Forum for CPAs [mailto:CPAS-L@LISTSERV.LOYOLA.EDU]
On Behalf Of Jim Fuehrmeyer Sent: Wednesday, April 07, 2010 10:21 AM To: CPAS-L@LISTSERV.LOYOLA.EDU Subject: FW: AT&T $1 billion write-down, Repo 105 and other dumb
questions
Bob,
I agree completely. This was strictly
for financial statement cosmetics around a particular ratio –
otherwise why convert high quality liquid securities into cash? But
as I said once before, we’re focusing on these particular cosmetics
and in the US business world there are a lot of things that are done
purely for cosmetics. Structuring a lease to get operating
treatment is cosmetic. Doing year-end clearance sales is cosmetic.
Securitizations themselves are cosmetic – who would want to show all
those subprime loans as assets? And by the way, in my humble
opinion, those are among the biggest of the “poisons” behind our
financial crisis – and I’ve been hearing the ads for loans with no
down-payment and no credit checks on the radio so it’s going to
continue. So long as we have an economy that is dependent on us
going into debt to buy things we don’t need or can’t afford, it
won’t get better.
As an aside, I suspect
some of the things that we in Academia do at the
department/college/university level for the purpose of improving the
ratings are also cosmetic.
J
Jim
From:
THE Internet Accounting List/Forum for CPAs [mailto:CPAS-L@LISTSERV.LOYOLA.EDU]
On Behalf Of Jensen, Robert Sent: Wednesday, April 07, 2010 10:43 AM To: CPAS-L@LISTSERV.LOYOLA.EDU Subject: Re: AT&T $1 billion write-down, Repo 105 and other dumb
questions
That is very helpful Jim. But I still
don’t understand how the Lehman Repo 105 contracts had any economic
purpose other than to deceive. The probability of not having the
poison returned seems asymptotically close to zero.
Bob Jensen
From:
AECM, Accounting Education using Computers and Multimedia [mailto:AECM@LISTSERV.LOYOLA.EDU]
On Behalf Of Jagdish Gangolly Sent: Wednesday, April 07, 2010 11:03 AM To: AECM@LISTSERV.LOYOLA.EDU Subject: Re: AT&T $1 billion write-down, Repo 105 and other dumb
questions
Bob and Jim,
The last sentence in Rule
203 states:
_______________________________________
If, however, the
statements or data contain such a
departure and the member
can demonstrate that
due to unusual
circumstances the financial
statements or data would
otherwise have been
misleading, the member
can comply with the rule
by describing the
departure, its approximate effects,
if practicable, and the
reasons why compliance with
the
principle would result in a misleading statement.
_____________________________________
From:
THE Internet Accounting List/Forum for CPAs [mailto:CPAS-L@LISTSERV.LOYOLA.EDU]
On Behalf Of Jim Fuehrmeyer Sent: Wednesday, April 07, 2010 10:21 AM To: CPAS-L@LISTSERV.LOYOLA.EDU Subject: FW: AT&T $1 billion write-down, Repo 105 and other dumb
questions
Bob,
I’ve just started working through
Lehman’s last 10Q and you certainly can’t see any specific evidence
of the Repo 105/108 arrangements in there. I suspect they’re
included in the derivative note and in MD&A in the liquidity
section. I’m guessing the Repo 105/8 arrangement is in the “Other
Commitments and Guarantees” table in the first number – the $114
billion of derivatives’ notional value maturing in 2008. But again,
the $50 billion isn’t even 10% of Lehman’s off-balance-sheet
derivative activity. I’m not aware of requirements to disclose in
detail the make-up of one’s derivatives by contracts or
counterparties so if that’s in fact where it is, they’ll argue that
the disclosure “is there”.
I’ve been struggling for a couple of days
trying to understand how they did qualify for sale treatment given
the fixed price repurchase provision. I’ve always understood fixed
price repurchase options to be terms that “constrain the transferee
and provide more than a trivial benefit to the transferor” thus
resulting in no sale treatment. Lehman had to use a fixed price
arrangement because an agreement to repurchase at market would have
resulted in the “05” being a loss on sale rather than a “derivative
asset”. I think this is one of those times where the effort to
structure transactions to meet the rules really shows up. In FAS
140, paragraphs 47 to 49 discuss the issues one has to look at for
repurchase agreements to meet the “sale” test. There are four key
points that if present cause the repo to be treated as a borrowing.
One of those points is having a fixed repurchase price (47c). It
appears to me that the way Lehman was able to comply with the rule
relates to 47b – which says that if Lehman had the means to
repurchase even on default by the transferee they could not get sale
treatment. This is explained in paragraph 49 as meaning Lehman
would have to obtain cash or other collateral sufficient to fund the
repurchase throughout the term of the agreement. They got the cash
but likely determined that if they paid down debt and thus didn’t
“fund” the repurchase, they’d meet this one requirement of the four
and thus not have to account for the repos as borrowings. I’m not
an expert on financial instruments, but so far, this is all I can
see. The FASB did deal with repos, though. Back in the discussion
about their deliberations on FAS 125 (in paragraph 210 et seq. of
FAS 140) they mention that at one point they had considered
requiring a 90-day period between “sale” and repurchase for these
things to qualify. They opted not to go that route after pressure
from respondents who argued this was an arbitrary rule. That
might have dampened this a little had that requirement been in
place.
This is a long and somewhat involved followup to my
previous post on ObamaCare. . For those of you
with O.A.D.D. (online attention-deficit disorder), I’ve provided an express
and local version.
EXPRESS:
The official projections for health-care reform,
which show it greatly reducing the number of uninsured and also reducing the
budget deficit, are simply not credible. There are three basic issues.
The cost and revenue projections rely on
unrealistic assumptions and accounting tricks. If you make some adjustments
for these, the cost of the plan is much higher.
The so-called “individual mandate” isn’t really a
mandate at all. Under the new system, many young and healthy people will
still have a strong incentive to go uninsured.
Once the reforms are up and running, some employers
will have a big incentive to end their group coverage plans and dump their
employees onto the taxpayer-subsidized individual plans, greatly adding to
their cost.
LOCAL:
For future reference (or possibly to roll up and
beat myself over the head with in my dotage) I have filed away a copy the
latest analysis (pdf) of health-care reform from the Congressional Budget
Office. By 2019, it says, the bills passed by the House and Senate will have
cut the number of uninsured Americans by thirty-two million, raised the
percentage of people with some form of health-care coverage from
eighty-three per cent to ninety-four per cent, and reduced the federal
deficit by a cumulative $143 billion. If all of these predictions turn out
to be accurate, ObamaCare will go down as one of the most successful and
least costly government initiatives in history. At no net cost to the
taxpayer, it will have filled a gaping hole in the social safety net and
solved a problem that has frustrated policymakers for decades.
Does Santa Claus live after all? According to the
C.B.O., between now and 2019 the net cost of insuring new enrollees in
Medicaid and private insurance plans will be $788 billion, but other
provisions in the legislation will generate revenues and cost savings of
$933 billion. Subtract the first figure from the second and—voila!—you get
$143 billion in deficit reduction.
The first objection to these figures is that the
great bulk of the cost savings—more than $450 billion—comes from cuts in
Medicare payments to doctors and other health-care providers. If you are
vaguely familiar with Washington politics and the letters A.A.R.P. you might
suspect that at least some of these cuts will fail to materialize. Unlike
some hardened skeptics, I don’t think none of them will happen. One part of
the reform involves reducing excessive payments that the Bush Administration
agreed to when it set up the Medicare Advantage program in 2003. If Congress
remains under Democratic control—a big if, admittedly—it will probably enact
these changes. But that still leaves another $300 billion of Medicare
savings to be found.
The second problem is accounting gimmickry. Acting
in accordance with standard Washington practices, the C.B.O. counts as
revenues more than $50 million in Social Security taxes and $70 billion in
payments towards a new home-care program, which will eventually prove very
costly, and it doesn’t count some $50 billion in discretionary spending.
After excluding these pieces of trickery and the questionable Medicare cuts,
Douglas Holtz-Eakin, a former head of the C.B.O., has calculated that the
reform will actually raise the deficit by $562 billion in the first ten
years. “The budget office is required to take written legislation at face
value and not second-guess the plausibility of what it is handed,” he wrote
in the Times. “So fantasy in, fantasy out.”
Holtz-Eakin advised John McCain in 2008, and he has
a reputation as a straight shooter. I think the problems with the C.B.O.’s
projections go even further than he suggests. If Holtz-Eakin’s figures
turned out to be spot on, and over the next ten years health-care reform
reduced the number of uninsured by thirty million at an annual cost of $56
billion, I would still regard it as a great success. In a $15 trillion
economy—and, barring another recession, the U.S. economy should be that
large in 2014—fifty or sixty billion dollars is a relatively small sum—about
four tenths of one per cent of G.D.P., or about eight per cent of the 2011
Pentagon budget.
My two big worries about the reform are that it
won’t capture nearly as many uninsured people as the official projections
suggest, and that many businesses, once they realize the size of the
handouts being offered for individual coverage, will wind down their group
plans, shifting workers (and costs) onto the new government-subsidized
plans. The legislation includes features designed to prevent both these
things from happening, but I don’t think they will be effective.
Consider the so-called “individual mandate.” As a
strict matter of law, all non-elderly Americans who earn more than the
poverty line will be obliged to obtain some form of health coverage. If they
don’t, in 2016 and beyond, they could face a fine of about $700 or 2.5 per
cent of their income—whichever is the most. Two issues immediately arise.
Even if the fines are vigorously enforced, many
people may choose to pay them and stay uninsured. Consider a healthy single
man of thirty-five who earns $35,000 a year. Under the new system, he would
have a choice of enrolling in a subsidized plan at an annual cost of $2,700
or paying a fine of $875. It may well make sense for him to pay the fine,
take his chances, and report to the local emergency room if he gets really
sick. (E.R.s will still be legally obliged to treat all comers.) If this
sort of thing happens often, as well it could, the new insurance exchanges
will be deprived of exactly the sort of healthy young people they need in
order to bring down prices. (Healthy people improve the risk pool.)
If the rules aren’t properly enforced, the problem
will be even worse. And that is precisely what is likely to happen. The
I.R.S. will have the administrative responsibility of imposing penalties on
people who can’t demonstrate that they have coverage, but it won’t have the
legal authority to force people to pay the fines. “What happens if you don’t
buy insurance and you don’t pay the penalty?” Ezra Klein, the Washington
Post’s industrious and well-informed blogger, asks. “Well, not much. The law
specifically says that no criminal action or liens can be imposed on people
who don’t pay the fine.”
So, the individual mandate is a bit of a sham.
Generous subsidies will be available for sick people and families with
children who really need medical care to buy individual coverage, but
healthy single people between the ages of twenty-six and forty, say, will
still have a financial incentive to remain outside the system until they get
ill, at which point they can sign up for coverage. Consequently, the number
of uninsured won’t fall as much as expected, and neither will prices.
Without a proper individual mandate, the idea of universality goes out the
window, and so does much of the economic reasoning behind the bill.
The question of what impact the reforms will have
on existing insurance plans has received even less analysis. According to
President Obama, if you have coverage you like you can keep it, and that’s
that. For the majority of workers, this will undoubtedly be true, at least
in the short term, but in some parts of the economy, particularly industries
that pay low and moderate wages, the presence of such generous subsidies for
individual coverage is bound to affect behavior eventually. To suggest this
won’t happen is to say economic incentives don’t matter.
Take a medium-sized firm that employs a hundred
people earning $40,000 each—a private security firm based in Atlanta,
say—and currently offers them health-care insurance worth $10,000 a year, of
which the employees pay $2,500. This employer’s annual health-care costs are
$750,000 (a hundred times $7,500). In the reformed system, the firm’s
workers, if they didn’t have insurance, would be eligible for generous
subsidies to buy private insurance. For example, a married forty-year-old
security guard whose wife stayed home to raise two kids could enroll in a
non-group plan for less than $1,400 a year, according to the Kaiser Health
Reform Subsidy Calculator. (The subsidy from the government would be
$8,058.)
In a situation like this, the firm has a strong
financial incentive to junk its group coverage and dump its workers onto the
taxpayer-subsidized plan. Under the new law, firms with more than fifty
workers that don’t offer coverage would have to pay an annual fine of $2,000
for every worker they employ, excepting the first thirty. In this case, the
security firm would incur a fine of $140,000 (seventy times two), but it
would save $610,000 a year on health-care costs. If you owned this firm,
what would you do? Unless you are unusually public spirited, you would take
advantage of the free money that the government is giving out. Since your
employees would see their own health-care contributions fall by more than
$1,100 a year, or almost half, they would be unlikely to complain. And even
if they did, you would be saving so much money you afford to buy their
agreement with a pay raise of, say, $2,000 a year, and still come out well
ahead.
Even if the government tried to impose additional
sanctions on such firms, I doubt it would work. The dollar sums involved are
so large that firms would try to game the system, by, for example, shutting
down, reincorporating under a different name, and hiring back their
employees without coverage. They might not even need to go to such lengths.
Firms that pay modest wages have high rates of turnover. By simply refusing
to offer coverage to new employees, they could pretty quickly convert most
of their employees into non-covered workers.
The designers of health-care reform and the C.B.O.
are aware of this problem, but, in my view, they have greatly underestimated
it. According to the C.B.O., somewhere between eight and nine million
workers will lose their group coverage as a result of their employers
refusing to offer it. That isn’t a trifling number. But the C.B.O. says it
will be largely offset by an opposite effect in which employers that don’t
currently provide health insurance begin to offer it in response to higher
demand from their workers as a result of the individual mandate. In this
way, some six to seven million people will obtain new group coverage, the
C.B.O. says, so the overall impact of the changes will be minor.
The C.B.O.’s analysis can’t be dismissed out of
hand, but it is surely a best-case scenario. Again, I come back to where I
started: the scale of the subsidies on offer for low and moderately priced
workers. If economics has anything to say as a subject, it is that you can’t
offer people or firms large financial rewards for doing something—in this
case, dropping their group coverage—and not expect them to do it in large
numbers. On this issue, I find myself in agreement with Tyler Cowen and
other conservative economists. Over time, the “firewall” between the
existing system of employer-provided group insurance and taxpayer-subsidized
individual insurance is likely to break down, with more and more workers
being shunted over to the public teat.
At that point, if it comes, politicians of both
parties will be back close to where they began: searching for health-care
reform that provides adequate coverage for all at a cost the country can
afford. What would such a system look like? That is a topic for another
post, but I don’t think it would look much like Romney-ObamaCare.
"Lessons from the Lehman
Autopsy: The SEC can learn from Anton Valukas, the lawyer who led
a probe into Lehman—and uncovered accounting chicanery that regulators
largely ignored," by Paul M. Barrett, Business Week via the
Young CPA Network, March 24, 2010 --- http://ow.ly/1qJvx
In 2008,
Anton R. Valukas, a trial attorney in Chicago, published a four-page
stiletto thrust of an essay entitled "Arrogance: My Favorite Sin."
The piece, included in a lawyers' guide to cross-examination,
recounted Valukas' delight in using understated questioning to tempt
executives into making implausible statements of the sort that
reliably alienate jurors. "Frequently, the smartest witnesses—the
most sophisticated and the most arrogant—are most susceptible to
this type of examination," he wrote.
The piece
reads today like a preamble to Valukas' voluminous autopsy of Lehman
Brothers, which he performed as the court-approved bankruptcy
examiner in the investment bank's formal unwinding. The 2,200-page
Lehman report, released on Mar. 11, constitutes the single most
penetrating document we have on the recent misbehavior on Wall
Street. Valukas' earlier primer suggests why he did such an
exemplary job: Although he heads a prestigious corporate law firm,
Jenner & Block, the former federal prosecutor just plain resents
dissembling by big shots in expensive suits. Not coincidentally,
Jenner, a pillar of the Chicago business elite, sues Wall Street
institutions as often as it defends them.
In the
interest of preventing future Lehman disasters, we might ponder how
to transplant Valukas' zeal into Washington's financial beat cops.
That could help preclude the need to call him back again as
corporate pathologist.
He'd be a
hard man to clone. During a four-decade career, Valukas, 66, has
represented all manner of white-collar rogues. When called to public
service, he used his knowledge of the market's shadowy corners to
prosecute well-heeled miscreants. In the late 1980s, as U.S.
Attorney in Chicago, he sent agents disguised as commodity traders
to clean up the futures exchanges. The probe protected investors and
led to a slew of indictments. Some called him the Rudy Giuliani of
the Midwest.
Unlike
Giuliani, Valukas avoided elective politics and returned to his law
firm. He prospered at Jenner, not least in his yearlong assignment
as the Lehman examiner. Backed by colleagues from Jenner, he went
over millions of pages of documents, interviewed scores of
witnesses, and billed the Lehman estate $38.4 million. I'd say it
was money well spent. His findings will provide the script for
what's likely to be a theatrical airing in April, when
Representative Barney Frank (D-Mass.) convenes his House Financial
Services Committee to interrogate Lehman's former CEO, Richard S.
Fuld Jr., and other participants in the debacle.
Dubious
Behavior What Valukas brought to the endeavor was a no-nonsense lack
of deference toward Wall Street game playing, says Francine McKenna,
a former managing director at PricewaterhouseCoopers. "That's a
Chicago thing," adds McKenna, herself a resident of the city. She
now runs an investigative Web site called Re: The Auditors. "The
mindset is: I've been around the block, I know how the game is
played, and I'm not impressed by fancy names," she says.
As the
Lehman examiner, Valukas doggedly unmasked the dubious behavior of
executives once lauded as among Wall Street's conquering heroes.
Fuld insisted to Valukas that he knew nothing about the accounting
trickery called Repo 105, which was used to hide the bank's
financial decline. Fuld's self-portrait—a veteran CEO blithely
unfamiliar with the workings of his company—was not just
implausible; it could support lucrative civil claims that he "was at
least grossly negligent," as Valukas wrote. The examiner noted that
Fuld's denials were undercut by evidence that he was thoroughly
briefed on the chicanery.
Contacted
by phone, Valukas declined to comment. Fuld's attorney, Patricia
Hynes, has said her client told the truth and did nothing wrong.
Lehman/Ernst Teaching Case
on the Largest Bankruptcy in History
March 18, 2010 reply from Bob Jensen
Dear Jim,
The Repo 105 issue was more
like having a poisoned CDO bond worth $1 that you sell for $1,000
with a guaranteed buyback in a week for $1,005. That way you report
a sale for $1,000, an asset of $0 in the balance sheet for a “sold
investment,” and $0 for the liability to buy it back. Sounds like a
bad economic deal and a great OBSF ploy. Of course it’s not
necessarily boosting earnings if you paid more than $1,000 for the
CDO cookie crumbles in the first place in the first place.
But it sure beats writing
investments down from $1,000 to a $1.
Ernst and Young claims
using these contracts to keep billions of dollars of poison
investments and unbooked debt out of the financial statements result
fairly present the financial status of sales and liabilities in the
financial statements.
Do our Accounting 101 and
Auditing 101 students concur?
God help this profession if our students side with Ernst & Young!
Frank Partnoy and Lynn
Turner contend that Wall Street bank accounting is an exercise in
writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy,
Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!
Bob Jensen
Lehman/Ernst Teaching Case on the Largest Bankruptcy in History
From The Wall Street Journal Accounting Weekly Review on March
19, 2010
SUMMARY: "A
federal judge released a scathing report on the collapse of Lehman
Brothers Holdings Inc. that singles out senior executives, auditor
Ernst & Young and other investment banks for serious lapses that led
to the largest bankruptcy in U.S. history...." The report focuses on
the use of "repos" to improve the appearance of Lehman's financial
condition as it worsened with the market declines beginning in 2007.
"Mr Valukus, chairman of law firm Jenner & Block, devotes more than
300 pages alone to balance sheet manipulation..." through repo
transactions. As explained more fully in the related articles,
repurchase agreements are transactions in which assets are sold
under the agreement that they will be repurchased within days. Yet,
when Lehman exchanged assets with a value greater than 105% of the
cash received for them, the company would report it as an outright
sale of the asset, not a loan, thus reducing the firms apparent
leverage. These transactions were based on a legal opinion of the
propriety of this treatment made for their European operations, but
the company never received such an opinion letter in the U.S., so
Lehman transferred assets to Europe in order to execute the trades.
The second related article clarifies these issues. Of course, this
was but one significant problem; other forces helped to "tip Leham
over the brink" into bankruptcy including J.P. Morgan Chases'
"demands for collateral and modifications to agreements...that hurt
Lehman's liquidity...."
CLASSROOM APPLICATION: The
questions ask students to understand repurchase agreements and cases
in which financing (borrowing) transactions might alternatively be
treated as sales. The role of the auditor, in this case Ernst &
Young, also is highlighted in the article and in the questions in
this review.
QUESTIONS:
1. (Introductory)
What report was issued in March 2010 regarding Lehman Brothers?
Summarize some main points about the report.
2. (Advanced)
Based on the discussion in the main and first related articles,
describe the "repo market'. What is the business purpose of these
transactions?
3. (Advanced)
How did Lehman Brothers use repo transactions to improve its balance
sheet? Note: be sure to refer to the related articles as some points
in the main article emphasize the impact of removing the assets that
are subject to the repo agreements from the balance sheet. The main
point of your discussion should focus on what else might have been
credited in the entries to record these transactions.
4. (Introductory)
Refer to the second related article. What was the role of Lehman's
auditor in assessing the repo transactions? What questions have been
asked of this firm and how has E&Y responded?
Reviewed By: Judy Beckman, University of Rhode Island
A scathing
report by a U.S. bankruptcy-court examiner investigating the
collapse of Lehman Brothers Holdings Inc. blames senior executives
and auditor Ernst & Young for serious lapses that led to the largest
bankruptcy in U.S. history and the worst financial crisis since the
Great Depression.
In the
works for more than a year, and costing more than $30 million, the
report by court-appointed examiner Anton Valukas paints the most
complete picture yet of the free-wheeling culture inside the 158
year-old firm, whose chief executive Richard S. Fuld Jr. prided
himself on his ability to manage market risk.
The
document runs thousands of pages and contains fresh allegations. In
particular, it alleges that Lehman executives manipulated its
balance sheet, withheld information from the board, and inflated the
value of toxic real estate assets.
Lehman
chose to "disregard or overrule the firm's risk controls on a
regular basis,'' even as the credit and real-estate markets were
showing signs of strain, the report said.
In one
instance from May 2008, a Lehman senior vice president alerted
management to potential accounting irregularities, a warning the
report says was ignored by Lehman auditors Ernst & Young and never
raised with the firm's board.
The
allegations of accounting manipulation and risk-control abuses
potentially could influence pending criminal and civil
investigations into Lehman and its executives. The Manhattan and
Brooklyn U.S. attorney's offices are investigating, among other
things, whether former Lehman executives misled investors about the
firm's financial picture before it filed for bankruptcy protection,
and whether Lehman improperly valued its real-estate assets, people
familiar with the matter have said.
The
examiner said in the report that throughout the investigation it
conducted regular weekly calls with the Securities and Exchange
Commission and Department of Justice. There have been no
prosecutions of Lehman executives to date.
Several
factors helped to tip Lehman over the brink in its final days, Mr.
Valukas wrote. Investment banks, including J.P. Morgan Chase & Co.,
made demands for collateral and modified agreements with Lehman that
hurt Lehman's liquidity and pushed it into bankruptcy.
Lehman's
own global financial controller, Martin Kelly, told the examiner
that "the only purpose or motive for the transactions was reduction
in balance sheet" and "there was no substance to the transactions."
Mr. Kelly said he warned former Lehman finance chiefs Erin Callan
and Ian Lowitt about the maneuver, saying the transactions posed
"reputational risk" to Lehman if their use became publicly known.
In an
interview with the examiner, senior Lehman Chief Operating Officer
Bart McDade said he had detailed discussions with Mr. Fuld about the
transactions and that Mr. Fuld knew about the accounting treatment.
In an April
2008 email, Mr. McDade called such accounting maneuvers "another
drug we r on." Mr. McDade, then Lehman's equities chief, says he
sought to limit such maneuvers, according to the report. Mr. McDade
couldn't be reached to comment.
In a
November 2009 interview with the examiner, Mr. Fuld said he had no
recollection of Lehman's use of Repo 105 transactions but that if he
had known about them he would have been concerned, according to the
report.
Mr.
Valukas's report is among the largest undertaking of its kind. Those
singled out in the report won't face immediate repercussions.
Rather, the report provides a type of road map for Lehman's
bankruptcy estate, creditors and other authorities to pursue
possible actions against former Lehman executives, the bank's
auditors and others involved in the financial titan's collapse.
One party
singled out in the report is Lehman's audit firm, Ernst & Young,
which allegedly didn't raise concerns with Lehman's board about the
frequent use of the repo transactions. E&Y met with Lehman's Board
Audit Committee on June 13, one day after Lehman senior vice
president Matthew Lee raised questions about the frequent use of the
transactions.
"Ernst &
Young took no steps to question or challenge the nondisclosure by
Lehman of its use of $50 billion of temporary, off-balance sheet
transactions," Mr. Valukas wrote.
In a
statement, Mr. Fuld's lawyer, Patricia Hynes, said, "Mr. Fuld did
not know what those transactions were—he didn't structure or
negotiate them, nor was he aware of their accounting treatment."
An Ernst &
Young statement Thursday said Lehman's collapse was caused by "a
series of unprecedented adverse events in the financial markets." It
said Lehman's leverage ratios "were the responsibility of
management, not the auditor."
Ms. Callan
didn't respond to a request for comment. An attorney for Mr. Lowitt
said any suggestion he breached his duties was "baseless." Mr. Kelly
couldn't be reached Thursday evening.
As Lehman
began to unravel in mid-2008, investors began to focus their
attention on the billions of dollars in commercial real estate and
private-equity loans on Lehman's books.
The report
said that while Lehman was required to report its inventory "at fair
value," a price it would receive if the asset were hypothetically
sold, Lehman "progressively relied on its judgment to determine the
fair value of such assets."
Between
December 2006 and December 2007, Lehman tripled its firmwide risk
appetite.
But its
risk exposure was even larger, according to the report, considering
that Lehman omitted "some of its largest risks from its risk usage
calculations" including the $2.3 billion bridge equity loan it
provided for Tishman Speyer's $22.2 billion take over of apartment
company Archstone Smith Trust. The late 2007 deal, which occurred as
the commercial-property market was cresting, led to big losses for
Lehman.
Lehman
eventually added the Archstone loan to its risk usage profile. But
rather than reducing its balance sheet to compensate for the
additional risk, it simply raised its risk limit again, the report
said.
"E&Y launches defence of
Lehman audit: Letter goes out to clients," by Gavin Hinks,
Accountancy Age, March 23, 2010 --- http://ow.ly/1qjQW
Ernst &
Young has launched a defence of its work as auditor of collapsed
investment bank Lehman writing letters directly to clients,
according to Reuters.
Ernsy &
Young were accused of negligence in their audit of Lehman in a 2,000
page report published two weeks ago by the US bankruptcy examiner
Anton Valukas.
The firm's response, according to
Reuters, has seen some partners write to
clients informing them that the lead audit partner "promptly" called
the chairman of Lehman's audit committee when he learned of a key
letter from a whistleblower about accounting at the bank.
The E&Y
letter, seen by Reuters, reportedly says
that the lead partner insisted that the Lehman management inform the
watchdog, the Securities and Exchange Commission, and the Federal
Reserve Bank of the letter.
E&Y say that
the letter was discussed with the Lehman audit committee at least
three times.
Criticism of
Lehman in the examiner's report centered on the accounting treatment
of so called Repo 105 transactions.
These involve the short-term sale of
assets
in order to raise cash. The deals come with an agreement to buy the
assets back at a later date. As a result the assets remain on the
seller's balance sheet because control of the assets has not been
surrendered.
In Lehman's
case the bankruptcy examiner claimed the bank used a technicality to
get risky assets off its balance sheet. This was achieved by
offering assets worth 105% of the cash received in consideration.
Because this would not cover the cost of buying the assets back,
control is said to have been lost, under US rules, and the assets
could be taken off the balance sheet temporarily, even though Lehman
would pay to take them back later. The difference between the price
received for the assets and the sum paid to take them back is called
the 'haircut'.
The E&Y letter
to clients said the firm believes it "will prevail" if the
examiner's claims turn into court action against the firm.
Reuters reports that the letter also
reveals that the time leading up to the collapse of Lehman was, for
E&Y, "among the most turbulent periods in our economic history."
The letter insists the failure of
Lehman came about as a result of a collapse in liquidity caused by
declining
asset
values and a loss of market confidence. The firm reportedly insists
it was not as a result of accounting or disclosure issues.
The examiner's
report said that there could be "colorable claims" against the
auditor.
In light of the extensive discussion of the Lehman Bros. and E&Y matter
on this listserv over the past couple of weeks, I thought readers might
be interested in the message I've copied below. This was sent to me in
my capacity as an audit committee chairman.
I hope this might balance the discussion somewhat. I would observe that
to date the postings have been based mainly on newspaper accounts of the
bankruptcy examiner's lengthy report that was completed for the purpose
of determining whether the bankruptcy estate might have claims against
various parties. In effect, basing one's conclusions about a situation
on this source material is roughly equivalent to a judge or jury
reaching a decision after hearing only the prosecution's side of the
case. While the message below is necessarily very brief, I think it
illustrates that there are other facts and arguments that should be
fairly evaluated before anyone is found guilty in the court of public
opinion or otherwise.
Denny Beresford
I hope this note finds you well and enjoying the early days of Spring.
In light of your role in our Audit Committee Leadership Network, I am
sending you this note to brief you on a matter given there have been
extensive media reports about the release of the Bankruptcy Examiner’s
Report relating to the September 2008 bankruptcy of Lehman Brothers. As
you may have read, Ernst & Young was Lehman Brothers’ independent
auditors.
The concept of an examiner’s report is a feature of US bankruptcy law.
It does not represent the views of a court or a regulatory body, nor is
the Report the result of a legal process. Instead, an examiner’s report
is intended to identify potential claims that, if pursued, may result in
a recovery for the bankrupt company or its creditors. EY is confident we
will prevail should any of the potential claims identified against us be
pursued.
We wanted to provide you with EY’s perspective on some of the potential
claims in the Examiner’s Report. We also wanted to address certain media
coverage and commentary on the Examiner’s Report that has at times been
inaccurate, if not misleading.
A few key points are set out below.
*_General Comments_*
· EY’s last audit was for the year ended November 30, 2007. Our opinion
stated that Lehman’s financial statements for 2007 were fairly presented
in accordance with US GAAP, and we remain of that view. We reviewed but
did not audit the interim periods for Lehman’s first and second quarters
of fiscal 2008.
· Lehman’s bankruptcy was the result of a series of unprecedented
adverse events in the financial markets. The months leading up to
Lehman’s bankruptcy were among the most turbulent periods in our
economic history. Lehman's bankruptcy was caused by a collapse in its
liquidity, which was in turn caused by declining asset values and loss
of market confidence in Lehman. It was not caused by accounting issues
or disclosure issues.
· The Examiner identified _no_ potential claims that the assets and
liabilities reported on Lehman’s financial statements (approximately
$691 billion and $669 billion respectively, at November 30, 2007) were
improperly valued or accounted for incorrectly.
*_Accounting and Disclosure Issues Relating to Repo 105 Transactions_* ·
There has been significant media attention about potential claims
identified by the Examiner related to what Lehman referred to as “Repo
105” transactions. What has not been reported in the media is that the
Examiner _did not_ challenge Lehman’s accounting for its Repo 105
transactions.
·As recognized by the Examiner, all investment banks used repo
transactions extensively to fund their operations on a daily basis;
these banks all operated in a high-risk, high-leverage business model.
Most repo transactions are accounted for as financings; some (the Repo
105 transactions) are accounted for as sales if they meet the
requirements of SFAS 140.
· The Repo 105 transactions involved the sale by Lehman of high quality
liquid assets (generally government-backed securities), in return for
which Lehman received cash. The media reports that these were “sham
transactions” designed to off-load Lehman’s “bad assets” are inaccurate.
· Because effective control of the securities was surrendered to the
counterparty in the Repo 105 arrangements, the accounting literature
(FAS 140) /required /Lehman to account for Repo 105 transactions as
sales rather than financings.
· The potential claims against EY arise solely from the Examiner’s
conclusion that these transactions ($38.6 billion at November 30, 2007)
should have been specifically disclosed in the footnotes to Lehman’s
financial statements, and that Lehman should have disclosed in its MD&A
the impact these transactions would have had on its leverage ratios if
they had been recorded as financing transactions.
· While no specific disclosures around Repo 105 transactions were
reflected in Lehman’s financial statement footnotes, the 2007 audited
financial statements were presented in accordance with US GAAP, and
clearly portrayed Lehman as a leveraged entity operating in a risky and
volatile industry. Lehman’s 2007 audited financial statements included
footnote disclosure of off balance sheet commitments of almost $1
trillion.
· Lehman’s leverage ratios are not a GAAP financial measure; they were
included in Lehman’s MD&A, not its audited financial statements. Lehman
concluded no further MD&A disclosures were required; EY did not take
exception to that judgment.
· If the Repo 105 transactions were treated as if they were on the
balance sheet for leverage ratio purposes, as the Examiner suggests,
Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at
November 30, 2007. Also, contrary to media reports, the decline in
Lehman’s reported leverage from its first to second quarters of 2008 was
not a result of an increased use of Repo 105 transactions*. *Lehman’s
Repo 105 transaction volumes were comparable at the end of its first and
second quarters.
*_Handling of the Whistleblower’s Issues_*
· The media has inaccurately reported that EY concealed a May 2008
whistleblower letter from Lehman’s Audit Committee. The whistleblower
letter, which raised various significant potential concerns about
Lehman’s financial controls and reporting /but did not mention Repo
105/, was directed to Lehman’s management. When we learned of the
letter, our lead partner promptly called the Audit Committee Chair; we
also insisted that Lehman’s management inform the Securities & Exchange
Commission and the Federal Reserve Bank of the letter. EY’s lead partner
discussed the whistleblower letter with the Lehman Audit Committee on at
least three occasions during June and July 2008.
· In the investigations that ensued, the writer of the letter did
briefly reference Repo 105 transactions in an interview with EY
partners. He also confirmed to EY that he was unaware of any material
financial reporting errors. Lehman’s senior executives did not advise us
of any reservations they had about the company’s Repo 105 transactions.
· Lehman’s September 2008 bankruptcy prevented EY from completing its
assessment of the whistleblower’s allegations. The allegations would
have been the subject of significant attention had EY completed its
third quarter review and 2008 year-end audit.
Should any of the potential claims be pursued,
we are confident we will prevail.
March 20, 2010 reply from Bob Jensen
Hi
Denny,
Thank you for this. I was worried that Ernst & Young would refrain from
commenting on this hot topic that will probably end up in pending
litigation.
The E&Y response is terribly discouraging to me because the audit firm
tries to hide behind the letter of the rules of GAAP rather than the
spirit of GAAP. Yesterday I pointed out that USC's Jerry Arnold (who is
truly an expert on the rules of GAAP) tried to earn his million dollars
defending Enron's founder, Ken Lay, by arguing in court that Enron
abided by the letter of GAAP (except where Andy Fastow was lying about
SPEs and really embezzling money from Enron itself). In Ken Lay's case
Arnold's testimony did not prevent his client's being found guilty on
ten counts of fraud and conspiracy to mislead investors in Enron's
audited financial statements. In court, the verdicts often focus on the
spirit of the law instead of the letter of the law.
I
am particularly distressed by the following claim (in the message below)
by Ernst & Young:
Begin Quotation Because effective control of the securities
was surrendered to the
counterparty in the Repo 105 arrangements, the accounting literature
(SFAS 140) /required /Lehman to account for Repo 105 transactions as
sales rather than financings.
End Quotation
If
Lehman is obligated in a matter of days to buy back the poisoned Repo
105 securities at prices greater than the “selling prices” I have a hard
time with the auditor’s assertion that these were legitimate sales where
the seller gave up control. The buyer is not like to keep those
securities or sell them to anybody other than Lehman since the selling
prices were phony inflated prices way above fair market value.
This is a Jerry Arnold déjà vu where auditors are trying to hide behind
the letter of accounting rules but not the spirit of accounting rules.
It makes a mockery out of the “present fairly” concept. If this was
anything but a ploy from having to show impaired-value assets on the
balance sheet I will eat my hat.
I
will never, ever accept the E&Y argument that the 2007 audited report of
Lehman fairly presented the poison CDO investments of Lehman. The poison
in those CDOs existed before the end of 2007, and surely the auditors
must've known the bad debt reserves were underestimated by hundreds of
billions of dollars. Where were the asset impairment tests required for
auditors?
It
seems to me that there’s a whole lot more professionalism issues
involved in the Lehman audits and reviews just like there should’ve been
a whole lot more involved in the Enron audits and reviews.
In any event, Andersen does not appear to have applied the GAAP
requirement to recognize asset impairment (FAS 121). From our reading of
the Powers Report, the put-options written by the SPEs that, presumably,
offset Enron's losses on its merchant investment, were not collectible,
because the SPEs did not have sufficient net assets.
"ENRON: what happened and what we can learn from it," by George J.
Benston and Al L. Hartgraves, Journal of Accounting and Public Policy,
2002, pp. 125-137:
3.3 Independent public accountants (CPAs)
The highly respected firm of Arthur Andersen audited and unqualifiedly
signed Enron's financial statements since 1985. According to the Powers
Report, Andersen was consulted on and participated with Fastow in
setting up the SPEs described above. Together, they crafted the SPEs to
conform to the letter of the GAAP requirement that the ownership of
outside, presumably independent, investors must be at least 3% of the
SPE assets. At this time, it is very difficult to understand why they
determined that Fastow was an independent investor. Kopper's
independence also is questionable, because he worked for Fastow. In any
event, Andersen appears, at best, to have accepted as sufficient Enron's
conformance with the minimum specified requirements of codified GAAP.
They do not appear to have realized or been concerned that the substance
of GAAP was violated, particularly with respect to the independence of
the SPEs that permitted their activities to be excluded from Enron's
financial statements and the recording of mark-to-market-based gains on
assets and sales that could not be supported with trustworthy numbers
(because these did not exist). They either did not examine or were not
concerned that the put obligations from the SPEs that presumably offset
declines in Enron's investments (e.g., Rhythms) were of no or little
economic value. Nor did they require Enron to record as a liability or
reveal as a contingent liability its guarantees made by or though SPEs.
Andersen also violated the letter of GAAP and GAAS by allowing Enron to
record issuance of its stock for other than cash as an increase in
equity. Andersen also did not have Enron adequately report, as
required, related-party dealings with Fastow, an executive officer of
Enron, and the consequences to stockholders of his conflict of interest.
4.1 GAAP
We believe that two important shortcomings have been revealed. First,
the US model of specifying rules that must be followed appears to have
allowed or required Andersen to accept procedures that accord with the
letter of the rules, even though they violate the basic objectives of
GAAP accounting. Whereas most of the SPEs in question appeared to have
the minimum-required 3% of assets of independent ownership, the evidence
outlined above indicates that Enron in fact bore most of the risk. In
several important situations, Enron very quickly transferred funds in
the form of fees that permitted the 3% independent owners to retrieve
their investments, and Enron guaranteed the SPEs liabilities. Second,
the fair-value requirement for financial instruments adopted by the FASB
permitted Enron to increase its reported assets and net income and
thereby, to hide losses. Andersen appears to have accepted these
valuations (which, rather quickly, proved to be substantially
incorrect), because Enron was following the specific GAAP rules.
Andersen, though, appears to have violated some important GAAP and GAAS
requirements. There is no doubt that Andersen knew that the SPEs were
managed by a senior officer of Enron, Fastow, and that he profited from
his management and partial ownership of the SPEs he structured. On that
basis alone, it seems that Andersen should have required Enron to
consolidate the Fastow SPEs with its financial statements and eliminate
the financial transactions between those entities and Enron.
Furthermore, it seems that the SPEs established by Fastow were unlikely
to be able to fulfill the role of closing put options written to offset
losses in Enron's merchant investments. If this were the purpose, the
options should and would have been purchased from an existing
institution that could meet its obligations.
Andersen also seems to have allowed Enron to violate the requirement
specified in FASB Statement 5 that guarantees of indebtedness and other
loss contingencies that in substance have the same characteristics,
should be disclosed even if the possibility of loss is remote. The
disclosure shall include the nature and the amount of the guarantee.
Even if Andersen were correct in following the letter, if not the spirit
of GAAP in allowing Enron to not consolidate those SPEs in which
independent parties held equity equal to at least 3% of assets, Enron's
contingent liabilities resulting from its loan guarantees should have
been disclosed and described.
In any event, Andersen does not appear to have applied the GAAP
requirement to recognize asset impairment (FAS 121). From our reading
of the Powers Report, the put-options written by the SPEs that,
presumably, offset Enron's losses on its merchant investment, were not
collectible, because the SPEs did not have sufficient net assets.
(Details on the SPEs' financial situations should have been available to
Andersen.) GAAP (FAS 5) also requires a liability to be recorded when
it is probable that an obligation has been incurred and the amount of
the related loss can reasonable be estimated. The information presently
available indicates that Enron's guarantees on the SPEs and Kopper's
debt had become liabilities to Enron. It does not appear that they were
reported as such.
GAAP (FAS 57) specifies that relationships with related parties "cannot
be presumed to be carried out on an arm's-length basis, as the requisite
conditions be competitive, free-market dealings may not exist". As
Executive Vice President and CFO, Fastow clearly was a "related party".
SEC Regulation S-K (Reg. §229.404. Item 404) requires disclosure of
details of transactions with management, including the amount and
remuneration of the managers from the transactions. Andersen does not
appear to have required Enron to meet this obligation. Perhaps more
importantly, Andersen did not reveal the extent to which Fastow profited
at the expense of Enron's shareholders, who could only have obtained
this information if Andersen had insisted on its inclusion in Enron's
financial statements.
4.2 GAAS
SAS 85 warns auditors not to rely on management representations about
onset values, liabilities, and related-party transactions, among other
important items. Appendix B to SAS 85 illustrates the information that
should be obtained by the auditor to review how management determined
the fair values of significant assets that do not have readily
determined market values. We do not have access to Andersen's working
papers to examine whether or not they followed this GAAS requirement.
In the light of the Wall Street Journal report presented above of
Enron's recording a fair value for the Braveheart project with
Blockbuster Inc., though, we find it difficult to believe that Andersen
followed the spirit and possibly not even the letter of this GAAS
requirement.
SAS 45 and AICPA, Professional Standards, vol. 1, AU sec. 334 specify
audit requirements and disclosures for transactions with related
parties. As indicated above, this requirement does not appear to have
been followed.
An additional lesson that should be derived from the Enron debacle is
that auditors should be aware of the ability of opportunistic managers
to use financial engineering methods, to get around the requirements of
GAAP. For example, derivatives used as hedges can be structured to have
gains on one side recorded at market or fair values while offsetting
losses are not recorded, because they do not qualify for restatement to
fair-value. Another example is a loan disguised as a sale of a
corporation's stock with guaranteed repurchase from the buyer at a
higher price. If this subterfuge were not discovered, liabilities and
interest expense would be understated. Thus, as auditors have learned
to become familiar with computer systems, they must become aware of the
means by which modern finance techniques can be used to subvert GAAP.
The above findings from the Powers Report appear to be inconsistent
with the testimony of four years later.
May 4, 2006 (Associated Press) — Last-minute changes to quarterly
earnings reports prosecutors contend were ordered by Enron Corp. Chief
Executive Jeffrey Skilling to improve the company's reputation on Wall
Street were accurate, and not the result of improper tapping of company
reserves, a defense expert testified Wednesday.
"The whole process of financial reporting, in a company as large as
Enron, to get financial statements out ... is an enormous undertaking,"
said Walter Rush, an accounting expert hired by Skilling. "And people
are scrambling, trying to get these estimates put together.
"There are changes going on up to the very last second. It is universal.
Every company goes through this."
Rush was the second consecutive accounting expert to take the stand,
following University of Southern California professor Jerry Arnold, who
testified for Enron founder and former CEO Kenneth Lay.
They are among the last defense witnesses, as lawyers for the two top
chiefs at Enron expect to conclude their case early next week, the 15th
week of their federal fraud trial.
Mark Koenig, former head of investor relations at Enron, testified early
in the trial that he believed top Enron executives were so bent on
meeting or beating earnings expectations to keep analysts bullish on the
company's stock that they made or knew of overnight changes to
estimates. Paula Rieker, Koenig's former top lieutenant, said Koenig
told her Skilling ordered abrupt last-minute changes to two quarterly
earnings reports to please analysts and investors.
"They could have just had a bad number," Rush said, referring to
Koenig's and Rieker's testimony about a late-night change in a
fourth-quarter 1999 report that boosted earnings per share from 30 cents
to 31 cents.
Arthur Andersen, Enron's outside accounting firm, already had the
31-cent number days earlier, Rush said.
"They could have been a couple steps behind the way the process was
evolving," he said of Koenig and Rieker.
In addition, Rush said the intention to "beat the street," a phrase
attributed to Skilling, was typical in business.
"Companies set goals and forecasts for themselves all the time," Rush
said.
Prosecutors also contend Enron achieved its rosy earnings by drawing
improperly from reserves. But Rush, responding specifically to
second-quarter earnings in 2000, said a transfer from one reserve was
not material since Enron had another, underreported reserve.
"That number had the effect of understating Enron's profits," he said.
He also disputed government contentions Enron executives improperly
moved parts of the company's retail operation into its highly profitable
wholesale business unit to hide financial problems under the guise of an
accounting process called "resegmentation."
"I do believe it was properly disclosed and properly accounted for,"
Rush said, adding that he believed Enron went beyond the rules in
disclosing particulars about the resegmentation.
"The rules only require we tell we have made a resegmentation. You just
merely need to alert the reader there has been a change."
Earlier Wednesday, Arnold repeated his sentiment that Lay did not
mislead investors about the company's financial health in the weeks
before it filed for bankruptcy protection in December 2001.
Arnold said third-quarter 2001 financial statements cited by Lay in
discussions with investors complied with Securities and Exchange
Commission rules.
"That is my view," he said, answering repeated questions about the
quarter when Enron reported $638 million in losses and a $1.2 billion
reduction in shareholder equity.
The government contends Lay knew many Enron assets were overvalued and
that losses were coming and misrepresented this to the public.
Several former high-ranking Enron executives have testified Lay misled
investors when he said the losses were one-time events.
"I disagree with their interpretation," Arnold said, who noted his
company had been paid $1 million for his work on the Enron defense.
Only 10 minutes into his testimony Wednesday, U.S. District Judge Sim
Lake grew impatient when Arnold and prosecutor Andrew Stolter repeatedly
went round and round on the same question.
"I'm not going to have sparring over minor, uncontroverted issues," a
clearly irritated Lake barked.
Skilling, who testified earlier, and Lay, who wrapped up six days on the
witness stand Tuesday, are accused of repeatedly lying to investors and
employees about Enron when prosecutors say they knew the company's
success stemmed from accounting tricks.
Skilling faces 28 counts of fraud, conspiracy, insider trading and lying
to auditors, while Lay faces six counts of fraud and conspiracy.
The two men counter no fraud occurred at Enron other than that committed
by a few executives, like Fastow, who stole money through secret side
deals. They attribute Enron's descent into bankruptcy proceedings to a
combination of bad publicity and lost market confidence.
This will be my one and only response to your comment.
As "the guy who wrote GAAP" for 10 plus years, it's pretty hard for me
to criticize anyone who followed the letter of the rules. However, much
more important is to understand the context of SFAS 140. While I was
gone from the Board when it was developed, I was there for its
predecessor, SFAS 125. That standard involved a very long, laborious
process of determining extremely precise rules for when liabilities
should and shouldn't be "derecognized" from the balance sheet. I can't
tell you how many meetings we had with lawyers involved with
securitization transactions and the like. In the end the document
attempted to walk a fine line like Goldilocks of getting it "just
right"- trying to derecognizing those liabilities where responsibility
for obligations had truly been passed to third parties while leaving
those on the balance sheet the ones for which the substance of an
obligation was retained. In the typical fashion of standards setting,
that necessitated very precise rules including legal opinions in some
cases.
Not too long after SFAS 125 was issued, it became clear that it wasn't
working very well and it wasn't accomplishing the "just right"
objective. So the Board began another project that took several more
years and resulted in SFAS 140. Still more (or, rather, different) rules
were developed in an effort to accomplish the same objective of keeping
true obligations on the balance sheet and derecognizing those for which
risks and rewards of ownership had passed to third parties.
SFAS 140 has been seen as not fully satisfactory by many parties, most
notably because of the "QSPE" exception that allowed Fannie Mae and many
other large financial institutions to keep huge amounts of
securitization trusts and similar amounts off the balance sheet when the
trusts were considered set up on "auto pilot." The FASB changed this
last year through SFAS 166 and 167 and Fannie Mae will consolidate $2.5
trillion of trust assets and liabilities that it doesn't own or owe in
its first quarter 2010 financial statements.
The bottom line is that this has been a highly contentious aspect of
accounting for many years. GAAP has been evolving and it may evolve
further. Would we have been better off with a "principle based"
approach? I personally doubt it although a New York Times article on
Friday suggested exactly that. The rules based approach to this general
area is far from perfect but I think it at least has resulted in more
consistency from company to company. I shudder to think how individual
companies would have applied a judgmental approach in an area like this.
Denny Beresford
March 20, 2010 reply from Bob Jensen
Hi
Denny,
I
will not prolong the agony, but I surely would like to have someone
explain to me how the Repo 105 accounting in the particular context used
by Lehman served any economic purpose other than to deceive investors
and creditors in the financial statements.
How in the world can the auditors conclude that Lehman severed "all
controls" over poisoned investments that they were 100% certain would
come back to Lehman in a few days. There was zero chance that the market
values of these poisoned CDOs would bounce back.
What could Lehman possibly gain other than balance sheet trickery?
Would Lehman have even entered into these Repo 105 transactions if
Lehman had to book the buy-back obligations as debt having higher values
than the sales prices at inflated and phony values.
I'm not sure auditors should follow any rules-based standards for
transactions only intended to deceive. Egads! Will Patricia Walters love
to hear me say that. Darn! She'll hang this one over my head for as long
as I live.
I
think I'm interpreting principles-based a little differently than you.
You are taking a micro view from the specific rules in FAS 140. I'm
taking a macro view that auditors have both a right and a duty to look
at any transactions that have only one purpose --- to deceive
investors and/or possibly members of the board. Accordingly auditors
have a right and a duty to disclose more to the persons being deceived,
whether they are members of the board of directors or individual
investors.
Also the seeking out an opinion from an England-based law firm has
shades of Enron painted all over it in the eyes of many of us in the
academy. This is especially the case for those of us that remember how
Ken Lay hired a shyster law firm to whitewash the whistle blowing of
Sherron Watkins --- http://www.trinity.edu/rjensen/FraudEnron.htm
You know the story. If it walks like a duck, quacks like a duck, and
looks like a duck then it probably is a duck.
I
really think that all Big Four auditors have for years been helping Wall
Street banks write fiction in their financial statements.
Frank Partnoy and Lynn Turner contend that Wall Street bank accounting
is an exercise in writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper "Make Markets Be
Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy,
Roosevelt Institute, March 2010 --- http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!
Begin Quote (about how top financial executives at Lehman were former
E=&Y auditors of Lehman) That kind of comfort
and confidence in your client and their technical competence comes from
a long, lucrative relationship. But it must have been more than that.
It could not have possibly come from confidence in the CFO suite, given
its revolving door and the lack of accounting interest and aptitude in
later years.
No.
Ernst and Young’s confidence
in Lehman’s CFO leadership was rooted in fraternity.
Both Christopher O’Meara and David Goldfarb,
his predecessor who was CFO from 2000 to 2004, are Ernst and Young
alumni. Prior to joining Lehman Brothers in 1994, Mr. O’Meara worked as
a senior manager in Ernst & Young’s Financial Services practice. Prior
to joining Lehman Brothers in 1993, Mr. Goldfarb served as the Senior
Partner of the Ernst & Young’s Financial Services practice, where he
worked from 1979 to 1993.
Mr. Goldfarb, the former EY
Senior Partner, was the Lehman CFO who created the Repo 105
transactions.
End Quote
Jensen Comment
But the Lehman-E&Y Fraternity was merely a local chapter of the larger
National Fraternity. The National Fraternity appears to have been among
the FASB, the Credit Rating Agencies (read that Moody’s) and Big Four
alumni working in all the troubled Wall Street Banks. When drowning in
the poison of AAA-rated CDO Bond Investments that should’ve been rated
as junk, the Repo 105 wash sale ploys were invented to keep the poisoned
bond investments off the balance sheet at fair values along with the
wash sale debt obligation to buy them back about a week after a Wall
Street bank’s books closed for the year.
Fraternity brothers at the FASB apparently joined in this
groupie by making FAS 140 mushy enough to make Repo 105 deceptive sales
appear to be legitimate. Lehman could sell a poisoned CDO bond the day
before the books closed as long as the Repo 105 sales contract had an
iron-clad clause to buy the poisoned CDO bond back at a higher price in
about a week. This was a costly Hail Mary effort to hide the poisoned
CDO bonds from the balance sheet and “pretend” with an orgiastic gasp
that the poisoned bonds were sold at a phony price immensely greater
than true fair value of junk.
And yet the FASB continues to stand before the
congregation and preach the virtues of “Fair Value Accounting.”
The FASB makes a huge deal in FAS 133 and FAS 157 about
booking financial contracts at fair value, but in FAS 140 allows its
fraternity brothers on Wall Street (and their Big Four auditors) not to
even have to disclose billions in Repo 105 buy-back obligations. Even an
Accounting 101 student can tell the FASB that this wasn’t really a sale,
and even if it was a sale the obligation to buy it back should’ve been
booked as debt.
Francine had the right idea about this being a groupie.
But she only hints at a local chapter of the groupie. I take that back.
She does provide the slightest hint of a National Chapter of that
fraternity.
Begin
Quote (actually Francine’s quoting the Examiner’s Report) Lehman initiated its Repo 105 program
sometime in 2001, soon after SFAS 140 took effect in September
2000 Lehman’s outside auditors and lawyers participated in
the firm’s review of SFAS 140. Indeed, Lehman vetted the concept of a SFAS 140 repo transaction with its outside auditor, before the firm
formalized a Repo 105 accounting policy and
approved Repo 105 transactions for use by firm personnel.
(Bankruptcy Examiner’s Report
V3, page 765) End Quote
What’s ironic is that Lehman could not even find a
shyster law firm in the U.S. to bless its Repo 105 transactions. If you
can’t get a U.S. law firm to lie for you it must really be a rotten lie.
Lehman and E&Y had to go all the way to England to find a shyster law
firm.
The rare look into the repo market embedded
in the report comes 18 months after Lehman Brothers collapsed in the
U.S.'s largest bankruptcy filing. While top Lehman executives were quick
to blame the real-estate market for their woes, the exhaustive report
singles out senior executives and auditor Ernst & Young for serious
lapses.
The report exposed for the first time what
appears to be an accounting slight of hand known as a Repo 105
transaction, where Lehman was able to book what looked like an ordinary
asset for cash as an out-and-out sale, drastically reducing its leverage
and making its financial picture look better than it really was. The
transactions often were done in flurries in a financial quarter's waning
days, before Lehman reported earnings.
Four days prior to the close of the 2007
fiscal year, Jerry Rizzieri, a member of Lehman's fixed-income division,
was searching for a way to meet his balance-sheet target, according to
the report. He wrote in an email: "Can you imagine what this would be
like without 105?"
A day before the close of Lehman's first
quarter in 2008, other employees scrambled to make balance-sheet
reductions, the report said. Kaushik Amin, then-head of Liquid Markets,
wrote to a colleague: "We have a desperate situation, and I need another
2 billion from you, either through Repo 105 or outright sales. Cost is
irrelevant, we need to do it."
Marie Stewart, the former global head of
Lehman's accounting policy group, told the examiner the transactions
were "a lazy way of managing the balance sheet as opposed to
legitimately meeting balance-sheet targets at quarter end."
Lehman's use of this accounting technique
goes back to the start of the decade when Lehman business units from New
York and London met to discuss how the firm could manage its balance
sheet using accounting rules that had taken effect in September 2000.
Lehman soon created the "Repo 105" maneuver: Because assets the firm
moved amounted to 105% or more of the cash it received in return, Lehman
could treat the transactions as sales and remove securities inventory
that otherwise would have to be kept on its balance sheet.
Because no U.S. law firm would bless the
transaction, Lehman got an opinion letter from London-based law firm
Linklaters. That letter essentially blessed using the maneuver for
Lehman's European broker-dealer under English law. If one of Lehman's
U.S. entities needed to engage in a Repo 105 transaction, the firm moved
the securities to its European arm to conduct the deal on the U.S.
entity's behalf, the report found. That is likely why the counterparties
on the repo transactions were largely a group of seven non-U.S. banks.
These included Germany's Deutsche Bank AG, Barclays PLC of the U.K. and
Japan's Mitsubishi UFJ Financial Group.
In a statement, a Linklaters spokeswoman said
the report "does not criticize" the legal opinions it gave Lehman "or
suggest or say they were wrong or improper." The law firm said it was
never contacted during the investigation.
Jensen Comment
Although Lehman could not find a shady U.S. law firm to "bless the
transaction," Ken Lay at Enron managed to find a shady U.S. law firm to
bless the Raptors' transactions after Sherron Watkins (an Enron
executive) sent her infamous whistle blowing memo to both Ken Lay and to
Andersen executives in Chicago.---
http://www.trinity.edu/rjensen/FraudEnron.htm
Yogi Berra says Lehman bankruptcy following Enron
bankruptcy is auditing “Déjà vu all over again.”
Teaching Case on Repo
105/108 "Sales" That are 100% Certain to be Returned
This is really a test of whether an audit firm should follow FASB rules
that, in a particular context, become deceptive for investors/creditors
Given a choice of choosing the client's interests versus the interests
of investors and creditors, the auditor chose the client in this case
If both Lehman and Ernst &
Young get off with no fines or penalties it reminds me of all the
instances in history where confessed serial killers or rapists got off
based upon some technicality in the law such as obtaining evidence
without a warrant. The FASB erred it in writing the FAS 140 rules, and
perhaps Lehman and Ernst will both walk away scott free on this clever
exploitation of an unintended loophole in the FAS 140 standard. But the
renowned audit firm will forever have a black mark in history where it
obviously put client requests for deception above its responsibility for
transparency accounting in the best interests of shareholders and
creditors.
From The Wall Street Journal
Weekly Accounting Review on March 18, 2011
SUMMARY: "In
recent months, Securities and Exchange Commission officials have
grown increasingly doubtful they can prove that Lehman violated U.S.
laws by using an accounting measure to move as much as $50 billion
in assets..." and debt off of its balance sheet. One year ago, a
report by "...a U.S. bankruptcy-court examiner investigating the
collapse of Lehman Brothers Holdings Inc. blame[d] senior executives
and auditor Ernst & Young for serious lapses that led to the largest
bankruptcy in U.S. history and the worst financial crisis since the
Great Depression."
CLASSROOM
APPLICATION: The article is useful to
discuss repurchase agreements ("repos"), auditors' responsibility to
ascertain whether a client is utilizing appropriate accounting and
has internal controls in place to ensure the sue of those methods,
and the Lehman Brothers collapse that led to the financial crisis.
QUESTIONS:
1. (Introductory) Who is the firm of Lehman Brothers? What
happened to this firm? Hint: you may use related articles to answer
this question.
2. (Advanced) What are "repos" or repurchase agreements?
How can they be used to reduce debt on a balance sheet and therefore
make a firm look healthier than it really is?
3. (Advanced) What is an auditor's responsibility for
assessing whether financial statements are prepared in accordance
with generally accepted accounting standards? What steps must the
auditor take if he or she finds transactions not accounted for in
accordance with generally accepted accounting principles?
4. (Introductory) How did the Lehman Brothers auditor,
Ernst & Young, view the firm's use of repo transactions? Who has
questioned their business purpose and the accounting for them? Why
is the accounting for these transactions being questioned?
5. (Advanced) What are the potential implications for E&Y
if the SEC had found evidence that Lehman Brothers executives
intentionally misused accounting for repo transactions to improve
the overall appearance of the financial statements?
6. (Advanced) Are U.S. accounting standards establish in
U.S. law? Explain your answer.
7. (Introductory) How could Lehman Brothers executives have
violated U.S. law and therefore have acted in a way that would bring
an SEC enforcement action against them? Cite explanations in the
article specifically related to the grounds on which the SEC would
be able to bring a civil suit and perhaps lead the justice
department to bring a criminal suit against these executives.
Reviewed By: Judy Beckman, University of Rhode Island
The U.S.
government's investigation into the collapse of Lehman Brothers
Holdings Inc. has hit daunting hurdles that could result in no civil
or criminal charges ever being filed against the company's former
executives, people familiar with the situation said.
In recent
months, Securities and Exchange Commission officials have grown
increasingly doubtful they can prove that Lehman violated U.S. laws
by using an accounting maneuver to move as much as $50 billion in
assets off its balance sheet, which made it appear that the
securities firm had reduced its debt levels.
SEC
officials also aren't confident they could win any lawsuit accusing
former Lehman employees, including former Lehman Chief Executive
Richard Fuld Jr., of failing to adequately mark down the value of
the large real-estate portfolio acquired in Lehman's takeover of
apartment developer Archstone-Smith Trust or to disclose the
resulting losses to investors, according to people familiar with the
matter.
People
close to the investigation cautioned that no decision has been
reached on whether to bring civil charges, adding that new evidence
still could emerge. Investigators are reviewing thousands of
documents turned over to the SEC since it began its probe shortly
after Lehman tumbled into bankruptcy in September 2008 and was sold
off in pieces. Officials also have questioned a number of former
Lehman executives, some of them multiple times, the people said.
But after
zeroing in last summer on the battered real-estate portfolio and an
accounting move known as Repo 105, SEC officials have grown more
worried they could lose a court battle if they bring civil charges
that allege Lehman investors were duped by company executives. The
key stumbling block: The accounting move, while controversial, isn't
necessarily illegal.
In a
possible sign that the probe has slowed, the SEC hasn't issued a
Wells notice to Lehman's longtime auditor, Ernst & Young, according
to people familiar with the situation. The firm had concluded that
the accounting in the Repo 105 transactions was acceptable. Wells
notices are a formal signal that the SEC's enforcement staff has
decided it might file civil charges against the recipient.
An SEC
spokesman declined to comment. In a statement, Ernst & Young said
the firm stands "behind our work on the Lehman audit and our opinion
that Lehman's financial statements were fairly stated in accordance
with the U.S. accounting standards that existed at the time."
The snags
are the latest sign of trouble for the SEC and other U.S. regulators
trying to punish companies and executives at the center of the
financial crisis. So far, no high-profile executives have been
successfully prosecuted. Last month, a federal criminal
investigation of former Countrywide Financial Corp. Chief Executive
Angelo Mozilo was closed without charges.
The U.S.
government lost the only crisis-related case to go to trial when
former Bear Stearns Cos. hedge-fund managers Ralph Cioffi and
Matthew Tannin were acquitted in November 2009 of criminal charges
related to the $1.6 billion collapse of their hedge funds.
If SEC
officials decide not to take enforcement action against former
Lehman executives, they likely would escape criminal prosecution,
too. The Justice Department "tends to follow the SEC's lead in these
complex financial cases, so reluctance to pursue civil charges
generally means the federal agencies won't take a criminal case,"
said Elizabeth Nowicki, a former SEC lawyer who is an associate
professor at Tulane University School of Law in New Orleans.
A
spokeswoman for the Justice Department declined to comment on
Lehman. In a statement, she said the agency "will continue to root
out financial fraud wherever it exists. When we find credible
evidence of criminal conduct—by Wall Street financiers, lawyers,
accountants or others—we will aggressively pursue justice. However,
we can and will only bring charges when the facts and the law
convince us that we can prove a crime beyond a reasonable doubt."
A year ago,
it looked as if the SEC and federal prosecutors had a road map to
use against Lehman's former top executives. Last March, the Repo 105
transactions were condemned by court-appointed examiner Anton R.
Valukas, who said in a report that they enabled Lehman to "paint a
misleading picture of its financial condition."
In the
transactions, Lehman swapped fixed-income assets for cash shortly
before the securities firm reported quarterly results, promising to
buy back the securities later. The cash was used to pay down the
company's debts. Emails sent by executives at the company referred
to Repo 105 as a "drug" and "basically window dressing."
Mr. Valukas
concluded there were "colorable," or credible, legal claims against
Ernst & Young, Mr. Fuld and former finance chiefs Ian Lowitt, Erin
Callan and Christopher O'Meara.
All four
former Lehman executives have been scrutinized by the SEC, according
to people familiar with the matter. Their lawyers didn't respond to
calls seeking comment. They previously have denied any wrongdoing
related to Repo 105.
A December
lawsuit against Ernst & Young by soon-to-depart New York Attorney
General Andrew Cuomo drew heavily on Mr. Valukas's findings. Mr.
Cuomo, who became New York's governor in January, criticized the
Repo 105 transactions as a "house-of-cards business model, designed
to hide billions in liabilities in the years before Lehman
collapsed."
Mr. Cuomo's
successor, Eric Schneiderman, is "fully committed" to pursuing the
case, a spokesman said. Ernst & Young has vowed to vigorously defend
itself against accusations that the maneuver violated generally
accepted accounting procedures.
In
contrast, SEC officials generally have concluded that the
transactions were consistent with accounting standards, according to
people familiar with the situation.
And agency
officials aren't convinced that Lehman shareholders suffered
material harm, since executives were trading one type of highly
liquid asset for another, these people said. They said the SEC would
face a far lower bar if Lehman had converted illiquid or damaged
assets, such as Archstone's real-estate holdings, into cash using
Repo 105.
Mr. Fuld
and other former executives could face charges of making misleading
statements about the company's health before it sank. That likely
would be an uphill battle for the government, according to people
familiar with the matter, partly because the executives relied on
legal and accounting opinions.
British law firm Linklaters LLP signed off on the Repo 105
transactions, all done through the securities firm's European arm.
Linklaters declined to comment.
Steve Kroft
talks to the bank examiner whose investigation reveals the how and
why of the spectacular financial collapse of Lehman Brothers, the
bankruptcy that triggered the world financial crisis. Web Extras
The case
against Lehman Brothers Kroft: When to give up on accountability
Inside the SEC More »
Update: A
statement from Ernst and Young: Lehman's bankruptcy occurred in the
midst of a global financial crisis triggered by dramatic increases
in mortgage defaults, associated losses in mortgage and real estate
portfolios, and a severe tightening of liquidity.
We firmly
believe that our work met all applicable professional standards,
applying the rules that existed at the time. Lehman's demise was
caused by the global financial crisis that impacted the entire
financial sector, not by accounting or financial reporting issues.
It's hard
to overstate the enormity of the 2008 collapse of Lehman Brothers.
It was the largest bankruptcy in history; 26,000 employees lost
their jobs; millions of investors lost all or almost all of their
money; and it triggered a chain reaction that produced the worst
financial crisis and economic downturn in 70 years.
Yet four
years later, no one at Lehman has been held responsible. Steve Kroft
investigates the collapse of Lehman Brothers: what the SEC did and
didn't know about the firm's finances, the role of a top accounting
firm, and why no one at Lehman has been called to account.
The
following script is from "The Case Against Lehman" which originally
aired on April 22, 2012. Steve Kroft is the correspondent. James
Jacoby and Michael Karzis, producers.
On
September 15, 2008, Lehman Brothers, the fourth largest investment
bank in the world, declared bankruptcy -- sparking chaos in the
financial markets and nearly bringing down the global economy. It
was the largest bankruptcy in history -- larger than General Motors,
Washington Mutual, Enron, and Worldcom combined. The federal
bankruptcy court appointed Anton Valukas, a prominent Chicago lawyer
and former United States attorney to conduct an investigation to
determine what happened.
Included in
the nine-volume, 2,200-page report was the finding that there was
enough evidence for a prosecutor to bring a case against top Lehman
officials and one of the nation's top accounting firms for
misleading government regulators and investors. That was two years
ago and there have been no prosecutions. Anton Valukas has never
given an interview about his report until now.
Steve
Kroft: This is the largest bankruptcy in the world. What were the
effects?
Anton
Valukas: The effects were the financial disaster that we are living
our way through right now.
Steve Kroft:
And who got hurt?
Anton
Valukas: Everybody got hurt. The entire economy has suffered from
the fall of Lehman Brothers.
Steve Kroft:
So the whole world?
Anton
Valukas: Yes, the whole world.
When Lehman
Brothers collapsed, 26,000 employees lost their jobs and millions of
investors lost all or almost all of their money, triggering a chain
reaction that produced the worst financial crisis and economic
downturn in 70 years. Anton Valukas' job was to provide the
bankruptcy court with accurate, reliable information that the judges
could use to resolve the claims of creditors picking over Lehman's
corpse.
Steve
Kroft: Had you ever done anything like this before?
Anton
Valukas: I've never done anything like Lehman Brothers. I don't
think anybody else has ever done anything like Lehman Brothers.
Steve
Kroft: So your job, I mean, in some ways, your job was to assess
blame?
Anton
Valukas: Our job is to determine what actually happened, put the
cards face up on the table, and let everybody see what the facts
truly are.
Valukas'
team spent a year and a half interviewing hundreds of former
employees, and pouring over 34 million documents. They told of how
Lehman bought up huge amounts of real estate that it couldn't unload
when the market went south -- how it had borrowed $44 for every one
it had in the bank to finance the deals -- and how Lehman executives
manipulated balance sheets and financial reports when investors
began losing confidence and competitors closed in.
Steve
Kroft: Did these quarterly reports represent to investors a fair,
accurate picture of the company's financial condition?
Anton
Valukas: In our opinion, they did not.
Steve
Kroft: And isn't that against the law?
Anton
Valukas: It certainly, in our opinion, was against civil law if you
will. There were colorable claims that this was a fraud, yes.
By
colorable claims Valukus means there is sufficient evidence for the
Justice Department or the Securities and Exchange Commission to
bring charges against top Lehman executives, including CEO Richard
Fuld, for overseeing and certifying misleading financial statements,
and against Lehman's accountant, Ernst and Young, for failing to
challenge Lehman's numbers.
Anton
Valukas: They'd fudged the numbers. They would move what turned out
to be approximately $50 billion of assets from the United States to
the United Kingdom just before they printed their financial
statements. And a week or so after the financial statements had been
distributed to the public, the $50 billion would reappear here in
the United States, back on the books in the United States.
Steve
Kroft: And then the next financial statement, they would move it
overseas again, and file the report, and then move it back?
Anton
Valukas: Right.
Steve
Kroft: It sounds like a shell game.
Anton
Valukas: It was a shell game. It was a gimmick.
Lehman
misused an accounting trick called Repo 105 to temporarily remove
the $50 billion from its ledgers to make it look as though it was
reducing its dependency on borrowed money and was drawing down its
debt. Lehman never told investors or regulators about it.
Steve Kroft:
This is really deception to make the company look healthier than it
was?
Anton
Valukas: Yes.
Steve Kroft:
Deliberate?
Anton
Valukas: Yes.
Steve Kroft:
How are you so sure of that?
Anton
Valukas: Because we read the emails in which we observed the people
saying that they were doing it. We interviewed the witnesses who
wrote those emails, or some of those emails, and asked them why they
were doing it, and they told us they were doing it for purposes of
affecting the numbers.
Steve Kroft:
Do you think that Lehman executives knew that this was wrong?
Anton
Valukas: For some of 'em, certainly. There was concerns being
expressed by-- at high levels about whether this is appropriate,
what happens if the street found out about it. So, you know, there
was a concern that there's a real question about whether we can do
this, whether this was right or not.
One of
those people was Matthew Lee who had been a senior executive at
Lehman and the accountant responsible for its global balance sheet.
Lee was one of the first to raise objections inside Lehman about the
accounting trick known as Repo 105.
Matthew
Lee: It sounded like a rat poison, Repo 105, when I first heard it.
So I investigated what it was, and I didn't like what I saw.
Continued in article
Jensen Comment
Lehman executives took an interesting tack when defending themselves
from the SEC. Their defense is that the SEC knew in advance about the
Repo 105 and Repo 108 transactions and could've prevented those
deceptions from happening in the first place. Hence if the SEC sues over
these deceptions the SEC will end up bringing a lawsuit against itself.
In any case who cares about an
SEC lawsuit. Director Mary Shapiro only throws marshmallows. Only the
Department of Justice can throw people in Jail, which is what the Lehman
Bankruptcy Examiner (Valukas) really wants in this case. But the DOJ is
too busy trying to get itself out of the mess its in for sending
terrifying weapons to the Mexican Drug Cartels.
The FASB tentatively
decided this week to propose specifying the types of repurchase
agreements (also known as “repos”) that should be accounted for as
secured borrowings based on six criteria. These types of transactions
would be an exception to the general guidance for derecognition of
financial assets. The existing criteria for assessing effective control
of repurchase
PwC In Brief
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=GBAD-8VQQLA&SecNavCode=MSRA-84YH44&ContentType=Content
Lehman never publicly disclosed its use of
Repo 105 transactions, its accounting treatment for these
transactions, the considerable escalation of its total Repo 105
usage in late 2007 and into 2008, or the material impact these
transactions had on the firm’s publicly reported net leverage ratio.
According to former Global Financial Controller Martin Kelly, a
careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal
Lehman’s use of Repo 105 transactions. Lehman failed to disclose its
Repo 105 practice even though Kelly believed “that the only purpose
or motive for the transactions was reduction in balance sheet”; felt
that “there was no substance to the transactions”; and expressed
concerns with Lehman’s Repo 105 program to two consecutive Lehman
Chief Financial Officers – Erin Callan and Ian Lowitt – advising
them that the lack of economic substance to Repo 105 transactions
meant “reputational risk” to Lehman if the firm’s use of the
transactions became known to the public. In addition to its material
omissions, Lehman affirmatively misrepresented in its financial
statements that the firm treated all repo transactions as financing
transactions – i.e., not sales – for financial reporting purposes.
Jensen Comment
Former employees of Big Four firms (alumni) have a blog that is
generally upbeat and tends not to be critical of their former employers
However, with respect to the impact of the Lehman Bankruptcy Examiners
Report, this Big Four Blog is unusually critical of Ernst and Young and
predicts a very tough time for E&Y in the aftermath.
The
next few days will reveal how the regulators, erstwhile shareholders of
Lehman and other stakeholders will move against E&Y. Valukas’ statement
that there is sufficient evidence to show that E&Y was negligent is
enough to spur a whole host of law suits. E&Y is in a very tough spot
now, and while it may escape an imploding collapse like Andersen, the
long tail of Lehman is sure to create a strong whiplash with painful
monetary, reputational and punitive "Ernst and Young Found Negligent in Lehman Report, Tough
Consequences," The Big Four Blog, March 17, 2010 ---
http://bigfouralumni.blogspot.com/2010/03/ernst-and-young-found-negligent-in.html
There’s
been so much press on the recently released report on the
spectacular failure of Lehman Brothers by Anton Valukas, so we’ll
just focus on the key elements which involve Lehman’s auditor Ernst
& Young.
Valukas is
highly critical of E&Y’s work, claiming that they did not perform
the due diligence needed by audit firms, the ultimate watchdog of
investors’ interests. He believes there is a case of negligence and
professional malpractice against the firm. Though in a very limited
sense Lehman perhaps followed standard accounting principles, and
this is the basis on which E&Y signed off on their annual and
quarterly filings, they wrongly categorized a repo as a sale to
knowingly report a lower leverage ratio, they exceeded internal
limits on the infamous Repo 105, and they found a loophole in the
British system to execute these transactions, and keep them off the
public eye.
Lehman was
clearly at fault and grossly fraudulent in hiding this from
investors, and then obfuscating answers to clear questions from
analysts. Is Ernst and Young equally culpable?
E&Y should
have been more rigorous in pursuing this issue, knowing that it was
material, being misrepresented and highly abused. With full
knowledge of its usage, and then signing off on SEC documents is
definitely negligent.
E&Y is now
being investigated by the FRC in the UK and very likely in due
course by the SEC. The Saudi government has already cancelled E&Y’s
security license in the kingdom. The law suits are yet to hit the
wires, but they are coming. The key is whether a criminal indictment
of the firm is likely, recall that this is what brought down
Andersen. Dealing with civil suits is only a matter of money, but a
criminal charge is going to send clients away in droves. The
critical question is whether the industry can withstand the loss of
a $20 billion accounting giant, the consequences of a Big Three are
quite hard to imagine.
E&Y was
recently hit with a $8.5 million fine by the SEC for its involvement
with Bally Fitness, and in that settlement E&Y agreed to tighten
internal procedures and refrain from audit abuse. So the SEC is
unlikely to look favorably on this.
The next
few days will reveal how the regulators, erstwhile shareholders of
Lehman and other stakeholders will move against E&Y. Valukas’
statement that there is sufficient evidence to show that E&Y was
negligent is enough to spur a whole host of law suits.
E&Y
is in a very tough spot now, and while it may escape an imploding
collapse like Andersen, the long tail of Lehman is sure to create a
strong whiplash with painful monetary, reputational and punitive
consequences.
Lehman never publicly disclosed its use of
Repo 105 transactions, its accounting treatment for these
transactions, the considerable escalation of its total Repo 105
usage in late 2007 and into 2008, or the material impact these
transactions had on the firm’s publicly reported net leverage ratio.
According to former Global Financial Controller Martin Kelly, a
careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal
Lehman’s use of Repo 105 transactions. Lehman failed to disclose its
Repo 105 practice even though Kelly believed “that the only purpose
or motive for the transactions was reduction in balance sheet”; felt
that “there was no substance to the transactions”; and expressed
concerns with Lehman’s Repo 105 program to two consecutive Lehman
Chief Financial Officers – Erin Callan and Ian Lowitt – advising
them that the lack of economic substance to Repo 105 transactions
meant “reputational risk” to Lehman if the firm’s use of the
transactions became known to the public. In addition to its material
omissions, Lehman affirmatively misrepresented in its financial
statements that the firm treated all repo transactions as financing
transactions – i.e., not sales – for financial reporting purposes.
It is the Wall
Street equivalent of a coroner’s
report — a
2,200-page document
that lays out,
in new and startling detail, how
Lehman Brothers
used
accounting sleight of hand to
conceal the bad investments that led
to its undoing.
The report, compiled by an examiner for the
bank, now bankrupt, hit Wall Street with a thud late Thursday. The
158-year-old company, it concluded, died from multiple causes. Among
them were bad mortgage holdings and, less directly, demands by
rivals like JPMorgan Chase and Citigroup, that the foundering bank
post collateral against loans it desperately needed.
But the examiner, Anton R. Valukas, also
for the first time, laid out what the report characterized as
“materially misleading” accounting gimmicks that Lehman used to mask
the perilous state of its finances. The bank’s bankruptcy, the
largest in American history, shook the financial world. Fears that
other banks might topple in a cascade of failures eventually led
Washington to arrange a sweeping rescue for the nation’s financial
system.
According to the report, Lehman used what
amounted to financial engineering to temporarily shuffle $50 billion
of troubled assets off its books in the months before its collapse
in September 2008 to conceal its dependence on leverage, or borrowed
money. Senior Lehman executives, as well as the bank’s accountants
at Ernst & Young, were aware of the moves, according to Mr. Valukas,
the chairman of the law firm Jenner & Block and a former federal
prosecutor, who filed the report in connection with Lehman’s
bankruptcy case.
Richard S. Fuld Jr., Lehman’s former chief
executive, certified the misleading accounts, the report said.
“Unbeknownst to the investing public,
rating agencies, government regulators, and Lehman’s board of
directors, Lehman reverse engineered the firm’s net leverage ratio
for public consumption,” Mr. Valukas wrote.
Mr. Fuld was “at least grossly negligent,”
the report states, adding that Henry M. Paulson Jr., who was then
the Treasury secretary, warned Mr. Fuld that Lehman might fail
unless it stabilized its finances or found a buyer.
Lehman executives engaged in what the
report characterized as “actionable balance sheet manipulation,” and
“nonculpable errors of business judgment.”
The report draws no conclusions as to
whether Lehman executives violated securities laws. But it does
suggest that enough evidence exists for potential civil claims.
Lehman executives are already defendants in civil suits, but have
not been charged with any criminal wrongdoing.
A large portion of the nine-volume report
centers on the accounting maneuvers, known inside Lehman as “Repo
105.”
First used in 2001, long before the crisis
struck, Repo 105 involved transactions that secretly moved billions
of dollars off Lehman’s books at a time when the bank was under
heavy scrutiny.
According to Mr. Valukas, Mr. Fuld ordered
Lehman executives to reduce the bank’s debt levels, and senior
officials sought repeatedly to apply Repo 105 to dress up the firm’s
results. Other executives named in the examiner’s report in
connection with the use of the accounting tool include three former
Lehman chief financial officers: Christopher O’Meara, Erin Callan
and Ian Lowitt.
Patricia Hynes, a lawyer for Mr. Fuld, said
in an e-mailed statement that Mr. Fuld “did not know what those
transactions were — he didn’t structure or negotiate them, nor was
he aware of their accounting treatment.”
Charles Perkins, a spokesman for Ernst &
Young, said in an e-mailed statement: “Our last audit of the company
was for the fiscal year ending Nov. 30, 2007. Our opinion indicated
that Lehman’s financial statements for that year were fairly
presented in accordance with Generally Accepted Accounting
Principles (GAAP), and we remain of that view.”
Bryan Marsal, Lehman’s current chief
executive, who is unwinding the firm, said in a statement that he
was evaluating the report to assess how it might help in efforts to
advance creditor interests.
Repos, short for repurchase agreements, are
a standard practice on Wall Street, representing short-term loans
that provide sometimes crucial financing. In them, firms essentially
lend assets to other firms in exchange for money for short periods
of time, sometimes overnight.
But Lehman used aggressive accounting in
its Repo 105 transactions: it appears to have structured
transactions such that they sold securities at the end of the
quarter, but planned to buy them back again days later. These assets
were mostly illiquid real estate holdings, meaning that they were
hard to sell in normal transactions.
Your
link word wrapped badly, so I snipped it to
http://snipurl.com/petersonlehman
You seem to ignore the many serious internal control weakness that
Section 404 audits uncovered, e.g. at Kodak. But that's another
matter.
No
matter how we take the Examiner's report and the possible politics
involved, it all boils down to a naïve investor (perhaps a
first-year accounting student) looking up at the Lehman's new Repo
105 suit of clothes and exclaiming the "Emperor's not wearing a
stitch of clothes."
A
standard setter on the IASB sent me a private message this morning
stated the following"
“As for Repo 105, I did read Volume 1 of the report.
Common sense tells me that if I “sell” something but have a binding
obligation to buy it back, I really didn’t sell it – no matter what
the technicalities of an accounting rule might say.”
This
may be as simple as the Accounting 101 cheating that Worldcom kept
from its Board and the public.
And
Andersen's sorry audit of Worldcom was a simple violation of
Auditing 101.
The
Repo 105 uproar boils down to the simplicity of Auditing 101.
And the Ernst & Young audit is a violation of Auditing 101 no matter
what rules are donned by the Emperor.
Bob
Jensen
My Hero Lawyer, Professor, and Wall Street Financial Expert Weighs In
Question
In the bankruptcy court examiner's report on Lehman's downfall, is Volume 3 more
or less important than Volume 2?
Answer
For Ernst & Young it is probably Volume 3, but my true hero exposing Wall Street
scandals opts for Volume 2.
The buzz on the Lehman
bankruptcy examiner’s report has focused on Repo 105, for good reason. That
scheme is one powerful example of how the balance sheets of major Wall Street
banks are fiction. It also shows why Congress must include real accounting
reform in its financial legislation, or risk another collapse. (If you have 8
minutes to kill, here is my
recent talk on the off-balance sheet problem,
from the Roosevelt Institute financial conference.)
But an even more troubling section of the Lehman report is not
Volume 3 on Repo 105. It is Volume 2, on
Valuation. The Valuation section is 500 pages of utterly terrifying reading. It
shows that, even eighteen months after Lehman’s collapse, no one – not the
bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and
Young, and certainly not the regulators – could figure out what many of Lehman’s
assets and liabilities were worth. It shows Lehman was too complex to do
anything but fail.
The report cites
extensive evidence of valuation problems. Check out page 577, where the report
concludes that Lehman’s high credit default swap valuations were reasonable
because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when
are Citigroup’s valuations the objective benchmark?
Or page 547, where the
report describes how Lehman’s so-called “Product Control Group” acted like
Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO
positions, and deferred to the traders’ models, saying “We’re not quants.” Here
are two money quotes:
While the function of the Product Control Group was to serve as a check on the
desk marks set by Lehman’s traders, the CDO product controllers were hampered in
two respects. First, the Product Control Group did not appear to have sufficient
resources to price test Lehman’s CDO positions comprehensively. Second, while the
CDO product controllers were able to effectively verify the prices of many positions
using trade data and third‐party prices, they did not have the same level of quantitative
sophistication as many of the desk personnel who developed models to price CDOs. (page 547)
Or this one:
However, approximately a
quarter of Lehman’s CDO positions were not affirmatively priced by the Product
Control Group, but simply noted as ‘OK’ because the desk had already written
down the position significantly. (page 548)
My favorite section
describes the valuation of Ceago, Lehman’s largest CDO position. My corporate
finance students at the University of San Diego School of Law understand that
you should use higher discount rates for riskier projects. But the Valuation
section of the report found that with respect to Ceago, Lehman used LOWER
discount rates for the riskier tranches than for the safer ones:
The discount rates used
by Lehman’s Product Controllers were significantly understated. As stated, swap
rates were used for the discount rate on the Ceago subordinate tranches.
However, the resulting rates (approximately 3% to 4%) were significantly lower
than the approximately 9% discount rate used to value the more senior S tranche.
It is inappropriate to use a discount rate on a subordinate tranche that is
lower than the rate used on a senior tranche. (page 556)
It’s one thing to have
product controllers who aren’t “quants”; it’s quite another to have people in
crucial risk management roles who don’t understand present value.
When the examiner
compared Lehman’s marks on these lower tranches to more reliable valuation
estimates, it found that “the prices estimated for the C and D tranches of Ceago
securities are approximately one‐thirtieth of the price reported
by Lehman. (pages 560-61) One thirtieth? These valuations weren’t even close.
Ultimately, the examiner
concluded that these problems related to only a small portion of Lehman’s
overall portfolio. But that conclusion was due in part to the fact that the
examiner did not have the time or resources to examine many of Lehman’s
positions in detail (Lehman had 900,000 derivative positions in 2008, and the
examiner did not even try to value Lehman’s numerous corporate debt and equity
holdings).
The bankruptcy examiner
didn’t see enough to bring lawsuits. But the valuation section of the report
raises some hot-button issues for private parties and prosecutors. As the report
put it, there are issues that “may warrant further review by parties in
interest.”
For example, parties in
interest might want to look at the report’s section on Archstone, a publicly
traded REIT Lehman acquired in October 2007. Much ink has been spilled
criticizing the valuation of Archstone. Here is the Report’s finding (at page
361):
… there is sufficient
evidence to support a finding that Lehman’s valuations for its Archstone equity
positions were unreasonable beginning as of the end of the first quarter of
2008, and continuing through the end of the third quarter of 2008.
And Archstone is just one
of many examples.
The Repo 105 section of
the Lehman report shows that Lehman’s balance sheet was fiction. That was bad.
The Valuation section shows that Lehman’s approach to valuing assets and
liabilities was seriously flawed. That is worse. For a levered trading firm, to
not understand your economic position is to sign your own death warrant.
Ernst & Young Explains Its
Side of the Lehman Bankruptcy Examiner's Report Controversy
In light of
the extensive discussion of the Lehman Bros. and E&Y matter on this
listserv over the past couple of weeks, I thought readers might be
interested in the message I've copied below. This was sent to me in
my capacity as an audit committee chairman.
I hope this
might balance the discussion somewhat. I would observe that to date
the postings have been based mainly on newspaper accounts of the
bankruptcy examiner's lengthy report that was completed for the
purpose of determining whether the bankruptcy estate might have
claims against various parties. In effect, basing one's conclusions
about a situation on this source material is roughly equivalent to a
judge or jury reaching a decision after hearing only the
prosecution's side of the case. While the message below is
necessarily very brief, I think it illustrates that there are other
facts and arguments that should be fairly evaluated before anyone is
found guilty in the court of public opinion or otherwise.
Denny
Beresford
I hope this
note finds you well and enjoying the early days of Spring.
In light of
your role in our Audit Committee Leadership Network, I am sending
you this note to brief you on a matter given there have been
extensive media reports about the release of the Bankruptcy
Examiner’s Report relating to the September 2008 bankruptcy of
Lehman Brothers. As you may have read, Ernst & Young was Lehman
Brothers’ independent auditors.
The concept of
an examiner’s report is a feature of US bankruptcy law.
It does not
represent the views of a court or a regulatory body, nor is the
Report the result of a legal process. Instead, an examiner’s report
is intended to identify potential claims that, if pursued, may
result in a recovery for the bankrupt company or its creditors. EY
is confident we will prevail should any of the potential claims
identified against us be pursued.
We wanted to
provide you with EY’s perspective on some of the potential claims in
the Examiner’s Report. We also wanted to address certain media
coverage and commentary on the Examiner’s Report that has at times
been inaccurate, if not misleading.
A few key
points are set out below.
*_General
Comments_*
·
EY’s last audit was for the year ended
November 30, 2007. Our opinion stated that Lehman’s financial
statements for 2007 were fairly presented in accordance with US GAAP,
and we remain of that view. We reviewed but did not audit the
interim periods for Lehman’s first and second quarters of fiscal
2008.
· Lehman’s
bankruptcy was the result of a series of unprecedented adverse
events in the financial markets. The months leading up to Lehman’s
bankruptcy were among the most turbulent periods in our economic
history. Lehman's bankruptcy was caused by a collapse in its
liquidity, which was in turn caused by declining asset values and
loss of market confidence in Lehman. It was not caused by accounting
issues or disclosure issues.
· The Examiner
identified _no_ potential claims that the assets and liabilities
reported on Lehman’s financial statements (approximately
$691 billion
and $669 billion respectively, at November 30, 2007) were improperly
valued or accounted for incorrectly.
*_Accounting
and Disclosure Issues Relating to Repo 105 Transactions_* · There
has been significant media attention about potential claims
identified by the Examiner related to what Lehman referred to as
“Repo 105” transactions. What has not been reported in the media is
that the Examiner _did not_ challenge Lehman’s accounting for its
Repo 105 transactions.
·As recognized
by the Examiner, all investment banks used repo transactions
extensively to fund their operations on a daily basis; these banks
all operated in a high-risk, high-leverage business model.
Most repo
transactions are accounted for as financings; some (the Repo
105
transactions) are accounted for as sales if they meet the
requirements of SFAS 140.
· The Repo 105
transactions involved the sale by Lehman of high quality liquid
assets (generally government-backed securities), in return for which
Lehman received cash. The media reports that these were “sham
transactions” designed to off-load Lehman’s “bad assets” are
inaccurate.
· Because
effective control of the securities was surrendered to the
counterparty in the Repo 105 arrangements, the accounting literature
(SFAS 140) /required /Lehman to account for Repo 105 transactions as
sales rather than financings.
· The
potential claims against EY arise solely from the Examiner’s
conclusion that these transactions ($38.6 billion at November 30,
2007) should have been specifically disclosed in the footnotes to
Lehman’s financial statements, and that Lehman should have disclosed
in its MD&A the impact these transactions would have had on its
leverage ratios if they had been recorded as financing transactions.
· While no
specific disclosures around Repo 105 transactions were reflected in
Lehman’s financial statement footnotes, the 2007 audited financial
statements were presented in accordance with US GAAP, and clearly
portrayed Lehman as a leveraged entity operating in a risky and
volatile industry. Lehman’s 2007 audited financial statements
included footnote disclosure of off balance sheet commitments of
almost $1 trillion.
· Lehman’s
leverage ratios are not a GAAP financial measure; they were included
in Lehman’s MD&A, not its audited financial statements. Lehman
concluded no further MD&A disclosures were required; EY did not take
exception to that judgment.
· If the Repo
105 transactions were treated as if they were on the balance sheet
for leverage ratio purposes, as the Examiner suggests, Lehman’s
reported gross leverage would have been 32.4 instead of 30.7 at
November 30, 2007. Also, contrary to media reports, the decline in
Lehman’s reported leverage from its first to second quarters of 2008
was not a result of an increased use of Repo 105 transactions*.
*Lehman’s Repo 105 transaction volumes were comparable at the end of
its first and second quarters.
*_Handling of
the Whistleblower’s Issues_*
·
The media has inaccurately reported that EY
concealed a May 2008 whistleblower letter from Lehman’s Audit
Committee. The whistleblower letter, which raised various
significant potential concerns about Lehman’s financial controls and
reporting /but did not mention Repo 105/, was directed to Lehman’s
management. When we learned of the letter, our lead partner promptly
called the Audit Committee Chair; we also insisted that Lehman’s
management inform the Securities & Exchange Commission and the
Federal Reserve Bank of the letter. EY’s lead partner discussed the
whistleblower letter with the Lehman Audit Committee on at least
three occasions during June and July 2008.
· In the
investigations that ensued, the writer of the letter did briefly
reference Repo 105 transactions in an interview with EY partners. He
also confirmed to EY that he was unaware of any material financial
reporting errors. Lehman’s senior executives did not advise us of
any reservations they had about the company’s Repo 105 transactions.
· Lehman’s
September 2008 bankruptcy prevented EY from completing its
assessment of the whistleblower’s allegations. The allegations would
have been the subject of significant attention had EY completed its
third quarter review and 2008 year-end audit.
Should any of
the potential claims be pursued, we are confident we will prevail.
March 20, 2010 reply from Bob
Jensen
Hi
Denny,
Thank
you for this. I was worried that Ernst & Young would refrain from
commenting on this hot topic that will probably end up in pending
litigation.
The
E&Y response is terribly discouraging to me because the audit firm
tries to hide behind the letter of the rules of GAAP rather than the
spirit of GAAP. Yesterday I pointed out that USC's Jerry Arnold (who
is truly an expert on the rules of GAAP) tried to earn his million
dollars defending Enron's founder, Ken Lay, by arguing in court that
Enron abided by the letter of GAAP (except where Andy Fastow was
lying about SPEs and really embezzling money from Enron itself). In
Ken Lay's case Arnold's testimony did not prevent his client's being
found guilty on ten counts of fraud and conspiracy to mislead
investors in Enron's audited financial statements. In court, the
verdicts often focus on the spirit of the law instead of the letter
of the law.
I am
particularly distressed by the following claim (in the message
below) by Ernst & Young:
Begin Quotation Because effective control of the
securities was surrendered to the
counterparty in the Repo 105 arrangements, the accounting literature
(SFAS
140) /required /Lehman to account for Repo 105 transactions as
sales rather than financings.
End Quotation
If
Lehman is obligated in a matter of days to buy back the poisoned
Repo 105 securities at prices greater than the “selling prices” I
have a hard time with the auditor’s assertion that these were
legitimate sales where the seller gave up control. The buyer is not
like to keep those securities or sell them to anybody other than
Lehman since the selling prices were phony inflated prices way above
fair market value.
This
is a Jerry Arnold déjà vu where auditors are trying to hide behind
the letter of accounting rules but not the spirit of accounting
rules. It makes a mockery out of the “present fairly” concept. If
this was anything but a ploy from having to show impaired-value
assets on the balance sheet I will eat my hat.
I will
never, ever accept the E&Y argument that the 2007 audited report of
Lehman fairly presented the poison CDO investments of Lehman. The
poison in those CDOs existed before the end of 2007, and surely the
auditors must've known the bad debt reserves were underestimated by
hundreds of billions of dollars. Where were the asset impairment
tests required for auditors?
It seems to me
that there’s a whole lot more professionalism issues involved in the
Lehman audits and reviews just like there should’ve been a whole lot
more involved in the Enron audits and reviews.
In any
event, Andersen does not appear to have applied the GAAP requirement
to recognize asset impairment (FAS 121). From our reading of the
Powers Report, the put-options written by the SPEs that, presumably,
offset Enron's losses on its merchant investment, were not
collectible, because the SPEs did not have sufficient net assets.
"ENRON: what happened and what we can learn from it," by George J.
Benston and Al L. Hartgraves, Journal of Accounting and Public
Policy, 2002, pp. 125-137:
3.3
Independent public accountants (CPAs)
The
highly respected firm of Arthur Andersen audited and unqualifiedly
signed Enron's financial statements since 1985. According to the
Powers Report, Andersen was consulted on and participated with
Fastow in setting up the SPEs described above. Together, they
crafted the SPEs to conform to the letter of the GAAP requirement
that the ownership of outside, presumably independent, investors
must be at least 3% of the SPE assets. At this time, it is very
difficult to understand why they determined that Fastow was an
independent investor. Kopper's independence also is questionable,
because he worked for Fastow. In any event, Andersen appears, at
best, to have accepted as sufficient Enron's conformance with the
minimum specified requirements of codified GAAP. They do not appear
to have realized or been concerned that the substance of GAAP was
violated, particularly with respect to the independence of the SPEs
that permitted their activities to be excluded from Enron's
financial statements and the recording of mark-to-market-based gains
on assets and sales that could not be supported with trustworthy
numbers (because these did not exist). They either did not examine
or were not concerned that the put obligations from the SPEs that
presumably offset declines in Enron's investments (e.g., Rhythms)
were of no or little economic value. Nor did they require Enron to
record as a liability or reveal as a contingent liability its
guarantees made by or though SPEs. Andersen also violated the letter
of GAAP and GAAS by allowing Enron to record issuance of its stock
for other than cash as an increase in equity. Andersen also did not
have Enron adequately report, as required, related-party dealings
with Fastow, an executive officer of Enron, and the consequences to
stockholders of his conflict of interest.
4.1
GAAP
We
believe that two important shortcomings have been revealed. First,
the US model of specifying rules that must be followed appears to
have allowed or required Andersen to accept procedures that accord
with the letter of the rules, even though they violate the basic
objectives of GAAP accounting. Whereas most of the SPEs in question
appeared to have the minimum-required 3% of assets of independent
ownership, the evidence outlined above indicates that Enron in fact
bore most of the risk. In several important situations, Enron very
quickly transferred funds in the form of fees that permitted the 3%
independent owners to retrieve their investments, and Enron
guaranteed the SPEs liabilities. Second, the fair-value requirement
for financial instruments adopted by the FASB permitted Enron to
increase its reported assets and net income and thereby, to hide
losses. Andersen appears to have accepted these valuations (which,
rather quickly, proved to be substantially incorrect), because Enron
was following the specific GAAP rules.
Andersen,
though, appears to have violated some important GAAP and GAAS
requirements. There is no doubt that Andersen knew that the SPEs
were managed by a senior officer of Enron, Fastow, and that he
profited from his management and partial ownership of the SPEs he
structured. On that basis alone, it seems that Andersen should have
required Enron to consolidate the Fastow SPEs with its financial
statements and eliminate the financial transactions between those
entities and Enron. Furthermore, it seems that the SPEs established
by Fastow were unlikely to be able to fulfill the role of closing
put options written to offset losses in Enron's merchant
investments. If this were the purpose, the options should and would
have been purchased from an existing institution that could meet its
obligations.
Andersen
also seems to have allowed Enron to violate the requirement
specified in FASB Statement 5 that guarantees of indebtedness and
other loss contingencies that in substance have the same
characteristics, should be disclosed even if the possibility of loss
is remote. The disclosure shall include the nature and the amount
of the guarantee. Even if Andersen were correct in following the
letter, if not the spirit of GAAP in allowing Enron to not
consolidate those SPEs in which independent parties held equity
equal to at least 3% of assets, Enron's contingent liabilities
resulting from its loan guarantees should have been disclosed and
described.
In any
event, Andersen does not appear to have applied the GAAP requirement
to recognize asset impairment (FAS 121). From our reading of the
Powers Report, the put-options written by the SPEs that, presumably,
offset Enron's losses on its merchant investment, were not
collectible, because the SPEs did not have sufficient net assets.
(Details on the SPEs' financial situations should have been
available to Andersen.) GAAP (FAS 5) also requires a liability to
be recorded when it is probable that an obligation has been incurred
and the amount of the related loss can reasonable be estimated. The
information presently available indicates that Enron's guarantees on
the SPEs and Kopper's debt had become liabilities to Enron. It does
not appear that they were reported as such.
GAAP (FAS
57) specifies that relationships with related parties "cannot be
presumed to be carried out on an arm's-length basis, as the
requisite conditions be competitive, free-market dealings may not
exist". As Executive Vice President and CFO, Fastow clearly was a
"related party". SEC Regulation S-K (Reg. §229.404. Item 404)
requires disclosure of details of transactions with management,
including the amount and remuneration of the managers from the
transactions. Andersen does not appear to have required Enron to
meet this obligation. Perhaps more importantly, Andersen did not
reveal the extent to which Fastow profited at the expense of Enron's
shareholders, who could only have obtained this information if
Andersen had insisted on its inclusion in Enron's financial
statements.
4.2
GAAS
SAS 85
warns auditors not to rely on management representations about onset
values, liabilities, and related-party transactions, among other
important items. Appendix B to SAS 85 illustrates the information
that should be obtained by the auditor to review how management
determined the fair values of significant assets that do not have
readily determined market values. We do not have access to
Andersen's working papers to examine whether or not they followed
this GAAS requirement. In the light of the Wall Street Journal
report presented above of Enron's recording a fair value for the
Braveheart project with Blockbuster Inc., though, we find it
difficult to believe that Andersen followed the spirit and possibly
not even the letter of this GAAS requirement.
SAS 45
and AICPA, Professional Standards, vol. 1, AU sec. 334 specify audit
requirements and disclosures for transactions with related parties.
As indicated above, this requirement does not appear to have been
followed.
An
additional lesson that should be derived from the Enron debacle is
that auditors should be aware of the ability of opportunistic
managers to use financial engineering methods, to get around the
requirements of GAAP. For example, derivatives used as hedges can
be structured to have gains on one side recorded at market or fair
values while offsetting losses are not recorded, because they do not
qualify for restatement to fair-value. Another example is a loan
disguised as a sale of a corporation's stock with guaranteed
repurchase from the buyer at a higher price. If this subterfuge
were not discovered, liabilities and interest expense would be
understated. Thus, as auditors have learned to become familiar with
computer systems, they must become aware of the means by which
modern finance techniques can be used to subvert GAAP.
The above findings from the Powers Report appear to be
inconsistent with the testimony of four years later.
May 4,
2006 (Associated Press) — Last-minute changes to quarterly earnings
reports prosecutors contend were ordered by Enron Corp. Chief
Executive Jeffrey Skilling to improve the company's reputation on
Wall Street were accurate, and not the result of improper tapping of
company reserves, a defense expert testified Wednesday.
"The
whole process of financial reporting, in a company as large as
Enron, to get financial statements out ... is an enormous
undertaking," said Walter Rush, an accounting expert hired by
Skilling. "And people are scrambling, trying to get these estimates
put together.
"There
are changes going on up to the very last second. It is universal.
Every company goes through this."
Rush was
the second consecutive accounting expert to take the stand,
following University of Southern California professor Jerry Arnold,
who testified for Enron founder and former CEO Kenneth Lay.
They are
among the last defense witnesses, as lawyers for the two top chiefs
at Enron expect to conclude their case early next week, the 15th
week of their federal fraud trial.
Mark
Koenig, former head of investor relations at Enron, testified early
in the trial that he believed top Enron executives were so bent on
meeting or beating earnings expectations to keep analysts bullish on
the company's stock that they made or knew of overnight changes to
estimates. Paula Rieker, Koenig's former top lieutenant, said Koenig
told her Skilling ordered abrupt last-minute changes to two
quarterly earnings reports to please analysts and investors.
"They
could have just had a bad number," Rush said, referring to Koenig's
and Rieker's testimony about a late-night change in a fourth-quarter
1999 report that boosted earnings per share from 30 cents to 31
cents.
Arthur
Andersen, Enron's outside accounting firm, already had the 31-cent
number days earlier, Rush said.
"They
could have been a couple steps behind the way the process was
evolving," he said of Koenig and Rieker.
In
addition, Rush said the intention to "beat the street," a phrase
attributed to Skilling, was typical in business.
"Companies set goals and forecasts for themselves all the time,"
Rush said.
Prosecutors also contend Enron achieved its rosy earnings by drawing
improperly from reserves. But Rush, responding specifically to
second-quarter earnings in 2000, said a transfer from one reserve
was not material since Enron had another, underreported reserve.
"That
number had the effect of understating Enron's profits," he said.
He also
disputed government contentions Enron executives improperly moved
parts of the company's retail operation into its highly profitable
wholesale business unit to hide financial problems under the guise
of an accounting process called "resegmentation."
"I do
believe it was properly disclosed and properly accounted for," Rush
said, adding that he believed Enron went beyond the rules in
disclosing particulars about the resegmentation.
"The
rules only require we tell we have made a resegmentation. You just
merely need to alert the reader there has been a change."
Earlier
Wednesday, Arnold repeated his sentiment that Lay did not mislead
investors about the company's financial health in the weeks before
it filed for bankruptcy protection in December 2001.
Arnold
said third-quarter 2001 financial statements cited by Lay in
discussions with investors complied with Securities and Exchange
Commission rules.
"That is
my view," he said, answering repeated questions about the quarter
when Enron reported $638 million in losses and a $1.2 billion
reduction in shareholder equity.
The
government contends Lay knew many Enron assets were overvalued and
that losses were coming and misrepresented this to the public.
Several
former high-ranking Enron executives have testified Lay misled
investors when he said the losses were one-time events.
"I
disagree with their interpretation," Arnold said, who noted his
company had been paid $1 million for his work on the Enron defense.
Only 10
minutes into his testimony Wednesday, U.S. District Judge Sim Lake
grew impatient when Arnold and prosecutor Andrew Stolter repeatedly
went round and round on the same question.
"I'm not
going to have sparring over minor, uncontroverted issues," a clearly
irritated Lake barked.
Skilling,
who testified earlier, and Lay, who wrapped up six days on the
witness stand Tuesday, are accused of repeatedly lying to investors
and employees about Enron when prosecutors say they knew the
company's success stemmed from accounting tricks.
Skilling
faces 28 counts of fraud, conspiracy, insider trading and lying to
auditors, while Lay faces six counts of fraud and conspiracy.
The two
men counter no fraud occurred at Enron other than that committed by
a few executives, like Fastow, who stole money through secret side
deals. They attribute Enron's descent into bankruptcy proceedings to
a combination of bad publicity and lost market confidence.
This will be my one
and only response to your comment.
As "the guy who
wrote GAAP" for 10 plus years, it's pretty hard for me to criticize
anyone who followed the letter of the rules. However, much more
important is to understand the context of SFAS 140. While I was gone
from the Board when it was developed, I was there for its
predecessor, SFAS 125. That standard involved a very long, laborious
process of determining extremely precise rules for when liabilities
should and shouldn't be "derecognized" from the balance sheet. I
can't tell you how many meetings we had with lawyers involved with
securitization transactions and the like. In the end the document
attempted to walk a fine line like Goldilocks of getting it "just
right"- trying to derecognizing those liabilities where
responsibility for obligations had truly been passed to third
parties while leaving those on the balance sheet the ones for which
the substance of an obligation was retained. In the typical fashion
of standards setting, that necessitated very precise rules including
legal opinions in some cases.
Not too long after
SFAS 125 was issued, it became clear that it wasn't working very
well and it wasn't accomplishing the "just right" objective. So the
Board began another project that took several more years and
resulted in SFAS 140. Still more (or, rather, different) rules were
developed in an effort to accomplish the same objective of keeping
true obligations on the balance sheet and derecognizing those for
which risks and rewards of ownership had passed to third parties.
SFAS 140 has been
seen as not fully satisfactory by many parties, most notably because
of the "QSPE" exception that allowed Fannie Mae and many other large
financial institutions to keep huge amounts of securitization trusts
and similar amounts off the balance sheet when the trusts were
considered set up on "auto pilot." The FASB changed this last year
through SFAS 166 and 167 and Fannie Mae will consolidate $2.5
trillion of trust assets and liabilities that it doesn't own or owe
in its first quarter 2010 financial statements.
The bottom line is
that this has been a highly contentious aspect of accounting for
many years. GAAP has been evolving and it may evolve further. Would
we have been better off with a "principle based" approach? I
personally doubt it although a New York Times article on Friday
suggested exactly that. The rules based approach to this general
area is far from perfect but I think it at least has resulted in
more consistency from company to company. I shudder to think how
individual companies would have applied a judgmental approach in an
area like this.
Denny Beresford
March 20, 2010
reply from Bob Jensen
Hi Denny,
I will not
prolong the agony, but I surely would like to have someone explain
to me how the Repo 105 accounting in the particular context used by
Lehman served any economic purpose other than to deceive investors
and creditors in the financial statements.
How in the
world can the auditors conclude that Lehman severed "all controls"
over poisoned investments that they were 100% certain would come
back to Lehman in a few days. There was zero chance that the market
values of these poisoned CDOs would bounce back.
What could
Lehman possibly gain other than balance sheet trickery?
Would Lehman
have even entered into these Repo 105 transactions if Lehman had to
book the buy-back obligations as debt having higher values than the
sales prices at inflated and phony values?
I'm not sure
auditors should follow any rules-based standards for transactions
only intended to deceive. Egads! Will Patricia Walters love to hear
me say that. Darn! She'll hang this one over my head for as long as
I live.
I think I'm
interpreting principles-based a little differently than you.
You are taking a micro view from the specific rules in FAS 140. I'm
taking a macro view that auditors have both a right and a duty to
look at any transactions that have only one purpose --- to
deceive investors and/or possibly members of the board. Accordingly
auditors have a right and a duty to disclose more to the persons
being deceived, whether they are members of the board of directors
or individual investors.
Also the
seeking out an opinion from an England-based law firm has shades of
Enron painted all over it in the eyes of many of us in the academy.
This is especially the case for those of us that remember how Ken
Lay hired a shyster law firm to whitewash the whistle blowing of
Sherron Watkins ---
http://www.trinity.edu/rjensen/FraudEnron.htm
You know the
story. If it walks like a duck, quacks like a duck, and looks like a
duck then it probably is a duck.
I really think
that all Big Four auditors have for years been helping Wall Street
banks write fiction in their financial statements.
Frank Partnoy
and Lynn Turner contend that Wall Street bank accounting is an
exercise in writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper "Make Markets
Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank
Partnoy, Roosevelt Institute, March 2010 --- http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!
The San Mateo County (Calif.) Investment Pool
sued executives of bankrupt Lehman Brothers
Holdings Inc. (LEHMQ) and their accountants,
accusing them of fraud, deceit and misleading
accounting practices that led to the loss of
more than $150 million in county funds.
The suit, filed in San Francisco Superior Court,
said executives of the former Wall Street
investment bank made repeated public statements
about its financial strength while privately
scrambling to save it from collapse.
The suit names former Lehman Chief Executive
Richard S. Fuld Jr., former Chief Financial
Officers Christopher M. O'Meara and Erin Callan,
former President Joseph M. Gregory, certain
directors and Ernst & Young, Lehman's auditor.
It accused Lehman of hiding its exposure to
mortgage-related losses while reporting record
profits for fiscal year 2007 and giving bonuses
to its executives.
"The defendants focused their efforts on trying
to save their company and their jobs with little
or no regard to how their egregious actions
harmed those who in good faith invested in
Lehman Brothers," said San Mateo County Counsel
Michael Murphy. "In our view, their actions were
blatantly illegal."
The San Mateo County Investment Pool consists of
the county, school districts, special districts
and other public agencies in the county.
San Mateo County Supervisors Richard Gordon and
Rose Jacobs Gibson called for a federal
investigation of the allegations in the suit,
and Supervisor Jerry Hill, newly elected to the
state Assembly, will request hearings on how
many California public entities face similar
losses.
Representatives of Lehman and of Ernst & Young
were not immediately available to comment.
This is but one of many lawsuits and criminal
investigations to be faced Ernst & Young and the
other large auditing firms. Survival of the Big
Four will be precarious ---
http://www.trinity.edu/rjensen/Fraud001.htm
“A
Lehman senior vice president raised questions about the propriety of
these transactions as early as May 2008, but the report said that the
accountants at Ernst & Young “took no steps to question or challenge the
non-disclosure of its use of $50bn of temporary, off balance sheet
transactions” ---
http://www.ft.com/cms/s/0/1be0aca2-2d79-11df-a262-00144feabdc0.html?nclick_check=1
I’m forwarding this message from Lynn Turner without comment,
because I’m in a bit over my head on this without having studied the
nine-volume set of the Examiner’s report (2,200 pages). In fairness,
I will probably still be in over my head after reading the 2,200
pages.
He’s one of my professional heroes, and I’ve enjoyed on occasion
sharing a speaking platform with him.
Robert E. (Bob) Jensen
Trinity University Accounting Professor (Emeritus)
190 Sunset Hill Road
Sugar Hill, NH 03586
Tel. 603-823-8482
www.trinity.edu/rjensen
From:
LynnETurne@aol.com [mailto:LynnETurne@aol.com] Sent: Friday, March 12, 2010 2:07 PM To: Jensen, Robert Subject: Fwd: The Lehman Examiners Report on Auditorfs
From: eorenstein@financialexecutives.org
To: lynneturne@aol.com
Sent: 3/12/2010 11:56:58 A.M. Mountain Standard Time
Subj: RE: The Lehman Examiners Report on Auditorfs
Lynn, are you on Prof. Bob Jensen’s listserve (technically, it’s an
accounting listserve out of Loyola University, but Bob Jensen is the
most frequent poster/unofficial chairman of that listserve, so to
speak). There have been numerous posts on their listserve today on
that topic (the AECM listserve, and the CPAs-L listserve), they
would probably be interested in the info you have provided here,
including your attachment, you may want to forward this material to
Bob at
rjensen@trinity.edu if you’d like him to share it. Thank you.
Regards, Edith
From:
LynnETurne@aol.com [mailto:LynnETurne@aol.com] Sent: Friday, March 12, 2010 1:44 PM To: lynneturne@aol.com Subject: The Lehman Examiners Report on Auditorfs
Below is the discussion regarding the independent auditors from the
Examiner's report on Lehman. It provides and excellent case study
for students as it properly highlights how the courts and SEC have
consistently said auditors cannot merely hide behind "GAAP." This
concept is also engrained in the language of Sarbanes Oxley which
requires executives to sign off on the fair presentation of
financial statements without mentioning GAAP.
The report also states the auditor did not inform the audit
committee of the transactions in question. There have been other
enforcement cases in which it was found the auditor did not inform
the audit committee of questionable accounting practices. The PCAOB
has done work in past years on the standard for communications
between the auditor and audit committee but has never updated that
standard.
From the Lehman Examiner Report - Volume 3, beginning page 945:
"(3) Lehman’s Board of Directors
Without exception, former Lehman directors were unaware of Lehman’s
Repo
105 program and transactions.3642
As discussed in greater detail below, Lehman’s own Corporate Audit
group led
by Beth Rudofker, together with Ernst & Young, investigated
allegations about balance
sheet substantiation problems made in a May 16, 2008
“whistleblower” letter sent to
senior management by Matthew Lee.3643 On June 12, 2008, during the
investigation, Lee
informed Ernst & Young about Lehman’s use of $50 billion of Repo 105
transactions in
the second quarter of 2008.3644 At a June 13, 2008 meeting,
Ernst & Young failed to
disclose that allegation to the Board’s Audit Committee.3645
Former Lehman director Cruikshank recalled that he made very clear
he wanted
a full and thorough investigation into each allegation made by Lee,
whether the allegation was contained in Lee’s May 16, 2008 letter or
raised by Lee in the course of
the investigation.3646 Another former Lehman director, Berlind,
similarly stated that the
Audit Committee explicitly instructed Lehman’s Corporate Audit Group
and Ernst &
Young to keep the Audit Committee informed of all of Lee’s
allegations.3647 Berlind also
said that he would have wanted to know about Lehman’s Repo 105
program and that if
he had known about Lehman’s Repo 105 transactions, he would have
asked Lehman’s
auditors to test the transactions to ensure they were
appropriate.3648 Upon learning from
the Examiner the volume of Repo 105 transactions at quarter‐end
in late 2007 and 2008,
Sir Christopher Gent said that he believed the volume mandated
disclosure to the Audit
Committee and further investigation.3649
Dr. Kaufman, on the other hand, stated that he would have wanted to
know
about Repo 105 transactions only if they were “huge” and fraudulent,
by which he
meant in violation of specific accounting rules or in violation of
the law.3650 Dr.
Kaufman did not believe that $50 billion in Repo 105 transactions
was significant even if
that volume changed Lehman’s net leverage ratio by approximately two
points.3651 Dr.Kaufman considered a four or five point change in the
net leverage ratio to be
significant.3652
In late 2007 and 2008, management made numerous presentations to the
Board
regarding balance sheet reduction and deleveraging; in no case was
the use of Repo 105
transactions disclosed in those presentations.3653
i) Ernst & Young’s Knowledge of Lehman’s Repo 105 Program
During several Rule 30(b)(6)‐type3654
interview sessions, the Examiner
interviewed members of Ernst & Young’s Lehman audit team regarding
Ernst &
Young’s knowledge of and involvement in Lehman’s Repo 105 program.
(1) Ernst & Young’s Comfort with Lehman’s Repo 105 Accounting
Policy
The Examiner interviewed Ernst & Young’s lead partner on the Lehman
audit
team, William Schlich, regarding Lehman’s Repo 105 program.
According to Schlich, Ernst & Young had been aware of Lehman’s Repo 105 policy and
transactions for many
years.3655
Consistent with the statements of Lehman’s John Feraca (Secured
Funding
Desk), Schlich stated that Lehman introduced its Repo 105 Accounting
Policy
on the
heels of the FASB’s promulgation of SFAS 140.3656
During that time, Ernst & Young
“discussed” the Repo 105 Accounting Policy (including Lehman’s
structure for Repo
105 transactions) and Ernst & Young’s team had a number of
additional conversations
with Lehman about Repo 105 over the years.3657 However, according to
Schlich, Ernst &Young had no role in the drafting or preparation of
Lehman’s Repo 105 Accounting
Policy.3658
Schlich stated definitively that Ernst & Young had no advisory role
with respect
to Lehman’s use of Repo 105 transactions and that Ernst & Young did
not “approve”
the Accounting Policy.3659 Rather, according to Schlich, Ernst &
Young “bec[a]me
comfortable with the Policy for purposes of auditing financial
statements.”3660
Following “consultation and dialogue” about the proper
interpretation and
application of SFAS 140, Ernst & Young “clearly. . .concurred with Lehman’s approach”
to SFAS 140 and subsequent literature by FASB on the issue of
“control” of assets
involved in a repo transactions.3661 Ernst &
Young’s view, however, was not based upon
an analysis of whether actual Repo 105 transactions complied with
SFAS 140.3662 Rather,
Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was
purely
“theoretical.”3663 In other words, Ernst & Young solely assessed
Lehman’s
understanding of the requirements of SFAS 140 in the abstract and as
reflected in its
Accounting Policy; Ernst & Young did not opine on the propriety of
the transactions as a balance sheet management tool.3664 Ernst &
Young did not review the Linklaters letter,
referenced in the Accounting Policy Manual.3665
According to Martin Kelly, it was not unusual for him to discuss
various issues,
including Repo 105, with Ernst & Young.3666 Indeed, Kelly recalled
specifically speaking
with Schlich about Repo 105 transactions soon after becoming
Financial Controller on
December 1, 2007, in an effort to learn more about the program and
“to understand
[Ernst & Young’s] approach before talking to Callan.”3667
Kelly “wanted to ensure that Ernst & Young analyzed the program in
the same
way that [Marie] Stewart [Global Head of Accounting Policy] had
analyzed it.”3668
Kelly’s conversations with Ernst & Young focused on the accounting
treatment of Repo
105 transactions.3669 According to Kelly,
Ernst & Young “was comfortable with the
treatment under GAAP for the same reasons that Lehman was
comfortable.”3670
Kelly also discussed with Ernst & Young Lehman’s inability to get a
true sale opinion under United States law for Repo 105
transactions.3671 Kelly could not recall whether he
discussed with Ernst & Young his discomfort with Lehman’s Repo 105
program.3672
(2) The “Netting Grid”
Throughout 2007, Lehman maintained a document entitled “Accounting
Policy
Review Balance Sheet Netting and Other Adjustments,” known
colloquially among
Lehman’s Accounting Policy and Balance Sheet Groups, as well at
Ernst & Young, as
the “Netting Grid.” The Netting Grid identified and described
various balance sheet
netting mechanisms employed by Lehman: one such balance sheet
mechanisms was
Lehman’s use of Repo 105 transactions.3673
Lehman provided the Netting Grid to Ernst & Young at least in August
2007 (the
close of Lehman’s third quarter 2007) and in November 2007 (the
close of Lehman’s
fiscal year 2007).3674 Notably, the Netting Grid provided by Lehman
to Ernst & Young in
August 2007 and November 2007 only contained Repo 105 volumes from
November 30, 2006 and February 28, 2007.3675 Schlich was unaware
whether Ernst & Young asked
Lehman to provide its second quarter 2007 and third quarter 2007
Repo 105 usage
figures or a forecast of Lehman’s fourth quarter 2007 Repo 105
numbers.3676
Ernst & Young reviewed the Netting Grid, analyzed the various
balance sheet
netting mechanisms identified in the Netting Grid, and used the
document in
connection with its 2007 year‐end audit of
Lehman.3677 According to Schlich, Ernst &
Young, as part of its review of Lehman’s Netting Grid, approved of
Lehman’s internal Repo 105 Accounting Policy only, and did not pass
upon the actual practice.3678
The Netting Grid described the transactions and United States GAAP
reference
as follows: “Under certain conditions that meet the criteria
described in
paragraphs 9
and 218 of SFAS 140,
Lehman policy permits reverse repo and repo agreements to be
recharacterized as purchases and sales of inventory.”3679
With respect to Lehman’s use
of Repo 105 transactions to reduce its net balance sheet, the
Netting Grid sets forth the conclusion that Lehman’s “current
practice [for Repo 105] is correct.”3680 Schlich noted
that this conclusion about the Repo 105 practice was Lehman’s, not
Ernst & Young’s.3681
To test Lehman’s conclusion, however, Ernst & Young “reviewed how
Lehman applied
the control provisions of the accounting rules.”3682
Ernst & Young’s review, however, applied only to the accounting
basis for these
transactions, not to their volume or purpose. Specifically, Ernst &
Young’s review and
analysis of Lehman’s Repo 105 program did not account for the
volumes of Repo 105
transactions Lehman undertook at quarter‐end.3683
Indeed, Schlich was unable to
confirm or deny the volumes of Repo 105 transactions Lehman
undertook at Lehman’s
fiscal year‐end 2007, or in the first two quarter‐ends
of 2008.3684 Nor was Schlich able to
confirm or deny that Lehman’s use of Repo 105 transactions was
increasing in late 2007
and into mid 2008.3685
(a) Quarterly Review and Audit
Through Schlich, Ernst & Young maintained that its duties as
Lehman’s auditor
required it to ensure that transactions were accounted for correctly
(i.e., that they
complied with accounting rules) and that Lehman’s financial
disclosures were not materially misstated.3686 According to Schlich,
Ernst & Young’s audit did not require
Ernst & Young to consider or review the volume or timing of Repo 105
transactions.3687
Accordingly, as part of its year‐end
2007 audit, Ernst & Young did not ask Lehman
about any directional trends, such as whether its Repo 105 activity
was increasing
during fiscal year 2007.3688 Notably, as part of its quarterly
review process, Ernst &
Young did not audit any of Lehman’s Repo 105 transactions.3689
(3) Ernst & Young Would Not Opine on the Materiality of
Lehman’s Repo 105 Usage
Ernst & Young, through Schlich,
was unwilling to
comment to the Examiner on
the materiality of the volume of Lehman’s quarter‐end
Repo 105 transactions.3690 Asked
whether, as part of its responsibility to ensure Lehman’s financial
statements were not
materially misstated, Ernst & Young should
have considered the possibility that strict technical adherence to
SFAS 140 or any other specific accounting rule could nonetheless
lead to a material misstatement in Lehman’s publicly‐reported
financial statements, Schlich refrained from comment.3691
When pressed further, Schlich stated that the volume of any
particular
transaction impacts neither the question of whether accounting rules
are applied correctly, nor the question of whether a financial
statement is materially misleading.3692
However, Schlich eventually acknowledged that “when you look at a
balance sheet
issue, volume is a factor.”3693
Notably, the definition of “materiality” contained in a “walk‐through”
document
related to Ernst & Young’s 2007 fiscal year‐end
audit of Lehman was: “any transaction
that would move Lehman’s firm‐wide
net leverage by 0.1 or more.”3694 This
definition
reflected “Lehman’s determination of a materiality threshold” in
connection with
Lehman’s own criteria for when to consider reopening and adjusting
its balance
sheet.3695
When Schlich was asked what level of impact to Lehman’s firm‐wide
net assets
Ernst & Young would have considered “material,” Schlich replied that
Ernst & Young
did not have a hard and fast rule defining materiality in the
balance sheet context, and
that, with respect to balance sheet issues, “materiality” depends
upon the facts and
circumstances.3696 Schlich agreed that Lehman made no specific
disclosures about Repo 105 transactions in its Forms 10‐K and
Form 10‐Q,
including the MD&A section.3697
Schlich believed, however, that Lehman’s public filings would have
included general
language regarding secured borrowings and compliance with SFAS
140.3698 Schlich was
not aware whether Ernst & Young ever discussed Lehman’s disclosures
vel non of Repo
105 activity with senior Lehman management.3699
(4) Matthew Lee’s Statements Regarding Repo 105 to Ernst &
Young
On May 16, 2008, Matthew Lee, then‐Senior
Vice President in the Finance
Division responsible for Lehman’s Global Balance Sheet and Legal
Entity Accounting,
sent a letter to certain members of Lehman’s senior management
identifying possible violations of Lehman’s Ethics Code related to
accounting/balance sheet issues.3700 Lehman involved Ernst & Young
in its investigation of the concerns raised in Lee’s May
16, 2008 letter.3701
Subsequently, less than a month later, on June 12, 2008, Ernst &
Young – Schlich
and Hillary Hansen – interviewed Lee.3702 Hansen’s notes of the
interview reveal that Lee made certain statements to Ernst & Young about Lehman’s Repo
105 practice,
including, most notably, the volume of Repo 105 activity that Lehman
engaged in at
quarter‐end
(May 31, 2008).3703 Hansen’s notes specifically recount Lee’s allegation that
Lehman moved $50 billion of inventory off its balance sheet at
quarter‐end
through
Repo 105 transactions and that these assets returned to the balance sheet approximately
a
week later.3704
When interviewed by the Examiner, Schlich did not recall Lee saying
anything
about Repo 105 transactions during that interview, although he did
not dispute the
authenticity of Hansen’s notes from the Lee interview.3705 In spite
of Hansen’s notes,
Schlich maintained that Ernst & Young did not know that Lehman
engaged in the
following Repo 105 activity during the listed time periods: $49.1
billion at first quarter
2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May
31, 2008).3706
During the Examiner’s interview of Hansen, Hansen recalled that
while Ernst &
Young questioned Lee about his May 16, 2008 letter, Lee “rattled
off” a list of additional
issues and concerns he held, one of which was Lehman’s use of Repo
105
transactions.3707 Ernst & Young had no further conversations with
Lee about Repo 105
transactions.3708 Prior to her interview of Lee in June 2008, Hansen
had heard the term
Repo 105 “thrown around” but she did not know its meaning; according
to Hansen,
Schlich described Repo 105 transactions to her shortly after they
met with Lee.3709
Following Ernst & Young’s June 12, 2008 interview of Lee, Schlich
and Hansen
met with Lehman’s Gerard Reilly to discuss Lee’s assertions
regarding improper valuations.3710 During that meeting, Hansen
informed Reilly of the $50 billion Repo 105
figure Lee provided during Ernst & Young’s interview of Lee.3711
According to Schlich,
Reilly (now deceased) told the auditors that he had no knowledge
that Lehman used
Repo 105 transactions to move $50 billion in assets off its balance
sheet.3712 “Hillary
[Hansen] took away from the meeting with Reilly that he did not know
and it was not
$50 billion.”3713
On June 13, 2008 – the day after Lee informed Ernst & Young of the
$50 billion in
Repo 105 transactions that Lehman undertook at the end of the second
quarter 2008 – Ernst & Young spoke to Lehman’s Audit Committee
but did not inform the committee
of Lee’s
allegation, even though the Chairman of the Audit Committee had
clearly stated that he wanted every allegation made by Lee – whether
in Lee’s May 16 letter or during the course of the investigation –
to be investigated.3714
Ernst & Young met with
the Audit Committee on July 8, 2008, to review the second quarter
financial statements and again did not mention Lee’s allegations
regarding Repo 105.3715 On July 22, 2008,
Ernst & Young was also present when Beth Rudofker, Head of Corporate
Audit, gave a
presentation to the Audit Committee on the results of the
investigation into Lee’s
allegations.3716
Ernst & Young did not disclose to the Audit Committee – either
during the
meetings or in private executive sessions after – that Lee made an
allegation related to
Repo 105 transactions being used to move assets off Lehman’s balance
sheet at quarterend.
3717 Cruikshank told the Examiner that he would have expected to be
told about
Lee’s Repo 105 allegations.3718 Similarly, Sir Gent told the
Examiner that the alleged volume of Lehman’s Repo 105 transactions
mandated disclosure to the Audit
Committee as well as further investigation.3719
Ernst & Young did not follow‐up on
either Lee’s allegations regarding Lehman’s
Repo 105 activity or Reilly’s claim that he had no knowledge of
Lehman’s alleged $50
billion Repo 105 usage figure.3720 Ernst & Young signed a Report of
Independent
Registered Public Accounting Firm for Lehman’s second quarter 2008
Form 10‐Q
on
July 10, 2008, less than four weeks after Schlich and Hansen
interviewed Lee.3721
(5) Accounting‐Motivated
Transactions
Ernst & Young did not evaluate the possibility that Repo 105
transactions were accounting‐motivated
transactions that lacked a business purpose.3722
Schlich
characterized the off‐balance sheet treatment of Lehman’s assets in Repo 105
transactions as a consequence of the accounting rules, rather than a
motive for the
transactions.3723
j) The Examiner’s Conclusions
There is sufficient evidence to support a determination by a trier
of fact that
Lehman’s failure to disclose that it relied upon Repo 105
transactions to temporarily
reduce the firm’s net balance sheet and net leverage ratio was
materially misleading. In
addition, a trier of fact could find that Lehman affirmatively
misrepresented its
accounting treatment for repos by stating that Lehman treated repo
transactions as
financing transactions rather than sales for financial reporting
purposes, despite the fact
that Lehman treated tens of billions of dollars in repo transactions
– namely, Repo 105
transactions – as true sale transactions.
The Examiner thus concludes that sufficient evidence exists from
which a trier of fact could find the existence of a colorable claim
that certain Lehman officers breached
their fiduciary duties to Lehman and its shareholders by causing the
company to file deficient and materially misleading financial
statements, thereby exposing the company
to potential liability.
Certain officers of Lehman not only failed to inform the public of
its reliance on Repo 105 transactions to reduce its balance sheet,
they also failed to
advise Lehman’s Board of Directors of the firm’s Repo 105 practice.
Thus, the Examiner
concludes that a trier of fact could find that certain Lehman
officers breached their
fiduciary duties to Lehman’s Board of Directors by failing to inform
them of: (1) the
firm’s reliance upon Repo 105 to reduce the balance sheet at quarter‐end,
(2) the rampup
in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions
on Lehman’s publicly reported net leverage ratio, or (4) the fact
that Lehman did not
disclose its Repo 105 practice in its publicly reported financials
statements and MD&A.
(1) Materiality
The materiality of information is evaluated from the perspective of
a reasonable
investor.3724 Information is deemed material if there is “a
substantial likelihood that the
disclosure of the omitted fact would have been viewed by the
reasonable investor as having significantly altered the ‘total mix’
of information made available.”3725
Materiality does not require, however, that the information be of a
type that would
cause an investor to change his investment decision.3726
(a) Whether Lehman’s Repo 105 Transactions Technically
Complied with SFAS 140 Does Not Impact Whether a
Colorable Claim Exists
This Report does not reach the question of whether Lehman’s Repo 105
transactions technically complied with the relevant financial
accounting standard, SFAS
140, because the answer to that question does not impact whether a
colorable claim
exists regarding Lehman’s failure to disclose its Repo 105 practice
and whether that
failure rendered the firm’s financial statements materially
misleading. Even if Lehman’s use of Repo 105 transactions technically
complied with SFAS 140, financial statements may be materially
misleading even when they do not violate GAAP.3727 The Second
Circuit has explained that “GAAP itself recognizes that technical
compliance with particular GAAP rules may lead to misleading
financial statements, and
imposes an overall requirement that the statements as a whole
accurately reflect the financial status of the company.”3728
Similarly, as noted in In re Global Crossing Ltd. Securities
Litigation, even if a
defendant established that its accounting practices
“were in technical compliance with
certain individual GAAP provisions . . . this would not necessarily
insulate it from liability. This is because, unlike other regulatory
systems, GAAP’s ultimate goals of fairness and accuracy in reporting
require more than mere technical compliance.”3729
The court
explained that “when viewed as a whole,” GAAP has no “loopholes”
because its
purpose, shared by the securities laws, is “to increase investor
confidence by ensuring
transparency and accuracy in financial reporting.”3730
Technical compliance with
specific accounting rules does not automatically lead to fairly
presented financial statements. “Fair presentation is the touchstone
for determining the adequacy of disclosure in financial statements.
While adherence to generally accepted accounting principles is a
tool to help achieve that end, it is not necessarily a guarantee of
fairness.”3731 Moreover,
registrants are “required to provide whatever additional information
would be necessary to make the statements in their financial reports
fair and accurate, and not
misleading.”3732
This view is echoed in an SEC enforcement order, concluding that
GAAP
compliance does not excuse a misleading or less than full disclosure
regarding a
transaction, especially if the transaction’s purpose is “the
attainment of a particular
financial reporting result.”3733 “[E]ven if the transactions comply
with GAAP, the issuer
is required to evaluate the material accuracy and completeness of
the presentation
made by its financial statements.”3734 Issuers must “ensure that the
way they publicly
portray themselves discloses, as required, the material elements of
[their] economic and
business realities and risks.”3735
3732 Id.
(citing 17 C.F.R. § 240.10b‐5(b)
and 17 C.F.R. § 230.408 (requiring that “in addition to the
information expressly required to be included in a registration
statement, there shall be added such further material information,
if any, as may be necessary to make the required statements, in the
light of the circumstances under which they are made, not
misleading”) (emphasis added); see also SEC
v. Seghers, 298 Fed. App’x 319, 331 (5th Cir. 2008) (“The Commission’s proof of
Segher’s misrepresentations and omissions does not depend on
compliance with GAAP, but instead depends on evidence that Segher’s
statements and omissions were false or misleading to investors.”); United
States v. Olis, Civil Action No. H‐07‐3295, Criminal No. H‐03‐217‐01,
2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) (“The scheme to
defraud alleged and proved in this case did not turn on whether the
treatment accorded to Project Alpha in Dynegy’s financial statements
technically complied with GAAP or whether Olis and his
coconspirators intended to violate GAAP but, instead, on whether the
defendants’ disclosures about Project Alpha intentionally omitted
material facts that caused Dynegy’s financial statements to be
materially false and misleading.”) (citing United States v. Rigas,
490 F.3d 208, 221 (2d Cir. 2007), and United States v. Ebbers, 458
F.3d 110, 125‐26
(2d Cir. 2006)).
"Colorable claims exist that Ernst & Young
did not meet professional standards, both in investigating Lee's
allegations and in connection with its audit and review of Lehman's
financial statements."
For those of you who don't have time to read the entire 2,200-page
Examiners Report
that's so unkind to Ernst & Young and Lehman Executives
Thursday, a U.S. bankruptcy-court examiner
investigating the collapse of Lehman Brothers Holdings Inc. released
a scathing 2,200-page report. Here are some highlights.
* * *
Criminal Case? -- "Colorable Claims"
The allegations lodged by a
bankruptcy-court examiner have raised questions about whether
prosecutors could build a case against former Lehman executives.
"Colorable claims exist against the senior
officers who were responsible for balance sheet management and
financial disclosure, who signed and certified Lehman's financial
statements and who failed to disclose Lehman's use and extent of
Repo 105 transactions to manage its balance sheet."
"Colorable claims exist that Ernst &
Young did not meet professional standards, both in investigating
Lee's allegations and in connection with its audit and review of
Lehman's financial statements."
"The Examiner finds colorable claims
against JPMorgan Chase ("Chase") and CitiBank in connection with
modifications of guaranty agreements and demands for collateral in
the final days of Lehman's existence. The demands for collateral by
Lehman's Lenders had direct impact on Lehman's liquidity pool;
Lehman's available liquidity is central to the question of why
Lehman failed."
Lehman employee Matthew Lee will gain
fame as one of whistleblowers who tried to prevent the company's
demise. The report says Lehman's auditors refer to Matthew Lee's
letter to senior management as a "whistleblower letter" and an
"ugly" one at that. No wonder Lehman's senior management and outside
auditors, Ernst & Young, said they were "stressed."
"[W]e are also dealing with a
whistleblower letter, that is on its face pretty ugly and will take
us a significant amount of time to get through. I am confident from
what I have seen it shouldn't result in any significant issues
around financial reporting, but again there is a lot of work to do
yet. This combined with some very difficult accounting issues around
off balance sheet items is adding stress to everyone." (From a June
8, 2008, email from William Schlich, a former lead partner on Ernst
& Young's Lehman team)
The examiner criticized Lehman for the
"materially misleading" approach it took to represent its financial
condition. He focused on the so-called "repo" market, in which firms
sell assets in exchange for cash to fund operations, often just
overnight or for a few days.
The examiner said that Lehman -- anxious to
maintain favorable credit ratings -- engaged in an accounting device
known within the firm as "Repo 105" to essentially park about $50
billion of assets away from Lehman's balance sheet. The move helped
Lehman look like it had less debt on its books.
"In this way, unbeknownst to the investing
public, rating agencies, Government regulators, and Lehman's Board
of Directors, Lehman reverse engineered the firm's net leverage
ratio for public consumption."
The Repo 105 strategy sparked debate inside
Lehman, according to the report. In an April 2008 email, Bart McDade
called such accounting maneuvers "another drug we r on." Mr. McDade,
then Lehman's equities chief, says he sought to limit such
maneuvers, according to the report (page 763..
Numerous internal Lehman e-mails referred
to Repo 105 transactions in pejorative terms, such as "balance sheet
window-dressing."
An illustrative example is found in the
following July 2008 e-mail exchange:
"Vallecillo: "So what's up with repo 105?
Why are we doing less next quarter end?"
McGarvey: "It's basically window-dressing.
We are calling repos true sales based on legal technicalities. The
exec committee wanted the number cut in half."
Vallecillo: "I see . . . so it's legally
do-able but doesn't look good when we actually do it? Does the rest
of the street do it? Also is that why we have so much BS [balance
sheet] to Rates Europe?
Senior management exerted pressure,
particularly at or near quarter-end, to utilize the Repo 105
mechanism to meet the firm-imposed balance sheet targets:
Four days before the close of Lehman's
fiscal year in November 2007, Mitch King wrote to Marc Silverberg:
"Let me know if we have room for any more repo 105. I have some more
I can put in over month end." Jerry Rizzieri, who reported directly
to Kaushik Amin, replied to King: "Can you imagine what this would
be like without 105?"
J.P. Morgan's Collateral Demands -- "Part
Art, Part Science, and Part Catch Up"
Several factors helped to tip Lehman over
the brink in its final days. Investment banks, including J.P. Morgan
Chase & Co., made demands for collateral and modified agreements
with Lehman that hurt Lehman's liquidity and pushed it into
bankruptcy.
On September 11, J.P. Morgan executives met
to discuss significant valuation problems with securities that
Lehman had posted as collateral over the summer. J.P. Morgan
concluded that the collateral was not worth nearly what Lehman had
claimed it was worth, and decided to request an additional $5
billion in cash collateral from Lehman that day. Discussions between
Lehman and J.P. Morgan executives were tense. According to J.P.
Morgan witnesses, Steven Black, a senior J.P. Morgan executive,
communicated the $5 billion collateral request to Richard Fuld by
telephone on September 9. Black stated that he explained that the
collateral was intended to cover J.P. Morgan's exposure to Lehman in
its entirety. Lehman posted $5 billion in cash to JPMorgan by the
afternoon of Friday, Sept. 12.
Mr. Black described J.P. Morgan's
formulation of the $5 billion amount to the examiner as "part art,
part science, and part catch up."
"Black stated that he relayed to Fuld that
JPMorgan was not trying to solve JPMorgan's problem by creating new
problems for Lehman. He asserted that he told Fuld that, if Lehman
was "near the edge," Fuld should say so. According to Black, Fuld
asked whether JPMorgan was interested in making a capital infusion,
but JPMorgan was not. Black stated that he advised Fuld that if
Lehman were skating close to the edge, Lehman should call the
Federal Reserve so that the Federal Reserve could "herd the cats"
needed to assist Lehman. According to Black, Fuld said Lehman was
not anywhere close to the point of needing such assistance."
More on J.P. Morgan's Role -- Good Faith
and Fair Dealing?
"Notwithstanding J.P. Morgan's concerns
with the quantity and quality of collateral posted by Lehman, Lehman
believed that J.P. Morgan was overcollateralized. There is no
evidence, however, that Lehman requested in writing the return of
the billions of dollars of collateral it had posted in September.
Lehman did informally request the return of at least some of its
collateral, and J.P. Morgan returned some securities to Lehman on
September 12. J.P. Morgan did not, however, release any of the cash
collateral that Lehman had posted in response to the September 9 and
September 11 requests.
"Finally, the examiner concludes that the
evidence may support the existence of a colorable claim – but not a
strong claim – that J.P. Morgan breached the implied covenant of
good faith and fair dealing by making excessive collateral requests
to Lehman in September 2008. A trier of fact would have to consider
evidence that the collateral requests were reasonable and that
Lehman waived any claims by complying with the requests."
New details in the report contain insights
on why Buffett passed on Lehman. They open a window on his methods
for assessing management and some of the red flags that waved him
off.
"Fuld and Buffett spoke on Friday, March
28, 2008. They discussed Buffett investing at least $2 billion in
Lehman.2439 Two items immediately concerned Buffet during his
conversation with Fuld.2440 First, Buffett wanted Lehman executives
to buy under the same terms as Buffett.2441 Fuld explained to the
Examiner that he was reluctant to require a significant buy‐in from
Lehman executives, because they already received much of their
compensation in stock.2442 However, Buffett took it as a negative
that Fuld suggested that Lehman executives were not willing to
participate in a significant way.2443 Second, Buffett did not like
that Fuld complained about short sellers.2444 Buffett thought that
blaming short sellers was indicative of a failure to admit one's own
problems."
"[T]he importance of liquidity to
investment bank holding companies cannot be overstated.
Broker-dealers are dependent on short-term financing to fund their
daily operations, and a robust liquidity pool is critical to a
broker-dealer's access to such financing."
"By the second week of September 2008,
Lehman found itself in a liquidity crisis; it no longer had
sufficient liquidity to fund its survival. Thus, an understanding of
Lehman's collateral transfers, and Lehman's attendant loss of
readily available liquidity, is essential to a complete
understanding of why Lehman ultimately failed."
"Lehman represented in regulatory filings
and in public disclosures that it maintained a liquidity pool that
was intended to cover expected cash outflows for 12 months in a
stressed liquidity environment and was available to mitigate the
loss of secured funding capacity. After the Bear Stearns crisis in
March 2008, it became acutely apparent to Lehman that any disruption
in liquidity could be catastrophic; Lehman thus paid careful
attention to its liquidity pool and how it was described to the
market. Lehman reported the size of its liquidity pool as $34
billion at the end of first quarter 2008, $45 billion at the end of
second quarter, and $42 billion at the end of the third quarter.
Lehman represented that its liquidity pool was unencumbered – that
it was composed of assets that could be "monetized at short notice
in all market environments."
"The Examiner's investigation of Lehman's
transfer of collateral to its lenders in the summer of 2008 revealed
a critical connection between the billions of dollars in cash and
assets provided as collateral and Lehman's reported liquidity. At
first, Lehman carefully structured certain of its collateral pledges
so that the assets would continue to appear to be readily available
(i.e., the Overnight Account at JPMorgan, the $2 billion comfort
deposit to Citi, and the three-day notice provision with BofA).
Witness interviews and documents confirm that Lehman's clearing
banks required this collateral and without it would have ceased
providing clearing and settlement services to Lehman or, at the very
least, would have required Lehman to prefund its trades. The market
impact of either of those outcomes could have been catastrophic for
Lehman. Lehman also included formally encumbered collateral in its
liquidity pool. Lehman included the almost $1 billion posted to HSBC
and secured by the U.K. Cash Deeds in its liquidity pool; Lehman
included the $500 million in collateral formally pledged to BofA;
Lehman included an additional $8 billion in collateral posted to
JPMorgan and secured by the September Agreements; and Lehman
continued to include the $2 billion at Citi, even after the Guaranty
and DCSA amendments."
"This Section of the Report examines the
circumstances surrounding Lehman's provision of approximately $15 to
$21 billion in collateral (both in cash and securities) to its
clearing banks, and Lehman's simultaneous inclusion of those funds
in its reported liquidity pool."
"Critically, the collateral posted by
Lehman with its various clearing banks was initially structured in a
manner that enabled Lehman to claim the collateral as nominally
lien-free (at least overnight), and continue to count it in its
reported liquidity pool. However, by September 2008, much of
Lehman's reported liquidity was locked up with its clearing banks,
and yet this fact remained undisclosed to the market prior to
Lehman's bankruptcy."
From the Lehman Examiner Report - Volume 3, beginning page 945
as Forwarded (with highlights) to Bob Jensen by Lynn Turner
"(3) Lehman’s Board of Directors
Without exception, former Lehman directors were unaware of Lehman’s
Repo 105
program and transactions.3642
As discussed in greater detail below, Lehman’s own Corporate Audit group
led
by Beth Rudofker, together with Ernst & Young, investigated allegations
about balance
sheet substantiation problems made in a May 16, 2008
“whistleblower” letter sent to
senior management by Matthew Lee.3643 On June 12, 2008, during the
investigation, Lee
informed Ernst & Young about Lehman’s use of $50 billion of Repo 105
transactions in
the second quarter of 2008.3644 At a June 13, 2008 meeting,
Ernst & Young failed to
disclose that allegation to the Board’s Audit Committee.3645
Former Lehman director Cruikshank recalled that he made very clear he
wanted
a full and thorough investigation into each allegation made by Lee,
whether the allegation was contained in Lee’s May 16, 2008 letter or
raised by Lee in the course of
the investigation.3646 Another former Lehman director, Berlind,
similarly stated that the
Audit Committee explicitly instructed Lehman’s Corporate Audit Group and
Ernst &
Young to keep the Audit Committee informed of all of Lee’s
allegations.3647 Berlind also
said that he would have wanted to know about Lehman’s Repo 105 program
and that if
he had known about Lehman’s Repo 105 transactions, he would have asked
Lehman’s
auditors to test the transactions to ensure they were appropriate.3648
Upon learning from
the Examiner the volume of Repo 105 transactions at quarter‐end
in late 2007 and 2008,
Sir Christopher Gent said that he believed the volume mandated
disclosure to the Audit
Committee and further investigation.3649
Dr. Kaufman, on the other hand, stated that he would have wanted to know
about Repo 105 transactions only if they were “huge” and fraudulent, by
which he
meant in violation of specific accounting rules or in violation of the
law.3650 Dr.
Kaufman did not believe that $50 billion in Repo 105 transactions was
significant even if
that volume changed Lehman’s net leverage ratio by approximately two
points.3651 Dr.Kaufman considered a four or five point change in the net
leverage ratio to be
significant.3652
In late 2007 and 2008, management made numerous presentations to the
Board
regarding balance sheet reduction and deleveraging; in no case was the
use of Repo 105
transactions disclosed in those presentations.3653
i) Ernst & Young’s Knowledge of Lehman’s Repo 105 Program
During several Rule 30(b)(6)‐type3654
interview sessions, the Examiner
interviewed members of Ernst & Young’s Lehman audit team regarding Ernst
&
Young’s knowledge of and involvement in Lehman’s Repo 105 program.
(1) Ernst & Young’s Comfort with Lehman’s Repo 105 Accounting
Policy
The Examiner interviewed Ernst & Young’s lead partner on the Lehman
audit
team, William Schlich, regarding Lehman’s Repo 105 program. According to
Schlich, Ernst & Young had been aware of Lehman’s Repo 105 policy and
transactions for many years.3655
Consistent with the statements of Lehman’s John Feraca (Secured Funding
Desk), Schlich stated that Lehman introduced its Repo 105 Accounting
Policy
on the heels
of the FASB’s promulgation of SFAS 140.3656
During that time, Ernst & Young
“discussed” the Repo 105 Accounting Policy (including Lehman’s structure
for Repo
105 transactions) and Ernst & Young’s team had a number of additional
conversations
with Lehman about Repo 105 over the years.3657 However, according to
Schlich, Ernst &Young had no role in the drafting or preparation of
Lehman’s Repo 105 Accounting
Policy.3658
Schlich stated definitively that Ernst & Young had no advisory role with
respect
to Lehman’s use of Repo 105 transactions and that Ernst & Young did not
“approve”
the Accounting Policy.3659 Rather, according to Schlich, Ernst & Young
“bec[a]me
comfortable with the Policy for purposes of auditing financial
statements.”3660
Following “consultation and dialogue” about the proper interpretation
and
application of SFAS 140, Ernst & Young “clearly. . .concurred with Lehman’s approach” to
SFAS 140 and subsequent literature by FASB on the issue of “control” of
assets
involved in a repo transactions.3661 Ernst &
Young’s view, however, was not based upon
an analysis of whether actual Repo 105 transactions complied with SFAS
140.3662 Rather,
Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely
“theoretical.”3663 In other words, Ernst & Young solely assessed
Lehman’s
understanding of the requirements of SFAS 140 in the abstract and as
reflected in its
Accounting Policy; Ernst & Young did not opine on the propriety of the
transactions as a balance sheet management tool.3664 Ernst & Young did
not review the Linklaters letter,
referenced in the Accounting Policy Manual.3665
According to Martin Kelly, it was not unusual for him to discuss various
issues,
including Repo 105, with Ernst & Young.3666 Indeed, Kelly recalled
specifically speaking
with Schlich about Repo 105 transactions soon after becoming Financial
Controller on
December 1, 2007, in an effort to learn more about the program and “to
understand
[Ernst & Young’s] approach before talking to Callan.”3667
Kelly “wanted to ensure that Ernst & Young analyzed the program in the
same
way that [Marie] Stewart [Global Head of Accounting Policy] had analyzed
it.”3668
Kelly’s conversations with Ernst & Young focused on the accounting
treatment of Repo
105 transactions.3669 According to Kelly,
Ernst & Young “was comfortable with the
treatment under GAAP for the same reasons that Lehman was comfortable.”3670
Kelly also discussed with Ernst & Young Lehman’s inability to get a true
sale opinion under United States law for Repo 105 transactions.3671
Kelly could not recall whether he
discussed with Ernst & Young his discomfort with Lehman’s Repo 105
program.3672
(2) The “Netting Grid”
Throughout 2007, Lehman maintained a document entitled “Accounting
Policy
Review Balance Sheet Netting and Other Adjustments,” known colloquially
among
Lehman’s Accounting Policy and Balance Sheet Groups, as well at Ernst &
Young, as
the “Netting Grid.” The Netting Grid identified and described various
balance sheet
netting mechanisms employed by Lehman: one such balance sheet mechanisms
was
Lehman’s use of Repo 105 transactions.3673
Lehman provided the Netting Grid to Ernst & Young at least in August
2007 (the
close of Lehman’s third quarter 2007) and in November 2007 (the close of
Lehman’s
fiscal year 2007).3674 Notably, the Netting Grid provided by Lehman to
Ernst & Young in
August 2007 and November 2007 only contained Repo 105 volumes from
November 30, 2006 and February 28, 2007.3675 Schlich was unaware whether
Ernst & Young asked
Lehman to provide its second quarter 2007 and third quarter 2007 Repo
105 usage
figures or a forecast of Lehman’s fourth quarter 2007 Repo 105
numbers.3676
Ernst & Young reviewed the Netting Grid, analyzed the various balance
sheet
netting mechanisms identified in the Netting Grid, and used the document
in
connection with its 2007 year‐end audit of
Lehman.3677 According to Schlich, Ernst &
Young, as part of its review of Lehman’s Netting Grid, approved of
Lehman’s internal Repo 105 Accounting Policy only, and did not pass upon
the actual practice.3678
The Netting Grid described the transactions and United States GAAP
reference
as follows: “Under certain conditions that meet the criteria described
in
paragraphs 9 and
218 of SFAS 140,
Lehman policy permits reverse repo and repo agreements to be
recharacterized as purchases and sales of inventory.”3679
With respect to Lehman’s use
of Repo 105 transactions to reduce its net balance sheet, the Netting
Grid sets forth the conclusion that Lehman’s “current practice [for Repo
105] is correct.”3680 Schlich noted
that this conclusion about the Repo 105 practice was Lehman’s, not Ernst
& Young’s.3681
To test Lehman’s conclusion, however, Ernst & Young “reviewed how Lehman
applied
the control provisions of the accounting rules.”3682
Ernst & Young’s review, however, applied only to the accounting basis
for these
transactions, not to their volume or purpose. Specifically, Ernst &
Young’s review and
analysis of Lehman’s Repo 105 program did not account for the volumes of
Repo 105
transactions Lehman undertook at quarter‐end.3683
Indeed, Schlich was unable to
confirm or deny the volumes of Repo 105 transactions Lehman undertook at
Lehman’s
fiscal year‐end 2007, or in the first two quarter‐ends
of 2008.3684 Nor was Schlich able to
confirm or deny that Lehman’s use of Repo 105 transactions was
increasing in late 2007
and into mid 2008.3685
(a)
Quarterly Review and Audit
Through Schlich, Ernst & Young maintained that its duties as Lehman’s
auditor
required it to ensure that transactions were accounted for correctly
(i.e., that they
complied with accounting rules) and that Lehman’s financial disclosures
were not materially misstated.3686 According to Schlich, Ernst & Young’s
audit did not require
Ernst & Young to consider or review the volume or timing of Repo 105
transactions.3687
Accordingly, as part of its year‐end
2007 audit, Ernst & Young did not ask Lehman
about any directional trends, such as whether its Repo 105 activity was
increasing
during fiscal year 2007.3688 Notably, as part of its quarterly review
process, Ernst &
Young did not audit any of Lehman’s Repo 105 transactions.3689
(3)
Ernst & Young Would Not Opine on the Materiality of
Lehman’s Repo 105 Usage
Ernst & Young, through Schlich,
was unwilling to
comment to the Examiner on
the materiality of the volume of Lehman’s quarter‐end
Repo 105 transactions.3690 Asked
whether, as part of its responsibility to ensure Lehman’s financial
statements were not
materially misstated, Ernst & Young should
have considered the possibility that strict technical adherence to SFAS
140 or any other specific accounting rule could nonetheless lead to a
material misstatement in Lehman’s publicly‐reported
financial statements, Schlich refrained from comment.3691
When pressed further, Schlich stated that the volume of any particular
transaction impacts neither the question of whether accounting rules are
applied correctly, nor the question of whether a financial statement is
materially misleading.3692
However, Schlich eventually acknowledged that “when you look at a
balance sheet
issue, volume is a factor.”3693
Notably, the definition of “materiality” contained in a “walk‐through”
document
related to Ernst & Young’s 2007 fiscal year‐end
audit of Lehman was: “any transaction that
would move Lehman’s firm‐wide
net leverage by 0.1 or more.”3694 This
definition
reflected “Lehman’s determination of a materiality threshold” in
connection with
Lehman’s own criteria for when to consider reopening and adjusting its
balance
sheet.3695
When Schlich was asked what level of impact to Lehman’s firm‐wide
net assets
Ernst & Young would have considered “material,” Schlich replied that
Ernst & Young
did not have a hard and fast rule defining materiality in the balance
sheet context, and
that, with respect to balance sheet issues, “materiality” depends upon
the facts and
circumstances.3696 Schlich agreed that Lehman made no specific
disclosures about Repo 105 transactions in its Forms 10‐K and
Form 10‐Q,
including the MD&A section.3697
Schlich believed, however, that Lehman’s public filings would have
included general
language regarding secured borrowings and compliance with SFAS 140.3698
Schlich was
not aware whether Ernst & Young ever discussed Lehman’s disclosures vel
non of Repo
105 activity with senior Lehman management.3699
(4)
Matthew Lee’s Statements Regarding Repo 105 to Ernst & Young
On May 16, 2008, Matthew Lee, then‐Senior
Vice President in the Finance
Division responsible for Lehman’s Global Balance Sheet and Legal Entity
Accounting,
sent a letter to certain members of Lehman’s senior management
identifying possible violations of Lehman’s Ethics Code related to
accounting/balance sheet issues.3700 Lehman involved Ernst & Young in
its investigation of the concerns raised in Lee’s May
16, 2008 letter.3701
Subsequently, less than a month later, on June 12, 2008, Ernst & Young –
Schlich
and Hillary Hansen – interviewed Lee.3702 Hansen’s notes of the
interview reveal that Lee made certain statements to Ernst & Young about Lehman’s Repo
105 practice,
including, most notably, the volume of Repo 105 activity that Lehman
engaged in at
quarter‐end
(May 31, 2008).3703 Hansen’s notes specifically recount Lee’s allegation that
Lehman moved $50 billion of inventory off its balance sheet at quarter‐end
through
Repo 105 transactions and that these assets returned to the balance sheet approximately a
week later.3704
When interviewed by the Examiner, Schlich did not recall Lee saying
anything
about Repo 105 transactions during that interview, although he did not
dispute the
authenticity of Hansen’s notes from the Lee interview.3705 In spite of
Hansen’s notes,
Schlich maintained that Ernst & Young did not know that Lehman engaged
in the
following Repo 105 activity during the listed time periods: $49.1
billion at first quarter
2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31,
2008).3706
During the Examiner’s interview of Hansen, Hansen recalled that while
Ernst &
Young questioned Lee about his May 16, 2008 letter, Lee “rattled off” a
list of additional
issues and concerns he held, one of which was Lehman’s use of Repo 105
transactions.3707 Ernst & Young had no further conversations with Lee
about Repo 105
transactions.3708 Prior to her interview of Lee in June 2008, Hansen had
heard the term
Repo 105 “thrown around” but she did not know its meaning; according to
Hansen,
Schlich described Repo 105 transactions to her shortly after they met
with Lee.3709
Following Ernst & Young’s June 12, 2008 interview of Lee, Schlich and
Hansen
met with Lehman’s Gerard Reilly to discuss Lee’s assertions regarding
improper valuations.3710 During that meeting, Hansen informed Reilly of
the $50 billion Repo 105
figure Lee provided during Ernst & Young’s interview of Lee.3711
According to Schlich,
Reilly (now deceased) told the auditors that he had no knowledge that
Lehman used
Repo 105 transactions to move $50 billion in assets off its balance
sheet.3712 “Hillary
[Hansen] took away from the meeting with Reilly that he did not know and
it was not
$50 billion.”3713
On June 13, 2008 – the day after Lee informed Ernst & Young of the $50
billion in
Repo 105 transactions that Lehman undertook at the end of the second
quarter 2008 – Ernst & Young spoke to Lehman’s Audit Committee
but did not inform the committee
of Lee’s
allegation, even though the Chairman of the Audit Committee had clearly
stated that he wanted every allegation made by Lee – whether in Lee’s
May 16 letter or during the course of the investigation – to be
investigated.3714
Ernst & Young met with
the Audit Committee on July 8, 2008, to review the second quarter
financial statements and again did not mention Lee’s allegations
regarding Repo 105.3715 On July 22, 2008,
Ernst & Young was also present when Beth Rudofker, Head of Corporate
Audit, gave a
presentation to the Audit Committee on the results of the investigation
into Lee’s
allegations.3716
Ernst & Young did not disclose to the Audit Committee – either during
the
meetings or in private executive sessions after – that Lee made an
allegation related to
Repo 105 transactions being used to move assets off Lehman’s balance
sheet at quarterend.
3717 Cruikshank told the Examiner that he would have expected to be told
about
Lee’s Repo 105 allegations.3718 Similarly, Sir Gent told the Examiner
that the alleged volume of Lehman’s Repo 105 transactions mandated
disclosure to the Audit
Committee as well as further investigation.3719
Ernst & Young did not follow‐up on
either Lee’s allegations regarding Lehman’s
Repo 105 activity or Reilly’s claim that he had no knowledge of Lehman’s
alleged $50
billion Repo 105 usage figure.3720 Ernst & Young signed a Report of
Independent
Registered Public Accounting Firm for Lehman’s second quarter 2008 Form
10‐Q
on
July 10, 2008, less than four weeks after Schlich and Hansen interviewed
Lee.3721
(5) Accounting‐Motivated
Transactions
Ernst & Young did not evaluate the possibility that Repo 105
transactions were accounting‐motivated
transactions that lacked a business purpose.3722
Schlich
characterized the off‐balance sheet treatment of Lehman’s assets in Repo 105
transactions as a consequence of the accounting rules, rather than a
motive for the
transactions.3723
j)
The Examiner’s Conclusions
There is sufficient evidence to support a determination by a trier of
fact that
Lehman’s failure to disclose that it relied upon Repo 105 transactions
to temporarily
reduce the firm’s net balance sheet and net leverage ratio was
materially misleading. In
addition, a trier of fact could find that Lehman affirmatively
misrepresented its
accounting treatment for repos by stating that Lehman treated repo
transactions as
financing transactions rather than sales for financial reporting
purposes, despite the fact
that Lehman treated tens of billions of dollars in repo transactions –
namely, Repo 105
transactions – as true sale transactions.
The Examiner thus concludes that sufficient evidence exists from which a
trier of fact could find the existence of a colorable claim that certain
Lehman officers breached their
fiduciary duties to Lehman and its shareholders by causing the company
to file deficient and materially misleading financial statements,
thereby exposing the company to
potential liability.
Certain officers of Lehman not only failed to inform the public of
its reliance on Repo 105 transactions to reduce its balance sheet, they
also failed to
advise Lehman’s Board of Directors of the firm’s Repo 105 practice.
Thus, the Examiner
concludes that a trier of fact could find that certain Lehman officers
breached their
fiduciary duties to Lehman’s Board of Directors by failing to inform
them of: (1) the
firm’s reliance upon Repo 105 to reduce the balance sheet at quarter‐end,
(2) the rampup
in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions
on Lehman’s publicly reported net leverage ratio, or (4) the fact that
Lehman did not
disclose its Repo 105 practice in its publicly reported financials
statements and MD&A.
(1)
Materiality
The materiality of information is evaluated from the perspective of a
reasonable
investor.3724 Information is deemed material if there is “a substantial
likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable
investor as having significantly altered the ‘total mix’ of information
made available.”3725
Materiality does not require, however, that the information be of a type
that would
cause an investor to change his investment decision.3726
(a)
Whether Lehman’s Repo 105 Transactions Technically
Complied with SFAS 140 Does Not Impact Whether a
Colorable Claim Exists
This Report does not reach the question of whether Lehman’s Repo 105
transactions technically complied with the relevant financial accounting
standard, SFAS
140, because the answer to that question does not impact whether a
colorable claim
exists regarding Lehman’s failure to disclose its Repo 105 practice and
whether that
failure rendered the firm’s financial statements materially misleading. Even if Lehman’s use of Repo 105 transactions technically
complied with SFAS 140, financial statements may be materially
misleading even when they do not violate GAAP.3727 The Second Circuit
has explained that “GAAP itself recognizes that technical compliance
with particular GAAP rules may lead to misleading financial statements,
and
imposes an overall requirement that the statements as a whole accurately
reflect the financial status of the company.”3728
Similarly, as noted in In re Global Crossing Ltd. Securities Litigation,
even if a
defendant established that its accounting practices
“were in technical compliance with
certain individual GAAP provisions . . . this would not necessarily
insulate it from liability. This is because, unlike other regulatory
systems, GAAP’s ultimate goals of fairness and accuracy in reporting
require more than mere technical compliance.”3729
The court
explained that “when viewed as a whole,” GAAP has no “loopholes” because
its
purpose, shared by the securities laws, is “to increase investor
confidence by ensuring
transparency and accuracy in financial reporting.”3730
Technical compliance with
specific accounting rules does not automatically lead to fairly
presented financial statements. “Fair presentation is the touchstone for
determining the adequacy of disclosure in financial statements. While
adherence to generally accepted accounting principles is a tool to help
achieve that end, it is not necessarily a guarantee of fairness.”3731 Moreover,
registrants are “required to provide whatever additional information
would be necessary to make the statements in their financial reports
fair and accurate, and not
misleading.”3732
This view is echoed in an SEC enforcement order, concluding that GAAP
compliance does not excuse a misleading or less than full disclosure
regarding a
transaction, especially if the transaction’s purpose is “the attainment
of a particular
financial reporting result.”3733 “[E]ven if the transactions comply with
GAAP, the issuer
is required to evaluate the material accuracy and completeness of the
presentation
made by its financial statements.”3734 Issuers must “ensure that the way
they publicly
portray themselves discloses, as required, the material elements of
[their] economic and
business realities and risks.”3735
3732 Id.
(citing 17 C.F.R. § 240.10b‐5(b)
and 17 C.F.R. § 230.408 (requiring that “in addition to the information
expressly required to be included in a registration statement, there
shall be added such further material information, if any, as may be
necessary to make the required statements, in the light of the
circumstances under which they are made, not misleading”) (emphasis
added); see also SEC v. Seghers,
298 Fed. App’x 319, 331 (5th Cir. 2008) (“The Commission’s proof of Segher’s misrepresentations and omissions
does not depend on compliance with GAAP, but instead depends on evidence
that Segher’s statements and omissions were false or misleading to
investors.”); United States v. Olis, Civil Action No. H‐07‐3295,
Criminal No. H‐03‐217‐01, 2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) (“The scheme
to defraud alleged and proved in this case did not turn on whether the
treatment accorded to Project Alpha in Dynegy’s financial statements
technically complied with GAAP or whether Olis and his coconspirators
intended to violate GAAP but, instead, on whether the defendants’
disclosures about Project Alpha intentionally omitted material facts
that caused Dynegy’s financial statements to be materially false and
misleading.”) (citing United States v. Rigas, 490 F.3d 208, 221 (2d Cir.
2007), and United States v. Ebbers, 458 F.3d 110, 125‐26 (2d Cir. 2006)).
This is just a reminder that the survival of auditing firms other
than Ernst & Young are threatened by shareholder/creditor lawsuits
resulting from audits of failed banks and the virtual failure of all
auditors to issue going concern opinions of thousands of banks that
failed in 2008 and 2009.
Where Were the Auditors ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Even the crooked credit rating agencies are suing the auditors.
Question
It appears that Lehman is was trying to whitewash it's creative
accounting with a ruling from a shady law firm.
Because no
U.S. law firm would bless the transaction, Lehman got an opinion
letter from London-based law firm Linklaters. That letter
essentially blessed using the maneuver for Lehman's European
broker-dealer under English law. If one of Lehman's U.S. entities
needed to engage in a Repo 105 transaction, the firm moved the
securities to its European arm to conduct the deal on the U.S.
entity's behalf, the report found. That is likely why the
counterparties on the repo transactions were largely a group of
seven non-U.S. banks. These included Germany's Deutsche Bank AG,
Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group.
What other loser corporation
and its auditing firm sought to hide behind a shady law firm's blessing
on deceptive accounting?
Hint: The law firm was contacted after a whistle blower notified
both the client's CEO and the its auditing firm.
Answer
If you don't recall the answer, scroll down past the following tidbit.
The rare
look into the repo market embedded in the report comes 18 months
after Lehman Brothers collapsed in the U.S.'s largest bankruptcy
filing. While top Lehman executives were quick to blame the
real-estate market for their woes, the exhaustive report singles out
senior executives and auditor Ernst & Young for serious lapses.
The report
exposed for the first time what appears to be an accounting slight
of hand known as a Repo 105 transaction, where Lehman was able to
book what looked like an ordinary asset for cash as an out-and-out
sale, drastically reducing its leverage and making its financial
picture look better than it really was. The transactions often were
done in flurries in a financial quarter's waning days, before Lehman
reported earnings.
Four days
prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member
of Lehman's fixed-income division, was searching for a way to meet
his balance-sheet target, according to the report. He wrote in an
email: "Can you imagine what this would be like without 105?"
A day
before the close of Lehman's first quarter in 2008, other employees
scrambled to make balance-sheet reductions, the report said. Kaushik
Amin, then-head of Liquid Markets, wrote to a colleague: "We have a
desperate situation, and I need another 2 billion from you, either
through Repo 105 or outright sales. Cost is irrelevant, we need to
do it."
Marie
Stewart, the former global head of Lehman's accounting policy group,
told the examiner the transactions were "a lazy way of managing the
balance sheet as opposed to legitimately meeting balance-sheet
targets at quarter end."
Lehman's
use of this accounting technique goes back to the start of the
decade when Lehman business units from New York and London met to
discuss how the firm could manage its balance sheet using accounting
rules that had taken effect in September 2000. Lehman soon created
the "Repo 105" maneuver: Because assets the firm moved amounted to
105% or more of the cash it received in return, Lehman could treat
the transactions as sales and remove securities inventory that
otherwise would have to be kept on its balance sheet.
Because
no U.S. law firm would bless the transaction, Lehman got an opinion
letter from London-based law firm Linklaters. That letter
essentially blessed using the maneuver for Lehman's European
broker-dealer under English law. If one of Lehman's U.S. entities
needed to engage in a Repo 105 transaction, the firm moved the
securities to its European arm to conduct the deal on the U.S.
entity's behalf, the report found. That is likely why the
counterparties on the repo transactions were largely a group of
seven non-U.S. banks. These included Germany's Deutsche Bank AG,
Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group.
In a
statement, a Linklaters spokeswoman said the report "does not
criticize" the legal opinions it gave Lehman "or suggest or say they
were wrong or improper." The law firm said it was never contacted
during the investigation.
Jensen Comment
Although Lehman could not find a shady U.S. law firm to "bless the
transaction," Ken Lay at Enron managed to find a shady law firm to bless
the Raptors' transactions after Sherron Watkins (an Enron executive)
sent her infamous whistle blowing memo to both Ken Lay and to Andersen
executives in Chicago.
Ms. Watkins, 46, attracted national attention
after testifying before Congress in February 2002 about Enron's collapse
two months earlier. She was named one of Time magazine's people of the
year in 2002 for raising red flags about the company's accounting while
still working there. She has since written a book with a Houston
journalist about Enron's fall, and formed a consulting practice that
advises companies on governance issues.
Defense lawyers, during combative
cross-examination, tried to paint Ms. Watkins as an opinionated
fame-seeker who had profited from the Enron scandal on the lecture
circuit. The defense lawyers also suggested that Ms. Watkins was never
charged with insider trading for selling Enron shares because she was
wrong in believing that the Raptors were fraudulent.
Prosecutors contend that the partnerships and
hedges Ms. Watkins testified about were part of a broad effort by Mr.
Skilling and Mr. Lay to manipulate earnings and hide debt. The former
chief executives are accused of overseeing a conspiracy to deceive
investors about Enron's finances so they could profit by selling Enron
shares at inflated prices.
Defense lawyers contend that prosecutors are
seeking to criminalize normal business practices and that the Enron
executives were the victims of thieving subordinates like Andrew S.
Fastow, the former chief financial officer.
Ms. Watkins's appearance on the stand came as
the government neared the end of its case. Judge Simeon T. Lake III said
Wednesday that he estimated that the case could be wrapped up by the end
of April.
Ben F. Glisan Jr., a former Enron treasurer,
is scheduled to take the stand next week. Mr. Glisan pleaded guilty to
conspiracy and is currently serving a five-year prison term.
In often-colorful testimony, Ms. Watkins
recounted how she became concerned around June 2001 that about a dozen
Enron assets were being hedged, or guaranteed against loss, by the
Raptors vehicles, which she soon learned contained only Enron stock. The
Raptors were intertwined with partnerships run by Mr. Fastow, who became
Ms. Watkins's boss that summer. The value of the assets, she said, "had
tanked," dragged down by Enron's plummeting share price.
After doing some investigation, she wrote an
anonymous letter about her concerns, then on Aug. 22, 2001, she met with
Mr. Lay to discuss them. The meeting came about a week after Mr. Lay had
stepped back into the role of chief executive after the resignation of
Mr. Skilling.
At the meeting, they discussed a letter of
hers in which she had said that she was "incredibly nervous that Enron
would implode in a wave of accounting scandals." She also noted to Mr.
Lay that employees were talking about a "handshake deal" that Mr. Fastow
had with Mr. Skilling that ensured that Mr. Fastow would not lose money
on transactions done with the LJM partnership, which Mr. Fastow was
running.
Mr. Lay seemed to take her seriously, Ms.
Watkins testified.
Days after the
meeting, she learned that Vinson & Elkins, the law firm that had
originally approved the Raptors, was doing the internal investigation
into the partnerships. The firm, after consulting with Arthur Andersen,
Enron's auditor, issued a report saying that while the "optics" or
appearances were bad, the accounting was appropriate.
Ms. Watkins said she remained adamant that
Andersen, which had received several high-profile setbacks, should not
be trusted.
"I thought this was bogus," she said of the
investigation.
Concerned that Enron was manipulating its
financial statements, Ms. Watkins stepped up efforts to leave the
company, which she had begun shortly after she concluded the Raptors
could be fraudulent. She did not leave until after the bankruptcy.
Ultimately, Mr. Lay decided to unwind the
Raptors and take a write-off in a single quarter rather than restate the
accounting of Enron's financial statements. Ms. Watkins, under
questioning from Chip B. Lewis, a lawyer for Mr. Lay, conceded that
while that was not her preference, "continuing the fraud would have been
worse."
Defense lawyers sparred with Ms. Watkins from
the outset. Mr. Lewis placed a copy of Ms. Watkins's book, "Power
Failure," in front of her, calling it a "housewarming present."
Ms. Watkins acknowledged that she could not
explain why prosecutors did not charge her with insider trading for
selling Enron shares.
A House committee asked Enron Corp. for
information related to a newly discovered letter written by an Enron
employee last summer warning the company's chairman about its accounting
practices, which prompted an internal investigation.
That inquiry, conducted by Enron's outside
law firm, Vinson & Elkins, "has the appearance of a whitewash," said
House Energy and Commerce Committee spokesman Ken Johnson.
A committee investigator combing through 40
boxes of documents supplied by Enron found the letter over the weekend.
The author, Sherron Watkins, an Enron Global Finance executive who
wasn't identified further, questioned the propriety of accounting
methods, writing: "I am incredibly nervous that we will implode in a
wave of accounting scandals."
Enron, suffering from a crisis of confidence
by investors, filed for Chapter 11 bankruptcy-court protection on Dec.
2, shielding it from creditors as it seeks to reorganize.
In concluding its review of the matters
raised in the letter, Vinson & Elkins told Enron that "further
widespread investigation by independent counsel and auditors" was
unwarranted. But the firm warned that "bad cosmetics" involving the
transactions and the decline of Enron's stock posed the "serious risk of
adverse publicity and litigation."
The internal review was dated Oct. 15, 2001
-- one day before Enron announced its big third-quarter loss and a $1.2
billion reduction in shareholder equity because of losses later
associated with various partnerships involving Enron officials.
Ms. Watkins's letter and the lawyers'
conclusion were quoted Monday in a request for additional documents from
the House committee to Enron Chairman Kenneth Lay; the firm's outside
auditor, Arthur Andersen LLP; and Vinson & Elkins. The panel is seeking
additional information about the letter and Enron's response to it.
Joe Householder, a spokesman for Vinson &
Elkins, said the firm had received the committee's request for
information, but that "we're not prepared to respond yet to the specific
questions in the letter."
An Enron spokesman didn't return a call
seeking comment. Ms. Watkins, who no longer works for Enron Global,
couldn't be reached for comment.
Her letter to Mr. Lay questioned
special-purpose entities that Enron used to help keep its debt off its
books, the adequacy of public disclosure and the financial impact of the
decline of Enron's stock.
The committee said the existence of the
internal investigation suggests that "senior officials at Enron and
Andersen were aware of the controversial financial transactions and
accounting practices that would ultimately contribute significantly to
Enron's demise."
Mr. Johnson said Vinson & Elkins "had one
hand tied behind its back" by Enron officials as it began its review of
Ms. Watkins's warnings. "As part of Vinson & Elkins's mandate for
investigating the letter, they were told [by Enron officials] not to
second guess Arthur Andersen and not to analyze specific transactions,"
he said.
Ms. Watkins wasn't the first Enron insider to
raise concerns about partnerships related to Chief Financial Officer
Andrew Fastow. Sometime before the end of 2000, then-Enron Treasurer
Jeffrey McMahon went to company President Jeffrey Skilling and
complained about potential conflicts of interest posed by partnerships
operated by Mr. Fastow, which began in 1999 and early 2000. Mr. Fastow
quit the partnerships last July.
Mr. Skilling didn't share Mr. McMahon's
concerns, say people familiar with the matter. Mr. McMahon requested and
received reassignment to another post. In October, Mr. McMahon was named
as successor to Mr. Fastow as Enron's chief financial officer in the
face of rising controversy over the partnerships.
Ms. Watkins's August 2001 letter came when
what now appears to be the first major crack in Enron's facade appeared.
Mr. Skilling, who had been given the chief-executive post earlier in the
year, unexpectedly resigned on Aug. 14. He initially cited unspecified
personal reasons.
But in an interview the next day, he said
that his frustration over Enron's falling stock price played a major
role in his decision to quit after only six months as chief executive.
That remark has since raised questions about whether Mr. Skilling saw
problems ahead for Enron because some of its partnership arrangements
relied heavily on the use of Enron stock and their stability could be
threatened by a falling price.
Separately, Andersen issued a statement
providing more details about an e-mail sent by an in-house attorney that
resulted in the destruction by Andersen employees of numerous
Enron-related audit documents.
Mr. Odom forwarded the e-mail to David
Duncan, the partner in charge of the Enron audit as a reminder of the
firm's existing policy, Andersen said. The firm added that the e-mails
"are not a representation that there were no inappropriate actions" and
said it is continuing to investigate the matter.
Andersen's records-retention policy goes into
great detail about what documents should be kept for what periods of
time and when they should be disposed of. But the policy does note, "In
cases of threatened litigation, no related information will be
destroyed." At the time the e-mail was sent, no subpoenas had been
issued, but Enron's problems were mounting and drawing the attention of
attorneys representing shareholders.
Ernst
& Young, the audit firm, had a long and lucrative relationship with
Lehman Brothers. Lehman Brothers has paid EY more than $160 million
in audit and other fees since fiscal year 2001. Although this isn’t
nearly as much as
Goldman Sachs and AIG pay PwC – almost
$230 million a year combined in 2008 – it was still a huge amount
and represented a significant client relationship for Ernst & Young.
It
all started with Shearson Lehman American Express back in 1975.
Lehman Brothers inherited an audit relationship with Ernst & Young
when Lehman was
spun off from American Express in 1994. Current
Ernst & Young Global Chairman Jim Turley
cut his teeth on American Express.
“The decision to make Lehman Brothers an independent company
again, owned by American Express shareholders and Lehman
employees, completes American Express’s effort to rid itself of
the draining weight of its extraordinary, and ultimately
unsuccessful, expansion in the 1980s…the two companies will
share no directors and that Richard S. Fuld Jr. will
continue as president and chief executive of Lehman.
Fuld, in a brief telephone press conference, said Lehman was
vigorously pursuing its plan to cut costs by $200 million but
could not say if that would result in further loss of jobs. “It
is much more important for us to talk in terms of
dollars and not in terms of people,” he said.”
Ernst
and Young (EY) was fired by American Express at the end of 2004.
After a string of issues
with independence that threatened their
credibility and ability to accept new audit work, American Express
unceremoniously dumped them and hired PricewaterhouseCoopers.
“In
2003, Amex shelled out $23 million to E&Y in audit fees, and
$3.5 million for other services. The audit fee was the largest
paid by any U.S.-based E&Y client…an E&Y spokesman declined to
comment on the reasons the firm was dropped…E&Y has been in the
Securities and Exchange Commission’s (SEC) cross-hairs for about
a year, including one probe into whether the audit firm violated
federal auditor independence rules by entering a so-called
profit-sharing agreement in the 1990s with Amex’s travel-service
unit…”
But
EY’s relationship with Lehman continued until the bitter end. So it
comes as no surprise to me that
EY had a hard time acting independently
with their “sticky” client. Lehman Bankruptcy Examiner Anton
Valukas, of local Chicago Jenner & Block, sums it up nicely:
The Examiner concludes that sufficient
evidence exists to support colorable claims against Ernst &
Young LLP for professional malpractice arising from Ernst &
Young’s failure to follow professional standards of care with
respect to communications with Lehman’s Audit Committee,
investigation of a whistleblower claim, and audits and reviews
of Lehman’s public filings. (V3,
Pg 1027)
For
my first installment in this series, let’s take each “colorable
claim” individually and give them a
Red
(toast) ,Yellow
(may be vulnerable), or Green
(not likely to be too damaging) rating. I’m
not going to repeat the details from
Anton Valukas’
superb
Bankruptcy Examiner Report
in detail. I’ll offer my opinion and analysis on the “colorable
claims,” EY’s potential defenses, and any details or issues I
believe may not have been covered or any questions left unanswered.
(There’s a great summary of E&Y’s myriad sins and probably
soon-to-be ill-fated Financial Services Office over at
Zerohedge. I will be writing more about
this story, including looking more deeply into the
valuation issues, the impact on the other
large audit firms, the role of
Lehman’s internal audit function, the
specific accounting for the Repo 105 transactions, the relationship
of this bankruptcy to the
Lehman bankruptcy case in the UK, and
my prior theory about the fraud
and additional theories for litigation. )
Ernst & Young failed to follow professional standards of care with
respect to communications with Lehman’s Audit Committee.
Ernst & Young failed to follow professional standards of care with
respect to an investigation of a whistleblower claim
Lehman’s own Corporate Audit group led by Beth Rudofker,
together with Ernst & Young, investigated allegations about
balance sheet substantiation problems made in a May 16, 2008
“whistleblower” letter sent to senior management by Matthew Lee.
On June 12, 2008, during the investigation, Lee informed Ernst &
Young about Lehman’s use of $50 billion of Repo 105 transactions
in the second quarter of 2008. At a June 13, 2008 meeting, Ernst
& Young failed to disclose that allegation to the Board’s Audit
Committee. (V3 page 945)
As
the lawyers would say, the optics are bad here. The Audit
Committee asks EY to support Lehman’s internal auditor in
investigating a
“whistleblower’s” allegations of balance
sheet improprieties. The auditors interview the “whistleblower” and
then don’t say anything at any of the Audit Committee meetings.
Turns out what Mr. Lee the “whistleblower” was alleging is what the
examiner believes is the fundamental problem and grounds for
“colorable claims” against top officers and EY.
The
word “whistleblower” is colored with tons of emotion post-Enron. We
now look at those called “whistleblowers” and see heroes. But let’s
look at what I think may have actually happened. Internal
Audit, not EY, was in charge of the
investigation. They “naturally” asked their trusted,
all-things-to-all-people advisor, EY, to help.
That
was their first mistake. If I’ve said it once, I’ve said it a
thousand times: The external auditor should not be conducting or
assisting with internal investigations of potential fraud or illegal
acts by top executives. I wrote about it at
Siemens, subject of the largest ever FCPA
settlement in history. KPMG,
their auditor, got sued.
The
external auditor should stay the hell away from internal
investigations because they may get caught up in something they
would rather not know. They may want to claim plausible
deniability. And a company should not engage the external auditor
to support internal investigations especially regarding fraud or
illegal acts by top management. Do they do it to be cheap or to
keep dirty laundry inside? The external auditor is too often part of
the problem, an enabler, instead of part of the solution.
If
Lehman had hired another firm, a law firm or anyone except their
external auditor, to do the investigation, the investigation would
have been
covered end to end in privilege, the
external auditor may or
may not (in this case EY would have been
better not) have been included in the “circle of privilege,” and
the investigation would have been completed professionally.
However, by supporting this investigation, EY was essentially doing
internal audit work, a prohibited
service under Sarbanes-Oxley
for independence reasons. It’s shocking to me
that the EY audit partners did not at least turn over the
investigation to EY’s Forensic Accounting and Investigations
Practice in order to provide some semblance of independence and
professionalism.
Even though
EY may have been an unwilling party to knowledge of an ugly
situation right before an audit committee meeting, they got stuck.
They had an obligation under AU 380, as the external auditor - not
as an investigator – to inform the Audit Committee. They could have
been on the other side being informed – or not – instead of being
the one supposed to be doing the informing.
AU 380, the
rules for auditor communication with the Audit Committee, are very
clear. But they relate to the auditors role as an auditor
not the role of an auditor who is lent as muscle to an internal
investigation. By playing the “trusted advisor” they screwed
themselves.
Stoplight? Yellow.
Looks bad, but EY may be able to talk their
way out of this one once it gets to court. They need to explain how
they were still looking into the issue, doing their “auditor” work
and make sure their full but limited role and responsibilities for
the process are explained. If they lose on this chalk it up to
another case of audit partners wanting to be supermen to their
clients, the corporation’s executives, rather than looking out for
their own best interests. Unfortunately in this situation, the
shareholders were probably going to lose either way.
Ernst & Young failed to
follow professional standards of care with respect to audits and
reviews of Lehman’s public filings.
The
Examiner finds that sufficient evidence exists to support the
finding of colorable claims against Richard Fuld, Christopher
O’Meara, Erin Callan, and Ian Lowitt in connection with their
actions in causing or allowing Lehman to file periodic reports
that did not disclose Lehman’s use of Repo 105 transactions and
against Ernst & Young for its failure to meet professional
standards in connection with that lack of disclosure…While there
were credible facts and arguments presented by each that may
form the basis for a successful defense, the Examiner concluded
that these possible defenses do not change the now final
conclusion that there is sufficient evidence to support
a finding that claims of breach of fiduciary duty exist against
Fuld, O’Meara [CFO 2004-2007], Callan [CFO 12/07 to 6/2008],
and Lowitt [CFO 6/2008 to Chapter 11 9/08] and a colorable
claim of professional malpractice exists against Ernst & Young.”
(V3, pages 990-991)
This one is about mandated
disclosure and unfortunately for EY – and these Lehman executives –
it looks like a prima facie case of securities laws
violation for the executives and malpractice for EY.
Color this
stoplight RED
for “EY is burnt toast.”
EY’s only
hope is perhaps an “in pari delicto” defense. The Lehman
executives will surely be subject to civil and criminal fraud
charges. In that case, given the challenges for a Bankruptcy
Trustee who, strictly speaking, stands in the shoes of felons whose
actions may be imputed to Lehman the corporation, EY may be able to
try what PwC and Grant Thornton/PwC/EY have tried in the
AIG and Refco cases coming before the New York Court of Appeals.
But if those questions are resolved in favor
of the plaintiffs, EY will not be able to count on Fuld, O’Meara,
Callan and Lowitt to shield them from accountability.
Why did this
happen? Well, any obfuscation, if intentional, was meant to fool
investors, ratings agencies,
short sellers, counterparties and anyone
else whose confidence the Lehman executives required. They wanted to
appear to be in better financial shape than they really
were – for as long as possible.
They may
have been prolonging the inevitable, but at some point they knew the
inevitable would occur. Liquidity crises are rarely sudden. But
they are often suddenly acknowledged. In Lehman’s case, the Bear
Stearns failure was probably the bell that tolled hollow, loud and
clear.
So
why did EY “fail to meet professional standards” in connection with
that lack of disclosure?
Brad Hintz, Lehman’s CFO in the late 1990’s told Bloomberg
on March 12, “over ten years, a lot of venial
sins add up…” I’m assuming he means the mortal sin of accounting
manipulation. I think that over almost ten years EY may have
ignored a lot of venial sins until “the drug we’re on,” as Lehman’s
McDade calls the now notorious
Repo 105 transactions,
added up to the mortal sin of accounting manipulation that was
hidden form investors by lack of disclosure.
Brad
Hintz told me that the average CFO tenure post-Lehman IPO 1994 was
540 days. The Examiners’s Report refers to three CFOs during the
period under examination alone. I’ve already told you what was
wrong with the last two,
Callan and Lowitt. You can sense their boredom and disdain for
accounting details when you read their testimony.
Ernst & Young pays up to settle audit negligence claim
The liquidator is suing one of the collapsed eyewear company's former
auditors, KPMG, for HK$472 million.
27 January 2010
South China Morning Post
Reported by Naomi Rovnick
Ernst & Young pays up to settle
negligence claim
The Hong Kong branch of accounting
giant Ernst & Young, which in September l paid US$200 million to
creditors of its collapsed former client Akai Holdings, has quietly
settled another audit negligence case involving a failed local
company.
Ernst & Young Hong Kong has paid to
resolve a claim of between HK$250 million and HK$300 million that
the liquidators of Moulin Global Eyecare had threatened to launch
against it.
Moulin, which once claimed to be
Asia's biggest manufacturer of eyewear, was wound up by the High
Court in 2006 amid fraud allegations, owing lenders HK$2.7 billion.
Ernst & Young was Moulin's auditor between 2002 and 2004.
The accounting firm declined to
comment.
The eyewear firm's liquidator,
Ferrier Hodgson, which also declined to comment, has consistently
accused Moulin of fraudulently inflating its revenues.
The liquidator told creditors in
private that one of Moulin's four biggest customers was really a
Chinese restaurant in McCook, a town of 8,000 in Nebraska in the
United States, people who attended the meetings said.
The terms of Ernst & Young's
settlement are confidential. A source with knowledge of the
accounting firm's local operations said it had paid "substantially
less" than Ferrier had threatened to seek.
The case, which was in mediation,
never reached a High Court trial.
"After Akai, Ernst & Young did not
want another public fight over alleged audit negligence involving an
allegedly fraudulent former client," the source said.
In September Akai's liquidator,
Borrelli Walsh, accused Ernst & Young in the High Court of faking
legal evidence to shield itself from a US$1 billion audit negligence
claim.
Akai was the Hong Kong-listed global
electronics empire of disgraced entrepreneur James Ting which
collapsed in 2000 owing lenders US$1.1 billion.
Like Akai, which was a stock market
darling before its fall from grace, Moulin was once a company that
made Hong Kong proud.
Rags-to-riches entrepreneur Ma Bo-kee
moved to Hong Kong from Guangdong in 1960 and began producing
spectacles from a small workshop with just a dozen employees.
Before its demise, Moulin boasted of
an optical business that spanned China, Europe and North America. It
produced more than 15 million frames a year for brands including
Benetton and Nikon.
But after examining its books,
Ferrier Hodgson believed the actual business was much smaller. The
liquidator once wrote to Moulin's lenders claiming the company's
accounts were a "morass of dodginess" that would take 14 years to
unravel. Officer's from the police force's commercial crime bureau
raided Moulin's offices in July 2005.
In February, police charged Ma and
his son Cary Ma Lit-kin, Moulin's former chief executive, with
offences including making false statements and conspiracy to
defraud. The criminal case is yet to come to trial.
In a separate civil action, Moulin's
creditors are suing accountant KPMG for HK$471 million over its role
as Moulin's auditor between 1999 and 2002
Police are also investigating Ernst
& Young's role in Akai's collapse
Lawyers for Borrelli Walsh alleged
in court that staff at Ernst & Young had falsified and doctored old
files relating to Akai and that the audit firm used the questionable
documents to support its witness statements and pleadings in the
negligence trial
In September, police raided Ernst &
Young's offices and arrested a partner who had audited Akai. Edmund
Dang, a junior member of staff when he worked on the Akai account,
was granted bail
No criminal proceedings have been
launched against Ernst & Young in relation to Moulin.
28 January 2010
South China Morning Post
Reported by Naomi Rovnick
Moulin father and son face trial for
fraud
The father and son who ran Moulin
Global Eyecare, the Hong Kong-based optics empire that collapsed in
2005, owing creditors HK$2.7 billion, will be tried on fraud charges
in September.
Ma Bo-kee, the rags to riches
entrepreneur who started Moulin in a Kowloon workshop, and his son
Cary Ma Lit-kin, who aggressively grew the firm into what he claimed
was the world's third-biggest eyewear business, will be joined by
eight other defendants in a 100-day High Court hearing beginning on
September 14.
Moulin's speedy and spectacular
failure in June 2005, which was triggered by the company's bank
lenders accusing it of false accounting, stunned Hong Kong
investors.
Six months earlier, chief executive
Cary Ma had presided over his firm's mega-buyout of 378-store United
States retail chain Eye Care Centers of America, which helped
Moulin's market capitalisation balloon to HK$2.08 billion.
The details of the criminal
prosecution's case against the Mas and the other defendants, who
include Moulin's former treasurer Lam Yuk-wah, former financial
controller Tang Yiu-leung and other company executives, will not
emerge until the case goes to a pretrial hearing in April.
Moulin's liquidator, Ferrier
Hodgson, which is trying to recover cash for creditors through the
civil courts, has accused the failed eyewear firm of vastly
inflating its revenues by creating phantom customers.
The liquidators discovered one of
Moulin's supposedly largest customers was in fact a Chinese
restaurant in McCook, a small town in the US state of Nebraska,
according to people who attended lenders' meetings.
The liquidators once wrote to the
failed eyewear company's creditors that its accounts were a "morass
of dodginess" that would take 14 years to unravel.
Ma Bo-kee, Moulin's chairman, was
declared bankrupt in November 2006. Cary Ma was declared bankrupt in
April 2007.
In January 2007, Standard Chartered
won a judgment against Cary Ma, forcing him to repay a HK$3.4
million personal overdraft. Moulin's former chief executive argued
in the High Court that the overdraft was a debt facility of his
collapsed company and that he was not responsible for repaying it.
But the judge found that Cary Ma had used the bank account in
question to place telephone bets with the Jockey Club and to buy his
groceries at ParknShop.
Ferrier Hodgson is investigating the
financial affairs of the two Mas but has not launched court actions
against them.
The liquidator is suing one of the
collapsed eyewear company's former auditors, KPMG, for HK$472
million
The case, in which the Big Four
accountancy firm will fight allegations of audit negligence, is set
for trial in February next year
Ernst & Young Hong Kong, which was
Moulin's auditor from 2002 to 2004, has just paid to settle a civil
claim of between HK$250 million and HK$300 million Ferrier Hodgson
had threatened to launch against it but which never reached the
court. The exact amount of the settlement is confidential.
A police spokesman confirmed the
details of the criminal trial and the charges.
The Mas could not be reached.
Borrelli Walsh, the Mas' bankruptcy trustee, said it was unable to
release contact details for the pair.
Following the
big lawsuits against the audit firms is fairly easy. Updates on
subprime and financial crisis suits typically hit my Google Alerts.
There area few more like the Banco Espiritu Santo v. BDO Seidman
case and the case against PwC re: Satyam that have their very own
customized alerts. And
Kevin
LaCroix can be counted on to pick up the
odd securities class action suit naming an auditor for sport and he
also tracks all of the Madoff related filings. Every once and a
while I depend on the kindness of handsome strangers to catch the
latest update like when
Francis
Pileggi told us the what happened in
Delaware Chancery Court with Deloitte’s suit against accused inside
trader and their own ex-Vice chairman Tom Flanagan.
The big
lawsuits – the ones that accuse the firms of accounting malpractice
or various federal securities law violations – have been chronicled
on this site and by fellow writers such as
James
Peterson ad infinitum. The accounting
industry’s response to these threats is to ask for liability caps.
As if we don’t have enough moral hazard in the financial system with
“too big to fail,” the auditors want to institutionalize
their insulation from accountability to their clients, the
shareholders, with a policy of “too few to pay for their
mistakes.”
If only the lawsuits
claiming lack of audit prowess were the only ones they had to worry
about. Unfortunately for them, and for their “partners” who go
along for the ride leaving the management of “matters” up to senior
leadership acting as caretakers for the 5-10 years they are at the
top of the heap, there are so many more suits that just show what
lousy managers they are.
Here are some of the
more interesting lawsuits and legal matters facing each of the Big
4.
[DOJ Tax
Division lawyer Judith] Hagley on Friday argued that the
work product privilege does not apply to the documents Dow
turned over to Deloitte because the documents were prepared
during what Hagley said was the ordinary course of business
– and not prepared for litigation purposes.
A former
Deloitte tax professional has agreed to pay approximately
$144,000 to settle insider trading charges with the
Securities and Exchange Commission.
The SEC
filed settled insider trading charges against four
individuals, including John A. Foley, who served as an
employee benefits specialist at Deloitte between July 2005
and May 2007. The others who settled the SEC charges were
Aaron M. Grassian, Timothy L. Vernier, and Bradley S. Hale.
They were accused of participating in insider trading in the
securities of four public companies — Crocs, Inc., YRC
Worldwide, Inc., Spectralink Corporation and SigmaTel, Inc.
— over a 22-month period, yielding illegal profits totaling
$210,580.62.
Despite
the high standard that Deloitte holds you to — higher than
the SEC, PCAOB, and the AICPA, we might add — this happened,
“Based on our own reviews and that of the PCAOB, we believe
compliance with our independence policies is not what it
should be, and the PCAOB has, in fact, questioned our
commitment to adhere to our own policies. This is clearly
not acceptable.”
Our contributor Francine McKenna reminded us that Deloitte
didn’t think too much of the PCAOB’s report from last year,
“They [are] the same firm that famously responded to the
PCAOB’s latest inspection report, ‘How
dare you second guess us?‘”
Although
Deloitte won a
preliminary victory against Flanagan,
they obviously still have a lot of work to do to improve their
independence compliance function and are still subject to PCAOB
and
SEC enforcement actions and potential
sanctions.
In the
meantime, they did
settle Parmalat,
but now they’re named in
several suits related to the Merrill
Lynch acquisition by Bank of America and the Bear Stearns
failure. Deloitte is the only Big 4 firm to have escaped any
Madoff feeder fund exposure even though they are supposedly the
number one choice of hedge funds.
Ernst &
Young
Ernst & Young
has its own inside trader case to go along with
the ones we saw a few months ago and the
rest of the SEC sanctions they’re collecting.
A former Ernst & Young LLP partner was sentenced
to a year and a day in prison on Monday
after he was convicted last year of fraud charges in an
insider-trading scheme where he allegedly tipped a Pennsylvania
broker about pending corporate takeovers.
At a
hearing, U.S. District Judge Miriam Goldman Cedarbaum in
Manhattan sentenced James Gansman, a lawyer who resigned from
Ernst & Young in October 2007. He was convicted of six counts of
securities fraud, but acquitted of conspiracy and three
securities fraud counts in May 2009.
The
Securities and Exchange Commission has instituted public
administrative proceedings against two former Ernst & Young
auditors who failed to uncover the misappropriation of
client funds by an investment advisor they were auditing.
The
proceedings were instituted against two CPAs: Gerard A.M.
Oprins, 50, who had been a partner in Ernst & Young’s
financial services practices group since 1995; and Wendy
McNeely, 33, a former audit manager in E&Y’s financial
services group who now works for another firm.
The EY list
includes the usual employment discrimination lawsuits that all of
the firms face, in particular given the significant cuts they have
all made to their ranks during the last two years. Ernst & Young
also has
several filings related to writedowns at
Regions Financial Corporation. Regions is
the largest audit client of Ernst & Young LLP’s Birmingham office.
Back in 2003, that office’s largest client had
been HealthSouth Corp., which turned out to be a massive fraud.
Tough luck…
The Regions
board and management team, as well as Ernst and Young, are accused
of “continued reporting a grossly
inflated value of the goodwill attributable to the AmSouth
acquisition,” which later caused a large $6 billion write-down equal
to more than 60 percent of the total acquisition, according to
the lawsuit.
Bankruptcy cases are
some of the biggest moneymakers for the firms now globally but can
become contentious.
A MP has
written to the insolvency regulator calling for an investigation
into the actions of Nortel’s administrator Ernst & Young (E&Y).
“Ernst &
Young’s handling of this insolvency case has been woeful and it
would appear that they may have failed to pay appropriate regard
to redundancy and employment legislation,” he said.
Next I’ll summarize
which cases KPMG and PricewaterhouseCoopers are spending their legal
dollars on.
Ernst
& Young has agreed to pay $8.5 million to settle civil charges that
it violated accounting rules in connection with a fraud at Bally
Total Fitness Holding Corp, the
U.S. Securities and Exchange Commission
said Thursday.
The SEC
accused the accounting firm of issuing unqualified audit opinions
that said that Bally's 2001 and 2003 financial statements conformed
with U.S. accounting rules.
“These
opinions were false and misleading,” the SEC said in a statement.
“Ernst &
Young has agreed to pay $8.5 million to settle civil charges that it
violated accounting rules in connection with a fraud at Bally Total
Fitness Holding Corp, theU.S. Securities and Exchange Commission
said Thursday.
The SEC
accused the accounting firm of issuing unqualified audit opinions
that said that Bally’s 2001 and 2003 financial statements conformed
with U.S. accounting rules.
Six of the
accounting firm’s current and former partners also agreed to settle
SEC accounting violation charges as part of this investigation, the
SEC said.
In settling
the allegations, Ernst & Young and the former and current partners
did not admit to any wrongdoing, the SEC said.
“These settlements allow us and several of our partners to put this
matter behind us and resolve issues that arose more than five years
ago,” Ernst & Young said.”
What none
of the stories that just hit tell you, though, is that at least two
of the EY partners charged, Fletchall and Sever, held leadership
positions with the AICPA in the past.
Three of
the partners were members of EY’s leadership team/national office,
giving advice, guidance, and making decisions about accounting
standards on behalf of engagement teams nationwide.
Did Mr.
Fletchall get off with a slap on the wrist given his AICPA
leadership position, AICPA PAC contributions and significant
campaign contributions to Senator Christopher Dodd? Mr. Fletchall is
used to telling the SEC what it should do. Quite used to it.
EY can put
an old case behind them… Yes, of course, since it’s December of 2009
and it’s taken the SEC six years to resolve a case from 2001-2003.
No wonder the firms’ answer to any settlement or disciplinary
proceeding is always, “that’s in the past.”
EY had
independence issues recently and was supended from taking on new
audit clients for six months. How many strikes does a firm get? Why
no strong statement, sanction or other disciplinary action from the
PCAOB for the partners or the firm in relation to this case? Maybe
because Mr. Fletchall was also a member of the PCAOB’s Standang
Advisory Group.
When the
creditors of bankrupt companies draw up lists of litigation targets,
auditing firms are often right there at the top. So it was for the
creditors trust of the bankrupt insurer, Frontier Insurance Group.
The trust, represented by John McKetta III of Graves Dougherty
Hearon & Moody, alleged that Ernst & Young underestimated the
reserves Frontier needed to hold, making the company look healthy
when it was actually insolvent. It claimed $140 million in damages,
plus interest.
But E&Y
decided to make a stand. It refused to chip up, and instead headed
for a jury trial before White Plains, N.Y., federal district court
Judge Cathy Seibel. On Wednesday, after 12 days of trial, jurors
needed only two hours to exonerate the auditor.
"This case
shows that E&Y is willing to go to trial in a case it believes has
no merit, even where the threatened damages are substantial," said
Ernst & Young's outside counsel, Dennis Orr of Morrison & Foerster.
Orr told us that Ernst & Young hopes other potential litigants get
the message.
Trust
counsel McKetta said no decision had been made about the trust's
next move in the case. But he was gracious in defeat, complimenting
Seibel, the jury, and even the team at Morrison & Foerster. "They
did a terrific job," McKetta said.
This
case points out the long-tail impact of a bad audit, in causing distress
to accounting firms, many years after the audit has been completed. And
we don't think this is the end of the affair, there are a lot of other
pending accounting investigations with the SEC, Huron Consulting for
example, and the outcomes for firms convicted of wrong doing are going
to be high. The SEC is just emerging itself from getting a bad rap in
the Madoff affair, so may be getting a little more aggressive and
assertive than in previous years. Also investors would hope for drastic
changes in the audit process of accounting firms, if the firms’
integrity as ultimate protectors of investors’ interests has to be fully
and firmly re-established.
"Big Ernst and Young Settlement on Bally Fitness, Large Implications,"
Big Four Blog, December 18, 2009 ---
http://bigfouralumni.blogspot.com/2009/12/big-ernst-and-young-settlement-on-bally.html
An Enron-Magnitude Fraud Involving
Ernst & Young in Hong Kong
It is quite rare for auditors of international CPA firms to be arrested
for criminal conduct
"KPMG (U.K.) accountancy chief fiddled £545,000 to pay for his new
wife's luxury tastes," by Julie Moult, Daily Mail, August 26,
2009 ---
Click Here
Many of the criminal
complaints concern tax shelter promotions by accounting firms. Thirteen
of 17 KPMG employees had charges eventually dropped in the most famous
of tax shelter cases, although others had earlier confessed to their
crimes ---
http://www.trinity.edu/rjensen/fraud001.htm#KPMG
Seven people including the former chief executive and chairman of
accounting firm BDO Seidman LLP have been charged criminally in an
allegedly fraudulent tax-shelter scheme that generated billions of
dollars in false tax losses for clients ---
http://www.trinity.edu/rjensen/fraud001.htm#BDO "Former BDO Seidman vice chair
pleads guilty to tax fraud," AccountingWeb, March 20, 2009 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=107235
Another exception was where Andersen
eventually folded after disclosure that the Houston office illegally
destroyed records sought by the court.
Edmund Dang, an Ernst & Young Hong
Kong partner who was previously a manager on the Akai audit, was
arrested on suspicion of forgery.
"Ernst & Young chief steps down Ernst
& Young chief steps down amid probe," by Enoch Yiu, Naomi Rovnick
and Clifford Lo, Lexis/Nexis News, October 1, 2009 ---
Click Here
The Hong Kong and
China chairman of Ernst & Young, whose Hong Kong offices were raided
on Tuesday by the police in connection with a fraud probe, has
stepped down from his post.
Ernst & Young told
the firm's partners yesterday in an e-mail that David Sun Tak-kei
had relinquished his position. He will remain a partner with the
firm and keep his other title as co-managing partner of its "Far
East" business, a unit that includes Hong Kong and the mainland.
An Ernst & Young
Hong Kong spokesman said Sun's move was not related to the Akai case
and that it was normal for the firm to announce appointments and
reorganisations on October 1.
In an e-mailed
statement, Ernst & Young Hong Kong also said that Sun's move had
been announced internally in July. Sun was not available for
comment.
The police
Commercial Crime Bureau is investigating Ernst & Young Hong Kong
after the firm was accused in court of falsifying documents to
shield itself from an audit negligence claim from the liquidators of
its former client, Akai Holdings.
Edmund Dang, an
Ernst & Young Hong Kong partner who was previously a manager on the
Akai audit, was arrested on Tuesday on suspicion of forgery. He was
released on bail without being charged.
Legal and police
sources familiar with the criminal investigation said police were
unlikely to focus their inquiries solely on Dang, as he was only a
junior member of the Akai audit team.
In the civil audit
negligence case, Akai's liquidators Borrelli Walsh alleged that
Ernst & Young's evidence contained files from the firm's Akai audits
that had been tampered with or invented after the electronics giant
collapsed. The liquidators alleged that Dang's handwriting was on
some of the suspect files. But Leslie Kosmin QC, for Borrelli Walsh,
also claimed that the actions went beyond that of a junior manager.
Kosmin alleged that Dang, who joined the Akai audit team in December
1997, had tampered with files dated as far back as 1994.
Solicitors
speculated that Dang could be granted immunity if he revealed that
other people at Ernst & Young Hong Kong were involved in the alleged
interference with papers that found their way into the firm's
evidence.
Sun was involved in
the auditing of Akai, which was wound up in 2000 in Hong Kong's
biggest ever corporate collapse. From 1991-99, Sun was Ernst &
Young's independent partner in charge of the Akai audit. It was his
job to review the firm's handling of Akai's financial statements.
A police officer
involved in the criminal investigation said of Dang's arrest: "Like
all other cases, police hope arrested persons and witnesses will
co-operate and tell us the facts." The officer said no further
arrests were made yesterday and that the investigation was
continuing.
On September 23,
Ernst & Young paid hundreds of millions of dollars to settle the
civil negligence case, saying it could not continue to fight, in
light of the altered documents. The liquidators alleged Ernst &
Young Hong Kong staff tampered with and falsified Akai-related audit
files in the months after the company collapsed, then used the
questionable papers in witness statements, court pleadings and
expert reports.
Yesterday, Ernst &
Young Hong Kong sent a memo to staff saying it was assisting and
co-operating with police inquiries. It confirmed that a partner who
had been suspended already by the firm, which it did not name as
Dang, had been arrested.
"Why is [Ernst &
Young] trying to pin everything on Dang?" asked a friend of Dang's,
who asked to remain nameless. "The firm is a partnership, and
partnerships are like families. It is horrible to isolate one man
who was only a junior member of Akai's audit team and to suggest he
was the cause of all this."
Sun will be replaced
as Hong Kong and China chairman by Ernst & Young tax partner Albert
Ng. Ng was formerly Arthur Andersen's head of China and joined
PricewaterhouseCoopers after Arthur Andersen collapsed following the
Enron scandal. He joined Ernst & Young a year ago.
Ernst & Young on
Wednesday agreed to make an undisclosed “substantial payment” to
liquidators of Hong Kong’s biggest ever bankruptcy, after admitting
that certain audit documents produced were no longer reliable.
Speaking in Hong
Kong’s high court on Wednesday, Leslie Kosmin, barrister for
liquidators Borrelli Walsh, described the settlement as “a very
favourable outcome for the creditors of Akai Holdings and another
milestone in the winding up of the company”.
&Y had been Akai’s
auditor prior to the Hong Kong consumer electronic company’s
collapse. The liquidators began suing the accounting firm for a $1bn
negligence claim in 2002.
The case has dragged
on for years but took a dramatic turn last week in the High Court,
when Borrelli Walsh claimed that more than 80 Akai-related files
produced by E&Y had been doctored or faked.
David Sun, E&Y
co-managing partner for the Far East, said the firm was “dismayed by
the unexpected circumstances that have arisen”.
E&Y also suspended a
partner, who was Akai’s audit manager, after an internal inquiry
determined that “certain documents produced for audits in 1998 and
1999 could no longer be relied on due to [his actions] in early
2000”.
The accountancy firm
on Wednesday expressed “dismay over the unexpected circumstances”
and suspended a partner, who was the Akai’s audit manager at that
time after an internal investigation determined that “certain
documents” could no longer be relied on due to the partner’s actions
in early 2000.
Jim Hassett, E&Y’s
co-managing partner for the Far East, said: “This settlement means
that we can now put this old matter behind us.
“This eliminates any
uncertainty or future burden on our business, allowing us to focus
all our efforts on our people and our clients.”
Jim Hassett, E&Y’s
co-area managing partner for the Far East Area said: “This
settlement means that we can now put this old matter behind us. This
eliminates any uncertainty or future burden on our business,
allowing us to focus all our efforts on our people and our clients.”
Akai – the namesake
of one of Japan’s oldest electronic companies – came into being
after Semi-Tech, founded by the flambuoyant entrepreneur James Ting,
bought a majority stake in the company in 1995. At the peak of Mr
Ting’s empire-building in the mid-1990s, his companies were listed
around the world. Akai Holdings itself had more than 160 interlinked
subsidiaries.
The structurally
complex company was eventually collapsed in 1999 shortly after the
Asian financial crisis. At the start of that year, audited
statements showed that the company had $2.3bn in assets and $262m in
cash. But by year-end, the company had to write-off $1.75bn.
Akai was
subsequently wound up in 2000. Mr Ting was imprisoned on charges of
false accounting in 2005, but was released two years later after the
Court of Appeal found errors in the prosecution’s case.
Justice William
Stone on Wednesday welcomed the result. “I am personally obviously
delighted the parties have come to an amicable settlement,” he said.
“The parties have acted with great good sense in coming to the
agreement you have come to.”
"PCAOB Rips E&Y on Revenue Recognition:
Two of Ernst & Young's clients had to restate financial results after the
accounting-firm overseer found departures from GAAP," by Sarah Johnson,
CFO.com, May 27, 2009 ---
http://www.cfo.com/article.cfm/13725058/c_13725042
Ernst & Young failed
to note when two clients strayed from revenue-recognition rules,
according to the latest inspection report on the Big Four firm by
the Public Company Accounting Oversight Board. Consequently, the
regulator's sixth annual inspection of E&Y resulted in those clients
having to restate their previously issued financial statements to
make up for the departure from U.S. generally accepted accounting
principles.
These companies —
whose identity the PCAOB keeps confidential — had "failed" to fully
follow FAS 48, Revenue Recognition When Right of Return Exists. The
rule calls on companies to, at the time of sale, make reasonable
estimates of how many products that customers will return as a
factor in deciding when revenue can be recorded.
Further criticizing
the audit firm for its work on a third client, the PCAOB claims E&Y
didn't test the issuer's VSOE, or vendor-specific objective
evidence, which is used to figure out whether the amount of revenue
recognized for individual parts of a technology contract was
reasonable.
The PCAOB noted the
revenue recognition audit deficiencies mentioned here, as well as
several others at eight of E&Y's clients after reviewing the firm's
work between April and December of last year. The deficiencies were
linked to the firm's national office in New York and 22 of its 85
U.S. offices. These errors were significant enough for the oversight
board to conclude the firm "had not obtained sufficient competent
evidential matter to support its opinion on the issuer's financial
statements or internal control over financial reporting."
The PCAOB also
criticized E&Y for not fully exploring a client's revenue contracts
to see how their terms could affect the issuer's revenue
recognition, for not doing enough work to assess the valuation of
another issuer's securities, and for relying on information an
issuer had deemed unreliable for estimating an income-tax valuation
allowance.
To be sure, eight
clients may not be many in terms of the number of audits looked at
by the oversight board, or when taking into account that E&Y audits
more than 2,300 publicly traded companies. The PCAOB, however,
doesn't specify how many audits it reviewed and discourages readers
of its inspection reports from drawing conclusion on a firm's
performance based solely on the number of the reported deficiencies
mentioned. "Board inspection reports are not intended to serve as
balanced report cards or overall rating tools," the PCAOB notes.
For its part, E&Y,
in all but two of the deficiencies cited, revisited its work and
made changes. "Although we do not always agree with the
characterization in the report ... in some instances we did agree to
perform certain additional procedures or improve aspects of our
audit documentation," E&Y wrote in a letter dated May 4, that was
included in the PCAOB report.
Britain’s
big four auditing firms have been left exposed to a surge in
negligence claims after the Government refused to limit further the
damages they could face.
Deloitte,
Ernst & Young, KPMG and PricewaterhouseCoopers (PwC) lobbied hard
for a cap on payouts. Senior figures involved in the discussions
said that Lord Mandelson, the Business Secretary, appeared receptive
to their concerns but stopped short of changing the law.
The
decision is a huge blow to the firms — some face lawsuits relating
to Bernard Madoff’s $65 billion fraud — which believe there may not
be another chance for a change in the law for at least two years.
They fear that they will be targeted by investors and liquidators
seeking to recover losses from Madoff-style frauds and big company
failures.
At present,
auditors can be held liable for the full amount of losses in the
event of a collapse, even if they are found to be only partly to
blame.
In April,
representatives of the companies met Lord Mandelson to plead for new
measures to cap their liability. They warned that British business
could be plunged into chaos if one of them were bankrupted by a
blockbuster lawsuit.
However, an
official of the Department for Business, Innovation and Skills said:
“The 2006 Companies Act already allows auditor liability limitation
where companies and their auditors want to take this course.”
Under
present company law, directors can agree to restrict their auditors’
liability if shareholders approve; however, to date, no blue-chip
company has done so. Directors have seen little advantage in
limiting their auditors’ liability, and objections by the US
Securities and Exchange Commission (SEC) have also been a
significant obstacle.
The SEC
opposes caps on the ground that their introduction could lead to
secret deals whereby directors agree to restrict liability in return
for auditors compromising on their oversight of a company’s
accounts. The SEC could attempt to block caps put in place by
British companies that have operations in the United States.
The big
four auditors had hoped to persuade Lord Mandelson to amend the
legislation to address the SEC’s concerns and to encourage companies
to limit their auditors’ liability.
Peter
Wyman, a senior PwC partner, who was involved in the discussions,
said that the Government’s lack of action was disappointing. He
said: “The Government, having legislated to allow proportionate
liability for auditors, is apparently content to have its policy
frustrated by a foreign regulator.”
Auditors
are often hit with negligence claims in the aftermath of a company
failure because they are perceived as having deep pockets and remain
standing while other parties may have disappeared or been declared
insolvent.
In 2005
Ernst & Young was sued for £700 million by Equitable Life, its
former audit client, after the insurance company almost collapsed.
The claim was dropped but could have bankrupted the firm’s UK arm if
it had succeeded.
This year
KPMG was sued for $1 billion by creditors of New Century, a failed
sub-prime lender, and PwC has faced questions over its audit of
Satyam, the Indian outsourcing company that was hit by a long-
running accounting fraud.
Three of
the big four are also facing numerous lawsuits relating to their
auditing of the feeder funds that channelled investors into Madoff’s
Ponzi scheme.
Investors
and accounting regulators worry that the big four’s dominance of the
audit market is so great that British business would be thrown into
disarray if one of the four were put out of business by a huge court
action. All but two FTSE 100 companies are audited by the four.
Mr Wyman
said: “The failure of a large audit firm would be very damaging to
the capital markets at a time when they are already fragile.”
Arthur
Andersen, formerly one of the world’s five biggest accounting firms,
collapsed in 2002 as a result of its role in the Enron scandal.
Suits
you
KPMG
A defendant in a class-action lawsuit in the Southern District of
New York against Tremont, a Bernard Madoff feeder fund
Ernst &
Young Sued by investors in a Luxembourg court with UBS for
oversight of a European Madoff feeder fund
PwC
Included in several lawsuits in Canada claiming damages of up to $2
billion against Fairfield Sentry, a big Madoff feeder fund
KPMG
Sued in the US for at least $1 billion by creditors of New Century
Financial, a failed sub-prime mortgage lender, which claimed that
KPMG’s auditing was “recklessly and grossly negligent”
Deloitte
Sued by the liquidators of two Bear Stearns-related hedge funds that
collapsed at the start of the credit crunch
Creditors of Lehman
Brothers’ international business, arriving at London’s gigantic O2
concert hall on Friday, had no illusions about getting their money
back any time soon.
In a three-hour
meeting in a hall usually reserved for rock bands like the Who,
Lehman’s administrators explained to about 1,000 creditors that
dismantling the bank’s European business would take “many years.”
This is at least
“ten times more complex than Enron,” the administrators from
PricewaterhouseCoopers said, adding that they had no idea what the
company’s total liabilities may be.
“It’s frustrating
that after nine weeks, we still haven’t come to any clarity,”
especially on how much counterparties hold with Lehman’s European
business, said Tony Lomas, the PricewaterhouseCoopers partner
leading the administration. “The prospect is that the creditors will
lose money.”
PricewaterhouseCoopers identified 11,500 creditors and
counterparties of Lehman’s European business, ranging from the
coffee machine maker Nespresso and taxi companies in Milan and
Zurich to Bulgari hotels and resorts and the financial news company
Bloomberg.
From Lehman’s glass
and steel offices in London’s Canary Wharf, the administrators are
working through the bank’s $1 trillion of assets and said they
cannot pay creditors until they have a “reasonable grip” on
liabilities.
Continued in article
Investigators have
subpoenaed Ernst & Young LLP, Lehman's auditor;
U.K.-based bank Barclays Plc, which bought Lehman's North American brokerage;
and the New Jersey Division of Investments, which runs a pension fund that lost
$115.6 million on a $180 million investment in the June stock sale, according to
people familiar with the case.
Linda Sandler and Christopher Scinta, "Lehman's
Collapse, Stock Sale Probed by Three U.S. Prosecutors ," Bloomberg,
October 18, 2008 ---
http://www.bloomberg.com/apps/news?pid=20601087&sid=ai0XSrkkEKEM&refer=worldwide
The San Mateo County
(Calif.) Investment Pool sued executives of bankrupt Lehman Brothers
Holdings Inc. (LEHMQ) and their accountants, accusing them of fraud,
deceit and misleading accounting practices that led to the loss of
more than $150 million in county funds.
The suit, filed in
San Francisco Superior Court, said executives of the former Wall
Street investment bank made repeated public statements about its
financial strength while privately scrambling to save it from
collapse.
The suit names
former Lehman Chief Executive Richard S. Fuld Jr., former Chief
Financial Officers Christopher M. O'Meara and Erin Callan, former
President Joseph M. Gregory, certain directors and Ernst & Young,
Lehman's auditor.
It accused Lehman of
hiding its exposure to mortgage-related losses while reporting
record profits for fiscal year 2007 and giving bonuses to its
executives.
"The defendants
focused their efforts on trying to save their company and their jobs
with little or no regard to how their egregious actions harmed those
who in good faith invested in Lehman Brothers," said San Mateo
County Counsel Michael Murphy. "In our view, their actions were
blatantly illegal."
The San Mateo County
Investment Pool consists of the county, school districts, special
districts and other public agencies in the county.
San Mateo County
Supervisors Richard Gordon and Rose Jacobs Gibson called for a
federal investigation of the allegations in the suit, and Supervisor
Jerry Hill, newly elected to the state Assembly, will request
hearings on how many California public entities face similar losses.
Representatives of
Lehman and of Ernst & Young were not immediately available to
comment.
This is but one of many lawsuits and
criminal investigations to be faced Ernst & Young and the other large
auditing firms. Survival of the Big Four will be precarious ---
http://www.trinity.edu/rjensen/Fraud001.htm
Soul Searching at E&Y
Certainly, the accounting profession, our firm
included, has taken some shots from regulators and others over the last
several years, and I'm here to tell you that we deserved some of those
shots. I do feel somewhat fortunate, though, that my profession has
faced some very tough times, and not only survived, but emerged better
for the experience. The times have taught us the dangers of being
arrogant...of not listening. We have been reminded of the importance of
engaging with others, not just with companies and boards, but with
policymakers, opinion leaders, academicians, and the investor community.
While what we have been through has been difficult, it has been to a
positive end because it has encouraged us to do some soul-searching--as
individuals and as a profession--to rediscover our roots. We have had
time to ask ourselves, as accounting professionals, why we do what we
do...why it matters. What is our purpose and how does that guide our
decisions? These are important questions in defining the culture of any
organization. Jim Turley, CEO of Ernst & Young, December 1, 2005 ---
http://eyaprimo.ey.com/natlmktgaprimoey/Attachments/Attachment42550.pdf
Google Officer and Ernst & Young Settle with the SEC Google’s chief legal officer and Ernst &
Young’s Irish branch have settled claims that they let the executive’s
former employer, SkillSoft, overstate profits, the Securities and
Exchange Commission said yesterday. The New York Times, July 20, 2007 ---
http://www.nytimes.com/2007/07/20/business/20skillsoft.html?_r=1&oref=slogin
The Accounting Firm Ernst & Young Dodges a Bullet (well sort of anyway) Four current and former partners of the accounting firm
Ernst & Young have been charged with tax fraud conspiracy over their work on
questionable tax shelters. The firm itself was not charged. But the indictment
against the four, which was announced yesterday, did not mean that Ernst &
Young, which has been under investigation since 2004, was entirely off the hook
in a widening criminal investigation of the web of banks, accounting firms, law
firms and investment boutiques that promoted questionable shelters.
Lynnley Browning, "Four Men, but Not Ernst & Young, Are Charged in Tax Shelter
Case," The New York Times, May 31, 2007 ---
http://www.nytimes.com/2007/05/31/business/31shelter.html?ref=business
Equitable trial: E&Y fights
for its future In one of the biggest court cases in British
accounting history, Ernst & Young battles it out with life assurance
firm, Equitable Life, at London's High Court. At stake? The future of
the Big Four firm. Equitable Life's £2bn lawsuit against Ernst & Young,
its former auditors, kicked off on Monday 11 April, 2005. Equitable is
suing E&Y for alleged negligence in the overseeing of its accounts in
the late 1990s. As well as explaining their cases in court, both parties
submitted written explanations of their case. Here, you can read
Equitable's claim against the Big Four firm, and E&Y's furious response.
"Equitable trial: E&Y fights for its future," Financial Director,
April 26, 2005 ---
http://www.financialdirector.co.uk/specials/1140053
The Equitable Life law suit against Ernst
&Young has been dismissed. This multi-billion dollar suit originally
had the potential to wipe out E&Y UK. Some columnists speculated
that it ahd the potential to bring down E&Y worldwide.
"Equitable's claim against Ernst & Young
was centered on the accountant's alleged failure to inform the then
board about the extent of the mutual's financial problems.
However, Equitable decided to abandon the
case after lawyers pointed out there was a good chance the former
directors would not have acted differently had Ernst & Young given
different advice."
The
California Board of Accountancy has taken disciplinary action against Big
Four firm Ernst & Young LLP because of independence questions that
arose from the firm's dealings with PeopleSoft Inc. In a related event,
the New Mexico board voted 4-0 to issue notice that it "contemplated
action" against E&Y for its PeopleSoft audits.
AccountingWeb, September 23, 2004 --- http://www.accountingweb.com/item/99798
Tax Whistleblower 7623: More Trouble for Ernst & Young Tax
Shelter Clients The Ferraro Law Firm has submitted the first
known $1 billion Tax Whistleblower submission to the newly created IRS
Whistleblower Office. The IRS specifically created the Whistleblower
Office to assist in identifying and capturing uncollected tax revenue
from individuals and corporations typically assisted by clever law
firms, accounting firms and banks. Tax
whistleblower cases under section 7623 are a new arrow in the
Commissioner's quiver to close the tax gap, which the GAO estimates to
be approximately $345 billion each year.
The submission involves a Fortune 500 company that entered into a series
of transactions to improperly reduce its taxes by over $1 billion. The
company was represented by Ernst & Young LLP, an established law firm
and multiple name-brand banks. The identity of the whistleblower is
strictly confidential to protect the individual and the identities of
the law firm, banks and company are confidential at this stage to aid in
the evaluation of the submission. This submission comes after an E&Y
employee pled guilty to one count of conspiracy to commit tax fraud, and
four E&Y tax partners have been indicted for their role in the sale of
fraudulent tax shelters. "The tax law is not always black and white and
taxpayers are all too often more than willing to use an extreme
interpretation that drastically reduces taxes. There is not necessarily
an element of fraud and people at these companies know the weak spots in
their positions," said founding partner, James L. Ferraro. Given
the recent modifications made to section 7623 of the Internal Revenue
Code, the potential award in this case could exceed $300 million. Accounting Education, October 25, 2007 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=145675
A report issued by the Public Company
Accounting Oversight Board states that Ernst & Young LLP appears to
have signed off on some public-company audits without having
sufficient evidence to support its opinion. The Associated Press
reported that Ernst & Young defended its work while acknowledging
that it agreed, in response to the findings, to perform additional
procedures for some clients.
"In no instance did these actions change
our original audit conclusions or affect our reports on the issuers'
financial statements," Ernst & Young said in an April 5 letter to
the oversight board that was included in the report.
The latest inspection findings found fault
with eight public-company audits by Ernst & Young, down from 10
deficient audits identified in the recently issued 2005 inspection
report. By law, the largest audit firms must undergo annual
inspection by the oversight body, created by Congress in 2002 to
inspect and discipline public company accountants.
Inspection findings provide limited insight
into audit quality since they don't identify audit clients by name.
In response to complaints that the oversight board has been slow to
issue findings, board chairman Mark Olson pledged last year to pick
up the pace.
"Timeliness of inspection reports continues
to be a priority for me, and I am pleased by our progress," Olson
said in a statement Wednesday.
According to the 2006 inspection report,
Ernst & Young didn't identify one client's departure from generally
accepted accounting principles with regard to lease abandonment
liability. The report also faulted the auditor's handling of the
client's self-insurance reserve and severance payments to former
executives. Ernst said it supplemented its work papers and performed
additional procedures but that its additional work didn't affect its
original conclusions on the unidentified client's financial
statement.
Inspectors flagged a second audit where
unrecorded audit differences would have reduced net income by as
much as 5 percent, saying Ernst & Young failed to consider
"quantitative or qualitative factors" relevant to the aggregate
uncorrected audit differences. Ernst & Young attributed the
difference to a prior-year error identified by its audit team, which
it said the client firm corrected in its current year results. While
Ernst & Young said it supplemented its 2005 audit record and
informed the client's audit committee of the audit differences, it
said the actions didn't change its original audit conclusions or
affect its report on the firm's financial statements.
The audit firm had the same response to
findings on a third audit, one where inspectors took issue with its
handling of a long-term licensing agreement paid for partly with
cash and partly with stock that would vest in the future. The audit
firm disputed findings that there was no evidence it had analyzed
the terms of the licensing agreement to ensure it complied with
relevant accounting rules.
In a fourth audit, the oversight board's
inspectors questioned whether Ernst & Young should have allowed the
audit client to aggregate business lines when evaluating impairment
of goodwill, saying certain factors indicated that aggregation
wasn't appropriate. It said there was no evidence in the audit
papers and "no persuasive other evidence" that Ernst & Young
considered those factors in reaching its conclusion. For its part,
Ernst & Young said it believes the issue was "properly evaluated"
and that it took no further action as a result.
SUMMARY: Ernst
& Young (E&Y) "was censured by the Securities and
Exchange Commission (SEC) and will pay $1.5 million to
settle charges that it compromised its independence
through work it did in 2001 for clients American
International Group Inc. and PNC Financial Services
Group. "Regulators claimed AIG hired E&Y to develop and
promote an accounting-driven financial product to help
public companies shift troubled or volatile assets off
their books using special-purpose entities created by
AIG." PNC accounted incorrectly for its special purpose
entities according to the SEC, who also said that "PNC's
accounting errors weren't detected because E&Y auditors
didn't scrutinize important corporate transactions,
relying on advice given by other E&Y partners.
QUESTIONS:
1.) What are "special purpose entities" or "variable
interest entities"? For what business purposes may they
be developed?
2.) What new interpretation addresses issues in
accounting for variable interest entities?
3.) What issues led to the development of the new
accounting requirements in this area? What business
failure is associated with improper accounting for and
disclosures about variable interest entities?
4.) For what invalid business purposes do regulators
claim that AIG used special purpose entities (now called
variable interest entities)? Why would Ernst & Young be
asked to develop these entities?
5.) What audit services issue arose because of the
combination of consulting work and auditing work done by
one public accounting firm (E&Y)? What laws are now in
place to prohibit the relationships giving rise to this
conflict of interest?
Reviewed By: Judy
Beckman, University of Rhode Island
Judge Approves $36M Settlement Balance in PNC Accounting Scandal:
$193 Million Out of $1.15 Billion
The separate suit against Ernst & Young is still pending A federal judge in Pittsburgh has approved the
last part of a settlement involving more than 73,000 shareholders who
lost money in a PNC Financial Services Group Inc. accounting scandal.
The shareholders are ready to receive about $2,600 each, for a total of
$36.6 million, based on the $193 million settlement and interest. That
amounts to 68 cents per share, the Pittsburgh Tribune-Review reported.
It's not clear when settlement money will be distributed, and the final
amount will be reduced by attorneys' fees. The last remaining portion of
the class-action lawsuit was approved by U.S. District Judge David S.
Cercone, July 13.
"Judge Approves $36M Settlement Balance in PNC Scandal,"
AccountingWeb, July 19, 2006 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=102357
Earnings were restated, as required by the
Federal Reserve, and the results were $155 million less than
originally reported. The lawsuit contends that stockholders who
bought the bloated shares between July 19, 2001, and July 18, 2002,
lost an estimated $1.15 billion.
PNC paid $25 million to the U.S. Department
of Justice to settle conspiracy to commit securities fraud charges
in June 2003. The government ordered PNC to place $90 million into
the $193 million restitution fund. Most of the rest of the escrow
fund came from insurance companies and from AIG, which paid in $44
million.
A separate shareholder lawsuit is pending
against Ernst & Young, which reviewed the questionable loan sales.
Just a Typical Day on the Fraud Beat A Houston investment fund, which started as a promising money- maker for a
group of wealthy, well-connected acquaintances, has ended in a Texas district
court with accounting firm KPMG on the hot
seat. http://www.accountingweb.com/item/100455 February
3, 2005
Well, Not Quite Typical to This Extreme Former E&Y Audit Partner Jailed for SOX Violations
Late last year, Thomas Trauger (Ernst & Young)
pled guilty to falsifying records in a federal investigation in violation of the
Sarbanes-Oxley Act. He admitted as part of this plea that he knowingly altered,
destroyed and falsified records with the intent to impede and obstruct an
investigation by the Securities and Exchange Commission. http://www.accountingweb.com/item/100445
Biovail Corp. said the U.S. Securities and
Exchange Commission has launched a formal investigation of the Canadian
pharmaceutical company's accounting and financial-disclosure practices,
upgrading the regulator's informal inquiry started in late 2003.
This company has so many warts," including complex accounting and
poor disclosure in recent years and a business model that focuses
heavily on one product, depression treatment Wellbutrin XL, said Anthony
Scilipoti, executive vice president of Toronto-based Veritas Investment
Research. Reports by Mr. Scilipoti and others have in the past
criticized Biovail for focusing on earnings excluding various items,
capitalizing costs related to acquired products not yet approved for
sale, and hard-to-follow acquisitions and product transactions.
Mark Heinzl, "SEC Begins Formal Accounting Probe of Biovail,"
The Wall Street Journal, March 7, 2005 --- http://online.wsj.com/article/0,,SB111014883344371591,00.html?mod=todays_us_marketplace
The independent auditor for Biovail is Ernst & Young.
"HealthSouth, Inc.: An Instructional Case Examining
Auditors' Legal Liability (for fraud detection)," by Ronald J.
Daigle, Timothy J. Louwers, and Jan Taylor Morris, Issues in
Accounting Education, November 2013 ---
http://aaajournals.org/doi/abs/10.2308/iace-50530
This instructional case explores
auditors' legal liability under the Securities Exchange Act of 1934
by asking students to assume the role of either the plaintiffs'
(investors') or defendants' (Ernst & Young's) legal counsel. By
using publicly available documents and testimony (provided on a
dedicated website for this instructional case) in their arguments,
students not only explore in depth one of the more egregious
accounting scandals of the new millennium, but also are exposed to
the plaintiff's burden of proof and the defendant's defenses in a
Rule 10b-5 action. Additionally, by understanding the root causes of
the fraud and why it took so long to uncover, students can better
understand a number of the provisions set forth by the
Sarbanes-Oxley Act of 2002. Results of a student survey after
completion of the case indicate that case objectives were met.
Students also report enjoying the case materials and welcoming other
cases using similar types of materials.
Difficult times for auditors to claim financial
statement audits should not uncover massive fraud HealthSouth Corp. has filed suit accusing its
former outside auditor, Ernst & Young, of intentionally or negligently
failing to uncover a massive accounting fraud at the medical services
chain.
"HealthSouth Sues Ernst & Young for Fraud," SmartPros, April 6,
2005 ---
http://accounting.smartpros.com/x47712.xml
Bob Jensen's threads on E&Y's legal woes are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
Difficult times for auditors to claim
financial statement audits should not uncover massive fraud HealthSouth Corp. has filed suit accusing its
former outside auditor, Ernst & Young, of intentionally or negligently
failing to uncover a massive accounting fraud at the medical services
chain.
"HealthSouth Sues Ernst & Young for Fraud," SmartPros, April 6,
2005 ---
http://accounting.smartpros.com/x47712.xml
Bob Jensen's threads on E&Y's legal woes are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
A federal judge in
Birmingham, Ala., sentenced former HealthSouth Corp. finance
chief William T. Owens, the star witness against company founder
Richard Scrushy at his criminal trial, to five years in prison.
U.S. District Judge Sharon Blackburn
expressed reservations at sending Mr. Owens, 47 years old, to
prison, saying she believed Mr. Scrushy directed the $2.7
billion accounting fraud at the health-care company. Mr.
Scrushy's trial ended in acquittal in June.
Friday, the judge called it a
"travesty" that Mr. Scrushy wouldn't spend any time in prison in
connection with the scheme. Mr. Scrushy and his lawyers have
repeatedly denied participating in the fraud, claiming that Mr.
Owens was the mastermind of the plan and hid it from Mr. Scrushy.
In a statement, Mr. Scrushy said Judge Blackburn's comments were
"totally inappropriate given that there was not one shred of
evidence or credible testimony linking me to the fraud."
Frederick Helmsing, the lawyer for Mr.
Owens, had sought probation, in light of Mr. Owens's extensive
cooperation with the government investigation since 2003.
Prosecutors requested an eight-year prison term.
Finding the auditors in the wreckage of a crashed airline “The jury is going to hear a tale of a very
strange, intimate relationship" between Tower and Ernst &
Young, said attorney Robert Weltchek of Weiner & Weltchek, arguing
on behalf of the creditors in a hearing last week. An Ernst & Young
spokesman said, "These charges have no merit, and we will
vigorously defend ourselves in court." Court papers say that
Ernst & Young's accounting failures led Tower Air to report a pretax
profit of $4.6 million in 1998, when it actually lost about $17 million.
And Tower Air's reported $3.9 million loss in 1997 was actually at least
$41 million larger, the suit states. It goes on to say that the firm
never reconciled Tower Air's payroll account, failed to disclose that
Tower Air owed $9 million in back excise taxes, and failed to book $2.75
million of travel agents' commissions as an expense. Ernst &
Young became the airline's independent auditor in 1993. The airline was
founded 10 years earlier to fly international routes for government and
military officers, but went public in 1993. Ernst & Young had done
accounting work for the firm and president Morris Nachtomi since the
airline's inception and performed lucrative financial advisory work for
the firm since the late 1990s, the suit says.
"Bankrupt Airline Sues Ernst & Young for Accounting
Fraud," AccountingWeb, March 16, 2005 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=100673
You can read more about the legal woes of Ernst & Young at http://www.trinity.edu/rjensen/fraud001.htm#Ernst
Ernst & Young LLP agreed to pay $84
million to settle a lawsuit in Boston over its audit work more than a
decade ago for the defunct Bank of New England Corp.
The settlement in the long-forgotten case,
one of the largest Ernst has made, is a reminder of the litigation
pressures on the Big Four accounting firms as they seek to restore
public trust in their audit work.
The accord, reached yesterday, came about two
weeks after trial proceedings had begun in a federal district court in
Boston, and a few days after Douglas Carmichael, chief auditor of the
Public Company Accounting Oversight Board, testified in court as the
plaintiff's lead expert witness. Mr. Carmichael had been retained as
an expert in the suit before he was hired by the accounting board, and
the board permitted him to conclude his work.
Ernst denied liability. In a statement, an
Ernst spokesman said: "We are pleased to have resolved this issue
in a reasonable manner. We believe that it was in the best interest of
all parties to resolve this matter to avoid continued litigation and
legal costs."
The suit, filed by the bank's bankruptcy
trustee in 1993, accused Ernst of malpractice, among other things.
Amid pressure from federal banking regulators, who began warning the
bank about its deteriorating financial condition in early 1989, the
bank in January 1990 announced it would report more than $1 billion in
previously undisclosed losses on bad loans for its 1989 fourth
quarter. Just four months earlier, the bank had raised $250 million
through a public debt offering. The bank filed for Chapter 7
bankruptcy protection in January 1991.
Texas software entrepreneur who
headed Sterling Software Inc. when it was sold to Computer
Associates International Inc. in March 2000 filed suit against
Ernst & Young LLP, which had audit relationships with both
companies in the $4 billion transaction.
In his suit, filed in Texas
District Court in Dallas, Sam Wyly claims he relied on Ernst &
Young's audit of Computer Associates' books for fiscal 1999, which
ended March 31, in making his decision to sell the company for
Computer Associates stock. Barely a month later, the shares fell 12%
in one day when the company delayed reporting year-end earnings, and
later that year the stock declined again when Computer Associates
failed to make the earnings it had forecast.
Computer Associates, a maker of
enterprise software systems based in Islandia, N.Y., is emerging from
a $2.2 billion accounting scandal that led to the indictment of its
former chief executive, Sanjay Kumar, in September and the
resignations and indictments of several other top officials. Mr. Kumar
has pleaded not guilty to charges related to the company's financial
problems. Computer Associates has admitted to backdating contracts and
keeping its books open days after they were supposed to be closed on
the last day of a quarter, in order to book extra revenue.
Continued in the article
Ernst & Young LLP has
agreed to pay $1.5 million to settle allegations that the firm's advice
led nine hospitals to over bill the federal Medicare program. ---
http://www.accountingweb.com/item/99508
We see from a recent
press release that PricewaterhouseCoopers has received a “Strong
Positive” rating in Gartner’s Global Finance Management Consulting
Services MarketScope Report, which was published recently on
December 21, 2009.
This is the highest
possible rating in the Marketscope, a "Strong Positive" shows a
provider who can be considered "a strong choice for strategic
investments" where customers can continue with planned investments
and potential customers can consider this vendor a strong choice for
strategic investments.. The research assesses the global
capabilities of nine leading finance management consulting service
providers on customer experience, market understanding, market
responsiveness, product/service, offering strategy, geographical
capabilities and vertical-industry strategy.
Congratulations to
PwC for this select honor.
Unfortunately,
there is a stiff price to see the contents of this report
(US$1,995), so we can’t say who the other 8 providers are, but very
likely some of the Big Four firms would be on that list, and
somewhat curious why PwC should feature this as a big release on
their global website, but other firms are quite silent on this
point.
Jensen Comment
At times it may be difficult for the world's largest auditing firm to
also be rated as the top firm for "Global Finance Management Consulting
Services." Nobody seems to question financial consulting since the
Andersen destruction gave rise to new independence rules, notably
Sarbanes-Oxley. In the past decade the Big Four auditing firms, except
for Deloitte, shed themselves of their consulting divisions and then
commenced to selectively build them back up once again. However, more
care is being devoted to the independence bounds of computer systems and
tax consulting.
However, less concern
seems surround newer thrusts into financial consulting by the Big Four.
TIAA-CREF’s leaders made “substantial
missteps” in managing conflict of interest charges involving the
relationship between some of its trustees and its external auditor
(Ernst & Young) last year, but the
company showed no bad faith and ultimately handled the situation
correctly, a high-profile investigator hired by the company
concluded Thursday.
In a report published on the pension
giant’s Web site, Nicholas deB. Katzenbach, former U.S. attorney
general, also blamed the problems on the company’s governance
structure, which places a board of overseers over separate boards of
directors for TIAA and CREF. The arrangement creates the “constant
risk of potential and actual conflict,” the report said.
The report also states clearly that the
conflict controversy did not “touch on the quality of TIAA-CREF’s
management of investor funds, or the integrity of the financial
statements it prepared.”
Two trustees — Stephen A. Ross of CREF and
William H. Waltrip of TIAA — resigned last November after
revelations that they had had a joint venture with Ernst & Young,
the company’s auditor, a situation that violated the Securities and
Exchange Commission’s rules on independent auditors.
Katzenbach’s 53-page report notes that
TIAA-CREF officials, upon learning informally of the trustees’
relationship with the auditor, underestimated the gravity of the
problem and failed to investigate the matter sufficiently.
“In sum, TIAA-CREF did not appreciate the
seriousness of the independence issue. While its personnel
recognized that there was a theoretical possibility of drastic
consequences, they saw it as a technical violation that would almost
certainly be resolved promptly and without difficulty,” Katzenbach
wrote.
Two TIAA-CREF trustees quit amid SEC pressure over a business venture
they formed with Ernst & Young, the firm's auditor Note that
one of them a the famous academic professor in mathematical economics
and finance from MIT. Steve Ross is probably best known for his
writings on Arbitrage Pricing Theory (APT) --- http://www.trinity.edu/rjensen/149wp/149wp.htm
Also note that, two the firm's credit, Ernst & Young reported
this violation of auditor independence to TIAA-CREF. My question
would be why an auditing firm would engage in such a venture in the
first place even if there was no conflict of interest with a client.Ernst and Young was already in a deep hole with the SEC before
this conflict of interest came to the attention of the SEC.
Two TIAA-CREF trustees have
resigned amid pressure by the Securities and Exchange Commission over
a business venture they formed last year with Ernst & Young LLP,
the investing titan's independent auditor, in violation of SEC
auditor-independence rules.
The nation's largest
institutional investor, which manages $325 billion in assets, plans to
disclose the resignations of William H. Waltrip and Stephen A. Ross in
an SEC filing today, people familiar with the matter said.
The episode is likely to be a
major embarrassment to TIAA-CREF, among the world's leading
corporate-governance activists, and Ernst. This year the audit firm
was suspended by the SEC from accepting new publicly held audit
clients for six months over a business partnership it entered during
the 1990s with PeopleSoft
Inc., a former audit client.
According to federal
auditor-independence rules, outside auditors are prohibited from
forming business ventures with audit clients, including their
executives, board members or trustees. According to people familiar
with the matter, the SEC has agreed to allow Ernst to conclude its
audit for this year, but TIAA-CREF will put its audit out for bidding
by other firms next year and likely will hire a different accounting
firm. Ernst has been TIAA-CREF's auditor for about seven years.
A board of overseers presides
over TIAA-CREF's structure, which includes two other boards of
trustees, one for the Teachers Insurance & Annuity Association of
America and one for the College Retirement Equities Fund. Mr. Waltrip
was a TIAA trustee, and Mr. Ross was a CREF trustee.
On Aug. 1, 2003, Ernst entered into an
agreement with a company owned by Messrs. Waltrip and Ross, called
Compensation Valuation Inc. Mr. Ross was CVI's chief executive and
majority owner. Ernst formed the venture with the two trustees'
company to sell services that help businesses determine the value of
corporate stock options. Ernst paid the company $1.33 million,
according to people familiar with the matter.
Ernst notified certain TIAA-CREF officials
and the SEC about the independence violation Aug. 9, these people
said. Aug. 20, the trustees' company ceased operations. However, the
trustees' company wasn't actually dissolved until Nov. 17, and members
of the TIAA-CREF board of overseers weren't told about the
auditor-independence problem until this week, angering some of them,
people familiar with the matter said.
Mr. Ross is a finance professor at
Massachusetts Institute of Technology and a director at Freddie
Mac. Mr. Waltrip is the former chairman of Technology
Solutions Co. Neither man returned phone calls yesterday. Their
resignations took effect Nov. 30. A TIAA-CREF spokeswoman, Stephanie
Cohen-Glass, declined to comment yesterday. In a statement, Ernst said
the firm had identified the matter itself and confirmed that it
notified TIAA-CREF and the SEC. The Big Four accounting firm said it
is "in the midst of implementing new independence procedures and
identifying any client issues," but declined to discuss
specifics.
Messrs. Waltrip and Ross were powerful
trustees who played important roles in the recruitment of Herbert M.
Allison Jr., the former Merrill Lynch & Co. president who became
the huge fund's chairman, president and CEO in November 2002. Mr.
Waltrip was chairman of the search committee, of which Mr. Ross was a
member.
Continued in the article
TIAA-CREF Brass Failed to Inform Key Panel About Improper Deal With
Ernst, Its Outside Auditor
The SEC's chief accountant, Donald
Nicolaisen, last week told TIAA-CREF that Ernst could complete its 2004
audit, but that he would be very upset if it rehires Ernst for its 2005
audit, people close to TIAA-CREF said. The saga marks yet another
embarrassment for Ernst and its chairman and CEO, James Turley. In
April, the SEC suspended the Big Four accounting firm from accepting new
audit clients for six months because of a 1990s business venture with
audit client PeopleSoft Inc. Under the SEC's auditor-independence rules,
accounting firms aren't permitted to form business ventures with audit
clients, including their officers, directors or trustees.
"TIAA-CREF Faces Question On Governance," by Jonathan Weil and
Joann S, Lublin, The Wall Street Journal, December 6, 2004, Page
C1 --- http://online.wsj.com/article/0,,SB110229989626191715,00.html?mod=home_whats_news_us
TIAA-CREF, a longtime standard
bearer for the corporate-governance movement, now has a governance
mess of its own, sparked by two trustees' improper business deal with
outside auditor Ernst
& Young LLP and a decision by the investing titan's top brass
not to promptly inform the fund's powerful board of overseers about
the problem.
The conflict centers on a
contract that the two TIAA-CREF trustees entered into with Ernst in
August 2003 to jointly sell valuation services for corporate stock
options, in violation of federal auditor-independence rules. Last
week, the two trustees resigned, amid pressure from the Securities and
Exchange Commission's office of chief accountant. Separately, the
SEC's enforcement division has opened an inquiry into the events
surrounding the violation, people familiar with it say.
TIAA-CREF Chairman and Chief
Executive Officer Herbert M. Allison Jr. knew about the independence
violation as of Aug. 9, when Ernst first notified the company and the
SEC. However, before late last week, he had informed only one of his
six fellow members on TIAA-CREF's star-studded board of overseers
about the matter. The panel is one of three boards at TIAA-CREF that
share control of the nation's largest pension system, which manages
$326 billion of assets for 3.2 million people.
TIAA-CREF's general counsel,
George Madison, on Friday said the other two boards' trustees were
told in August and that, under TIAA-CREF's unique corporate structure,
Mr. Allison wasn't obligated until last week to notify the full board
of overseers. Messrs. Allison and Madison did tell Stanley O.
Ikenberry, the president of the board of overseers, in September. But
Mr. Ikenberry didn't tell the other overseers either, among them,
former SEC Chairman Arthur Levitt.
Instead, Mr. Ikenberry's
colleagues were left in the dark until Thursday, one day before
TIAA-CREF disclosed the violation in SEC filings. Corporate-governance
activists long have pushed for companies to disclose any significant
bad news as early and widely as possible.
Through a TIAA-CREF spokesman,
Mr. Allison said: "I, along with my management team, continue to
work for the best interests of the participants and our institutions
to strengthen TIAA-CREF for the competitive challenges we are
facing." He declined to comment further.
The saga marks yet another
embarrassment for Ernst and its chairman and CEO, James Turley. In
April, the SEC suspended the Big Four accounting firm from accepting
new audit clients for six months because of a 1990s business venture
with audit client PeopleSoft Inc. Under the SEC's auditor-independence
rules, accounting firms aren't permitted to form business ventures
with audit clients, including their officers, directors or trustees.
The SEC's chief accountant,
Donald Nicolaisen, last week told TIAA-CREF that Ernst could complete
its 2004 audit, but that he would be very upset if it rehires Ernst
for its 2005 audit, people close to TIAA-CREF said.
Best
Buy Co. said it is dropping Ernst
& Young LLP as its outside auditor next year, citing a
conflict of interest stemming from a business relationship between the
Big Four accounting firm and a former Best Buy director.
The nation's largest
electronics retailer said its dismissal of Ernst will take effect upon
the completion of its audit for the fiscal year ending Feb. 26, 2005.
The Richfield, Minn., company said it will put work on its fiscal 2006
audit out for bids sometime next year.
The move by Best Buy is the
latest in a series of recent auditor-independence controversies for
Ernst. In April, the Securities and Exchange Commission imposed a
six-month suspension on the firm, during which Ernst was barred from
accepting new publicly held audit clients. The SEC case centered on an
improper joint venture with former audit client PeopleSoft Inc. In her
decision imposing the suspension, the SEC's chief administrative-law
judge, Brenda P. Murray, wrote that Ernst "had no procedures in
place that could reasonably be expected to deter violations and assure
compliance with the rules on auditor independence with respect to
business dealings with audit clients."
Since that decision, under an
SEC-mandated independent review of its dealings with audit clients,
Ernst has notified dozens of clients of auditor-independence
violations, though few have been deemed serious enough to warrant
Ernst's dismissal. The violations have included improperly taking
custody of clients' cash when performing tax work overseas and
engaging in direct business relationships with audit clients, among
other things.
Generally, SEC rules prohibit
direct business relationships between accounting firms and their audit
clients, including officers, directors and trustees. The one exception
is where a firm is acting as a consumer in the ordinary course of
business.
This month, officials at
TIAA-CREF, a large institutional investor that also is a prominent
corporate-governance activist, said the fund probably would drop Ernst
next year, once its 2004 audit is because of a business relationship
that the accounting firm entered into last year with two of the fund's
trustees. Both the TIAA-CREF and Best Buy matters remain the subjects
of SEC inquiries.
In an SEC filing yesterday,
Best Buy said its dismissal of Ernst was directly related to the May 4
resignation of Mark C. Thompson from the company's board. Mr.
Thompson, a "leadership development" consultant and former
Charles Schwab Corp. executive, was a member of Best Buy's audit
committee from 2000 through 2003.
In a May 14 SEC filing
disclosing Mr. Thompson's resignation, Best Buy said neither Ernst nor
Mr. Thompson had disclosed their business relationship to the company
until May 4. Ernst paid Mr. Thompson $377,500 plus expense
reimbursements from December 2002 to April 2004, according to Best Buy
filings. Ernst's payments to Mr. Thompson stem from audio interviews
he conducted with leading corporate executives, industry executives
and Ernst's own executives for the accounting firm's marketing
materials. In regulatory disclosures, Best Buy has said Mr. Thompson
had a "personal service agreement" with Ernst.
AccountingWEB.com - Nov-4-2004 - Former Ernst &
Young audit partner Thomas Trauger went to great lengths to keep from being
“second-guessed” and last week pleaded guilty to charges he obstructed a
federal investigation. The subject of the government's probe was NextCard
Inc., a San Francisco company that distributed credit cards via the Internet.
The company's troubles began when it handed out too many cards to unqualified
holders, the Associated Press reported. Federal regulators shut down the
company's banking unit in early 2002.
Trauger admitted to knowingly altering, destroying
and falsifying records with the intent to impede and obstruct an investigation
by the U.S. Attorney's Office, CFO.com reported, but at heart, his goal was
seemingly to avoid being "second-guessed" for failing to recognize
red flags at a company that he had audited.
SEC official Robert Mitchell was interviewed at
the time of Trauger's September 2003 arrest and said
the audit partner was trying to "downplay or eliminate evidence of
problems" that would have been red flags, according to USA Today, adding
that he had previously given the company a clean bill of health.
An FBI affidavit showed that Trauger wanted to give
the appearance that E&Y's audit of NextCard had been "right on the
mark" so that "some smart-ass lawyer" wouldn't be able to
second-guess him, the San Francisco Recorder, a legal newspaper, reported.
Trauger admitted last week that when testifying
before the SEC he had failed to disclose that NextCard documents and quarterly
working papers had been tampered with.
The Securities and Exchange Commission on
September 27, 2006 announced securities fraud charges against James
N. Stanard and Martin J. Merritt, the former CEO and former
controller, respectively, of RenaissanceRe Holdings Ltd. (RenRe) and
also against Michael W. Cash, a former senior executive of RenRe's
wholly-owned subsidiary, Renaissance Reinsurance Ltd. The complaint,
filed in the federal court in Manhattan, alleges that Stanard,
Merritt, and Cash structured and executed a sham transaction that
had no economic substance and no purpose other than to smooth and
defer over $26 million of RenRe's earnings from 2001 to 2002 and
2003. The Commission also announced a partial settlement of its
charges against Merritt, who has consented to the entry of an
antifraud injunction and other relief.
Mark K. Schonfeld, Director of the Commission's Northeast Regional
Office, said, "This is another case arising from our ongoing
investigation of the misuse of finite reinsurance to commit
securities fraud. The defendants enabled RenRe to take excess
revenue from one good year and, in effect, 'park' it with a
counterparty so it would be available to bring back in a future year
when the company's financial picture was not as bright."
Andrew M. Calamari, Associate Director of the Commission's Northeast
Regional Office, said, "The investing public relies upon senior
executives of public companies not to engage in transactions that
are designed to misstate their companies' financial statements.
Today's enforcement action underscores that the Commission will
pursue culpable senior officials who are instrumental in
constructing fraudulent transactions."
The Defendants
Stanard, age 57 and a resident of
Maryland and Bermuda, was Ren Re's chairman and chief executive
officer from 1993 until he resigned in November 2005.
Merritt, age 43 and a Bermuda
resident, held various positions, including that of controller,
at both the holding company and the subsidiary.
Cash, age 38 and a Bermuda resident,
was a senior vice president of the subsidiary until he resigned
in July 2005.
RenRe's Fraud
The Commission alleges that Stanard, Merritt and Cash committed
fraud in connection with a sham transaction that they concocted to
smooth RenRe's earnings. The complaint concerns two seemingly
separate, unrelated contracts that were, in fact, intertwined.
Together, the contracts created a round trip of cash. In the first
contract, RenRe purported to assign at a discount $50 million of
recoverables due to RenRe under certain industry loss warranty
contracts to Inter-Ocean Reinsurance Company, Ltd. in exchange for
$30 million in cash, for a net transfer to Inter-Ocean of $20
million. RenRe recorded income of $30 million upon executing the
assignment agreement. The remaining $20 million of its $50 million
assignment became part of a "bank" or "cookie jar" that RenRe used
in later periods to bolster income.
The second contract was a purported reinsurance agreement with
Inter-Ocean that was, in fact, a vehicle to refund to RenRe the $20
million transferred under the assignment agreement plus the
purported insurance premium paid under the reinsurance agreement.
This reinsurance agreement was a complete sham. Not only was RenRe
certain to meet the conditions for coverage; it also would receive
back all of the money paid to Inter-Ocean under the agreements plus
investment income earned on the money in the interim, less
transactional fees and costs.
RenRe accounted for the sham transaction as if it involved a real
reinsurance contract that transferred risk from RenRe to Inter-Ocean
when in fact, the complaint alleges, each of these individuals knew
that this was not true. Merritt and Stanard also misrepresented or
omitted certain key facts about the transaction to RenRe's auditors.
As a result of RenRe's accounting treatment for this transaction,
RenRe materially understated income in 2001 and materially
overstated income in 2002, at which time it made a "claim" under the
"reinsurance" agreement. It then received as apparent reinsurance
proceeds the funds it had paid to Inter-Ocean and that Inter-Ocean
held in a trust for RenRe's benefit.
On Feb. 22, 2005, RenRe issued a press release announcing that it
would restate its financial statements for the years ended Dec. 31,
2001, 2002 and 2003. On March 31, 2005, RenRe filed its Form 10-K
for the year ended Dec. 31, 2004, which contained restated financial
statements for those years. Stanard signed and certified the 2004
Form 10-K. Both the press release and the Form 10-K attributed the
restatement of the Inter-Ocean transaction to accounting "errors"
due to "the timing of the recognition of Inter-Ocean reinsurance
recoverables." These statements were misleading. In fact, the
transaction contained no real reinsurance and the company's restated
financial statements accounted for the transaction as if it had
never occurred. In short, the entire transaction was a sham, and the
company failed to disclose that fact and misrepresented the reasons
for the restatement.
The Commission's Charges
The Commission's complaint charges Stanard, Merritt and Cash with
securities fraud in violation of Section 17(a) of the Securities Act
and Section 10(b) and Rule 10b-5(a), (b) and (c) of the Exchange
Act; with violating the reporting, books-and-records and internal
control provisions of Exchange Act Section 13(b)(5) and Rule 13b2-1;
and with aiding and abetting RenRe's violations of Exchange Act
Sections 10(b), 13(a) and 13(b)(2) and Exchange Act Rules 10b-5(a),
(b) and (c), 12b-20, 13a-1 and 13a-13. In addition, the complaint
charges Stanard and Merritt with violating Exchange Act Rule 13b2-2
for making materially false statements to RenRe's auditors and
charges Stanard with violating Exchange Act Rule 13a-14 for
certifying financial statements filed with the Commission that he
knew contained materially false and misleading information. The
complaint seeks permanent injunctive relief, disgorgement of
ill-gotten gains, if any, plus prejudgment interest, civil money
penalties, and orders barring each defendant from acting as an
officer or director of any public company.
Partial Resolution
Merritt agreed to partially settle the Commission's claims against
him. In addition to undertaking to cooperate fully with the
Commission, and without admitting or denying the allegations in the
complaint, Merritt consented to a partial final judgment that, upon
entry by the court, will permanently enjoin him from violating or
aiding or abetting future violations of the securities laws, bar him
from serving as an officer or director of a public company, and
defer the determination of civil penalties and disgorgement to a
later date. Merritt also agreed to a Commission administrative
order, based on the injunction, barring him from appearing or
practicing before the Commission as an accountant, under Rule 102(e)
of the Commission's Rules of Practice. Merritt was a certified
public accountant licensed to practice in Massachusetts.
Back in the heady days of the 1990s, it was
unimaginable that the existence of even one of the Big Five accounting
firms could ever be threatened. The collapse of Arthur Andersen left a
Big Four and one more faces the possibility of collapse if a
negligence claim against the firm is successful. Ernst & Young's
battle with Equitable Life took on epic proportions in the United
Kingdom this week, with Ernst & Young's chairman Nick Land writing
to the Office of Fair Trading to put the office on notice that the
firm's potential liability exceeds its insurance coverage.
In Land's letter to Office of Fair Trading
Chairman John Vickers, Land signaled the company could collapse if
Equitable Life succeeds in its £2.6bn negligence claim with Ernst
& Young. Land wrote, 'our cover is not adequate to meet claims at
the level we are currently facing.' The case is due to be heard at the
High Court in April, the UK's Financial Director magazine reported.
A spokesman for Equitable Life said that 'the
board's advice is that it has a strong claim against E&Y,'
although he would not comment on whether it would seek a settlement or
take the case to trial.
Meanwhile, E&Y was due to submit its
response to complaints made by the Joint Disciplinary Scheme by Friday
last week. Roland Foord, a partner at City law firm Stephenson
Harwood, said that while the JDS findings would not influence the
civil judge should a trial go ahead, it 'could have some effect in
terms of settlement' decisions, Financial Director reported.
From the Stanford University
Law School Class Action Archives
Washington's
insurance commissioner is seeking millions of dollars from accounting firm
Ernst & Young for its alleged neglect in overseeing finances at
Metropolitan Mortgage & Securities.
Washington State Sues E&Y Over Met Mortgage Woes," AccounitngWeb,
October 19m 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=99940
Ernst
& Young already has put into effect
changes to the way it audits savings-and-loan associations that comply
with the OTS consent order, the firm said. "And we are voluntarily
taking the extra step of implementing these changes throughout our bank
audit practice," said Charles Perkins, a spokesman in New York.
Ernst & Young LLP, one of
the four largest U.S. accounting firms, agreed to pay a total of $125
million to settle U.S. claims arising from its audits of a failed
Illinois savings bank.
Under a consent order agreed to
with the Office of Thrift Supervision, the New York-based partnership
will pay the Federal Deposit Insurance Corp. $85 million as receiver
for the failed Superior Bank FSB. In addition, Ernst & Young will
pay $40 million in restitution to the FDIC, which insures deposits at
the 9,025 U.S. banks and savings-and-loan associations, said an FDIC
spokesman.
Superior was declared insolvent
in July 2001 after running into trouble over its loans to borrowers
with spotty credit records. At the time of its failure, Superior had
assets of about $2 billion. The FDIC sued Ernst & Young in 2002,
contending that it delayed alerting regulators to improper accounting
practices at the thrift out of concern that negative publicity could
disrupt the sale of its consulting unit.
In April 2003, a federal judge
dismissed the suit, saying the FDIC wasn't able to sue in its capacity
as administrator for the government's Bank Insurance Fund and Savings
Association Fund. The FDIC appealed the decision.
Ernst has disputed allegations that it was to
blame for the bank's failure, citing testimony in 2002 before the
Senate by the FDIC's inspector general that Superior Bank's failure
was "directly attributable" to "the bank's board of
directors and executives ignoring sound risk-management
principles."
In settling, Ernst & Young didn't admit
or deny that its audits failed to comply with any professional
accounting standards. It said the decision to settle underscored a
commitment to work cooperatively with regulators and to make sure the
firm had "the strongest policies and procedures to serve our
clients and the public interest."
Ernst & Young already has put into effect
changes to the way it audits savings-and-loan associations that comply
with the OTS consent order, the firm said. "And we are
voluntarily taking the extra step of implementing these changes
throughout our bank audit practice," said Charles Perkins, a
spokesman in New York.
In one of the longest suspensions
ever of a major accounting firm,
Ernst & Young LLP was barred for six months from accepting any new
audit clients among publicly traded companies as punishment for
participating in a lucrative business venture with a company whose books
it audited.
The ruling Friday by the
Securities and Exchange Commission's chief administrative-law judge
marks the latest sanction of an accounting firm for violating the
agency's auditor-independence rules, which are intended to ensure that
accounting firms remain impartial in their evaluations of corporate
clients' financial statements. The suspension applies to American or
foreign companies whose stock or debt trades on U.S. markets.
Ernst had fiercely contested the
SEC enforcement division's allegations that it compromised its
independence by engaging in a joint venture with
PeopleSoft Inc. at the same time that it was the software maker's
outside auditor, at one point calling the allegations "outrageous." On
Friday, Ernst, the nation's third-largest accounting firm, said it
wouldn't appeal the decision.
The conduct occurred in the
1990s, at a time when accounting firms' fees weren't disclosed and the
prevailing culture within the major firms was to use audits as a loss
leader to generate other, more-lucrative business with clients.
Three of the four major
accounting firms, including Ernst, since have sold their consulting
practices in response to pressure from regulators. Only Deloitte &
Touche LLP continues to maintain a sizable consulting practice, though
it too has come under pressure to part ways with its consulting
business. Nowadays, companies with publicly traded securities must
disclose how much they pay their independent accounting firms for audit
and nonaudit work.
Ernst & Young, the big accounting firm, was
barred yesterday from accepting any new audit clients in the United
States for six months after a judge found that the firm acted improperly
by auditing a company with which it had a highly profitable business
relationship.
The unusual order, which included a $1.7
million fine, brought to an end a bitter fight in which the Securities
and Exchange Commission had contended that Ernst violated rules on
auditor independence by jointly marketing consulting and tax services
with an audit client,
PeopleSoft Inc.
The overwhelming evidence," wrote Brenda P.
Murray, the chief administrative law judge at the S.E.C., is that
Ernst's "day-to-day operations were profit-driven and ignored
considerations of auditor independence." She said the firm "committed
repeated violations of the auditor independence standards by conduct
that was reckless, highly unreasonable and negligent."
The rebuke to Ernst, which said it would not
appeal the decision, is the latest embarrassment for one of the Big Four
accounting firms, which have come under heavy criticism and increased
regulation as a result of accounting scandals in recent years. Those
scandals led to the demise of Arthur Andersen, which had formerly been
among the Big Five.
The judge was harshly critical of the Ernst
partner who was in charge of independence issues, saying he kept no
written records and had failed to learn enough facts before saying the
relationships between Ernst and PeopleSoft were proper. That partner,
Edmund Coulson, was chief accountant of the S.E.C. before he joined
Ernst in 1991.
Ernst's consulting and tax practices used
PeopleSoft software in their business, and the two companies
participated in some joint promotion activities. Ernst contended that it
should be viewed as a customer of PeopleSoft in the relationship, but
the judge said it went far beyond that.
She noted that Ernst had billed itself in
marketing materials as an "implementation partner" of PeopleSoft and had
earned $500 million over five years from installing PeopleSoft programs
at other companies, which use the software to manage payroll, human
resources and accounting operations.
She issued a cease-and-desist order against the
firm, saying it had refused to admit it had done anything wrong and that
there was no reason to believe it would not violate the rules again. She
also fined it $1,686,500, the total amount of audit fees the company
received from PeopleSoft in the years that were involved, plus interest
of $729,302, and ordered that an outside monitor be brought in to assure
the firm complied with the rules in the future.
S.E.C. officials said the decision would send a
message to other firms. "Auditor independence is one of the centerpieces
of ensuring the integrity of the audit process," said Paul Berger, an
associate director of the commission's enforcement division, adding that
the judge's decision "vindicates our view that Ernst & Young engaged in
a business relationship that clearly violated" the rules.
Ernst, based in New York, had previously
denounced the commission for seeking a ban on new business, saying any
such punishment was completely unwarranted. But last night the firm said
it would accept the ruling and would not appeal. It had the right to
appeal to the full S.E.C. and then to federal courts if the commission
ruled against it.
"Independence is the cornerstone of our
practice and our obligation to the public," said Charlie Perkins, a
spokesman for Ernst & Young. "We are fully committed to working closely
with an outside consultant in the review of our independence policies
and procedures."
Mr. Perkins said the firm had decided not to
appeal because it wanted to put the matter behind it, and emphasized
that it would be able to continue serving its existing clients.
The six-month suspension appears to match the
longest suspension on signing new business ever imposed on a leading
accounting firm.
In 1975, Peat Marwick, a predecessor of KPMG,
agreed to accept a similar six-month suspension as part of a settlement
of charges it had failed to properly audit five companies, including
Penn Central, the railroad that went bankrupt.
Reports coming out of the US tell us that
Ernst & Young has been selling wealthy US citizens four legal
techniques for reducing their income tax bill, one of which experts claim
could be illegal. Accountancy Age, June 21, 2002 ---
http://www.financialdirector.co.uk/News/1129611
The Securities and Exchange Commission's
enforcement division has begun an inquiry into Ernst & Young LLP's
business relationships with three major audit clients, including
American Express Co., and whether the dealings were appropriate under
federal auditor-independence rules.
Ernst's contracts with American Express, AMR
Corp.'s American Airlines, and Continental Airlines for travel services
came to light this autumn in connection with a lawsuit in an Arkansas
state circuit court where Ernst and other accounting firms are
contesting allegations that they overbilled clients for travel expenses.
In a court filing last week, attorneys for the plaintiff said they
received a request from a federal agency for documents relating to
Ernst's relationships with the three companies, which were the subject
of Wall Street Journal articles on Nov. 20.
"We will fully cooperate with the SEC in its
review of this matter," Ernst said in a statement, confirming the
agency's identity. An SEC spokesman declined to comment.
One October 1996 contract called for American
Express, as Ernst's exclusive travel agent, to receive commissions on
all Ernst airfare, hotel rooms and car rentals and return a portion to
Ernst. A section called "profit sharing" said Ernst would receive 53%
and American Express 47% "of the net profit of Total Commission Revenue
and pooled expenses." Ernst also received portions of commissions paid
to American Express on leisure travel booked by Ernst employees.
Continued in article
Guess who ultimately ends up paying the $510 million
for accounting fraud?
Time Warner, the world's largest
media-entertainment company, said Wednesday it had agreed to pay a
total of 510 million dollars to resolve federal probes into accounting
irregularities at its America Online (AOL) units.
The company said 210 million dollars would be
paid in agreement with the Department of Justice (DoJ), while a
further 300-million-dollar penalty would be levied under a proposed
settlement with the Securities and Exchange Commission (SEC).
Deputy US Attorney General James Comey said
the Justice Department would file a criminal complaint against AOL
that charges several employees with securities fraud.
However, the prosecution will be deferred for
two years and then dismissed, so long as the company adheres to all
stipulations of its deal with the government.
"If AOL fails to comply with the
agreement, the deal is off. And they are in a world of trouble,"
Comey said.
As well as the 210-million-dollar payout, the
agreement requires AOL to undertake a wide range of corporate reforms.
The charges levelled against AOL arose out of
a scheme to falsify the financial results of a company called Purchase
Pro -- a dot-come startup which is now bankrupt.
"As so often happens, during the dot-com
bubble days, the revenues that AOL and Purchase Pro were counting on
did not materialize, Comey said.
"And instead of confronting that harsh
reality, AOL and Purchase Pro cooked up a scheme to inflate Purchase
Pro's revenues," he added.
Four former Purchase Pro executives have
agreed to plead guilty to felony charges based on their roles in the
scheme.
The multi-million dollar settlement
incorporates a 60-million-dollar fine and the establishment of a
150-million-dollar fund to settle any related shareholder or
securities legislation.
The proposed 300-million-dollar settlement
with the SEC would resolve an investigation by the securities watchdog
into whether AOL improperly accounted for a 400-million-dollar payment
made by German media company Bertelsmann, which used to own 50 percent
of AOL Europe.
Question
How can you "PUT" away your cares about clear-cut rules of accounting?
Answer
See how AOL did it in conspiracy with Goldman Sachs
With the AOL-Time Warner deal due to close
in just three months, Bertelsmann needed to reduce its AOL Europe
holding -- pronto. But the obvious buyer, AOL, didn't want to own more
than 50% or more of the venture, either. Going above half might trigger
a U.S. accounting rule that would force AOL to consolidate all the
struggling unit's losses on its books when AOL was already grappling
with deteriorating ad revenues and a declining stock price. Enter
Goldman Sachs Group Inc. (GS ) Business Week has learned that the
premier Wall Street bank agreed to buy 1% of AOL Europe -- half a
percent from each parent -- for $215 million. AOL Europe, in return,
agreed to a "put" contract promising Goldman that it could
sell back the 1% by a specific date and at a set price. That simple
transaction solved Bertelsmann's EU problem without trapping AOL in an
accounting conundrum -- a perfect solution.
Goldman's 1% Solution
In 2000, it cut a questionable deal that smoothed
the AOL-Time Warner merger. Will the SEC take action?
In more
ways than one, the news from the European Union was bad. It was
October, 2000, and the EU's executive arm, the European Commission,
had just jolted America Online Inc. with a ruling that its pending
acquisition of Time Warner Inc. (TWX
) could harm competition in Europe's media markets, especially the
emerging online music business. The EC was concerned that AOL was a
50-50 partner with German media giant Bertelsmann in one of Europe's
biggest Internet service providers, AOL Europe. Now the EC was
ordering Bertelsmann to give up control over AOL Europe.
With the
AOL-Time Warner deal due to close in just three months, Bertelsmann
needed to reduce its AOL Europe holding -- pronto. But the obvious
buyer, AOL, didn't want to own more than 50% or more of the venture,
either. Going above half might trigger a U.S. accounting rule that
would force AOL to consolidate all the struggling unit's losses on
its books when AOL was already grappling with deteriorating ad
revenues and a declining stock price.
Enter
Goldman Sachs Group Inc. (GS ) Business Week has learned that
the premier Wall Street bank agreed to buy 1% of AOL Europe -- half
a percent from each parent -- for $215 million. AOL Europe, in
return, agreed to a "put" contract promising Goldman that
it could sell back the 1% by a specific date and at a set price.
That simple transaction solved Bertelsmann's EU problem without
trapping AOL in an accounting conundrum -- a perfect solution.
LEGAL
HEADACHES
Or so it
seemed at the time. But the deal also may have violated U.S.
securities laws. The Securities A: Exchange Commission and the
Justice Dept. have construed some deals involving promises to buy
back assets at a specific time and price as share-parking
arrangements designed to mislead investors. The former chief
executive of AOL Europe says the Goldman deal may have kept up to
$200 million in 2000 losses off of the combined AOL-Time Warner
financials -- enough, he says, that Time Warner might have tried to
change the terms of the $120 billion merger, since AOL wouldn't have
looked as healthy. But as the deal moved toward consummation, the
Goldman arrangement was never disclosed in public documents to AOL
or Time Warner shareholders.
The AOL
Europe transaction threatens to create problems for Goldman Sachs.
But it could also prolong the legal headaches of Time Warner Inc.,
as the AOL-Time Warner combine is now called. For the past two
years, Time Warner has been in heated negotiations with the SEC over
AOL's accounting for advertising revenues (BW -- June 7). Just as
the SEC is wrapping up that case -- it could warn Time Warner as
early as this summer that it intends to bring civil fraud charges --
the Goldman transaction raises troubling new questions about AOL's
financial dealings prior to the merger.
The SEC has
not brought charges over the 1% solution, and an SEC spokesman would
not comment on whether the agency is probing the deal. Time Warner
spokeswoman Tricia Primrose Wallace says the company will not
comment on any part of the Goldman arrangement. A lawyer for Stephen
M. Case, AOL's chairman and CEO at the time of the deal, referred
questions to Time Warner. Thomas Middelhoff, who was Bertelsmann's
chairman at the time of the deal and negotiated the AOL Europe joint
venture with Case in 1995, says through a spokesman that the sale of
a 0.5% stake was "purely a financial technique" handled by
others. And Lucas van Praag, a Goldman Sachs spokesman, says:
"We handled this entirely appropriately. We don't believe there
is anything untoward here."
The University of California has joined with
Amalgamated Bank to file a lawsuit against AOL Time Warner Inc.,
claiming their stakes have lost more than $500 million in value
because the media company allegedly lied about its financial
condition.
The University of California, which dropped out of a federal
class-action suit against AOL earlier this month, filed the complaint
Monday in the Superior Court of California in Los Angeles. The
university and co-plaintiff Amalgamated Bank, a New York institution
that manages funds for several dozen union pension funds, are being
represented by Milberg Weiss Bershad Hynes & Lerach.
The plaintiffs allege that AOL Time Warner materially misrepresented
its revenue and subscriber growth after the merger of AOL and Time
Warner in January 2001. In two separate restatements in October and
March, AOL slashed nearly $600 million from previously reported
revenue over the past two years.
The University of California and Amalgamated allege that AOL's
admissions so far have been "too conservative," and that the
company may have overstated results by almost $1 billion.
In a March 28 filing with the Securities and Exchange Commission, AOL
Time Warner said it faces 30 shareholder lawsuits that have been
centralized in the U.S. District Court for the Southern District of
New York. The company said in the filing it intends to defend itself
"vigorously." The lawsuit filed by the University of
California and Amalgamated names several current and former AOL Time
Warner executives, as well as financial-services giants Citigroup and
Morgan Stanley.
Citigroup is the parent of Salomon Smith Barney, now called Smith
Barney, which with Morgan Stanley allegedly reaped $135 million in
advisory fees from the AOL and Time Warner merger.
Defendants include Stephen Case, who resigned as chairman in January;
former Chief Executive Gerald Levin, who left the company in May;
current Chairman and Chief Executive Richard Parsons; and Ted Turner,
who recently stepped down as vice chairman.
The lawsuit claims they and more than two dozen other insiders sold
off $779 million in stock just after the merger closed but before the
accounting revelations that would cause the stock price to plummet.
The suit also names AOL's auditor, Ernst & Young.
The University of California claims it lost $450 million in the value
of its AOL Time Warner shares, which were converted from more than
11.3 million Time Warner shares in the merger. At the end of 2002, the
value of the university's portfolio was at $49.9 billion.
Continued in the article
Cendant CEO Guilty at Cendant in 3rd Trial It took eight years and three trials, but
federal prosecutors finally won their case on Tuesday against Walter A.
Forbes, the former chairman of the Cendant Corporation. Mr. Forbes was
convicted here on charges that he masterminded an accounting fraud that
was considered at the time it was discovered — 1998 — to be the largest
on record. Investors lost $19 billion when Cendant’s stock fell after
the disclosure. The Cendant fraud was later eclipsed by the scandals at
Enron and WorldCom. A jury of eight men and four women in Federal
District Court deliberated for two and a half days before finding Mr.
Forbes, 63, of New Canaan, Conn., guilty of conspiracy and of two counts
of submitting false reports to the Securities and Exchange Commission in
overstating his company’s earnings by more than $250 million. He was
acquitted on a fourth count, securities fraud.
Stacey Stowe, "Chief Guilty at Cendant in 3rd Trial," The New York
Times, November 1, 2006 ---
http://www.nytimes.com/2006/11/01/business/01cendant.html?ref=business
The company's auditor, Ernst & Young,
paid $335 million to settle.
The
fraud that time forgot is
finally going to trial.
Tomorrow
in Federal District Court
in Hartford, opening
arguments are scheduled to
begin in the case against
Walter A. Forbes, former
chairman of the Cendant
Corporation, and E.
Kirk Shelton, former vice
chairman. The government
has accused the two men of
orchestrating a titanic
accounting and securities
fraud that misled
investors over a decade
beginning in the late
1980's. The trial will
open more than six years
after the problems at
Cendant came to light.
Cendant
was formed in late 1997
when CUC International, a
seller of shopping-club
memberships that was run
by Mr. Forbes, merged with
HFS Inc., a hotel,
car-rental and real estate
company overseen by Henry
R. Silverman.
Three
months after the merger,
Cendant disclosed evidence
of accounting
irregularities; the stock
lost almost half its value
in one day. Later, Cendant
told investors that
operating profits for the
three years beginning in
1995 would be reduced by
$640 million.
Mr.
Forbes and Mr. Shelton
have been accused of
securities fraud,
conspiracy and lying to
the Securities and
Exchange Commission. The
charges of fraud and
making false statements to
regulators each carry a
maximum penalty of 10
years in prison and a $1
million fine. Mr. Forbes
is also accused of insider
trading, relating to an
$11 million stock sale he
made about a month before
the accounting
irregularities were
disclosed.
Both
men have pleaded not
guilty. Mr. Forbes's
lawyer did not return a
phone call requesting an
interview. Mr. Shelton's
lawyer said: "He is
innocent and expects to be
vindicated."
Thanks
to the creative corporate
minds at Enron,
WorldCom,
Tyco
and Adelphia, investors
are up to their necks in
revelations of accounting
shenanigans. But the
scandal at Cendant still
ranks as one of the
world's costliest
corporate calamities.
The
day after the company
disclosed evidence of
accounting irregularities,
holders of Cendant stock
and convertible bonds lost
more than $14 billion. And
in 2000, Cendant, now
based in New York, paid
$2.85 billion to settle a
securities suit filed by
investors who had bought
its stock. The company's
auditor, Ernst &
Young, paid $335 million
to settle.
And
the scandal is still
costing Cendant. Under the
company's bylaws, Mr.
Forbes is entitled to
reimbursement for his
legal fees, which are
running $1 million a
month, according to court
documents. The company can
sue to recover the fees if
Mr. Forbes is convicted.
Cendant
has also sued Mr. Forbes
to recover $35 million in
cash and $12.5 million
worth of stock options he
received after he resigned
from the company in July
1998.
Prosecutors
have built their case
against Mr. Forbes and Mr.
Shelton with help from
three former CUC financial
executives who have
pleaded guilty to fraud.
The case has taken six
years to reach the
courtroom, in part because
lawyers for Mr. Forbes and
Mr. Shelton persuaded a
judge to move the trial
from New Jersey, where
Cendant had been based, to
Hartford, closer to Mr.
Forbes's home in New
Canaan, Conn., and Mr.
Shelton's home in Darien,
Conn.
Arguments that the Sarbanes-Oxley corporate
reform law is unconstitutionally vague did not convince a federal
judge, who has rejected Richard Scrushy's claims in his HealthSouth
fraud case. Attorneys for Scrushy, HealthSouth's former chief
executive, said the law should not be part of the indictment accusing
him of fraud, the Associated Press reported. U.S. District Judge Karon
O. Bowdre said jurors - not a judge - should decide central questions
raised in the case.
"If the jury finds that the reports did
not fairly present, in all material aspects, the financial condition
and results of operations of HealthSouth, the jury must then determine
whether Mr. Scrushy willingly certified these reports knowing that the
reports did not comport with the statute's accuracy
requirements," she wrote.
HealthSouth Corp. founder Richard M.
Scrushy was convicted of paying $500,000 in bribes in return for a
spot on a state regulatory panel, a victory for the federal
government a year and a day after it failed to pin a massive
accounting fraud at the health-care company on him.
The guilty verdict on all six charges
against the 53-year-old Mr. Scrushy, including bribery, conspiracy
and mail fraud, could put him behind bars for as long as 20 years,
though the judge has wide discretion on sentencing. Prosecutors and
defense lawyers are likely to argue over how to weigh factors such
as Mr. Scrushy's background and the size of the contributions for
which he was convicted. Sentencing isn't expected until this fall at
the earliest.
The Montgomery, Ala., jury also convicted
former Alabama Gov. Don Siegelman on 10 political-corruption-related
counts, six of them linked to Mr. Scrushy. During the two-month
trial, prosecutors alleged that Mr. Scrushy arranged two hidden
$250,000 payments to a lottery campaign backed by Mr. Siegelman, who
put the then-chief executive of HealthSouth on a board that approves
hospital-construction projects. The charges weren't related to the
accounting fraud.
It wasn't clear what swayed jurors after 11
days of deliberation, or ended a deadlock that emerged last week.
Mr. Scrushy's defense team clearly failed to win over the jury with
its strategy of comparing him to civil-rights icons who suffered
injustice. In his closing argument, Fred D. Gray, who represented
Rosa Parks when she was arrested in 1955 for refusing to give up her
seat on a Montgomery bus, quoted a favorite Biblical passage of
Martin Luther King Jr., adding that an acquittal of Mr. Scrushy
would mean that "justice will run down like water and righteousness
as a mighty stream."
Federal prosecutors denounced the rhetoric
as a racially motivated attempt to influence the jury of seven
African-Americans and five whites, the same composition as the jury
that acquitted Mr. Scrushy last year. They alleged that Mr. Scrushy
had used his money and power to gain political influence that helped
fuel HealthSouth's growth. Mr. Scrushy was forced out at HealthSouth
when the accounting fraud surfaced in 2003.
Charlie Russell, a spokesman for Mr.
Scrushy, said the former HealthSouth CEO was "shocked" by his
conviction. "He maintains that he is absolutely innocent, and he
intends to appeal." Before the trial, Mr. Scrushy's lawyers fought
unsuccessfully to have him tried separately and objected to the
makeup of the jury pool.
In a statement, Louis V. Franklin Sr.,
criminal-division chief of the U.S. attorney's office in Montgomery,
said the verdict "sends a clear message that the integrity of
Alabama's government is not for sale." HealthSouth said Mr.
Scrushy's conviction "has no impact on the company," which continues
to pursue a turnaround strategy under new management. HealthSouth
has filed a lawsuit against him in connection with the fraud, while
Mr. Scrushy has sued the company for wrongful termination and breach
of contract, citing his acquittal in last year's trial. Mr. Scrushy
also faces fraud-related civil lawsuits filed by shareholders and
the Securities and Exchange Commission.
Doug Jones, a former U.S. attorney now
representing HealthSouth shareholders in a suit against Mr. Scrushy,
said the verdict could help plaintiffs in the remaining cases
because Mr. Scrushy likely will be forced to answer questions about
his conviction. Sean Coffey, a lawyer representing bondholders,
added, "Even though it's not directly related, the folks we
represent can't see enough hurt get on that guy."
Jurors acquitted the two other defendants,
Paul Hamrick, a onetime chief of staff to the former governor, and
Gary Roberts, former head of the Alabama transportation department.
The HealthSouth Settlement Does Not Include Ernst & Young
From The Wall Street Journal Accounting Weekly Review on November 10,
2006
TITLE: UnitedHealth Expects Probe to Result in 'Greater' Charges
REPORTER: Steve Stecklow and Vanessa Fuhrmans
DATE: Nov 09, 2006
PAGE: B1
LINK:
http://online.wsj.com/article/SB116299996219517252.html?mod=djem_jiewr_ac
TOPICS: Accounting, Accounting Changes and Error Corrections,
Sarbanes-Oxley Act, Securities and Exchange Commission, Stock Options
SUMMARY: "UnitedHealth Group Inc. said it would have to take charges
related to its backdated stock options that will be 'significantly
greater' than its previous estimates and expects the charges to impact
more than 10 years of previously reported earnings."
QUESTIONS:
1.) Describe the options backdating scandal that has developed since
March, 2006. If you are unfamiliar with the issue, you may click on the
link for "Perfect Payday: Complete coverage" on the left hand side of
the on-line article.
2.) For how long has options backdating been going on at
UnitedHealth? Have the accounting requirements remained the same
throughout that period of time? Summarize the required accounting and
other financial reporting practices for executive and employee stock
options over the last 10 years.
3.) Suppose that, once UnitedHealth finishes its review, the
restatement of earnings nearly doubles to $500 million and that the
restatement applies equally to each of the preceding 10 years. What
accounting entry must be made to correct this $500 million error? What
will be the ultimate impact on each year's earnings and on stockholders'
equity at the end of each year? How will this correction be disclosed?
In your answer, cite the accounting standards which require the
treatment you present.
4.) Click on "Read the full text" of UnitedHealth's Nov. 8 filing
with the SEC on the right-hand side of the on-line article. What Form
number did UnitedHealth file? Summarize the implications of the depth of
the options backdating problem found at this company.
5.) Refer to the related article. What role does the Public
Accounting Oversight Board fill in assisting accountants to audit
companies' accounting for stock options?
Reviewed By: Judy Beckman, University of Rhode Island
HealthSouth Corp. announced on Wednesday
that it will pay $445 million to settle several lawsuits that were
filed against the company and some of its former directors after an
accounting scandal.
HealthSouth will pay $215 million in common
stock and warrants, and its insurance carriers will pay $230 million
in cash, the company said. Also, federal securities class-action
plaintiffs will get 25 percent of any future judgments obtained by
or on behalf of HealthSouth regarding certain claims against fired
CEO Richard Scrushy, former auditors Ernst & Young, and the
company’s former investment bank, UBS. Each party remains a
defendant in the derivative actions and the federal securities class
actions.
A judge must approve the settlement, which
is nearly the same as a preliminary settlement that was reached in
February.
"This settlement represents another
significant milestone in HealthSouth's recovery and is a powerful
symbol of the progress we have made as a company," said HealthSouth
President and CEO Jay Grinney. HealthSouth, the Birmingham,
Ala.-based rehabilitation and medical services chain, does not admit
any wrongdoing in the settlement, nor does any other settling
defendant, the company said.
The settlement does not include Ernst &
Young, UBS, Scrushy or any former HealthSouth officer who entered a
guilty plea or was convicted of a crime in connection with the
company's financial reporting activities ending in March 2003.
Scrushy and more than a dozen top
executives were accused of recording as much as $2.7 billion in
bogus revenues on the company's books over six years. UBS and Ernst
& Young have denied knowing about the fraud. Last year, Scrushy was
acquitted of all criminal charges in the fraud. He was convicted of
conspiracy, bribery and mail fraud charges in a separate government
corruption trial.
How to
Improve Audit Reports
Meet our new AECM Subscriber"
Diane Jules
Assistant Chief Auditor
Office of Chief Auditor
PCAOB
1666 K Street NW
Washington DC 20006 www.pcaobus.org
tel 202-207-9065
cell 202-538-2691
fax 1- 877-532-3143
.
Diane contacted me on another
matter. She then took me up on my suggestion that she subscribe to
the AECM. In doing so whe says that her main interest lies in
finding out more about what investors want in an auditor's report.
.
Perhaps some of you could help
me recall previous threads on this issue and add to a new thread on
this issue.
.
Misleading Conclusion
That Failing Clients Are Still Going Concerns
I think our most important
thread(s) about auditor reports concerns the binary reporting choice
that a client either is or is not a going concern --- a choice that
forces auditing firms to make very hard and rare choices that client
is not likely to survive. Many of our threads focused on the abysmal
record failing to make going concern warnings of nearly 2,000 banks
that failed since 2007. It seems highly unlikely that CPA external
auditors did not know that some of these failing banks were not
going concerns. Some of our threads on this topic are at
http://www.trinity.edu/rjensen/2008bailout.htm#AuditFirms
It would seem that investors might be better served with a continuum
of going concern choices in an audit report as opposed to an up or
down choice unless the client is for all practical purposes already
failed when the audit report is issued.
.
Loss of "Subject to" Clauses in Audit Reports
We had other threads lamenting
the loss of the "subject to" opinion in auditor reports. The
"subject to" clauses allowed for warnings that there were certain
problems in the audit that did not completely destroy the
certification
A summary
is provided below with Bob Jensen's comments in blue.
September 26, 2008
HP-1158
Fact
Sheet: Final Report of the Advisory Committee on the Auditing
Profession
The U.S. Treasury
Department's Advisory Committee on the Auditing Profession adopted a
Final Report containing more than 30 recommendations to improve the
sustainability of the public company auditing profession. The
report is separated into three sections by principal areas of focus.
Human
Capital
recommendations focused on improving accounting education and
strengthening human capital, including:
Implementation of
accounting education curricula and content that continuously
evolves to reflect current market developments to help prepare
new entrants to the profession.
This is motherhood and apple pie, but keep in mind that the
financial accounting part of the curriculum is 95% driven by the
CPA examination. To change the curriculum all NASBA has to do is
change the CPA Exam, which I will now have to do since all FASB
standards will be trashed in favor of IFRS standards because
Chris Cox abused his authority as Chair of the SEC ---
http://www.trinity.edu/rjensen/theory01.htm#MethodsForSetting
Ensuring an adequate supply
of qualified accounting faculty through public and private
sector funding to meet future demands and help prepare students
to execute high quality audits.
This is an enormous failure because virtually all doctoral
programs wanted to become mathematics programs more than
accounting programs ---
http://www.trinity.edu/rjensen/theory01.htm#DoctoralPrograms
Development and maintenance
of demographic data on the accounting profession so that the
profession can understand the human capital situation and its
impact on the profession's future and sustainability.
The AICPA keeps a pretty good database for this.
Study of the future of
education for the accounting profession, including the potential
for graduate schools of accounting, to determine the best way to
educate students to deal with the challenging financial
reporting and auditing environment.
The AICPA is so concerned about the shortage of auditing and tax
professors that it just now created a fund to provide five years
of full ride funding to each of 30 doctoral students who will
commit to auditing and tax specialties Requests for applications and
additional information may be obtained online from the AICPA
Foundation at
ADSprogram@AICPA.org. or by calling
919-402-4524
Firm
Structure and Finances
recommendations focused on enhancing auditing firm governance,
transparency, responsibility, communications, and audit quality,
including:
Creation of a national
center at the Public Company Accounting Oversight Board to
provide a forum for auditing firms and other market participants
to share their fraud detection experiences in order to improve
audit quality.
Probably a good idea, but I doubt that firms will devote a whole
lot of hours making this a success.
Granting accountants
licensed in one state with reciprocity to practice in other
states to foster a more efficient operation of the capital
markets given the multi-state operations of many public
companies and multi-state practices of many auditing firms.
This has some real problems. For example, most but not all
states now require five-years (150 semester credits) to sit for
the CPA examination, but there are some states that only require
four years. Should students will four-year degrees become
licensed in states that have tougher standards? Also there’s a
huge problem with varying experience requirements among states.
And there are societal problems. Florida does not want all the
semi-retired CPAs from NY to set up shop in Florida.
Exploration of the
feasibility of appointing independent members with full voting
power to firm boards and/or advisory boards to improve the
governance and transparency of auditing firms.
Probably a good idea, but there are problems with
confidentiality of client information.
Enhancement of disclosure
requirements regarding public company auditor changes will
improve transparency and enhance investor confidence.
There has been progress here with SEC rules, but more could be
accomplished. It’s hard to separate reasons from excuses.
Enhancements to make the
auditor's standard reporting model more useful to investors by
including more relevant information, such as key accounting
estimates and judgments.
The estimation process is so complex, that “more relevant
information” might only add trees in front of somebody already
lost in the forest.
Mandating the engagement
partner's signature on the auditor's report to improve
accountability among auditing firms.
A good idea, but not as important as rotating the engagement
partner more frequently, including bringing in new engagement
partners from other offices.
Requirement for larger
auditing firms to produce a public annual report with relevant
firm information and file on a confidential basis with the PCAOB
audited financial statements to improve transparency at auditing
firms.
Yes, yes, yes.
The
Concentration and Competition
recommendations focused on ways to increase audit market competition
and auditor choice, including:
Having the PCAOB monitor
potential sources of catastrophic risk at auditing firms to
prevent reduced auditor choice and significant market
disruptions.
At the moment really large clients like Bank of America can
create a catastrophe by dropping their auditing firm. The audit
model is basically broken since audit firms are chosen by and
paid by executives of firms that they audit. I’m not saying that
government auditors would be an improvement, because we all know
that industries pretty much get control of the government
agencies that regulate them. But there should be some type of
“accounting court” for resolving auditor-client conflicts in
confidentiality. This was first proposed in a big way by a
managing partner of Arthur Andersen named Leonard Spacek ---
http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/leonard-paul-spacek/
Especially note ---
http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
Creation of a mechanism for
the preservation and rehabilitation of troubled larger public
company auditing firms to prevent reduced auditor choice and
significant market disruptions.
Especially note ---
http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
Development and
publication of key indicators of audit quality and effectiveness
to promote competition and choice in the industry based on audit
quality.
The PCAOB is doing a pretty good job in this department. For
example it has found deficiencies in some of the audits of
public accounting firms of all sizes, including the recent PCAOB
fine of $1 million for Deloitte ---
http://www.pcaobus.org/Inspections/index.aspx
Promotion of the
understanding of and compliance with auditor independence
requirements to enhance investor confidence in the quality of
audit processes and audits.
Academics have been clamoring about this for years, but it’s
almost impossible to make significant progress beyond the
litigation threat. At the moment, the risk of being sued in the
U.S. is probably the biggest factor keeping auditing firms
professional and honest, but there are many failures ---
http://www.trinity.edu/rjensen/Fraud001.htm
It should be noted that most of the litigation of CPA firms
centers on mistakes, incompetence, and cost-saving practices
that were not a good idea such as substituting substantive
testing with analytical reviews. There have been some, but very
few, outright frauds and collusions of auditors in frauds.
Adoption of annual
shareholder ratification of public company auditors by all
public companies to enhance the audit committee's oversight to
ensure that the auditor is suitable for the company's size and
financial reporting needs.
Shareholder ratifications are a pile of crap since most of the
shares are held by enormous funds (pension funds, mutual funds,
etc.). The ideal that Main Street will thereby have a huge input
into the choice of an auditor is nonsense. Most individuals
don’t know one auditor from another. And for huge clients there
are only about six choices anyway.
Enhancement of
collaboration and coordination between the PCAOB and its foreign
counterparts so that investors can be confident that auditing
firms of all sizes are contributing effectively to audit
quality.
Sounds great but this is motherhood and apple pie that’s
difficult to implement effectively in practice. Mostly it sounds
good on paper.
Closing
Comment
What’s really needed is an Accounting Court much like operates in
The Netherlands, although it will be much more difficult to operate
in the U.S. because of the much greater size of the U.S. I still
like Spacek’s basic idea of an Accounting Court. Especially
note ---
http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
The main
advantage of an Accounting Court is that auditors could get more
backing from experts when confronting clients on some sticky issues,
and clients would have a more difficult time bullying their
auditors.
THE MAIN
PROBLEM WITH OUR BROKEN AUDITING MODEL IS THAT IT ENCOURAGES CLIENTS
TO BECOME BULLIES JUST TO HAVE THEIR OWN WAYS!
The
most serious problem in the U.S. audit model is that clients are
becoming bigger and bigger due to non-enforcement of anti-trust
laws. For example, the merger of Mobile and Exxon created an even
larger single client. The merger of Bear Stearns and JP Morgan
created a much larger client. The number of potential clients is
shrinking while the size of the clients is exploding.
As
these giants merge to become bigger giants, it gets to a point where
their auditors cannot afford to lose a giant client producing
upwards of $100 million in audit revenue each year. Real
independence of audits breaks down because executives running
virtually any giant client can become a bully with its audit firm.
Enron
was an extreme but not necessarily an outlier. It will most likely
be alleged in court over the next few years that giant Wall Street
banks bullied their auditors into going along with understating
financial risk before the 2008 banking meltdown. We certainly
witnessed the understating of financial risk in 2007 and 2008.
**************
We had many more threads on
problems investors are having with regulation and enforcement.
Enforcement of rules and laws is essential to meaningfulness of such
rules and laws. Because tax rules are so poorly enforced in Greece and
some other nations, tax cheating is rampant. Because traffic law
enforcement is so lax in some parts of the world, traffic law violations
are rampant in such places as Mexico City, Rome, and Ankara.
Our SEC has a pretty good
record of enforcement settlements but the settlement amounts are often
miniscule relative to the damages. And investors lament some negligent
and possibly fraudulent inactions of the SEC with the Madoff Scandal
leading the way (a monumental black eye for the SEC) ---
http://www.trinity.edu/rjensen/FraudRotten.htm#Ponzi
There have been AECM debates
about whether the courageous negative PCAOB audit inspection reports,
Francine McKenna leads the way in contending that negative inspection
reports are simply being ignored by large audit firms. Bob Jensen leads
the way in contending that the audit firms are making serious
adjustments to auditing policies, procedures, and supervision but that
the steps taken are not enough and have not led to the desired
improvements in audit firm performance ---
http://www.trinity.edu/rjensen/Fraud001.htm#Professionalism
There have been more recent
threads on the AECM about the controversial re-branding of PwC and the
accelerating efforts of large auditing firms to greatly expand
consulting practices that jeopardize audit independence. One of my
tidbits yesterday was the following:
“In today’s environment, emerging managers need
recognized industry heavyweights for professional services. Deloitte has
launched the hedge fund emerging manager platform to provide emerging
managers with a solution that offers access to our global network, and
customized, creative and responsive service,” said Cary Stier, vice chairman
and Deloitte’s U.S. asset management services leader. “If you launch with
Deloitte, you stay with Deloitte. A client cannot outgrow our services.
Deloitte delivers results that matter.”
Jensen Comment
Could Deloitte also add: "We especially know more than most folks about
firms we've audited!"
Actually Deloitte claims that their auditors are not allowed to communicate with
their consultants about audit clients, but this does not necessarily prevent
public perception that Big Four investor consultants do not have inside
information about corporations they audit. Advancing Quality through Transparency
Deloitte LLP Inaugural Report ---
http://www.cs.trinity.edu/~rjensen/temp/DeloitteTransparency Report.pdf
Perhaps audit reports should
disclose the extent to which an audit client is also paying consulting
revenues and/or being recommended as an investment in other consulting
engagements.
If I were to conduct research
on problems with auditor reports, I would consider investigating audit
firm litigation in search of incidents where the audit report played a
pivotal role ---
http://www.trinity.edu/rjensen/Fraud001.htm
My friend Jack up
here in the White
Mountains who was
Dennis Kozlowski's
bodyguard remains
loyal to Kozlowski
and thinks that what
Dennis did for Tyco
(in terms of share
value) more than
offset what Dennis
stole from Tyco.
Dennis sends Jack
Christmas cards from
prison. Makes me
wonder whether
shareholders will
tolerate most any
kind of criminal
executives who keep
pumping up share
prices.
In fairness, some
of Kozlowksi’s
legitimate business
acquisitions for
Tyco were very
profitable for Tyco
shareholders.
Did you know
that, before Tyco,
Dennis Kozlowksi
briefly worked for
Enron? Maybe that’s
where he learned how
to loot a company
while pumping up
share values.
How often have we
witnessed how agency
theory is invalid
for executive
agents? This should
make us wonder about
all the accountics
research papers
built upon fictional
agency theory
assumptions.
PricewaterhouseCoopers
also fell prone to
faulty risk assessments.
In July, the SEC forced
Tyco, the industrial
conglomerate, to restate
its profits, which it
inflated by $1.15
billion, pretax, from
1998 to 2001. The next
month, the SEC barred
the lead partner on the
firm's Tyco audits from
auditing publicly
registered companies.
His alleged offense:
fraudulently
representing to
investors that his firm
had conducted a proper
audit. The SEC in its
complaint said that the
auditor, Richard Scalzo,
who settled without
admitting or denying the
allegations, saw warning
signs about top Tyco
executives' integrity
but never expanded his
team's audit procedures.
"Behind Wave of
Corporate Fraud: A
Change in How Auditors
Work: 'Risk Based' Model
Narrowed Focus of Their
Procedures, Leaving Room
for Trouble,' " by
Jonathan Weil, The
Wall Street Journal,
March 25, 2004, Page
A1---
http://www.trinity.edu/rjensen/Fraud001.htm
“The problem is that there’s not a lot of evidence
that auditors are very good at assessing risk,” says
Charles Cullinan, an accounting professor at Bryant
College in Smithfield, R.I., and co-author of a 2002
study that criticized the re-engineered audit
process as ineffective at detecting fraud. “If you
assess risk as low, and it really isn’t low, you
really could be missing the critical issues in the
audit.”
Even before the recent rash of accounting scandals,
the shift away from extensive line-by-line number
crunching was drawing criticism. In an October 1999
speech, Lynn Turner, then the SEC’s chief
accountant, noted that more than 80% of the agency’s
accounting-fraud cases from 1987 to 1997 involved
top executives. While the risk-based approach was
focusing on information systems and the employees
who fed them, auditors really needed to expand their
scrutiny to include top executives, who with a few
keystrokes could override their companies’ systems.
An Ernst &
Young spokesman,
Charlie Perkins,
says the firm
“performed appropriate procedures” on the
contractual-adjustment account.
At an April 2003 court hearing, Ernst & Young
auditor William Curtis Miller testified that his
team mainly had performed “analytical type
procedures” on the contractual adjustments. These
consisted of mathematical calculations to see if the
account had fluctuated sharply overall, which it
hadn’t. As for the balance-sheet entries,
prosecutors say HealthSouth executives knew the
auditors didn’t look at increases of less than
$5,000, a point Ernst & Young acknowledges.
Jensen Comments
We see a lot of ranting about Sarbox and the supposedly-toothless PCAOB ---
Click Here
But here's what I see in the hundreds upon hundreds of
PCAOB negative inspection reports of CPA firm audits
What I see is repeated stress on negligent or otherwise sloppy detailed testing
that, in addition to uncovering client mistakes, serves in large measure to
prevent audit mistakes (like the fear that the cops will show up) ---
http://pcaobus.org/Inspections/Reports/Pages/default.aspx
Here's my favorite and oft-repeated example: KPMG Should Be Tougher on Testing, PCAOB
Finds The Big Four audit firm was cited for not ramping up its tests of some
clients' assumptions and internal controls. KPMG did not show enough
skepticism toward clients last year, according to the Public Company Accounting
Oversight Board, which cited the Big Four accounting firm for deficiencies
related to audits it performed on nine companies. The deficiencies were detailed
in an inspection report released this week by the PCAOB that covered KPMG's 2008
audit season. The shortcomings focused mostly on a lack of proper evidence
provided by KPMG to support its audit opinions on pension plans and securities valuations.
But in some instances, the firm was cited for weak testing of internal controls
over financial reporting and the application of generally accepted accounting
principles.
Marie Leone, CFO.com, June 19, 2009 ---
http://www.cfo.com/article.cfm/13888653/c_2984368/?f=archives
In one instance, the audit lacked evidence
about whether the pension plans contained subprime assets. In another case, the
PCAOB noted, the audit firm didn't collect enough supporting material to gain an
understanding of how the trustee gauged the fair values of the assets when no
quoted market prices were available.
The PCAOB, which inspects the largest
public accounting firms on an annual basis, also found that three other KPMG
audits were shy an appropriate amount of internal controls testing related to
loan-loss allowances, securities valuations, and financing receivables.
In one audit, KPMG accepted its client's
data on non-performing loans without determining whether the information was
"supportable and appropriate." In another case, KPMG "failed to perform
sufficient audit procedures" with regard to the valuation of hard-to-price
financial instruments.
In still another case, the PCAOB found
that KPMG "failed to identify" that a client's revised accounting of an
outsourcing deal was not in compliance with GAAP because some of the deferred
costs failed to meet the definition of an asset - and the costs did not
represent a probably future economic benefit for the client.
Benford's Law: How a mathematical phenomenon can help CPAs uncover fraud
and other irregularities
Benford's Law: It's interesting to read the "Silly" comments that
follow the article.
"Benford's Law And A Theory of Everything: A new relationship
between Benford's Law and the statistics of fundamental physics may hint at a
deeper theory of everything," MIT's Technology Review. May 7, 2010
---
http://www.technologyreview.com/blog/arxiv/25155/?nlid=2963
In 1938, the physicist Frank Benford made an
extraordinary discovery about numbers. He found that in many lists of
numbers drawn from real data, the leading digit is far more likely to be a 1
than a 9. In fact, the distribution of first digits follows a logarithmic
law. So the first digit is likely to be 1 about 30 per cent of time while
the number 9 appears only five per cent of the time.
That's an unsettling and counterintuitive
discovery. Why aren't numbers evenly distributed in such lists? One answer
is that if numbers have this type of distribution then it must be scale
invariant. So switching a data set measured in inches to one measured in
centimetres should not change the distribution. If that's the case, then the
only form such a distribution can take is logarithmic.
But while this is a powerful argument, it does
nothing to explan the existence of the distribution in the first place.
Then there is the fact that Benford Law seems to
apply only to certain types of data. Physicists have found that it crops up
in an amazing variety of data sets. Here are just a few: the areas of lakes,
the lengths of rivers, the physical constants, stock market indices, file
sizes in a personal computer and so on.
However, there are many data sets that do not
follow Benford's law, such as lottery and telephone numbers.
What's the difference between these data sets that
makes Benford's law apply or not? It's hard to escape the feeling that
something deeper must be going on.
Today, Lijing Shao and Bo-Qiang Ma at Peking
University in China provide a new insight into the nature of Benford's law.
They examine how Benford's law applies to three kinds of statistical
distributions widely used in physics.
These are: the Boltzmann-Gibbs distribution which
is a probability measure used to describe the distribution of the states of
a system; the Fermi-Dirac distribution which is a measure of the energies of
single particles that obey the Pauli exclusion principle (ie fermions); and
finally the Bose-Einstein distribution, a measure of the energies of single
particles that do not obey the Pauli exclusion principle (ie bosons).
Lijing and Bo-Qiang say that the Boltzmann-Gibbs
and Fermi-Dirac distributions distributions both fluctuate in a periodic
manner around the Benford distribution with respect to the temperature of
the system. The Bose Einstein distribution, on the other hand, conforms to
benford's Law exactly whatever the temperature is.
What to make of this discovery? Lijing and Bo-Qiang
say that logarithmic distributions are a general feature of statistical
physics and so "might be a more fundamental principle behind the complexity
of the nature".
That's an intriguing idea. Could it be that
Benford's law hints at some kind underlying theory that governs the nature
of many physical systems? Perhaps.
But what then of data sets that do not conform to
Benford's law? Any decent explanation will need to explain why some data
sets follow the law and others don't and it seems that Lijing and Bo-Qiang
are as far as ever from this.
It's interesting to read the "Silly" comments
that follow the article.
Jensen Comment
In recent years the PCAOB has had a tremendous impact on the writing of auditing
controls and in conducting inspections of actual audits and audit firms.
For example, the
PCAOB imposed a record fine of $1 million on Deloitte.
Here’s an
example of an inspection (in this case KPMG’s lack of detailed testing of
poisoned mortgages):
KPMG Should Be Tougher on Testing, PCAOB
Finds The Big Four audit firm was cited for not ramping up its tests of some
clients' assumptions and internal controls. KPMG did not show enough
skepticism toward clients last year, according to the Public Company Accounting
Oversight Board, which cited the Big Four accounting firm for deficiencies
related to audits it performed on nine companies. The deficiencies were detailed
in an inspection report released this week by the PCAOB that covered KPMG's 2008
audit season. The shortcomings focused mostly on a lack of proper evidence
provided by KPMG to support its audit opinions on pension plans and securities valuations.
But in some instances, the firm was cited for weak testing of internal controls
over financial reporting and the application of generally accepted accounting
principles.
Marie Leone, CFO.com, June 19, 2009 ---
http://www.cfo.com/article.cfm/13888653/c_2984368/?f=archives
In one instance, the audit lacked evidence
about whether the pension plans contained subprime assets. In another case, the
PCAOB noted, the audit firm didn't collect enough supporting material to gain an
understanding of how the trustee gauged the fair values of the assets when no
quoted market prices were available.
The PCAOB, which inspects the largest
public accounting firms on an annual basis, also found that three other KPMG
audits were shy an appropriate amount of internal controls testing related to
loan-loss allowances, securities valuations, and financing receivables.
In one audit, KPMG accepted its client's
data on non-performing loans without determining whether the information was
"supportable and appropriate." In another case, KPMG "failed to perform
sufficient audit procedures" with regard to the valuation of hard-to-price
financial instruments.
In still another case, the PCAOB found
that KPMG "failed to identify" that a client's revised accounting of an
outsourcing deal was not in compliance with GAAP because some of the deferred
costs failed to meet the definition of an asset - and the costs did not
represent a probably future economic benefit for the client.
The
long-awaited PCAOB
auditor inspection
reports
We had a
visiting accounting
researcher in recently
who claimed that the Big
Four can charge more for
audits because they do
better audits than the
second tier auditing
firms. There are some
global advantages of the
largest firms, but audit
quality does not
necessarily justify
higher pricing.
The
following is sad,
because Deloitte was
once viewed as the
auditors' auditor much
like a skilled physician
is viewed as the
doctors' doctor.
The U.S. audit
overseer on Thursday
rebuked Deloitte &
Touche LLP for
weaknesses in its
audits of public
companies, including
an instance where
the accounting firm
allowed a company to
gloss over an
auditing error.
The Public Company
Accounting Oversight
Board said that an
inspection of the
accounting giant
from May through
November 2004 found
that "in some cases,
the deficiencies
identified were of
such significance
that it appeared to
the inspection team
that the firm had
not, at the time it
issued its audit
report, obtained
sufficient competent
evidential matter to
support its opinion
on the issuer's
financial
statements."
The U.S. audit
oversight board also
noted that Deloitte
& Touche had
improperly applied
lease accounting
standards in one
audit and that it
had come to an
inaccurate
conclusion about a
company's ability to
continue as a going
concern.
"We have taken
appropriate action
to address the
matters identified
by the inspection
team for each of the
instances
identified," said
Deborah Harrington,
a spokeswoman for
Deloitte & Touche.
"We are supportive
of this process and
committed to work
collectively to
continuously improve
the independent
audit process."
The audit board was
created by Congress
in 2002 following a
spate of accounting
scandals that rocked
the U.S. stock
markets. Under law,
it must inspect the
Big Four firms each
year. It does not
identify any of the
public companies
alluded to in its
inspections reports.
The PCAOB's report
did not include
details about the
quality-control
systems at Deloitte
& Touche or the
"tone at the top."
Under law, that
information must
remain confidential
for at least a year.
If firms fail to
address criticism
about their quality
controls within 12
months, then the
PCAOB may make
public its
criticisms.
Denny
Beresford
clued me
into the
fact that,
after
several
months
delay, the
Big Four and
other
inspection
reports of
the PCAOB
are
available,
or will soon
be
available,
to the
public ---
http://www.pcaobus.org/Inspections/Public_Reports/index.aspx
Look for
more to be
released
today and
early next
week.
The firms
themselves
have seen
them and at
least one,
KPMG, has
already
distributed
a
carefully-worded
letter to
all
clients. I
did see that
letter from
Flynn.
Denny did
not mention
it, but my
very (I
stress very)
cursory
browsing
indicates
that the
firms will
not be
comfortable
with their
inspections,
at least not
some major
parts of
them.
I would like
to state a
preliminary
hypothesis
for which I
have no
credible
evidence as
of yet. My
hypothesis
is that the
major
problem of
the large
auditing
firms is the
continued
reliance
upon cheaper
risk
analysis
auditing
relative to
the much
more costly
detail
testing.
This is what
got all the
large firms,
especially
Andersen,
into trouble
on many
audits where
there has
been
litigation
---
http://www.trinity.edu/rjensen/Fraud001.htm#others
While
doing
some
grading,
I have
been
listening
to the Webcast
of the
February
meeting of
the PCAOB
Standing
Advisory
Group
(see
http://www.connectlive.com/events/pcaob/)
(yes, I
know, I
have no
life!
<g>).
There is
an
interesting
discussion
on the
role/future
of the
risk-based
audit. Seehttp://tinyurl.com/8f5nt at
42
minutes
into the
discussion.
A
variety
of
viewpoints
are
expressed
in the
discussion.
This
refers
back to
an
earlier
discussion
we had
on AECM.
Roger
--
Roger
Debreceny
School
of
Accountancy
College
of
Business
Administration
University
of
Hawai'i
at Manoa
2404
Maile
Way
Honolulu,
HI
96822,
USA
www.debreceny.com
A required report by
the Public Company
Accounting Oversight
Board, released last
week, uncovered
flaws in 18 audits
performed by KPMG
LLP for publicly
held companies.
The PCAOB reviewed
just 76 of KPMG's
1,900 publicly
traded clients
between June and
October 2004. Some
of the failures by
KMPG, according to
the PCAOB, include
not thoroughly
evaluating some
known or likely
errors, not keeping
crucial
documentation, and
not backing up its
opinion with
"sufficient
competent evidential
matter."
In a prepared
statement, KPMG
Chairman Timothy
Flynn said, "KPMG is
committed to the
goal of continuous
improvement in audit
quality. We
appreciate the
constructive
dialogue and
consider it an
important element in
the process of
improving our system
of quality
controls."
The Sarbanes-Oxley
Act, which
established the
oversight board,
requires the
inspections. The
PCAOB may not make
certain criticisms
public, however, so
some portions of the
KPMG report remain
undisclosed. This
report is the first
of four reports that
will inspect the
nation's top four
accounting firms.
KPMG is the
fourth-largest
accounting firm. The
remaining reports
are expected in the
coming weeks.
Auditors looking into the fraud at HealthSouth have found it to be far
more extensive than originally thought-as much as $4.6 billion in all.
Initially, estimates put the fraud at $3.5 billion at the Birmingham,
AL-based operator of rehabilitative clinics. The auditing firm
implicated in the HealthSouth scandal is Ernst & Young ---
http://www.AccountingWEB.com/cgi-bin/item.cgi?id=98609
Ernst & Young LLP hoped the
$377,500 it paid a marketing consultant would deliver results. It did
-- only not the sort it wanted.
The Securities and Exchange
Commission has begun an informal inquiry into whether the money paid
to the consultant impaired the accounting firm's independence as an
outside auditor at three companies: executive-search firm Korn/Ferry
International, big-box retailer Best
Buy Co. and TeleTech
Holdings Inc., which runs telephone call centers. The
"leadership development" consultant, Mark C. Thompson, was
sitting on the boards of the three companies while working for Ernst
& Young.
News of the SEC's inquiry comes
less than two months after the commission barred Ernst from accepting
new audit clients for six months because of auditor-independence
violations at former audit client PeopleSoft
Inc. The SEC criticized Ernst in that case for not having sufficient
internal procedures to guard against such violations.
Unlike the PeopleSoft case,
which involved nearly $500 million of revenue that Ernst received from
the software maker, the latest inquiry focuses on much-smaller
payments made by Ernst itself. Those payments were made from December
2002 through April 2004, ending at about the time of the suspension
handed down by an SEC administrative-law judge in the PeopleSoft
matter.
Whether the payments by Ernst
constituted an auditor-independence violation will hinge on whether
the agency determines that the firm made them as a consumer in the
ordinary course of business, which is the only exception to the SEC's
general rule that auditors not enter into business relationships with
audit clients.
Continued
in article
"Behind Wave of Corporate Fraud: A Change in How Auditors Work:
'Risk Based' Model Narrowed Focus of Their Procedures, Leaving Room for
Trouble,' " by Jonathan Weil, The Wall Street Journal, March 25,
2004, Page A1
The recent wave of corporate fraud is raising a
harsh question about the auditors who review and bless companies'
financial results: How could they have missed all the wrongdoing? One
little-discussed answer: a big change in the way audits are performed.
Consider what happened when James Lamphron and
his team of Ernst & Young LLP accountants sat down early last year to
plan their audit of HealthSouth Corp.'s 2002 financial statements. When
they asked executives of the Birmingham, Ala., hospital chain if they
were aware of any significant instances of fraud, the executives replied
no. In their planning papers, the auditors wrote that HealthSouth's
system for generating financial data was reliable, the company's
executives were ethical, and that HealthSouth's management had "designed
an environment for success."
As a result, the auditors performed far fewer
tests of the numbers on the company's books than they would have at an
audit client where they perceived the risk of accounting fraud to be
higher. That's standard practice under the "risk-based audit" approach
now used widely throughout the accounting profession. Among the items
the Ernst & Young auditors didn't examine at all: additions of less than
$5,000 to individual assets on the company's ledger.
Those numbers are where HealthSouth executives
hid a big part of a giant fraud. This blind spot in the firm's auditing
procedures is a key reason why former HealthSouth executives, 15 of whom
have pleaded guilty to fraud charges, were able to overstate profits by
$3 billion without anyone from Ernst & Young noticing until March 2003,
when federal agents began making arrests.
A look at the risk-based approach also helps
explain why investors continue to be socked by accounting scandals, from
WorldCom Inc. and Tyco International Ltd. to Parmalat SpA, the Italian
dairy company that admitted faking $4.8 billion in cash. Just because an
accounting firm says it has audited a company's numbers doesn't mean it
actually has checked them.
In a September 2003 speech,
Daniel Goelzer, a member of the auditing profession's new regulator, the
Public Company Accounting Oversight Board, called the risk-based
approach one of the key factors "that seem to have contributed to the
erosion of trust in auditing." Faced with difficulty in raising audit
fees, Mr. Goelzer said, the major accounting firms during the 1990s
began to stress cost controls. And they began to place greater emphasis
on planning the scope of their work based on auditors' judgments about
which clients are risky and which areas of a company's financial reports
are most prone to error or fraud.
Auditors still plow through "high
risk" items, such as derivative financial instruments or "related party"
business dealings between a company and its executives. But ostensibly
"low risk" items -- such as cash on the balance sheet or accounts that
fluctuate little from year to year -- often get no more than a cursory
review, for years at a stretch. Instead, auditors rely more heavily on
what management tells them and the auditors' assessments of a company's
"internal controls."
Old and New
A 2001 brochure by KPMG LLP,
which claims to have pioneered the risk-based audit during the early
1990s, explained the difference between the old and new ways. Under a
traditional "bottom up" audit, "the auditor gains assurance by examining
all of the component parts of the financial statements, ensuring that
the transactions recorded are complete and accurate." By comparison,
under the "top down" risk-based audit methodology, auditors focus "less
on the details of individual transactions" and use their knowledge of a
company's business and organization "to identify risks that could affect
the financial statements and to target audit effort in those areas."
So, for instance, if controls
over a company's sales and customer IOUs are perceived to be strong, the
auditor might mail out only a limited number of confirmation requests to
companies that do business with the audit client at the end of the year.
Instead, the auditor would rely more on the numbers spit out by the
company's computers.
For inventory, the lower the
perceived risk of errors or fraud, the less frequently junior-level
accountants might be dispatched on surprise visits to a client's
warehouses to oversee the company's procedures for counting unsold
goods. If cash and securities on the balance sheet are deemed low risk,
the auditor might mail out only a relative handful of confirmation
requests to a company's banks or brokerage firms.
In theory, the risk-based
approach should work fine, if an auditor is good at identifying the
areas where misstatements are most likely to occur. Proponents advocate
the shift as a cost-efficient improvement. They also say it forces
auditors to pay needed attention to areas that are more subjective or
complex.
"The problem is that there's not
a lot of evidence that auditors are very good at assessing risk," says
Charles Cullinan, an accounting professor at Bryant College in
Smithfield, R.I., and co-author of a 2002 study that criticized the
re-engineered audit process as ineffective at detecting fraud. "If you
assess risk as low, and it really isn't low, you really could be missing
the critical issues in the audit."
Auditors can't check all of a
company's numbers, since that would make audits too expensive,
particularly in an age of sprawling multinationals. The tools at
auditors' disposal can't ensure the reliability of a company's numbers
with absolute certainty. And in many ways, they haven't changed much
over the modern industry's 160-year history.
Auditors scan the accounting
records for inconsistencies. They ask people questions. That can mean
independently contacting a client's customers to make sure they haven't
struck undocumented side deals -- such as agreeing to buy more products
today in exchange for a salesperson's oral promises of future discounts.
They search for unrecorded liabilities by tracing cash disbursements to
make sure the obligations are recorded properly. They examine invoices
and the terms of sales contracts to check if a company is recording
revenue prematurely.
Auditors are supposed to avoid
becoming predictable. Otherwise, a client's management might figure out
how to sneak things by them. It's also important to sample-test tiny
accounting entries, even as low as a couple of hundred dollars. An old
accounting trick is to fudge lots of tiny entries that appear
insignificant individually but materially distort a company's financial
statements when taken together.
Facing a crush of shareholder
lawsuits over the accounting scandals of the past four years, the Big
Four accounting firms say they are pouring tens of millions of dollars
into improving their auditing techniques. KPMG's investigative division
has doubled to 280 its force of forensic specialists, some hailing from
the Federal Bureau of Investigation. PricewaterhouseCoopers LLP auditors
attend seminars run by former Central Intelligence Agency operatives on
how to spot deceitful managers by scrutinizing body language and verbal
cues. Role-playing exercises teach how to stand up to a company's
management.
But the firms aren't backing away
from the concept of the risk-based audit itself. "It would really be
negligent" not to take a risk-based approach, says Greg Weaver, head of
Deloitte & Touche LLP's U.S. audit practice. Auditors need to
"understand the areas that are likely to be more subject to error," he
says. "Some might believe that if you cover those high-risk areas, you
could do less work in other areas." But, he adds, "I don't think that's
been a problem at Deloitte."
Mr. Lamphron, the Ernst & Young
partner, and his firm blame HealthSouth's former executives for
deceiving them. Mr. Lamphron declined to comment for this article.
Testifying before a congressional subcommittee in November, he said he
had looked through his audit papers and "tried to find that one string
that, had we yanked it, would have unraveled this fraud. I know we
planned and conducted a solid audit. We asked the right questions. We
sought out the right documentation. Had we asked for additional
documentation here or asked another question there, I think that it
would have generated another false document and another lie."
The pioneers of the auditing
industry had a more can-do spirit. In Britain during the 1840s, William
Deloitte, whose firm continues today as Deloitte & Touche, made a name
for himself by helping to unravel frauds at the Great Eastern Steamship
Co. and Great Northern Railway. A growing breed of professionals such as
William Cooper, whose name lives on in PricewaterhouseCoopers, began
advertising their services as an essential means for rooting out fraud.
"The auditor who is able to
detect fraud is -- other things being equal -- a better man than the
auditor who cannot," wrote influential British accountant Lawrence
Dicksee in his 1892 book, "Auditing," one of the earliest on the
subject.
But in the U.S., the notion of
the auditor as detective never quite took off. The Securities and
Exchange Commission in the 1930s made audits mandatory for public
companies. The auditing profession faced its first real public test in
1937, when an accounting scandal broke open at McKesson & Robbins: More
than 20% of the assets reported by the drug company were fictitious
inventory and customer IOUs. The auditors had been fooled by forged
documents.
The case triggered some reforms.
Auditing standards began requiring that auditors perform more
substantive tests, such as contacting third parties to confirm customer
IOUs and physically inspecting clients' warehouses to check inventories.
However, the American Institute of Certified Public Accountants, the
group that set auditing standards, repeatedly emphasized the limitations
on auditors' ability to detect fraud, fearing liability exposure for its
members.
By the 1970s, a new force emerged
to erode audit quality: price competition. For decades, the AICPA had
barred auditors from publicly advertising their services, making
uninvited solicitations to rival firms' clients or participating in
competitive-bidding contests. The institute was forced to lift those
bans, however, when the federal government deemed them anticompetitive
and threatened to bring antitrust lawsuits.
Bidding wars ensued. The
pressures to hold down hours on a job "inadvertently discouraged
auditors to look for" fraud, says Toby Bishop, president of the
Association of Certified Fraud Examiners, a professional association.
Increasingly, audits became a
commodity product. Flat-fee pricing became common. The big accounting
firms spent much of the 1980s and 1990s building more-lucrative
consulting operations. Many audit clients soon were paying their
independent accounting firms far more money for consulting than
auditing. The audit had become a mere foot in the door for the
consultants. Economic pressures also brought a wave of mergers,
winnowing down the number of accounting firms just as the number of
publicly traded companies was exploding and corporate financial
statements were becoming more complex.
Even before the recent rash of
accounting scandals, the shift away from extensive line-by-line number
crunching was drawing criticism. In an October 1999 speech, Lynn Turner,
then the SEC's chief accountant, noted that more than 80% of the
agency's accounting-fraud cases from 1987 to 1997 involved top
executives. While the risk-based approach was focusing on information
systems and the employees who fed them, auditors really needed to expand
their scrutiny to include top executives, who with a few keystrokes
could override their companies' systems.
Looking back, the risk-based
approach's flaws are on display at a variety of accounting scandals,
from WorldCom to Tyco to HealthSouth.
When WorldCom was a small,
start-up telecommunications company, its outside auditor, Arthur
Andersen LLP, did things the old-fashioned way. It tested the thousands
of details of individual transactions, and it reviewed and confirmed the
items in WorldCom's general ledger, where the company's accounting
entries were first logged.
But as WorldCom grew, Andersen
shifted toward what it called a risk-based "business audit process." By
1998, it was incurring more costs to audit WorldCom than it was billing,
making up the difference with fees for consulting and other work,
according to an investigative report last year by WorldCom's audit
committee. In its 2000 audit proposal to WorldCom, Andersen said it
considered itself "a committed member of [WorldCom's] team" and saw the
company as a "flagship client and a crown jewel" of the firm.
Under the revised audit approach,
Andersen used sophisticated software to analyze WorldCom's financial
statements. The auditors gathered for brainstorming sessions, imagining
ways WorldCom might cook its books. After identifying areas of high
risk, the auditors checked the adequacy of internal controls in those
areas by reviewing the company's procedures, discussing them with some
employees and performing sample tests to see if the procedures were
followed.
'Maximum Risk'
When questions arose, the
auditors relied on the answers supplied by management, even though their
software had rated WorldCom a "maximum risk" client, according to a
January report by WorldCom's bankruptcy examiner, former U.S. Attorney
General Richard Thornburgh.
One question that Andersen
auditors routinely asked WorldCom management was whether they had made
any "top side" adjustments -- meaning unusual accounting entries in a
company's general ledger that are recorded after the books for a given
quarter had closed. Each year, from 1999 through 2002, WorldCom
management told the auditors they hadn't. According to Mr. Thornburgh's
report, the auditors conducted no testing to corroborate if that was
true.
They did check to see if there
were any major swings in the items on the company's consolidated balance
sheet. There weren't any, and from this, the auditors concluded that
follow-up procedures weren't necessary. Indeed, WorldCom executives had
manipulated its numbers so there wouldn't be any unusual variances.
Had the auditors dug into
specific journal entries -- the debits and credits that are the initial
entries of transactions or events into a company's accounting systems --
they would have seen hundreds of huge entries of suspiciously round
numbers that had no supporting documentation.
The sole documentation for one
$239 million journal entry, recorded after the close of the 1999 fourth
quarter, was a sticky note bearing the number "$239,000,000," according
to the WorldCom audit committee's report. Sometimes the "top side"
adjustments boosted earnings by reversing liabilities. Other times they
reclassified ordinary expenses as assets, which delayed recognition of
costs. Other unsupported journal entries included one for precisely $334
million in July 2000, three weeks after the second quarter's books were
closed. Another was for exactly $560 million in July 2001.
Andersen signed its last audit
report for WorldCom in March 2002, saying the numbers were clean. Three
months later, WorldCom announced that top executives, including its
former chief financial officer, had improperly classified billions of
dollars of ordinary expenses as assets. The final tally of fraudulent
profits hit $10.6 billion. WorldCom filed for Chapter 11 reorganization
in June 2002, marking the largest bankruptcy in U.S. history. Now out of
business, Andersen is appealing its June 2002 felony conviction for
obstruction of justice in connection with its botched audits of Enron
Corp.
"No matter what kind of audit you
do, it is virtually impossible for an auditor to detect purposeful fraud
by management," says Patrick Dorton, an Andersen spokesman. "And that's
exactly what happened at WorldCom."
PricewaterhouseCoopers also fell
prone to faulty risk assessments. In July, the SEC forced Tyco, the
industrial conglomerate, to restate its profits, which it inflated by
$1.15 billion, pretax, from 1998 to 2001. The next month, the SEC barred
the lead partner on the firm's Tyco audits from auditing publicly
registered companies. His alleged offense: fraudulently representing to
investors that his firm had conducted a proper audit. The SEC in its
complaint said that the auditor, Richard Scalzo, who settled without
admitting or denying the allegations, saw warning signs about top Tyco
executives' integrity but never expanded his team's audit procedures.
Mr. Scalzo declined to comment. A
PricewaterhouseCoopers spokesman declined to comment on the SEC's
findings in the Tyco matter.
Like Tyco and WorldCom,
HealthSouth grew mainly by buying other companies, using its own shares
as currency. So it needed to keep its stock price up. To do that, the
company admitted last year, it faked its profits.
In their audit-planning papers,
Ernst & Young auditors noted HealthSouth executives' "excessive
interest" in maintaining or increasing its stock price and earnings.
Twice since the 1990s, the Justice Department had filed Medicare-fraud
suits against HealthSouth.
But none of that shook the Ernst
& Young audit team's confidence in management's integrity, members of
the team later testified. And at little more than $1 million annually,
Ernst & Young's audits were fairly low cost. The firm charged slightly
less to audit HealthSouth's financial statements than it did for one of
its other services for HealthSouth: performing janitorial inspections of
the company's 1,800 health-care facilities. The inspections, performed
by junior-level accountants armed with 50-point checklists, included
checking to see that the toilets and ceilings were free of stains, the
magazine racks were neat and orderly, and the trash receptacles all had
liners.
Most of HealthSouth's fraud
occurred in an account called "contractual adjustments." This is an
allowance on the income statement that estimates the difference between
the gross amount charged to a patient and the amount that various
insurers, including Medicare, will pay for a specific treatment. The
company manipulated the account to make net revenue and bottom-line
earnings look higher. But for every dollar of illicit revenue,
HealthSouth executives had to make a corresponding entry on the balance
sheet, where the company listed its assets and liabilities.
An Ernst & Young spokesman,
Charlie Perkins, says the firm "performed appropriate procedures" on the
contractual-adjustment account.
At an April 2003 court hearing,
Ernst & Young auditor William Curtis Miller testified that his team
mainly had performed "analytical type procedures" on the contractual
adjustments. These consisted of mathematical calculations to see if the
account had fluctuated sharply overall, which it hadn't. As for the
balance-sheet entries, prosecutors say HealthSouth executives knew the
auditors didn't look at increases of less than $5,000, a point Ernst &
Young acknowledges. So the executives broke up the entries into tiny
pieces, sprinkling them across lots of assets.
The company's ledger showed
thousands of unusual journal entries that reclassified everyday expenses
-- such as gasoline and auto-service bills -- as assets. Had the
auditors seen those items, one congresswoman noted at a November
hearing, they would have spotted that something was wrong. Mr. Lamphron
conceded her point.
March 27, 2004 reply from MacEwan Wright, Victoria University
[Mac.Wright@VU.EDU.AU]
-----Original Message-----
From:
Sent: Saturday, March 27, 2004 10:29 PM
Subject: Re: Attacks on Risk-Based Auditing
Dear Bob,
I wonder if this is not a case of throwing the
baby out with the bathwater. I mean the idea of risk based auditing is
not in itself a bad idea, The problem is that the idea of what
constitutes risk is not properly understood. As I interpret it - risk
means probability of event multiplied by cost of event. Risk as used in
audit planning means probability of event. It is obvious that the team
did not do enough to properly evaluate the inherent risk or more
properly stated - the probability that management wouold lie and cheat
for profit.
It is am American attitude problem. An American
executive posted to an Australian company found the amount of work put
into finding out how honest potential employees were a waste of time -
"just bond them and sack them and claim the bond insurance if they
cheat". Bonding is virtually unheard of in Australia.
I feel that attitude may encourage fraud - the
game is what can each party get away with!
Sorry about the social implications.
Kind regards,
Mac Wright
March 27, 2004 reply from Bob Jensen
Hi Mac,
You are correct about the fact that risk-based auditing has led to
game playing. Somehow the HealthSouth executives figured out that the
risk of getting caught with fraudulent transactions under $6,000 each
was nearly zero under their auditor's (E&Y) risk-based model, so they
looted the company with transactions under $6,000 each.
I agree with you that some form of risk-based auditing should be
utilized.
I think
this was the case long before KPMG formalized the concept. However, in
addition the fear of detailed testing of small transactions must
still remain high among client employees. Auditors must invest more in
unpredictable detailed testing up to a point where the probability of
being audited for even small transactions is significant.
Probably the worst-case scenario that virtually eliminated fear of
getting caught was Andersen's notoriously defective audits of Worldcom.
I'm told (rumor mill) that an Andersen auditor had not even been seen in
Worldcom's purchasing department for a number of years. What is the
first department an auditor should investigate for fraud?
I know a treasurer of a major company. It used
to bug him that the auditors came by every year and take up her staff's
time collecting & reconciling bank and investment information. Then a
few years ago, they just stopped showing up in the treasury dept. I've
always wondered what the auditor's risk model was if suddenly cash and
investments were no longer important.
A Little Like Dirty Pooling Accounting Tyco Undervalues Acquired Assets and Overvalues Acquired Liabilities:
Tyco International Ltd. said Monday it has agreed to
pay the Securities and Exchange Commission $50 million to settle charges related
to allegations of accounting fraud by the high-tech conglomerate's prior
management. The regulatory agency had accused Tyco of inflating operating
earnings, undervaluing acquired assets, overvaluing acquired liabilities and
using improper accounting rules, company spokeswoman Sheri Woodruff said. 'The
accounting practices violated federal securities laws,'' she said. "Tyco to Pay S.E.C. $50 Million on Accounting Charges,"
The New York Times,
April 17, 2006 ---
http://www.nytimes.com/aponline/business/AP-Tyco-SEC-Fine.html?_r=1&oref=slogin
April 17, 2006 reply from Saeed Roohani
Bob,
Assuming improper accounting
practices by Tyco negatively impacted investors and
creditors in the capital markets, why SEC gets the $50 M?
Shouldn't SEC give at least some of it back to the people
potentially hurt by such practices? Or damage to investors
should only come from auditors' pocket?
Saeed Roohani
April 18, 2006 reply from Bob Jensen
Hi Saeed,
In a case like this it is difficult to identify
particular victims and the extent of the damage of this one
small set of accounting misdeeds in the complex and
interactive multivariate world of information.
The damage is also highly dispersed even if you confine
the scope to just existing shareholders in Tyco at the
particular time of the financial reports.
One has to look at motives. I'm guessing that one motive
was to provide overstated future ROIs from acquisitions in
order to justify the huge compensation packages that the CEO
(Kozlowski) and the CFO (Schwarz) were requesting from
Tyco's Board of Directors for superior acquisition
performance. Suppose that they got $125 million extra in
compensation. The amount of damage for to each shareholder
for each share of stock is rather minor since there were so
many shares outstanding.
Also, in spite of the illegal accounting, Kozlowski's
acquisitions were and still are darn profitable for Tyco. I
have a close friend (and neighbor) in New Hampshire, a
former NH State Trooper, who became Koslowski's personal
body guard. To this day my friend, Jack, swears that
Kozlowski did a great job for Tyco in spite of possibly
"stealing" some of Tyco's money. Many shareholders wish
Kozlowski was still in command even if he did steal a small
portion of the huge amount he made for Tyco. He had a skill
at negotiating some great acquisition deals in spite of
trying to take a bit more credit for the future ROIs than
was justified under purchase accounting instead of virtual
pooling accounting.
I actually think Dennis Kozlowski was simply trying to
get a bit larger commission (than authorized by the Board)
for some of his good acquisition deals.
Would you rather have a smart crook or an unimaginative
bean counter managing your company? (Just kidding)
On April 17, 2006, the Securities and
Exchange Commission issued Litigation Release No. 19657, which
states that the SEC and Tyco have settled terms over this fraud. In
its civil complaint, the SEC alleges that Tyco undervalued assets
and overvalued liabilities acquired in business combinations,
inflated operating income and cash flows from operating activities,
and bribed foreign officials in Brazil. The SEC also contends that
Tyco covered up these activities with false and misleading financial
reports. In the usual fashion of these decrees, Tyco neither admits
nor denies the charges; nevertheless, it consents to the judgment.
In this case, Tyco must pay a $50 million penalty.
But, just a minute! Who is really paying
this $50 million fine? It's not management, neither Kozlowski nor
Schwartz (the SEC continues its investigation of them, and they may
receive additional fines), nor Tyco's present management team. The
board of directors is not paying the fine either. Given the firm
itself is paying this ticket, it implies that the real payers are
the investors of Tyco, who in effect must cough up $50,000,000. So
this raises the question -- why should the investors get ripped off
twice?
Let's go back to basics: civil penalties
and criminal sentences serve two purposes in our society. First,
they satisfy, however partially, our collective sense of justice.
Kozlowski and Schwartz defrauded many investors, and these aggrieved
investors seek justice, but they seek justice against the
perpetrators of the conspirators, not the victims. Not themselves.
Second, society issues civil penalties and criminal sentences to
deter future crimes. The idea is that if the disincentives are
sufficiently obnoxious and if the probably of enforcement is
sufficiently high, then future managers are less likely to follow
suit with their own crimes against investors. In this case too, the
argument is persuasive as long as the courts levy fines and
punishment against the malefactors and not against the victims.
The SEC has for a long time engaged in
these civil judgments against firms that have experienced accounting
and securities fraud. It would do well for the SEC to re-examine
this policy, realize that its effects are pernicious and
counterproductive, and then repeal the strategy. It is silly for the
investors to suffer for the wrongdoing by corporate thieves
masquerading as managers.
As an aside, the reader may remember the
infamous committee headed by David Boies, on behalf of Tyco's board
of directors, to examine the Tyco situation and determine whether
Tyco had engaged in an accounting scam. Tyco issued this report in
an 8-K filed on December 30, 2002. That committee kept its eyes
closed and found that "there was no significant or systemic fraud."
I wonder what excuse David Boies or the other members of the
committee could provide today for their wanting analysis.
If the SEC really desires to deter future
accounting frauds, it must align its punishment with the scoundrels
who carry out these misdeeds. The SEC also must enforce the
securities laws to the fullest extent possible. If today's managers
see other managers hauled off to prison or paying huge fines, they
will be less apt to steal from and cheat investors. If today's
managers see the corporation fined and thus feel little or no impact
themselves, well, the firm becomes one's personal piggy bank.
Adelphia Communications Corp.
revealed its real results and its publicly reported inflated numbers
in the books given to many employees, including founder John Rigas and
two of his sons, a former executive testified.
But these financial statements,
detailing actual numbers and phony ones dating back to 1997, weren't
disclosed to the company's auditors, Deloitte & Touche, said
former Vice President of Finance James Brown in his second day on the
stand. Former Chief Financial Officer Timothy Rigas supported the
system to keep employees aware of the company's real performance, Mr.
Brown testified.
For example, one internal
document showed that while Adelphia's operating cash flow was $177
million for the quarter ended in September 1997, its publicly reported
operating cash flow was $228 million, Mr. Brown said.
Mr. Brown has pleaded guilty in
the case and is testifying in hopes of receiving a reduced sentence.
John Rigas, his sons Timothy
Rigas and former Executive Vice President Michael Rigas, and former
Assistant Treasurer Michael Mulcahey are on trial here on charges of
conspiracy and fraud. Michael Rigas was back in court yesterday, one
day after court was canceled due to a medical issue that sent him to
the hospital over the weekend. People close to the case said the
problem was minor.
Mr. Brown said he devised
various schemes to inflate Adelphia's publicly reported financial
measures. Company executives were afraid that if Adelphia's true
performance was revealed, the company would be found in default of
credit agreements, he said. "I used the term 'accounting magic,' "
Mr. Brown said.
In March 2001, phony documents
dated 1999 and 2000 were created "to fool the auditors into
believing that they were real economic transactions," he
testified.
Mr. Brown discussed the details
of how to inflate Adelphia's financial measures with Timothy Rigas
more than the other defendants, but John Rigas and Michael Rigas also
knew that the company's public filings didn't represent its real
performance, he testified. John Rigas occasionally showed discomfort
with the inflation, but did nothing to stop it, Mr. Brown said.
Mr. Brown testified he used to
regularly tell John Rigas Adelphia's real results and how they
compared with those of other cable companies. "On one occasion
John told me, 'We need to get away from this accounting magic,' "
he recalled. Mr. Brown added that he understood that to mean that
Adelphia needed to boost its operations so that at some point in the
future, the inflation could stop.
In another discussion about
inflated numbers in early 2001, John Rigas "told me he felt sorry
for Tim Rigas and me because the operating results were putting so
much pressure on us ... but he said, 'You have to do what you have to
do,' " Mr. Brown testified. "He also said we can't
afford to have a default." Mr. Brown said he took that to mean
that reporting inflated numbers was preferable to defaulting.
Federal agents arrested a former Ernst & Young
LLP audit partner on criminal charges of obstruction of justice, in one
of the first cases of alleged document destruction brought under the
14-month-old Sarbanes-Oxley Act.
The U.S. Attorney's Office for the Northern
District of California alleged that the former partner obstructed an
examination by federal-bank regulators, and later by securities
regulators, into NextCard Inc., an Internet-based credit-card issuer, by
destroying work papers from its audits of the company. The auditor,
prosecutors alleged, altered and deleted documents to make it appear
that Ernst & Young had thoroughly considered key financial issues at the
San Francisco company.
Another former E&Y employee has pleaded guilty
to a criminal-obstruction charge in connection with the matter, while a
third faces civil-administrative proceedings brought by the Securities
and Exchange Commission.
In a statement, E&Y said that it had contacted
federal authorities when it first became aware of "the violation" and
also launched an internal probe. All three employees are no longer with
the firm as a result of the investigation, E&Y said, and the firm is
co-operating with various governmental agencies. Ed Swanson, a lawyers
for the former partner, Thomas C. Trauger, 40 years old, said that his
client intends to pleas not guilty and to fight the charges. "Tom is a
good man and well-respected accountant and I am confident he will be
exonerated," said Mr. Swanson.
Federal officials noted the investigation
continues, leaving open the possibility that E&Y itself could be
charged. But some accounting and legal specialists noted significant
differences between the E&Y matter and the case against Arthur Andersen
LLP that led to its swift downfall.
Most notably, Andersen already was on a
probation of sorts with the SEC when its auditors shredded thousands of
pages of documents tied to its Enron Corp. audits; E&Y isn't under any
similar probation. To date, no indication has surfaced that the alleged
criminal conduct at E&Y reached beyond the former auditor and the two
other former Ernst employees.
The legal action takes advantage of "additional
tools" provided by last year's sweeping securities reform, Sarbanes
Oxley, "to aggressively prosecute this kind of conduct," said Ross Nadel,
head of the criminal division in the U.S. Attorney's Office in San
Francisco. Specifically, the act gives prosecutors more leeway in
prosecuting those who seek to destroy, alter or falsify financial
information and records.
Continued in the article.
Ernst & Young in Trouble With
the SEC
SEC seeks
sanctions against Ernst and Young
By Joshua
Chaffin in
Washington
Published:
New York Times, May
29 2003
Ernst & Young,
one of the world's largest auditing firms, faces a six-month ban
from taking on new public company auditing clients following a
Securities and Exchange Commission investigation.
The SEC,
the chief
US
financial regulator, has asked an executive judge for the temporary
ban and other sanctions against E&Y to remedy claims that the firm
compromised its independence with respect to one of its clients,
PeopleSoft, the software maker.
Ernst &
Young has denied the SEC's claims, and called its recommendations
"irresponsible". The judge is not likely to rule on the case for
months.
Nonetheless, the severity of the proposed penalties reflect the
SEC's effort to stop abuses in an accounting industry that has
featured prominently in corporate scandals at Enron and other
US
companies. The SEC has requested the temporary auditing ban only a
few times in the last 20 years.
The SEC
ruled out an outright ban on audits at E&Y out of fear that it would
unfairly punish the firm's corporate clients, observers say.
Such a
measure might also have jeopardised the firm's existence. The
US
accounting sector has already been pared from five to four large
firms with the dissolution of Andersen.
The SEC
accused E&Y of compromising its independence as PeopleSoft's auditor
by entering into two side arrangements with the software maker.
In one
case, E&Y sold a PeopleSoft software programme used to calculate
taxes for overseas employees. In another, E&Y installed PeopleSoft's
products for corporate customers, according to the SEC. That
arrangement netted E&Y $452m in fees from 1995 to 1999.
In addition
to the ban, the SEC is also seeking the disgorgement of $1.7m in
audting fees from E&Y and the appointment of an independent officer
to review the firm's auditing independence. The requests, filed with
the court last week, were first reported by The Washington Post.
E&Y said it
was "confident that the firm in no way violated the independence
rules and there is no basis for the imposition of any sanctions of
any sort against the Firm."
60 Minutes is going to air a report this Sunday
about accounting firms' promotion of "abusive" tax shelters. The
synopsis from the CBS web site is below. Also, they apparently aired an
interview with HealthSouth CEO Richard Scrushy last week. Did anybody
see that episode and was it any good?
Gimme Shelter Oct. 17, 2003
The tax shelters the rich use to avoid an
estimated $50 billion in taxes a year are the "schemes" of reputable
accounting and law firms that profit immensely by selling them to their
clients, says Sen. Charles Grassley (R-Iowa), chairman of the Senate
Finance Committee.
He appears in Steve Kroft's report on abusive
tax shelters to be broadcast on 60 Minutes, Sunday, Oct. 19, at 7 p.m.
ET/PT.
"The source of the problem is the accounting
firms and the law firms that peddle these schemes," says Grassley of the
tax shelters, which are usually rejected by courts and the Internal
Revenue Service. "You just can't write tax laws precisely enough to
avoid the ingenuity of lawyers and accountants."
The "schemes" put a taxable income through
elaborate financial transactions that create artificial losses to offset
that income. "The products they're selling generally don't work," says
Stanford University law professor Joseph Bankman, a tax shelter expert.
"If it's not illegal... it's certainly somewhat
unethical, I think," says Bankman. Competitive pressure is pushing the
firms into the business. "Mavericks without these moral scruples went
into the business and did really well and their clients didn't get
caught," adds Bankman.
But now, firms and their clients are getting
caught and fined for using abusive tax shelters. Henry Camferdam blames
his troubles with the IRS on the firms that sold him a $50 million tax
shelter.
"Ernst and Young came to us...and said, 'Look,
instead of paying all these taxes, why don't we do a tax shelter,'" says
Camferdam, who was selling his business with the help of accountants
Ernst and Young. "When they're a trusted advisor, you're going to
listen."
The shelters are so lucrative and proprietary
that Camferdam had to pay $1 million in fees and sign a strict
non-disclosure agreement. He had to also pay $2 million to the law firm
of Jenkins and Gilchrist for providing an "independent" legal opinion
saying the shelter would work.
"You can't make $2 million a pop and be
independent in any meaningful way. I would think that [Jenkins and
Gilchrist] were quite interested in how many people bought that
shelter," says Bankman.
Camferdam and scores of other clients bought
the shelter, called the Currency Options Bring Reward Alternatives, or
COBRA, but had their names turned over to the IRS by Ernst and Young
when the IRS began an investigation.
"[The IRS] talked like we're the cheats...who
defrauded the government," says Camferdam, who the IRS says owes it $13
million, plus interest and penalties. The IRS is auditing all the other
clients who purchased the tax shelter, too.
"What I don't understand is why they have not
gone after Ernst and Young, Jenkins and Gilchrist and Deutsche Bank, who
designed, marketed and led us into this transaction," asks Camferdam.
"That's what you use these people for. If they tell us not to do
something, we don't do it. If they tell us to do something, we do it."
Ernst and Young and Jenkins and Gilchrist
refused 60 Minutes' request to be interviewed on camera, but issued
statements saying everything they did was completely legal. Camferdam is
suing them for $1 billion, alleging they knowingly lured customers into
an "illegitimate tax sham."
Paul Clikeman
Robins School of Business
University of Richmond Richmond, VA 23173 804-287-6575
pclikema@richmond.edu
Forwarded by David Albrecht on July 20, 2003
July 19, 2003
Business: S.E.C. Demands 6-Month Ban on New Ernst & Young Clients
By JONATHAN D. GLATER
Federal regulators reiterated their demand yesterday that the accounting
firm Ernst & Young be banned from accepting new audit clients for six
months as a penalty for violating conflict-of-interest rules in the
1990's.
Matthew Whitley wanted to work for Coca-Cola
Co. so much he submitted his resume 15 times. After being hired, the
auditor and finance manager drank nothing but water and Coke and
decorated a room in his house with company trinkets.
Eleven years later, Whitley is drinking only
water. His wife sold the Coke plates, glasses and memorabilia at a
garage sale. He is out of his $140,000-a-year job after accusing
officials of the world's largest soft drink maker of shady accounting
and fraudulent marketing practices.
Whitley, 37, was fired March 26, five days
after sending his allegations to the company's top lawyer, although Coke
said he was dismissed as part of a restructuring and not because he
spoke up. Whitley demanded $44.4 million from Coke in exchange for his
silence, but was refused, and is now suing the company for unspecified
damages, charging Coke with wrongful termination, fraud, slander and
intentional infliction of emotional distress.
"I'm the last one who wanted any of this to
happen," Whitley said. "I wanted somebody to take what I was saying
seriously."
In some ways, he's gotten his wish. Federal
prosecutors are conducting a criminal investigation of claims in his
suit, including allegations that Coke rigged a marketing test of Frozen
Coke, a slush drink, at Burger King restaurants in Virginia in 2000.
Coke has offered to pay Burger King $21 million as part of an apology.
A Superior Court judge earlier this month
dismissed more than half of Whitley's claims, including allegations that
Atlanta-based Coke sought to hide fraud, but ruled the lawsuit may
continue. The suit also is filed in federal court; that case was not
affected by the judge's decision.
E. Christopher Murray, an employment law expert
in Garden City, N.Y., said the fact that the suit survived a motion to
dismiss, even if it is a scaled-down version, is a victory for Whitley,
who will now be able to depose Coke executives and obtain documents from
the company. Most such cases are thrown out, he said.
Because the judge left intact Whitley's claims
of intentional infliction of emotional distress and slander, he will be
able to delve into the fraud allegations to show Coke had a motive for
its actions, Murray said.
But legal tactics Coke is likely to use could
prolong the case, he said.
"With the larger companies, what they normally
do is fight you tooth and nail, file thousands of discovery motions, put
you through the wringer, until they wear you out," Murray said. "I'm
sure that's what Coca-Cola will do."
Coke has denied most of the charges but
conceded that some employees improperly influenced the marketing test.
Ernst &
Young was awarded $98.8 million of undisclosed rebates on airline
tickets from 1995 through 2000, mostly on client-related travel for
which the accounting firm billed clients at full fare, internal Ernst
records show.
The rebates are at the crux of a civil lawsuit here in a state circuit
court, in which Ernst & Young LLP, KPMG LLP and PricewaterhouseCoopers
LLP are accused of fraudulently overbilling clients for travel expenses
by hundreds of millions of dollars since the early 1990s. The tallies
are the first precise annual airline-rebate figures to emerge in the
case for any of the three accounting firms.
Ernst and the other defendants,
in the lawsuit brought by closely held shopping-mall operator Warmack-Muskogee
LP, have acknowledged retaining large rebates from travel companies
without disclosing their existence to clients. But they deny that their
conduct was fraudulent, saying they used the proceeds to offset costs
they otherwise would have billed to clients through higher hourly rates.
Confidentiality provisions in the firms' contracts, standard in the
airline industry, barred parties from disclosing the contracts'
existence or terms.
Court records show that Ernst had
rebate agreements with three airlines: American Airlines' parent
AMR Corp.,
Continental Airlines, and
Delta Air Lines. The airline rebates soared to $36.7 million in
2000, compared with $21.2 million in 1999 and $5.2 million in 1995,
reflecting a trend among major accounting firms to structure their
volume discounts with select airlines as rebates rather than upfront
price reductions.
A May 2001 chart by Ernst's
travel department shows the firm estimated that its 2001 rebates would
be $39.8 million to $44 million, including at least $21.2 million from
AMR and $8.3 million from Continental.
Of Ernst's three "preferred
carriers," two -- AMR and Continental -- are audit clients of the firm.
Some investors say the large dollar figures, combined with a reference
in one Ernst document to the firm's arrangements with AMR, Continental
and seven other travel companies as "strategic partnering
relationships," raise questions about how such payments mesh with
Securities and Exchange Commission requirements that auditors be
independent. The reference was contained in a 2001 presentation
outlining the travel department's goals and objectives for the following
year.
Audit firms generally aren't
allowed to have partnership arrangements with clients in which the
auditor would appear to be a client's advocate, rather than a watchdog
for the public. SEC rules bar auditors from having direct business
relationships with audit clients, with one exception: if the auditor is
acting as "a consumer in the normal course of business."
The rules don't clearly spell out
the full range of business relationships that would fall under that
category. Ernst says its relationships with AMR and Continental
qualified for the exception. Generally, auditors can buy goods and
services from audit clients at volume discounts, if the prices are fair
market and negotiations are arm's length. Ernst, American and
Continental say theirs were. Ernst's terms with American and Continental
were similar to those with Delta, which wasn't an audit client.
In a January 2000 e-mail to an
Ernst consultant, Ernst's travel director explained that, within the
airline industry, "point-of-sale discounts are the industry norm, not
back-end rebates." Many large professional-services firms tended to
prefer back-end rebates, however. A September 2000 presentation by
Ernst's travel department said "the back-end rebate structure is
consistent with practices in other large professional-services firms,"
including the other four major accounting firms and investment banks
Credit Suisse First Boston and Morgan Stanley. It also said an outside
consulting firm, Caldwell Associates, had deemed the competitiveness of
Ernst's travel contracts "to be above average," compared with those of
the other four major accounting firms.
In a statement, Ernst says:
"There is no independence rule of any sort that would prohibit our
receipt of rebates for volume travel in the normal course of business.
As is the case with any large airline customer, we receive discounts on
tickets purchased from American based on the volume of our business. ...
It is entirely unrelated to our audit work for the airline."
AccountingWEB
US - May-7-2003 - Drug distributor Accredo Health Inc. has fired
its auditor, Big Four firm Ernst & Young, and is suing the firm for more
than $53.3 million.
Last year E&Y
examined the financial statements of home health care service company
Gentiva Health Services and provided information to Accredo that led to
the acquisition of Gentiva by Accredo. After the acquisition Accredo
determined that Gentiva's allowance for doubtful accounts was
understated.
In the lawsuit
Accredo claims that E&Y failed to properly determine reserves needed to
cover Gentiva's bad debts. Accredo accuses E&Y of accounting and
auditing malpractice, negligent misrepresentation, breach of contract,
and violating the Tennessee Consumer Protection Act. In response, Ken
Kerrigan, E&Y spokesman,
said, "Ernst & Young was surprised by Accredo's action today. We
believe our work fully complied with all professional standards and we
will defend ourselves vigorously."
This isn't the
only legal issue Ernst & Young has to contend with. The firm is
currently working with a Senate panel that is investigating
possible abuses regarding tax shelters sold by the firm. E&Y has
also been in the news lately for its involvement in providing
tax
advice to Sprint executives, its questionable
audit
techniques with regard to the Swiss state of Geneva, and its
recently
dismissed charges regarding the audit of British-based Equitable
Life, among other high-profile cases.
AccountingWEB US - Apr-17-2003 -
The University of California (UC)
filed suit on April 14 against Big Four accounting firm Ernst &
Young LLP and 32 other defendants, claiming it misrepresented the
financial situation of America Online and Time Warner around the time of
the firms’ 2001 merger.
AOL stock plummeted soon after the merger with
Time-Warner and UC lost $450 million.
In the suit, the university claims that E&Y,
concerned with holding on to a fat contract, helped falsify financial
facts and continued to offer an unqualified audit opinion of the company
long after it was clear that the company was in trouble.
An EY spokesman denied the charges. "We
continue to strongly stand behind our work," E&Y spokesman Ken Kerrigan
said.
Despite the lawsuit, another branch of E&Y
will continue its wide-scale review of the University of California's
Los Alamos National Laboratory’s financial operations. The university
manages the laboratory, which is the subject of congressional charges of
theft, fraud and mismanagement.
"It's like you being indicted because your
brother stole something," UC spokesman Trey Davis said. "It's really
quite separate."
Only a few firms are qualified to do the kind
of work E&Y is doing at Los Alamos and more than 30 consultants from
E&Y’s government contract services group are involved in a
top-to-bottom review of the lab’s operations.
Dec. 31, 2002 (Crain's New York Business) — Ernst & Young
International (E&Y) is being sued by former clients for setting up a
tax shelter for them ---
http://www.smartpros.com/x36550.xml
AccountingWEB US - May-1-2003 -
Two Ernst & Young partners
settled a civil lawsuit filed by the Securities and Exchange
Commission (SEC) by agreeing to a suspension from auditing public
companies for at least four years. The suit alleged that Kenneth
Wilchort and Marc Rabinowitz, who both work in E&Y’s Stamford, CT
office, failed to detect accounting fraud at Cendant Corporation and its
predecessor, CUC International.
In 1977 CUC International merged with HFS Inc.
to form Cendant, a travel and real estate provider that is also the
franchiser of Jackson Hewitt, the second-largest tax service in the
United States. Mr. Wilchort served as audit engagement partner for
Cendant from 1990 until 1996. He was succeeded by Mr. Rabinowitz, who
held the position until 1998.
In its complaint letter, the SEC claims that
between 1995 and 1998, Cendant managers devised a scheme that inflated
operating income by more than $500 million. The SEC alleges that Mr.
Wilchort and Mr. Rabinowitz aided and abetted these violations by
approving financial statements that did not conform to generally
accepted accounting principles. The SEC further alleges that the two men
excessively relied on management’s representations and failed to
perform independent testing even when there were "multiple,
conflicting and sometimes contradictory" financial documents.
Continued in the article.
HealthSouth and
Earnst & Young
Nonetheless, Mr. Smith and HealthSouth's chief
executive, Richard Scrushy, on two occasions
last year swore in public filings that the company's financial statements
fairly presented HealthSouth's financial
condition and operating results. Those quarterly certifications, which the
Sarbanes-Oxley Act began requiring last year,
appear to have made it much easier for prosecutors to build their case
against Mr. Smith. The SEC filed civil charges against Mr.
Scrushy Wednesday, but he hasn't been charged
criminally. Prosecutors referred to HealthSouth's
CEO and other unnamed HealthSouth senior
executives as co-conspirators throughout Wednesday's court filings.
Neither Mr. Scrushy nor his lawyer could be
reached for comment.
Jonathon Weil
Auditors looking into the fraud at HealthSouth
have found it to be far more extensive than originally thought-as much as
$4.6 billion in all. Initially, estimates put the fraud at $3.5 billion at
the Birmingham, AL-based operator of rehabilitative clinics. The auditing
firm implicated in the HealthSouth scandal is Ernst & Young AccountingWeb, January 22, 2004 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=98609
The Panel's role is to alert the nation to the
immense social and economic damage caused by fraud and help both public
and private sectors to fight back. It is dedicated to a holistic
approach and the long view. The Panel works to:
originate proposals to reform the law and
public policy on fraud
develop proposals to enhance the
investigation and prosecution of fraud
advise business on fraud prevention,
detection and reporting
assist in improving fraud related education
and training in business and the professions establish a more accurate
picture of the extent, causes and nature of fraud
Established in 1998 through a public spirited
initiative by the Institute of Chartered Accountants in England and
Wales, the Panel exists to challenge complacency and supply remedies.
The Panel is an independent body of volunteers
drawn from the law and accountancy, banking, insurance, commerce,
regulators, the police, government departments and public agencies. It
is not restricted by seeing the problem from any single point of view
but works to encourage a truly multi-disciplinary perspective. The Panel
is given a serious hearing as a consequence and has contributed to the
new, and more vigorous attitude in government towards fraud.
There actually
ARE Tax Shelters out there. A tax shelter is an investment that usually
requires substantial contributions with a degree of risk. It often
involves current losses to produce future gains. An investment in low
income property that provides depreciation benefits is one example of a
legitimate tax shelter. Generally, the amount of your deductions or
losses from most activities is limited to the amount that you have at
risk. You are considered at risk in an activity for the following
amounts:
The amount of
cash you invested in the activity, The adjusted basis of other property
you contributed to the activity; and The amount you borrowed to invest
in the activity, to the extent that you are personally liable on the
loan or have pledged property not used in the activity as security. For
more information on the at risk rules, refer to Publication 925 (PDF),
Passive Activity and At Risk Rules.
Note Tax
shelter trade or business activity losses or credits are often
considered passive activity losses or credits. Such losses or credits
may only be used to offset income from other passive activities. They
cannot be deducted against other income such as wages, salaries,
professional fees, or portfolio income such as interest and dividends.
Allowable losses or credits are computed on Form 8582 (PDF), Passive
Activity Loss Limitations.
The excess
passive losses and credits generated from passive activity tax shelters
can be carried forward until you can use them or until you dispose of
your investment in the tax shelter.
For more
information on passive income and losses, refer to Tax Topic 425, or
refer to Publication 925.
Abusive tax
shelters exist solely to reduce taxes unrealistically. Abusive tax
shelters are often marketed by promising a larger write-off than the
amount invested. These schemes involve artificial transactions with
little or no economic foundation. Generally, one invests money to make
money. A legitimate tax shelter exists to reduce taxes fairly and also
produce income. As with any investment, a real tax shelter involves
risks, while an abusive tax shelter involves little risk, despite
outward appearances.
A series of tax
laws has been designed to halt abusive tax shelters. These include
requiring sellers of tax shelters to register them using Form 8264
(PDF), Application for Registration of a Tax Shelter, requiring sellers
to maintain a list of investors, and requiring investors to report the
tax shelter registration number on their tax return using Form 8271
(PDF), Investor Reporting of Tax Shelter Registration Number.
Investors in
abusive tax shelters whose returns are examined may be required to pay
more tax, plus penalties and interest. Also, promoters of abusive tax
shelters may be liable for significant penalties.
There are
several legitimate investments you can make that will defer income until
a later date, such as Individual Retirement Arrangements, retirement
plans for self employed individuals, and deferred annuities. These are
not considered tax shelters because they usually do not involve tax
losses. For more information concerning tax shelters, including issues
to consider before investing, refer to Publication 550 (PDF), Investment
Income and Expenses.
...hopefully
your client is NOT looking for an ABUSIVE one...
"Officials face probe for Vivendi share moves," by Jo
Johnson, The New York Times, March 30, 2004
French prosecutors yesterday put the head of
Deutsche Bank's equities business in France and two senior officials in
Vivendi Universal's finance department under formal investigation for
alleged share-price manipulation at the French media group.
These are the first formal investigations since prosecutors opened their
probe into Vivendi Universal in October 2002, four months after the
resignation of Jean-Marie Messier as chief executive.
. . .
The developments in France come three months
after the media group agreed to pay $50m (£28m) to the Securities and
Exchange Commission last year to settle fraud claims.
Coke: Gone Flat at the Bright Lines of Accounting Rules and
Marketing Ethics
The king of carbonated beverages is still a moneymaker, but its growth has
stalled and the stock has been backsliding since the late '90s. Now
it turns out that the company's glory days were as much a matter of
accounting maneuvers as of marketing magic. Guizuenta's most ingenious contribution to Coke,
the ingredient that added rocket fuel to the stock price, was a bit of
creative though perfectly legal balance-sheet rejeiggering that in some
ways prefigured the Enron Corp. machinations. Known inside the
company as the "49% solution," it was the brain child of
then-Chief Financial Officer M. Douglas Ivester. It worked like
this: Coke spun off its U.S. bottling operations in late 1986 into a
new company known as Coca-Cola Enterprises Inc., retaining a 49% state for
itself. That was enough to exert de facto control but a hair below
the 50% threshold that requires companies to consolidate results of
subsidiaries in their financials. At a stroke, Coke erased $2.4
billion of debt from its balance sheet.
Dean Foust, "Gone Flat," Business Week, December 20,
2004, Page 77.
This is a Business Week cover story.
Coca Cola's outside independent auditor is Ernst & Young
Bob Jensen's Most Difficult Message (written December 4, 2001) ---
http://www.trinity.edu/rjensen/fraud.htm#Blame
The theme is how large CPA firms wear two faces like the theatrical
symbol. Bob
Jensen's Commentary on the Above Message
From the CEO of Andersen
(The Most Difficult Message That I Have Perhaps Ever
Written!)
This is followed by replies from other accounting
educators.
The Two Faces of
Large Public Accounting Firms
When the Enron/Anderson scandals were just commencing to unfold, I
wrote "The Most Difficult Message That I have Ever Written" at
http://www.trinity.edu/rjensen/fraud.htm#Blame
Note that you have to read the preliminaries and then scroll down to my
message.
Year 2003 Update on the Same Theme of Two Faces of Public Accounting
Firms
KPMG's Smiling Face
KPMG provides a sad illustration of the two faces. KPMG has done
wonderful things in support of accounting education and accounting
research. They have helped to fund faculty, and even helped to
fund my salary when I was a KPMG Professor of Accounting at Florida State
University. The KPMG Foundation has taken on a huge commitment
to raise funds for supporting minority students in doctoral programs.
Some of KPMG's most wonderful programs are described at
http://www.kpmgfoundation.org/
A recent example of KPMG's initiative to help reduce fraud.
December 3, 2003 message from Colleen Sayther
[mailmanager@feiexpress.fei.org]
KPMG Fraud Survey
Provides detailed examination of fraud, new anti-fraud measures, and how
organizations will manage this pervasive problem in the future. Over 450
U.S. business executives and government officials were interviewed to
help determine how organizations are confronting fraud in the
post-Sarbanes-Oxley era. The results produced several interesting
insights.
Click on the link for a full copy of the study.
Auditor refuses to give Commodity Futures
Trading Commission clean bill of health because of what it says is
significant error on the books.
The Commodity Futures Trading Commission is
fighting with its outside auditor, which is refusing to give the
agency a clean bill of health because of what it says is a
significant error on the CFTC’s books.
The auditor, KPMG LLP, says the CFTC
understated its obligations by about $212 million in fiscal 2014 and
$194 million in fiscal 2015, according to a KPMG opinion included in
the CFTC’s 2015 financial report. The agency hasn’t properly
accounted for its future costs of leasing office space, KPMG said.
The auditor issued only a “qualified”
opinion, indicating its judgment that the CFTC’s financial
statements for fiscal 2015, which ended Sept. 30, were flawed. The
CFTC has a material weakness in its internal controls as a result,
KPMG said.
The CFTC said it “does not concur” with
KPMG’s position, but in a letter also included in the 2015 financial
report, the agency acknowledged it was “reasonably possible” KPMG
was correct. The CFTC said the Government Accountability Office, the
congressional watchdog agency, is investigating the matter.
A CFTC spokesman said the agency believes
the dispute is a technical accounting issue and is waiting for the
GAO to weigh in before the CFTC acts to address it. A KPMG spokesman
declined to comment on the matter, citing client confidentiality.
The Financial Reporting Council
has launched an investigation into KPMG's auditing of the
Co-operative Bank. The FRC, the disciplinary body for accountants
and actuaries in the UK, will investigate the preparation, approval
and audit of the financial statements of the Co-op Bank, up to the
year ended 31 December 2012. The Co-op Bank was forced to withdraw a
bid to buy 632 Lloyds Banking Group last year when it discovered a
£1.5bn capital black hole. Earlier this month the FCA and Prudential
Regulation Authority announced they are launching enforcement
investigations into the Co-op Bank.
The Co-op Bank is also subject to
an internal review, an independent Treasury-commissioned inquiry and
a Treasury select committee inquiry into the failed Lloyds' branches
bid. There is also a police investigation into former Co-op Bank
chair Reverend Paul Flowers over drug allegations last year. In
December partners at KPMG were grilled by Treasury select committee
MPs over KPMG's role in the Co-op's takeover of Britannia Building
Society and its financial troubles. Following the FRC investigation,
the body will decide whether to bring disciplinary proceedings and
if so will refer the matter to a disciplinary tribunal, which can
impose sanctions and costs orders.
A spokeswoman for KPMG says:
"Given the issues which the bank has experienced in recent months
and in the light of the high media profile and public interest
associated with these issues, it is understandable that there should
be appropriate regulatory scrutiny. "As auditor to the bank we
believe that we have provided, and continue to provide, robust
audits which provide rigorous challenge to the judgments and
disclosures proposed by the bank's management. "We look forward to
co-operating fully with the FRC and other regulatory authorities in
their investigations."
"The
investigation was sparked by auditors at KPMG Fides Peat in
Switzerland working for the Swiss Federal Banking Commission in 2004
after they stumbled upon documents detailing the transfer of €20
million by Alstom into various shell companies, according to The
Wall Street Journal".
KPMG is getting into venture-capital investing,
according to an article today in the Times of London. It’s one more
signthat the
Big Four audit firms are moving beyond traditional accounting
services and getting themselves into other more far-flung endeavors.
The
newspapersaid
the fund, called KPMG Capital, will be based in London and “will
invest predominantly in small British and American data and
analytics businesses.” We can presume that KPMG would be smart
enough to avoid auditing the books at places where it invests,
although you never know.
Even if KPMG doesn’t audit the companies it owns, an obvious problem
is that KPMG inevitably will be in the position of funding companies
that compete against its own audit clients. That may not be a
violation of any rules, but it can create conflicting interests
nonetheless. (Then again, so can audit fees themselves, because the
client is paying the auditor.)
Adversarial relationships can be as damaging to the notion of
auditor independence as overly cozy ones. Plus, you have to wonder
if this even makes good business sense. If I were on the board at a
KPMG audit client and saw a KPMG-owned startup trying to take away
my company’s market share, I would want to drop KPMG and hire a
different firm.
This line from the Times article, quoting a senior KPMG partner
named Simon Collins, caught my attention in particular: “Mr. Collins
said that it would be `very difficult’ to provide audit services to
the companies it invested in -- `but we can incubate them, we can
advise them.’”
Let’s get this much straight: “Very difficult” is the wrong answer
here. The correct response is that it should be impossible. Any
first-year accounting student can tell you that auditors aren’t
supposed to audit companies in which they have ownership stakes.
But maybe we shouldn’t be surprised. In February 2011
the Securities and Exchange Commission
censuredKPMG’s
Australia affiliate over independence violations at two audit
clients with U.S.-registered securities. The SEC found the firm sent
staff members to work at an audit client under the client’s
supervision and direction. In another situation the firm was paid
commissions for promoting an audit client’s products and was
retained by the client to provide legal services.
In another case, the SEC in 2005 settled with KPMG’s
Canadian affiliate and two of its partners over audit-independence
violations at a
Colorado company, Southwestern Water Exploration Co. The firm
prepared some of the company’s basic accounting records and
financial statements and then audited its own work, the SEC said.
In 2002, the SEC censured KPMG because it purported to serve as the
independent auditor for a mutual fund at the same time it had
invested $25 million in the same fund. At one point KPMG accounted
for 15 percent of the fund’s assets, the SEC said. That was a
black-and-white violation of the auditor-independence rules.
Accounting firm KPMG has been selected by
the YAI/National Institute for People with Disabilities (NIPD)
Network as its "2005 Corporation of the Year" recipient.
The annual award was accepted by KPMG LLP
chairman and CEO Timothy P. Flynn at the agency's "Share the Joy"
gala in Manhattan this month. The YAI/NIPD Network is a network of
not-for-profit health and human services agencies for people with
developmental and learning disabilities.
"This award recognizes KPMG for their long
and continued commitment to helping create jobs for people with
disabilities, and also their support of YAI's fundraising
activities," said Dr. Joel M. Levy, CEO of the YAI/NIPD Network. "We
are thankful for their continued support, and we are pleased to
recognize KPMG as a firm that is dedicated to making a difference in
the lives of these individuals."
KPMG's Flynn commented, "KPMG has supported
the YAI/NIPD Network and its programs through volunteerism, board
participation and individual and corporate fundraising initiatives
for more than a decade. We are honored to be chosen for this
distinguished award and pleased to be among an impressive list of
past and present honorees."
Past honorees of the award have included
Pfizer, Avon Products, RJR Nabisco and Time.
In a break from other large U.S. accounting
firms, KPMG LLP offered a peek at its financial results for its most
recently completed fiscal year, though it stopped well short of
disclosing a complete set of financial statements.
KPMG, the fourth-largest U.S. accounting firm,
said it had $4.1 billion in revenue for the year ended Sept. 30, up 8%
from a year earlier. The New York-based firm, which is the U.S.
affiliate of KPMG International, also reported a 4% decline in profits
available for distribution to partners, though it declined to disclose
what its fiscal 2004 profits were. Globally, KPMG International said its
world-wide affiliates had $13.44 billion of combined revenue for fiscal
2004, up 15% from a year earlier.
Among the factors that weighed on the U.S.
firm's earnings were higher litigation costs, including settlements,
insurance costs and legal fees. In a statement, Eugene O'Kelly, KPMG
LLP's chairman and chief executive, said such costs "as a
percentage of revenue across the U.S. accounting profession are running
in the double digits, second only to compensation costs, a level that is
unsustainable for our profession in the long run."
KPMG, like the other major accounting firms,
faces a host of potentially costly lawsuits over its audit work for
companies that have disclosed accounting irregularities.
Additionally,
the U.S. firm's sales of allegedly abusive tax shelters remain the focus
of a criminal investigation by a federal grand jury in New York.
The firm says it is cooperating with investigators. Last week, KPMG
announced that U.S. District Judge Sven Erik Holmes of Tulsa, Okla., 53
years old, will join the firm as its vice chairman of legal affairs, a
new position from which he will direct the firm's office of general
counsel.
KPMG's decision to disclose its U.S. revenue --
and offer even a directional indication about U.S. profit -- represents
a departure from the recent practice at other major accounting firms.
Unlike corporations with parent-subsidiary structures, the Big Four
accounting firms are structured as loose alliances of independent
partnerships that belong to so-called global membership organizations.
Generally, their practice has been to announce member firms' combined
global revenue, broken down by continent.
Note that fraud "risk" warnings
are not the same as fraud warnings. It's a little like a local broadcast
of a tornado watch versus a tornado warning. A tornado warning reflects
an actual tornado is nearby whereas a tornado watch merely states that
conditions are ripe for the formation of a tornado that might or might
not actually be formed ---
http://en.wikipedia.org/wiki/Tornado_Watch
There's an old saying that the
Wizard's magic ball predicted every earthquake in Japan in the past 100
years. But then the Wizard's ball predicts an earthquake for each of 365
days of every year for earthquake-prone Japan.
HSBC Holdings Plc (HSBA),
Europe’s biggest lender, was warned twice
by auditors that entrusting as much as $8 billion in client funds to
Bernard Madoff
opened it up to “fraud and operational risks.”
KPMG LLP
told the London-based bank about the risks in 2006 and 2008 reports.
The firm was hired to review how Madoff invested and accounted for
the funds, for which HSBC served as custodian. KPMG reported 25 such
risks in 2006, and in 2008 found 28, according to copies of the
reports obtained by Bloomberg News, which was allowed access to them
on the condition they not be published.
Twenty-five
“fraud and related operational risks were identified throughout the
process whereby Madoff LLC receive, check and account for client
funds,” KPMG said in the 56-page report dated Feb. 16, 2006. The
limited controls in place “may not prevent fraud or error occurring
on client accounts if management or staff at Madoff LLC either
override controls or undertake activities where appropriate controls
are not in place,” according to the report.
A 66-page
KPMG report dated Sept. 8, 2008, cited 28 risks and described them
in the same words as the 2006 document.
Irving H.
Picard, the trustee liquidating Bernard L. Madoff Investment
Securities LLC, sued HSBC and a dozen feeder funds for $9 billion in
December in U.S. Bankruptcy Court in Manhattan. The suit was partly
based on the KPMG reports and alleges the bank knew of concerns
Madoff’s business was a fraud and didn’t protect investors. KPMG’s
reports haven’t been made public. Picard has filed more than $50
billion in so-called clawback suits to compensate victims. Reviews
‘Foiled’
In the
reports, KPMG didn’t present evidence the risks it identified had
materialized or that it found signs of actual fraud, and said HSBC
had told the firm “no allegations of fraud or misconduct have been
raised.”
HSBC
confirmed hiring KPMG in 2005 and 2008 to review Madoff’s firm,
adding it now believed Madoff had tricked the auditors. “It appears
from U.S. government filings that Madoff and his employees foiled
these reviews by, among other things, providing forged documentation
to KPMG,” the bank said in an e- mailed statement.
“KPMG did
not conclude in either of its reports that a fraud was being
committed by Madoff,” HSBC said. “HSBC did not know that a fraud was
being committed and lost $1 billion of its own assets as a victim.”
HSBC
Spokesman Patrick Humphris, KPMG spokesman Mark Hamilton and Amanda
Remus, a spokeswoman for Picard’s lawyers Baker & Hostetler LLP, all
declined to confirm the authenticity of the reports obtained by
Bloomberg. Custodian
At the time
of the first report, HSBC was custodian for eight funds that had
invested $2 billion with Madoff, KPMG said. By 2008, the bank was
custodian for 12 funds with as much as $8 billion invested.
“We
continue to believe that we have strong defenses to the claims made
against us and we will defend ourselves,” the London-based bank
added.
Tougher rules in Australia and overseas and
fatter audit fees have helped push KPMG's global revenue up 14.7 per
cent to $US13.44 billion ($17.58 billion) for the year to September 30.
The result shows that the demise of global
rival Andersen and the advent of tougher regulations forcing accounting
firms to focus on quality audit work have not hampered their growth.
Under the new conflict of interest rules, accountants are also picking
up non-audit work, such as advisory services and tax, from their
competitors' audit clients.
In Australia, KPMG's revenue rose 10.2 per cent
to $606 million in the year to June 30, 2004.
More than half came from the Australian firm's
audit and risk advisory service, which generated revenue of $346
million, up 10.5 per cent, as corporations called in experts on the
international financial reporting standards and the United States'
Sarbanes-Oxley Act.
Demand was also driven by Australian companies
adjusting to new regulations under the Corporate Law Economic Reform
Package (CLERP 9), which includes requirements for chief executives and
chief financial officers of listed companies to make declarations that
financial reports are in line with accounting standards and are true and
fair.
The fatter revenue also reflects increased
audit fees. These have been rising as all the big firms, except
Deloitte, have sold off their consulting practices to avoid being
tainted with accusations of conflicts of interest.
KPMG Australia's chief executive officer,
Lindsay Maxsted, said the increased revenue came from a mix of bigger
fees and higher demand from risk-averse company boards.
A survey by High Fliers Research of more
than 7,000 graduating university students has ranked audit, tax and
advisory firm KPMG as the top graduate employer out of 500 organisations. Double Entries, December 2, 2004 --- http://accountingeducation.com/news/news5680.html
Duke and Pace researchers shed light on corporate tax shelters A study by researchers from Duke University and
Pace University found that use of corporate tax shelters not only allows
organizations to avoid billions of dollars in annual tax payments, it
may also help companies artificially enhance their attractiveness to
investors by reducing levels of debt. The study also explores some
commonly used tax shelters and the characteristics of firms that have
employed these shelters. Finance professors John R. Graham of Duke's
Fuqua School of Business and Alan L. Tucker of Pace's Lubin School of
Business collected the largest known sample of tax shelters utilized by
corporations during the past 25 years.
"Duke and Pace researchers shed light on corporate tax shelters," Lubin,
December 22, 2004 ---
http://snipurl.com/DukePace
KPMG International announced the launch of the
Global Center for Leadership & Business Ethics, designed to
recognize those individuals who exhibit extraordinary business ethics
and leadership qualities.
The establishment of the Global Center follows
the announcement
that KPMG International had been named the Global Founding Partner of
the Nobel Peace Center in Oslo, Norway.
"As a demonstration of our fundamental
commitment to the principles of leadership, integrity and ethics, KPMG
is serving as a catalyst to establish an independent entity, the Global
Center, that will recognize those business leaders who reflect the
attributes of accomplishment and innovation," said Gene O'Kelly,
chairman and chief executive of KPMG LLP, the U.S. member firm.
O'Kelly said that the separate role of
Global Founding Partner of the Nobel Peace Center -- in combination
with the creation of the independently operated Global Center -- as well
as the Laureate & Award Medal Series comprises the "Global
Initiative on Leadership & Business Ethics."
The Global Center will manage and administer
the nomination process for the Laureate Award & Medal Series, which
will honor those who are committed to excellence in business ethics. The
processes, governance and nomination of the Laureate Award and Medal
Series are modeled on Nobel.
The Laureate Award will honor a leader who best
exemplifies business ethics and who has shown his or her commitment to
excellence. In addition to the Laureate Award, medals will be awarded
for Leadership, Corporate Governance, Reporting & Disclosure, Social
Responsibility and Education.
A chairman for the Global Center will be
appointed shortly, and a call for nominations for the Laureate Award
& Medal Series will follow. Winners will be determined in November
and the awards will be presented in December the same week that Nobel
prizes are given.
"One of our highest priorities at KPMG is
leading the restoration of credibility to the accounting
profession," said Timothy R. Pearson, vice chair, marketing and
communications, KPMG LLP. "The Global Initiative is inspired by the
spirit of the Nobel Prizes and the principles and guidelines of the
Nobel Foundation and the Norwegian Nobel Committee, and is aimed at
recognizing outstanding business leaders."
I do have a PwC Direct password, but I really doubt
that the Switzerland link is using a cookie.
In any case the home page of PwC does not require any
login ---
http://www.pwc.com/
The video is now on this home page.
This takes me back to the days when Bob Eliott,
eventually as President of the AICPA, was proposing great changes in
the profession, including SysTrust, WebTrust, Eldercare Assurance,
etc. For years I used Bob’s AICPA/KPMG videos as starting points for
discussion in my accounting theory course. Bob relied heavily on the
analogy of why the railroads that did not adapt to innovations in
transportation such as Interstate Highways and Jet Airliners went
downhill and not uphill. The railroads simply gave up new
opportunities to startup professions rather than adapt from
railroading to transportation.
Bob’s underlying assumption was that CPA firms could
extend assurance services to non-traditional areas (where they were
not experts but could hire new kinds of experts) by leveraging the
public image of accountants as having high integrity and
professional responsibility. That public image was destroyed by the
many auditing scandals, notably Enron and the implosion of Andersen,
that surfaced in the late 1990s and beyond ---
http://www.trinity.edu/rjensen/Fraud001.htm
The AICPA commenced initiatives on such things as
Systrust. To my knowledge most of these initiatives bit the dust,
although some CPA firms might be making money by assuring Eldercare
services.
The counter argument to Bob Elliot’s initiatives is
that CPA firms had no comparative advantages in expertise in their
new ventures just as railroads had few comparative advantages in
trucking and airline transportation industries, although the concept
of piggy backing of truck trailers eventually caught on.
I still have copies of Bob’s great VCR tapes, but I
doubt that these have ever been digitized. Bob could sell
refrigerators to Eskimos.
KPMG’s “Unusual Twist”
While KPMG's strategy isn't uncommon among corporations with lots of
units in different states, the accounting firm offered an unusual twist:
Under KPMG's direction, WorldCom treated "foresight of top management"
as an intangible asset akin to patents or trademarks.
See http://www.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud
Punch Line
This "foresight of top management" led to a 25-year prison sentence for
Worldcom's CEO, five years for the CFO (which in his case was much to
lenient) and one year plus a day for the controller (who ended up having
to be in prison for only ten months.) Yes all that reported goodwill in
the balance sheet of Worldcom was an unusual t
Two
former KPMG auditors agreed to be suspended from practicing before
the U.S. Securities and Exchange Commission after the financial
regulator charged them with improper professional conduct during an
audit of the since-closed College of New Rochelle in New York.
Christopher Stanley, a
former KPMG partner, has the right to apply for reinstatement after
three years. Jennifer Stewart, a former senior manager at the
auditing firm, can apply for reinstatement after one year. They
agreed to be suspended without admitting to or denying the SEC’s
findings.
The two were involved in the approval
of an unmodified audit opinion for the College of New Rochelle’s
2015 fiscal year financial statements, even though important audit
steps had not been completed, according to an SECnews
release. KPMG
encountered difficulty finishing the audit after the College of New
Rochelle’s controller provided inaccurate, incomplete and
contradictory information -- but the auditors nonetheless decided to
issue a report after the college’s president and controller told
them on Nov. 30, 2015, that a report was needed by the end of the
day, according to the SEC.
Resulting financial
statements overstated the College of New Rochelle’s net assets by
$33.8 million, according to the SEC. The statements were published
online as a disclosure to bond investors.
“Auditors of municipal
issuers are key gatekeepers in upholding the reliability and
integrity of financial information provided to investors in
municipal bonds,” Matthew S. Jacques, chief accountant of the SEC’s
enforcement division, said in a statement. “It is critical that they
exercise professional care and skepticism.”
The College of New Rochelle collapsed
after its financial problems became clear, announcing its closurein
2019. The SECchargedits
by-then-former controller with fraud that year. He was convicted of
securities fraud and failure to pay payroll taxes and sentenced to
three years in federal prison,according
tothe Westchester
& Fairfield County Business Journals.
Currently he is at a Brooklyn halfway house, the business journals
reported.
This is sad and timely given the sign stealing
scandals of the Houston Astros, Boston Redsox, and suspected other
teams.
In both KPMG and the MLB teams the instigators at the
top were punished (not enough). But it's really sad that more
punishments were not handed out down the line to people who knew about
the scandals and did not blow the whistle. Especially in the case of the
baseball scandals, the players that benefited the most (batting
averages, RBIs, etc.) seemingly will get off scott free when they should
be banned from professional baseball.
I'm almost certain that in the case of KPMG that
auditors down the line got wind of the scandal. They're still performing
audits.
From the CFO Journal's Morning Ledger on October 7, 2019
Former KPMG Executive Pleads Guilty in
‘Steal the Exam’ Scheme
A former partner at KPMG pleaded guilty for his role in the
“steal the exam” scandal that exposed major
weaknesses
at the Big Four accounting firm, the U.S. attorney for the Southern
District of New York said.
David Britt, who had his case severed from the other
partners charged in the scandal, admitted guilt to one count
of conspiracy to commit wire fraud, CFO Journal reports. The
charge carries a maximum sentence of 20 years in prison and
a maximum fine of $250,000, the attorney’s office said. Mr.
Britt’s sentencing is scheduled for May 2020.
From the CFO Journal's Morning Ledger on
January 23, 2019
An U.K. audit
watchdog is investigating KPMG LLP over
documents it submitted related to an audit
of Carillion PLC, the country’s second-largest
construction firm that collapsed a year ago after it failed to
restructure its debts.
The action, by the Financial Reporting Council, is the second
investigation into KPMG’s audits of Carillion. It comes amid
increased scrutiny of major auditors following a number of
high-profile corporate failures, writes Ms. Trentmann. The latest
investigation was launched in November but only became public
Tuesday.
It revolves around several documents KPMG submitted to the regulator
in 2017, before Carillion’s collapse. The FRC previously decided to
conduct a quality review of the audit KPMG conducted on Carillion’s
2016 results. Under this standard procedure, the regulator reviews
up to 160 audits of listed U.K. companies a year to assess the
quality of auditors’ work.
KPMG in November said some of the documents submitted to the FRC as
part of the review were problematic and notified the regulator, a
KPMG spokesman said.
From the CFO Journal's Morning Ledger on June 14 2019
KPMG
LLP is preparing to pay as much as $50 million to settle civil claims
related to the conduct of former partners who learned which of their
audits would be subject to surprise regulatory examinations,
according to people familiar with the matter.
Accountancy used to be boring –
and safe. But today it’s neither. Have the ‘big four’ firms become
too cosy with the system they’re supposed to be keeping in check?
In the summer of 2015, seven years after the
financial crisis and with no end in sight to the ensuing economic
stagnation for millions of citizens, I visited a new club. Nestled
among the hedge-fund managers on Grosvenor Street in Mayfair, Number
Twenty had recently been opened by accountancy firm
KPMG.
It was, said the firm’s then UK chairman Simon Collins in the fluent
corporate-speak favoured by today’s top accountants, “a West End
space” for clients “to meet, mingle and touch down”. The cost of the
15-year lease on the five-story building was undisclosed, but would
have been many tens of millions of pounds. It was evidently a price
worth paying to look after the right people.
Inside, Number Twenty is
patrolled by a small army of attractive, sharply uniformed serving
staff. On one floor are dining rooms and cabinets stocked with fine
wines. On another, a cocktail bar leads out on to a roof terrace.
Gazing down on the refreshed executives are neo-pop art portraits of
the men whose initials form today’s KPMG: Piet Klynveld (an early
20th-century Amsterdam accountant), William Barclay Peat and James
Marwick (Victorian Scottish accountants) and Reinhard Goerdeler (a
German concentration-camp survivor who built his country’s leading
accountancy firm).
KPMG’s
founders had made their names forging a worldwide profession charged
with accounting for business. They had been the watchdogs of
capitalism who had exposed its excesses. Their 21st-century
successors, by contrast, had been found badly wanting. They had
allowed a series of US subprime mortgage companies to fuel the
financial crisis from which the world was still reeling.
“What do
they say about hubris and nemesis?” pondered the unconvinced insider
who had taken me into the club. There was certainly hubris at Number
Twenty. But by shaping the world in which they operate, the
accountants have ensured that they are unlikely to face their own
downfall. As the world stumbles from one crisis to the next, its
economy precarious and its core financial markets inadequately
reformed, it won’t be the accountants who pay the price of their
failure to hold capitalism to account. It will once again be the
millions who lose their jobs and their livelihoods. Such is the
triumph of the bean counters.
The demise of sound accounting
became a critical cause of the early 21st-century financial crisis.
Auditing limited companies, made mandatory in Britain around a
hundred years earlier, was intended as a check on the so-called
“principal/agent problem” inherent in the corporate form of
business. As Adam Smith once pointed out, “managers of other
people’s money” could not be trusted to be as prudent with it as
they were with their own. When late-20th-century bankers began
gambling with eye-watering amounts of other people’s money, good
accounting became more important than ever. But the bean counters
now had more commercial priorities and – with limited liability of
their own – less fear for the consequences of failure. “Negligence
and profusion,” as Smith foretold, duly ensued.
After
the fall of Lehman Brothers brought economies to their knees in
2008, it was apparent that Ernst & Young’s audits of that bank had
been all but worthless. Similar failures on the other side of the
Atlantic proved that balance sheets everywhere were full of dross
signed off as gold. The chairman of HBOS, arguably Britain’s most
dubious lender of the boom years, explained to a subsequent
parliamentary enquiry: “I met alone with the auditors – the two main
partners – at least once a year, and, in our meeting, they could air
anything that they found difficult. Although we had interesting
discussions – they were very helpful about the business – there were
never any issues raised.
Six accountants, including former
partners at KPMG LLP, were arrested Monday morning and charged with
conspiring to defraud securities regulators and misuse of
confidential auditing information.
Federal prosecutors in Manhattan
alleged in a criminal indictment unsealed Monday that KPMG
executives recruited employees from the Public Company Accounting
Oversight Board to join the accounting firm, who then shared
confidential information about the PCAOB’s plans to audit the firm.
The
accounting watchdog has warned that it may launch an investigation
into KPMG over its audit of Carillion, the construction and services
group that has collapsed into liquidation putting thousands of jobs
at risk.
The Financial
Reporting Council said that it would “follow due process and will
make a further statement on this matter shortly”.
KPMG, which has
audited Carillion since its creation in 1999, came under fire from
experts who questioned why the outsourcing company had imploded only
months after being given a clean bill of health for its 2016
accounts.
Prem Sikka,
professor of accounting and finance at Sheffield University,
said: “The accounts for 2016 were signed off on March 1, 2017, yet
by July the company was in serious trouble.
“The auditor
is supposed to satisfy itself that a company is a
going concern. It must look at cashflow forecasts and what kind of
margin of error is built in. It is very strange that within three to
four months the chief executive walked and the forecast was
erroneous.”
Tim Bush,
head of governance and financial analysis at Pirc, the investor
advisory service, questioned the large amount of intangible assets
on Carillion’s balance sheet and the IFRS standard used for
contracts, which allows companies to book revenues long before they
are generated. Both “might be relevant factors” in Carillion’s
collapse, he said.
A spokesman for
KPMG said that the firm had promised to “co-operate fully” with any
Financial Reporting Council inquiry, but emphasised that it had
acted “appropriately and responsibly”. KPMG said that it had stepped
up its work on Carillion over the summer. In June it had
“accelerated some of the audit procedures in relation to
underperforming construction contracts”, which involved “KPMG’s
internal contract specialists, including quantity surveyors”.
That work was
prompted by the company’s concerns about late payments on contracts.
It was taken into account by Carillion when it reported £845 million
of writedowns on construction contracts announced in its half-year
trading update on July 10, KPMG said.
Carillion issued
three profit warnings in five months last year, the first on July 10
when Richard Howson, its chief executive, also resigned. The second
was in September and the third was in November.
The company hired
EY, another accounting giant, to carry out a review of its finances
after its July profit warning. At the time, analysts said that the
move might help to shore up confidence in Carillion’s accounting
methods.
A spokesman for EY
said: “On July 14 the company appointed EY to support its strategic
review, with focus on cost reduction and cash collection.”
Carillion, whose
operations range from school meals to managing prisons, collapsed
into liquidation yesterday after its banks refused to extend credit
because of its debts and spiralling costs on several large projects.
The demise has led to uncertainty about almost 20,000 jobs in the UK
and the prospect that almost 30,000 people will suffer a cut to
their pensions.
Some believe that
there were warning signs about Carillion months before it revealed
that it was struggling in the summer. Pirc said in a research note
in April last year that Carillion’s “value of intangible assets,
including goodwill, exceeds the value of its net assets, meaning
that the company has negative tangible assets”.
The company was “highly dependent on extracting the value from its
intangible assets and goodwill”. Intangible assets are not physical
and can include patents, trademarks and intellectual property.
LONDON — "Big Four"
accounting firms KPMG and PwC have both been handed
multi-million-pound fines for auditing failures,
amid growing concerns about the quality of audits from the major
providers.
Auditor KPMG has been fined
more than $6.2 million (£4.8 million) by the US Securities and
Exchanges Commission (SEC) for failing to properly audit an energy
company that grossly overstated the value of its assets.
KPMG issued an unqualified
audit of oil and gas company Miller Energy Resources in 2011,
despite the fact that the company had overvalued various assets
bought in Alaska by 100 times their real worth. The facts presented
to auditors "should have raised serious doubts," the SEC said.
Separately, PwC was also
hit with a £5.1 million fine on Wednesday and "severely reprimanded"
by UK watchdog the Financial Reporting Council, after admitting
misconduct when auditing professional services company RSM Tenon
Group in 2011.
Earlier this year, the
watchdog issued a damning
report stating that KPMG, Deloitte and
Grant Thornton were producing below-quality audits. The fines will
do little to dispel fears that auditing standards are slipping,
leaving investors exposed.
All the largest CPA firms have been fined in the
USA by the PCAOB for negligence in auditing.
The sad thing is that repeat offenders seemingly
shrug off their relatively small PCAOB fines as being part of the
cost of being in the auditing business. In other words fines and
even adverse publicity don't seem to be working as intended. Civil
court actions such as the recent lawsuits against PwC exceeding a
billion dollars are more troublesome for the firms.
In the public sector the Government Audit Agency
(GAO) has a more disheartening approach. Just declare some enormous
"clients" like the Pentagon and the IRS as incapable of being
audited.
From the CFO
Journal's Morning Ledger on August 23, 2017
Where was Wells Fargo’s auditor?
Wells Fargo & Co.’s
external auditor KPMG should have served as the first line of
defense against the misbehavior that toppled the bank’s CEO and left
thousands of workers without jobs.
From the CFO Journal's Morning Ledger on June 29, 2017
SEC charges Obsidian Energy with accounting fraud The
Securities and Exchange Commission filed charges against Obsidian Energy
Ltd., the company’s former chief financial officer, and its former vice
president with accounting fraud. The executives allegedly reclassified
operating expenses as capital expenditures in order to make costs appear
lower and boost net income.
Jensen Comment
Sounds a little like the infamous WorldCom fraud that helped bring the Andersen
auditing firm down ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm
That fraud also entailed capitalizing costs that should have been expensed.
WarldCom executives were sent to prison.
From the CFO Journal's Morning Ledger on April 12, 2017
Scott Marcello was
supposed to be the man to redeem KPMG LLP’s audit business. Instead,
the 54-year-old and other top partners became the center of a
scandal that tarnished the firm’s reputation
Scott
Marcello was supposed to be the man to redeem KPMG LLP’s audit
business. Instead, he and other top partners became the center of a
scandal that tarnished the firm’s reputation.
The
accounting world was stunned last week when Mr. Marcello, KPMG’s top
audit official, was fired over a leak of confidential information.
The firm said Mr. Marcello, who turns 54 this month, and four other
partners were let go over the mishandling of a tip that gave the
firm improper advance word about which of its audits its regulator
planned to scrutinize in its annual inspections.
Mr.
Marcello, a three-decade veteran at the firm, was a highly regarded
and technically accomplished auditor, specializing in the intricate
financial statements of banks and insurers. He climbed the ladder at
KPMG to become the Big Four accounting firm’s vice chair of audit,
managing a workforce of thousands of auditors. After his 2015
promotion from national leader of the firm’s financial-services
practice, he faced the challenge of satisfying KPMG’s regulator, the
Public Company Accounting Oversight Board, which in recent years had
scored KPMG’S auditing performance below that of other big firms.
People
who know Mr. Marcello said they were surprised such an experienced,
knowledgeable auditor—someone who volunteered as a mission hospital
consultant in Africa, and has chaired a Christian school in
Connecticut—is accused of having gotten into such a fix.
“It’s a
huge and disappointing thing to happen to such a fine individual,”
said Dennis Beresford, former chairman of the Financial Accounting
Standards Board, the U.S. accounting rule-writing panel, who knows
Mr. Marcello from common ties to a professional organization. He
called Mr. Marcello “personable and extremely competent.”
Mr.
Marcello declined to comment to a Wall Street Journal reporter at
his Connecticut home. KPMG and the accounting board declined to
comment.
Details
of the leak to KPMG are still unclear, as are the precise roles that
Mr. Marcello and his deputy David Middendorf, who also was fired,
are alleged to have played in the process. But they were aware that
others at KPMG had received leaked information and “failed to report
the situation in a timely manner,” KPMG said in a statement Tuesday.
Lynne
Doughtie, the firm’s chairman and CEO, said KPMG has “zero tolerance
for such unethical behavior,” and KPMG has said it told the
accounting board about the matter as soon as top management learned
of it.
The
leaked information could have given KPMG a leg up in preparing for
the PCAOB’s inspection, widely seen as a key report card on the
quality of the firm’s audits. Among the Big Four accounting firms,
KPMG has had the highest number of deficiencies cited by the
accounting board in each of the past two years.
The leak
reflects the tension between the Big Four accounting firms and the
rigorous demands of the accounting board, which was created in the
wake of the Enron Corp. scandal.
Some
auditors have long felt stressed by the board’s inspections, feeling
their careers could be set back if the regulator finds problems with
too many of their audits. “They are all feeling the pain and the
frustration,” said Bob Conway, a former KPMG partner who later ran
the accounting board’s Southern California office.
Mr.
Marcello took over as KPMG’s vice chair of audit aft
er
several years in which the firm’s inspection results had steadily
worsened. The rate of deficient audits found by the PCAOB had risen
from 22% for 2010 to 54% for 2014.
Several
months before Mr. Marcello’s appointment, the accounting board
unsealed previously confidential criticisms that the firm had failed
to sufficiently evaluate information that could have contradicted
its audit conclusions—a public rebuke of the firm, similar to what
the regulator had done with other Big Four firms.
Mr.
Marcello cast the image of an auditor well prepared for the job: He
had deep knowledge of accounting practices through his auditing of
complex financial companies as well as a two-year fellowship at the
FASB, which also gave him experience as a rule maker and in dealing
with the Securities and Exchange Commission.
He was
“straight out of central casting,” said a person who had worked with
him. He was an everyman, “the exact opposite of flashy,” the person
said.
Mr.
Marcello wanted to find a way to provide more timely services to
companies and investors than an auditor’s typical annual audit
opinion on a company. “We’ve got to get to this place where we are
really dealing in the real time with the things that people use to
make important decisions,” he told an industry conference last
August.
Outside the accounting world, Mr. Marcello has volunteered as a
consultant for missionary hospitals in Africa and contributed to the
construction of a clinic for HIV-infected Kenyans, said Jon Fielder,
president of the African Mission Healthcare Foundation
Jensen
Comment Texas-based oil company Magnum Hunter
Resources Corporation appears to use KPMG. SOX legislation was intended
to prevent this from happening via added internal control testing by the
auditors
KPMG was at the bottom (worst) of the PCAOB's inspection
reports of the Big Four audit firms in 2015. KPMG also ended up in the bottom in
the UK in 2016.
Feb 3 Britain's accounting watchdog came under
further political pressure on Wednesday to undertake a full, independently
supervised investigation into the auditing of HBOS's accounts by KPMG before
the bank collapsed in 2008.
The Financial Reporting Council said last month it
would undertake an initial enquiry into how KPMG and its staff audited HBOS
before it went bust at the height of the financial crisis.
That announcement followed calls for a full probe
from Andrew Tyrie, chairman of parliament's Treasury Select Committee, who
on Wednesday intervened again to detail the conditions he wanted for the FRC
enquiry to "command public confidence".
"This work is long overdue. Furthermore, the
process by which the FRC has reached this decision, as well as the approach
it plans for its preliminary enquiries, both raise a number of concerns,"
Tyrie said in a letter to the FRC and released to the media.
The FRC, which had no immediate comment, looked at
aspects of KPMG's accounts of HBOS during 2013, but found no grounds to take
matters further.
In his letter, Tyrie asked why the FRC was still
only looking at two elements of the HBOS audit rather than undertaking a
broader review.
He said a review of the HBOS collapse by the Bank
of England and the Financial Conduct Authority published last November had
benefited from independent supervision.
"What provision will be made for independent and
external oversight of the FRC's enquiries into the auditing of HBOS ?"
Tyrie asked what deadline the FRC was working to,
and whether the findings will be published in full.
Continued in article
After KPMG paid $456 million in 2006 fines for selling phony tax
shelters, KPMG promised it would never happen again. Yeah Right!
Of all the
individuals and firms tied up in the scandal over bribery and
corruption at FIFA, scrutiny has so far largely escaped KPMG, the
soccer association’s external auditor.
The
accounting and consulting firm’s Swiss member is responsible not
only for the audit of the multibillion-dollar umbrella FIFA
organization, and has been since before the period under scrutiny by
U.S. and Swiss prosecutors, but also audits a large sample of member
associations around the world that receive FIFA funding on an annual
basis. KPMG also prepares a compilation of all financial reports
after the completion of each four-year World Cup cycle.
KPMG
was also the auditor and adviser for the official
Russia and
Qatar organizing committees when they
prepared the winning bids that are now targeted in corruption
investigations in the U.S. and Switzerland. KPMG continues to
support Russia’s organizing committee, while Qatar switched to Ernst
& Young in 2011.
A spokesman
from KPMG declined to comment. “As FIFA’s statutory auditor, we are
bound by professional confidentiality and have to refrain from any
comment regarding our client.”
Robert
Appleton, a former assistant United States attorney, a special
investigations counsel with Paul Volcker’s U.N. Iraqi Oil for Food
Commission Investigation and the former chief of the United Nations
Anti-Corruption Task Force, said KPMG absolutely should have caught,
and called out, these alleged illegal activities.
“There were
sufficient red flags of improper and highly suspicious payments, as
well as money transfers to and from officials and others, including
other highly questionable activities coupled with a history of
similar issues, that should have been identified and that should
have caused the auditors to highlight and report on them internally,
and recommend further investigation. This is especially the case in
light of the recent history of this organization, where recent
investigations already had found bribery and corruption activity,”
Appleton said.
Though not a publicly traded company, FIFA is
required by Swiss law to be audited by a
qualified firm because of its size as measured by revenue and number
of employees. KPMG Switzerland actually claims to be an expert in
not-for-profit association audits in Switzerland, including
sponsoring a
“competence center” to share knowledge
inside and outside the firm.
KPMG’s
audit is intended to express an opinion on whether the financial
statements, prepared by FIFA personnel according to International
Financial Reporting Standards, are free from material misstatements.
KPMG reviews the organization’s internal controls when deciding
which audit procedures to perform but did not, in this case, express
an opinion on the effectiveness of FIFA’s internal control system.
Jerry Silk,
a partner at law firm Bernstein Litowitz Berger and Grossman who has
represented investors in lawsuits against the global audit firms,
said the country-level member associations that pay dues to belong
to FIFA and participate in its programs and events are FIFA’s true
stakeholders.
“Even
though a few FIFA member associations were named in the indictment,
the vast majority of the national associations and their executives
are innocent of any wrongdoing. They have a fundamental right to
know what KPMG did or did not do as auditor to protect their
interests in the global association,” Silk said.
The
Department of Justice indictment states that the FIFA officials
conspired to solicit and receive well over $150 million in bribes
and kickbacks in exchange for their official “support.” This
“support” included influencing the award of marketing, broadcast
rights and sponsorship contracts to those who paid bribes and, in
one case, allegedly selling votes to award the 2010 World Cup to
South Africa. FIFA’s internal controls would govern which payments
require authorization and by what level of executive. Strict
controls would also prevent a payment to an executive’s personal
account if it is not a payroll transaction, for example, and would
provide special instructions for international wire transactions for
the bank and within FIFA.
Some
of those transactions went through FIFA headquarters and
used FIFA bank accounts to send money to
U.S. bank accounts controlled by the indicted officials, according
to the Justice Department. That means KPMG, as FIFA’s independent
external auditor, could have seen the transactions while performing
annual audit tests.
KPMG
selects activities and transactions to be tested based on their risk
of causing a material misstatement of financial reports. The
transactions highlighted by the DOJ indictment may not have met
KPMG’s materiality threshold, given the size of the organization.
FIFA recorded more than
$3 billion in revenue in 2014. However,
Silk is
surprised that after all this time working so closely with FIFA,
KPMG would not have uncovered evidence of the illegal acts the DOJ
is now alleging.
“With all
the prior allegations of corruption and bribery leveled against FIFA
and some of its member associations over the years, KPMG should have
been on high alert to the potential for corruption,” he said.
“Auditors are supposed to do more and be more vigilant when there’s
clearly higher risk.”
Accounting
firms often contend that their audits are only as good as the
information they receive from clients, but they are supposed to
recognize patterns or anomalies that suggest they should dig a
little deeper.
A key
element in the Justice Department’s case is a $10 million payment
that prosecutors say was transferred in 2008 from FIFA to accounts
controlled by a soccer official, Jack Warner, as a bribe in exchange
for helping South Africa secure the right to host the 2010 World
Cup.
Mr. Epstein
said that while the $10 million payment could be insignificant, or
immaterial in accounting terms, given FIFA’s size, it would not be
immaterial in qualitative terms. “That’s something people would want
to know about,” he said.
KPMG had
questioned another payment a decade earlier. In a 1999 “Revised
Audit Management Letter” sent to FIFA, KPMG noted an unusual payment
in connection with the Confederations Cup — an important tournament
involving soccer’s continental champions that is now held the year
before the World Cup.
“To cover
the excess expenditure at the Confederations Cup in Saudi Arabia,
the organizer has made an additional payment of 470,000 Swiss
francs,” the letter, obtained by the independent journalist Andrew
Jennings, says in German. “The payment was authorized by the
president of FIFA, but without the authorization of the finance
committee or the executive committee.”
It is
unclear to whom the payment was made or which Confederations Cup in
Riyadh was involved — Saudi Arabia hosted them in 1995 and 1997,
part of the four-year financial cycle covered in the 1999 letter.
Even before
the indictments, there was no shortage of potential red flags.
In 2002,
Michel Zen-Ruffinen, FIFA’s secretary general at the time, wrote an
explosive report accusing Mr. Blatter and his lieutenants of
extensive fraud. The report, parts of which were published in the
Swiss news media, contended that from 1999 to 2002, FIFA, which was
struggling financially, booked 336 million Swiss francs in revenue
from its sale of marketing rights to the 2006 World Cup in Germany —
an unusual move for an organization that at the time used accounting
methods that recorded income when it was received, not in advance,
according to accounting experts.
KPMG noted
the move in its audit of the period. Mr. Zen-Ruffinen’s report added
that FIFA had destroyed financial documents before 1998, a year
before KPMG was hired.
In 2008, a
trial in Zug, Switzerland, of former executives of International
Sports and Leisure, a FIFA-affiliated marketing firm that had
collapsed amid allegations of fraud and theft, fell apart after the
group’s lawyers produced internal documents contending that FIFA was
involved.
By 2012,
FIFA named Michael J. Garcia, a prominent former federal prosecutor,
as the lead investigator of its ethics committee. Mr. Garcia, who
extended his inquiry into bidding practices for the 2018 World Cup
in Russia and the 2022 World Cup in Qatar, gave FIFA his final
report last September but resigned from the role in December after
FIFA released a redacted version that Mr. Garcia complained was
erroneous and misleading.
And last
November, a member of FIFA’s eight-person audit and compliance
committee, Canover Watson, was charged in his native Cayman Islands
with fraud and money laundering in connection with procurement of a
card-swipe system for the public hospitals there. FIFA’s most recent
annual report notes that Mr. Watson has “temporarily left the
committee.”
“You’re
looking for the tip of the iceberg in an audit,” Mr. Epstein said,
adding that in KPMG’s work for FIFA, “the tip should have gotten the
auditor’s attention sometime over the years.”
June 3, 2015 reply from Linda Kidwell in Romania
Bob,
All I can tell you from 3 months of living in a
country with a highly corrupt political elite is that bribery is unlike
other frauds for two reasons. One is that the money doesn’t pass through the
firm, so there’s no evidence within the financial records for the auditors
to find (though with the rife rumors, one would hope their engagement risk
assessments were high). The other is that only two parties know about the
bribery: the bribe payer and the bribe receiver. There may be no other
people in the know, eliminating the potential for whistle-blowing. This is
what the anti-corruption prosecutors here have told me. In the FIFA case,
because the bribe payers were groups instead of individuals, it may be there
was indeed a whistle-blower; conversely, someone on the board may have been
cut out of the take, leading to revenge. But either way, the money was
unlikely to flow through FIFA or any of its units.
On a related note, while I was here, the Dutch
embassy released a study of convicted corrupt politicians conducted by a
group of criminal justice students who interviewed them. The crux of their
findings is that the convicts readily admitted to every detail of their
corruption. They just didn’t think they’d done anything wrong, because
that’s just the benefit of being in power. If you think of the old fraud
triangle, the rationalization is completely unnecessary in a corrupt
environment.
The U.S. Securities and Exchange
Commission is charging a small Houston-based oil company with
accounting fraud and falsely inflating the values of its assets.
The SEC is levying the charges at
current Miller Energy’s Chief Operating Officer David M. Hall and
former Chief Financial Officer Paul W. Boyd, who left the company in
2011. The audit team leader at the company’s former independent
auditor also was charged.
The financially struggling
company, which focuses its exploration and production in Alaska, was
delisted from the New York Stock Exchange after July 30 because its
stock was trading under $1 a share since April 22. Miller Energy
relocated from Tennessee to Houston earlier this year.
The SEC’s Division of Enforcement
alleges that, after acquiring assets in Alaska’s Cook Inlet area in
late 2009, Miller Energy overstated their value by more than $400
million, boosting the company’s net income and total assets. The
allegedly inflated valuation turned a penny-stock company into one
that reached a 2013 high of nearly $9 per share, the SEC stated.
Law360, Los Angeles (April 14,
2015, 8:55 PM ET) -- A California judge on Tuesday denied KPMG’s bid
to dismiss billionaire investor Ronald Burkle’s $10 million suit
alleging the accounting firm led him to invest in tax shelters that
didn’t withstand scrutiny by state tax officials, saying Burkle’s
claims aren’t time-barred under the “simple logic” he couldn’t sue
before he was audited.
KPMG had argued in its demurrer to
Burkle’s second amended complaint that the Yucaipa Cos. LLC managing
partner was on notice that the supposed tax shelters were
ineffective in 2007, when he reached a...
Continued at
What happened to KPMG's 2007 promise to no longer
sell questionable tax shelters?
Federal prosecutors indicted 19 individuals on tax-fraud charges in 2005
for their roles in the sale and marketing of bogus shelters . . .
KPMG admitted to criminal wrongdoing but
avoided indictment that could have put the tax giant out of business.
Instead, the firm reached a deferred-prosecution agreement that included
a $456 million penalty. Last week, the federal court in Manhattan
received $150,000 from Mr. Makov as part of a bail modification
agreement that allows him to travel to Israel.
Paul Davies, "KPMG Defendant to Plead Guilty," The Wall Street
Journal, August 21, 2007; Page A11
KPMG and its chief operating
officer James Marsh have been fined by the Financial Reporting
Council for breaching ethical standards
The auditing firm and its
executive were taken to tribunal over Marsh's failure to sell shares
in Cable and Wireless Worldwide when he became a partner of KPMG in
2011.
The telecoms giant, where Marsh
had previously “been in a position to exert significant influence
over the financial statements” was a client of the Dutch financial
firm.
The tribunal agreed this was a
form of misconduct, and fined Marsh £60,000, though this has been
reducd to £39,000 to reflect his admissions.
KPMG was fined £350,000, though
this was similarly reduced to £227,000. In addition KPMG agreed to
pay the majority of the FRC’s costs.
Paul George, executive director of
conduct at the FRC, said: “I welcome the sanctions imposed by the
tribunal in these matters which serve to emphasise the central
importance of the ethical standards for auditors to the audit
process.
“As the tribunal observes, they
are at the very heart of trust in the audit process on which public
confidence in capital markets and the conduct of public entities
depends.”
The 28 deficient audits were out of 52 KPMG
audits and partial audits reviewed by the Public Company Accounting
Oversight Board in its annual inspection report issued Tuesday, for
a deficiency rate of 54%. That is up from a year ago, when PCAOB
inspectors found 23 deficient audits out of 50 reviewed, for a rate
of 46%.
Continued in article
KPMG's 2014 PCAOB Inspection Report Is Out and It's Not Good
Teaching Case from The Wall
Street Journal Weekly Accounting Review on October 31, 2014
SUMMARY: The
23 deficient audits the Public Company Accounting Oversight Board
found in its 2013 inspection of the firm, were out of 50 audits or
partial audits conducted by KPMG that the PCAOB evaluated - a
deficiency rate of 46%. In the previous year's inspection, the PCAOB
found deficiencies in 17 of 50 KPMG audits inspected, or 34%. The
report spotlights the PCAOB's continuing concerns about audit
quality. Overall, 39% of audits inspected in the latest evaluations
of the Big Four firms - KPMG, PricewaterhouseCoopers LLP, Deloitte &
Touche LLP and Ernst & Young LLP - were found to have deficiencies,
compared with 37% the previous year.
CLASSROOM APPLICATION: This
is useful for an auditing class to present recent results of PCAOB
inspections.
QUESTIONS:
1. (Introductory) What is the PCAOB? What is its function?
2. (Advanced) What are the "Big Four" accounting firms?
What are the results of the annual inspections of the Big Four
accounting firms? Did one firm perform better than others?
3. (Advanced) What is the purpose of these inspections?
What do the inspectors do? What is a deficiency? What do the firms
do with the inspection results?
4. (Advanced) What happens once these results are
determined? Are the financial statements changed as a result of
these inspections? Are the firms sanctioned?
5. (Advanced) The article notes that the PCAOB has made
public what was previously secret criticism of the firms. Why were
those previous results secret? Should this information be secret?
Why or why not?
6. (Advanced) Should these results impact the reputations
of the Big Four firms? Why or why not? How should the firms handle
these public revelations?
Reviewed By: Linda Christiansen, Indiana University
Southeast
Audit regulators found deficiencies in 23
of the KPMG LLP audits they evaluated in their latest annual
inspection of the Big Four accounting firm’s work.
The 23 deficient audits the Public Company
Accounting Oversight Board found in its 2013 inspection of the firm,
released Thursday, were out of 50 audits or partial audits conducted
by KPMG that the PCAOB evaluated—a deficiency rate of 46%. In the
previous year’s inspection, the PCAOB found deficiencies in 17 of 50
KPMG audits inspected, or 34%.
In a statement responding to the PCAOB
inspection, KPMG said, “We are always mindful of our responsibility
to the capital markets, and we are committed to continually
improving our firm and to working constructively with the PCAOB to
improve audit quality.”
The 23 deficiencies were significant enough
that it appeared KPMG hadn’t obtained sufficient evidence to support
its audit opinions that a company’s financial statements were
accurate or that it had effective internal controls, the PCAOB said.
A deficiency in the audit doesn’t mean a company’s financial
statements were wrong, however, or that the problems found haven’t
since been addressed.
Still, the report spotlights the PCAOB’s
continuing concerns about audit quality. Overall, 39% of audits
inspected in the latest evaluations of the Big Four firms—KPMG,
PricewaterhouseCoopers LLP, Deloitte & Touche LLP and Ernst & Young
LLP—were found to have deficiencies, compared with 37% the previous
year.
In addition, all of the Big Four have now
seen the PCAOB make public some of its previously secret criticisms
of the firms. Separately from the latest report, the PCAOB on
Thursday unsealed previously confidential criticisms of KPMG’s
quality controls it had made in 2011 and 2012, mirroring previous
moves the board had made with regard to PwC, E&Y and Deloitte. The
unsealing amounts to a public rebuke to KPMG for not acting quickly
enough to fix quality-control problems, in the regulator’s view.
In the unsealed passages, the board said
some of the firm’s personnel had failed to sufficiently evaluate
“contrary evidence” that seemed to contradict its audit conclusions.
In the latest inspection report, among the
areas in which the PCAOB found audit deficiencies at KPMG were
failure to sufficiently test companies’ loan-loss reserves, testing
of companies’ valuations of hard-to-value securities, and audits of
certain kinds of derivatives transactions.
The PCAOB didn’t identify the clients
involved in the deficient audits, in accordance with its usual
practice.
PCAOB inspectors evaluate a sample of
audits every year at each of the major accounting firms—focused on
those the board believes are at highest risk for problems. Because
of that focus, the PCAOB says the inspection results may not reflect
how frequently a firm’s overall audit work is deficient. The
inspections are intended only to evaluate the firms’ performance and
highlight areas for potential improvement, so the firms aren’t
subject to any penalties.
Only part of the inspection reports
typically becomes public. A separate portion, with the PCAOB’s
criticisms of the firm’s quality controls, is kept confidential to
give the firm an opportunity to address any concerns. If the firm
does so, that portion of the report stays sealed permanently.
If the firm doesn’t do enough to satisfy
the PCAOB within a year, however, the board makes the concerns
public. Again, though, the unsealing doesn’t carry any formal
penalties for the firms.
Jensen Comment
I keep recalling the 1990s when KPMG Executive Partner and AICPA
President Bob Elliott more than any other accountant made a public pitch
that the big accounting firms could expand their services beyond
auditing (remember Elder Care and SysTrust) because the auditing
profession more than any other profession had a reputation for
competence, quality, and integrity. The Big Four firms, especially
KPMG, have nearly destroyed that reputation.
http://www.trinity.edu/rjensen/Fraud001.htm
Maybe audit quality really hasn't
declined so much. Instead it may be that no regulatory agencies really
investigated audit firm quality controls before the PCAOB was created.
In the good old days audit quality was mostly regulated by separate
professional boards in the 50 states. For example, the New York Society
of CPAs only suspended the licenses for auditors convicted of drunk
driving. The same state agency that regulated audit firms in Florida
also regulated funeral parlors and para psychologists.
From the CFO Journal's Morning Ledger on January 27. 2014
KPMG settles SEC
charges KPMGhas
agreed to pay $8.2 million to settle SEC allegations that the Big
Four accounting firm violated rules intended to keep outside
auditors from getting too close to their clients,
the WSJ reports.
KPMG provided nonaudit services such as bookkeeping and payroll to
affiliates of two of its audit clients, the SEC said, and the firm
also hired a recently retired senior-level tax counsel of a third
audit client’s affiliate only to lend him back to the affiliate to
do the same work. KPMG didn’t admit or deny wrongdoing in agreeing
to the settlement.
The Securities and Exchange
Commission today charged public accounting firm KPMG with
violating rules that require auditors to remain independent from
the public companies they’re auditing to ensure they maintain
their objectivity and impartiality.
The SEC
issued a separate report about the
scope of the independence rules, cautioning audit firms that
they’re not permitted to loan their staff to audit clients in a
manner that results in the staff acting as employees of those
companies.
An SEC investigation found
that KPMG broke auditor independence rules by providing
prohibited non-audit services such as bookkeeping and expert
services to affiliates of companies whose books they were
auditing. Some KPMG personnel also owned stock in companies or
affiliates of companies that were KPMG audit clients, further
violating auditor independence rules.
KPMG agreed to pay $8.2
million to settle the SEC’s charges.
“Auditors are vital to the
integrity of financial reporting, and the mere appearance that
they may be conflicted in exercising independent judgment can
undermine public confidence in our markets,” said John T. Dugan,
associate director for enforcement in the SEC’s Boston Regional
Office. “KPMG compromised its role as an independent audit firm
by providing prohibited non-audit services to companies that it
was supposed to be auditing without any potential conflicts.”
According to the SEC’s order
instituting settled administrative proceedings, KPMG repeatedly
represented in audit reports that it was “independent” despite
providing services to three audit clients that impaired KPMG’s
independence. The violations occurred at various times from
2007 to 2011.
According to the SEC’s order,
KPMG provided various non-audit services – including
restructuring, corporate finance, and expert services – to an
affiliate of one company that was an audit client. KPMG
provided such prohibited non-audit services as bookkeeping and
payroll to affiliates of another audit client. In a separate
instance, KPMG hired an individual who had recently retired from
a senior position at an affiliate of an audit client. KPMG then
loaned him back to that affiliate to do the same work he had
done as an employee of that affiliate, which resulted in the
professional acting as a manager, employee, and advocate for the
audit client. These services were prohibited by Rule 2-01 of
Regulation S-X of the Securities Exchange Act of 1934.
The SEC’s order finds that
KPMG’s actions violated Rule 2-02(b) of Regulation S-X and Rule
10A-2 of the Exchange Act, and caused violations of Section
13(a) of the Exchange Act and Rule 13a-1. The order further
finds that KPMG engaged in improper professional conduct as
defined by Section 4C of the Exchange Act and Rule 102(e) of the
Commission’s Rules of Practice. Without admitting or denying
the findings, KPMG agreed to pay $5,266,347 in disgorgement of
fees received from the three clients plus prejudgment interest
of $1,185,002. KPMG additionally agreed to pay a penalty of
$1,775,000 and implement internal changes to educate firm
personnel and monitor the firm’s compliance with auditor
independence requirements for non-audit services. KPMG will
engage an independent consultant to evaluate such changes.
The SEC’s investigation
separately considered whether KPMG’s independence was impaired
by the firm’s practice of loaning non-manager tax professionals
to assist audit clients on-site with tax compliance work
performed under the direction and supervision of the clients’
management. While the SEC did not bring an enforcement action
against KPMG on this basis, it has issued a report of
investigation noting that by their very nature, so-called
“loaned staff arrangements” between auditors and audit clients
appear inconsistent with Rule 2-01 of Regulation S-X, which
prohibits auditors from acting as employees of their audit
clients.
The report also emphasized:
An auditor may not
provide otherwise permissible non-audit services (such as
permissible tax services) to an audit client in a manner
that is inconsistent with other provisions of the
independence rules.
An arrangement that
results in an auditor acting as an employee of the audit
client implicates Rule 2-01 regardless of whether the
accountant also acts as an officer or director, or performs
any decision-making, supervisory, or ongoing monitoring
functions, for the audit client.
Audit firms and audit
committees must carefully consider whether any proposed
service may cause the auditors to resemble employees of the
audit client in function or appearance even on a temporary
basis.
The SEC’s Office of the Chief
Accountant has a Professional Practice Group that is devoted to
addressing questions about auditor independence among other
matters. Auditors and audit committees are encouraged to
consult the SEC staff with questions about the application of
the auditor independence rules, including the permissibility of
a contemplated service.
“The accounting profession
must carefully consider whether engagements are consistent with
the requirements to be independent of audit clients,” said Paul
A. Beswick, the SEC’s chief accountant. “Resolving questions
about permissibility of non-audit services is always best done
before commencing the services.”
The SEC’s investigation was
conducted by Britt K. Collins, Dawn A. Edick, Michael Foster,
Heidi M. Mitza, and Kathleen Shields. The SEC appreciates the
assistance of the Public Company Accounting Oversight Board.
Teaching Case
From TheWall Street Journal Accounting Weekly Review on January
31, 2014
SUMMARY: "The Big Four firms have drawn attention
for their push to provide more consulting and nonaudit services in
recent years. They've been deriving much of their growth recently
from consulting, rather than from their core auditing businesses."
Regarding the $8.2 million in charge specifically, "KPMG provided
nonaudit services such as bookkeeping and payroll to affiliates of
two of its audit clients, the SEC said, and the firm also hired a
recently retired senior-level tax counsel of a third audit client's
affiliate only to loan him back to the affiliate to do the same
work. Those moves by KPMG between 2007 and 2011... , the commission
said, violated "auditor independence" rules...."
CLASSROOM APPLICATION: The article may be used in
an auditing or other professional accounting class to discuss
concerns about current trends in the public accounting profession
and the specific need for independence as a cornerstone of the
practice of accounting.
QUESTIONS:
1. (Introductory) List all actions in the article the SEC
alleges were committed by KPMG. Describe how each action might lead
to loss of independence from audit clients
2. (Advanced) Why do Securities and Exchange Commission
rules require auditors to maintain independence from audit clients?
3. (Advanced) Do any other rules besides the SEC require
independence of public accountants? Explain your answer and again
comment on the reason for this needed independence by accountants.
Reviewed By: Judy Beckman, University of Rhode Island
KPMG LLP agreed Friday to pay $8.2 million
to settle Securities and Exchange Commission allegations that the
Big Four accounting firm violated rules intended to keep outside
auditors from getting too close to their clients.
KPMG provided nonaudit services such as
bookkeeping and payroll to affiliates of two of its audit clients,
the SEC said, and the firm also hired a recently retired
senior-level tax counsel of a third audit client's affiliate only to
loan him back to the affiliate to do the same work.
Those moves by KPMG between 2007 and 2011,
the commission said, violated "auditor independence" rules that
require auditors to avoid conflicts of interest that could
compromise their ability to audit a company's financial statements
impartially and rigorously.
In addition, certain KPMG employees owned
stock in one of the clients and in affiliates of another, the SEC
said. The clients weren't identified.
KPMG didn't admit or deny wrongdoing in
agreeing to the settlement.
In a statement, KPMG said it is "fully
committed to ensuring our independence with respect to all of our
audit clients" and has implemented internal changes to help make
sure it complies with the independence rules.
The settlement spotlights concerns that
have lingered since the Enron Corp. scandal of more than a decade
ago, in which the now-defunct audit firm Arthur Andersen earned
lucrative fees from both auditing Enron and providing it with
consulting and other nonaudit services.
Many observers believed that affected
Andersen's impartiality as a watchdog of Enron's financial
statements during the scandal, and the Sarbanes-Oxley Act
subsequently barred audit firms from providing many types of
consulting and nonaudit services to their audit clients.
The SEC previously reached a separate but
similar settlement with KPMG's Australian affiliate in 2011, in
which the SEC alleged the affiliate had provided nonaudit services
to audit clients from 2001 to 2004. The Australian firm didn't admit
or deny any wrongdoing.
In addition to the KPMG settlement, the SEC
also issued a separate report warning audit firms that they aren't
permitted to loan staff to their audit clients if it results in the
staff acting as employees of the clients. The report was prompted by
an SEC investigation of KPMG's practices in that area—the commission
ultimately decided not to bring an enforcement action from its
probe, but said it was "appropriate and in the public interest" to
clarify the rules regarding loans of staff and how they might affect
an auditor's independence.
The Big Four firms have drawn attention for
their push to provide more consulting and nonaudit services in
recent years. They've been deriving much of their growth recently
from consulting, rather than from their core auditing businesses.
Revenues from KPMG's advisory business, for
instance, rose 4.8% in U.S. dollar terms in fiscal 2013, and tax
revenues rose 2.3%, compared with a 1% decline in audit revenues.
Even though the consulting-revenue growth
comes from companies that aren't audit clients, the trend has led to
concern among some critics.
"I think that this is an indication they're
more focused on the bottom line than they are on their audits," said
Lynn Turner, a former SEC chief accountant.
Though the Sarbanes-Oxley rules are
supposed to prevent any conflicts of interest from arising, the
critics contend the firms' increased concentration on consulting
still could be problematic, by leading them to lose focus on their
responsibilities as auditors.
The claims of about 450 women
remain pending, including the nine named plaintiffs, according to
Tuesday’s motion. The court filing noted that an average claimant
will receive around $16,000 under the settlement, with the exact
amount to be based on a set of criteria laid out in the agreement.
MORE THAN 140
current KPMG US fee-earning female staff have opted in to a lawsuit
against the firm.
Lawyers
contacted 9,000
current and former fee-earning female staff from KPMG in the US, in
October 2014, to join the
classaction. A
former KPMG manager, Donna Kassman, spent 17 years in the firm's New
York office before resigning, claiming that she and other women had
suffered gender discrimination.
Nearly 900 women have
currently opted into the case.
Of the 845 that have been processed
by class action representative Kate Kimpel, of law firm Sanford
Heisler, 142 are from existing staff. The opt-in period runs until
31 January.
Kimpel claimed that the number of
current
employeesthat had
already opted in was high. In similar instances, they tend to wait
until the end of the time period before opting-in, to gauge response
from their peers, she added.
"It's
easierfor previous
employees to opt in, they're less worried about retaliation. I'm
sure the number of current employees [opted in] will rise
dramatically," she told Accountancy Age.
KPMG has previously vigorously
denied the allegations in the claim against the firm. "We will not
comment on pending litigation, except to say that KPMG thoroughly
and repeatedly reviewed the allegations in this case and found them
totally unsupported by the facts," said a statement from a KPMG
spokesman.
For reasons that will be explained, the
Court also finds that BB&T is liable for tax penalties for its
participation in the STARS transaction. The conduct of those
persons from BB&T, Barclays, KPMG, and the Sidley Austin law
firm who were involved in this and other transactions was
nothing short of reprehensible. Perhaps the business
environment at the time was “everyone else is doing it, why
don’t we?” Perhaps some of those who participated simply were
following direction from others. Nevertheless, the professionals
involved should have known better than to follow the STARS path,
rife with its conflicts of interest, questionable pro forma
legal and accounting opinions, and a taxpayer with a seemingly
insatiable appetite for tax avoidance. One of Defendant’s
experts, Dr. Michael Cragg, aptly stated that “enormous
ingenuity was focused on reducing U.S. tax revenues.” Cragg, Tr.
4687. After wading through the intricacies of the STARS
transaction, the Court shares Dr. Cragg’s view that “[t]he human
effort, the amount of creativity and overall effort that was put
into this transaction . . . is a waste of human potential.”
Continued in article
Earnings Misstatements, Restatements and Corporate Governance
Abstract
We investigate the corporate governance characteristics of firm s
that restate previously-reported accounting data. Unlike other stud
ies that focus on either the misstatement or the restatement only,
we examine changes in the governance characteristics of restating
firms from the initial misstatement to the restatement. While the
other studies are concerned with the causes of financial
misreporting, we endeavor to obtain insight s into the changes that
lead to the detection and correction of such misreporting. We find
that prior to the misstatement, misstating firms are more likely to
have CEOs who sit on nominating committees, less independent boards
of directors, and less independent audit committees, relative to
control firms. Our results indicate that pre-misstatement agency
conflicts are not resolved prior to restatements. Boards and audit
committees of restating firms continue to be re latively less
independent at the time of the restatement. We also find that
restating firms are more likely to experience CFO turnover than
control firms. Based on the results, we conclude that the
restatements, which constitute an admission and correction of
accounting irregulari ties, are not attribut able to governance
improvements in firms.
. . .
When a company restates its financial
statements it is admitting to a material error or irregularity in
previously issued financial statements. In 2004, 414 public
companies restated their financial statements due to accounting
errors This represents a 28% increase over 2003 restatements and,
except for a 2% decrease in 2 003, it also represents the e
continuation of an increasing trend in the number of restated
financial statements by an average of 16% since 2000. In addition,
15% of the companies s restating their financial statements in 2004
had restated their financial statements at least one other time
times since 1997. However, even more troubling is the finding
that nearly 40% of the 2004 restatements re ported errors in at
least three prior annual reports (Huron Consulting Group, 2005).
These multi-year restatements point to recurring accounting errors.
Recurring errors and repeated restatements suggest that, in many
cases, it is difficult to resolve agency conflicts that lead to
misreporting of financial statements.
. . .
Our results also suggest that restating
firms are more likely to be audited by Big-6 auditors than are
control firms. This result calls into question the belief that audit
quality is always positively related to audit firm size (e.g.,
Palmrose 1988), and is consistent with regulators’ concerns (Roman
2002) that conflicts of interest ma y often impair the independence
of large audit firms. Finally our examination of how firms change
over the misstatement- restatement period indicates that restating
firms ar e more apt to change their CFOs than are the control firms.
While this result is consiste nt with new-CFO diligence, we cannot
exclude the possibility that accounting problems cause the old-CFO
departures. The latter explanation, nevertheless, underscores the
impor tant role that corporate gove rnance plays in the financial
reporting process.
Jensen Comment
It's important to remember that correlation is not necessarily
causation. My wife's superstar spine surgeon in Boston has a somewhat
higher record of surgical "errors" because he's willing to take on many
referrals that other spine surgeons will not touch due to high risks
such as older patients that are lousy candidates for 15-hour surgeries
and otherwise high risk delicate surgeries that can lead to
complications or death.
This guy is very, very good and has a lot of guts.
In a somewhat similar manner the "Big 6" audit firms take on clients
that smaller audit firms will not or cannot touch. The medical analogy
only goes so far. I don't think it's so much "guts" as it is having the
capability to do complicated audits. The "Big 6" may be the only auditor
firms with needed experts in specialized global operations, derivative
financial instruments experts, etc. where audit mistakes have a higher
probability of happening in spite of having the needed experts around
the world.
The "Big 6" are also sought out by some clients because they have the
deepest pockets when the audits get screwed up as when KPMG performed a
horrid audit of Fannie Mae that required Deloitte to make over a million
correcting journal entries.
From the CFO Journal's Morning Ledger on June 5, 2013
KPMG: Safeguards ‘sound and effective’
KPMG is completing an internal review that’s likely to result in
only minor changes to the accounting firm’s controls,
the WSJ’s Michael Rapoport reports.
The insider-trading scandal involving Scott London, a
former KPMG senior partner, prompted the firm to review its internal
safeguards, which the firm has said already were “world-class.” The review
is almost done, and the KPMG “will be considering possible enhancements to
our training and monitoring,” a spokesman said. But the review “supports the
conclusion that the fundamental architecture of our insider-trading policies
is sound and effective.” The firm’s code of conduct states that employees
“should not disclose any confidential or private information to third
parties.”
Jensen Comment
This is on the heels of KPMG having to pay out $153 million in a negotiated
settlement on its botched Fannie Mae audit (from which it was fired).
KMPG was fired
from what was arguably its largest client in history. Fannie Mae under a
bonus-seeking CEO perpetrated one of the largest earnings management frauds in
history ---
http://www.trinity.edu/rjensen/Theory02.htm#Manipulation
A former partner with accounting giant KPMG was
sentenced to 14 months in federal prison for giving confidential information
about his firm’s clients to a golfing buddy, who used it to make more than
$1 million in profits trading stocks.
Scott London, 51, pleaded guilty to insider trading
last year, admitting that he gave confidential information about KPMG
clients, including Herbalife Ltd. and Skechers USA Inc., to his
stock-trading friend several times from October 2010 to May 2012.
U.S. District Judge George Wu issued the sentence
Thursday in Los Angeles. He also ordered London to pay a $100,000 fine.
Defense attorney Harland Braun had argued for a
sentence of 6 to 12 months, noting that his client had already paid dearly
for his crime: losing his $900,000-a-year job, his reputation and a host of
KPMG friends who are not permitted to talk to him.
The prosecutor in the case, Assistant U.S. Atty.
James A. Bowman, said three years was appropriate because of the significant
violation of London’s duties to his clients and the damage it caused them.
Herbalife and Skechers were required to hire new accounting firms and
restate their earnings after learning of London’s actions.
London benefited from the crimes. As a reward for
the tips, London’s friend, Bryan Shaw, gave him thousands of dollars in
cash, concert tickets and jewelry, including a Rolex watch, prosecutors
said.
London was a senior partner at KPMG in charge of
the audit practice for clients in California, Arizona and Nevada. He also
personally oversaw audits of Herbalife and Skechers.
He gave Shaw inside information at least 14 times,
reading him news releases before they were issued, telling him about planned
acquisitions and giving him advance word about company earnings, prosecutors
said.
The tips enabled Shaw to make numerous profitable
trades.
Shaw snapped up thousands of Herbalife shares in
the weeks before a May 2011 announcement of the company's record sales,
prosecutors said. The news drove Herbalife shares up 13%. Shaw sold his
shares within days, netting about $450,000 in profit.
In February 2012, London told Shaw that KPMG client
Pacific Capital Bancorp was about to be acquired by Union Bank, prosecutors
said. Pacific Capital's shares soared 57% when the news was announced in
March 2012. Shaw made $365,000.
The scheme unraveled after regulators became
suspicious of Shaw’s well-timed trades. He later agreed to cooperate in an
investigation of London, secretly recording their conversations and handing
him an envelope stuffed with cash while FBI agents snapped photographs.
Shaw, who has also pleaded guilty, is scheduled to
be sentenced May 19.
In April 2012, KPMG shocked the financial world by
announcing it had fired London and withdrawn several past audits of
Herbalife and Skechers. The criminal case was filed a few days later.
SUMMARY: Following the admission by Scott
London--former KPMG senior partner responsible for the Herbalife
Ltd., Skechers USA Inc. , and other audit engagements-that he
disclosed inside information to a friend, KPMG reviewed its internal
control systems. System controls in place are described by the firm
as 'world-class' and "...the review 'supports the conclusion that
the fundamental architecture of our insider trading policies is
sound and effective,'...." The article then describes the actions
taken by the firm to inform its clients before they might learn on
the news of accusations about Mr. London's actions.
CLASSROOM APPLICATION: The article may be used in
an auditing class or in another class covering internal control
systems.
QUESTIONS:
1. (Introductory) Who is Scott London? To what wrongdoing
has he admitted?
2. (Advanced) What is the objective of internal controls at
public accounting firms?
3. (Introductory) According to the article, what are some
of the internal control procedures in place at KPMG?
4. (Advanced) Given the actions to which Mr. London has
confessed, how can KPMG conclude that its own internal control
systems are "sound and effective" as stated in the title?
5. (Introductory) At how many of the large public
accounting firms have there been cases of insider trading?
6. (Introductory) According to the article, what factors
have led to KPMG not having lost significant numbers of clients due
to this debacle? In your answer, comment on who selects a company's
auditor.
KPMG LLP is completing an internal review
that is likely to result in only minor changes to the accounting
firm's controls in the wake of an insider-trading scandal.
Scott London, a former KPMG senior partner,
last week agreed to plead guilty to securities fraud after admitting
in April that he had passed confidential information on Herbalife
Ltd., HLF +1.66% Skechers USA Inc. SKX +0.36% and other KPMG
auditing clients to a friend, who made profits by illegally trading
on the tips.
Mr. London is expected to enter his plea in
court in the next few weeks.
The case prompted KPMG to review its
internal safeguards, which the firm has said already were
"world-class." They include training for employees, a whistleblower
system and monitoring of the personal investments of partners and
managers. All KPMG employees must agree annually to comply with the
firm's code of conduct, which prohibits insider trading and warns
against practices that could lead to the release of confidential
client information.
The review is nearing completion, and the
firm "will be considering possible enhancements to our training and
monitoring," a KPMG spokesman said. But the review "supports the
conclusion that the fundamental architecture of our insider trading
policies is sound and effective," he said.
The firm's code of conduct states that
employees "should not disclose any confidential or private
information to third parties." Even with other KPMG partners and
employees, such information should be shared only on "a need-to-know
basis." Documents with confidential information are supposed to be
placed in secure bins for shredding when they are disposed of.
Mr. London has said KPMG had no involvement
in the scheme. Nevertheless, the firm acted quickly to protect its
reputation and prevent any loss of clients when it learned of Mr.
London's conduct.
In a matter of hours, KPMG moved to tell
clients the news, before they could find it out elsewhere. The firm
even tracked down a client in Tokyo, and issued a news release to
inform the public after 9 p.m. on a Monday night. KPMG's message:
Mr. London was a rogue partner who flouted its rules, an isolated
case that wasn't reflective of the firm.
Clients said the quick response was
critical. "There would have been nothing worse than reading it in
the paper before I got a call," said Lester Aaron, chief financial
officer of Unico American Corp., UNAM +0.85% a Woodland Hills,
Calif., insurance company that uses KPMG as its auditor.
The outreach is one major reason KPMG has
been able to avoid serious damage to its reputation, attorneys and
accounting experts said. KPMG hasn't lost any audit clients in the
Pacific Southwest region, where Mr. London headed the firm's audit
practice and where a tally by The Wall Street Journal suggests KPMG
has about 40 clients. Many of them have publicly reiterated their
support for KPMG since the London incident by issuing proxy
statements recommending that shareholders ratify the company's
continuing use of the firm.
Another reason KPMG has emerged relatively
unscathed: Clients and investors recognize how hard it is for even
the most-stringent safeguards to prevent all misconduct, and realize
that such cases could happen at their own companies, some say.
"As long as it appears to be a one-off, a
rogue employee, they're not going to take a hit," said Charles
Elson, a corporate-governance expert at the University of Delaware.
"Only if you can demonstrate the issue is systemic should it have
any impact on them."
There was "disappointment and a sense of
betrayal" in KPMG's Los Angeles practice after Mr. London's conduct
was disclosed, said a person familiar with the situation, but the
practice has since "gotten back to business."
Harland Braun, Mr. London's lawyer, doesn't
dispute KPMG's characterization of his client as a lone wolf, but he
noted Mr. London came clean quickly once he was exposed. Mr. Braun
said the confession freed up KPMG to move to prevent any damage.
If Mr. London had contested the case
against him, "the thing could have dragged on for months," Mr. Braun
said, hurting the firm and causing uncertainty for its clients.
"There would have been no way for KPMG to protect itself if Scott
kept his mouth shut."
Companies' reluctance to bolt also might
reflect the sometimes entrenched, long-term relationships between
companies and audit firms, some auditing experts said. Many
companies have used the same auditor for decades or even a century
or more. Critics have said that leads to coziness that can threaten
the independence of an audit. Some favor "term limits" for audit
firms, which the accounting industry opposes.
Continued in article
Jensen Comment
KMPG was fired from what was arguably its largest client in history. Fannie Mae
under a bonus-seeking CEO perpetrated one of the largest earnings management
frauds in history ---
http://www.trinity.edu/rjensen/Theory02.htm#Manipulation
Fannie Mae FNMA +9.76% and its former auditor KPMG
LLP agreed Tuesday to pay $153 million to settle a long-running class-action
lawsuit in which Ohio public pension funds and other shareholders accused
the company of issuing false and misleading financial reports in the early
2000s.
The settlement was reached through mediation,
according to documents filed in federal court in Washington, and is subject
to court approval. Fannie and KPMG will each pay half of the $153 million.
"We are satisfied with the outcome and pleased to
put the matter behind us," said Bradley Lerman, general counsel at Fannie
Mae.
Seth Oster, a KPMG spokesman, said that it was in
the firm's best interest to "avoid the significant additional costs and the
distraction and inherent uncertainty of protracted litigation." A person
familiar with the situation said KPMG has already accounted for the
settlement.
The litigation began in 2004 after federal
regulators accused Fannie of violating accounting rules, partly in a bid to
boost executives' bonuses, and ordered the company to restate four years'
worth of earnings. The regulators said Fannie had incorrectly applied the
rules relating to derivatives contracts to allow it to spread out losses
over a long period of time instead of recognizing them upfront.
The class-action suit had also named Franklin
Raines, Fannie's former chief executive, as a defendant, but last year U.S.
District Judge Richard Leon dismissed the suit against Mr. Raines and two
other senior executives. The judge said the plaintiffs hadn't produced any
direct evidence showing that executives intended to deceive investors or
even that executives knew their statements were false.
The Ohio Public Employees Retirement System and the
State Teachers Retirement System of Ohio were the lead plaintiffs in the
lawsuit. Ohio Attorney General Mike DeWine, who announced the settlement,
said in a statement that he was "pleased to see this litigation finally
resolved" and that it "brings closure to this matter."
The settlement "represents a reasonable agreement
to end this long-standing dispute," said Alfred Pollard, general counsel for
the Federal Housing Finance Agency, which regulates Fannie.
Fannie Mae sued KPMG in 2006 alleging negligence
and breach of contract. The two sides reached a settlement in 2010; details
of that settlement weren't disclosed.
Fannie and its smaller sibling, Freddie Mac, FMCC
+9.05% have spent tens of millions of dollars beating back securities
class-action lawsuits on behalf of former executives as a result of the
accounting scandals, even after the companies were seized by the U.S.
government through a legal process known as conservatorship in 2008.
. . . flexibility also gave Fannie the ability
to manipulate earnings to hit -- within pennies -- target numbers
for executive bonuses. Ofheo details an example from 1998, the year
the Russian financial crisis sent interest rates tumbling. Lower
rates caused a lot of mortgage holders to prepay their existing home
mortgages. And Fannie was suddenly facing an estimated expense of
$400 million.
Well, in its
wisdom, Fannie decided to recognize only $200 million, deferring the
other half. That allowed Fannie's executives -- whose bonus plan is
linked to earnings-per-share -- to meet the target for maximum bonus
payouts. The target EPS for maximum payout was $3.23 and Fannie
reported exactly . . . $3.2309. This bull's-eye was worth $1.932
million to then-CEO James Johnson, $1.19 million to
then-CEO-designate Franklin Raines, and $779,625 to then-Vice
Chairman Jamie Gorelick.
That same year
Fannie installed software that allowed management to produce
multiple scenarios under different assumptions that, according to a
Fannie executive, "strengthens the earnings management that is
necessary when dealing with a volatile book of business." Over the
years, Fannie designed and added software that allowed it to assess
the impact of recognizing income or expense on securities and loans.
This practice fits with a Fannie corporate culture that the report
says considered volatility "artificial" and measures of precision
"spurious."
This
disturbing culture was apparent in Fannie's manipulation of its
derivative accounting. Fannie runs a giant derivative book in an
attempt to hedge its massive exposure to interest-rate risk.
Derivatives must be marked-to-market, carried on the balance sheet
at fair value. The problem is that changes in fair-value can cause
some nasty volatility in earnings.
So, Fannie
decided to classify a huge amount of its derivatives as hedging
transactions, thereby avoiding any impact on earnings. (And we mean
huge: In December 2003, Fan's derivatives had a notional value of
$1.04 trillion of which only a notional $43 million was not
classified in hedging relationships.) This misapplication continued
when Fannie closed out positions. The company did not record the
fair-value changes in earnings, but only in Accumulated Other
Comprehensive Income (AOCI) where losses can be amortized over a
long period.
Fannie had
some $12.2 billion in deferred losses in the AOCI balance at
year-end 2003. If this amount must be reclassified into retained
earnings, it might punish Fannie's earnings for various periods over
the past three years, leaving its capital well below what is
required by regulators.
In all, the
Ofheo report notes, "The misapplications of GAAP are not limited
occurrences, but appear to be pervasive . . . [and] raise serious
doubts as to the validity of previously reported financial results,
as well as adequacy of regulatory capital, management supervision
and overall safety and soundness. . . ." In an agreement reached
with Ofheo last week, Fannie promised to change the methods involved
in both the cookie-jar and derivative accounting and to change its
compensation "to avoid any inappropriate incentives."
But we don't
think this goes nearly far enough for a company whose executives
have for years derided anyone who raised a doubt about either its
accounting or its growing risk profile. At a minimum these
executives are not the sort anyone would want running the U.S.
Treasury under John Kerry. With the Justice Department already
starting a criminal probe, we find it hard to comprehend that the
Fannie board still believes that investors can trust its management
team.
Fannie Mae
isn't an ordinary company and this isn't a run-of-the-mill
accounting scandal. The U.S. government had no financial stake in
the failure of Enron or WorldCom. But because of Fannie's implicit
subsidy from the federal government, taxpayers are on the hook if
its capital cushion is insufficient to absorb big losses. Private
profit, public risk. That's quite a confidence game -- and it's time
to call it.
**********************************
:"Sometimes
the Wrong 'Notion': Lender Fannie Mae Used A Too-Simple Standard For
Its Complex Portfolio," by Michael MacKenzie, The Wall Street
Journal, October 5, 2004, Page C3
Lender Fannie Mae Used A Too-Simple
Standard For Its Complex Portfolio
Much has been
made of the accounting improprieties alleged by Fannie's regulator,
the Office of Federal Housing Enterprise Oversight.
Some investors
may even be aware the matter centers on the mortgage giant's $1
trillion "notional" portfolio of derivatives -- notional being the
Wall Street way of saying that that is how much those options and
other derivatives are worth on paper.
But
understanding exactly what is supposed to be wrong with Fannie's
handling of these instruments takes some doing. Herewith, an effort
to touch on what's what -- a notion of the problems with that
notional amount, if you will.
Ofheo alleges
that, in order to keep its earnings steady, Fannie used the wrong
accounting standards for these derivatives, classifying them under
complex (to put it mildly) requirements laid out by the Financial
Accounting Standards Board's rule 133, or FAS 133.
For most
companies using derivatives, FAS 133 has clear advantages, helping
to smooth out reported income. However, accounting experts say FAS
133 works best for companies that follow relatively simple hedging
programs, whereas Fannie Mae's huge cash needs and giant portfolio
requires constant fine-tuning as market rates change.
A Fannie
spokesman last week declined to comment on the issue of hedge
accounting for derivatives, but Fannie Mae has maintained that it
uses derivatives to manage its balance sheet of debt and mortgage
assets and doesn't take outright speculative positions. It also uses
swaps -- derivatives that generally are agreements to exchange
fixed- and floating-rate payments -- to protect its mortgage assets
against large swings in rates.
Under FAS 133, if
a swap is being used to hedge risk against another item on the
balance sheet, special hedge accounting is applied to any gains and
losses that result from the use of the swap. Within the application
of this accounting there are two separate classifications:
fair-value hedges and cash-flow hedges.
Fannie's
fair-value hedges generally aim to get fixed-rate payments by
agreeing to pay a counterparty floating interest rates, the idea
being to offset the risk of homeowners refinancing their mortgages
for lower rates. Any gain or loss, along with that of the asset or
liability being hedged, is supposed to go straight into earnings as
income. In other words, if the swap loses money but is being applied
against a mortgage that has risen in value, the gain and loss cancel
each other out, which actually smoothes the company's income.
Cash-flow
hedges, on the other hand, generally involve Fannie entering an
agreement to pay fixed rates in order to get floating-rates. The
profit or loss on these hedges don't immediately flow to earnings.
Instead, they go into the balance sheet under a line called
accumulated other comprehensive income, or AOCI, and are allocated
into earnings over time, a process known as amortization.
Ofheo claims
that instead of terminating swaps and amortizing gains and losses
over the life of the original asset or liability that the swap was
used to hedge, Fannie Mae had been entering swap transactions that
offset each other and keeping both the swaps under the hedge
classifications. That was a no-go, the regulator says.
"The major
risk facing Fannie is that by tainting a certain portion of the
portfolio with redesignations and improper documentation, it may
well lose hedge accounting for the whole derivatives portfolio,"
said Gerald Lucas, a bond strategist at Banc of America Securities
in New York.
The bottom line is that both the FASB and the IASB must someday soon
take another look at how the real world hedges portfolios rather than
individual securities. The problem is complex, but the problem has come
to roost in Fannie Mae's $1 trillion in hedging contracts. How the SEC
acts may well override the FASB. How the SEC acts may be a vindication
or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie
violate the rules of IAS 133.
"It’s hardly news that the near meltdown of America’s
financial system enriched a few at the expense of the rest of us. Who’s
responsible? The recent report of the Financial Crisis Inquiry Commission blamed
all the usual suspects — Wall Street banks, financial regulators, the mortgage
giants Fannie Mae and Freddie Mac, and subprime lenders — which is tantamount to blaming
no one. “Reckless Endangerment” concentrates on particular individuals who
played key roles.
The authors, Gretchen Morgenson, a Pulitzer
Prize-winning business reporter and columnist at The New York Times, and Joshua
Rosner, an expert on housing finance, deftly trace the beginnings of the
collapse to the mid-1990s, when the Clinton administration called for a
partnership between the private sector and Fannie and Freddie to encourage home
buying. The mortgage agencies’ government backing was, in effect, a valuable
subsidy, which was used by Fannie’s C.E.O., James A. Johnson, to increase home ownership while
enriching himself and other executives. A 1996 study by the Congressional Budget
Office found that Fannie pocketed about a third of the subsidy rather than
passing it on to homeowners. Over his nine years heading Fannie, Johnson
personally took home roughly $100 million. His successor, Franklin D. Raines,
was treated no less lavishly...."
KPMG KPMG.UL said late on Monday it had
fired a senior partner in the accounting firm's Los Angeles office
for allegedly providing inside information to an unnamed third
party, who then used that information to trade in stocks of several
West Coast companies.
KPMG, one of the "Big Four" accounting and
audit firms, said it has resigned as the auditor for two clients
upon discovery of the individual's action.
"We have informed those companies it is
necessary to withdraw our auditor reports. We have no reason to
believe that the financial statements of these companies have been
materially misstated," KPMG spokesman Tim Connolly said in a
statement.
KPMG did not name the client firms in its
statement. The firm also did not identify the West Coast companies
whose stocks were traded by the unnamed third party.
The accounting firm did not name the
partner nor did it say how it learned of the individual's alleged
activity.
KPMG spokesman Tim Connolly declined to
comment beyond the statement when contacted by Reuters.
KPMG is at it again. In the most recent
allegation of violating independence standards of the accounting
profession,
KPMG’s Columbus, Ohio office
was auditing
JobsOhio’s books while, at the same time, an out-of-state office of
the firm was seeking $1 million in taxpayer money from JobsOhio for
an unnamed client. As the state’s lead economic-development agency,
JobsOhio is charged with recommending financial incentives for
companies seeking to relocate in the state. On November 5, 2012,
about the time that the audit was being conducted, KPMG was also
listed on a sheet of eight pending grant commitments from the state
for fiscal year 2013, one of which was for the unnamed client.
I will return to this case later on, but
first a review of the recent insider trading charges against the
firm. I have previously
written about
about insider trading at KPMG. In that case, KPMG resigned two audit
accounts and withdrew its blessing on the financial statements of
Herbalife for the past three years and of Skechers for the past two.
KPMG withdrew its audit opinions, a serious step for any auditor,
after concluding it was not independent because of alleged insider
trading.
The KPMG insider trading case is a
particularly egregious one because it involves an auditor tipping
off a friend about stock of audit clients. Scott London, the KPMG
auditor, did not trade in the stock himself but he did gain personal
wealth (“unjust enrichment”) when his friend, Brian Shaw, used the
inside information to trade in stock of Herbalife Ltd. and Skechers
USA Inc. Shaw benefitted by $1.27 million on the trades. Shaw paid
London $50,000 cash and gave him a Rolex watch.
Looking at the JobsOhio case, as KPMG was
auditing JobsOhio's books in the fall of 2012 the firm also was
seeking $1 million in taxpayer money from JobsOhio for an unnamed
client. JobsOhio, the state's privatized development agency, said
that the grant request was handled separately from and without the
knowledge of the firm's auditing division.
The ethical problem for KPMG in the
JobsOhio case is independence in appearance. This is an important
requirement of an independent audit because factual independence is
sometimes difficult to determine. Factual independence goes to the
mindset of the auditor in approaching an audit with objectivity and
professional skepticism. It is difficult to assess so appearances
serve as a proxy in that regard.
JobsOhio denies any conflict of interest.
Laura Jones, a spokeswoman for JobsOhio,
said KPMG LLP's Columbus office conducted the audit, but the grant
was sought by an out-of-state office. "The fact that KPMG serves
JobsOhio and countless other businesses ... from the same office
here in Columbus is not a conflict in our minds," she said, adding
that “the state also monitors and ultimately approves
taxpayer-funded incentives to companies.”
Most observers would probably conclude that
the two offices of KPMG would never collude on their own to achieve
some benefit for the firm. However, the more troubling issue is
whether JobsOhio might perceive some pressure on them to provide
financial incentives to the KPMG audit client perhaps to make it
less likely that KPMG would point out problems with the JobsOhio
audit, assuming any occur.
The accounting profession has strict
independence standards to protect the public interest. Shareholders,
creditors, and the beneficiaries of public funds rely on the
honesty, trustworthiness, and responsibility of auditors to go the
extra mile to ensure that the financial statements of entities that
operate in the public interest are based on an independent audit –
both in fact and in appearance.
KPMG is not alone in violating the most
basic and cherished independence standards. As I have previously
blogged, in 2010 Deloitte and Touche was
investigated by the SEC for repeated insider trading by Thomas P.
Flanagan, a former management advisory partner and a Vice Chairman
at Deloitte. Flanagan traded in the securities of multiple Deloitte
clients on the basis of inside information that he learned through
his duties at the firm. The inside information concerned market
moving events such as earnings results, revisions to earnings
guidance, sales figures and cost cutting, and an acquisition.
Flanagan’s illegal trading resulted in profits of more than
$430,000. In the SEC action, Flanagan was sentenced to 21 months in
prison after he pleaded guilty to securities fraud.
On January 7, 2013, the
SEC announced it is investigating whether
Ernst & Young violated independence rules by letting its lobbying
unit perform work for several major audit clients. The SEC inquiry
began shortly after Reuters reported in March 2012 that Washington
Council Ernst & Young, the E&Y unit, was registered as a lobbyist
for several corporate audit clients including Amgen, CVS Caremark,
and Verizon Communications.
The problem for EY is that U.S.
independence rules bar auditors from serving in an "advocacy role"
for audit clients. The goal is to allow auditors to maintain some
degree of objectivity regarding the companies they audit, based on
the idea that auditors are watchdogs for investors and should not be
promoting management's interests.
Finally, in December 2012,
Thomson Reuters announced it signed a
three-year contract with PwC, the company’s auditor, to provide use
of the Thomson Reuters ONESOURCE Corporate Tax solution for China.
PwC U.K. also uses this Thomson Reuters software for its tax
clients. Business alliances between a company and its auditor are
prohibited under U.S. and U.K. auditor regulations. Once again an
independence violation exists because such arrangements create a
“mutuality of interests” as a result of the business relationship
between the auditor and audit client.
KPMG KPMG.UL said late on Monday it had fired a
senior partner in the accounting firm's Los Angeles office for allegedly
providing inside information to an unnamed third party, who then used that
information to trade in stocks of several West Coast companies.
KPMG, one of the "Big Four" accounting and audit
firms, said it has resigned as the auditor for two clients upon discovery of
the individual's action.
"We have informed those companies it is necessary
to withdraw our auditor reports. We have no reason to believe that the
financial statements of these companies have been materially misstated,"
KPMG spokesman Tim Connolly said in a statement.
KPMG did not name the client firms in its
statement. The firm also did not identify the West Coast companies whose
stocks were traded by the unnamed third party.
The accounting firm did not name the partner nor
did it say how it learned of the individual's alleged activity.
KPMG spokesman Tim Connolly declined to comment
beyond the statement when contacted by Reuters.
There are things you anticipate, worry
about, know will be troublesome once they happen. It’s safe to say
global audit firm KPMG wasn’t worrying it would someday hear the
leader of its Los Angeles audit practice was passing confidential
client information to someone else who then traded on it.
KPMG announced late Monday via press
release that the firm had “separated” a senior partner, one with a
very visible role, from the firm. The firm had” “been informed”
about his “rogue” actions and “regrets” the impact his actions may
have had.
I was half-expecting, “He’s not our kind”.
That’s a lot of passive construction. Who
informed the firm about the illegal and unethical activity? The
firm clearly did not discover
Scott London’s betrayal on its own. If
London was not trading on the information himself, the anomalies
wouldn’t show up in the information he’s required to provide to the
firm to prove his independence from audit clients each year.
Deloitte wasn’t the one who discovered that
its Vice Chairman and
Chicago charity circuit regular
Tom Flanagan was trading on the inside
information of several Fortune 500 companies including
Berkshire Hathaway. In that case it was
FINRA, the securities self-regulatory organization, that saw trading
activity by an audit firm partner in a company with M&A activity.
When Deloitte tax partner
Arnie McClellan’s wife “eavesdropped”
on
her husband’s phone calls where he discussed his client’s M&A
targets and then called her sister in London, Deloitte didn’t know
until London authorities called. McClellan’s wife said her husband
was innocent and everyone believed her. She did serve time for
initially lying about her own involvement.
It wasn’t
Ernst & Young that uncovered tax partner James
Gansman passing M&A tips to his lover who,
in turn, passed them to hers. Gansman’s “swinging” partner ended up
on an SEC watch list and
Gansmen went to jail based on her
testimony against him. He did not profit from his breach of client
confidentiality other than in ways some men might prefer to the
discounted watch, dinners, and few thousand dollars Scott London,
the KPMG partner we heard about yesterday, says he received.
Surely more information will come out over
the next few week, from KPMG, from additional companies affected
and from the media, who will pursue this story like pit bulls. One
reporter who emailed me yesterday said these stories of have “legs”.
Hubris, and stupidity in unexpected places, are great media fodder.
KPMG said in its press release that the
firm resigned as auditor from two of London’s clients,
Herbalife and Skechers, although it did
not name them. He was the top partner on those audits. The time and
money those companies will have to spend to appoint a new auditor,
re-audit years of financial statements and fend off media attention
will probably be subsidized, one-way or another, by KPMG. In the
Flanagan case,
Deloitte paid for the necessary independent investigations
to support the firm’s claim to clients that it
was still independent as an auditor. None of them – Berkshire
Hathaway, Walgreens, Sears Holdings among the victims – fired the
firm.
The SEC and PCAOB did not fine or sanction
Deloitte or Ernst & Young in any of the
cases.
But surely Scott London, KPMG’s “rogue”,
had access to confidential information about more clients of the
firm than just the ones he was directly responsible for. He was the
partner in charge of the audit practice for a huge market, Los
Angeles. He has the right, and the responsibility, to know about
every interesting or problematic thing going on at the audit clients
in his practice group. He may be a “concurring” or quality review
partner on more companies’ audits and can “drop by” audit committee
and other client meetings on a relationship-building basis. The
exposure to KPMG and to the clients of this practice unit, and
perhaps others, may be larger than what’s been admitted by the firm
so far.
Scott London is
making statements to the press. He’s
wealthy enough to afford a lawyer and PR – but obviously not wealthy
enough to resist the temptation of
a “discount” on a watch and a few bucks.
(London didn’t even get a watch. He got a discount. Looking
for the tippee? Go look for a prominent LA jeweler in financial
trouble who’s too cheap to pay well for stealing a man’s career,
professional reputation and, possibly, his freedom.)
My sources tell me KPMG is not paying for
London’s defense. Deloitte
sued Flanagan to assuage its clients. I
would expect that’s next. If KPMG’s
behavior during the 2005 tax shelter scandal
is any indication, Scott London will be completely abandoned, not
just fired, as long as he’s not needed to absolve the firm of any
guilt or accountability for his actions. KPMG has been “duped”,
betrayed by its own, and that’s a tragedy, for sure.
Bob, Maybe if the KPMG Los Angeles partner
ultimately is sentenced to 45 years in prison (such as Attica) it
would actually put an end to this kind of "white collar" crime.
Denny
April 10, 2013 reply from Bob Jensen
Hi Denny,
It will never happen. The biggest problem with white
collar crime is that it pays even if you know you're going to get
caught (at least if you know the rudiments of hiding the loot off
shore or with friends and understand time value of money) ---
http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays
They say that patriotism is the last refuge
To which a scoundrel clings.
Steal a little and they throw you in jail,
Steal a lot and they make you king.
There's only one step down from here, baby,
It's called the land of permanent bliss.
What's a sweetheart like you doin' in a dump like this?
Lyrics of a Bob Dylan song forwarded by Amian Gadal
[DGADAL@CI.SANTA-BARBARA.CA.US]
The law does not pretend to punish everything that is dishonest.
That would seriously interfere with business. Clarence Darrow ---
Click Here
Why white collar crime pays for Chief Financial
Officer:
Andy Fastow's fine for filing false Enron financial statements:
$30,000,000
Andy Fastow's stock sales benefiting from the false reports:
$33,675,004
Andy Fastow's estimated looting of Enron cash:
$60,000,000
That averages out to winnings, after his court fines, of $10,612,500
per year for each of the six years he spent in prison.
You can read what others got at
http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales
Nice work if you can get it: Club Fed's not so bad if you earn
$29,075 per day plus all the accrued interest over the past 15 years
(includes years where he got away with it).
If you aren’t now, you
will by the time you finish the new Bebchuk and Fried paper on
executive compensation. They paint a fairly gloomy picture of
managers exerting their power to “extract rents and to camouflage
the extent of their rent extraction.” Rather than designed to solve
agency cost problems, the paper makes the case that executive pay
can by an agency cost in and of itself. Let’s hope things aren’t
this bad.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=364220
They say that patriotism is the last refuge
To which a scoundrel clings.
Steal a little and they throw you in jail,
Steal a lot and they make you king.
There's only one step down from here, baby,
It's called the land of permanent bliss.
What's a sweetheart like you doin' in a dump like this?
Lyrics of a Bob Dylan song forwarded by Amian Gadal
[DGADAL@CI.SANTA-BARBARA.CA.US]
The law does not
pretend to punish everything that is dishonest. That would seriously interfere
with business. Clarence Darrow ---
Click Here
Teaching Case from The Wall Street Journal Accounting Weekly Review on
June 27, 2013
SUMMARY: Scott London, the former KPMG LLP partner
who has admitted to an insider-trading scheme, will plead guilty to
fraud. Mr. London, who had been a senior partner in charge of KPMG's
Pacific Southwest audit practice, had previously agreed to plead
guilty to one count of securities fraud. Mr. London has admitted
passing confidential information about KPMG clients to a friend,
Bryan Shaw, who prosecutors say made $1.27 million in illegal
profits by trading on the information and paid Mr. London at least
$60,000 in cash and gifts. Mr. Shaw has already pleaded guilty.
CLASSROOM APPLICATION: This article would be an
excellent addition to an auditing class for part of a discussion
regarding the importance of ethics and independence when dealing
with client information. The stakes are high for those who violate
rules, as illustrated in the downfall of this KPMG partner. You can
combine this article with the attached Related Articles to serve as
a case study of the case.
QUESTIONS:
1. (Introductory) Who is Scott London? What was his
professional position? What are the accusations against him?
2. (Advanced) For what reasons might Mr. London have
decided to enter a guilty plea? What would be his other options?
3. (Advanced) What is insider trading? Why is it
prohibited? How was Mr. London able to access information to use to
commit this crime? What auditing rules has Mr. London violated?
4. (Introductory) What is KPMG? What was KPMG's response to
the discovery of Mr. London's activities? How was the firm impacted?
5. (Advanced) What, if anything, could KPMG have done to
prevent this situation from happening? How should KPMG proceed going
into the future? What additional internal controls or procedures
could the firm implement?
6. (Advanced) How likely is it that similar activities
occur in the public accounting industry? How could these activities
be prevented or detected earlier?
Reviewed By: Linda Christiansen, Indiana University Southeast
RELATED ARTICLES:
Trading Case Embroils KPMG by Jean Eaglesham, Juliet Chung, and Hannah Karp
Apr 10, 2013
Page: A1
Scott London, the former KPMG LLP partner
who has admitted to an insider-trading scheme, will plead guilty to
fraud on July 1, according to a court docket and his attorney.
Mr. London, who had been a senior partner
in charge of KPMG's Pacific Southwest audit practice, had previously
agreed to plead guilty to one count of securities fraud. At his
arraignment earlier this week, a not-guilty plea was automatically
entered for him, but he had been expected to change that plea once
some procedural matters were resolved.
According to an entry filed Friday on the
court docket in his case, a "change of plea" hearing has been set
for July 1 before U.S. District Judge George H. Wu in Los Angeles.
"We're going to go in and plead guilty on
July 1," Harland Braun, Mr. London's attorney, said Friday.
Mr. London has admitted passing
confidential information about KPMG clients to a friend, Bryan Shaw,
who prosecutors say made $1.27 million in illegal profits by trading
on the information and paid Mr. London at least $60,000 in cash and
gifts. Mr. Shaw has already pleaded guilty.
I wrote today in Forbes about a small
little thing I noticed in one of the first stories about Scott
London. As I tried to research and write about it, I waited for
someone else to pick up on it. (No one else did.) I’ve been busy the
last couple of weeks since the KPMG press release about Scott
London’s breach of client confidentiality hit the wires on April 8
but I researched the issue and called KPMG and Skechers and waited.
There’s one small detail that came out
early, mentioned in The
Financial Times by Kara Scannell and Dan McCrum
when they
interviewed Skecher’s CFO David Weinberg, that matters a lot to
the current debate in the U.S. and U.K regarding audit firm
rotation and the compromise rules for lead partner rotation on
audit engagements.
Mr
London had worked on Skechers’ audits in seven or eight of the
last 13 years, said Mr Weinberg, returning after a five-year
rotation away two or three years ago. He said that he
had worked with him regularly, and never had questions about his
work or integrity: “not even the slightest”, he said.
The rest of the column goes on to explain
that London seems to have subverted the intent of
Sarbanes-Oxley Section 203
that requires lead engagement partner rotation off engagements to
promote objectivity, independence and professional skepticism. But
he’s not alone. The more I looked into this the more I realized it’s
probably pretty common in the firms. After ten plus years of
Sarbanes-Oxley, we’ve probably got quite a few of these roll off,
roll back on partners out there. An
early draft of a paper by four academics,
including former PCAOB academic fellow Brian Daughtery, says almost
everyone does it.
Assignments for
the lead engagement partner, concurring partner, and
other senior members of the audit team are planned
well in advance of required rotation so members are
not rotated simultaneously. Some firms have policies
that specify the qualifications of the partner
assigned to client engagements. Depending on the
engagement, regional or national office approval may
be required on partner assignments. One OMP
indicated firm policy does not allow a partner to be
a concurring partner before being a lead partner.
Another indicated his international firm now has a
policy that does not allow partners to ever return
to a former public client unless the national office
agrees to make an exception based on extenuating
circumstances.
An important
element of mitigating the negative aspects of
rotation is ensuring partners are properly trained.
One OMP noted the path to partnership is now
approximately 13-15 years, primarily driven by the
complexity of GAAP. Another noted many senior
managers rotate to larger practice offices or the
national office for training before standing for
partnership.
But…
By the time the
Daugherty/Dickins/Hatfield/Higgs paper was published in 2012,
Brian Daugherty told me that none of the
Big Four audit firms prohibited a partner from returning to a
former public client as lead engagement partner. None, that he
became aware of during the research, prohibit the audit partner
from acting as an advisory/consulting partner before, after, or
during the cooling off period as lead audit engagement partner
or as concurring/quality partner. One firm that did forbid
partners to return to a lead audit engagement partner role after
a rotation off, except on an exception basis, dropped the
prohibition before the paper was published.
Despite being very open and chatty with the
press about the London incident – looks like KPMG fed
a positive story to the WSJ about all they
are doing to review internal policies - KPMG did not want to give me
exact dates of London’s assignments on Skechers and what he did
during his roll-off. Neither did Skecher’s CFO.
Did London act as concurring or quality
review partner during those five years? Even worse, did London
act as Advisory partner, responsible for increasing non-audit
tax and consulting fees at Skechers like Deloitte’s
Tom Flanagan did at the Fortune 500
clients he traded illegally on?
Skechers spent $351,000 for “All Other”
services with KPMG between 2003 and 2008. Given the
Sarbanes-Oxley prohibitions against an auditor providing
services other than tax and “audit related” this seems odd. The
explanation? ”These are fees for other permissible work
performed by KPMG LLP that does not meet the other category
descriptions.” Translated, that means, “We don’t think we have
to explain it you.”
Skechers paid KPMG an awful lot, too,
for tax services compared to its audit fee, $4, 512,000 over the
ten year period 2002-2011, or 34% of total audit fees for the
same period of $13,129,000. In 2004, Skechers paid KPMG
approximately $680,000 for acquisition due diligence services,
categorized as “audit related” when due diligence services are
prohibited consulting services by an auditor unless they’re
tax-related.
There’s more at Forbes,
KPMG’s Inside Trader: What The Auditor, and Skechers, Don’t Want To
Talk About. You might be asking, though,
how can we as investors know if the Big Four are complying with the
audit partner rotation law? Who checks to see that they are
following any of these laws Congress makes that are supposed to make
us believe that auditors are back on the job, looking out for
shareholders after Enron?
We can’t.
If an audit firm violates the rule, we’ll
probably find out about it only if something worse happens that
causes that information to be disclosed. The audit firms know which
partners are assigned to clients, audit and non-audit. They have to
know to manage their business as well as insure compliance in case
that audit is selected for inspection. Public companies and their
Audit Committees know who is assigned to their engagements. Rarely
do the firms and their clients volunteer information about tenure on
engagement unless there’s a lawsuit, or if feelings are hurt such as
in the Skecher’s case. The Skecher CFO’s disclosures to the FT about
Scott London’s tenure on the engagement are unusual since there’s
been no lawsuit.
Every once in a
while I almost write “I don’t envy big bank CEOs,” and then I
consider my own finances and the mood passes. But it does seem hard,
no? The job is basically that you run around all day looking at
horrible messes – even in good times, there are some horrible messes
somewhere, and what is a CEO for if not to look at them and make
decisive noises? – and then you get on earnings calls, or go on
CNBC, or sign 10Ks under penalty of perjury, and say “everything is
great.” I mean: you can say that some things aren’t great, if it’s
really obvious that they’re not. If you lost money, GAAPwise, go
ahead and say that; everyone already knows. But for the most part,
you are in the business of inspiring enough confidence in people
that they continue to fund you, and if you don’t persuade them that,
on a forward-looking basis, things will be pretty good, then they
won’t be.
Also, when
you’re not in the business of convincing people to fund you, you’re
in the business of convincing people to buy what you’re selling and
sell what you’re buying, which further constrains you from saying
“what we’re selling is dogshit.”1
Anyway I found
a certain poignancy in Citi’s correspondence with the SEC over
Morgan Stanley Smith Barney, which was
released on Friday.
Citi and Morgan Stanley had a joint venture in MSSB, and MS valued
it at around $9bn, and Citi valued it at around $22bn, and at most
one of them was right and, while the answer turned out to be
“neither,” it was much closer to MS than C. Citi was quite wrong,
and since this was eventually resolved by a willing seller (Citi)
selling to a willing buyer (MS)
at a valuation of $13.5bn, Citi had to
admit its wrongness in the form of a $4.7 billion write-down,
and the stock did this:
Which is the
market’s way of saying: no biggie Vikram, we already knew you’d be
taking the writedown, honestly we thought it’d be worse than that,
we just didn’t say anything because we didn’t want you to feel bad,
but we’re glad that’s cleared up now.
But the SEC
doesn’t get to do that, because – and this is sort of endearing –
the SEC has to pretend that a company’s financial statements convey
meaningful information about the actual world, and so last year they
sent Citi a bunch of letters to the effect of “um, really, with that
MSSB valuation?” To be fair even Citi was admitting, back in its
10-K a year ago, that MSSB wasn’t worth
what its balance sheet said it was worth – but it said that this was
a temporary impairment and so didn’t need to be reflected on Citi’s
financials since MSSB would recover soon and anyway it’s not as if
Citi was looking to sell at a depressed price. Here is how the SEC
responded in April:
We note your
disclosure related to the temporary impairment of your equity
method investment in the Morgan Stanley Smith Barney (MSSB)
joint venture. Please address the following:
You assert
that, as of December 31, 2011, you do not plan to sell your
investment in this joint venture prior to recovery of the
value. Please tell us how you were able to reach this
conclusion given the fact that you are currently in
negotiations with Morgan Stanley to sell at least part of
your equity interest in this joint venture pursuant to
options held by Morgan Stanley.
We note
that you have based the fair value of this equity investment
on “the midpoint of the current range of estimated values.”
However, you do not disclose this range, nor do you disclose
how the range was estimated.
We are not in
fact negotiating with Morgan Stanley about selling the rest of
MSSB, and
We can’t
disclose our internal estimate of MSSB’s value, because that
would hurt us in our negotiations with Morgan Stanley about
selling the rest of MSSB.
See what they
did there?2
The SEC did, a few months later anyway, when the negotiations got so
advanced that the SEC
pushed Citi
for more information about its internal valuation of the MSSB joint
venture. Citi obligingly
provided that valuation to the SEC,
confidentially, ten days after it disclosed the write-down.
Also during
these negotiations Citi’s investment banking division
provided a valuation of MSSB “that
slightly exceeded Citi’s carrying value of approximately $11 billion
for that 49% interest as of June 30, 2012.” So:
Citi
provided a valuation of an asset to its counterparty as a
negotiation tool,3
which was
higher than the valuation it reflected in its publicly filed
financial statements,
which was
higher than its internal estimate of the correct valuation,
which was
closest to the market’s estimate of the correct valuation, and
the ultimate valuation at which Citi sold the asset.
So Citi “knew”
that its financials, and the valuation it gave in negotiations with
MS, were “wrong.”
Jensen Question
Did KPMG shift its entire Fannie Mae auditing team to HSBC?
Question
What was the largest audit client lost by KPMG in the USA?
Answer
I did not research this, but the leading contender has to be when KPMG
was fired from the Fannie Mae scandal in what was one of the largest
earnings management frauds in history coupled with incompetent auditing
of financial derivative financial instruments ---
http://www.trinity.edu/rjensen/Theory02.htm#Manipulation
From the CFO.com Morning
Ledger on March 7, 2013
KPMG audit
contract with HSBC at risk. KPMG could lose the biggest audit
contract in Britain after HSBC decided to consider bringing in a
fresh pair of eyes to vet its accounts, the FT reports. The bank
said it would put its audit contract out to tender for the first
time in more than two decades in the most striking sign yet that
regulatory pressure is starting to break down the ties that bind
many big companies to their auditor. The tender could give KPMG
rival Ernst & Young an opportunity to pick up a big British bank as
an audit client. HSBC said it wanted the winner of the tender to be
in place by 2015.
"HSBC paid
out $4.2bn (£2.8bn) last year to cover the cost of past wrongdoing.
As well as $1.9bn in fines for money laundering, the bank also set
aside another $2.3bn for mis-selling financial products in the UK.
The figures came as HSBC reported rising underlying profitability
and revenue in 2012, and an overall profit before tax of $20.6bn
Chief
executive Stuart Gulliver's total remuneration for 2012 was some
$7m, compared with $6.7m the year before. And after taking account
of the deferral of pay this year and in more highly-remunerated
years previously, Mr Gulliver actually received $14.1m in 2012, up
from $10.6m in 2011.
The
company's 16 top executives received an average of $4.9m each."
"During a
conference call to present the results, Mr Gulliver told investors
that the bank was not reconsidering whether to relocate its
headquarters from London back to Hong Kong, in order to avoid a
recently agreed worldwide cap on bonuses of all employees of banks
based in the EU."
"HSBC's
underlying profits - which ignore one-time accounting effects as
well as the impact of changes in the bank's creditworthiness - rose
18%."
"The bank's
results were heavily affected by a negative "fair value adjustment"
to its own debt of $5.2bn in 2012, compared with a positive
adjustment of $3.9bn the year before. The adjustment is an
accounting requirement that takes account of the price at which HSBC
could buy back its own debts from the markets. It has the perverse
effect of flattering a bank's profits at a time when markets are
more worried about its ability to repay its debts, and vice versa."
More in
article.
Regards,
Roger Roger Collins
Associate Professor
OM1275 TRU School of Business & Economics
Jensen Question
Did KPMG shift its entire Fannie Mae auditing team to HSBC?
Something very
unusual happened at the Securities and Exchange Commission this
week: The SEC accused three former bank executives of committing
fraud by deliberately understating their company's loan losses
during the financial crisis. Such accusations have not been made
often in recent years.
Unless you happen to
live in Nebraska, you probably haven't heard of Lincoln-based
TierOne Corp., which had about $3 billion assets when it failed in
2010. Yet it's an important story because of what it shows about the
state of securities-law enforcement in the U.S.
On Tuesday the SEC
said it had reached settlements with the company's former chief
executive officer and chairman, Gilbert Lundstrom, and another
former senior executive, who will both pay fines. (Per the usual
custom, neither admitted or denied any wrongdoing.) A third former
executive is contesting the agency's claims, which include
allegations of egregious accounting violations.
Several times in
recent years the SEC's enforcement division has seemed to bend over
backwards to avoid accusing anyone at a failed financial institution
of committing accounting fraud. To name a few: When the SEC filed
fraud claims against former executives of Countrywide Financial
Corp., IndyMac Bancorp, Freddie Mac and Fannie Mae, it accused them
of making false disclosures. But it made sure not to allege that any
of the companies' books were wrong; none of them ever admitted to
any accounting errors.
At Countrywide, for
instance, the SEC accused former CEO Angelo Mozilo of failing to
disclose known loan losses. If the SEC's allegations against him
were true, then the company's financial reports by definition must
have contained misstatements -- except the SEC never alleged so in
its complaint against him. He committed disclosure fraud, the SEC
said, not accounting fraud.
The main beneficiary
of the SEC's approach in such cases has been the Big Four auditing
firms, as I wrote in a column last year. They can claim their audits
were fine, because there was never any official finding that the
numbers were incorrect. That has helped the firms enormously in
class-action litigation brought by investors.
TierOne's auditor
was KPMG LLP, which also was the auditor for Countrywide. (The other
Big Four firms are Ernst & Young LLP, PricewaterhouseCoopers LLP and
Deloitte & Touche LLP.) Neither KPMG nor any of its personnel were
named as defendants in the SEC's complaint this week. One of the
allegations against the former TierOne executives was that they lied
to KPMG auditors. Under the Sarbanes-Oxley Act, passed in 2002,
lying to an auditor is a punishable offense.
Does this mean KPMG
got a pass from the SEC? My guess is yes. An SEC spokesman, John
Nester, declined to say. A spokesman for KPMG, Manuel Goncalves,
declined to comment.
There is somebody
out there, however, who believes KPMG should be held liable for
failing to catch TierOne's accounting chicanery. TierOne's Chapter 7
bankruptcy trustee earlier this year sued the accounting firm,
accusing it of negligence and breaches of fiduciary duty. KPMG has
denied the allegations and asked that the matter be resolved in
arbitration proceedings rather than in court. It was TierOne's
regulator, the U.S. Office of Thrift Supervision, that caught the
bank's accounting manipulations -- not KPMG, which continually
blessed TierOne's financial statements and resigned as auditor in
2010 only weeks before the bank failed.
The financial crisis
was in large part about financial institutions' cooked books. A big
reason that companies such as Lehman Brothers, Fannie Mae and
Freddie Mac failed was that investors could tell from the outside
looking in that their balance sheets were bogus. Even Hank Paulson,
the former Treasury secretary, said as much in his memoir. (The SEC
never brought a single enforcement action against a former Lehman
executive.)
TOPICS: Audit Quality, Auditing, Banking, Loan Loss
Allowance
SUMMARY: "The Securities and Exchange Commission
charged two KPMG LLP employees[-John A. Aesoph and Darren M.
Bennett-]with failing to uncover problems at a Nebraska bank that
later failed....[The SEC said that the two auditors] didn't do
enough to scrutinize bad loan reserves...."
CLASSROOM APPLICATION: The article may be used in
any class to introduce the role of auditors versus accountants using
questions 1 through 3. It may be used in an auditing class
discussing validation procedures over judgment based accounts and
auditor responsibilities using all questions in the review. NOTE:
INSTRUCTORS WILL WANT TO ELIMINATE THE REMAINING STATEMENTS BEFORE
DISTRIBUTING TO STUDENTS. The review should bring students to
discuss the statement in the article that the bank had begun making
riskier loans. Doing so would lead auditors to consider expanding
loan loss review procedures. On the other hand, hindsight in 2013
about the riskiness of the loans made during the height of the
mortgage boom in 2008 might be different than was the view at the
time of the loan originations.
QUESTIONS:
1. (Introductory) Explain the role of auditors, internal
accountants, and executive management at a bank or any business.
2. (Introductory) Based on the description in the article,
with what wrongful acts does the SEC charge the two auditors?
Compare these actions to the wrongful acts the SEC alleges of the
bank's managers.
3. (Advanced) How do these alleged wrongful acts in 2008
lead to culpability for the bank failure in 2010? In your answer,
explain the accounting for loan loss reserves (allowances) and
specifically highlight the role of accounting in the bank's steps
towards failure.
4. (Advanced) What are the audit objectives related to
loans receivable and the allowance for uncollectible accounts (or
loan loss reserve)? How are appraisals of loan collateral related to
that process?
5. (Advanced) Consider the difficulty of deciding on audit
procedures for bank loan loss reserve accounts. What factors must be
considered in deciding on the procedures to undertake? What factors
will likely limit the planning of procedures? In your answer,
discuss the role of "red flags" (as described in the article) that
the SEC alleges were present in this case.
6. (Introductory) How do you think that "20/20 hindsight"
might influence the assessment of the audit work performed at
TierOne Bank? In your answer, comment on KPMG's statement about
looking forward to "presenting the facts in support of the work that
was performed under the circumstances at TierOne.'"
Reviewed By: Judy Beckman, University of Rhode Island
The
Securities and Exchange Commission charged two KPMG LLP employees
with failing to uncover problems at a Nebraska bank that later
failed, marking the first time the agency has taken action against
auditors related to the financial crisis.
The two
KPMG auditors, John J. Aesoph and Darren M. Bennett, didn't do
enough to scrutinize bad-loan reserves at TierOne Bank of Lincoln,
Neb., the SEC said in an administrative proceeding filed Wednesday.
The action could result in the two auditors losing their right to
audit public companies.
TierOne hid
millions of dollars in losses on troubled loans made during the
height of the financial crisis before the bank eventually failed in
2010, according to the commission, which filed suit against three
TierOne executives last year.
The SEC
case against the auditors, more than four years after the crisis,
revives lingering questions about whether auditors did enough to
prevent questionable practices and whether authorities have done
enough to hold them to account.
While
auditors weren't involved in financial institutions' bad lending and
risk-management decisions that helped prompt the crisis, all of the
Big Four accounting firms had major clients which collapsed or
required huge government bailouts, without any warning from the
auditors.
"I think it
is about time [the SEC] took action against the gatekeepers," said
John Coffee, a Columbia University securities-law professor. The SEC
has been "somewhat egregious and far less than aggressive" in taking
action against auditors, attorneys and other outside professionals
who may have abetted the conduct that led to the crisis, he said.
"This is an
area where there ought to be a lot more cases," added Barbara Roper,
director of investor protection for the Consumer Federation of
America. "It does suggest a pretty significant problem with the
auditors, and with audits of financial institutions a lot bigger and
more central to the financial system than this bank in Nebraska."
An SEC
spokesman, said "the criticisms are misinformed and belied by our
unmatched record of achievement in financial crisis cases." KPMG,
which wasn't charged in the TierOne case, said in a statement that
its auditors "look forward to presenting the facts in support of the
work that was performed under the circumstances at TierOne."
Attorneys for Mr. Aesoph and Mr. Bennett couldn't be reached for
comment.
Other
authorities have filed only a handful of crisis-related cases
against auditors. The New York attorney's general office has sued
Ernst & Young LLP, alleging the firm turned a blind eye to
accounting fraud at its client Lehman Brothers Holdings Inc. before
Lehman collapsed. Last fall, the Federal Deposit Insurance Corp.
sued PricewaterhouseCoopers LLP and Crowe Horwath LLP, alleging they
failed to prevent a fraud scheme that led to the failure of
Alabama's Colonial Bank. The accounting firms have denied any
wrongdoing in those cases.
In the
TierOne case, the SEC alleges that Mr. Aesoph, a KPMG partner, and
Mr. Bennett, a senior manager, ignored red flags and relied on
outdated appraisals of the collateral backing TierOne's loans when
their 2008 audit gave the bank a clean bill of health. In fact,
according to the SEC, the bank had expanded into riskier types of
lending in Las Vegas, Arizona and Florida, and its top executives
misled investors and regulators about the losses TierOne was
experiencing.
The
Securities and Exchange Commission is finally doing something that
desperately needed to be done: Suing the auditors of a failed bank
that got caught cooking its books.
Today
the SEC’s enforcement division
accused two accountants at KPMG LLP of
engaging in unprofessional conduct during their 2008 audit of
TierOne Corp., a Lincoln, Nebraska- based lender that had about $3
billion in assets when it collapsed in 2010. The agency hasn’t
reached settlements with either of the men, John Aesoph, 40, and
Darren Bennett, 35, and their lawyers didn’t immediately return
phone calls.
The SEC’s
administrative order accuses the pair of “failing to subject
TierOne’s loan loss estimates -- one of the highest risk areas of
the audit -- to appropriate scrutiny.” It also said they “violated
numerous PCAOB audit standards, failed to obtain sufficient
competent evidential matter to support their audit conclusions, and
failed to exercise due professional care and appropriate
professional skepticism.” (PCAOB stands for Public Company
Accounting Oversight Board.)
The SEC
already had filed accounting-fraud claims against three former
TierOne executives, two of whom reached settlements and paid fines
last September. As I asked at the time: When will the SEC finally go
after the auditors? At least in these particular auditors’ instance,
the answer is today.
It was
TierOne’s regulator, the U.S. Office of Thrift Supervision, that
caught the bank’s accounting manipulations -- not KPMG, which
continually blessed TierOne’s financial statements and resigned as
auditor only weeks before the bank failed in 2010. Last year
TierOne’s Chapter 7 bankruptcy trustee sued KPMG, accusing it of
negligence and breaches of fiduciary duty. The SEC didn’t file
claims against KPMG itself today.
It has been
frustrating to look at the SEC’s own highlights of the lawsuits it
has filed in connection with the financial crisis -- and to see that
none of them had been against an auditor. Now the SEC will have one
case to cite, albeit against a couple of small fries. It also should
be stressed that the agency hasn’t proved any of its allegations
against these two accountants. Surely the SEC can find some bigger
targets out there in the auditing world if it wants to.
All of the
large accounting firms are experiencing litigation dealing with the
issue of overtime. One such case that commenced on January 19, 2011
is Pippins, Schindler, and Lambert v. KPMG, LLP. KPMG filed several
motions in this case and recently the judge denied two of them.
While early, it isn’t looking good for KPMG.
We
earlier discussed these overtime cases in “Consistency
in Accounting and Legal Discourses: The Overtime Cases.”
While we are sympathetic to the position of
the Big Four, we noted that they might have a hard time meeting the
exemptions in the Fair Labor Standards Act (FLSA), which normally
requires payment of at least 150 percent of one’s salary when the
employee works overtime.
The FLSA
provides two exemptions that might apply in this case. The first
exemption exists if the worker is an administrative employee. For
this to occur, the employee’s primary duty must involve the
management or general business operations of the firm. The second
exemption, the learned professional exemption, accrues if the
worker’s primary duty involves the performance of work that requires
knowledge of an advanced type and acquired by specialized
intellectual instruction.
Difficulty arises with both of these possible exemptions because
they come face-to-face with Code of Professional Conduct
Rule 201 and PCAOB
Standard No. 10. Rule 201 and Standard
No. 10 require partners and managers of audit firms to supervise the
accounting associates. They must inform them of the audit
objectives and the audit procedures; additionally, the partners and
managers have to monitor the work of the associates. Such oversight
appears to negate any assertions for an administrative or
professional exemption.
Be that as
it may, we find interesting recent activity in the Pippins,
Schindler, and Lambert v. KPMG case. The first motion concerned
whether KPMG has to preserve computer hard drives of its former
associates. The audit firm argued against this requirement
primarily because of the expense, which it estimated to be at least
$1.5 million. It claimed that the benefits did not justify the
costs. KPMG suggested that it preserve only a random sample of 100
hard drives. Further, KPMG sought the court to order the plaintiffs
to bear the costs of preserving the hard drives.
Judge
Colleen McMahon denied all parts of the motion. She noted that
plaintiffs desire access to the hard drives because they might
contain information pertaining to the job duties performed by the
audit associates and to the hours they worked. In addition, as the
court conditionally certified FLSA collective action, more employees
or former employees may opt-in the collective lawsuit. Accordingly,
as information on the hard drives is relevant to the case and
because more individuals may join the collective action, Judge
McMahon ordered preservation of all the hard drives.
The judge
apparently was miffed at KPMG. She chastises the firm as
“unreasonable.” Specifically she calls unreasonable
(1)KPMG’s refusal to turn over so much as a single hard drive
so its contents could be examined; and (2) its refusal to do
what was necessary in order to engage in good faith negotiations
over the scope of preservation …
Thus, on
February 3, 2012, Judge McMahon denied KPMG’s motion in its
entirety.
Continued in article
Question
Will the largest auditing firms ever really honor the spirit of their
repeated pledges of independence?
Why do they keep pushing toward the edge of the cliff known as audit
firm rotation?
Last fall, we reported that
KPMG had issued an internal preservation notice
to its employees in regards to "General
Electric's Loan Staff Arrangements." As you may remember, this
arrangement consisted of KPMG employees being loaned to GE to help
supplement the work of the world's best tax law firm. Oh, and KPMG
is the auditor for GE. Last year, Francine
McKenna reported that this sketchy
arrangement included KPMG employees, "having GE email addresses, are
supervised by GE managers – there is no KPMG manager or partner on
premises – and have access to GE employee facilities." In short, she
wrote, "KPMG should know better" than try to pull this type of stunt
on the PCAOB.
This morning,
McKenna reports on the latest
development on this little arrangement:
KPMG will no longer loan tax
professionals to GE during busy season, according to a
source close to the situation. KPMG was billing an extra
$8-10 million, over and above the audit each year, for the
service. It looks like a regulator got to both KPMG and GE,
but quietly. I doubt we’ll ever see a public sanction or
fine from the PCAOB or the SEC for KPMG.
It's not immediately clear when the
arrangement ended but I can't imagine any of the staff being too
broken up about this. The partners, on the other hand...well,
yeah, that's $10 million in fees that will probably go away. If
you ever worked under this arrangement or have worked for
another client under something similar,
email us
your story and any background you might have.
KPMG will no longer loan tax professionals
to GE during busy season, according to a source close to the
situation. KPMG was billing an extra $8-10 million, over and above
the audit each year, for the service.
Loaning, assigning, or “seconding” tax or
any “bookkeeping” staff to an audit client is prohibited by the
Sarbanes-Oxley Act of 2002 and by regulations that precede
Sarbanes-Oxley. It looks like a regulator got to both KPMG and GE,
but quietly. I doubt we’ll ever see a public sanction or fine from
the PCAOB or the SEC for KPMG.
My story exposing this prohibited activity
by an auditor for an audit client was published in Forbes last
March.
KPMG has been GE’s auditor for more than
100 years. Former SEC Chief Accountant Lynn Turner was surprised and
quite angered at my revelation. In addition, Turner commented in his
newsletter on an email I received from the Carpenters Pension Fund
after my column appeared at Forbes.com. The pension fund sought to
hold GE and KPMG accountable for auditor independence and have a
discussion at the annual meeting about auditor rotation. They were
blocked by GE and the SEC:
Continued in article
Jensen Comment
Recall that KPMG paid the largest fine ($456 million) in the history of
accounting firms for selling phony tax shelters and pledged to cut back
on tax consulting that tainted appearances of the firm's auditing
independence.
Another KPMG defendant
pleads guilty of selling KPMG's bogus tax shelters One of the five remaining defendants in the
government's high-profile tax-shelter case against former KPMG LLP
employees is expected to plead guilty ahead of a criminal trial set to
begin in October, according to a person familiar with the situation. The
defendant, David Amir Makov, is expected to enter his guilty plea in
federal court in Manhattan this week, this person said. It is unclear
how Mr. Makov's guilty plea will affect the trial for the remaining four
defendants. Mr. Makov's plea deal with federal prosecutors was reported
yesterday by the New York Times. A spokeswoman for the U.S. attorney in
the Southern District of New York, which is overseeing the case,
declined to comment. An attorney for Mr. Makov couldn't be reached. Mr.
Makov would be the second person to plead guilty in the case. He is one
of two people who didn't work at KPMG, but his guilty plea should give
the government's case a boost. Federal prosecutors indicted 19
individuals on tax-fraud charges in 2005 for their roles in the sale and
marketing of bogus shelters . . . KPMG admitted to criminal wrongdoing
but avoided indictment that could have put the tax giant out of
business. Instead, the firm reached a deferred-prosecution agreement
that included a $456 million penalty. Last week, the federal court in
Manhattan received $150,000 from Mr. Makov as part of a bail
modification agreement that allows him to travel to Israel.
Paul Davies, "KPMG Defendant to Plead Guilty," The Wall Street
Journal, August 21, 2007; Page A11 ---
Click Here
Jensen Comment
The criminal case fell apart for complicated reasons, but that did not
exonerate KPMG as a firm nor return its $456 million settlement reached
with the IRS.
After the
2005 $456 million settlement with the U.S.
Treasury, the Chairman and CEO of KPMG, Timothy
Flynn, issued the following Open Letter. Among
other things, KPMG announced it will almost
entirely stop preparing tax returns for
"individuals."
August
29, 2005
AN
OPEN LETTER TO KPMG LLP'S CLIENTS
(from Timothy P. Flynn Chairman &
CEO KPMG LLP)
This
is to advise you that KPMG LLP
(U.S.) has reached an agreement with
the U.S. Attorney's Office for the
Southern District of New York,
resolving the investigation by the
Department of Justice into tax
shelters developed and sold by the
firm from 1996 to 2002. This
settlement also resolves the
Internal Revenue Service's
examination of these activities.
As a
result of this settlement, KPMG LLP
(U.S.) continues as a
multidisciplinary firm providing
high quality audit, tax, and
advisory services to large
multinational and middle market
companies, as well as federal, state
and local governments.
The
Public Company Accounting Oversight
Board (PCAOB) has reaffirmed that
the resolution of this matter with
the Department of Justice does not
affect the ability of KPMG to
perform quality audit services.
Additionally, the Department of
Justice states in the agreement that
KPMG is currently a responsible
contractor and expressly concludes
that the suspension or debarment of
KPMG is not warranted. KPMG
currently audits the Department of
Justice financial statements.
Further
details on the resolution of this
matter can be found in the attached
Media Statement
that the firm issued today; a Key Provisions and Terms
document detailing the settlement;
and a Quality & Compliance
Measures document that
provides an overview of the quality
initiatives the firm has undertaken
since 2002, including specific
changes to Tax operations.
KPMG
accepts the high level of
responsibility inherent in
performing its role as a steward of
the capital markets. Let me be very
clear: The conduct by former tax
partners detailed in the KPMG
statement of facts attached to the
agreement is inexcusable. I am
embarrassed by the fact that, as a
firm, we did not identify this
behavior from the outset and stop
it. You have my personal assurance
that the actions of the past do not
reflect the KPMG of today.
I am
proud to be Chairman of this
remarkable organization and proud of
the tremendous professionals of
KPMG. We are resolute in our
commitment to maintain the trust of
the public, our clients and our
regulators. You have my promise
that, as our first priority, KPMG
will deliver on our commitment to
the highest levels of
professionalism — integrity,
transparency, and accountability.
We
truly appreciate the strong support
of our clients throughout this
investigation. Your Lead Partner
will be contacting you later to make
sure that you have the information
you need about this matter.
On
behalf of all of our partners and
employees, thank you for your
continued support.
Timothy P. Flynn
Chairman & CEO
KPMG LLP
Attachments following below:
Media Statement
Key
Provisions and Terms
Quality & Compliance Measures
News
For Immediate Release
Contact:
George Ledwith KPMG LLP Tel. (201) 505-3543
KPMG LLP STATEMENT REGARDING
SETTLEMENT
IN DEPARTMENT OF JUSTICE
INVESTIGATION
NEW YORK,
Aug 29 — KPMG LLP made the
following statement today in
regard to a resolution
reached by the U.S. firm
with the Department of
Justice in its investigation
into tax shelters developed
and sold from 1996 to 2002
and related conduct:
KPMG has reached an
agreement with the U.S.
Attorney's Office for the
Southern District of New
York and the Internal
Revenue Service, resolving
investigations regarding the
U.S. firm's previous tax
shelter activities.
"KPMG LLP is pleased to have
reached a resolution with
the Department of Justice.
We regret the past tax
practices that were the
subject of the
investigation. KPMG is a
better and stronger firm
today, having learned much
from this experience," said
KPMG LLP Chairman and CEO
Timothy P. Flynn. "The
resolution of this matter
allows KPMG to confidently
face the future as we
provide high quality audit,
tax and advisory services to
our large multinational,
middle market and government
clients."
As part of the agreement,
KPMG has agreed to make
three monetary payments,
over time, totaling $456
million to the U.S.
government. KPMG will also
implement elevated standards
for its tax business.
Under the terms of the
settlement, a deferred
prosecution agreement, the
charges will be dismissed on
December 31, 2006, when the
firm complies with the terms
of the agreement. Richard C.
Breeden has been selected to
independently monitor
compliance with the
agreement for a three-year
period.
All of the individuals
indicted today are no longer
with the firm. KPMG has put
in place a process to ensure
that individuals responsible
for the wrongdoing related
to past tax shelter
activities are separated
from the firm.
"As KPMG's new leaders, Tim
Flynn and I are extremely
proud of the 1,600 partners
and 18,000 employees of
today's KPMG," said John
Veihmeyer, KPMG Deputy
Chairman and COO. "Looking
toward the future, our
people, our clients and the
capital markets can be
confident that KPMG, as its
first priority, will deliver
on our commitment to the
highest levels of
professionalism."
With regard to claims by
individual taxpayers, KPMG
looks forward to resolving
the civil litigation
expeditiously and with full
and fair accountability.
The resolution of the
Department of Justice's
investigation into the U.S.
firm's past tax shelter
activities has no effect on
KPMG International member
firms outside the United
States.
KPMG LLP SETTLEMENT WITH THE U.S.
DEPARTMENT OF JUSTICE
KEY PROVISIONS AND TERMS
SCOPE
OF SETTLEMENT
"Global settlement" that resolves
both the IRS examination and the DOJ
investigation into the U.S. firm's
past tax shelter activities and
related conduct.
STRUCTURE OF AGREEMENT
KPMG
"Statement of Facts" accepting
responsibility for unlawful conduct
of certain KPMG tax leaders,
partners and employees relating to
tax shelter activities.
Deferred Prosecution Agreement (DPA)
– Filing of charges, directed to
past tax shelter activities.
– Dismissal of the charges on
December 31, 2006, when KPMG has
complied with the terms of the
agreement.
– The agreement provides various
remedies to the government,
including extension of the term,
should the firm fail to comply with
the agreement.
KPMG
currently audits the financial
statements of the Department of
Justice. The Department of Justice
states in the agreement that KPMG is
currently a responsible contractor
and expressly concludes that the
suspension or debarment of KPMG is
not warranted.
KEY
CONDITIONS TO BE MET BY KPMG LLP
Monetary Payments
Fine
of $128 million; restitution to the
IRS of $228 million; and IRS penalty
of $100 million.
Total of $456 million to the U.S.
government.
Timing: $256 million by September 1,
2005; $100 million by June 1, 2006;
$100 million by December 21, 2006.
Payments will not be deductible for
tax purposes, nor will they be
covered by insurance.
Tax
Practice Restrictions and Elevated
Standards
Discontinue by February 26, 2006,
the remainder of the private client
tax practice and the compensation
and benefits tax practice (exclusive
of technical expertise maintained
within Washington National Tax).
Continue individual tax planning and
compliance services for (a) owners
or senior executives of privately
held business clients of KPMG; (b)
individuals who are part of the
international executive (expatriate)
service program, which serves
personnel stationed outside of their
home country; and (c) trust tax
return services provided to large
financial institutions. Any tax
planning and compliance services for
individuals that do not meet these
criteria will be discontinued by
February 26, 2006, and no new
engagements for individuals that do
not meet these criteria will be
accepted.
Prohibit pre-packaged tax products,
covered opinions with respect to any
listed transaction, providing tax
services under conditions of
confidentiality, charging fees other
than based solely on hours worked
(with the exception of revenue sales
and use tax audits), relying on
opinions of others unless KPMG
concurs with the conclusions of such
opinion, and defending any "listed
transaction."
Comply with elevated standards
regarding minimum opinion and tax
return position thresholds.
Cooperation and Consistent Standards
Full
cooperation with the government's
ongoing larger investigation into
the tax shelter activities; and toll
the statute of limitations for five
years.
All
future statements must be consistent
with the information in the KPMG
statement of facts, and any
contradicting statement will be
publicly repudiated.
Compliance and Ethics Program
Maintain a compliance and ethics
program that meets the criteria set
forth in the U.S. Sentencing
Guidelines.
Program to include related training
programs and maintenance of hotline
to contact monitor on an anonymous
basis.
Independent Monitor
Richard Breeden
Term: Three years.
Scope:
– Review and monitor compliance
with the provisions of the
agreement, the compliance and ethics
program, and the restrictions on the
Tax practice as set forth in
Paragraph 6 of the agreement.
– Review and monitor implementation
and execution of personnel decisions
made by KPMG regarding individuals
who engaged in or were responsible
for the illegal conduct described in
the Information.
Internal Revenue Service Closing
Agreement
An
IRS closing agreement is part of the
global settlement and DPA, which
provides for enhanced IRS oversight
of KPMG's Tax practice extending two
years following the expiration of
the monitor's term.
Provisions include instituting a
Compliance and Professional
Responsibility Program that is
focused on disclosure requirements
of IRC Section 6111 and
list-maintenance requirements of IRC
Section 6112. (The program is
intended to enhance the
recordkeeping and review processes
that KPMG has in place to comply
with existing disclosure and
list-maintenance requirements.
One Lie You Learned in School: "Crime Doesn't Pay" (Yeah Right!)
Former Olympus Corp. (7733) Chairman
Tsuyoshi Kikukawa received a suspended sentence for his role in a
$1.7 billion accounting fraud that caused the Japanese camera
maker’s market value to plunge 80 percent.
Olympus itself, also the world’s largest
maker of endoscopes, was ordered to pay 700 million yen ($7 million)
in fines by Tokyo District Judge Hiroaki Saito today. Former Olympus
Executive Vice President Hisashi Mori and Hideo Yamada, a former
auditing officer, also got suspended sentences.
Judge Saito’s decision comes almost two
years after revelations that the company had falsified financial
reports to conceal losses on investments. The sentences reflect the
defendants’ claims that former Olympus presidents Masatoshi
Kishimoto and Toshiro Shimoyama made the decision to hide losses,
while he inherited the aftermath.
“Kikukawa and Yamada succeeded in a
negative legacy and weren’t involved in the decision-making process
to hide losses,” Saito said in court today. “They were distressed
and didn’t benefit personally from hiding losses. Mori followed
their orders.”
The camera maker still faces lawsuits by
investors including State Street Bank and Trust & Co. and Government
of Singapore Investment Corporation Pte Ltd. in a joint complaint
seeking 19.1 billion yen in damages. Suspended Years
Kikukawa and Yamada were given three years
of jail time suspended for five years, while Mori got two and a half
years jail time suspended for four years. Kishimoto and Shimoyama
haven’t been charged because the statute of limitations has expired,
Kyodo News reported on April 23.
Prosecutors had asked for a five-year jail
term for Kikukawa and a 1 billion yen fine for Tokyo-based Olympus,
Kyodo News reported on March 26. Lawyers for the defendants said
jailing them would be unfair because other executives involved
weren’t charged, the news service reported.
The fraud, “destroyed the image of Japanese
companies internationally,” Kikukawa told the court in September
when pleading guilty along with the other executives.
Olympus fell 0.9 percent to 3,170 yen at
the close in Tokyo trading. The shares have more than doubled in the
past 12 months, compared with a 55 percent jump in the benchmark
Nikkei 225 Stock Average. Whistleblower Woodford
Kikukawa resigned in October 2011, weeks
after the board fired former President Michael Woodford, who
uncovered the accounting discrepancies and went public with them
after the Olympus board declined to take action. The company and
three former executives eventually admitted using fraudulent
takeover deals to hide losses for 13 years starting in the 1990s.
Olympus restated five years of earnings
results to account for the bookkeeping fraud, wiping $1.3 billion
off its balance sheet and prompting speculation the company would
seek a capital infusion. Reports of the attempts to hide losses in
mid-October 2011 triggered an 82 percent drop in the company’s
shares between Oct. 13 and Nov. 11, 2011.
The company said in July last year it would
pay 191.8 million yen in fines to Japan’s financial regulators,
while the camera maker itself has sued 19 former executives for
damages related to the cover up of losses.
Founded in 1919 as a microscope and
thermometer maker, Olympus produced its first camera in 1936 and a
predecessor to the modern-day endoscope in 1950, according to its
website. The company controls 75 percent of the global market for
endoscopes, instruments doctors use to peer inside the body to help
diagnose disease.
hey
say that patriotism is the last refuge
To which a scoundrel clings.
Steal a little and they throw you in jail,
Steal a lot and they make you king.
There's only one step down from here, baby,
It's called the land of permanent bliss.
What's a sweetheart like you doin' in a dump like this?
Lyrics of a Bob Dylan song forwarded by Amian Gadal
[DGADAL@CI.SANTA-BARBARA.CA.US]
Japan’s Financial Services Agency is to
determine whether auditors deliberately falsified Olympus’s
financial statements in a series of hearings. Both KPMG Azsa and
Ernst & Young ShinNihon could be forced to cease their business
operations. If either company’s activities are found to be negligent
or fraudulent by the agency, they could also face private suits for
damages.
Olympus has stated in a press conference
that it is investigating the two Big4 firms’ involvement in the
false accounting scandal, although Ernst & Young insists that an
internal probe concluded that nothing was wrong with its audit. KPMG
has said that it will cooperate with the investigations but insists
that its auditing was in line with Japanese auditing standards.
Both companies are under increasing
pressure as they are due to sign off on Olympus’s latest earnings
results due next week, although neither company exposed the $1.5
billion in investment losses incurred throughout the thirteen-year
long coverup.
Although auditors from both firms had given
an unqualified opinion when producing their reports of Olympus’s
accounts, KPMG had expressed concern over the four deals that are at
the center of the scandal in 2008. The Big4 firm said that it
thought Olympus had overpaid for Gyrus Group PLC, a British medical
company, and three Japanese venture firms. In January 2009, KPMG
conducted an on-site audit and warned Olympus that a shareholder
lawsuit could result from the acquisitions. In April of that year,
KPMG then threatened to notify authorities of the discrepancies.
By the middle of May, KPMG demanded the
resignation of then Olympus president Tsuyoshi Kikukawa and two
executives and threatened to resign as auditor. On May 7, 2009, KPMG
said that it would “be difficult to continue as your auditor” if
Olympus continued to insist that the deals were appropriate,
according to the firm’s report. Olympus then agreed to write down a
large portion of the value of the purchases and convened an external
panel, who concluded that Olympus’s executives had done nothing
wrong. Satisfied, KPMG Azsa signed off. Shortly thereafter, Kikukawa
and Olympus executive Hideo Yamada cancelled their contract with
KPMG.
KPMG’s
auditors in Tokyo are under scrutiny after signing off on reports
issued by Olympus Corp. Auditors found several accounting
irregularities when they reviewed financial statements provided by
Olympus executives. The auditors were particularly concerned over
$600 million worth of takeover advisory fees and payments on
acquisitions. Despite their concerns, auditors chose to sign off on
the reports after an outside consultant approved of the findings.
Although
the consultant said the takeover costs were justified, they were
also hired from Olympus Corp. This has raised some red flags over a
possible conflict of interest in the matter.
Olympus has
now been revealed to have engaged in financial fraud for more than
two decades. Following the revelation of the accounting scandal at
Olympus, regulators are looking closely at KPMG and Ernst & Young.
Regulators feel the auditors should have seen signs of the fraud and
taking measures to stop them.
According
to allegations, KPMG was Olympus’s auditor for years. They failed to
catch the discrepancies and Ernst & Young was called in as well.
According
to Yuuki Sakurai of Fukoku Capital Management, auditors work for the
companies that pay them. Auditors are going to have a hard time
staying in business if they get a reputation for being the kind of
company that goes to the regulators without solid evidence of
malfeasance.
Although
the manner in which KPMG handled the Olympus case created some
concern for regulators, it may signify greater concern over the
corporate culture that has created a serious conflict of interest
between auditors’ responsibilities for their clients and need to
uphold the law.
TOPICS: Audit Quality, Audit Report, Auditing, Auditor Changes,
Auditor/Client Disagreements, business combinations, Business Ethics,
Fraudulent Financial Reporting
SUMMARY: The series of events leading to questions about auditing
practices at Olympus that failed to uncover a decades-long coverup of
investment losses is highlighted in this review. The company must submit its
next financial statement filing to the Tokyo Stock Exchange by December 14,
2011 for the period ended September 30, 2011 or face delisting.
CLASSROOM APPLICATION: The review focuses on auditing questions
about sufficient competent evidence, change of auditors, and ability to
provide an audit report given knowledge of the length of time this coverup
has been ongoing.
QUESTIONS:
1. (Introductory) What fraudulent accounting and reporting
practices has Olympus, the Japanese optical equipment maker, admitted to
committing?
2. (Advanced) What services is Mr. Woodford calling for to
investigate the inappropriate payments and accounting practices by Olympus?
Specifically name the type of engagement for which Mr. Woodford thinks that
Olympus should contract with outside accountants.
3. (Introductory) Refer to the related articles. What questions
have been raised about outside accountants' examinations of Olympus's
financial statements for many years?
4. (Advanced) Based only on the discussion in the article, what
evidence did Olympus's auditors rely on to resolve their questions about the
propriety of accounting for mergers and acquisitions? Again, based only on
the WSJ articles, how reliable was that audit evidence?
5. (Advanced) What happened with Olympus's engagement of KPMG AZSA
LLC as its outside auditor? What steps must be taken under U.S. requirements
when a change of auditors occurs?
6. (Introductory) What challenges will Olympus face in meeting the
deadline of December 14 to file its latest financial statements? What will
happen to the company if it cannot do so?
Reviewed By: Judy Beckman, University of Rhode Island
From The Wall Street Journal Weekly
Accounting Review on December 9, 2011
SUMMARY: This review continues coverage from last week of
the accounting scandal at Olympus Corp. The Investigation Report
into Olympus Corporation and its management, written by the "Third
Party Committee" hired by the Board of Directors on October 14,
2011, is available directly online at
http://online.wsj.com/public/resources/documents/third_party_olympus_report_english_summary.pdf
The report provides the clearest description yet of the investment
loss and accounting scandal that has brought the Japanese imaging
equipment maker to the brink of delisting from the Tokyo Stock
Exchange. As described in the opening page of the document, the
Olympus Corporation Board of Directors called for a third party
review because "the shareholders and others doubted that" payments
by Olympus to a financial advisor and acquisitions by Olympus, along
with subsequent recognition of impairment losses on those
investments, were appropriate. The findings in the report
essentially state that Olympus began incurring financial losses on
speculative investments that were originally hoped to bolster
corporate earnings when operating earnings declined due to a
strengthening yen in the late 1980s. "However, in 1990 the bubble
economy burst and the loss incurred on Olympus by the financial
assets management increased" (p. 6). Then, in 1997 to 1998, "when
the unrealized loss was ballooning," Japanese accounting standards
were changed to require fair value reporting of financial assets, as
did those in the U.S. "In that environment, Olympus led by Yamada
and Mori started seeking a measure to avoid the situation where the
substantial amount of unrealized loss would come up to the
surface..." because of this change in accounting standards. The
technique was so common in Japan that it was given a name, "tobashi."
As noted in the WSJ article, the Olympus auditors at the time, KPMG
AZSA LLC "...came across information that indicated the company was
engaged in tabshi, which recently had become illegal in Japan....[T]he
auditor pushed them...to admit to the presence of one [tobashi
scheme] and unwind it, booking a loss of 16.8 billion yen."
CLASSROOM APPLICATION: Questions relate to the accounting
environment under historical cost accounting that allows avoiding
recognition of unrealized losses and to the potential for audit
issues when management is found to have engaged in one unethical or
illegal act.
QUESTIONS:
1. (Introductory) For how long were investment losses
hidden by accounting practices at Olympus Corp?
2. (Advanced) What is the difference between realized and
unrealized investment losses? How are these two types of losses
shown in financial statements under historical cost accounting and
under fair value accounting methods for investments?
3. (Introductory) What accounting change in the late 1990s
led Olympus Corp. management to search for further ways to hide
their investment losses? In your answer, comment on the meaning of
the Japanese term "tobashi."
4. (Introductory) What happened in 1999 when KPMG AZSA
"came across information that indicated the company was engaged in
tobashi, which recently had become illegal in Japan"?
5. (Advanced) Given the result of the KPMG AZSA finding in
1999, what concerns should that raise for any auditor about overall
ability to conduct an audit engagement?
Reviewed By: Judy Beckman, University of Rhode Island
An independent panel
has determined that KPMG Azsa LLC and Ernst & Young ShinNihon LLC
did not break the law and did not violate any legal obligations when
auditing Olympus. The panel determined that both Big4 firms were not
responsible for the accounting fraud scandal in which Olympus hid
$1.7 billion in assets over a 13-year long period.
The panel’s decision
clears KPMG and Ernst & Young from culpability, meaning that no
party has grounds to file a suit against either accounting firm.
The panel also
determined that five internal auditors, some of which are still with
Olympus, were responsible for hiding the assets. The panel concluded
that those auditors were responsible for 8.4 billion yen ($109
million) in damages.
Continued in article
Jensen Comment
I have no idea why this "panel" has the power "that
no party has grounds to file a suit against either accounting firm."
If this were a lower court decision,
there are generally routes of appeal in higher courts.
How does an appointed panel decide that
shareholders and creditors have no right to sue in lower or higher
courts?
Of course in the case of Olympus the
guilty executives were purportedly tied to organized crime. Well now I'm
beginning to understand. Organized crime members have their own ways of
determining that no lawsuits will ever be filed.
PCAOB Snags KPMG Yet Another
Time (this time for a client named Motorola with dubious revenue
recognition to meet an earnings target)
The oversight board said a significant portion of the company’s earnings
for the 2006 third quarter came from two licensing agreements that were
recorded during the last three days of the quarter. One was the Qualcomm
deal that wasn’t signed until the fourth quarter. The board also cited
other deficiencies in KPMG’s review of Motorola’s accounting for the
transactions.
"Dirty Secrets Fester in 50-Year Relationships," byJonathan Weil,
Bloomberg News, June 9, 2011 ---
http://www.bloomberg.com/news/2011-06-09/dirty-secrets-fester-in-50-year-relationships-jonathan-weil.html
Another financial scandal. Another cover-up by regulators. Four
years ago, inspectors for the auditing industry's chief watchdog
discovered that KPMG LLP had let Motorola Inc. record revenue during
the third quarter of 2006 from a transaction with
Qualcomm Inc. (QCOM), even though the
final contract wasn’t signed until the early hours of the fourth
quarter. That’s no small technicality. Without the deal, Motorola
would have missed its third-quarter earnings target.
The
regulator, the
Public Company Accounting Oversight Board,
later criticized KPMG for letting Motorola book the revenue when it
did. Although KPMG had discussed the transaction’s timing with both
Motorola and Qualcomm, the board said the firm “failed to obtain
persuasive evidence of an arrangement for revenue-recognition
purposes in the third quarter.” In other words, KPMG had no good
reason to believe the deal shouldn’t have been recorded in the
fourth quarter.
The
oversight board didn’t tell the public that this happened at
Motorola, though. The maker of wireless- communications equipment,
now known as Motorola Solutions Inc., didn’t restate its earnings
for the period in question. And there’s no sign the Securities and
Exchange Commission ever followed up with an investigation of
Motorola’s accounting, even though it oversees the board and had
access to its findings.
All
of this is business as usual for America’s numbers cops. Since the
board’s creation by the
Sarbanes-Oxley Act in 2002, its inspectors
have found audit failures by large accounting firms at hundreds of
U.S.-listed companies. Yet its policy is to keep the identities of
those clients secret.
‘Issuer C’
Likewise, in August 2008 when the board released its annual
inspection
report on KPMG, it referred to Motorola as
“Issuer C” in the section on the auditor’s work for the company. For
what it’s worth, Motorola paid the firm $244.2 million from 2000 to
2010.
This is the
third column I’ve written revealing the name of a client whose
accounting practices were a subject of a major auditing firm’s
inspection report. Motorola is the biggest yet. I hope a
whistleblower comes forward someday to leak many more. This is
information investors need to know.
The
Sarbanes-Oxley Act
authorizes the oversight board to disclose “such confidential and
proprietary information as the board may determine to be
appropriate” in the public portions of its inspection reports. So
it’s the board’s call whether to disclose clients’ names, although
the SEC could overrule it. The board never does, bowing to the
wishes of the accounting firms.
Identity
Revealed
Motorola’s identity was disclosed in public records last month as
part of a class-action shareholder lawsuit against the company in a
federal district court in
Chicago. The
plaintiffs in the case, led by the Macomb County Employees’
Retirement System in
Michigan, filed a transcript of a
September 2010 deposition of a KPMG auditor, David Pratt, who
testified that Issuer C was Motorola.
KPMG isn’t a defendant in the lawsuit.
Pratt also
identified the Motorola customers cited in the board’s inspection
report. It’s his deposition that allows me to describe the report’s
findings using real names.
The
oversight board said a significant portion of the company’s earnings
for the 2006 third quarter came from two licensing agreements that
were recorded during the last three days of the quarter. One was the
Qualcomm deal that wasn’t signed until the fourth quarter. The board
also cited other deficiencies in KPMG’s review of Motorola’s
accounting for the transactions.
Making the
Numbers
Motorola
booked $275 million of earnings during the 2006 third quarter as a
result of the Qualcomm deal, according to estimates by the
plaintiffs in the shareholder suit. The plaintiffs allege that all
of it was recorded in violation of generally accepted accounting
principles. That’s 28 percent of the net income Motorola reported
for the quarter.
A
Motorola spokesman, Nicholas Sweers, said the company’s accounting
complied with GAAP, and that the financial statements for the
periods covered in the inspection report have never been the subject
of an SEC investigation. He declined to discuss details of
Motorola’s accounting, citing the litigation. A KPMG spokesman,
George Ledwith, declined to comment. So did an oversight board
spokeswoman, Colleen Brennan, and an SEC spokesman,
John Nester.
The
story doesn’t end there. Last week the board’s new chairman, James
Doty, gave a
speech in which he said the board should
consider setting mandatory
term limits
for auditors at public companies. To prove his point, he cited two
instances that were “galling in their simplicity” where auditors
“have failed to exercise the required skepticism and have accepted
evidence that is less than persuasive.”
Making a
Match
One
of his examples matched the fact pattern of KPMG’s 2006 review at
Motorola exactly. “PCAOB inspectors found at one large firm that an
engagement team was aware that a significant contract was not signed
until the early hours of the fourth quarter,” Doty said.
“Nevertheless, the audit partner allowed the company to book the
transaction in the third quarter, which allowed the company to meet
its earnings target.”
Continued in article
Jensen Comment
Recall that KPMG was fired from the big Fannie Mae audit because of
alleged cooperation in helping Fannie's top executives creatively meet
earnings targets for their personal bonuses ---
http://www.trinity.edu/rjensen/Theory02.htm
In case you missed it, note how
cheaply some Big Four auditing firms wiggled out of some major bank
failure litigation. What could have been billions were settled for
pennies on the dollar.
Latest
available figures for the Big Four indicate total annual global
revenues of some $ 102 billion.
Applied to
those figures, the model indicates that the break-up threshold for
any one of the Big Four firm’s litigation “worst-cases” would be in
the range from a maximum of $ 6 billion down to $ 2.2 billion,
if viewed at the global level.
That is a
considerable increase from the earlier numbers, owing to the great
leap in total big-firm revenues in the intervening years.
But
cautions remain. Most importantly, cohesion of the international
networks under the strain of death-threat litigation, or the
extended availability of collegial cross-border financial support,
cannot be assumed. Arthur Andersen’s rapid disintegration in 2002
with the flight of its non-US member firms is illustrative.
So it is
necessary to look at the bust-up range based on figures alone from
the Americas, the most hazardous region. If left to their local
resources, as was Andersen’s US firm, the disintegration range
shrinks, from a maximum of less than $ 3 billion down to a truly
frightening $ 675 million.
Amounts at that level compare ominously with the litigation
settlements recently extracted from the larger debacles of the last
decade – examples led by Bank of America’s post-Countrywide
mortgage-securities settlement of $8.5 billion (here)
and including such investor settlements as
Enron ($7.2 billion), WorldCom ($6.2 billion) and Tyco ($3.2
billion) (here).
But those
amounts were only available because inflicted on the investor-funded
balance sheets of the corporations contributing to the settlements –
resources not available to the private accounting partnerships. And
they are even more darkly comparable with the exposures looming in
the pending claims inventory.
True, in recent months the large accounting firms have enjoyed
remarkable success in disposing of large litigations for modest sums
– examples include KPMG resolving Countrywide for $ 24 million
(here)
and New Century for $ 45 million
(here),
and Deloitte settling Washington Mutual for
$ 18.5 million (here).
However,
hope for the indefinite continuation of such forbearance on the part
of the plaintiffs is not a strategy, but only a wish.
As the
catastrophic impact of “black swan” events makes clear, it only
takes one. And at that tipping point, all the marginal fiddling by
Barnier, Doty and their ilk becomes academic.
The
government's auditing regulator found deficiencies in 28 audits
conducted by PricewaterhouseCoopers LLP and 12 audits by KPMG LLP in
its annual inspections of the Big Four accounting firms.
The Public
Company Accounting Oversight Board (PCAOB) said many of the
deficiencies it found in its 2010 inspection reports of the two
firms, released Monday, were significant enough that it appeared the
firms didn't obtain sufficient evidence to support their audit
opinions. The regulator hasn't yet issued its yearly reports on its
inspections of the other Big Four firms, Ernst & Young LLP and
Deloitte LLP.
The 28
deficient PwC audits the inspectors found were out of 75 audits and
partial audits reviewed, and were an increase from nine deficient
audits found in the previous year's report. The deficiencies
inspectors found in various audits concerned, among other areas,
testing of "fair value" of the firm's assets, testing of revenue and
receivables, derivatives accounting and asset impairments. In two
cases, the companies involved later restated their financial
statements; in a third case, the company later made "substantial
adjustments."
The board
didn't identify the audit clients involved, in accordance with its
practice.
PwC is
"focused on the increase" in the number of deficiencies reported
over past years, and is "working to strengthen and sharpen the
firm's audit quality, including making investments designed to
improve our performance over both the short and long term," Robert
Moritz, PwC's head partner and chairman, said in a statement.
KPMG's 12
deficient audits were out of 54 audits and partial audits reviewed,
and were an increase from eight deficient audits found the previous
year. The accounting watchdog said the areas in which deficiencies
were found included fair-value testing, receivables testing,
goodwill and testing of loan-loss allowances. None of the
deficiencies resulted in restatements, though one led to a
"substantial adjustment" in an aspect of the company's financial
statements.
KPMG
"shares a common objective with the PCAOB" to make sure high-quality
audits are provided, and the board's inspectors "have measurably
helped KPMG as we work to continuously improve our audit performance
and strengthen our system of audit quality control," George Ledwith,
a KPMG spokesman, said in a statement.
The
accounting watchdog conducts annual inspections of the biggest
accounting firms, examining a sample of each firm's audits to assess
their performance and make sure they're complying with auditing
standards. Only part of the report is made public; a section in
which the board assesses the firm's quality controls is sealed and
never made public as long as the firm addresses any criticisms to
the board's satisfaction within a year.
Sherry Hunt never expected to be a senior
manager at a Wall Street bank. She was a country girl, raised in
rural Michigan by a dad who taught her to fish and a mom who showed
her how to find wild mushrooms. She listened to Marty Robbins and
Buck Owens on the radio and came to believe that God has a bigger
plan, that everything happens for a reason.
She got married at 16 and didn’t go to
college. After she had her first child at 17, she needed a job. A
friend helped her find one in 1975, processing home loans at a small
bank in Alaska. Over the next 30 years, Hunt moved up the ladder to
mortgage-banking positions in Indiana, Minnesota and Missouri,
Bloomberg Markets magazine reports in its July issue.
On her days off, when she wasn’t fishing
with her husband, Jonathan, she rode her horse, Cody, in Wild West
shows. She sometimes dressed up as the legendary cowgirl Annie
Oakley, firing blanks from a vintage rifle to entertain an audience.
She liked the mortgage business, liked that she was helping people
buy houses.
In November 2004, Hunt, now 55, joined
Citigroup (C) Inc. as a vice president in
the mortgage unit. It looked like a great career move. The housing
market was
booming, and the New York- based bank, the
sixth-largest lender in the U.S. at the time, was responsible for
3.5 percent of all home loans. Hunt supervised 65 mortgage
underwriters at CitiMortgage Inc.’s sprawling headquarters in
O’Fallon, Missouri, 45 minutes west of St. Louis.
Avoiding Fraud
Hunt’s team was responsible for protecting
Citigroup from fraud and bad investments. She and her colleagues
inspected loans Citi wanted to buy from outside brokers and lenders
to see whether they met the bank’s standards. The mortgages had to
have properly signed paperwork, verifiable borrower income and
realistic appraisals.
Citi would vouch for the quality of these
loans when it sold them to investors or approved them for government
mortgage insurance.
Investor demand was so strong for mortgages
packaged into securities that Citigroup couldn’t process them fast
enough. The Citi stamp of approval told investors that the bank
would stand behind the mortgages if borrowers quit paying.
At the mortgage-processing factory in
O’Fallon, Hunt was working on an assembly line that helped inflate a
housing bubble whose implosion would shake the world. The O’Fallon
mortgage machinery was moving too fast to check every loan, Hunt
says.
Phony Appraisals
By 2006, the bank was buying mortgages from
outside lenders with doctored tax forms, phony appraisals and
missing signatures, she says. It was Hunt’s job to identify these
defects, and she did, in regular reports to her bosses.
Executives buried her findings, Hunt says,
before, during and after the financial crisis, and even into 2012.
In March 2011, more than two years after
Citigroup took $45 billion in bailouts from the U.S. government and
billions more from the
Federal Reserve -- more in total than any
other
U.S. bank -- Jeffery Polkinghorne, an
O’Fallon executive in charge of loan quality, asked Hunt and a
colleague to stay in a conference room after a meeting.
The encounter with Polkinghorne was brief
and tense, Hunt says. The number of loans classified as defective
would have to fall, he told them, or it would be “your asses on the
line.”
Hunt says it was clear what Polkinghorne
was asking -- and she wanted no part of it.
‘I Wouldn’t Play Along’
“All a dishonest person had to do was
change the reports to make things look better than they were,” Hunt
says. “I wouldn’t play along.”
Instead, she took her employer to court --
and won. In August 2011, five months after the meeting with
Polkinghorne, Hunt sued Citigroup in Manhattan federal court,
accusing its home-loan division of systematically violating U.S.
mortgage regulations.
The U.S.
Justice Department decided to join her
suit in January. Citigroup didn’t dispute any of Hunt’s facts; it
didn’t mount a defense in public or in court. On Feb. 15, 2012, the
bank agreed to pay $158.3 million to the U.S. government to settle
the case.
Citigroup admitted approving loans for
government insurance that didn’t qualify under Federal Housing
Administration rules. Prosecutors kept open the possibility of
bringing criminal charges, without specifying targets.
‘Pure Myth’
Citigroup behaving badly as late as 2012
shows how a big bank hasn’t yet absorbed the lessons of the credit
crisis despite billions of dollars in bailouts, says
Neil Barofsky, former special inspector
general of the Troubled Asset Relief Program.
“This case demonstrates that the notion
that the bailed-out banks have somehow found God and have reformed
their ways in the aftermath of the financial crisis is pure myth,”
he says.
As a reward for blowing the whistle on her
employer, Hunt, the country girl turned banker, got $31 million out
of the settlement paid by Citigroup.
Hunt still remembers her first impressions
of CitiMortgage’s O’Fallon headquarters, a complex of three
concrete-and-glass buildings surrounded by manicured lawns and vast
parking lots. Inside are endless rows of cubicles where 3,800
employees trade e-mails and conduct conference calls. Hunt says at
first she felt like a mouse in a maze.
“You only see people’s faces when someone
brings in doughnuts and the smell gets them peeking over the tops of
their cubicles,” she says.
Jean Charities
Over time, she came to appreciate the
camaraderie. Every month, workers conducted the so-called Jean
Charities. Employees contributed $20 for the privilege of wearing
jeans every day, with the money going to local nonprofit
organizations. With so many workers, it added up to $25,000 a month.
“Citi is full of wonderful people,
conscientious people,” Hunt says.
Those people worked on different teams to
process mortgages, all of them focused on keeping home loans moving
through the system. One team bought loans from brokers and other
lenders. Another team, called underwriters, made sure loan paperwork
was complete and the mortgages met the bank’s and the government’s
guidelines.
Yet another group did spot-checks on loans
already purchased. It was such a high-volume business that one
group’s assignment was simply to keep loans moving on the assembly
line.
Powerful Incentive
Still another unit sold loans to
Fannie Mae,
Freddie Mac and Ginnie Mae, the
government-controlled companies that bundled them into securities
for sale to investors. Those were the types of securities that blew
up in 2007, igniting a global financial crisis.
Workers had a powerful incentive to push
mortgages through the process even if flaws were found:
compensation. The pay of CitiMortgage employees all the way up to
the division’s chief executive officer depended on a high percentage
of approved loans, the government’s complaint says.
By 2006, Hunt’s team was processing $50
billion in loans that Citi-Mortgage bought from hundreds of mortgage
companies. Because her unit couldn’t possibly review them all, they
checked a sample.
When a mortgage wasn’t up to federal
standards -- which could be any error ranging from an unsigned
document to a false income statement or a hyped-up appraisal -- her
team labeled the loan as defective.
Missing Documentation
In late 2007, Hunt’s group estimated that
about 60 percent of the mortgages Citigroup was buying and selling
were missing some form of documentation. Hunt says she took her
concerns to her boss, Richard Bowen III.
Bowen, 64, is a religious man, a former Air
Force Reserve Officer Training Corps cadet at Texas Tech University
in Lubbock with an attention to detail that befits his background as
a certified public accountant. When he saw the magnitude of the
mortgage defects, Bowen says he prayed for guidance.
In a Nov. 3, 2007,
e-mail, he alerted Citigroup executives,
including
Robert Rubin, then chairman of Citigroup’s
executive committee and a former
Treasury secretary; Chief Financial
Officer
Gary Crittenden; the bank’s senior risk
officer; and its chief auditor.
Bowen put the words “URGENT -- READ
IMMEDIATELY -- FINANCIAL ISSUES” in the subject line.
“The reason for this urgent e-mail concerns
breakdowns of internal controls and resulting significant but
possibly unrecognized financial losses existing within our
organization,” Bowen wrote. “We continue to be significantly out of
compliance.”
No Change
There were no noticeable changes in the
mortgage machinery as a result of
Bowen’s warning, Hunt says.
Just a week after Bowen sent his e-mail,
Sherry and Jonathan were driving their Toyota Camry about 55 miles
(89 kilometers) per hour on four-lane Providence Road in Columbia,
Missouri,
when a driver in a Honda Civic hit them head-on. Sherry broke a foot
and her sternum. Jonathan broke an arm and his sternum.
Doctors used four bones harvested from a
cadaver and titanium screws to stabilize his neck.
“You come out of an experience like that
with a commitment to making the most of the time you have and making
the world a better place,” Sherry says.
Three months after the accident, attorneys
from
Paul, Weiss, Rifkind, Wharton & Garrison LLP,
a New York law firm representing Citigroup,
interviewed Hunt. She had no idea at the time that it was related to
Bowen’s complaint, she says.
Home Computer
The lawyers’ questions made her search her
memory for details of loans and conversations with colleagues, she
says. She decided to take notes from that time forward on a
spreadsheet she kept on her home computer.
Bowen’s e-mail is now part of the archive
of the Financial Crisis Inquiry Commission, a panel created by
Congress in 2009. Citigroup’s
response to
the commission, FCIC records show, came from
Brad Karp, chairman of
Paul Weiss.
He said Citigroup had reviewed Bowen’s
issues, fired a supervisor and changed its underwriting system,
without providing specifics.
Both the corporate CEO and the external auditing firm are to
explicitly sign off on the following and are subject (turns out
to be a ha, ha joke) to huge fines and jail time for egregious
failure to do so:
Assess both the design and
operating effectiveness of selected internal controls
related to significant accounts and relevant assertions, in
the context of material misstatement risks;
Understand the flow of
transactions, including IT aspects, in sufficient detail to
identify points at which a misstatement could arise;
Evaluate company-level
(entity-level) controls, which correspond to the components
of the
COSO framework;
Perform a fraud risk assessment;
Evaluate controls designed to
prevent or detect fraud, including management override
of controls;
Evaluate controls over the
period-end
financial
reporting process;
Scale the assessment based on the
size and complexity of the company;
Rely on management's work based on
factors such as competency, objectivity, and risk;
Conclude on the adequacy of
internal control over financial reporting.
Most importantly as far as the CPA auditing firms are
concerned is that Sarbox gave those firms both a responsibility
to verify that internal controls were effective and the
authority to charge more (possibly twice as much) for each
audit. Whereas in the 1990s auditing was becoming less and less
profitable, Sarbox made the auditing industry quite prosperous
after 2002.
There's a great gap between the theory of Sarbox and its enforcement
In theory, the U.S. Justice Department (including the FBI) is to
enforce the provisions of Section 404 and subject top corporate
executives and audit firm partners to huge fines (personal fines
beyond corporate fines) and jail time for signing off on Section 404
provisions that they know to be false. But to date, there has not
been one indictment in enormous frauds where the Justice Department
knows that executives signed off on Section 404 with intentional
lies.
In theory the SEC is to also enforce Section 404, but the SEC in
Frank Partnoy's words is toothless. The SEC cannot send anybody to
jail. And the SEC has established what seems to be a policy of
fining white collar criminals less than 20% of the haul, thereby
making white collar crime profitable even if you get caught. Thus,
white collar criminals willingly pay their SEC fines and ride off
into the sunset with a life of luxury awaiting.
And thus we come to the December 4 Sixty Minutes module that
features two of the most egregious failures to enforce Section 404: The astonishing case of CitiBank
The astonishing case of Countrywide (now part of Bank of America)
The Astonishing Case of CitiBank
What makes the Sixty Minutes show most interesting are the
whistle blowing revelations by a former Citi Vice President in Charge
of Fraud Investigations
What has to make the CitiBank revelations the most embarrassing
revelations on the Sixty Minutes blockbuster emphasis that
top CItiBank executives were not only informed by a Vice President
in Charge of Fraud Investigation of huge internal control
inadequacies, the outside U.S. government top accountant, the U.S.
Comptroller General, sent an official letter to CitiBank executives
notifying them of their Section 404 internal control failures.
What the Sixty Minutes show failed to mention is that the
external auditing firm of KPMG also flipped a bird at the U.S.
Comptroller General and signed off on the adequacy of its client's
internal controls.
A few months thereafter CitiBank begged for and got hundreds of
billions in bailout money from the U.S. Government to say afloat.
The implication is that CitiBank and the other Wall Street
corporations are just to0 big to prosecute by the Justice
Department. The Justice Department official interviewed on the Sixty
Minutes show sounded like hollow brass wimpy taking hands off
orders from higher authorities in the Justice Department.
The SEC worked out a settlement with CitiBank, but the fine is
such a joke that the judge in the case has to date refused to accept
the settlement. This is so typical of SEC hand slapping settlements
--- and the hand slaps are with a feather.
The astonishing case of Countrywide (now part of Bank of America)
Countrywide Financial before 2007 was the largest issuer of
mortgages on Main Streets throughout the nation and by estimates of
one of its own whistle blowing executives in charge of internal
fraud investigations over 60% of those mortgages were fraudulent.
After Bank of America purchased the bankrupt Countrywide, BofA
top executives tried to buy off the Countrywide executive in charge
of fraud investigations to keep him from testifying. When he refused
BofA fired him.
Whereas the Justice Department has not even attempted to indict
Countrywide executives and the Countrywide auditing firm of Grant
Thornton (later replaced by KPMG) to bring indictments for Section
404 violations, the FTC did work out an absurdly low settlement of
$108 million for 450,000 borrowers paying "excessive fees" and the
attorneys for those borrowers ---
http://www.nytimes.com/2011/07/21/business/countrywide-to-pay-borrowers-108-million-in-settlement.html
This had nothing to do with the massive mortgage frauds committed by
Countrywide.
Former Countrywide CEO Angelo Mozilo settled the SEC’s
Largest-Ever Financial Penalty ($22.5 million) Against a Public
Company's Senior Executive
http://sec.gov/news/press/2010/2010-197.htm
The CBS Sixty Minutes show estimated that this is less than 20% of
what he stole and leaves us with the impression that Mozilo deserves
jail time but will probably never be charged by the Justice
Department.
I was disappointed in the CBS Sixty Minutes show in that it
completely ignored the complicity of the auditing firms to sign off on
the Section 404 violations of the big Wall Street banks and other huge
banks that failed. Washington Mutual was the largest bank in the world
to ever go bankrupt. Its auditor, Deloitte, settled with the SEC for
Washington Mutual for
$18.5 million. This isn't even a hand slap relative to the billions
lost by WaMu's investors and creditors.
No jail time is expected for any partners of the negligent auditing
firms. .KPMG settled for peanuts with Countrywide for
$24 million of negligence and New Century for
$45 million of negligence costing investors billions.
Five times
since 2003 the Securities and Exchange Commission has accused
Citigroup Inc. (C)’s main broker-dealer subsidiary of securities
fraud. On each occasion the company’s SEC settlements have followed
a familiar pattern.
Citigroup
neither admitted nor denied the SEC’s claims. And the company
consented to the entry of either a court injunction or an SEC order
barring it from committing the same types of violations again. Those
“obey-the-law” directives haven’t meant much. The SEC keeps accusing
Citigroup of breaking the same laws over and over, without ever
attempting to enforce the prior orders. The SEC’s most recent
complaint against Citigroup, filed last month, is no different.
Enough is
enough. Hopefully Jed Rakoff will soon agree.
Rakoff, the
U.S. district judge in New York who was assigned the newest
Citigroup case, is saber-rattling again, threatening to derail the
SEC’s latest wrist-slap. The big question is whether he has the guts
to go through with it. Twice since 2009, Rakoff has put the SEC
through the wringer over cozy corporate settlements, only to give in
to the agency later.
That the
SEC went easy on Citigroup again is obvious. The commission last
month accused Citigroup of marketing a $1 billion collateralized
debt obligation to investors in 2007 without disclosing that its own
traders picked many of the assets for the deal and bet against them.
The SEC’s complaint said Citigroup realized “at least $160 million”
in profits on the CDO, which was linked to subprime mortgages. For
this, Citigroup agreed to pay $285 million, including a $95 million
fine -- a pittance compared with its $3.8 billion of earnings last
quarter. Looking Deliberate
On top of
that, the agency accused Citigroup of acting only negligently,
though the facts in the SEC’s complaint suggested deliberate
misconduct. The SEC named just one individual as a defendant, a
low-level banker who clearly didn’t act alone. Plus, the SEC’s case
covered only one CDO, even though Citigroup sold many others like
it.
Here’s what
makes the SEC’s conduct doubly outrageous: The commission already
had two cease-and-desist orders in place against the same Citigroup
unit, barring future violations of the same section of the
securities laws that the company now stands accused of breaking
again. One of those orders came in a 2005 settlement, the other in a
2006 case. The SEC’s complaint last month didn’t mention either
order, as if the entire agency suffered from amnesia.
The SEC’s
latest allegations also could have triggered a violation of a court
injunction that Citigroup agreed to in 2003, as part of a $400
million settlement over allegedly fraudulent analyst-research
reports. Injunctions are more serious than SEC orders, because
violations can lead to contempt-of-court charges.
The SEC
neatly avoided that outcome simply by accusing Citigroup of
violating a different fraud statute. Not that the SEC ever took the
prior injunction seriously. In December 2008, the SEC for the second
time accused Citigroup of breaking the same section of the law
covered by the 2003 injunction, over its sales of so-called
auction-rate securities. Instead of trying to enforce the existing
court order, the SEC got yet another one barring the same kinds of
fraud violations in the future.
It gets
worse: Each time the SEC settled those earlier fraud cases,
Citigroup asked the agency for waivers that would let it go about
its business as usual. (This is standard procedure for big
securities firms.) The SEC granted those requests, saying it did so
based on the assumption that Citigroup would comply with the law as
ordered. Then, when the SEC kept accusing Citigroup of breaking the
same laws again, the agency granted more waivers, never revoking any
of the old ones. Legal Standard
Rakoff
seems aware of the problem, judging by the questions he sent the SEC
and Citigroup last week. Noting that the SEC is seeking a new
injunction against future violations by Citigroup, he asked: “What
does the SEC do to maintain compliance?” Additionally, he asked:
“How many contempt proceedings against large financial entities has
the SEC brought in the past decade as a result of violations of
prior consent judgments?” We’ll see if the SEC finds any. A hearing
is set for Nov. 9.
The legal
standard Rakoff must apply is whether the proposed judgment is
“fair, reasonable, adequate and in the public interest.” Among
Rakoff’s other questions: “Why should the court impose a judgment in
a case in which the SEC alleges a serious securities fraud but the
defendant neither admits nor denies wrongdoing?” And this: “How can
a securities fraud of this nature and magnitude be the result simply
of negligence?”
A Citigroup
spokeswoman, Shannon Bell, said, “Citi has entered into various
settlements with the SEC over the years, and there is no basis for
any assertion that Citi has violated the terms of any of those
settlements.” I guess it depends on the meaning of the words
“settlement” and “violated.”
Rakoff
gained fame in 2009 when he rejected an SEC proposal to fine Bank of
America Corp. (BAC) $33 million for disclosure violations related to
its $29.1 billion purchase of Merrill Lynch & Co. Rakoff said the
settlement punished Bank of America shareholders for the actions of
its executives, none of whom were named as defendants.
Months later, though, Rakoff approved a $150 million fine for the
same infractions, on the condition that the money would be
redistributed to Bank of America stockholders who supposedly were
harmed. The stipulation was classic window dressing. Even so, Rakoff
became something of a folk hero, simply for daring to question an
SEC settlement. Most other judges are rubber stamps.
“As I look at the deficiencies cited in
the letter, taken as a whole, it appears that Citigroup had a
material weakness with respect to valuing these financial
instruments,” said Ed Ketz, an accounting professor at Pennsylvania
State University, who reviewed the OCC’s letter to Pandit at my
request. “It just is overwhelming by the time you get to the end of
it."
Jonathan Weil writes in his column
today about Citigroup and their “acceptable
group of auditors,” (aka
KPMG) and he’s having trouble connecting the dots on a few
things. Specifically, how a love letter (it was sent on February
14, 2008, after all)
sent by the Office of the Comptroller of the Currencyto Citigroup CEO Vikram Pandit:
The gist of the
regulator’sfindings:
Citigroup’s internal controls were a mess. So were its
valuation methods for subprime mortgage bonds, which had
spawned record losses at the bank. Among other things,
“weaknesses were noted with model documentation, validation
and control group oversight,” the letter said. The main
valuation model Citigroup was using “is not in a controlled
environment.” In other words, the model wasn’t reliable.
Okay, so the bank’s internal
controls weren’t worth the paper they were printed on.
Ordinarily, one could reasonably expect management and
perhaps their auditors to be aware of such a fact and that
they were handling the situation accordingly. We said,
“ordinarily”:
Eight days later, on Feb. 22,
Citigroup filed its
annual reportto
shareholders, in which it said “management believes that, as
of Dec. 31, 2007, the company’s
internal controlover
financial reporting is effective.” Panditcertifiedthe report personally,
including the part about Citigroup’s internal controls. So
did Citigroup’s chief financial officer at the time,
Gary Crittenden.
The annual report also included
a Feb. 22 letter from KPMG LLP, Citigroup’s outside auditor,vouchingfor the effectiveness of the
company’s financial-reporting controls. Nowhere did
Citigroup or KPMG mention any of the problems cited by the
OCC. KPMG, which earned $88.1 million in fees from Citigroup
for 2007, should have been aware of them, too. The lead
partner on KPMG’s Citigroup audit, William O’Mara, was
listed on the “cc” line of the OCC’s Feb. 14 letter.
Huh. There has to be an
explanation, right? It’s just one of the largest banks on
Earth audited by one of the largest audit firm on Earth.
You’d think these guys would be more than willing to stand by
their work. Funny thing – no one felt compelled to return JW’s
calls. So, he had no choice to piece it together himself:
[S]omehow KPMG and Citigroup’s
management decided they didn’t need to mention any of those
weaknesses or deficiencies. Maybe in their minds it was all
just a difference of opinion. Whatever their rationale, nine
months later Citigroup had taken a $45 billion taxpayer
bailout, [Ed. note: OH, right. That.] still
sporting a balance sheet that made it seem healthy.
Actually, just kidding, he ran it
by an expert:
“As I look at the deficiencies
cited in the letter, taken as a whole, it appears that
Citigroup had a material weakness with respect to valuing
these financial instruments,” said Ed Ketz, an accounting
professor at Pennsylvania State University, who reviewed the
OCC’s letter to Pandit at my request. “It just is
overwhelming by the time you get to the end of it."
Yet somehow KPMG and Citigroup’s
management decided they didn’t need to mention any of those
weaknesses or deficiencies. Maybe in their minds it was all just
a difference of opinion. Whatever their rationale, nine months
later Citigroup had taken a $45 billion taxpayer bailout, still
sporting a balance sheet that made it seem healthy.
“As I look at the deficiencies
cited in the letter, taken as a whole, it appears that Citigroup
had a material weakness with respect to valuing these financial
instruments,” said Ed Ketz, an accounting professor at
Pennsylvania State University, who reviewed the OCC’s letter to
Pandit at my request. “It just is overwhelming by the time you
get to the end of it.”
One company that did get a
cautionary note from its auditor that same quarter was American
International Group Inc. In February 2008,
PricewaterhouseCoopers LLP warned of a material weakness related
to AIG’s valuations for credit-default swaps. So at least
investors were told AIG’s numbers might be off. That turned out
to be a gross understatement.
At Citigroup, there was no such
warning. The public deserves to know why.
Although
KPMG LLP – one of the "Big Four" accounting firms – publicly touts
its commitment to diversity and equal opportunity, the numbers tell
a different story entirely. Women comprise about half of KPMG's
employees, but are conspicuously absent from the top leadership
positions. The Company's 20-member global executive team and
24-member global board each have only one female representative.
Similarly, women are only 18% of all KPMG Partners compared to
nearly 50% of all employees.
Aiming to
put an end to the systemic gender discrimination at KPMG, a former
female Senior Manager filed a $350 million class action
discrimination lawsuit against the company today in the U.S.
District Court for the Southern District of New York. The Plaintiff,
Donna Kassman, lives in New York and worked in KPMG's New York
office for seventeen years before resigning as a result of gender
discrimination. Plaintiff Kassman and the class are represented by
Janette Wipper, Siham Nurhussein, and Deepika Bains of Sanford
Wittels & Heisler, LLP.
KPMG is an
audit, tax, and advisory services firm headquartered in Netherlands
with U.S. offices headquartered in New York City. In 2010, KPMG
reported global revenues of $20.63 billion.
Plaintiff
Kassman alleges that KPMG engages in systemic discrimination against
its female Managers, including but not limited to Managers, Senior
Managers and Managing Directors. The lawsuit is intended to change
KPMG's discriminatory pay and promotion policies and practices, as
well as its systemic failure to properly investigate and resolve
complaints of discrimination and harassment. The Plaintiff is filing
this action on behalf of a class of thousands of current and former
female employees who have worked as Managers at KPMG from 2008
through the date of judgment.
KPMG
promotes fewer women to Partner (18%) than the industry average
(23%) and fewer women to Senior Manager (35%) than the industry
average (44%). "Across the accounting industry, women are
conspicuously absent from leadership positions; but at KPMG, women
fare even worse," said Janette Wipper. "As soon as women come within
reach of partnership, the Company's male-dominated owners find ways
to block their advancement,"
Despite
Plaintiff Kassman's long tenure and stellar performance, KPMG
refused to promote her along the partnership track. Ms. Kassman's
supervisors repeatedly told her throughout 2008 and 2009 that she
was next in line for a promotion to Managing Director. Around the
time Ms. Kassman was to be promoted, however, two male employees
complained that she was "unapproachable" and "too direct,"
thinly-veiled gender-based criticisms designed to derail her career
advancement. Based on these unfounded, discriminatory comments, KPMG
removed Ms. Kassman from the promotion track, subjected her to
numerous hostile interrogations, and advised her to meet with a
"coach" to work on her supposed issues. Instead of disciplining the
two male employees for their campaign of harassment, KPMG rewarded
them by putting them up for promotion.
KPMG's
female Managers are not only under-promoted, but underpaid as well.
In one particularly egregious act of discrimination, KPMG slashed
Ms. Kassman's base salary by $20,000 while she was on maternity
leave because she was paid "too much." KPMG cited no business
justification for slashing her salary. When Ms. Kassman complained
about the salary cut, her male supervisor asserted that she did not
need the money because she "ha[d] a nice engagement ring."
"Unfortunately, Ms. Kassman's story is completely representative of
the treatment of women at KPMG," Siham Nurhussein said. "Ms. Kassman
repeatedly complained up the chain of command about the gender
discrimination and harassment she was experiencing, and the Company
reacted with neither surprise nor concern. Her supervising Partner
told her matter-of-factly that her male colleague might have a
problem working with women, and the Office of Ethics and Compliance
told Ms. Kassman that men had ganged up on women at KPMG before.
KPMG not only tolerates gender discrimination, but displays an
active interest in perpetuating it."
Courthouse News has
the lawsuit: GSP Finance LLC v. KPMG LLC, an alphabet soup's worth
of names that sounds thoroughly uninteresting. Until, that is, you
crack open the case and discover that GSP Finance is the lending arm
of Galatioto Sports Partners -- the same company Hicks hired in
February 2010 to find prospective investors in or a buyer for the
Dallas Stars after Hicks Sports Group defaulted on that $525 million
in loans in the spring of '09.
Says the suit, GSP
Finance loaned Hicks's HSG Sports Group $67 million based upon
KPMG's audit, which said everything was fine even though it was far
from.
One of the
long-standing raps on the auditing profession is that too many of
its practitioners suffer from a check-the-box mentality, where rigid
adherence to mindless rules obscures their ability to see the bigger
picture.
For once,
that mindset has worked to investors’ advantage.
Two
weeks ago, the
Public Company Accounting Oversight Board
released its triennial inspection
report on the
Hamilton, Bermuda-based affiliate of
KPMG, the Big
Four accounting firm. And it was an ugly one. In one of the audits
performed by
KPMG- Bermuda, the board said its
inspection staff had identified an audit deficiency so significant
that it appeared “the firm did not obtain sufficient competent
evidential matter to support its opinion on the issuer’s financial
statements.”
This being
the hopelessly timid PCAOB, however, the report didn’t say whose
audit KPMG-Bermuda had blown. That’s because the agency, as a matter
of policy, refuses to name companies where its inspectors have found
botched audits. It just goes to show that the PCAOB’s first priority
isn’t “to protect the interests of investors,” as the board’s motto
goes. Rather, it is to protect the dirty little secrets of the
accounting firms and their corporate audit clients.
That’s why it gives me great pleasure to be able to break the
following bit of news: The unnamed company cited in KPMG- Bermuda’s
inspection report was
Alterra Capital Holdings Ltd. (ALTE), a
Hamilton-based insurance company with a $2.3 billion stock- market
value, which used to be known as Max Capital Group Ltd.
One Client
You see,
just like their checklist of instructions told them to do, the folks
who wrote this report were kind enough to disclose the number of
U.S.-listed companies that KPMG-Bermuda had as audit clients at the
time it was inspected. That number, the report said, was one.
The
report also said the board’s staff conducted their inspection in
November 2009, and that the audit deficiency they found was “the
failure to perform sufficient procedures to test the estimated fair
value of certain available-for-sale securities.” Armed with those
data points and some stock- screening software, I quickly found
KPMG-Bermuda’s
audit report on Alterra’s 2008 financial
statements, dated Feb. 19, 2009.
Alterra
actually was one of two U.S.-listed companies for which KPMG-Bermuda
signed an audit report that year. The other one got acquired before
the agency’s inspection work began. And of the two, Alterra was the
only one that classified any of its securities as
available-for-sale.
Big
Screw-Up
It’s
when you look at Alterra’s financial statements that the magnitude
of KPMG-Bermuda’s screw-up becomes apparent. Available-for-sale
securities are the single biggest line item on Alterra’s balance
sheet. They represented almost half of the company’s $7.3 billion of
total assets as of Dec. 31, 2008, and a little more than half of its
$9.9 billion of total assets at the end of last year.
Continued in article
Jensen Comment
We might call this Bermuda Shorts in the auditing profession, but this
might be going a bit too far.
In the Big
Four world, truth sometimes appears to be stranger than fiction. A
tale of how the Big Four firm KPMG is involved in a global financial
intrigue is revealed by globalwitness.org which has obtained papers
which were prepared by KPMG UK on Libyan leader Col. Muammar
el-Qaddafi’s ill-gotten and stashed wealth.
First, globalwitness.org has obtained a
leaked full investment profile of Libyan
Investment Authority for the period ending June 30, 2010. http://www.globalwitness.org/sites/default/files/LIA.pdf
This report
appears to be prepared by KPMG UK.
The New
York Times notes, “The document, independently verified as authentic
by The New York Times, is a summary of the Libyan Investment
Authority’s investments, created for the fund by the London office
of the KPMG consulting firm and dated June 30, 2010. “
And it is
clear from this document that Qaddafi stashed $53 billion of Libyan
oil revenues, with some big amounts with HSBC, Goldman Sachs, JP
Morgan, HSBC Holdings and Société Générale. Goldman Sachs held $43
million in 3 accounts and HSBC held $292.69 million in 10 accounts.
LIA also invested $1 billion in structured financial products
through Société Générale and JPMorgan Chase; and in Central Bank of
Libya, the Arab Banking Corporation and the British Arab Commercial
Bank. The fund held large investments in top multinationals such as
General Electric, Halliburton, Schlumberger, Caterpillar, BP and
Nokia, and United States government bonds.
While this
amount is mind boggling, it was not immune from market downtrends,
the report notes that total market value of the fund’s investments
fell 4.53% from $55.9 billion in March 2010 to $53.3 billion in June
2010.
The
investments appear to have been legal at the time, although the
United Nations, the European Union and the United States in February
imposed targeted financial sanctions against the assets of Colonel
Qaddafi and his family. The United States also froze the assets of
Libyan government-owned and controlled entities.
Global
Witness, which issued a statement on its website, said,” However the
Libyan people could not know where it was invested or how much it
was, because banks have no obligation to disclose state assets they
hold. Global Witness asked both banks to confirm that they held
funds for the state-owned Libyan Investment Authority, and whether
they still hold them. They both refused, with HSBC citing client
confidentiality. Numerous other banks and financial firms are listed
including Societe Generale, UniCredit and the Arab Banking
Corporation.”
Global
Witness then pummels the banks….“It is completely absurd that banks
like HSBC and Goldman Sachs can hide behind customer confidentiality
in a case like this. These are state accounts, so the customer is
effectively the Libyan people and these banks are withholding vital
information from them,” said Charmian Gooch, director of Global
Witness.
KPMG does
not appear to be involved in any malfeasance or accused of any
misdemeanor, as far as these public reports go, though it appears to
have been the author of this leaked investment portfolio report.
How KPMG
will be specifically affected by any fallout will be interesting to
see.
“As I look
at the deficiencies cited in the letter, taken as a whole, it appears
that Citigroup had a material weakness with respect to valuing these
financial instruments,” said Ed Ketz, an accounting professor at
Pennsylvania State University, who reviewed the OCC’s letter to Pandit
at my request. “It just is overwhelming by the time you get to the end
of it."
Jonathan Weil writes in his column today about Citigroup and their “acceptable
group of auditors,” (aka KPMG) and
he’s having trouble connecting the dots on a few things.
Specifically, how a love letter (it was sent on February 14, 2008,
after all)
sent by the Office of the Comptroller of the Currency
to Citigroup CEO Vikram Pandit:
The gist of the
regulator’s findings: Citigroup’s
internal controls were a mess. So were its valuation methods for
subprime mortgage bonds, which had spawned record losses at the
bank. Among other things, “weaknesses were noted with model
documentation, validation and control group oversight,” the
letter said. The main valuation model Citigroup was using “is
not in a controlled environment.” In other words, the model
wasn’t reliable.
Okay, so
the bank’s internal controls weren’t worth the paper they were
printed on. Ordinarily, one could reasonably expect management and
perhaps their auditors to be aware of such a fact and that
they were handling the situation accordingly. We said, “ordinarily”:
Eight days later, on Feb. 22, Citigroup filed its
annual report to shareholders, in
which it said “management believes that, as of Dec. 31, 2007,
the company’s
internal control over financial
reporting is effective.” Pandit
certified
the report personally, including the part about Citigroup’s
internal controls. So did Citigroup’s chief financial officer at
the time,
Gary Crittenden.
The annual report also included a Feb. 22 letter from KPMG LLP,
Citigroup’s outside auditor,
vouching
for the effectiveness of the company’s financial-reporting
controls. Nowhere did Citigroup or KPMG mention any of the
problems cited by the OCC. KPMG, which earned $88.1 million in
fees from Citigroup for 2007, should have been aware of them,
too. The lead partner on KPMG’s Citigroup audit, William O’Mara,
was listed on the “cc” line of the OCC’s Feb. 14 letter.
Huh. There
has to be an explanation, right? It’s just one of the largest banks
on Earth audited by one of the largest audit firm on
Earth. You’d think these guys would be more than willing to
stand by their work. Funny thing – no one felt compelled to return
JW’s calls. So, he had no choice to piece it together himself:
[S]omehow
KPMG and Citigroup’s management decided they didn’t need to
mention any of those weaknesses or deficiencies. Maybe in their
minds it was all just a difference of opinion. Whatever their
rationale, nine months later Citigroup had taken a $45 billion
taxpayer bailout, [Ed. note: OH, right. That.] still
sporting a balance sheet that made it seem healthy.
Actually,
just kidding, he ran it by an expert:
“As I
look at the deficiencies cited in the letter, taken as a whole,
it appears that Citigroup had a material weakness with respect
to valuing these financial instruments,” said Ed Ketz, an
accounting professor at Pennsylvania State University, who
reviewed the OCC’s letter to Pandit at my request. “It just is
overwhelming by the time you get to the end of it."
Yet somehow
KPMG and Citigroup’s management decided they didn’t need to mention
any of those weaknesses or deficiencies. Maybe in their minds it was
all just a difference of opinion. Whatever their rationale, nine
months later Citigroup had taken a $45 billion taxpayer bailout,
still sporting a balance sheet that made it seem healthy.
“As I look
at the deficiencies cited in the letter, taken as a whole, it
appears that Citigroup had a material weakness with respect to
valuing these financial instruments,” said Ed Ketz, an accounting
professor at Pennsylvania State University, who reviewed the OCC’s
letter to Pandit at my request. “It just is overwhelming by the time
you get to the end of it.”
One company
that did get a cautionary note from its auditor that same quarter
was American International Group Inc. In February 2008,
PricewaterhouseCoopers LLP warned of a material weakness related to
AIG’s valuations for credit-default swaps. So at least investors
were told AIG’s numbers might be off. That turned out to be a gross
understatement.
At
Citigroup, there was no such warning. The public deserves to know
why.
Treasury taps
KPMG as auditors in controversial decision while at the same time the
Justice Department has a criminal investigation of KPMG for selling nearly
$2 billion in illegal tax shelters. Will KMPG employees have to be
paroled to conduct the Treasury audit?
The Treasury Department is simultaneously
investigating KPMG’s tax shelter practice while hiring the firm to
audit its own consolidated financial statements.
Senate Finance Committee Chairman Charles E. Grassley, R-Iowa, was
angered at the news, according to the Washington Post. He said Treasury
is undercutting its own tax probe by awarding KPMG the contract to
examine the books of Treasury’s 12 bureaus, which account for $6.9
trillion in assets and would be KPMG’s biggest audit ever.
"What signal does it send when the
government is hauling one of the big accounting firms into the grand
jury room over tax fraud while handing that same company millions of
dollars in taxpayer-funded contracts?" Grassley asked.
Treasury Department spokesman Robert S. Nichols
said the agency's independent inspector general picked KPMG. With 70
percent of the inspector general’s resources moved to the Department
of Homeland Security, the office decided to seek private bids for the
work.
"On the issue of tax shelters, let me
affirm that the Bush administration has taken aggressive action to
address the abusive tax shelter problem, more so than in any period in
recent memory," he said.
KPMG said that it would not be auditing the
books of the IRS, which has repeatedly demanded that the firm release
the names of clients who use its tax shelters. The General Accounting
Office, by statute, must conduct the IRS audit. Also, KPMG spokesman
George Ledwith said that none of the firm’s employees involved in the
federal investigation will be working on the Treasury audit.
The Senate Finance Committee pointed to the
KPMG contract as one example of federal agencies overlooking tax abuses.
The committee claims the Transportation Department has encouraged
abusive leasing arrangements, the Patent and Trademark Office has issued
patents for tax shelters and the Interior Department has engaged in
inflating land swaps. The committee has set hearings for Wednesday on
federal efforts to collect taxes owed.
"If we could just get federal agencies not
to work at cross purposes, it would go a long way toward ensuring
everybody pays their fair share of taxes," Grassley said. "The
IRS's job would be a lot easier if other government agencies were part
of the solution, not part of the problem."
This fits perfectly into Bob Jensen's earlier theme of The Two Faces
of KPMG (see below)
KPMG manager took HK$300,000
bribe: ICAC
“ICAC” is the Hong Kong
Independent Commission Against Corruption. They have storefront offices
all over Hong Kong at which any type of corruption of business or
government can be reported.
Saturday, 8 May 2010
South China Morning Post
Reported by Enoch Yiu
KPMG
manager took HK$300,000 bribe: ICAC
The ICAC
yesterday slapped an additional charge on a senior manager of KPMG
for accepting a bribe of HK$300,000 in connection with the Hontex
International Holdings' initial public offering scandal.
Leung
Sze-chit, 32, a senior manager of KPMG, allegedly received the bribe
from an unidentified person as compensation for preparing the
accountant's report in the prospectus for the global offering of
Hontex, Independent Commission Against Corruption officer Caroline
Yu said at the Eastern Court yesterday.
No plea
was taken. Magistrate Bina Chainrai adjourned the case until May 28,
pending transfer to the District Court.
Leung
last month was charged by the ICAC with offering HK$100,000 to
another employee of KPMG, whose identify has not been disclosed,
"for preparing the accountant's report for the global offering" of
Hontex, a Fujian sports clothing firm.
The
Securities and Futures Commission in March won a court order
freezing the HK$1 billion that Hontex raised in its initial public
offering in December. The SFC alleged the firm had overstated its
financial results and misled investors about its finances in the
prospectus. The SFC ordered a suspension of trading of Hontex shares
on March 30, two months after its listing.
KPMG was
the auditor responsible for ensuring the accuracy of Hontex's
prospectus in the share sale. Yesterday KPMG said it was the one
that discovered the malpractices.
"KPMG wishes to emphasise again that the alleged payment was in fact
reported through KPMG's internal hotline. After investigation, the
member of staff in question was suspended by KPMG and a report was
then made by KPMG to the relevant authority. KPMG has been, and
continues, to co-operate fully with the authorities," the company
said.
Hontex, controlled by
Taiwanese businessman Shao Ten-po, said in its listing prospectus
that it produces fabrics and makes garments for brands including
Decathlon, Kappa and mainland sports chain Li Ning.
And
in the naked light I saw
Ten thousand people maybe more
People talking without speaking
People hearing without listening
People writing songs that voices never shared
No one dared
Disturb the sound of silence
It’s no
coincidence that settlements were announced less than a week apart
for both New Century and Countrywide. As two of the earliest
subprime failures, all parties were probably anxious to clear some
clutter and make room for other matters.
Fortune, August 3, 2010: A federal
judge
signed off Monday on a settlement
under which former shareholders of the troubled mortgage
[originator] will get $624 million, the Los Angeles Times
reported. The plaintiff lawyers called the sum the largest
shareholder settlement since the mortgage meltdown started in
2007.
Bank of America (BAC),
which acquired the mortgage lender two
years ago and has since stopped using the Countrywide name, will
pay $600 million and accounting firm KPMG will pay $24 million.
The Countrywide settlement comes just days after officers and
directors in another big
subprime class action agreed to pay
$90 million to settle claims in that case. New Century
co-founder Brad Morrice
said then
that he hoped the settlement “would make up for some of the
losses suffered and provide closure to me and the shareholders.”
Closure isn’t coming any time soon for Countrywide. Bank of
America’s
annual report provides a list of legal
cases tied to Countrywide that covers parts of three pages.
Nor is [Angelo] Mozilo [Countrywide former CEO] out of the
woods. He and two other former Countrywide execs still face a
Securities and Exchange Commission
fraud suit that centers on familiar
allegations, that the company duped shareholders by failing to
disclose the growing risk of its subprime lending business.
Countrywide
was not, strictly speaking, a failure. Bank of America agreed to
buy them in January of 2008, before the bigger “failures” of Lehman,
AIG, and Bear Stearns changed the language describing our economic
challenges from subprime crisis to full-blown,
“is-it-a-second-coming-of-the-depression-well-at-least-it’s-a-serious-recession”
financial crisis.
Reuters, January 11, 2008: “Regulators
and politicians in Washington are very keen to see troubled
lenders find solutions to their problems, experts said. Egan
said the Federal Deposit Insurance Corp did not want to deal
with the potential failure of Countrywide. And Bove said: “The
people in Washington must be having fits about what would happen
if a bank or a thrift with $55 billion in assets went under, so
I think they pushed Countrywide hard in this direction.”
I
started writing about the subprime crisis in early 2007.
Countrywide was already
spinning out of control.
“Countrywide, the nation’s biggest
mortgage lender in terms of loan volume, said it faces
“unprecedented disruptions” in debt and mortgage-finance markets
that could hurt earnings and the company’s financial condition.
In its quarterly filing with the SEC, the bank said “the
situation is rapidly evolving and the impact on the company is
unknown.”
Countrywide
became a black hole for Bank of America. The bank was still gushing
red ink in March, while due diligence continued, before the deal
closed.
Countrywide Financial Corp.’s mortgage portfolio continues to
deteriorate rapidly as defaults increase and home prices fall, a
securities filing shows…The lender also said it took a big loss
in the fourth quarter on home-equity lines of credit. Further
losses may lie ahead…Countrywide was blindsided during the
quarter by obligations on home-equity lines of credit that it
had sold to investors in the form of securities…Countrywide said
the likelihood of such a situation was “deemed remote”
until late 2007. It blamed a “sudden deterioration” in
the housing market. As a result, it recorded a $704 million loss
to cover the estimated costs of its obligations on the lines of
credit…A
Countrywide computer model used to gauge risks
on these securities didn’t take into
account the possible effects of exceeding the loss levels that
cut off reimbursements…
Much
has been written about Countrywide and its failings. There was
enough evidence, I suppose,
in re Countrywide Financial Corp. Securities Litigation, 07-05295
that
“former Countrywide Chief Executive Officer Angelo Mozilo and other
executives hid the fact that the company was fueling its growth by
letting underwriting standards deteriorate”
to scare the defendants away from a trial.
Mozilo is still subject to SEC civil suits and potential criminal
indictments for fraud. But Countrywide, its executives and its
auditors, KPMG, were not subjected to a bankruptcy filing and a
bankruptcy examiner’s report like New Century was.
The
judge in the Countrywide case has agreed to accept KPMG’s
acknowledgment of $24 million of the $624 million liability or about
4% culpability. Without a bankruptcy examiner’s report such as the
New Century report or a trial, we will never know the full extent,
if any, of KPMG’s knowledge, negligence,
aiding or abetting of the alleged
Countrywide fraud.
Michael Missal’s New Century bankruptcy examiner report was a tour
de force, the complete anatomy of a pre-financial crisis fraud,
including several smoking guns pointed at auditors KPMG. Let me
remind you that pros like
Mr. Missal, who cut his teeth on the World
Com bankruptcy and Arthur Andersen, drew the map used by Anton
Valukas and the Lehman bankruptcy examiner’s report. Missal set the
standard for Valukas’ colorable
claims against Ernst and Young for
professional impotence and complacency when faced with Lehman’s Repo
105 activities.
Paul Barrett of Business Week reminded us,
too, of the important role of the virtuoso bankruptcy examination
when setting up Trustees’ litigation and criminal indictments:
“The
unavoidable question is whether the SEC will hold someone
responsible for what happened at Lehman,” says Michael J.
Missal, a partner in Washington with the law firm K&L Gates.
Missal, who makes a living defending companies faced with
government investigations, is another of those attorneys
capable, when asked by a court, of transforming himself into a
public-spirited, if generously compensated, pit bull. He
published an impressive bankruptcy examiner’s report of his own
in 2008 in the case of New Century Financial, one of the
subprime mortgage giants that, with Wall Street’s assistance,
recklessly inflated the housing bubble.
I spoke to
Michael Missal recently. He told me that to have a successful
bankruptcy examiner’s engagement, the examiner must be:
1) Thorough
2) Accurate
3) Fair
4)
Objective
5) Timely
I think his
New Century report, clocking in at 551 pages plus appendices, did a
great job of explaining, for the first time, difficult issues we
would see so many times in later subprime and financial crisis
litigation.
Bloomberg, April 2, 2009: KPMG’s
audits of New Century violated both professional standards
promoted by its international body and regulatory requirements,
according to the complaint. Dissenters within the auditing firm
were silenced by senior partners to protect the firm’s business
relationship with New Century and KPMG LLP’s fees from the
company.
One
KPMG specialist who complained about an incorrect accounting
practice on the eve of the company’s 2005 annual report filing
was told by a lead KPMG audit partner “as far as I am concerned
we are done. The client thinks we are done. All we are going to
do is piss everybody off,” the complaint said.
Attorney for the New Century Trustee, Steven Thomas, thought so much
of this smoking gun he put a
$1 billion price tag
on the litigation by the Trustee against KPMG
General Electric, the nation’s largest corporation,
had a very good year in 2010.
The company reported worldwide profits of $14.2
billion, and said $5.1 billion of the total came from its operations in the
United States.
Its American tax bill? None. In fact, G.E. claimed
a tax benefit of $3.2 billion.
That may be hard to fathom for the millions of
American business owners and households now preparing their own returns, but
low taxes are nothing new for G.E. The company has been cutting the
percentage of its American profits paid to the Internal Revenue Service for
years, resulting in a far lower rate than at most multinational companies.
Its extraordinary success is based on an aggressive
strategy that mixes fierce lobbying for tax breaks and innovative accounting
that enables it to concentrate its profits offshore. G.E.’s giant tax
department, led by a bow-tied former Treasury official named John Samuels,
is often referred to as the world’s best tax law firm. Indeed, the company’s
slogan “Imagination at Work” fits this department well. The team includes
former officials not just from the Treasury, but also from the I.R.S. and
virtually all the tax-writing committees in Congress.
While General Electric is one of the most skilled
at reducing its tax burden, many other companies have become better at this
as well. Although the top corporate tax rate in the United States is 35
percent, one of the highest in the world, companies have been increasingly
using a maze of shelters, tax credits and subsidies to pay far less.
In a regulatory filing just a week before the
Japanese disaster put a spotlight on the company’s nuclear reactor business,
G.E. reported that its tax burden was 7.4 percent of its American profits,
about a third of the average reported by other American multinationals. Even
those figures are overstated, because they include taxes that will be paid
only if the company brings its overseas profits back to the United States.
With those profits still offshore, G.E. is effectively getting money back.
Such strategies, as well as changes in tax laws
that encouraged some businesses and professionals to file as individuals,
have pushed down the corporate share of the nation’s tax receipts — from 30
percent of all federal revenue in the mid-1950s to 6.6 percent in 2009.
Yet many companies say the current level is so high
it hobbles them in competing with foreign rivals. Even as the government
faces a mounting budget deficit, the talk in Washington is about lower
rates. President Obama has said he is considering an overhaul of the
corporate tax system, with an eye to lowering the top rate, ending some tax
subsidies and loopholes and generating the same amount of revenue. He has
designated G.E.’s chief executive, Jeffrey R. Immelt, as his liaison to the
business community and as the chairman of the President’s Council on Jobs
and Competitiveness, and it is expected to discuss corporate taxes.
“He understands what it takes for America to
compete in the global economy,” Mr. Obama said of Mr. Immelt, on his
appointment in January, after touring a G.E. factory in upstate New York
that makes turbines and generators for sale around the world.
A review of company filings and Congressional
records shows that one of the most striking advantages of General Electric
is its ability to lobby for, win and take advantage of tax breaks.
Over the last decade, G.E. has spent tens of
millions of dollars to push for changes in tax law, from more generous
depreciation schedules on jet engines to “green energy” credits for its wind
turbines. But the most lucrative of these measures allows G.E. to operate a
vast leasing and lending business abroad with profits that face little
foreign taxes and no American taxes as long as the money remains overseas.
Company officials say that these measures are
necessary for G.E. to compete against global rivals and that they are acting
as responsible citizens. “G.E. is committed to acting with integrity in
relation to our tax obligations,” said Anne Eisele, a spokeswoman. “We are
committed to complying with tax rules and paying all legally obliged taxes.
At the same time, we have a responsibility to our shareholders to legally
minimize our costs.”
The assortment of tax breaks G.E. has won in
Washington has provided a significant short-term gain for the company’s
executives and shareholders. While the financial crisis led G.E. to post a
loss in the United States in 2009, regulatory filings show that in the last
five years, G.E. has accumulated $26 billion in American profits, and
received a net tax benefit from the I.R.S. of $4.1 billion.
But critics say the use of so many shelters amounts
to corporate welfare, allowing G.E. not just to avoid taxes on profitable
overseas lending but also to amass tax credits and write-offs that can be
used to reduce taxes on billions of dollars of profit from domestic
manufacturing. They say that the assertive tax avoidance of multinationals
like G.E. not only shortchanges the Treasury, but also harms the economy by
discouraging investment and hiring in the United States.
So it’s not surprising that GE uses their
auditor, KPMG, to help them put their “zero” tax return
together.
The Sarbanes-Oxley Act of 2002
started out tough on tax. The rules regarding prohibited
activities by the auditor, intended
to preserve
their independence,
scared the living daylights out of the largest firms. It
appeared initially that the SEC would prohibit the tax side of
the firms from providing highly lucrative tax advice to their
audit clients. Many of those professionals started planning an
exit from their firms so they could continue working with long
time clients.
A compromise was reach
ed.The
result is one of the loosest and most generous exceptions to
auditor independence rules on the books.
The concern was
focused on potential exposure from the credit default swaps
portfolio they inherited from Wachovia. In WFC's annual report the
Buiness Insider saw limited discussion of this risk and no details
of the reserves for it.
There are two
possible ways to account for the lack of discussion of Collateral
Call Risk. Either Wachovia wrote its derivative contracts in ways
that don’t permit buyers to demand more collateral or Wells Fargo is
not disclosing this risk. (A third possibility—that they don't even
seem aware that they have this risk — seems remote after AIG.)
When I read that, I saw eerie parallels with
New Century, all the more so because of the auditor connection –
both Wells Fargo and Wachovia and New Century (now in Chapter 11)
are audited by KPMG. New Century was not too transparent either
and, as a result, many people, including
some very sophisticated investors
were caught with their pants down. KPMG is accused in a $1 billion
dollar lawsuit of not just being incompetent, but of aiding,
abetting, and covering up New Century’s fraudulent loan loss reserve
calculations just so they could keep their lucrative client happy
and viable.
KPMG’s audit and review
failures concerning New Century’s reserves highlights KPMG’s gross
negligence, and its calamitous effect — including the bankruptcy of
New Century. New Century engaged in admittedly high risk lending.
Its public filings contained pages of risk factors…New Century’s
calculations for required reserves were wrong and violated GAAP. For
example, if New Century sold a mortgage loan that did not meet
certain conditions, New Century was required to repurchase that
loan. New Century’s loan repurchase reserve calculation assumed
that all such repurchases occur within 90 days of when New Century
sold the loan, when in fact that assumption was false.
In 2005 New Century
informed KPMG that the total outstanding loan repurchase requests
were $188 million. If KPMG only considered the loans sold within
the prior 90 days, the potential liability shrank to $70 million.
Despite the fact that KPMG knew the 90 day look-back period excluded
over $100 million in repurchase requests, KPMG nonetheless still
accepted the flawed $70 million measure used by New Century to
calculate the repurchase reserve. The obvious result was that New
Century significantly under reserved for its risks.
How
does the New Century situation and KPMG’s role in it remind me of
Wells Fargo now? Well, in both cases, there’s no disclosure of the
quantity and quality of the repurchase risk to the organization.
Back in
March of 2007, I wrote about the lack of disclosure of this
repurchase risk in New Century’s 2005 annual report:
There are 17 pages of
discussion of general and REIT specific risk associated with this
company, but no mention of the specific risk of the potential for
their banks to accelerate the repurchase of mortgage loans financed
under their significant number of lending arrangements….it does not
seem that reserves or capital/liquidity requirements were sufficient
to cover the possibility that one of or more lenders could for some
reason decide to call the loans. Did the lenders have the right to
call the loans unilaterally? It does say that if one called the
loans it is likely that all would. Didn’t someone think that this
would be a very big number (US 8.4 billion) if that happened.
Even if a lender sells
most of the loans it originates, and, theoretically, passes the risk
of default on to the buyer of the loan, there remains an elephant
lurking in the room: the risk posed to mortgage bankers from the
representations and warranties made by them when they sell loans in
the secondary market… in bad times, the holders of the loans have
been known to require a second "scrubbing" of the loan files,
looking for breaches of representations and warranties that will
justify requiring the originator to repurchase the loan. …A "pure"
mortgage banker, who holds and services few loans, may think he's
passed on the risk (absent outright fraud). Sophisticated
originators know better…When the cycle turns (as it always does) and
defaults rise, those originating lenders who sacrificed sound
underwriting in return for fee income will find the grim reaper
knocking at their door once again, whether or not they own the loan.
But earlier, on page
114, there is a footnote to a chart representing loans in their
balance sheet that have been securitized--including residential
mortgages and securitzations sold to FNMA and FHLMC--where servicing
is their only form of continuing involvement.
Delinquent loans and
net charge-offs exclude loans sold to FNMA and FHLMC. We continue to
service the loans and would only experience a loss if required to
repurchasea delinquent loan due to a breach in original
representations and warranties associated with our underwriting
standards.
So where are those
numbers? Where is the number that correlates to the $8.4 billion
dollar exposure that brought down New Century? Wells Fargo saw an
almost 300% increase from 2007 to 2008 in delinquencies and 200%
increase in charge offs from commercial loans and a 300% increase in
delinquencies and 350% increase in charge offs on residential loans
they still hold. Can anyone say with certainty that we won’t see
FNMA and FHLMC come back and force some repurchases on Wells Fargo
for lax underwriting standards?
This is all we
get from Wells Fargo in the 2008 Annual Report:
The lack of disclosure of this issue here
mirrors the lack of disclosure in New Century and perhaps in other
KPMG clients such at Citigroup, Countrywide ( now inside Bank of
America) and others. How do I know there could be a pattern?
Because
the inspections of KPMG by the PCAOB,
their regulator, tell us they have been called on auditing
deficiencies just like this. Do we have to wait for a post-failure
lawsuit to bring some sense, and some sunshine, to the system?
KPMG Should Be Tougher on
Testing, PCAOB Finds The Big Four audit firm was cited for not ramping
up its tests of some clients' assumptions and internal controls. KPMG did not show enough skepticism toward
clients last year, according to the Public Company Accounting Oversight
Board, which cited the Big Four accounting firm for deficiencies related
to audits it performed on nine companies. The deficiencies were detailed
in an inspection report released this week by the PCAOB that covered
KPMG's 2008 audit season. The shortcomings focused mostly on a lack of
proper evidence provided by KPMG to support its audit opinions on
pension plans and securities valuations. But in some instances, the firm
was cited for weak testing of internal controls over financial reporting
and the application of generally accepted accounting principles.
Marie Leone, CFO.com, June 19, 2009 ---
http://www.cfo.com/article.cfm/13888653/c_2984368/?f=archives
In one
instance, the audit lacked evidence about whether the pension plans
contained subprime assets. In another case, the PCAOB noted, the
audit firm didn't collect enough supporting material to gain an
understanding of how the trustee gauged the fair values of the
assets when no quoted market prices were available.
The PCAOB,
which inspects the largest public accounting firms on an annual
basis, also found that three other KPMG audits were shy an
appropriate amount of internal controls testing related to loan-loss
allowances, securities valuations, and financing receivables.
In one
audit, KPMG accepted its client's data on non-performing loans
without determining whether the information was "supportable and
appropriate." In another case, KPMG "failed to perform sufficient
audit procedures" with regard to the valuation of hard-to-price
financial instruments.
In still
another case, the PCAOB found that KPMG "failed to identify" that a
client's revised accounting of an outsourcing deal was not in
compliance with GAAP because some of the deferred costs failed to
meet the definition of an asset - and the costs did not represent a
probably future economic benefit for the client.
Britain’s
big four auditing firms have been left exposed to a surge in
negligence claims after the Government refused to limit further the
damages they could face.
Deloitte,
Ernst & Young, KPMG and PricewaterhouseCoopers (PwC) lobbied hard
for a cap on payouts. Senior figures involved in the discussions
said that Lord Mandelson, the Business Secretary, appeared receptive
to their concerns but stopped short of changing the law.
The
decision is a huge blow to the firms — some face lawsuits relating
to Bernard Madoff’s $65 billion fraud — which believe there may not
be another chance for a change in the law for at least two years.
They fear that they will be targeted by investors and liquidators
seeking to recover losses from Madoff-style frauds and big company
failures.
At present,
auditors can be held liable for the full amount of losses in the
event of a collapse, even if they are found to be only partly to
blame.
In April,
representatives of the companies met Lord Mandelson to plead for new
measures to cap their liability. They warned that British business
could be plunged into chaos if one of them were bankrupted by a
blockbuster lawsuit.
However, an
official of the Department for Business, Innovation and Skills said:
“The 2006 Companies Act already allows auditor liability limitation
where companies and their auditors want to take this course.”
Under
present company law, directors can agree to restrict their auditors’
liability if shareholders approve; however, to date, no blue-chip
company has done so. Directors have seen little advantage in
limiting their auditors’ liability, and objections by the US
Securities and Exchange Commission (SEC) have also been a
significant obstacle.
The SEC
opposes caps on the ground that their introduction could lead to
secret deals whereby directors agree to restrict liability in return
for auditors compromising on their oversight of a company’s
accounts. The SEC could attempt to block caps put in place by
British companies that have operations in the United States.
The big
four auditors had hoped to persuade Lord Mandelson to amend the
legislation to address the SEC’s concerns and to encourage companies
to limit their auditors’ liability.
Peter
Wyman, a senior PwC partner, who was involved in the discussions,
said that the Government’s lack of action was disappointing. He
said: “The Government, having legislated to allow proportionate
liability for auditors, is apparently content to have its policy
frustrated by a foreign regulator.”
Auditors
are often hit with negligence claims in the aftermath of a company
failure because they are perceived as having deep pockets and remain
standing while other parties may have disappeared or been declared
insolvent.
In 2005
Ernst & Young was sued for £700 million by Equitable Life, its
former audit client, after the insurance company almost collapsed.
The claim was dropped but could have bankrupted the firm’s UK arm if
it had succeeded.
This year
KPMG was sued for $1 billion by creditors of New Century, a failed
sub-prime lender, and PwC has faced questions over its audit of
Satyam, the Indian outsourcing company that was hit by a long-
running accounting fraud.
Three of
the big four are also facing numerous lawsuits relating to their
auditing of the feeder funds that channelled investors into Madoff’s
Ponzi scheme.
Investors
and accounting regulators worry that the big four’s dominance of the
audit market is so great that British business would be thrown into
disarray if one of the four were put out of business by a huge court
action. All but two FTSE 100 companies are audited by the four.
Mr Wyman
said: “The failure of a large audit firm would be very damaging to
the capital markets at a time when they are already fragile.”
Arthur
Andersen, formerly one of the world’s five biggest accounting firms,
collapsed in 2002 as a result of its role in the Enron scandal.
Suits
you
KPMG
A defendant in a class-action lawsuit in the Southern District of
New York against Tremont, a Bernard Madoff feeder fund
Ernst &
Young Sued by investors in a Luxembourg court with UBS for
oversight of a European Madoff feeder fund
PwC
Included in several lawsuits in Canada claiming damages of up to $2
billion against Fairfield Sentry, a big Madoff feeder fund
KPMG
Sued in the US for at least $1 billion by creditors of New Century
Financial, a failed sub-prime mortgage lender, which claimed that
KPMG’s auditing was “recklessly and grossly negligent”
Deloitte
Sued by the liquidators of two Bear Stearns-related hedge funds that
collapsed at the start of the credit crunch
Complicated Derivatives Used in
Tax Fraud: This Case is Dragging on for Years
"Galleon Rajaratnam Sued KPMG In 2005, But Did KPMG Pay?" Big
Four Blog, April 30, 2010 ---
http://www.bigfouralumni.blogspot.com/
Bob Jensen's threads on the
saga that led to KPMG paying a $456 million fine are reported deeper
below.
One Auditing Firm Has Become
Better Known for Its Auditing Specialty Than Other Firms that are only
pretenders
If you are a regular reader of this site, you
may remember the first time I warned you about the poor disclosure
practices surrounding repurchase risk. It was all the way back in March
of 2007 and I was referring to the lack of disclosures surrounding New
Century Financial. I warned you again seven months ago that another KPMG
client, Wachovia/Wells Fargo, has the same disclosure issues with regard
to repurchase risk. The latest announcements of potentially material
losses due to forced repurchases of mortgages from Fannie Mae (Deloitte)
and Freddie Mac (PwC) were made by JP Morgan and Bank of America – both
audited by PwC. Maybe ya’ll should kick the tires a little more on
Citibank’s big comeback
Continued in article
Jensen Comment
Francine also added a video entitled “It’s Like Déjà Vu All Over
Again!”
KPMG’s “Unusual Twist”
While KPMG's strategy isn't uncommon among corporations with lots of units in
different states, the accounting firm offered an unusual twist: Under KPMG's
direction, WorldCom treated "foresight of top management" as an intangible asset
akin to patents or trademarks.
See http://www.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud
Punch Line
This "foresight of top management" led to a 25-year prison sentence for
Worldcom's CEO, five years for the CFO (which in his case was much to lenient)
and one year plus a day for the controller (who ended up having to be in prison
for only ten months.) Yes all that reported goodwill in the balance sheet of
Worldcom was an unusual twist.
Integrity is a cornerstone
of our culture and we continue to make great progress in our effort to
build a model ethics and compliance program. This means fostering
awareness, trust, and personal responsibility at every level of the
firm. This year, we issued our first ever ethics and compliance progress
report and guidebook. This report,
Ethics and Compliance Report 2007: It Starts with You,
highlights initiatives that we have in place to
support our values-based compliance culture, and features real-life
stories of some of KPMG's partners and employees who faced ethical
challenges and how they handled them. We responded to heightened
interest in ethics education and input from your fellow academics and
created our KPMG Ethical Compass—A
Toolkit for Integrity in Business, a three-module package of
classroom materialsto help you present ethics-related topics to your
students. An Open Letter From Tim Flynn, Chairman and CEO, KPMG LLP This was part of an email message that I assume was sent to
the academy of accountants.
"KPMG accountancy chief fiddled £545,000 to
pay for his new wife's luxury tastes," by Julie Moult, Daily Mail, August
26, 2009 ---
Click Here
A director
who stole more than half a million pounds from global accountancy
firm KPMG was trying to keep up with his second wife's extravagant
demands, a court heard yesterday.
Andrew
Wetherall, 49, claimed he was under pressure to add to his
six-figure salary because 'he did not want her lifestyle to suffer'.
His
wife of four years, Catherine, cost him an astonishing £15,000 a
month to keep happy, and without the expenditure he feared a
divorce, he told police on his arrest.
And last
night when the Daily Mail sought to approach Mrs Wetherall, 47, for
comment, her husband said: 'She's out shopping.'
Wetherall,
who pleaded guilty to false accounting and fraud, was warned to
expect a prison term when he is sentenced next month.
To the
undoubted embarrassment of bosses at KPMG, whose business is to spot
other companies' fraudulent activity, he was able to steal from
under their noses for six years, Southwark Crown Court heard.
He made
false claims totalling £545,620 so he could splash out on expensive
cars, designer watches and five-star holidays.
Samantha
Hatt, prosecuting, said: 'He didn't want to go through a second
divorce so he started up the fraud.
'He felt
the pressure of his current wife's financial expectations which were
in the sum of £15,000 a month. He didn't want her lifestyle to
suffer so he turned to crime to ensure that it didn't.'
Judge
Gregory Stone asked: 'Did you really say £15,000 a month?' before
shaking his head in disbelief.
The court
heard how father-of-two Wetherall, a director of the worldwide
company, used his knowledge of the expenses system to steal.
He kept
each item of fraudulent activity under £5,000, meaning he did not
need authorisation from his bosses.
He claimed
for hundreds of flights worth a total of £480,000, of which at least
£243,000 was supported with fake documents.
He altered
bills, created false invoices, made multiple claims for legitimate
expenses and submitted bills for luxury holidays he took with his
wife, claiming they were business trips.
However
last year a colleague began to raise questions about his claims for
air travel.
Initially
Wetherall said he had made a simple mistake and offered to pay back
£18,000, but an investigation was started which unravelled the full
extent of the fraud.
During a
disciplinary hearing Wetherall owned up to his crimes and handed
bosses a cheque for £305,000, but police were called in.
Miss Hatt
continued: 'Claims had been made for flights and expenses when such
trips were not in fact made. Further, the claims were supported by
falsely created invoices or genuine ones that had been altered.
'He also
made multiple claims for legitimate trips and claimed personal
expenditure as business expenditure including holidays to Singapore
and Thailand, a £4,000 watch, a £2,000 camera and high value
computer equipment.'
Wetherall
explained he had put most of the money in a savings account and the
'shortfall was due to paying for his lifestyle'.
Miss Hatt
said: 'He attributed this to legal costs from his divorce from his
first wife, the purchase of a motor vehicle for himself for £60,000
and the part payment of a motor vehicle for his current wife for
£14,000.'
When he was
arrested he told investigators that his financial worries began when
his second wife's ex-husband tried to reduce maintenance payments to
her.
He told
officers once he started stealing it became easier and easier as
there were few controls or restrictions upon him, and he became
cavalier in his approach.
A spokesman
for KPMG said yesterday its system had since been tightened up.
'Mr
Wetherall's frauds were detected via our own internal checks and he
was dismissed in 2008. Since this case, KPMG has made changes to its
internal expenses procedures to prevent fraud of the type committed
by Mr Wetherall being perpetrated today. No client funds were
involved.'
The
disgraced executive has paid back £337,228.60, but still owes more
than £200,000.
Judge
Gregory Stone QC adjourned sentence until September 15 for further
financial investigations to be carried out, but warned Wetherall
that jail was the likely outcome.
'Mr
Wetherall has got to understand there is likely to be a prison
sentence at the end of the day,' he said.
"KPMG accountancy chief fiddled £545,000 to pay for his new
wife's luxury tastes," by Julie Moult, Daily Mail, August 26, 2009
---
Click Here
A director who stole more than
half a million pounds from global accountancy firm KPMG was trying
to keep up with his second wife's extravagant demands, a court heard
yesterday.
Andrew Wetherall, 49, claimed he
was under pressure to add to his six-figure salary because 'he did
not want her lifestyle to suffer'.
His wife of four years, Catherine,
cost him an astonishing £15,000 a month to keep happy, and without
the expenditure he feared a divorce, he told police on his arrest.
And last night when the Daily Mail
sought to approach Mrs Wetherall, 47, for comment, her husband said:
'She's out shopping.'
Wetherall, who pleaded guilty to
false accounting and fraud, was warned to expect a prison term when
he is sentenced next month.
To the undoubted embarrassment of
bosses at KPMG, whose business is to spot other companies'
fraudulent activity, he was able to steal from under their noses for
six years, Southwark Crown Court heard.
He made false claims totalling
£545,620 so he could splash out on expensive cars, designer watches
and five-star holidays.
Samantha Hatt, prosecuting, said:
'He didn't want to go through a second divorce so he started up the
fraud.
'He felt the pressure of his
current wife's financial expectations which were in the sum of
£15,000 a month. He didn't want her lifestyle to suffer so he turned
to crime to ensure that it didn't.'
Judge Gregory Stone asked: 'Did
you really say £15,000 a month?' before shaking his head in
disbelief.
The court heard how father-of-two
Wetherall, a director of the worldwide company, used his knowledge
of the expenses system to steal.
He kept each item of fraudulent
activity under £5,000, meaning he did not need authorisation from
his bosses.
He claimed for hundreds of flights
worth a total of £480,000, of which at least £243,000 was supported
with fake documents.
He altered bills, created false
invoices, made multiple claims for legitimate expenses and submitted
bills for luxury holidays he took with his wife, claiming they were
business trips.
However last year a colleague
began to raise questions about his claims for air travel.
Initially Wetherall said he had
made a simple mistake and offered to pay back £18,000, but an
investigation was started which unravelled the full extent of the
fraud.
During a disciplinary hearing
Wetherall owned up to his crimes and handed bosses a cheque for
£305,000, but police were called in.
Miss Hatt continued: 'Claims had
been made for flights and expenses when such trips were not in fact
made. Further, the claims were supported by falsely created invoices
or genuine ones that had been altered.
'He also made multiple claims for
legitimate trips and claimed personal expenditure as business
expenditure including holidays to Singapore and Thailand, a £4,000
watch, a £2,000 camera and high value computer equipment.'
Wetherall explained he had put
most of the money in a savings account and the 'shortfall was due to
paying for his lifestyle'.
Miss Hatt said: 'He attributed
this to legal costs from his divorce from his first wife, the
purchase of a motor vehicle for himself for £60,000 and the part
payment of a motor vehicle for his current wife for £14,000.'
When he was arrested he told
investigators that his financial worries began when his second
wife's ex-husband tried to reduce maintenance payments to her.
He told officers once he started
stealing it became easier and easier as there were few controls or
restrictions upon him, and he became cavalier in his approach.
A spokesman for KPMG said
yesterday its system had since been tightened up.
'Mr Wetherall's frauds were
detected via our own internal checks and he was dismissed in 2008.
Since this case, KPMG has made changes to its internal expenses
procedures to prevent fraud of the type committed by Mr Wetherall
being perpetrated today. No client funds were involved.'
The disgraced executive has paid
back £337,228.60, but still owes more than £200,000.
Judge Gregory Stone QC adjourned
sentence until September 15 for further financial investigations to
be carried out, but warned Wetherall that jail was the likely
outcome.
'Mr Wetherall has got to
understand there is likely to be a prison sentence at the end of the
day,' he said.
It Just Gets Deeper and Deeper for
KPMG
"Subprime Suit Accuses KPMG of
Negligence: A trustee for New Century Financial claims KPMG
partners ignored lower ranks' concerns about the lender's accounting for
loan reserves," by Sarah Johnson, CFO.com, April 2, 2009 ---
http://www.cfo.com/article.cfm/13431126/c_2984368?f=FinanceProfessor/SBU
Two complaints filed
in federal courts yesterday claim that KPMG auditors were complicit
in allowing "aggressive accounting" to occur under their watch at
New Century Financial, the mortgage lender that collapsed two years
ago at the beginning of the subprime-mortgage mess.
The plaintiff, a New
Century trustee, alleges that misstated financial reports were filed
with the audit firm's rubber stamp because of its partners' fears of
losing the lender's business. "KPMG acted as a cheerleader for
management, not the public interest," one of the complaints says.
The trustee further accuses the firm of "reckless and grossly
negligent audits."
The plaintiff's law
firm, Thomas Alexander & Forrester LLP, filed one action against
KPMG LLP in California and another in New York against KPMG
International. With the authority to "manage and control" its member
firm, KPMG International failed to "ensure that audits under the
KPMG name" lived up to the quality control and branding value that
"it promised to the public," the lawsuit alleges.
Similar litigation
has been unsuccessful in holding international auditing firms
responsible for their affiliated but independent members. For
example, a lawsuit that Thomas Alexander filed against BDO Seidman
in a negligence case involving Banco Espirito Santo's financial
statements resulted in a $521 million win for the plaintiff, pending
an appeal. A case against BDO International is expected to go to
trial later this year after an appeals court ruled that a jury
should have decided whether it should have also been considered
liable in the Banco case. Initially, a lower-court judge had
dismissed the international organization from the case.
the international
arm was intitially ruled as not being c, accused of also , the trial
against BDO International for the same matter has yet to occur;
courts have yet to decide whether BDO International could be held
liable in the same matter after the international firm was but
lawyers have been unable to get a judgment against BDO International
in the same case. Steven Thomas, a partner at the law firm, did not
immediately return CFO.com's request for comment.
KPMG resigned as New
Century's auditor soon after the Irvine, California-based lender
filed for bankruptcy protection in 2007. The auditor's role in the
firm's failure has been questioned since then, by New Century's
unsecured creditors and the bankruptcy court.
In the new lawsuit,
KPMG LLP is accused of not giving credence to lower-level employees'
concerns about their client's accounting flaws and not finishing its
audit work before giving its final opinion — an account the firm
disputes. In 2005, for instance, a partner was said to have
"silenced" one of the firm's specialists who had questioned New
Century's "incorrect accounting practice." The partner allegedly
said, "I am very disappointed we are still discussing this.... The
client thinks we are done. All we are going to do is piss everybody
off."
Dan Ginsburg, KPMG
LLP spokesman,says the above account is taken out of context and
that the firm had followed its normal process; the firm's national
office had already reviewed and signed off on the issue being
disputed.
Furthermore,
Ginsburg says any claims that the firm gave in to its client's
demands "is unsupportable." He adds, "any implication that the
collapse of New Century was related to accounting issues ignores the
reality of the global credit crisis. This was a business failure,
not an accounting issue."
New Century's
business was heavy on loaning subprime-level mortgages, but its
accounting methods did not fully recognize the risk of doing so, the
lawsuit alleges. It also says the firm violated GAAP by using
inaccurate loan-reserve calculations by taking out certain factors
to keep its liability numbers down and its net income falsely
propped up. KPMG is accused of ignoring this GAAP violation and
advising the firm on how to get around the rules. The complaint says
this was a $300 million mistake.
In its most recent
inspection of KPMG, the Public Company Accounting Oversight Board
noted two occasions when the firm did not do enough audit work to be
able to confidently trust its clients' allowances for loan losses.
Questions about survival of the
world's largest auditing firms in the wake of the subprime scandals ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Auditors failed to warn shareholders of virtually all recent bank
failures due to toxic investments. Let the class action lawsuits
commence.
The settlements announced today, including the
largest penalties ever imposed on individual auditors, reflect the
seriousness with which the SEC regards the responsibilities of
gatekeepers."
It took forever, but KPMG partners finally settle with the SEC on
the really old Xerox accounting fraud The Commission (SEC) has announced on February
22, 2006 that all four remaining defendants in an action brought against
them and KPMG LLP by the agency in connection with a $1.2 billion
fraudulent earnings manipulation scheme by the Xerox Corporation from
1997 through 2000 have agreed to settle the charges against them. Three
partners agreed to permanent injunctions, payment of record civil
penalties and suspensions from practice before the Commission with
rights to reapply in from one to three years. The fourth partner agreed
to be censured by the Commission. "This case represents the SEC's
willingness to litigate important accounting fraud allegations against
major accounting firms and their audit partners, even where the
accounting was complex," said Linda Chatman Thomsen, the SEC's Director
of Enforcement. "The settlements announced
today, including the largest penalties ever imposed on individual
auditors, reflect the seriousness with which the SEC regards the
responsibilities of gatekeepers."
Andrew Priest, "FOUR CURRENT OR FORMER KPMG PARTNERS SETTLE SEC
LITIGATION RELATING TO XEROX AUDITS," Accounting Education News,
February 23, 2006 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=142393
Diebold (DBD)
will change the way revenue is reported after its accounting
practices came under SEC scrutiny, the company said in a press
release issued Oct 2. Diebold may now record sales only after its
products are delivered or installed, said spokesman Mike Jacobsen.
A
quick scan of their financial statements includes this note to
financial statements that defines revenue recognition.
Revenue
Recognition The company's revenue recognition policy is
consistent with the requirements of Statement of Position [SOP]
97-2, Software Revenue Recognition and Staff Accounting Bulletin
104 (SAB 104). In general, the company records revenue when it
is realized, or realizable and earned. The company considers
revenue to be realized or realizable and earned when the
following revenue recognition requirements are met: persuasive
evidence of an arrangement exists, which is a customer contract;
the products or services have been provided to the customer; the
sales price is fixed or determinable within the contract; and
collectibility is probable. The sales of the company's products
do not require production, modification or customization of the
hardware or software after it is shipped.
Kudos to
the SEC for finally protecting the investor. The corporate press
release makes mention that while they are still figuring it out,
they will have to restate previous financial reports, but do not
believe that the cash position will be affected. This is universal
corporate baffle gab. Investors are supposed to be quiet if the cash
position does not change, everything else is not so important.
Essentially
Diebold was not following its publicly stated policies. Diebold was
not following accounting standards that investors should be able to
rely on. KPMG the auditors in this case certified the statements
when they should not have. The Board OK'ed everything. Governance!
Governance! Governance!
What
consequences will Diebold executives have for this inadequacy? Many
in the political arena contend that their voting machines cannot
count correctly. The SEC has definitively determined that the
corporate accounting was not counting correctly.
The
Securities and Exchange Commission today charged Diebold, Inc. and
three former financial executives for engaging in a fraudulent
accounting scheme to inflate the company's earnings. The SEC
separately filed an enforcement action against Diebold's former CEO
seeking reimbursement of certain financial benefits that he received
while Diebold was committing accounting fraud.
The SEC
alleges that Diebold's financial management received "flash reports"
sometimes on a daily basis comparing the company's actual
earnings to analyst earnings forecasts. Diebold's financial
management prepared "opportunity lists" of ways to close the gap
between the company's actual financial results and analyst
forecasts. Many of the opportunities on these lists were fraudulent
accounting transactions designed to improperly recognize revenue or
otherwise inflate Diebold's financial performance.
Diebold
an Ohio-based company that manufactures and sells ATMs, bank
security systems and electronic voting machines agreed to pay a
$25 million penalty to settle the SEC's charges. Diebold's former
CEO Walden O'Dell agreed to reimburse cash bonuses, stock, and stock
options under the "clawback" provision of the Sarbanes-Oxley Act.
The SEC's
case against Diebold's former CFO Gregory Geswein, former Controller
and later CFO Kevin Krakora, and former Director of Corporate
Accounting Sandra Miller is ongoing.
"Diebold's
financial executives borrowed from many different chapters of the
deceptive accounting playbook to fraudulently boost the company's
bottom line," said Robert Khuzami, Director of the SEC's Division of
Enforcement. "When executives disregard their professional
obligations to investors, both they and their companies face
significant legal consequences."
Scott W.
Friestad, Associate Director of the SEC's Division of Enforcement,
added, "Section 304 of Sarbanes-Oxley is an important investor
protection provision because it encourages senior management to
proactively take steps to prevent fraudulent schemes from happening
on their watch. We will continue to seek reimbursement of bonuses
and other incentive compensation from CEOs and CFOs in appropriate
cases."
Section 304
of the Sarbanes-Oxley Act deprives corporate executives of certain
compensation received while their companies were misleading
investors, even in cases where that executive is not alleged to have
violated the securities laws personally. The SEC has not alleged
that O'Dell engaged in the fraud. Under the settlement, O'Dell has
agreed to reimburse the company $470,016 in cash bonuses, 30,000
shares of Diebold stock, and stock options for 85,000 shares of
Diebold stock.
According
to the SEC's complaint against Diebold, filed in U.S. District Court
for the District of Columbia, the company manipulated its earnings
from at least 2002 through 2007 to meet financial performance
forecasts, and made material misstatements and omissions to
investors in dozens of SEC filings and press releases. Diebold's
improper accounting practices misstated the company's reported
pre-tax earnings by at least $127 million. Among the fraudulent
accounting practices used to inflate earnings and meet forecasts
were: Improper use of "bill and hold" accounting.
Recognition
of revenue on a lease agreement subject to a side buy-back
agreement.
Manipulating reserves and accruals.
Improperly
delaying and capitalizing expenses.
Writing up
the value of used inventory.
Without
admitting or denying the SEC's charges, Diebold consented to a final
judgment ordering payment of the $25 million penalty and permanently
enjoining the company from future violations of the antifraud,
reporting, books and records, and internal control provisions of the
federal securities laws.
The SEC
charged Geswein, Krakora, and Miller, in a complaint filed in U.S.
District Court for the Northern District of Ohio, with violating
Section 17(a) of the Securities Act of 1933, Sections 10(b) and
13(b)(5) of the Securities Exchange Act of 1934, and Exchange Act
Rules 10b 5 and 13b2-1; and aiding and abetting Diebold's violations
of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act
and Exchange Act Rules 12b-20, 13a-1, 13a-11, and 13a-13. In
addition, the SEC charged Geswein and Krakora with violating
Exchange Act Rules 13a-14 and 13b2-2 and Section 304 of the
Sarbanes-Oxley Act. The Commission seeks permanent injunctive
relief, disgorgement of ill-gotten gains with prejudgment interest,
and financial penalties. The SEC also seeks officer-and-director
bars against Geswein and Krakora as well as their reimbursement of
bonuses and other incentive and equity compensation.
Scott
Friestad, Robert Kaplan, Brian Quinn, Christopher Swart, Pierron
Leef, and Kristen Dieter conducted the SEC's investigation in this
matter. Litigation efforts in the ongoing case will be led by David
Gottesman and Robyn Bender. The SEC acknowledges the assistance of
the U.S. Attorney's Office for the Northern District of Ohio and the
Federal Bureau of Investigation.
We had
blogged earlier about Overstock.com, which had changed three
auditors in 2008-2009, from PricewaterhouseCoopers to Grant Thornton
to KPMG, all in a space of about a year, and been in trouble with
Nasdaq for filing unaudited financials.
See our
earlier posts for all the drama with the company and its erstwhile
auditors taking three disparate viewpoints on restatements,
ownership and reporting.
However,
over the last few months in 2010, things seem to have become much
better for the company, and the online retailer seems to have put
its heart back into retailing and put away the distraction of
accounting from previous months.
Here’s a
chronology of events:
Dec 29,
2009 Overstock.com Engages KPMG as the company's independent
registered public accounting firm of record for the fiscal year
ending December 31, 2009. KPMG will conduct an integrated audit of
the company's 2009 financial statements, including review of the
company's quarterly information for the periods ending March 31,
2009, June 30, 2009 and September 30, 2009.
KPMG is
hired after a lot of back and forth with previous auditors, Grant
Thornton.
March 31,
2010 Overstock.com Reports Restated FY 2009 Results with Revenue:
$876.8M in FY 2009 vs. $829.9M in FY 2008 (6% increase); Gross
margin: 18.8% vs. 17.4% (140 basis point improvement); Gross profit:
$164.8M vs. $144.2M (14% increase); Contribution (non-GAAP measure):
$109.2M vs. $86.6M (26% increase); Net income (loss) attributable to
common shares: $7.7M vs. $(11.1M) ($18.8M increase in net income);
and Diluted EPS: $0.33/share vs. $(0.48)/share ($0.81/share
improvement)
Overstock.com ranked for the second year in a row, number 2 in the
NRF/Amex survey of American consumers, behind only LL Bean and ahead
of Amazon, Zappos, eBay, Nordstrom, and many other fine firms.
Patrick M.
Byrne said, “As you may know, at the end of Q4 we engaged KPMG as
our independent auditors, and announced that we were restating our
FY 2008 and Q1, Q2 and Q3 2009 financial statements. I thank you for
being patient with us as we worked through the questions raised by
the SEC, the transition to the KPMG team, and the extra time it took
to ensure that our financial statements are accurate.”
KPMG passed
the actual audit of the company without adverse opinion, saying “In
our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
Overstock.com, Inc. and subsidiaries as of December 31, 2009, and
the results of their operations and their cash flows for the year
ended December 31, 2009, in conformity with U.S. generally accepted
accounting principles. Also in our opinion, the related financial
statement schedule, when considered in relation to the basic
consolidated financial statements taken as a whole, presents fairly,
in all material respects, the information set forth therein.”
But they
did qualify that Overstock.com’s internal audit over financial
reporting was not up to standards and provided an adverse opinion on
internal controls. The company’s Audit Committee initiated strong
steps to enhance internal audit by hiring competent professionals
and instituting appropriate processes.
Overstock.com did restate its FY 2008 and Q1-2009 to Q3-2009
financial statements to account for a number of auditing issues and
concerns.
A nice
event, with all the accounting restatements done and good results to
boot compared to FY 2008.
April
5, 2010 Overstock.com Regains Compliance with NASDAQ Listing Rules,
receiving a notice from the NASDAQ Stock Market that the company is
in compliance with the periodic filing requirement and this matter
has been closed. Earlier, Overstock.com had received a letter on
November 19, 2009 from the NASDAQ notifying the company that it had
violated NASDAQ Listing Rule 5250(c)(1) when it filed its Quarterly
Report on Form 10-Q for the period ended September 30, 2009 because
the filing wasn't reviewed in accordance with Statement of Auditing
Standards No. 100. In response to a compliance plan submitted by the
company, NASDAQ granted an exception to enable the company to regain
compliance by May 17, 2010.
A close
examination of Overstock.com's (NASDAQ: OSTK) Q1 2010 10-Q report
financial disclosures reveals that the company still failed to
remediate serious material weaknesses in internal controls that have
resulted in three restatements of financial reports in four years to
correct GAAP violations. In addition, a close examination of the
company's financial disclosures reveals serious questions about the
quality of its reported Q1 2010 earnings of $3.7 million and claimed
improvement in financial performance when compared to Q1 2009.
Continuing
Weaknesses in Internal Controls
Each and
every initial financial report for every reporting period issued by
Overstock.com from the company's inception in 1999 to Q3 2009
violated GAAP or some other SEC disclosure rules. Likewise, every
single audit report from 1999 to 2008 was wrong and every single
Sarbanes-Oxley internal control certification signed by management
turned out to be false, too.
In its Q1
2010 10-Q report, Overstock.com disclosed that the company has not
remediated serious weaknesses in internal controls:
...the
Chief Executive Officer (principal executive officer) and Senior
Vice President, Finance (principal financial officer) concluded
that our disclosure controls and procedures were not effective
as of the end of the period covered by this Quarterly Report on
Form 10-Q due to the following material weaknesses:
We
lacked a sufficient number of accounting professionals with the
necessary knowledge, experience and training to adequately
account for and perform adequate supervisory reviews of
significant transactions that resulted in misapplications of
GAAP. • Information technology program change and program
development controls were inadequately designed to prevent
changes in our accounting systems which led to the failure to
appropriately capture and process data. [Snip]
As of
March 31, 2010, we had not remediated the material weaknesses.
Based on
Overstock.com's past history of accounting irregularities and
financial reporting violations, we cannot be reasonably assured that
Overstock.com's current Q1 2010 financial report is free of GAAP and
SEC disclosure violations due to continuing reported material
weaknesses in internal controls.
Quality
of Earnings Issues for Q1 2010
In Q1 2010,
Overstock.com reported a net profit of $3.72 million compared to a
net loss of $3.96 million in Q1 2009 or a $7.68 million improvement
in earnings. However, Overstock.com's reported Q1 2010 $3.72 million
profit was helped in large part by a $3.1 million reduction in its
estimated allowance for returns or sales returns reserves when
compared to Q1 2009.
According
to Overstock.com's Q1 2010 10-Q report:
The
allowance for returns was $7.4 million and $11.9 million at
March 31, 2010 and December 31, 2009, respectively. The decrease
in the sales returns reserve at March 31, 2010 compared to
December 31, 2009 is primarily due to decreased revenues due to
seasonality.
It is
normal for sales return reserves to drop from Q4 2009 to Q1 2010
"due to seasonality" issues such as decreased revenues from an
earlier quarter (Q4 2009) compared to a later quarter (Q1 2010).
However, in many cases such reserves drop due to changes from
previous reserve estimates that artificially increase reported
profits in later periods when such estimates are adjusted.
As the
chart demonstrates, Overstock.com's reduction in allowances for
returns may not be seasonal at all, but instead due to a change of
estimate. As I detailed above, Overstock.com claimed that its
reduction in sales return reserves was "primarily due
to...seasonality" and the company did not claim any other factors
such as operating improvements as a significant reason for the drop
in reserves.
After Q4
2008, Overstock.com's allowance for returns steadily dropped in
total dollars from $16.2 million to $7.4 million in Q1 2010, or a
54% reduction in reserves. On a relative basis, Overstock.com's
allowance for returns steadily dropped from 6.38% of revenues in Q4
2008 to a mere 2.8% of revenues in Q1 2010, or a 56% drop in
relative reserves.
If
Overstock.com's return allowance had not dropped in dollar amounts
from $10.5 million in Q1 2009 to $7.4 million in Q1 2010, the
company would have reported a Q1 2010 profit of only $672k instead
of $3.72 million.
In Q1 2010,
Overstock.com's allowance for returns was 2.80% of revenues compared
to 5.65% of revenues in Q1 2009. If we use that same percentage of
revenues in Q1 2010 that Overstock.com used in Q1 2009 (5.65%), the
company's allowance for reserves would have been $14.9 million,
instead of $7.4 million as reported by the company. In such case,
Overstock.com would have reported a Q1 2010 $3.78 million loss
instead of a $3.72 profit.
The Largest Earnings Management Fraud in
History
and Congressional Efforts to Cover it Up
Without trying to place the blame on
Democrats or Republicans, here are some of the facts that led to the
eventual fining of Fannie Mae executives for accounting fraud and the
firing of KPMG as the auditor on one of the largest and most lucrative
audit clients in the history of KPMG. The restated earnings purportedly
took upwards of a million journal entries, many of which were
re-valuations of derivatives being manipulated by Fannie Mae accountants
and auditors (PwC was charged with overseeing the financial statement
revisions.
Fannie Mae may have conducted the largest
earnings management scheme in the history of accounting.
. . . flexibility
also gave Fannie the ability to manipulate earnings to hit -- within
pennies -- target numbers for executive bonuses. Ofheo details an
example from 1998, the year the Russian financial crisis sent
interest rates tumbling. Lower rates caused a lot of mortgage
holders to prepay their existing home mortgages. And Fannie was
suddenly facing an estimated expense of $400 million.
Well, in its
wisdom, Fannie decided to recognize only $200 million, deferring the
other half. That allowed Fannie's executives -- whose bonus plan is
linked to earnings-per-share -- to meet the target for maximum bonus
payouts. The target EPS for maximum payout was $3.23 and Fannie
reported exactly . . . $3.2309. This bull's-eye was worth $1.932
million to then-CEO James Johnson, $1.19 million to
then-CEO-designate Franklin Raines, and $779,625 to then-Vice
Chairman Jamie Gorelick.
That same year
Fannie installed software that allowed management to produce
multiple scenarios under different assumptions that, according to a
Fannie executive, "strengthens the earnings management that is
necessary when dealing with a volatile book of business." Over the
years, Fannie designed and added software that allowed it to assess
the impact of recognizing income or expense on securities and loans.
This practice fits with a Fannie corporate culture that the report
says considered volatility "artificial" and measures of precision
"spurious."
This
disturbing culture was apparent in Fannie's manipulation of its
derivative accounting. Fannie runs a giant derivative book in an
attempt to hedge its massive exposure to interest-rate risk.
Derivatives must be marked-to-market, carried on the balance sheet
at fair value. The problem is that changes in fair-value can cause
some nasty volatility in earnings.
So, Fannie
decided to classify a huge amount of its derivatives as hedging
transactions, thereby avoiding any impact on earnings. (And we mean
huge: In December 2003, Fan's derivatives had a notional value of
$1.04 trillion of which only a notional $43 million was not
classified in hedging relationships.) This misapplication continued
when Fannie closed out positions. The company did not record the
fair-value changes in earnings, but only in Accumulated Other
Comprehensive Income (AOCI) where losses can be amortized over a
long period.
Fannie had
some $12.2 billion in deferred losses in the AOCI balance at
year-end 2003. If this amount must be reclassified into retained
earnings, it might punish Fannie's earnings for various periods over
the past three years, leaving its capital well below what is
required by regulators.
In all, the
Ofheo report notes, "The misapplications of GAAP are not limited
occurrences, but appear to be pervasive . . . [and] raise serious
doubts as to the validity of previously reported financial results,
as well as adequacy of regulatory capital, management supervision
and overall safety and soundness. . . ." In an agreement reached
with Ofheo last week, Fannie promised to change the methods involved
in both the cookie-jar and derivative accounting and to change its
compensation "to avoid any inappropriate incentives."
But we don't
think this goes nearly far enough for a company whose executives
have for years derided anyone who raised a doubt about either its
accounting or its growing risk profile. At a minimum these
executives are not the sort anyone would want running the U.S.
Treasury under John Kerry. With the Justice Department already
starting a criminal probe, we find it hard to comprehend that the
Fannie board still believes that investors can trust its management
team.
Fannie Mae
isn't an ordinary company and this isn't a run-of-the-mill
accounting scandal. The U.S. government had no financial stake in
the failure of Enron or WorldCom. But because of Fannie's implicit
subsidy from the federal government, taxpayers are on the hook if
its capital cushion is insufficient to absorb big losses. Private
profit, public risk. That's quite a confidence game -- and it's time
to call it.
**********************************
:"Sometimes
the Wrong 'Notion': Lender Fannie Mae Used A Too-Simple Standard For
Its Complex Portfolio," by Michael MacKenzie, The Wall Street
Journal, October 5, 2004, Page C3
Lender Fannie
Mae Used A Too-Simple Standard For Its Complex Portfolio
Much has been
made of the accounting improprieties alleged by Fannie's regulator,
the Office of Federal Housing Enterprise Oversight.
Some investors
may even be aware the matter centers on the mortgage giant's $1
trillion "notional" portfolio of derivatives -- notional being the
Wall Street way of saying that that is how much those options and
other derivatives are worth on paper.
But
understanding exactly what is supposed to be wrong with Fannie's
handling of these instruments takes some doing. Herewith, an effort
to touch on what's what -- a notion of the problems with that
notional amount, if you will.
Ofheo alleges
that, in order to keep its earnings steady, Fannie used the wrong
accounting standards for these derivatives, classifying them under
complex (to put it mildly) requirements laid out by the Financial
Accounting Standards Board's rule 133, or FAS 133.
For most
companies using derivatives, FAS 133 has clear advantages, helping
to smooth out reported income. However, accounting experts say FAS
133 works best for companies that follow relatively simple hedging
programs, whereas Fannie Mae's huge cash needs and giant portfolio
requires constant fine-tuning as market rates change.
A Fannie
spokesman last week declined to comment on the issue of hedge
accounting for derivatives, but Fannie Mae has maintained that it
uses derivatives to manage its balance sheet of debt and mortgage
assets and doesn't take outright speculative positions. It also uses
swaps -- derivatives that generally are agreements to exchange
fixed- and floating-rate payments -- to protect its mortgage assets
against large swings in rates.
Under FAS 133, if
a swap is being used to hedge risk against another item on the
balance sheet, special hedge accounting is applied to any gains and
losses that result from the use of the swap. Within the application
of this accounting there are two separate classifications:
fair-value hedges and cash-flow hedges.
Fannie's
fair-value hedges generally aim to get fixed-rate payments by
agreeing to pay a counterparty floating interest rates, the idea
being to offset the risk of homeowners refinancing their mortgages
for lower rates. Any gain or loss, along with that of the asset or
liability being hedged, is supposed to go straight into earnings as
income. In other words, if the swap loses money but is being applied
against a mortgage that has risen in value, the gain and loss cancel
each other out, which actually smoothes the company's income.
Cash-flow
hedges, on the other hand, generally involve Fannie entering an
agreement to pay fixed rates in order to get floating-rates. The
profit or loss on these hedges don't immediately flow to earnings.
Instead, they go into the balance sheet under a line called
accumulated other comprehensive income, or AOCI, and are allocated
into earnings over time, a process known as amortization.
Ofheo claims
that instead of terminating swaps and amortizing gains and losses
over the life of the original asset or liability that the swap was
used to hedge, Fannie Mae had been entering swap transactions that
offset each other and keeping both the swaps under the hedge
classifications. That was a no-go, the regulator says.
"The major
risk facing Fannie is that by tainting a certain portion of the
portfolio with redesignations and improper documentation, it may
well lose hedge accounting for the whole derivatives portfolio,"
said Gerald Lucas, a bond strategist at Banc of America Securities
in New York.
The bottom line is that both the FASB and the IASB must someday soon
take another look at how the real world hedges portfolios rather than
individual securities. The problem is complex, but the problem has come
to roost in Fannie Mae's $1 trillion in hedging contracts. How the SEC
acts may well override the FASB. How the SEC acts may be a vindication
or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie
violate the rules of IAS 133.
Big Four auditing firm KPMG LLP has been ordered by a New Jersey
Superior Court judge to stand trial in an accounting fraud lawsuit
involving Cast Art Industries, according to a statement issued
Friday by law firm Eagan O'Malley & Avenatti, which represents Cast
Art.
Cast Art sued KPMG
in 2003 for professional malpractice and negligence for allegedly
failing to detect a pervasive financial fraud at Papel Giftware,
Inc. prior to Cast Art acquiring Papel in December 2000 for nearly
$50 million.
In a written
opinion, Judge Heidi Willis Currier found sufficient evidence for a
jury trial to proceed against KPMG, Papel's auditor.
In one email
uncovered during the lawsuit, a member of Papel's management
described how the company had "raped and pillaged to an extreme" in
order to meet its forecasts. A KPMG partner later acknowledged, in a
memorandum he sent to others at KPMG, that Papel's management could
not be trusted.
The lawsuit alleges
that KPMG knew Papel's management could not be trusted yet
repeatedly represented to Cast Art and others that Papel's financial
statements were accurate and no fraud had occurred.
"Wall Street, Main
Street, investors, and the public at large depend on auditing firms
to be truthful and accurate when reporting on the financial
condition of company," stated Michael Avenatti, a lawyer for Cast
Art. "In this case, like in too many others, KPMG cut every possible
corner and fell woefully short."
Cast Art claims that
for three years prior to its acquisition of Papel, KPMG repeatedly
affirmed that Papel's financial statements were accurate when in
reality the company's management had engaged in a number of
fraudulent schemes designed to inflate the value of the company to
potential buyers. Cast Art alleges that Papel's management booked
tens of thousands of fraudulent transactions on the company's books
and records by, among other things, purposely shipping product to
phony customers and double and triple shipping the same product to
the same customer.
Cast Art plans to
seek close to $50 million at trial. Opening statements are expected
to begin in the trial on Sept. 15, 2008.
One Case in Which KPMG is Not in Favor of Transparency
"KPMG Aims to Cloak Details of Client's Case: Auditor's
Settlement Offer Would Muzzle Targus Group Regarding Sanctions Order,"
by David Reilly, The Wall Street Journal, March 20, 2006; Page C3
---
Click Here
In trying to settle a lawsuit brought
against it by a former client, KPMG LLP has proposed terms aimed at
preventing other clients from learning the auditor was sanctioned by
a judge in the matter.
KPMG has offered to settle for $22.5
million a suit filed against it by Targus Group International Inc.,
a California computer-case maker, according to a draft settlement
proposal reviewed by The Wall Street Journal. Targus claimed the
accounting giant was negligent in failing to detect alleged
embezzlement by a former executive at the company. KPMG has disputed
that claim.
The proposed settlement payout is small
compared with the $465 million KPMG agreed to pay last year as part
of a deferred-prosecution agreement reached with the Justice
Department. That agreement, which helped the firm avoid a
potentially catastrophic criminal indictment, related to KPMG's sale
of questionable tax shelters.
But the nonmonetary settlement terms being
proposed by KPMG to Targus underscore how big accounting firms are
pursuing every means at their disposal to limit their litigation
liability and curtail the ability of clients to bring cases against
them. Other measures taken include terms that some auditors are
writing into their engagement contracts that would limit the
clients' ability to pursue legal action against them.
In the proposed settlement with Targus,
KPMG wants details of the case sealed and wants Targus to ask the
state judge who sanctioned KPMG to vacate, or overturn, that order,
according to the settlement document. The order, filed last July,
sanctioned KPMG for obstruction during pretrial proceedings, known
as discovery, and fined it $30,000. The judge also instructed any
jury hearing the case against KPMG to take into account the firm's
failure to produce "requested documents in a full and timely
manner." At the time, KPMG said that it complied with the judge's
discovery orders and appealed the ruling. That appeal is pending in
the California Court of Appeal.
KPMG LLP agreed to pay a former audit client $22.5
million as part of a legal settlement that also calls for a California judge
to set aside a sanctions order imposed on the accounting giant last July,
according to a person familiar with the matter and documents related to the
case.
The settlement terms will allow KPMG to clear the
legal record of a disciplinary action that could potentially be used against
it by other parties who might sue the firm in the future. Orange County
Superior Court Judge Geoffrey T. Glass sanctioned KPMG last summer for
obstruction during pretrial proceedings.
The order emanated from proceedings related to a
lawsuit brought against KPMG by former client Targus Group International
Inc. The California-based computer-case maker sued the firm for malpractice,
alleging KPMG's audit failed to spot alleged embezzlement by a former
executive that cost the company as much as $50 million.
In settling the case, KPMG had proposed that Targus
agree not to oppose a request for Judge Glass to vacate the sanctions order,
according to a draft settlement proposal reviewed by The Wall Street
Journal. The accounting firm also wanted records related to the case, as
well as the sanctions order and its own appeal of that order, sealed, while
precluding executives at Targus, or their attorneys, from speaking about or
referring to the matter, according to the draft settlement proposal.
In a statement released yesterday, KPMG said: "The
parties have reached a settlement. We cannot discuss the terms, which are
confidential. We have settled the case to avoid more costly litigation." An
attorney for Targus didn't return a call seeking comment. The company's
general counsel, Michael Ward, was traveling outside the country and was
unavailable for comment.
Siemens to Pay $1.34 Billion in Bribery Settlement
One major question spiraling out of all this is what roll Siemens' auditor, KPMG
played in allowing all this to come to pass. The Daily Caveat, November 26, 2008 ---
http://www.michaeldavidthomas.com/dailycaveat/labels/Siemens.html
The American settlement includes a $350 million
payment to the Securities and Exchange Commission to settle allegations
of accounting rule violations, which
Siemens neither admitted nor denied. Siemens falls under American
jurisdiction because its shares are listed in New York. Siemens pleaded
guilty to circumventing and failing to maintain adequate internal
controls, a requirement of the antibribery law, and will pay $450
million to the Justice Department. Three Siemens subsidiaries also
pleaded guilty to more specific charges.
Siemens, the German engineering
conglomerate, closed the book on Monday on wide-ranging criminal
investigations in the United States and Germany by agreeing to pay a
record $1.34 billion in fines to settle cases accusing it of bribery
around the world.
In Washington, Siemens’s general
counsel, Peter Solmssen, signed an $800 million settlement with the
Department of Justice and the Securities and Exchange Commission to
end an inquiry into possible violations of the Foreign Corrupt
Practices Act. The fine is, by a colossal margin, the largest ever
imposed under the antibribery legislation, now 31 years old.
Munich prosecutors, whose
trailblazing work revealed the outlines of a huge system of slush
funds and illegal payments, also announced a deal with Siemens that
would cost the company 395 million euros , or $540 million.
German authorities are still
looking into potential wrongdoing by former Siemens employees that
could result in criminal charges.
Crucially, Siemens avoided either
a guilty plea or a conviction for bribery, allowing it to maintain
its status as a “responsible contractor” with the United States
Defense Logistics Agency. Without this benchmark certification,
Siemens could have been excluded from public procurement contracts
in the United States and elsewhere. German authorities are preparing
a similar certification.
The fine in the United States was
nearly 17 times more than the next-largest imposed for overseas
commercial bribery. Yet it still represents victory for Siemens,
because it is far below what might have been levied under the
Justice Department’s guidelines.
With $1.36 billion identified as
potentially corrupt payments worldwide, a fine of up to $2.7 billion
would have been possible. But American authorities said in court
papers filed in Washington that they were impressed by the company’s
efforts to identify wrongdoing and prevent new occurrences.
“Compared to other cases that have
been brought, we have been dealt with very fairly,” Mr. Solmssen of
Siemens said in a telephone interview.
The next-highest fine imposed by
American authorities for bribery was $48 million, paid by the oil
field services company Baker Hughes in 2007.
Shares of Siemens, based in the
southern German city of Munich, initially rallied on the news, which
was lower than what investors had anticipated as settlement talks
entered their final phase this autumn. But the shares later fell
lower in Frankfurt, ending at 47.15 euros, down 23 euro cents. On
the New York Stock Exchange, the American depository receipts of
Siemens gained 55 cents, to $64.47.
“Before Siemens started giving
hints, we would have expected much more,” said Roland Pitz, an
analyst at UniCredit in Munich. “The employees must be celebrating.”
Gerhard Cromme, the Siemens
chairman — who had to juggle the sudden departure of a chief
executive as a result of the crisis, and a two-year distraction from
its core business of manufacturing energy, medical and other
industrial equipment, — allowed himself just a few smiles as he
announced the deals in Munich.
“Siemens is closing a painful
chapter in its history,” Mr. Cromme said at a news conference.
The American settlement includes a
$350 million payment to the Securities and Exchange Commission to
settle allegations of accounting rule violations, which Siemens
neither admitted nor denied. Siemens falls under American
jurisdiction because its shares are listed in New York.
Siemens pleaded guilty to
circumventing and failing to maintain adequate internal controls, a
requirement of the antibribery law, and will pay $450 million to the
Justice Department. Three Siemens subsidiaries also pleaded guilty
to more specific charges.
The Siemens approach was also
striking for its alacrity. The Baker Hughes settlement took five
years to reach, but Siemens, determined to end a persistent
distraction to a new management team, pulled off a settlement in
less than two.
Munich prosecutors are still
investigating former Siemens employees and say they have not ruled
out criminal charges. So far, they have leveled only minor charges
of failing to effectively supervise the company against two former
chief executives, Heinrich von Pierer and Klaus Kleinfeld, which
could result at most in fines.
“This investigation will continue
as planned and might take considerable time,” Christian Schmidt-Sommerfeld,
the lead Munich prosecutor, said in a statement on Monday.
But the company itself is no
longer in danger of being charged.
“We have wrapped up all of the
potential claims against Siemens arising out of the alleged conduct
in both countries,” Mr. Solmssen said.
"Big Four accounting firm KPMG LLP faces a class action lawsuit against
its Canadian division," SmartPros, September 10, 2007 ---
http://accounting.smartpros.com/x59025.xml
The lawsuit, filed this week in Ontario
Superior Court, claims overtime compensation for non-chartered
accountant KPMG employees who worked more than 44 hours in a week,
were not paid overtime pay, and are not exempt under applicable
regulation.
Chartered accountants, who make up the bulk
of KPMG's staff, are excluded from overtime provisions.
The lead plaintiff, Toronto resident Alison
Corless, was employed by KPMG as a "technician" between 2000 and
2004 and is seeking $87,000 in overtime pay for that period. The
lawsuit filed this week seeks $20 million for the class.
This is the second unpaid-overtime class
action lawsuit against a major company in Canada, following a
lawsuit against Canadian Imperial Bank of Commerce.
KPMG Hit Once Again for Negligence
"The UK's economic elites cannot effectively regulate themselves:
The disciplining of major accounting firms is still little more than a cynical
public relations exercise," by Prim Sikka, The Guardian, July 4, 2008 ---
http://www.guardian.co.uk/commentisfree/2008/jul/04/economy
Governments talk of heavy fines
and incarceration for antisocial behaviour for normal people, but it
is entirely different for economic elites, as exemplified by major
accountancy firms. Despite recurring audit failures, they get their
own courts, puny fines and little or no public accountability.
Appeals professionalism and private disciplinary arrangements disarm
journalists and critics and mask the usual predatory moneymaking
business.
Last week, seven years after the
collapse of Independent Insurance Group, the UK accountancy
profession frightened KPMG with a fine of £495,000 over its audit
failures. The partner in charge of the audits was fined £5,000 and
the firm had to pay disciplinary hearings costs of £1.15m. The audit
failures played a part in helping the company to report a loss of
£105m into a profit of £22m. In October 2007, two Independent
directors were jailed for seven years.
The puny fines will hardly worry
KPMG or its partners. The firm boasts worldwide income of nearly
$20bn (£10bn) and about £1.6bn of this is from its UK operations.
Its partners are charged out at an hourly rate of £600. Last year,
its 559 UK partners enjoyed profits of £806,000 each and also shared
a Christmas bonus of £100m.
The seven-year delay is not
unusual. The professional structures took eight years to levy a fine
on Coopers & Lybrand (now part of PricewaterhouseCoopers) for audit
shortcomings that might have prevented the late Robert Maxwell from
looting his companies and employee's pension funds. The frauds came
to light after his suicide in 1991. A UK government investigation
did not report until 2001. In 1999, a professional disciplinary
hearing placed most of the blame for audit failures on an audit
partner who died in the intervening years. The firm was fined £1.2m
for its audit failures and ordered to pay costs of £2.2m. Taken
together this amounted to £6,000 per partner. Coopers had collected
over £25m in fees from Maxwell. In 1999, PricewaterhouseCoopers had
UK income of £1.8bn.
The fraud-ridden Bank of Credit
and Commerce International (BCCI) was closed down in July 1991.
Nearly 1.4 million depositors lost some part of their $8bn savings,
though some UK savers were bailed out by the taxpayer funded
depositor protection scheme. The UK government failed to appoint an
independent inquiry to investigate the role of auditors, but a US
Senate report published in 1992, raised numerous questions about the
conduct of auditors. Eventually, in 2006, without commenting on any
of the findings of the US Senate, a disciplinary panel of the UK
accountancy profession found some faults with the audits conducted
by the UK arm of Price Waterhouse (now part of
PricewaterhouseCoopers). The firm was fined £150,000 and ordered to
pay hearing costs of £825,000. At that time the firm had UK income
of around £2bn.
The above is a small sample of
what passes for self-regulation in the UK accountancy profession.
The sinking ship of self-regulation has now been refloated, albeit
with a few deckchairs rearranged. The government has delegated the
investigation of major audit failures to the Financial Reporting
council (FRC), a statutory regulator dominated by corporate and
accounting elites. In August 2005, it announced an investigation
into the audits of MG Rover conducted by Deloitte & Touche. So far
no report has materialised.
The usual excuse is that the
accountancy regulators can't do anything until all litigation is
resolved. Such an excuse did not stop the US government from
investigating auditors of Enron or WorldCom. There is hardly any
evidence to show that the UK fines are effective or have resulted in
any improvement in audit quality. Despite recurring failures, no
partner from any major UK auditing firm has ever been banned from
practising and no major firm has ever been suspended from selling
audits. Most stakeholder lawsuits against auditors are barred after
six years, and the much-delayed disciplinary findings are of little
use to them. In any case, generally auditors only owe a "duty of
care" to the company as a legal person and not to any individual
shareholder, creditor or other stakeholder who may have suffered
loss as a result of auditor negligence.
The above cases do not suggest
that auditors directly participated in any of the irregular
activities. Nevertheless, the disciplining of major accounting firms
remains a cynical public impression management exercise. The victims
of poor audits can submit evidence to disciplinary panels, but
cannot appeal against its findings, or feather-duster fines. In
contrast, the firms and their partners can. There is no way of
knowing how any evidence gathered by the disciplinary panels is
weighted or filtered. None of it is available for public scrutiny.
The fines levied swell the coffers of the regulators and their
sponsors and are not used to compensate the victims of audit
failures. Neither the professional bodies nor any disciplinary
structure owes a "duty of care" to any individual affected by their
policies. It is time the economic elites were subjected to the legal
processes that apply to normal people.
$2.2 Billion Alleged Accounting Fraud by
Founder of Computer Associates A special committee of the board of directors has
accused Charles Wang, founder and former chairman of Computer Associates
International Inc., of directing and participating in fraudulent accounting
during the 1980s and 1990s. The committee's report, filed late Friday afternoon
in Chancery Court in Delaware, is the first investigation that publicly ties Mr.
Wang to what the government has described as a $2.2 billion accounting fraud.
The committee recommended that the Islandia, N.Y., software company, which has
changed its name to CA Inc., file suit to recover at least $500 million from Mr.
Wang in costs related to his conduct, including a $225 million payment CA made
to a government-ordered restitution fund . . . In a strongly worded statement,
Mr. Wang said he is "appalled" by the "fallacious" committee report, saying it
is based on the statements of "those who perpetrated the crimes at issue and
then lied about them." Mr. Wang said he felt "personally wronged" by Mr. Kumar
-- his successor and onetime protégé -- and called his own decision in 1994 to
recommend him for the position that would eventually take him to the corner
office a "major mistake."
William Bulkeley and Charles Forelle, "Directors' Probe Ties CA Founder To
Massive Fraud Report Suggests Suing Wang for $500 Million; Evidence of
Backdating, The Wall Street Journal, April 14, 2007; Page A1 ---
http://online.wsj.com/article/SB117649886174069499.html?mod=todays_us_page_one
A judge has signed off on a restitution
agreement requiring the former chief executive of Computer
Associates International Inc. to pay at least $52 million -
including proceeds from the sale of his yacht and pair of Ferraris -
to victims of a huge accounting fraud at one of the world's largest
software companies.
U.S. District Judge Leo Glasser approved
the deal on Friday following a brief hearing in Brooklyn at which a
special master overseeing a restitution fund announced that tens of
thousands of people who lost money on the company would recover only
a small fraction of their investments.
The agreement with Sanjay Kumar, who was
sentenced to 12 years in prison in November for his role in the
scandal, would theoretically make him liable for as much as $798.6
million in payments to investors.
Prosecutors acknowledge, though, that Kumar
and his family will probably never have enough money to pay that
amount.
The deal, which was filed earlier this
month, calls for Kumar to instead make installment payments of $40
million, $10 million and $2 million by December of 2008, then pay 20
percent of his annual income once he is released from prison.
Those payments would continue for the rest
of his life.
Kumar, 45, will be forced to sell off his
stock portfolio, a 57-foot yacht in Naples, Fla., and four cars,
including the Ferraris. But his family will keep its estate in Upper
Brookville, on Long Island.
The agreement "allows his family to live
reasonably well," said Kumar's attorney, Lawrence McMichael. "That's
fair. They didn't commit a crime."
Kumar, who attended the hearing, left court
without speaking to reporters. He must report to prison on Aug. 14.
The $52 million will go into a restitution
fund that currently totals about $235 million, said the special
master, Kenneth Feinberg. The roughly 95,000 investors who are
eligible for restitution will recover only about 2.3 percent of
their loss, he said.
The judge acknowledged that many investors
would be disappointed with the payouts. "But that's the nature of
the beast," he said.
Continued in article
The independent auditor of
Computer Associates is KPMG.
Update on the ConAgra Case
Some questions were raised at a subsequent date about independence between
KPMG and head of ConAgra's Audit Committee who is a former CEO of KPMG ---
http://www.secinfo.com/drFan.z2d.d.htm
ConAgra Allegedly Cooks the Books The Securities and Exchange Commission filed a civil
complaint accusing three former ConAgra Foods Inc. executives of improper
accounting practices that helped pump up profit statements. The SEC named former
Chief Financial Officer James P. O'Donnell, former Controller Jay D. Bolding and
Debra L. Keith, a former vice president of taxes, as defendants in the complaint
filed in U.S. District Court. The complaint alleged improper accounting from
fiscal 1999 through 2001. The SEC filed a separate complaint against former
controller Kenneth W. DiFonzo, 55, of Newport Beach, Calif.
"ConAgra's Books Draw SEC Action," The Wall Street Journal, July 2, 2007;
Page A10 ---
Click Here
The Securities and Exchange Commission has
filed civil charges against ConAgra Foods, Inc., alleging that it
engaged in improper, and in certain instances fraudulent, accounting
practices during its fiscal years 1999 through 2001, including the
misuse of corporate reserves to manipulate reported earnings in fiscal
year 1999 and a scheme at its former subsidiary, United Agri-Products (UAP),
in 2000 that involved, among other things, improper and premature
revenue recognition. ConAgra is a diversified international food company
headquartered in Omaha, Neb. Linda Thomsen, Director of the Commission's
Division of Enforcement, said, "This case again illustrates that the
Commission will take strong action when a company and its officers
engage in accounting fraud that distorts the company's true financial
condition. The facts here are particularly troubling because of the
number of different improprieties engaged in by Con Agra, the length of
time over which they occurred, and the fact that senior management was
involved in the misconduct."
AccountingEducation.com, August 9, 2007 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=145322
Executive Compensation Fraud at Apple Corporation:
Apple's mea culpa on backdating last week was eloquently incomplete Apple's mea culpa on backdating last week was
eloquently incomplete, and all the more intriguing because the gaps seemed
almost Socratically mapped to invite the media to fill the holes by asking
obvious questions. The big joke here is that the logic of the witch hunt will
stop the media from asking the obvious questions, not least because CEO Steve
Jobs is a hero to much of the press and there's little appetite for bringing him
down. Don't misunderstand. We believe it would be a gross injustice if he were
defenestrated over backdating, just as we have serious doubts about the
prosecutions launched against other backdating CEOS. And Apple's likely purpose
in issuing its statement, naturally, was not lexical comprehensiveness but
saving Mr. Jobs's job.
Holman W. Jenkins, Jr., "A Typical Backdating Miscreant, The Wall Street
Journal, October 11, 2006; Page A15 ---
http://online.wsj.com/article/SB116052823194588801.html?mod=opinion&ojcontent=otep
"Apple C.E.O. Apologizes for Stock Practices," The New
York Times, October 5, 2006 ---
Click Here
Now that an internal investigation over Apple
Computer Inc.'s stock-option practices has helped abate investor worries
over Steve Jobs' role as CEO, a key lingering concern will be the impact of
pending earnings restatements.
Apple said Wednesday its three-month investigation
did not uncover any misconduct of any current employees but did raise
''serious concerns'' over the accounting actions of two unnamed former
officers.
The iPod and Macintosh maker also said its former
chief financial officer, Fred Anderson, had resigned from the company's
board of directors.
Jobs -- his position intact -- apologized.
The probe found that Jobs knew that some option
grants had been given favorable dates in ''a few instances,'' but he did not
benefit from them and was not aware of the accounting implications, the
company said.
''I apologize to Apple's shareholders and employees
for these problems, which happened on my watch,'' Jobs said in a statement.
''We will now work to resolve the remaining issues as quickly as possible
and to put the proper remedial measures in place to ensure that this never
happens again.''
Apple said it will likely have to restate some
earnings due to revised tax and stock option-related charges. Auditors are
still reviewing the situation, and Apple said it has not yet determined the
extent of the financial impact.
The looming restatements could dramatically reduce
some of the windfall generated during the company's recent run of record
profit, analysts said.
Shares of Apple shed 10 cents to $75.28 in midday
trading Thursday on the Nasdaq Stock Market. The stock has traded between
$47.87 and $86.40 over the past year.
Apple has reported profit totaling $3.1 billion
during the past four years. If the restatements are severe, it could dent
Apple's stock, said IDC analyst Richard Shim.
''The restatements have the potential to bite them
again depending on how large they end up being,'' Shim said. ''That said,
the company is certainly firing on all cylinders so investors may be willing
to forgive them, but it's something that will linger in the backs of their
minds.''
Piper Jaffray analyst Gene Munster said he and
other investors are breathing a sigh of relief that Jobs kept his job
throughout the scandal.
''The risk was that if something bizarre happened
and Steve Jobs got fired over it,'' Munster said from his office in
Minneapolis. ''That could have significantly impacted the company in a
negative way. Steve Jobs is Apple. Ultimately, the scope of the backdating
was bigger than we thought, but the impact turned out to be less severe.''
Apple is one of the most prominent among more than
100 companies caught in the nationwide stock options mishandling scandal.
Cupertino-based Apple initiated its own stock-options investigation in June
after problems at other companies began to unravel.
In many instances, the problem has centered on the
''backdating'' of stock options -- a practice in which insiders could make
the rewards more lucrative by retroactively pinning the option's exercise
price to a low point in the stock's value.
Apple said its probe found irregularities in the
recording of stock option grants made on 15 dates between 1997 and 2002,
with the last one involving a January 2002 grant, the company said. The
grants had dates that preceded the approval of those grants.
Apple spokesman Steve Dowling said the 15 grants
represented 6 percent of the total issued during that period. He said he did
not have further details regarding the specific grants or whether they were
awarded to officers or employees.
The company did not identify the two former
officers whose accounting, recording and reporting of option grants raised
''serious concerns'' during the probe.
Apple said Anderson, who served as the company's
chief financial officer from 1996 until 2004, resigned from the board,
citing he did so in ''Apple's best interest.''
Dowling said the company will provide more details
about the probe to the Securities and Exchange Commission.
The company's special committee conducting the
investigation examined more than 650,000 e-mails and documents, and
interviewed more than 40 current and former employees, directors and
advisers.
"Apple Says Jobs Knew of Options," by Laurie J. Flynn,
The New York Times, October 5, 2006 ---
Click Here
The SEC is not yet done with Apple: Where were the KPMG
auditors?
"Apple's Former CFO Settles Options Case: Finance
Official Ties CEO Jobs To Stock Backdating Plan," by Carrie Johnson, The
Washington Post, April 25, 2007; Page D01 ---
Click Here
A former chief financial officer of Apple reached a
settlement with the Securities and Exchange Commission yesterday over the
backdating of stock options and said company founder Steve Jobs had
reassured him that the questionable options had been approved by the company
board.
Fred D. Anderson, who left Apple last year after a
board investigation implicated him in improper backdating, agreed yesterday
to pay $3.5 million to settle civil charges.
Chief executive Steve Jobs has not been charged in
the probe. (Alastair Grant - AP)
Complaint: S.E.C. v. Heinen, Anderson
Separately, SEC enforcers charged Nancy R. Heinen,
former general counsel for Apple, with violating anti-fraud laws and
misleading auditors at KPMG
by signing phony minutes for a board meeting that government lawyers say
never occurred.
Heinen, through her lawyer, Miles F. Ehrlich, vowed
to fight the charges. Ehrlich said Heinen's actions were authorized by the
board, "consistent with the interests of the shareholders and consistent
with the rules as she understood them."
Anderson issued an unusual statement defending his
reputation and tying Jobs to the scandal in the strongest terms to date. He
said he warned Jobs in late January 2001 that tinkering with the dates on
which six top officials were awarded 4.8 million stock options could have
accounting and legal disclosure implications. Jobs, Anderson said, told him
not to worry because the board of directors had approved the maneuver.
Regulators said the action allowed Apple to avoid $19 million in expenses.
Late last year, Apple said that Jobs helped pick some favorable dates but
that he "did not appreciate the accounting implications."
Explaining Anderson's motive for issuing the
statement, his lawyer Jerome Roth said: "We thought it was important that
the world understand what we believe occurred here."
Roth said his client, a prominent Silicon Valley
figure and a managing director at the venture capital firm Elevation
Partners, will not be barred from serving as a public-company officer or
board member under the settlement, in which Anderson did not admit
wrongdoing. Roth declined to characterize the current relationship between
Anderson and Jobs.
The SEC charges are the first in the months-long
Apple investigation. Jobs was interviewed by the SEC and federal prosecutors
in San Francisco, but no charges have been filed against him.
Steve Dowling, a spokesman for Apple, declined to
comment on Jobs's conversations with Anderson. Dowling emphasized that the
SEC did not "file any action against Apple or any of its current employees."
Government authorities praised Apple for coming
forward with the backdating problems last year and for sharing information
with investigators. Apple has not publicly released its investigation
report.
Continued in article
"SEC charges former Apple executive in options case:
The SEC accuses Apple's former general counsel of fraudulently backdating stock
options," by Ben Ames, The Washington Post, April 24, 2007 ---
Click Here
The SEC said it did not plan to
pursue any further action against Apple itself, which cooperated with
the government's probe, but it stopped short of saying its investigation
was closed. Commission officials declined to comment on whether possible
charges could still be filed against Jobs or other current officers.
"Options troubles at Apple remain despite SEC case against 2 former
officers," Associated Press, MIT's Technology Review, April
25, 2007 ---
http://www.technologyreview.com/Wire/18587/
That question, frequently heard
during financial scandals earlier this decade, is being asked
again as an increasing number of companies are being probed
about the practice of backdating employee stock options, which
in some cases allowed executives to profit by retroactively
locking in low purchase prices for stock.
For the accounting industry, the
question raises the possibility that the big audit firms didn't
live up to their watchdog role, and presents the Public Company
Accounting Oversight Board, the regulator created in response to
the past scandals, its first big test.
"Whenever the audit firms get caught
in a situation like this, their response is, 'It wasn't in the
scope of our work to find out that these things are going on,' "
said Damon Silvers, associate general counsel at the AFL-CIO and
a member of PCAOB's advisory group.
"But that logic leads an investor to say, 'What are we hiring
them for?' "
. . .
While the Securities and Exchange
Commission has contacted the Big Four accounting firms about
backdating at some companies, the inquiries have been of a
fact-finding nature and are related to specific clients rather
than firmwide auditing practices, according to people familiar
with the matter. Class-action lawsuits filed against companies
and directors involved in the scandal haven't yet targeted
auditors.
Backdating of options appears to have
largely stopped after the passage of the Sarbanes-Oxley
corporate-reform law in 2002, which requires companies to
disclose stock-option grants within two days of their
occurrence.
Backdating practices from earlier
years took a variety of forms and raised different potential
issues for auditors. At UnitedHealth Group Inc., for example,
executives repeatedly received grants at low points ahead of
sharp run-ups in the company's stock. The insurer has said it
may need to restate three years of financial results. Other
companies, such as Microsoft Corp., used a monthly low share
price as an exercise price for options and as a result may have
failed to properly book an expense for them.
At the PCAOB advisory group meeting,
Scott Taub, acting chief accountant at the Securities and
Exchange Commission, said there is a "danger that we end up
lumping together various issues that relate to a grant date of
stock options." Backdating options so an executive can get a
bigger paycheck is "an intentional lie," he said. In other
instances where there might be, for example, a difference of a
day or two in the date when a board approved a grant, there
might not have been an intent to backdate, he added.
"The thing I think that is more
problematic is there have been some allegations that auditors
knew about this and counseled their clients to do it," said
Joseph Carcello, director of research for the
corporate-governance center at the University of Tennessee. "If
that turns out to be true, they will have problems."
From The Wall Street Journal Accounting Weekly Review
on March 2, 2007
"KPMG Germany's Failure to Spot Siemens Problems Raises Questions"
by Mike Esterl, David Crawford, and David Reilly, The Wall Street
Journal, Feb 24, 2007, Page: B3 --- Click here to view the full article on WSJ.com
TOPICS: Audit Quality, Auditing
SUMMARY: "German prosecutors say they suspect Siemens employees
funneled money through sham consulting contracts into slush funds to
bribe potential customers." Part of the evidence may indicate that KPMG
failed to investigate questionable items uncovered by a junior auditor.
This possibility was documented in statements made by a former executive
financial officer of Siemen's telecom equipment unit while imprisoned
subsequent to a German police raid of the company's offices. The
executive has been released after agreeing to cooperate with authorities
and remains a suspect. KPMG Germany has not been charged and has denied
any wrongdoing in its auditing practices.
QUESTIONS:
1.) "Despite...alarm bells, KPMG Germany signed off on Siemens's books
and the adequacy of its internal controls..." What are the "alarm bells"
described in the article that authorities are now saying should have
brought potentially fraudulent payments to the attention of Siemens's
auditors, KPMG Germany?
2.) What is an auditor's responsibility to detect fraud?
3.) In general, what are an auditor's responsibilities in reporting
on a company's internal controls? To verify the types of reports issued,
you may examine the Siemens 2005 financial statements filed with the SEC
on Form 20-F and referred to in the article
http://www.sec.gov/Archives/edgar/data/1135644/000132693205000152/f01125e20vf.htm
4.) Given that "Siemens, with KPMG Germany's help,
identified...($551.8 million) in suspicious transactions spanning seven
years and restated its financial results in December," is it possible
that KPMG Germany fulfilled its audit obligations identified above?
Explain.
5.) What makes it likely that a junior auditor would be the one to
uncover questionable practices at a large company? How does a staff
auditor's inexperience make it difficult for him or her to exercise
judgment on matters examined in an audit?
SMALL GROUP ASSIGNMENT: Allow students to form small groups of two or
three. Provide each student with the following statement: Suppose that
you are the junior auditor who raised questions about the payments made
by Siemens for consulting services, now alleged to be fraudulently
reported to cover payments for bribes. Suppose further that you observe
that your management letter comment about the matter was removed in
"partner review", but that you were convinced there were potentially
improper payments you had not investigated during your audit field work.
What should you do? Discuss all possible courses of action.
One of the larger SEC civil penalties for accounting fraud In one of the largest civil penalties the
Securities and Exchange Commission has ever obtained against an
individual in an accounting-fraud case, a federal judge has ordered
Henry C. Yuen, former chief executive officer of Gemstar-TV Guide
International Inc., to pay $22.3 million for his role in a fraud that
led the company to overstate revenue by more than $225 million between
2000 and 2002. The ruling comes four years after the SEC launched its
investigation of Gemstar, a once highflying Hollywood company that
publishes TV Guide magazine and holds patents on technology used for
cable- and satellite-television programming guides. Earlier this year
following a three-week trial, U.S. District Judge Mariana Pfaelzer found
Mr. Yuen liable for securities fraud, lying to auditors and falsifying
Gemstar's books.
Jane Spencer and Kara Scannell, "Gemstar Ex-CEO Is Ordered To Pay $22.3
Million: Henry Yuen's Civil Penalty Is Among Largest Sought By SEC
Against Individual," The Wall Street Journal, May 9, 2006; Page
A3 ---
http://online.wsj.com/article/SB114713467418347300.html?mod=todays_us_page_one
Jensen Comment
The outside auditor was KPMG.
It
Just Gets Deeper and Deeper for KPMG
KPMG
knew that FAS 91 and FAS 133 were being violated, but KPMG did not insist
on correcting the books. How
much of Fannie’s current trouble can be blamed on KPMG?
Fannie's auditor, KPMG, disagreed with the way the company decided how
much (derivatives instruments debt and earnings fluctuations)
to book in 1998. The matter was recorded as "an audit
difference" -- a disagreement between a company and its auditor that
doesn't require a change in the books.
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up
On Fannie's Pugnacious Chief," The Wall Street Journal,
December 17, 2004 --- http://online.wsj.com/article/0,,SB110323877001802691,00.html?mod=todays_us_page_one
Bob Jensen's Fannie Mae threads are at http://www.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen’s threads on KPMG’s troubles are at http://www.trinity.edu/rjensen/fraud001.htm#KPMG
KPMG was eventually fired, due to SEC pressure, from the enormous
Fannie Mae audit.
Investigators combing through Fannie Mae's
finances have found new accounting violations, including evidence
that the company may have overvalued assets, underreported credit
losses and misused tax credits, according to people close to or
previously involved in the inquiries.
Some people familiar with the examination
said evidence also indicates the company may have bought so-called
finite insurance policies to hide losses after they were incurred.
Securities regulators, including New York state Attorney General
Eliot Spitzer, are cracking down on corporations that they say
bolstered earnings by using abusive financial reinsurance policies
that are more akin to loans, where little or no risk is transferred
to the insurer.
These people didn't provide details on the
new violations, and it isn't clear how much new damage -- if any --
these problems will create for the company. But the people indicated
that the alleged new accounting violations were designed to
embellish the company's earnings and are in addition to the
violations that the company and its regulator have already
disclosed.
According to the people who have been
involved with or are close to the investigations, for example, there
are questions about how Fannie booked certain tax credits, including
those used to lower its annual tab with the Internal Revenue
Service. Fannie reduced its corporate-tax rate in 2003 from a
statutory minimum of 35% to an effective rate of 26% by recording
tax savings of $988 million in tax credits and an additional $479
million from its tax-exempt investments, according to its year-end
earnings disclosure.
Earlier this year, Fannie Mae acknowledged
that it violated accounting principles in recording its derivatives
and other transactions, estimating a possible cumulative after-tax
loss for the restatement period from 2001 through mid-2004 of as
much as $10.8 billion, based on the company's finances as of Dec.
31, 2004. The company has said that its restatement process won't be
completed until the second half of 2006.
In a statement released late yesterday,
Fannie Mae noted that its regulator, the Office of Federal Housing
Enterprise Oversight, has found that the company was "adequately
capitalized" at the end of the second quarter. The company also said
it believes it is "on track" to reach an Ofheo mandate that it build
up its capital to 30% above the normal requirement by the end of
this month. Regarding the various investigations, the company said:
"We will continue to provide updates through our regulatory filings
as issues are identified and resolved."
Ofheo said Fannie's projected surplus over
minimum capital requirements "is sufficient to absorb uncertainties
in the estimated impact to capital of the [company's] accounting
errors, based on current information."
News that investigators may have found new
accounting irregularities triggered a selloff in Fannie Mae stock,
which dropped 11%, the largest percentage decline since the
stock-market crash of 1987. The stock was off $4.99 to $41.71 in 4
p.m. composite trading on the New York Stock Exchange. That is the
lowest closing price since July 1997.
The company's board initiated its own
review of Fannie's finances after Ofheo accused executives of
manipulating accounting rules in a scathing report delivered to the
board 12 months ago. Fannie vehemently defended its accounting until
the Securities and Exchange Commission sided with Ofheo last
December and directed the company to correct errors in its
application of two rules under generally accepted accounting
principles, or GAAP. Fannie began its multiyear earnings restatement
and ousted Chief Executive Franklin Raines and Chief Financial
Officer Timothy Howard shortly thereafter.
We have no proprietary information about
Fannie Mae, but what is publicly known is scary enough. As you may
recall, last December the SEC required Fannie to restate prior
financial statements while the Office of Federal Oversight (OFHEO)
accused the company of widespread accounting regularities that
resulted in false and misleading statements. Significantly, the
questionable practices included the way Fannie accounted for their
huge amount of derivatives. On Tuesday, a company press release gave
some alarming hints on how extensive the problem may be.
The press release stated that in order to
accomplish the restatements, “we have to obtain and validate market
values for a large volume of transactions including all of our
derivatives, commitments and securities at multiple points in time
over the restatement period. To illustrate the breadth of this
undertaking, we estimate we will need to record over one million
lines of journal entries, determine hundreds of thousands of
commitment prices and securities values, and verify some 20,000
derivative prices…”
“…This year we expect that over 30 percent
of our employees will spend over half their time on it, and many
more are involved. In addition we are bringing some 1,500
consultants on board by year’s end to help with the
restatement…Altogether, we project devoting six to eight million
labor hours to the restatement. We are also investing over $100
million in technology projects to enhance or create new systems
related to accounting and reporting…we do not believe the
restatement will be completed until sometime during the second half
of 2006…”
Here's another one of those
accounting tempered misdeed confessions "Without
admitting or denying the allegations"
I wonder if Dennis the Menace got away with these confessions as often
as accounting firms and their corporate clients?
I also wonder how KPMG made Citigroup account for this
swap under FAS 133?
The SEC and
Citigroup
settled charges regarding Citigroup’s accounting
relating to the impact of the economic and political
crisis in Argentina on the company’s operations during
the fourth quarter of 2001. In the latter part of 2001
and continuing into 2002, Argentina experienced a severe
economic and political crisis during which, among other
things, the Argentine government defaulted on certain of
its sovereign debt obligations, devalued its currency,
and abandoned the one-to-one ratio between the Argentine
peso and the United States dollar. The actions of the
Argentine government during the crisis required
Citigroup to make a number of
significant accounting decisions for the fourth quarter
of 2001. Citigroup was
required to account for (1) the impact of the company’s
participation in a government-sponsored exchange of
Argentine government bonds for loans (the “Bond Swap”);
(2) the value of Argentine government bonds held by
Citigroup that were not eligible for the Bond Swap (the
“Non-Swapped Bonds”); (3) the sale of Banco Bansud S.A.
(“Bansud”), the Argentine subsidiary of Banco Nacional
de Mexico, S.A. (“Banamex”), which Citigroup had
acquired in August 2001; and (4) the impact of
government actions that resulted in the conversion of
over $1 billion of Citigroup loans from dollars to
Argentine pesos. According to the SEC, Citigroup
accounted for each of these items in a manner that did
not conform with generally accepted accounting
principles (“GAAP”) and overstated its income reported
in the company’s earnings press release included in a
Form 8-K filed with the Commission on January 18, 2002,
and in the company’s annual report on Form 10-K for 2001
filed with the Commission on March 12, 2002.
Without
admitting or denying the allegations,
Citigroup consented to the entry of an Order Instituting
Cease-and-Desist Proceedings, Making Findings, and
Imposing a Cease-and-Desist Order Pursuant to Section
21C of the Securities Exchange Act of 1934 (“Order”).
Accounting
Snags Push
Dresser to
Restate
Problems
with
derivative
transactions,
inventory
controls
Dresser Inc.
said it will
restate its
financial
statements
for 2001
through 2003
based on a
host of
accounting
errors. In
May, the
industrial
engineering
company had
warned that
it would
restate its
2004 annual
filing, its
2004 and
2005
quarterly
financial
statements,
and would be
evaluating
the
potential
need to
restate
prior
periods. The
accounting
errors
relate to
inventory
valuation
and
derivative
transactions
under the
Financial
Accounting
Standards
Board's FAS
133. Other
accounting
errors
relate to
the
company's
businesses
which were
sold in
November
2005.
Stephen Taub,
"Accounting
Snags Push
Dresser to
Restate
Problems
with
derivative
transactions,
inventory
controls,
keep IPO on
hold,"
CFO Magazine,
November 26,
2006 ---
http://www.cfo.com/article.cfm/8346406/c_8347143?f=FinanceProfessor.com
Dresser Inc. changed its independent
auditor to Pricewaterhouse Coopers (PwC) in 2002 and with plans to restate its
2001 financial statements after it changed auditors. The previous auditor was
KPMG.
Monster says
it made
monster
accounting
errors
Monster
Worldwide
Inc. said on
Wednesday it
overstated
profit from
1997 to 2005
by a total
of $271.9
million, a
result of
its
investigation
into
historical
stock option
grants and
accounting.
In a filing
with the
U.S.
Securities
and Exchange
Commission,
the parent
of job
search Web
site
Monster.com
recorded a
net charge
of $9.2
million for
2005, $14.4
million for
2004, $27
million for
2003, $44.9
million for
2002, $65.6
million for
2001, and
$110.8
million for
the
cumulative
period of
1997 through
2000.
"Monster
says
overstated
'97-'05
profit by
$271.9 m,"
Rueters,
December 13,
2006 ---
Click Here
Fannie
Mae Sues
KPMG
The mortgage
lending
company
Fannie Mae
filed suit
on Tuesday
against its
former
auditor
KPMG,
accusing the
firm of
negligence
and breach
of contract
for its part
in the
flawed
accounting
that led to
a $6.3
billion
restatement
of earnings.
Fannie Mae
states in
its
complaint
that KPMG
applied more
than 30
flawed
principles
and cost it
more than $2
billion in
damages.
Fannie Mae
fired the
accounting
firm in
mid-December
2004, just a
week after
the
Securities
and Exchange
Commission
ordered the
company to
restate more
than two
years of
flawed
earnings. A
KPMG
spokesman,
Tom
Fitzgerald,
said the
company
planned to
“pursue our
own claims
against
Fannie Mae.”
"Fannie Mae
Sues KPMG,"
The New York
Times,
December 13,
2006 ---
http://www.nytimes.com/2006/12/13/business/13kpmg.html?_r=1&oref=slogin
KPMG fired
back at
former audit
client
Fannie Mae
this week,
saying it
would
counter the
mortgage
giant’s $2
billion
negligence
and breach
of contract
lawsuit.
KPMG “will
pursue our
own claims
against
Fannie Mae”
in the U.S.
District
Court in
Washington,
D.C.,
spokesman
Tom
Fitzgerald
told
reporters
Tuesday.
Fannie Mae
filed its
lawsuit
Tuesday in
the Superior
Court of the
District of
Columbia.
Fitzgerald
said the
issues
raised in
Fannie Mae's
lawsuit “are
already
pending" in
shareholder
lawsuits
before the
federal
district
court. He
did not
elaborate on
what claims
KPMG would
make against
Fannie Mae,
Reuters
reported.
"KPMG Plans
Counter Suit
of Fannie
Mae,"
AccountingWeb,
February 14,
2006 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=102902
The
first set of PCAOB
auditor
inspection
reports
Denny
Beresford
clued me
into the
fact
that,
after
several
months
delay,
the Big
Four and
other
inspection
reports
of the
PCAOB
are
available,
or will
soon be
available,
to the
public
---
http://www.pcaobus.org/Inspections/Public_Reports/index.aspx
Look for
more to
be
released
today
and
early
next
week.
The
firms
themselves
have
seen
them and
at least
one,
KPMG,
has
already
distributed
a
carefully-worded
letter
to all
clients.
I did
see that
letter
from
Flynn.
Denny
did not
mention
it, but
my very
(I
stress
very)
cursory
browsing
indicates
that the
firms
will not
be
comfortable
with
their
inspections,
at least
not some
major
parts of
them.
I would
like to
state a
preliminary
hypothesis
for
which I
have no
credible
evidence
as of
yet. My
hypothesis
is that
the
major
problem
of the
large
auditing
firms is
the
continued
reliance
upon
cheaper
risk
analysis
auditing
relative
to the
much
more
costly
detail
testing.
This is
what got
all the
large
firms,
especially
Andersen,
into
trouble
on many
audits
where
there
has been
litigation
---
http://www.trinity.edu/rjensen/Fraud001.htm#others
While
doing
some
grading,
I
have
been
listening
to
the Webcast
of
the
February
meeting of
the PCAOB
Standing
Advisory
Group
(see
http://www.connectlive.com/events/pcaob/)
(yes,
I
know,
I
have
no
life!
<g>).
There
is
an
interesting
discussion
on
the
role/future
of
the
risk-based
audit. Seehttp://tinyurl.com/8f5nt at
42
minutes
into
the
discussion.
A
variety
of
viewpoints
are
expressed
in
the
discussion.
This
refers
back
to
an
earlier
discussion
we
had
on
AECM.
Roger
--
Roger
Debreceny
School
of
Accountancy
College
of
Business
Administration
University
of
Hawai'i
at
Manoa
2404
Maile
Way
Honolulu,
HI
96822,
USA
www.debreceny.com
A required
report by the
Public Company
Accounting
Oversight Board,
released last
week, uncovered
flaws in 18
audits performed
by KPMG LLP for
publicly held
companies.
The PCAOB
reviewed just 76
of KPMG's 1,900
publicly traded
clients between
June and October
2004. Some of
the failures by
KMPG, according
to the PCAOB,
include not
thoroughly
evaluating some
known or likely
errors, not
keeping crucial
documentation,
and not backing
up its opinion
with "sufficient
competent
evidential
matter."
In a prepared
statement, KPMG
Chairman Timothy
Flynn said,
"KPMG is
committed to the
goal of
continuous
improvement in
audit quality.
We appreciate
the constructive
dialogue and
consider it an
important
element in the
process of
improving our
system of
quality
controls."
The
Sarbanes-Oxley
Act, which
established the
oversight board,
requires the
inspections. The
PCAOB may not
make certain
criticisms
public, however,
so some portions
of the KPMG
report remain
undisclosed.
This report is
the first of
four reports
that will
inspect the
nation's top
four accounting
firms. KPMG is
the
fourth-largest
accounting firm.
The remaining
reports are
expected in the
coming weeks.
Former KPMG Partner Pfaff Indicted in Tax-Shelter
Case
Former KPMG LLP tax partner Robert Pfaff has been
charged in a new two-count criminal indictment over alleged fraudulent
tax-shelter transactions in the U.S. and the Northern Mariana Islands,
according to court papers made public yesterday. Mr. Pfaff, who was at
KPMG from 1993 to August 1997, was charged with conspiracy and
obstructing or impeding the due administration of the Internal Revenue
laws, according to the indictment. The government also separately filed
a civil forfeiture action, seeking nearly $1.84 million related to fee
income Mr. Pfaff allegedly received as a result of the shelters'
implementation.
Chad Bray, The Wall Street Journal, March 19, 2008 ---
http://online.wsj.com/article/SB120589548197447523.html?mod=todays_us_page_one
Second Circuit Affirms Dismissal of
Indictment Against Former KPMG Partners and Employees Because of 6th Amendment Violation In a major
victory for the white collar defense bar, the Second Circuit affirmed
the district court's dismissal of the indictment against former KPMG
partners and employees because the government deprived the defendants of
their Sixth Amendment right to counsel by causing KPMG to place
conditions on the advancement of legal fees and to cap the fees and
ultimately end them. U.S. v. Stein (2d Cir. August 28, 2008).
Securities Law Professor Blog, August 28, 2008 ---
http://lawprofessors.typepad.com/securities/
Question
What may be the largest criminal tax fraud prosecution in U.S. history?
"Prosecutors in KPMG Tax Shelter Case Offer to Try 2 Groups of
Defendants Separately," Lynnley Browning, The New York Times,
October 5, 2006 ---
Click Here
Last year, 16 former KPMG employees,
as well as a lawyer and an outside investment adviser, were indicted
by a federal grand jury in Manhattan on charges that they conspired
to defraud the Internal Revenue Service by creating and selling
certain questionable tax shelters.
The proposal to split the group comes
after Judge Kaplan raised concerns about some prosecutorial tactics
in the complex case. KPMG narrowly averted criminal indictment last
year over certain questionable shelters and instead reached a $456
million deferred-prosecution agreement. Judge Kaplan has criticized
prosecutors for pressuring KPMG to cut off the payment of legal fees
to the defendants.
His concerns how appear to extend to
the indictments of the defendants.
According to a transcript of the
hearing on Tuesday, Judge Kaplan said: “The government indicted 18
people knowing that the effect of doing that would be to put
economic pressure on people, along with whatever else puts pressure
on people to cave and to plead, because they can’t afford to defend
themselves and because perhaps there are other risks involved in a
joint trial. That is the patent reality of this case.”
A representative for the United States
attorney’s office in Manhattan did not have a comment on the letter
yesterday.
The letter, which was not filed under
seal but did not appear on the court’s docket, was confirmed by two
persons close to the proceedings.
Under the proposal, the junior
defendants would include Jeffrey Eischeid, the rising star who was
in charge of KPMG’s personal financial planning division; John
Larson, a former KPMG employee who set up an investment boutique
that sold shelters; David Amir Makov, a onetime Deutsche Bank
employee who later worked with Mr. Larson’s investment boutique,
Presidio Advisory Services; and Gregg Ritchie, a former partner;
among others.
The senior defendants would include
Jeffrey Stein, a former vice chairman who was the No. 2. executive
at the firm; John Lanning, a former vice chairman in charge of tax
services; Richard Rosenthal, a former chief financial officer;
Steven Gremminger, a former associate in-house lawyer; Robert Pfaff,
a former KPMG partner who worked with Mr. Larson to set up Presidio
Advisory Services; David Greenberg, a former senior tax partner; and
Raymond J. Ruble, a former lawyer at Sidley Austin Brown & Wood;
among others.
Lawyers for the defendants maintain
that their clients did nothing illegal, while prosecutors contend
that they created and sold tax shelters, some involving fake loans,
that deprived the Treasury of $2.5 billion in tax revenue.
The government’s criminal case against
promoters of questionable tax shelters took
a step forward yesterday when an investment
adviser at the center of the inquiry pleaded
guilty and provided new details on those
involved.
The plea by David Amir
Makov, 41, in Federal District Court in
Manhattan is expected to bolster the
government’s investigation of
Deutsche Bank over
its work with questionable shelters,
including one known as Blips, whose workings
Mr. Makov described in detail yesterday.
No charges have been filed against Deutsche
Bank, and it was not named in court
documents yesterday. In a statement that he
read yesterday, Mr. Makov described his tax
shelter work with Bank A, which people close
to the case have identified as Deutsche
Bank. A spokesman for the bank declined to
comment.
Mr. Makov’s plea is also expected to help
the government’s case against the four
remaining defendants, who include three
former employees of the accounting firm KPMG
and an outside lawyer. Those four are
scheduled to go to trial in October.
As part of the plea agreement, Mr. Makov
agreed to pay a $10 million penalty; he will
be sentenced at a later date. His lawyers
declined to comment yesterday.
His guilty plea to conspiracy to commit tax
evasion puts back on track a faltering case
that had become, to the consternation of
prosecutors, a referendum on the
constitutional rights of white-collar
defendants, rather than the largest criminal
inquiry ever into abusive tax shelters.
Continued in article
Another KPMG defendant
pleads guilty of selling
KPMG's bogus tax shelters One
of the five remaining
defendants in the
government's high-profile
tax-shelter case against
former KPMG LLP employees is
expected to plead guilty
ahead of a criminal trial
set to begin in October,
according to a person
familiar with the situation.
The defendant, David Amir
Makov, is expected to enter
his guilty plea in federal
court in Manhattan this
week, this person said. It
is unclear how Mr. Makov's
guilty plea will affect the
trial for the remaining four
defendants. Mr. Makov's plea
deal with federal
prosecutors was reported
yesterday by the New York
Times. A spokeswoman for the
U.S. attorney in the
Southern District of New
York, which is overseeing
the case, declined to
comment. An attorney for Mr.
Makov couldn't be reached.
Mr. Makov would be the
second person to plead
guilty in the case. He is
one of two people who didn't
work at KPMG, but his guilty
plea should give the
government's case a boost.
Federal prosecutors indicted
19 individuals on tax-fraud
charges in 2005 for their
roles in the sale and
marketing of bogus shelters
. . . KPMG admitted to
criminal wrongdoing but
avoided indictment that
could have put the tax giant
out of business. Instead,
the firm reached a
deferred-prosecution
agreement that included a
$456 million penalty. Last
week, the federal court in
Manhattan received $150,000
from Mr. Makov as part of a
bail modification agreement
that allows him to travel to
Israel.
Paul Davies, "KPMG Defendant
to Plead Guilty," The
Wall Street Journal,
August 21, 2007; Page A11
---
Click Here
Charges Dropped for 13 of 16 KPMG Defendants (a 17th pleaded
guilty a year ago)
The federal judge overseeing a large criminal tax-shelter case has
dismissed charges against 13 defendants from the accounting firm KPMG,
in a sharply worded ruling that blamed prosecutors for the setback in
the faltering case. Judge Lewis A. Kaplan, of Federal District Court in
Manhattan, wrote that he had no choice but to dismiss the charges
because prosecutors had violated the constitutional rights of the
defendants when they pressured their former employer KPMG to cut off
their legal fees.Charges against
three other KPMG defendants still stand . . . Judge
Kaplan declined to dismiss charges against a former KPMG partner David
Greenberg, and two former KPMG employees, Robert Pfaff and John Larson.
The judge said that the case would proceed to trial against former KPMG
employees who had not established that KPMG would have paid their
defense costs even if the government had left the company alone in
regards to defense costs. He also let the case proceed against two
defendants who were not employed by KPMG and whose rights were not
affected. Lynnley Browning, "Charges Dropped in KPMG Tax-Shelter Case,"
The New York Times, July 16, 2007 ---
Click Here
Guilty Plea Made in Trial Over Shelters From KPMG A businessman pleaded guilty yesterday to
charges of conspiracy and fraud and agreed to help federal prosecutors
pursue indicted former employees of the accounting firm KPMG in a
widening investigation into questionable tax shelters. The businessman,
Chandler Stuart Moisen, who appeared in Federal District Court in
Manhattan, is the third person to enter a guilty plea in the tax shelter
investigation, which has ensnared accountants, bankers, lawyers and
investment advisers. . . . . . . Although Mr. Moisen is a relatively
minor figure in the tax shelter inquiry, his offer to cooperate with the
prosecution could have major consequences for the KPMG defendants, in
particular for Robert Pfaff, a former KPMG partner with whom Mr. Moisen
worked closely to sell questionable tax shelters.
Lynnley Browning, "Guilty Plea Made in Trial Over Shelters From KPMG," The
New York Times, December 22, 2006 ---
http://www.nytimes.com/2006/12/22/business/22shelter.html?ref=business
New Appeal by KPMG A California superior-court judge sanctioned
KPMG LLP last week for withholding documents in an
accounting-malpractice lawsuit brought by a small private computer-case
maker, the third time the big accounting firm has been criticized by a
judge for its legal tactics in recent months. In an order issued
Wednesday, Orange County Superior Court Judge Geoffrey Glass instructed
KPMG to pay $30,000 for "its abuse of the discovery process" and
directed the jury to consider such behavior as it weighs the case
brought by Targus Group International Inc. Judge Glass wrote that KPMG
"deliberately or recklessly withheld or delayed in producing many
responsive documents," adding that "the Court warned KPMG-US at least
twice about gamesmanship in discovery." "We're disappointed by the
Court's ruling," a KPMG spokesman said in a statement. "We fully
complied with all discovery orders in the Targus case. We plan to seek
appellate review of this order."
Diya Gullapalli, "Judge Fines KPMG Over Tactics In
Accounting-Malpractice Suit," The Wall Street Journal, July 18,
2005; Page C4 ---
http://online.wsj.com/article/0,,SB112164712739487960,00.html?mod=todays_us_money_and_investing
The investigation and possible prosecution
of KPMG has been the focus of a larger investigation by the
Department of Justice (DOJ) into abusive tax shelters sold to
corporate taxpayers and wealthy individuals by accounting firms,
banks, and law firms. There are now signs that DOJ is working toward
a decision. DOJ found that KPMG sold four types of overly aggressive
tax shelters to over 350 people between 1997 and 2001 that brought
in $214 million in fees according to the Senate Subcommittee on
Investigations. These shelters cost the Government around $1.4
billion in unpaid taxes.
The firm has been cooperating with the
government and issued a statement in June implicating their
“wrongful conduct” and “full responsibility” by their former
partners. They also pledged further cooperation in the case. They
have initiated corporate reforms to ensure this situation will not
occur again.
The Washington Post has reported that up to
20 ex-KPMG partners may be facing prosecution for their roles in
selling the shelters. Other firms implicated in government documents
include a law firm now called Sidley Austin Brown & Wood and
Deutsche Bank according to the New York Times.
DOJ officials have authorized David Kelley,
the U.S. attorney for the Southern District of New York, to
negotiate a deal with KPMG that will not drive the firm out of
business. The DOJ does not want to repeat the collapse of Arthur
Anderson that destablized the industry in 2002. Arthur Anderson
employed some 85,000 people worldwide.
If the firm were to negotiate a settlement
instead of receiving an indictment to resolve the case as well as
prosecution of the ex-KPMG executives, concerns over their clients
abandoning the firm might be avoided. Significant legal exposure
from civil suits by investors and shareholders might also be
avoided.
“The Justice Department’s issue is do we
really want to take this down to the Big Three or is there some way
short of destroying this company that we can get some comfort that
this going to be recurring in the future?” said David Gourevitch, a
former prosecutor and now in private practice in New York.
The outcome of this case may come down to a
large fine, changes in their corporate culture, and oversight. The
firm continues to negotiate with the Government to resolve this
case. If these negotiations fail, the Government may go for an
corporate indictment. The prosecution of this case is still out
except for the referral of potential cases against several former
KPMG partners and other individuals to the DOJ. No indictments have
been passed down.
The accounting firm KPMG struck back
yesterday against 16 former employees and the federal judge
overseeing their coming tax shelter trial, filing court papers
seeking compensation from certain defendants and saying that it
would appeal a ruling ordering a related trial over their legal
fees.
KPMG itself narrowly averted criminal
indictment last year, reaching a $456 million deferred-prosecution
agreement with the Justice Department over questionable shelters.
The case against the former KPMG employees,
an outside investment adviser and a lawyer, is described as the
largest criminal tax trial ever. It has attracted criticism of the
tough prosecutorial tactics adopted by the Justice Department in
early 2003 after the accounting scandals at Enron and elsewhere.
Prosecutors accuse the defendants of
conspiring to defraud the government by making and selling abusive
tax shelters. In counterclaim papers filed yesterday, KPMG accused
five defendants of breach of fiduciary duty or embezzlement and
sought unspecified damages.
The claim accuses David Greenberg, a former
top KPMG West Coast partner, and Robert Pfaff, a former KPMG
employee and later an outside investment adviser, of embezzling from
KPMG through their sale of tax shelters. It also accuses Jeffrey
Stein, a former vice chairman; Richard Rosenthal, a former chief
financial officer; and Richard Smith, a former vice chairman of tax
services, of breach of fiduciary duty to the firm.
In a separate motion filed yesterday,
lawyers for KPMG said they were asking the United States Court of
Appeals for the Second Circuit to reconsider a decision made earlier
this month by the judge overseeing the case of the former employees.
In his decision, Judge Lewis A. Kaplan of
Federal District Court in Manhattan denied KPMG’s request either to
dismiss a recent civil case filed by the defendants seeking to force
KPMG to pay the legal fees, or to compel the defendants to submit to
arbitration. Judge Kaplan had ordered a civil trial to be held next
month.
But the KPMG filing challenged Judge
Kaplan’s jurisdiction over the legal fees issue, and asked him to
delay the civil trial indefinitely, pending its appeal.
A spokeswoman for KPMG said yesterday that
the firm was “asserting its right to seek arbitration” as outlined
in the defendants’ employment contracts.
In a blistering ruling last June, Judge
Kaplan found that federal prosecutors violated the constitutional
rights of the KPMG defendants and exerted undue pressure on KPMG
when they urged KPMG to cut off the legal fees and disclose legal
communications, even though the defendants had not yet been
indicted. The Justice Department appealed that ruling in July.
In its motion filed yesterday, KPMG asked
that its own appeal regarding the civil trial on fees next month be
heard in conjunction with the Justice Department appeal.
Another KPMG defendant pleads guilty of selling KPMG's bogus tax
shelters One of the five remaining defendants in the
government's high-profile tax-shelter case against former KPMG LLP
employees is expected to plead guilty ahead of a criminal trial set to
begin in October, according to a person familiar with the situation. The
defendant, David Amir Makov, is expected to enter his guilty plea in
federal court in Manhattan this week, this person said. It is unclear
how Mr. Makov's guilty plea will affect the trial for the remaining four
defendants. Mr. Makov's plea deal with federal prosecutors was reported
yesterday by the New York Times. A spokeswoman for the U.S. attorney in
the Southern District of New York, which is overseeing the case,
declined to comment. An attorney for Mr. Makov couldn't be reached. Mr.
Makov would be the second person to plead guilty in the case. He is one
of two people who didn't work at KPMG, but his guilty plea should give
the government's case a boost. Federal prosecutors indicted 19
individuals on tax-fraud charges in 2005 for their roles in the sale and
marketing of bogus shelters . . . KPMG admitted to criminal wrongdoing
but avoided indictment that could have put the tax giant out of
business. Instead, the firm reached a deferred-prosecution agreement
that included a $456 million penalty. Last week, the federal court in
Manhattan received $150,000 from Mr. Makov as part of a bail
modification agreement that allows him to travel to Israel.
Paul Davies, "KPMG Defendant to Plead Guilty," The Wall Street
Journal, August 21, 2007; Page A11 ---
Click Here
The federal judge overseeing the KPMG tax
shelter case has refused to dismiss charges against 18 defendants
accused of setting up questionable shelters for rich clients to
defraud the Internal Revenue Service.
In a decision dated Friday and released
yesterday, the judge, Lewis A. Kaplan, of Manhattan, said the
government had proved the possible existence of a conspiracy well
enough to allow the case to go forward.
He also rejected arguments that prosecutors
would be unable to show that the defendants acted with criminal
intent because either the shelters were legal, or were governed by
"uncertain" law.
The government is accusing 18 defendants,
including 16 former KPMG executives, of planning to defraud the
I.R.S. Prosecutors said the questionable shelters created at least
$11.2 billion in fake tax losses, and deprived the government of
$2.5 billion in taxes.
KPMG agreed in August to pay $456 million,
accept an outside monitor and admit to wrongdoing in resolving a
federal inquiry into the shelters.
KPMG Tax-Shelter Settlement May Be Revised Amid Opt-Outs "This settlement could be in jeopardy," said
attorney Edmundo Ramirez, whose client was one of 284 potential members of
the KPMG class. Mr. Ramirez said his client rejected the original
settlement, considering it "a sweetheart deal for KPMG."
Nathan Koppel, "KPMG Tax-Shelter Settlement May Be Revised Amid Opt-Outs,"
The Wall Street Journal, February 10, 2006; Page C4 ---
http://online.wsj.com/article/SB113953761206570322.html?mod=todays_us_money_and_investing
KPMG's Knight in Shining Armor
Denny Beresford forwarded me an interesting article entitled “KPMG's
Knight in Shining Armor” by Sue Reisinger.
This is a most interesting document on what was going on behind the
scenes to convict versus same KPMG. It took a second generation Norwegian
immigrant to get the job done. Now that made me feel good.
One statistic popped out. Sue’s article claims KPMG “raked in $128
million in ill-gotten profits while thumbing its nose at the law.” This
is the supposed return on over $1 billion sales of illegal tax shelters,
many of which were sold after the IRS warned KPMG to stop selling these
shelters. Details are given at
http://www.trinity.edu/rjensen/Fraud001.htm#KPMG
The eventual $453 million settlement to stay in business is costly to
KPMG. Civil suits are still pending and these could become astronomical.
And nearly 20 former KPMG tax partners are still facing criminal charges
that could send them to jail.
But KPMG is still in business. Like Andersen many of Andersen’s
professionals, there are many, many outstanding KPMG employees who bear
no responsibility for the bad things that went down.
Nine Are Charged In KPMG Case On Tax Shelters In the first indictments in the government's
investigation of KPMG LLP tax shelters, a federal grand jury charged
nine people, including the firm's former No. 2 executive, with
conspiring to defraud the U.S. government in connection with four types
of shelters that KPMG sold to wealthy Americans. The defendants include
three former chiefs of KPMG's tax practice, one of whom, Jeffrey Stein,
was KPMG's deputy chairman from 2002-04. The other former heads of
KPMG's tax practice who were indicted are former KPMG vice chairmen
Richard Smith, who left the firm last year, and John Lanning, who left
in 2000.
Jonathan Weil, "Nine Are Charged In KPMG Case On Tax Shelters," The
Wall Street Journal, August 30, 2005; Page C1 ---
http://online.wsj.com/article/0,,SB112533172910025699,00.html?mod=todays_us_money_and_investing
U.S. Expects to Indict At Least 12 More Over KPMG Shelters The lead prosecutor in the KPMG LLP tax-shelter
investigation said the government expects to seek indictments against at
least 12 more individuals in the coming weeks, on top of the nine people
who were arraigned yesterday in a federal court in Manhattan. The
additional defendants will be named as part of a superseding indictment
and could include additional charges against the nine people whose bond
requirements were set yesterday by U.S. District Judge Lewis A. Kaplan.
The government's lead prosecutor, Assistant U.S. Attorney Justin Weddle,
said the additional charges in the superseding indictment likely would
include obstruction of justice, as well as tax evasion, in addition to
the existing conspiracy count.
Jonathan Weil and Kara Scannell, "U.S. Expects to Indict At Least 12
More Over KPMG Shelters," The Wall Street Journal, September 7,
2005; Page C1 ---
http://online.wsj.com/article/0,,SB112603926421333075,00.html?mod=todays_us_money_and_investing
The Courts Inevitably Protect Fees of Lawyers Above All Others
Something remarkable and salutary happened
in a Manhattan courtroom this week: U.S. District Court Judge Lewis
A. Kaplan upheld the logic and meaning of the Constitution's Due
Process Clause and the Sixth Amendment.
The case involves the Justice Department's
prosecution of 16 former KPMG executives, accused of having
engineered fraudulent tax shelters for their clients. We have our
doubts about just how "fraudulent" those shelters were, seeing that
they were never banned by the IRS, their legality was never tested
in court, and KPMG stopped marketing them long before the IRS listed
them as suspect. The criminal trial will be no slam dunk.
But the real whopper was the decision by
KPMG to stop paying the legal fees of its former executives, largely
to satisfy the requirements of the so-called Thompson memo. That
2002 document, written by then-Deputy Attorney General Larry
Thompson amid corporate scandal fever, laid out the measures that
companies facing prosecution could take to demonstrate cooperation
and thereby avoid firm-wide indictment. Not wishing to share the
fate of bankrupted Arthur Andersen, KPMG complied with the Thompson
diktat and hung its executives out to dry while negotiating a
deferred prosecution accord.
Enter Judge Kaplan, who on Monday delivered
a scathing 83-page rebuke of the government's case. Noting that
Constitutional rights to a fair trial and competent counsel were at
stake here, he went on to limn a third principle, "not of
constitutional dimension," but "very much a part of American life."
To wit:
"Bus drivers sued for accidents, cops sued
for allegedly wrongful arrests, nurses named in malpractice cases,
news reporters sued in libel cases, and corporate chieftains
embroiled in securities litigation generally have [the right] to
have their employers pay their legal expenses." By holding "the
proverbial gun to [KPMG's] head" with the threat of a company-wide
indictment, the Judge wrote, the government had used the company as
a proxy to violate the defendants' rights.
The 16 defendants must still contend with
the charges of the indictment. But with KPMG now required to foot
their legal bills, at least they don't face the bleak choice between
financial ruin or copping a plea. As for the Justice Department, now
is the time for Attorney General Alberto Gonzales to reinterpret, or
better yet rewrite, those parts of the Thompson memo that his
too-zealous prosecutors have been using in violation of defendants'
due process rights.
Big Four accounting firm KPMG LLP wasn't
just a tax-shelter promoter. It also was a client.
Internal KPMG documents show the firm used
one of its own mass-marketed corporate-tax strategies to record a
$34 million deduction on its 2001 tax return, just months before the
Internal Revenue Service listed the strategy as an abusive
tax-avoidance transaction.
The IRS added the strategy, called 401(k)
Deduction Acceleration Strategy, or "401kAccel," to its published
list of abusive transactions in June 2002. KPMG sold it to at least
143 companies, which together "claimed undisclosed millions in
accelerated tax deductions," according to a July 2002 court filing
by the IRS in connection with its probe into KPMG shelters.
While much of the news about tax avoidance
has focused on wealthy individuals, 401kAccel offers a rare look at
a type of questionable shelter that KPMG and other major accounting
firms shopped to big corporations. Other firms that once sold
strategies similar to 401kAccel include Deloitte & Touche LLP,
PricewaterhouseCoopers LLP and Arthur Andersen LLP. The IRS allowed
companies, including KPMG, to avoid penalties by unwinding the
strategies voluntarily.
In a statement, KPMG said it "made full
disclosure of the 401kAccel transaction to the IRS on the firm's
2001 federal return," and "took the prescribed corrective measures
immediately when the IRS listed the transaction" as abusive.
Internal KPMG records from 1998 through
2002, reviewed by The Wall Street Journal, show a variety of
prominent companies bought 401kAccel from KPMG. Among them: Circuit
City Stores Inc., Allegheny Energy Inc., Pulte Homes Inc., PetsMart
Inc., Tenet Healthcare Corp. and the U.S. unit of Mexican cement
maker Cemex SA.
Circuit City Chief Financial Officer
Michael Foss said the electronics retailer, a KPMG audit client,
used the strategy from 2000 to 2002 and later unwound it without
penalty. "Multiple companies were utilizing the strategy," he said.
Continued in article
Even if the Feds let KPMG off, there are 50 states waiting in the
wings
Mississippi probably will file criminal charges
against accounting giant KPMG because it created a tax strategy that the
state says illegally let WorldCom, now called MCI Inc., shield billions
of dollars from taxes, sources close to the case said Friday.
Although a few other states have also weighed this strategy, Mississippi
Atty. Gen. Jim Hood is the most determined, and his state would be the
first to take this step, said the sources, who requested anonymity.
"Mississippi May File KPMG Charges," Los Angeles Times, August
20, 2005 ---
http://www.latimes.com/business/la-fi-kpmg20aug20,1,7703307.story?coll=la-headlines-business
Jensen Comment:
My guess is that KMPG will survive the criminal charges but will emerge
badly crippled with the burden of over a billion in settlement payments
with former clients and many of the states like Mississippi and
California. The IRS alleges over $1.4 billion in damages in uncollected
taxes. Add to this the damages of many of the states with income taxes
and the added costs of punitive damages and serious litigation costs on
the back of KPMG. Why in the world didn't KPMG stop selling these
shelters when the IRS warned KPMG that it was selling illegal tax
shelters?
The distinct possibility that KPMG may fail is the reason the SEC is
developing a contingency plan. See below.
Is paying out a $300-$500 million settlement "good news?" KPMG has had their fair share of bad news
since becoming the focus of federal prosecutors but there is unofficial
word that an agreement will be announced later this week. Better yet,
their Big Four competitors have each told their partners should refrain
from "poaching" KPMG's clients. The settlement calls for the smallest of
the Big Four accounting firms to pay a fine totaling between $300 and
$500 million and accept independent oversight of its operations in order
to avoid prosecution. In the deferred prosecution, there will also be a
yet unstated probationary period. If the firm stays out of trouble
during that set time, the charges will be dropped by the U.S. Attorney
for the Southern District of New York. The firm has about 1,600 partners
and currently audits the financial statements of more than 1,000
companies.
"More Good News Than Bad for KPMG," AccountingWeb, August 24,
2005 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=101231
Jensen Comment: I guess this is good news in that KPMG
is thereby allowed to stay in business and will not implode in
the manner that Andersen imploded following the document
shredding conviction. but there is still the worry about
individual state prosecutions. The $456 settlement does
not include legal costs and future settlements pending with sta
The IRS estimates that the loss to the U.S. treasury was $1.4
billion in illegal tax shelters that KPMG confessed to selling.
The added losses in at least eleven states having state income taxes has
not been reported. KPMG is not alone in its troubles over sales of
illegal tax shelters and other huge amounts of settlements and pending
litigation. All large accounting firms were selling questionable
shelters, although KPMG admittedly took it to an extreme. See
http://www.trinity.edu/rjensen/fraud001.htm#others
From The Wall Street Journal Accounting Weekly Review on
September 2, 2005
SUMMARY: Indictments are handed down in the KPMG case on abusive tax
shelters; those indicted are expected to plead not guilty. The U.S.
Attorney's Office in Manhattan also announced that KPMG had settled the
case against it for $456 million and had admitted criminal wrongdoing.
QUESTIONS:
1.) What are the facts and circumstances surrounding this KPMG
settlement and the indictments against its partners and others
associated with the firm?
2.) Why did the U.S. authorities allow KPMG a "deferred prosecution
agreement"? What does that phrase mean?
3.) Why are the individual partners, managers, and outside lawyers
who developed the KPMG taxx shelters being treated differently than is
the firm?
4.) What is the likely impact of KPMG's legal issues on their future
operations? Consider the effect of the settlement and indictment on
other aspects of the firms business; document all issues that you
identify in the articles and that you can think of yourself.
Reviewed By: Judy Beckman, University of Rhode Island
TITLE: Hong Kong Moves to Stop Leaks of Analysts' Pre-IPO Research
REPORTER: Kate Linebaugh
DATE: Aug 29, 2005
PAGE: C4
LINK:
http://online.wsj.com/article/0,,SB112527709636625205,00.html
TOPICS: Accounting, Financial Analysis, Financial Statement Analysis,
International Accounting, Regulation
SUMMARY: Each of the world's major markets has a different policy
covering dissemination of information based on analyst research done
prior to an initial public offering (IPO). Hong Kong's regulator ,
called the Securities and Futures Commission (SFC) is considering a
policy to ban all such written research or to require steps to make it
equally available to all. The U.S. bans disclosures of this type of
information.
QUESTIONS:
1.) Why must analysts write reports in advance of an initial public
offering of stock (IPO)? How does accumulating this information help to
establish the price for an offering?
2.) What is the problem if an investor relies on information in
analysis prior to an IPO rather than a prospectus. In your answer,
define the term "prospectus.'
3.) What services do accounting firms provide in the process of
preparing a prospectus and undertaking an IPO? How might those services
help to alleviate issues arise from the bias present in analysts reports
that is described in the article?
4.) What regulatory factors do companies consider selecting a market
for an IPO?
5.) What are the benefits of investing internationally? How might
your answer to question #4 raise issues you might consider in
undertaking international investments?
Reviewed By: Judy Beckman, University of Rhode Island
What started as the "largest criminal
tax-fraud case in history" ended this week with a whimper -- one
acquittal and three partial convictions for four defendants in the
long-running KPMG tax-shelter case. The Justice Department had
charged 19 people back in 2005. Two pleaded guilty, while 13 had
their charges dismissed after federal Judge Lewis Kaplan found the
government had violated their Fifth and Sixth Amendment rights by
coercing KPMG into denying them legal assistance, among other
offenses.
The remaining four stood trial this fall.
David Greenberg, who was jailed for five months after the government
argued he was a flight risk if permitted to post bail, was acquitted
on all counts. The other three were convicted on some tax evasion
charges while acquitted on others. No one was convicted on the
original, underlying conspiracy charge.
Justice may consider this as a partial
vindication, and it is certainly a setback for the three defendants
who now face possible jail time on the tax evasion charges. But the
fact that the government could not prove its case for a criminal
conspiracy calls into question the premise of the entire
prosecution. We argued from the beginning that prosecuting tax
advisers for selling tax shelters that had never been found illegal
in a court of law had an Alice-in-Wonderland quality. This
aggressive legal theory produced, in turn, the government misconduct
that ultimately led to the dismissals. Now a jury has found that the
conspiracy alleged by the government never existed.
Without a conspiracy, even the convictions
the government did secure look dubious and could be overturned on
appeal. Whether those convictions stand up or not, there are at
least 14 innocent people whose lives were turned upside down and
careers ruined by overreaching prosecutors. No moral victory can
give back what was taken from them by this regrettable, and abusive,
episode.
Jensen Comment
The criminal case fell apart for complicated reasons, but that did not
exonerate KPMG as a firm nor return its $456 million settlement reached
with the IRS.
After the
2005 $456 million settlement with the U.S. Treasury, the
Chairman and CEO of KPMG, Timothy Flynn, issued
the following Open Letter. Among other things,
KPMG announced it will almost entirely stop
preparing tax returns for "individuals."
August
29, 2005
AN
OPEN LETTER TO KPMG LLP'S CLIENTS
(from Timothy P. Flynn Chairman &
CEO KPMG LLP)
This
is to advise you that KPMG LLP
(U.S.) has reached an agreement with
the U.S. Attorney's Office for the
Southern District of New York,
resolving the investigation by the
Department of Justice into tax
shelters developed and sold by the
firm from 1996 to 2002. This
settlement also resolves the
Internal Revenue Service's
examination of these activities.
As a
result of this settlement, KPMG LLP
(U.S.) continues as a
multidisciplinary firm providing
high quality audit, tax, and
advisory services to large
multinational and middle market
companies, as well as federal, state
and local governments.
The
Public Company Accounting Oversight
Board (PCAOB) has reaffirmed that
the resolution of this matter with
the Department of Justice does not
affect the ability of KPMG to
perform quality audit services.
Additionally, the Department of
Justice states in the agreement that
KPMG is currently a responsible
contractor and expressly concludes
that the suspension or debarment of
KPMG is not warranted. KPMG
currently audits the Department of
Justice financial statements.
Further details on the resolution of
this matter can be found in the
attached Media Statement
that the firm issued today; a Key
Provisions and Terms
document detailing the settlement;
and a Quality & Compliance Measures
document that provides an overview
of the quality initiatives the firm
has undertaken since 2002, including
specific changes to Tax operations.
KPMG
accepts the high level of
responsibility inherent in
performing its role as a steward of
the capital markets. Let me be very
clear: The conduct by former tax
partners detailed in the KPMG
statement of facts attached to the
agreement is inexcusable. I am
embarrassed by the fact that, as a
firm, we did not identify this
behavior from the outset and stop
it. You have my personal assurance
that the actions of the past do not
reflect the KPMG of today.
I am
proud to be Chairman of this
remarkable organization and proud of
the tremendous professionals of
KPMG. We are resolute in our
commitment to maintain the trust of
the public, our clients and our
regulators. You have my promise
that, as our first priority, KPMG
will deliver on our commitment to
the highest levels of
professionalism — integrity,
transparency, and accountability.
We
truly appreciate the strong support
of our clients throughout this
investigation. Your Lead Partner
will be contacting you later to make
sure that you have the information
you need about this matter.
On
behalf of all of our partners and
employees, thank you for your
continued support.
Timothy P. Flynn
Chairman & CEO
KPMG LLP
Attachments following below:
Media Statement
Key Provisions and Terms
Quality & Compliance Measures
News
For Immediate Release
Contact:
George Ledwith KPMG LLP Tel. (201) 505-3543
KPMG LLP STATEMENT REGARDING
SETTLEMENT
IN DEPARTMENT OF JUSTICE
INVESTIGATION
NEW YORK,
Aug 29 — KPMG LLP made the
following statement today in
regard to a resolution
reached by the U.S. firm
with the Department of
Justice in its investigation
into tax shelters developed
and sold from 1996 to 2002
and related conduct:
KPMG has reached an
agreement with the U.S.
Attorney's Office for the
Southern District of New
York and the Internal
Revenue Service, resolving
investigations regarding the
U.S. firm's previous tax
shelter activities.
"KPMG LLP is pleased to have
reached a resolution with
the Department of Justice.
We regret the past tax
practices that were the
subject of the
investigation. KPMG is a
better and stronger firm
today, having learned much
from this experience," said
KPMG LLP Chairman and CEO
Timothy P. Flynn. "The
resolution of this matter
allows KPMG to confidently
face the future as we
provide high quality audit,
tax and advisory services to
our large multinational,
middle market and government
clients."
As part of the agreement,
KPMG has agreed to make
three monetary payments,
over time, totaling $456
million to the U.S.
government. KPMG will also
implement elevated standards
for its tax business.
Under the terms of the
settlement, a deferred
prosecution agreement, the
charges will be dismissed on
December 31, 2006, when the
firm complies with the terms
of the agreement. Richard C.
Breeden has been selected to
independently monitor
compliance with the
agreement for a three-year
period.
All of the individuals
indicted today are no longer
with the firm. KPMG has put
in place a process to ensure
that individuals responsible
for the wrongdoing related
to past tax shelter
activities are separated
from the firm.
"As KPMG's new leaders, Tim
Flynn and I are extremely
proud of the 1,600 partners
and 18,000 employees of
today's KPMG," said John
Veihmeyer, KPMG Deputy
Chairman and COO. "Looking
toward the future, our
people, our clients and the
capital markets can be
confident that KPMG, as its
first priority, will deliver
on our commitment to the
highest levels of
professionalism."
With regard to claims by
individual taxpayers, KPMG
looks forward to resolving
the civil litigation
expeditiously and with full
and fair accountability.
The resolution of the
Department of Justice's
investigation into the U.S.
firm's past tax shelter
activities has no effect on
KPMG International member
firms outside the United
States.
KPMG LLP SETTLEMENT WITH THE U.S.
DEPARTMENT OF JUSTICE
KEY PROVISIONS AND TERMS
SCOPE
OF SETTLEMENT
"Global settlement" that resolves
both the IRS examination and the DOJ
investigation into the U.S. firm's
past tax shelter activities and
related conduct.
STRUCTURE OF AGREEMENT
KPMG "Statement of Facts" accepting
responsibility for unlawful conduct
of certain KPMG tax leaders,
partners and employees relating to
tax shelter activities.
Deferred Prosecution Agreement (DPA)
– Filing of charges, directed to
past tax shelter activities.
– Dismissal of the charges on
December 31, 2006, when KPMG has
complied with the terms of the
agreement.
– The agreement provides various
remedies to the government,
including extension of the term,
should the firm fail to comply with
the agreement.
KPMG currently audits the financial
statements of the Department of
Justice. The Department of Justice
states in the agreement that KPMG is
currently a responsible contractor
and expressly concludes that the
suspension or debarment of KPMG is
not warranted.
KEY
CONDITIONS TO BE MET BY KPMG LLP
Monetary Payments
Fine of $128 million; restitution to
the IRS of $228 million; and IRS
penalty of $100 million.
Total of $456 million to the U.S.
government.
Timing: $256 million by September 1,
2005; $100 million by June 1, 2006;
$100 million by December 21, 2006.
Payments will not be deductible for
tax purposes, nor will they be
covered by insurance.
Tax
Practice Restrictions and Elevated
Standards
Discontinue by February 26, 2006,
the remainder of the private client
tax practice and the compensation
and benefits tax practice (exclusive
of technical expertise maintained
within Washington National Tax).
Continue individual tax planning and
compliance services for (a) owners
or senior executives of privately
held business clients of KPMG; (b)
individuals who are part of the
international executive (expatriate)
service program, which serves
personnel stationed outside of their
home country; and (c) trust tax
return services provided to large
financial institutions. Any tax
planning and compliance services for
individuals that do not meet these
criteria will be discontinued by
February 26, 2006, and no new
engagements for individuals that do
not meet these criteria will be
accepted.
Prohibit pre-packaged tax products,
covered opinions with respect to any
listed transaction, providing tax
services under conditions of
confidentiality, charging fees other
than based solely on hours worked
(with the exception of revenue sales
and use tax audits), relying on
opinions of others unless KPMG
concurs with the conclusions of such
opinion, and defending any "listed
transaction."
Comply with elevated standards
regarding minimum opinion and tax
return position thresholds.
Cooperation and Consistent Standards
Full cooperation with the
government's ongoing larger
investigation into the tax shelter
activities; and toll the statute of
limitations for five years.
All future statements must be
consistent with the information in
the KPMG statement of facts, and any
contradicting statement will be
publicly repudiated.
Compliance and Ethics Program
Maintain a compliance and ethics
program that meets the criteria set
forth in the U.S. Sentencing
Guidelines.
Program to include related training
programs and maintenance of hotline
to contact monitor on an anonymous
basis.
Independent Monitor
Richard Breeden
Term: Three years.
Scope:
– Review and monitor compliance
with the provisions of the
agreement, the compliance and ethics
program, and the restrictions on the
Tax practice as set forth in
Paragraph 6 of the agreement.
– Review and monitor implementation
and execution of personnel decisions
made by KPMG regarding individuals
who engaged in or were responsible
for the illegal conduct described in
the Information.
Internal Revenue Service Closing
Agreement
An IRS closing agreement is part of
the global settlement and DPA, which
provides for enhanced IRS oversight
of KPMG's Tax practice extending two
years following the expiration of
the monitor's term.
Provisions include instituting a
Compliance and Professional
Responsibility Program that is
focused on disclosure requirements
of IRC Section 6111 and
list-maintenance requirements of IRC
Section 6112. (The program is
intended to enhance the
recordkeeping and review processes
that KPMG has in place to comply
with existing disclosure and
list-maintenance requirements.
Some added bad news for KPMG Although the U.S. Justice Department is seeking
a settlement, although harsh, with KPMG, the state of Mississippi is
also likely to file a criminal suit against the embattled accounting
firm. KPMG devised the tax strategy for WorldCom after it reorganized as
MCI. Although the state approved the tax plan and MCI has moved its
corporate headquarters to Virginia, the state maintains that the tax
plan sheltered billions of potential tax dollars in its treatment of
royalties. It has been recommended that Mississippi join about 15 other
states and the District of Columbia in prosecuting this case together
but Mississippi continues on its own. In May of this year, the state
became the first state to resolve back tax claims with the telcom giant
in accepting MCI’s former headquarters building and $100 million in
cash.
"More Good News Than Bad for KPMG," AccountingWeb, August 24,
2005 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=101231
Obviously tax consulting has been a huge problem for KPMG that has
spilled over into the auditing profession in general. You might
read KPMG’ June 2005 guilt admission statement about this at
http://www.us.kpmg.com/news/index.asp?cid=1872
It says KPMG no longer provides the “services in question,” but is
somewhat vague as to what tax advisory services have been eliminated.
Later (in the above Open Letter) it was announced that KPMG will no
longer prepare tax returns for most individuals.
KPMG is not alone in its troubles over sales of illegal tax shelters
and other huge amounts of settlements and pending litigation. All large
accounting firms were selling questionable shelters, although KPMG
admittedly took it to an extreme. See
http://www.trinity.edu/rjensen/fraud001.htm#others
One of the disappointments that I
found in the KPMG 2004 Annual Report (what KPMG called its "Transparency
Report") is virtually no mention of the U.S. Justice Department and IRS
investigations taking place that could have jeopardized the entire
future of KPMG.
All I could find is a vague statement on Page 27 that reads
"Despite significant challenges for our Tax practices during FY04" with
no mention what comprised those "challenges" or that those unspecified
"challenges" threatened the entire existence of the firm and could have
imploded KPMG's audit practice in much the same way as the Andersen
firm's audit practice disappeared from the world.
This transparency report is for a September 2004 fiscal closing
when, in fact, the financial news media commenced reporting these
criminal investigations of KPMG in the spring of 2004. Media
coverage was especially heavy in June of 2004. I would have
expected mention of these well-known investigations in KPMG's subsequent
"2004 Transparency Annual Report." Ironically, mention is made of
the great importance of "Social Responsibility" (Page 3) and "Helping to
Restore the Public Trust in Our Profession" (Page 12) and "Raising Our
Tax Risk Architecture to a Level Consistent with That of Audit (Page
12)."
The CPA profession needs a more credible definition of
"transparency."
It would seem that Art Wyatt was correct when entitled his August
2003 Plenary Speech "Accounting Professionalism
--- They Still Don't Get It" ---
http://aaahq.org/AM2003/WyattSpeech.pdf
From The Wall Street Journal Accounting Weekly Review, June 24,
2005
TITLE: SEC Weighs a 'Big Three' World
REPORTERS: Deborah Solomon and Diya Gullapalli
DATE: Jun 22, 2005
PAGE: C1 LINK:
http://online.wsj.com/article/0,,SB111939468387765810,00.html
TOPICS: Auditing, Auditing Services, Auditor Changes, Auditor
Independence, Personal Taxation, Public Accounting, Regulation,
Sarbanes-Oxley Act, Securities and Exchange Commission, Tax Shelters
SUMMARY: As described in the related article, Justice Department
officials are debating whether to seek an indictment of KPMG from a
criminal case built by Federal prosecutors for the firm's sale of what
the prosecutors consider to be abusive tax shelters. The Justice
Department is concerned about competitiveness of the audit profession if
KPMG collapses as did Arthur Andersen and only three large firms are
left. As described in the main article covered in this review, the SEC
already is considering relaxing some of the auditor independence rules
because of the difficulties in implementing them with only four large
firm auditing most publicly-traded companies.
QUESTIONS:
1.) What auditor independence rules have been implemented as a result of
Sarbanes-Oxley? Hint: to help answer this question, you may refer to the
AICPA's summary of this Act available at
http://www.aicpa.org/info/sarbanes_oxley_summary.htm
2.) What steps has the SEC taken to relax some standards for firms
switching auditors? When did the SEC institute these allowances? What
trade-offs do you think the commissioners considered in making these
allowances to relax the standards?
3.) Why is the SEC again concerned about what actions it may have to
take to allow for firms to switch auditors?
4.) What is the Public Company Accounting Oversight Board? What role
can this entity play in establishing public policy because of the
concerns with the shrinking number of large public accounting firms?
5.) Refer to the related article. For what reason might KPMG LLP be
indicted? Does this potential indictment have anything to do with the
audit services provided by this firm?
6.) How is the potential indictment affecting all aspects of KPMG's
practice regardless of the culpability of the firm's audit partners? How
do you think this potential indictment affects all firm employees'
perception of the need for control procedures over the firms' activities
in all practice areas?
Reviewed By: Judy Beckman, University of Rhode Island
Yet the word now seems to be that the
Justice Department will probably not indict the firm (KPMG).
This is partly because KPMG has belatedly apologized, admitted the
tax shelters were "unlawful," and cut adrift its former rising stars
(and tried to shift the blame for the shelters to them). And it is
working to come up with a deal with prosecutors that, however
painful, will fall short of the death penalty.
But it's also because the government is
afraid of further shrinking the number of major accounting firms.
Remember when people used to say that the major money center banks
were "too big to fail"- meaning that if they ever got in real
trouble the government would have to somehow ensure their survival?
It appears that with only four big accounting firms left, down from
eight 16 years ago, there are now "too few to fail." How pathetic is
that?
. . .
"What infuriates me about the accounting
firms is the enormous power they have," said Howard Shilit,
president of the Center for Financial Research and Analysis. "You
just can't compel them to do things they ought to do. And the fewer
firms there are, the more concentrated their power." To my mind, the
biggest problem is the hardest to change - that accounting firms are
paid by the same managements they are auditing. Nobody really thinks
about changing this practice mainly because it's been that way
forever. But, "it's the elephant in the room," said Alice Schroeder,
a former staff member at the Financial Accounting Standards Board
who later became a Wall Street analyst. In the memorable phrase of
Warren E. Buffett's great friend and the vice chairman of Berkshire
Hathaway, Charles T. Munger - quoting a German proverb: "Whose bread
I eat his song I sing."
KPMG could face criminal charges for obstruction of justice and the
sale of abusive tax shelters. Federal prosecutors have built a criminal case
against KPMG LLP for obstruction of justice and the sale of abusive tax
shelters, igniting a debate among top Justice Department officials over
whether to seek an indictment -- at the risk of killing one of the four
remaining big accounting firms. Federal prosecutors and KPMG's lawyers
are now locked in high-wire negotiations that could decide the fate of
the firm, according to lawyers briefed on the case. Under unwritten
Justice Department policy, companies facing possible criminal charges
often are permitted to plead their case to higher-ups in the department.
These officials are expected to take into account the strength of
evidence in the case -- the culmination of a long-running investigation
-- and any mitigating factors, as well as broader policy issues posed by
the possible loss of the firm. A KPMG lawyer declined to comment. The
chief spokesman for the firm, George Ledwith, said yesterday that "we
have continued to cooperate fully" with investigators. He declined to
discuss any other aspect of the case.
John R. Wilke, "KPMG Faces Indictment Risk On Tax Shelters:
Justice Officials Debate Whether to Pursue Case; Fears of 'Andersen
Scenario'," The Wall Street Journal, June 16, 2005; Page A1
---
http://online.wsj.com/article/0,,SB111888827431261200,00.html?mod=todays_us_page_one
KPMG Addresses Ex-Partners Unlawful Conduct The specter of felled Arthur Andersen LLP
hovers in federal prosecutors' calculations as they negotiate with
another accounting titan, KPMG, over sales of dubious tax shelters. The
Big Four accounting firm acknowledged Thursday that there was unlawful
conduct by some former KPMG partners and said it takes ''full
responsibility'' for the violations as it cooperates with the Justice
Department's investigation. Deals allowing companies to avoid criminal
prosecution are becoming an increasingly attractive alternative for the
Justice Department and a clear option in the KPMG case. Just Wednesday,
the government announced a deal with Bristol-Myers Squibb Co. in which
the drugmaker agreed to pay $300 million to defer prosecution related to
its fraudulent manipulation of sales and income, in exchange for its
cooperation and meeting certain terms. The Justice Department has been
investigating KPMG and some former executives for promoting the tax
shelters from 1996 through 2002 for wealthy individuals. The shelters
allegedly abused the tax laws and yielded big fees for KPMG while
costing the government as much as $1.4 billion in lost revenue, The Wall
Street Journal reported in Thursday's editions.
"KPMG Addresses Ex-Partners Unlawful Conduct," The New York Times,
June 16, 2005 ---
http://www.nytimes.com/aponline/business/AP-KPMG-Investigation.html?
KPMG Apologizes for Tax Shelters Seeking to stave off possible federal criminal
charges that it promoted improper tax shelters and obstructed probes
into them, KPMG LLP acknowledged that former partners had acted
illegally and apologized. "KPMG takes full responsibility for the
unlawful conduct by former KPMG partners during that period, and we
deeply regret that it occurred," the firm said in a statement issued
yesterday. The public contrition has been common with other firms and
companies under legal pressure, but it hasn't been with KPMG. It came
after The Wall Street Journal reported that Justice Department officials
were debating whether to indict the firm, and it marks a reversal. The
firm for years used aggressive litigation tactics that set it apart from
the three other Big Four accounting firms, which moved more quickly to
resolve allegations that they peddled improper tax shelters. KPMG's past
uncompromising stance is at the heart of a possible obstruction charge,
a person familiar with the matter said.
Kara Scannell, "KPMG Apologizes for Tax Shelters," The Wall Street
Journal, June 17, 2005; Page A3 ---
http://online.wsj.com/article/0,,SB111896597467162114,00.html?mod=todays_us_page_one
A federal judge on Wednesday agreed that
former KPMG accounting executive David Greenberg can be freed on $25
million bail in his tax fraud case - but he attacked Greenberg's
character and vowed to ruin his family financially should he decide
to flee.
Greenberg is not expected to meet strict
bail conditions for at least several days in what prosecutors call
the largest criminal tax case in U.S. history, a fraud that helped
rich people evade $2.5 billion in taxes.
Even as he set bail, U.S. District Judge
Lewis A. Kaplan described Greenberg as "an extremely skilled
individual who spent his whole life trying to figure out how to hide
the pea."
He was referring to a version of a
deceitful street game known as three-card monte, in which a pea is
moved among three cups and viewers are asked to guess where the pea
ended up.
The judge said Greenberg's finances were in
such disarray that it was impossible to figure out where his assets
were and how much he was worth.
"I have no idea how much went in, came out
and remains," he said.
The judge warned Greenberg's family members
that if he flees, the court would make sure they "will be
financially ruined and stripped of everything they have."
He added, "If they're willing to take that
risk, I'm willing to take that risk of non-appearance."
He also required Greenberg to live in
Manhattan and submit to electronic monitoring.
The judge said Greenberg spent his
professional career "scheming how to protect other people's assets
from the United States government."
Greenberg is charged in an indictment
accusing 17 former KPMG partners and managers with devising and
marketing fraudulent tax shelters that cost the U.S. Treasury $2.5
billion.
The indictment says the ex-KPMG executives
teamed with a former partner at a prominent law firm and another
defendant to defraud the Internal Revenue Service by filing false
income tax returns and by concealing the tax shelters from the IRS.
The judge said he was particularly
disturbed that Greenberg apparently forged the signatures of his
ex-wife and his father on papers establishing a limited liability
company holding assets worth up to $13 million. He noted that the
government has alleged Greenberg boasted that he could flee with
money he controlled in the names of others.
Greenberg has denied the allegations. His
lawyers declined to comment after Wednesday's hearing.
KPMG is a worldwide network of professional
firms providing audit, tax and advisory services, according to its
Web site. It operates in 144 countries and has more than 6,700
partners.
Just a Typical Day on the Fraud Beat A Houston investment fund, which started as a promising money- maker for a
group of wealthy, well-connected acquaintances, has ended in a Texas district
court with accounting firm KPMG on the hot
seat. http://www.accountingweb.com/item/100455 February
3, 2005
In February 1998, two managers at UBS AG in
London received an anonymous letter warning that the Swiss bank's
derivatives unit was "offering an illegal capital-gains tax evasion
scheme to U.S. taxpayers." The cost to the Internal Revenue Service:
"hundreds of millions of dollars a year," according to the missive.
"I am concerned that once IRS comes to know
about this scheme they will levy huge financial/criminal penalties
on UBS," said the letter, which named three UBS employees the author
believed were involved. "My sole objective is to let you know about
this scheme, so that you can take some concrete steps to minimise
the financial and reputational damage to UBS."
UBS responded by halting all trades related
to two KPMG LLP tax shelters, known as Foreign Leveraged Investment
Program and Offshore Portfolio Investment Strategy, or Flip and Opis.
Several months later, though, the bank "resumed selling the
products, stopping only after KPMG discontinued the sales,"
according to an April report by the U.S. Senate Permanent
Subcommittee on Investigations. Citing UBS documents, the report
said the bank appeared to have reasoned that its participation "did
not signify its endorsement of the transactions and did not
constitute aiding or abetting tax evasion." The identity of the 1998
letter's author, a self-described UBS "insider," hasn't surfaced
publicly. A UBS spokesman declined to comment.
CEO Raines, CFO Howard Feel Push From
Regulators; KPMG Is Out as Auditor
Fannie Mae's CEO, Franklin Raines, and Timothy Howard, the chief financial
officer, stepped down amid growing pressure from regulators over
accounting violations. The mortgage company's board also dismissed
KPMGas outside auditor.
James R. Hagerty, John R. Wilke and Johathan Weil, "At Fannie Mae,
Two Chiefs Leave Under Pressure," The Wall Street Journal,
December 22, 2004, Page A1 --- http://online.wsj.com/article/0,,SB110366339466106334,00.html?mod=home_whats_news_us
Fannie Mae, which has borrowings of more than
$950 billion and is involved in financing more than a quarter of U.S.
residential mortgage debt, described the exit of the 55-year-old Mr.
Raines as a retirement and that of Mr. Howard, 56, as a resignation. But
people familiar with the board's deliberations said directors had
decided that both men had to leave to satisfy the company's regulator,
the Office of Federal Housing Enterprise Oversight, or Ofheo.
KPMG
knew that FAS 91 and FAS 133 were being violated, but KPMG did not insist
on correcting the books. How
much of Fannie’s current trouble can be blamed on KPMG?
Fannie's auditor, KPMG, disagreed with the way the company decided how
much (derivatives instruments debt and earnings fluctuations)
to book in 1998. The matter was recorded as "an audit
difference" -- a disagreement between a company and its auditor that
doesn't require a change in the books.
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up
On Fannie's Pugnacious Chief," The Wall Street Journal,
December 17, 2004 --- http://online.wsj.com/article/0,,SB110323877001802691,00.html?mod=todays_us_page_one
Bob Jensen's Fannie Mae threads are at http://www.trinity.edu/rjensen/caseans/000index.htm Bob Jensen’s threads on KPMG’s troubles are at http://www.trinity.edu/rjensen/fraud001.htm#KPMG
FAS 133 says Fannie can't get hedge accounting for non-homongenious
portfolios. Will the SEC let they (and auditor KPMG) get way with it
anyway? Fannie Mae estimated it will have to post a $9
billion loss if the SEC finds it has been accounting improperly for
derivatives. Ofheo, the mortgage firm's regulator, said Fannie incorrectly
applied accounting rules in a way that let it spread out losses over many
years rather than taking an immediate hit. James R. Hagerty, "Fannie Warns of $9 Billion Loss If
Derivatives Ruling Is Adverse," The Wall Street Journal,
November 16, 2004, Page A3 ---http://online.wsj.com/article/0,,SB110055804528874668,00.html?mod=home_whats_news_us Bob Jensen's threads on the Freddie and Fannie derivatives
scandals are at http://www.trinity.edu/rjensen/caseans/000index.htm
Our review indicates that during the period
under our review, from 2001 to mid-2004, Fannie Mae's accounting practices
did not comply in material respects with the accounting requirements in
Statement Nos. 91 and 133. http://www.sec.gov/news/press/2004-172.htm
When Four Just Isn't Enough!
When audits go bad, the clients just get
traded around. It appears that Deloitte may take the Fannie Mae
audit from KPMG due to SEC pressures. But Deloitte is not facing a
life-threatening lawsuit. The SEC is pressuring TIAA-CREF to drop
E&Y due to violation of auditor independence. The SEC is acting
on bad audits but appears to be limited in how to correct the situation
since there are only four in the Big Four.
The Securities and Exchange
Commission's decision directing Fannie
Mae to restate its earnings is sparking a debate among investors,
proxy advisers and accounting experts about whether the mortgage titan
should dump outside auditor KPMG LLP.
And as demonstrated by the recent
experience of Fannie's government-chartered cousin, Freddie
Mac, once a company gets a fresh set of eyes to pore over its books
and records, there's no telling what other accounting issues may pop up.
A proposal by the Office of
Federal Housing Enterprise Oversight could require Fannie to change its
auditor by Jan. 1, 2006, and rotate its auditor at least every 10 years
after that. The proposal is under review by the White House Office of
Management and Budget.
With both the SEC and Ofheo
agreeing that Fannie violated the accounting rules for derivative
financial instruments, "they should immediately change auditors
given this apparent lack of quality in the audit work," says Mike
Lofing, an analyst in Broomfield, Colo., at Glass Lewis & Co., one
of the nation's most prominent proxy-advisory firms. If Fannie doesn't
replace KPMG, he says, his firm likely would advise its
institutional-investor clients to oppose the ratification of KPMG as
Fannie's auditor at the company's annual meeting next spring.
A Fannie spokeswoman declined to
comment on any possible change in auditors. In a statement, KPMG said:
"We accept the company's decision to follow the direction of the
[SEC's] Office of the Chief Accountant with respect to Fannie Mae's
prior financial statements." A KPMG spokesman declined to respond
to suggestions that Fannie should replace KPMG as its auditor.
To be sure, not all investors
believe an immediate auditor switch is necessary. "I'd like to get
more information about why [the SEC's staff] made their
interpretation" before deciding on whether KPMG should be replaced,
says David Dreman, chairman of investment firm Dreman Value Management
LLC, which held about eight million shares as of Sept. 30.
Still, two years ago, Freddie
Mac's decision to replace the imploding Arthur Andersen LLP with
PricewaterhouseCoopers LLP helped the company turn over a new leaf.
Shortly after the switch, the new auditor found widespread accounting
manipulations, including false asset valuations. After restating
financials and ousting its chief executive officer last year, Freddie's
stock has risen over 20% this year and the firm is gaining market share
from Fannie.
In the same vein, a new auditor
at Fannie might identify potentially bigger issues than the ones
identified by Ofheo and the SEC. Fannie's estimate last month that a
restatement could reduce its past earnings and regulatory capital by $9
billion is based on the assumption that the derivatives and other assets
and liabilities on Fannie's balance sheet already were being valued
appropriately as of Sept. 30. Conceivably, a new auditor might find they
weren't.
"It would be astute for
Fannie to contemplate whether an auditor that was not involved with the
prior circumstance might not bring more credibility to their future
financial statements," adds Tom Linsmeier, an accounting professor
and derivatives specialist at Michigan State University, who testified
last year before Congress on Fannie's accounting practices.
The audit fees that Fannie paid
KPMG in recent years were paltry, raising questions among investors and
analysts about just how much audit work KPMG could have been performing.
Last year Fannie paid KPMG $2.7 million to audit its financial
statements. It paid even less in years before -- just $1.4 million in
2001. By himself, Fannie Mae Chief Financial Officer Tim Howard got $5.4
million in compensation last year, including stock options. By
comparison, Freddie Mac, with roughly $800 billion of assets at Dec. 31,
paid PricewaterhouseCoopers more than $46 million for its 2003 audit.
The Fannie debacle comes at a
critical time for KPMG, which has been in crisis-management mode for the
past few years over a host of audit failures and government
investigations. Among other things, the firm's sales of allegedly
abusive tax shelters remain the focus of a criminal grand-jury
investigation that began about a year ago.
If Fannie wants a new Big Four
auditor, the least likely choice would appear to be Ernst
& Young LLP, which is advising Fannie's audit committee in
responding to the government probes. Conceivably, Fannie could hire
Deloitte & Touche LLP, which has been assisting Ofheo's examination.
As the World Economic Forum got under way in
the Alpine resort of Davos, Switzerland, critics of globalization handed
out "Public Eye Awards" for irresponsible corporate behavior.
"Critics Give 'Public Eye' Awards for Corporate
Irresponsibility," AccountingWeb, February 1, 2005
---
http://www.accountingweb.com/item/100440
As the World Economic Forum got under way in
the Alpine resort of Davos, Switzerland, critics of globalization handed
out “Public Eye Awards” for irresponsible corporate behavior.
According to Agence France-Presse, Nestle, oil giant Shell and Dow
Chemicals, as well as Wal-Mart and KPMG International, were criticized
as being among the worst corporate performers from 20 multinational
nominees that have allegedly failed in their responsibilities regarding
human rights, labor relations, the environment or taxes.
“They are model cases for all the corporate
groups that have excelled in socially and environmentally irresponsible
behavior. They reveal the negative impacts of economic globalization,”
the organizers of the Public Eye on Davos, said in a statement, AFP
reported. The nonprofit groups behind the awards are Berne Declaration
and Pro Natura Friends - Friends of the Earth Switzerland.
Protests coincided with the start of the annual
World Economic Forum, which the Canadian Press termed a “schmooze-fest”
for 2,000 top corporate executives, political leaders and celebrities
from around the world. The theme for this year's forum is “Taking
Responsibility for Tough Choices.”
Nestle won the “most blatant case of
corporate irresponsibility” Public Eye award for its marketing of baby
foods along with a labor conflict in which it allegedly fired all the
staff at a factory in Colombia, replacing every employee with cheaper
labor.
The award for the human rights category went to
Dow Chemicals, which was nominated for its role in the Bhopal chemical
disaster of 1984. About 50 Greenpeace activists lay on the street,
dressed in skeleton suits to bring attention to the 20,000 victims of
the world's worst chemical disaster.
Shell, meanwhile, was awarded the environment
prize for its “numerous oil spills” in the Delta region of Nigeria,
according to Ethical Corporation magazine.
Other award winners include Wal-Mart, which was
chosen for allegedly allowing poor working conditions in its African and
Asian factories, and the professional services firm KPMG for promoting
"agressive tax avoidance."
KPMG, which is based in 148 countries, was
nominated by the Tax Justice Network. A spokesman for the campaign said:
"Many tax practitioners earn huge fee income from developing tax
avoidance strategies and promoting them to corporate clients."
A spokeswoman for KPMG International said that
the allegations were "misleading and inaccurate,” according to
the Guardian of London. She added: "We have not provided the tax
practices at issue for a number of years."
A
series of e-mails dating
from the mid-1990s to 2003
show that even after KPMG
was ordered by the IRS to
stop pushing tax shelters
considered abusive, the firm
continued to promote at
least a dozen new similar
shelters.AccountingWeb,
September2, 2004 --- http://www.accountingweb.com/item/99690
According to the Sydney Morning Herald
(September 20, 2004) the Chief Accountant of the Securities Exchange
Commission, Donald Nicolaisen, has told KPMG's Eugene O'Kelly "in a
letter released on Friday that the fourth-biggest accounting firm was
wrong to say [to its clients] that the SEC "would not challenge"
it for entering into contingency-fee arrangements with audit
clients." More details athttp://accountingeducation.com/news/news5441.html Double Entries, September 23, 2004
The February 19, 2004
Frontline worldwide broadcast is going to greatly sadden the already
sad face of KPMG. As a former KPMG Professor, it also saddens me
that the primary focus of the Frontline broadcast was on the bogus
tax shelters marketed by KPMG over the past few years. All the other
large firms were selling such shelters to some extent, but when their
tactics were exposed the others quickly apologized and promised to abandon
sales of such shelters. KPMG stonewalled and lied to a much greater
extent in part because their illegality went much deeper. The video
can now be viewed online for free from
http://www.pbs.org/wgbh/pages/frontline/shows/tax/view/
We used to sympathize with modern day CPA firms to a certain extent,
and most certainly with Andersen in Houston, by viewing them as victims of
huge and greedy clients like Enron who demanded that their accounting
firms help them in cooking the books and in dreaming up illegal tax
shelters.
What the Frontline and other news accounts now reveal is that the large
CPA firms have not been victims caught in the squeeze. They have
been co-conspirators earning billions in fees in partnerships with some of
the world's largest banks in efforts to defraud the public in stock
dealings and defraud local and state governments of tax revenues.
While the world media focuses on Michael Jackson's sickness, our
supposed watchdogs of fair reporting and fair business dealings have been
robbing us blind.
As professors of accountancy, we must strive in every way to restore
true professionalism, not just the appearance of professionalism, to our
profession. The large have not helped us one in spite of the
contributions that you trickle down to our students and our programs.
They have not helped us one bit because next week we must stand before
our students and perhaps not mention the Frontline broadcast while
hoping that our students were too busy worrying about Michael Jackson's
sex life. Or we must stand in front of our students, put on a
concerned face, and proclaim that every large organization like KPMG has a
few bad apples.
But we are lying to ourselves if we fail to admit to our students that
the top executives in KPMG and the other large CPA firms knew full well
that they were promoting illegal acts while at the same time trying to
sell the public that they are better than any other profession in
protecting the public from financial frauds.
KPMG Ousts Executive, Partners; Steps Tied to
Tax-Shelter Scrutiny Accounting firm KPMG LLP this week fired
a senior executive who had headed its tax-services division as it
promoted tax shelters earlier this decade, another sign of the pressure
KPMG is facing as law-enforcement officials investigate the
now-contentious sales effort. The New York firm also dismissed two
partners who had sat on its 15-member board, the latest personnel change
tied to the tax-shelter scrutiny. A KPMG spokesman says the firm doesn't
discuss personnel matters. Since February 2004, KMPG has been under
criminal investigation by the Justice Department's U.S. attorney's
office in Manhattan for its sale of tax shelters in the 1990s and as
recently as 2002. KPMG's marketing effort was publicized in hearings in
2003 by the Senate Permanent Subcommittee on Investigations, which
concluded in a report that KPMG had been an "active and, at times,
aggressive" promoter of tax shelters to individuals and corporations
that were later determined by the Internal Revenue Service to be
potentially abusive or illegal tax shelters.
Diya Guollapalli, "KPMG Ousts Executive, Partners; Steps Tied to
Tax-Shelter Scrutiny," The Wall Street Journal, April 28, 2005; Page C2
---
http://online.wsj.com/article/0,,SB111465047380019062,00.html?mod=todays_us_money_and_investing
A
series of e-mails dating from the mid-1990s to 2003 show that even after
KPMG was ordered by the IRS to stop pushing tax shelters considered
abusive, the firm continued to promote at least a dozen new similar
shelters.AccountingWeb, September2, 2004 --- http://www.accountingweb.com/item/99690
Bob Jensen's threads on KPMG's scandals are at http://www.trinity.edu/rjensen/fraud.htm#KPMG
"Report Criticizes KPMG, Banks Committee urges expanded probe of
tax-shelter abuses," Elliott Blair Smith, USA Today, February
14, 2005
Senate investigators urged federal regulators
Thursday to expand a probe of abusive tax shelters to the banking and
securities industries after finding that a few accounting and law firms
had shared $275 million in fees from the products' sale to wealthy
investors.
Estimating Treasury losses from the shelters at
more than $85 billion over the last decade, the Senate Permanent
Subcommittee on Investigations said it backs legislation to compel the
IRS to share confidential taxpayer information with other federal
agencies.
Last week, the Bush administration proposed to
increase the IRS's enforcement budget by 8%, equal to more than $400
million. IRS spokesman Terry Lemons credited Senate investigators with
''groundbreaking work.'' He declined to comment on the panel's proposal
to make the IRS share taxpayer returns.
''Any time you talk about information sharing
between the IRS and anybody else, it's going to raise red flags,''
Taxpayer Notes reporter Allen Kenney said.
Senate aides said the egregiousness of the
abuses the panel identified would propel reforms.
Many of the alleged abuses surfaced previously
during the panel's three-year investigation, but the 141-page final
report contains damaging new details.
In particular, investigators criticized the
KPMG audit firm, two law firms and several investment banks, saying they
worked together to promote shelters that featured paper losses and sham
charitable contributions.
Investigators said KPMG made more than $124
million by aggressively marketing the deeply flawed shelters to wealthy
investors while taking ''steps to conceal its tax-shelter activities''
from federal tax authorities.
KPMG allegedly paid the law firm known now as
Sidley Austin Brown & Wood $23 million to provide supportive legal
opinions on more than 600 shelters. It allowed one former Sidley Austin
lawyer, R.J. Ruble, to bill it at the equivalent rate of $9,000 an hour.
In turn, KPMG allegedly referred many of its
shelter clients to another law firm, Sutherland Asbill & Brennan,
for legal defense work while failing to disclose it had paid the law
firm nearly $14 million for unrelated work. Investigators said they
found evidence that Sutherland Asbill shared with KPMG details of
confidential discussions the lawyers had with the IRS.
When shelter clients asked about suing the
auditor, the lawyers declined to help, without stating why,
investigators said. One Sutherland Asbill attorney told his client, ''I
need to duck my head in the sand on these,'' according to his notes,
contained in the report.
KPMG spokesman George Ledwith said the firm
''regrets its participation'' in the now-discredited tax shelters and
cited ''fundamental changes that KPMG vigorously undertook in its tax
practice.'' In January 2004, the firm replaced three top tax executives.
It also dismantled much of its shelter business. It remains subject to a
federal grand jury probe and civil lawsuits.
Sidley Austin officials in New York and
Washington did not return a reporter's phone calls.
Sutherland Asbill managing partner James
Henderson issued a statement that the firm ''respectfully disagrees''
with the panel's conclusions. He said the firm advised clients of the
potential conflict of interest regarding KPMG.
Senate investigators also criticized Deutsche
Bank, HVB Bank, UBS and the former First Union National Bank, now part
of Wachovia Bank, for advancing more than $15 billion in credit to KPMG
tax-shelter clients.
It said Deutsche Bank earned $44 million, First
Union $13 million and HVB $5.45 million for financing shelters the banks
knew posed ''reputational risk.''
Investigators particularly criticized KPMG and
the banks for working together when the firm audited the banks' books.
The report says KPMG knew the relationship ''raised auditor-independence
concerns,'' concluding that the firm was ''auditing its own work.''
KPMG says it "regrets its participation" in four tax shelters
studied by a Senate subcommittee, which on Thursday released new details
about how the accounting firm developed and sold the products being
investigated. http://www.accountingweb.com/item/100520
In a statement Thursday, KPMG said that while
the new report "acknowledges cultural, structural and institutional
changes to KPMG's tax practices" in recent years, KPMG
"nevertheless regrets its participation in them." KPMG
spokesman George Ledwith said “them” referred to the four tax
shelters examined by the subcommittee in late 2003. The Justice
Department and the Internal Revenue Service are investigating KPMG,
which is cooperating.
The new report also said that the $10 billion
Los Angeles Department of Fire and Police Pensions and the $400 million
Austin Fire Fighters Relief and Retirement Fund in Texas participated in
more than half of KPMG's 58 deals for SC2 from 1999 to 2002.
The above paragraphs are quoted from the body of the article.
My summary of the highlights
is as follows:
These illegal acts added an
enormous amount of revenue to KPMG, over $1 billion dollars of fraud.
American investigators have discovered that
KPMG marketed a tax shelter to investors that generated more than $1bn
(£591m) in unlawful benefits in less than a year.
David Harding, Financial Director ---
http://www.financialdirector.co.uk/News/1135558
While KPMG and all the other
large firms were desperately promising the public and the SEC that they
were changing their ethics and professionalism in the wake of the
Andersen melt down and their own publicized scandals, there were signs
that none of the firms, and especially KPMG, just were not getting it.
See former executive partner Art Wyatt's August 3, 2004 speech entitled
"ACCOUNTING PROFESSIONALISM: THEY JUST DON'T GET IT" ---
http://aaahq.org/AM2003/WyattSpeech.pdf
KPMG's illegal acts in
not registering the bogus tax shelters was deliberate with the strategy
that if the firm got caught by the IRS the penalties were only about 10%
of the profits in those shelters such that the illegality was approved
all the way to the top executives of KPMG.
Former Partner's Memo Says Fees Reaped From
Sales of Tax Shelter Far Outweigh Potential Penalties
KPMG LLP in 1998 decided not to register a
new tax-sheltering strategy for wealthy individuals after a tax
partner in a memo determined the potential penalties were vastly lower
than the potential fees.
The shelter, which was designed to minimize
taxes owed on large capital gains such as from the sale of stock or a
business, was widely marketed and has come under the scrutiny of the
Internal Revenue Service. It was during the late 1990s that sales of
tax shelters boomed as large accounting firms like KPMG and other
advisers stepped up their marketing efforts.
Gregg W. Ritchie, then a KPMG
LLP tax partner who now works for a Los Angeles-based investment firm,
presented the cost-benefit analysis about marketing one of the firm's
tax-shelter strategies, dubbed OPIS, in a three-page memorandum to a
senior tax partner at the accounting firm in May 1998. By his
calculations, the firm would reap fees of $360,000 per shelter sold
and potentially pay only penalties of $31,000 if discovered, according
to the internal note.
Mr. Ritchie recommended that
KPMG avoid registering the strategy with the IRS, and avoid potential
scrutiny, even though he assumed the firm would conclude it met the
agency's definition of a tax shelter and therefore should be
registered. The memo, which was reviewed by The Wall Street Journal,
stated that, "The rewards of a successful marketing of the OPIS
product [and the competitive disadvantages which may result from
registration] far exceed the financial exposure to penalties that may
arise."
The directive, addressed to
Jeffrey N. Stein, a former head of tax service and now the firm's
deputy chairman, is becoming a headache itself for KPMG, which
currently is under IRS scrutiny for the sale of OPIS and other
questionable tax strategies. The memo is expected to play a role at a
hearing Tuesday by the Senate's Permanent Subcommittee on
Investigations, which has been reviewing the role of KPMG and other
professionals in the mass marketing of abusive tax shelters. A second
day of hearings, planned for Thursday, will explore the role of
lawyers, bankers and other advisers.
Richard Smith, KPMG's current
head of tax services, said Mr. Ritchie's note "reflects an internal
debate back and forth" about complex issues regarding IRS regulations.
And the firm's ultimate decision not to register the shelter "was made
based on an analysis of the law. It wasn't made on the basis of the
size of the penalties" compared with fees. Mr. Ritchie, who left KPMG
in 1998, declined to comment. Mr. Stein couldn't be reached for
comment Sunday.
KPMG, in a statement Friday,
said it has made "substantial improvements and changes in KPMG's tax
practices, policies and procedures over the past three years to
respond to the evolving nature of both the tax laws and regulations,
and the needs of our clients. The tax strategies that will be
discussed at the subcommittee hearing represent an earlier time at
KPMG and a far different regulatory and marketplace environment. None
of the strategies -- nor anything like these tax strategies -- is
currently being offered by KPMG."
Continued in the article.
KPMG would probably still be
selling the bogus tax shelters if a KPMG whistle blower named Mike
Hamersley had not called attention to the highly secretive bogus tax
shelter sales team at KPMG. His recent and highly damaging
testimony to KPMG is available at
http://finance.senate.gov/hearings/testimony/2003test/102103mhtest.pdf
This is really, really bad for the image of professionalism that KPMG
tries to portray on their happy face side of the firm. KPMG is now
under criminal investigation by the U.S. Department of Justice.
The reason that KPMG and the
other large accounting firms did and can continue to sell illegal tax
shelters at the margin is that they have poured millions into an
expensive lobby team in Washington DC that has been highly successful in
blocking Senator Grassley's proposed legislation that would make all tax
shelters illegal if the sheltering strategy served no economic purpose
other than to cheat on taxes. Your large accounting firms in
conjunction with the world's largest banks continue to block this
legislation. If the accounting firms
wanted to really improve their professionalism image they would announce
that they have shifted their lobbying efforts to supporting Senator
Grassley's proposed cleanup legislation. But to do so would put
these firms at odds with their largest clients who are the primary
benefactors of abusive tax shelters.
The co-conspirators in these
tax frauds along with the Big Four CPA firms are the large banks.
The Frontline program focused in particular on Wachovia, a KPMG
client.
ISLANDIA, N.Y., Jan. 13, 2004 (The Charlotte
Observer, N.C.) — When Walter Brashier's family was selling some
commercial property it owned in 1998, his First Union Corp. financial
planner gave him what turned out to be costly advice.
Brashier was told he could make big profits and
reduce his tax bill by investing his proceeds in a "capital gains
investment strategy" offered by accounting firm KPMG LLP, according to a
lawsuit filed in May 2003.
But more than five years later, the big returns
haven't materialized. Instead, he has been audited by the Internal
Revenue Service and expects to pay more than $10 million in back taxes
plus possible penalties and interest, according to court records.
Brashier, who lives in Greenville County, S.C.,
is among a number of wealthy individuals who used the tax strategy and
have since filed lawsuits against KPMG, one of accounting's Big Four,
and Charlotte-based Wachovia, which merged with First Union in 2001.
According to a recent congressional
investigation, accounting firms, banks and other advisers have made a
lucrative industry of marketing "potentially abusive and illegal tax
shelters."
Some of the shelters "improperly deny the U.S.
Treasury of billions of dollars in tax revenues," according to the
129-page report, issued in late November by the minority staff of the
Senate Permanent Subcommittee on Investigations.
To combat the problem, the IRS has launched a
crackdown. Last month, the agency proposed new guidelines for tax
advisers. Sen. Carl Levin of Michigan, ranking Democrat on the
investigations subcommittee, plans to introduce legislation that would
give the IRS more resources and impose stricter penalties for promoting
tax shelters.
For KPMG, Wachovia and other firms, the issue
has led to lawsuits and regulatory scrutiny.
The issue is unfolding at a time when banks and
other financial-services firms are vying for more business from wealthy
individuals. According to court documents, Brashier paid $100,000 to
First Union for its investment advice.
In an e-mailed statement, a KPMG spokesman said
the tax strategies probed by the subcommittee "represent an earlier time
at KPMG and a far different regulatory and marketplace environment." The
company no longer sells such products, he said.
"We have adopted clear, new guiding principles
for our tax practice," he said. "It is no longer enough that tax
strategies comply with the law or are technically correct; they must in
no way risk the reputation of the firm or our clients."
Wachovia spokeswoman Christy Phillips said
civil claims against First Union are without merit.
"First Union did not develop, market or
implement any tax strategies for clients," Phillips said. "As part of a
service to our clients, from time to time, we would introduce our
clients to outside entities that provided tax strategy services. The
client established separate contractual relationships with the tax
strategy providers."
Court documents and the congressional report,
however, depict the banks and other firms as drawing clients into
dubious tax schemes in return for rich fees. Brashier, who is suing
along with a dozen of his children and grandchildren, paid more than
$4.4 million in fees, according to his lawsuit.
James Gilreath, an attorney who represents
Brashier and seven other plaintiffs in the Carolinas, said the tax
strategies were sold to his clients as legitimate investments with
favorable tax consequences.
To be sure, taxpayers have long sought
loopholes to pay less tax.
But in its investigation, the Senate
subcommittee found that today's tax shelter industry is increasingly
driven by firms aggressively developing and marketing "generic" shelters
-- products designed to be sold en masse, irrespective of an
individual's needs.
The subcommittee defines improper tax shelters
as complex transactions used to incur large tax benefits not intended by
Congress. Often the goal is to produce losses on paper that can reduce a
taxpayer's bill.
From October 2001 to August 2003, IRS officials
linked 131,000 taxpayers to abusive schemes, and they estimated several
hundred thousand more were likely engaged in them, according to a recent
study by the General Accounting Office, Congress' investigative arm.
Tax shelter use ballooned in the late 1990s as
the stock market boomed and investors reaped larger capital gains, said
Douglas Shackelford, accounting professor at the UNC's Kenan-Flagler
Business School. But since the market has slowed, he said, their use has
declined. "What you're seeing now is the IRS and the government catching
up with what was going on," he said.
In its inquiry, the subcommittee focused on
four "tax products" KPMG sold to 350 individuals from 1997 to 2001,
raking in revenues of more than $124 million, according to the report.
In the Carolinas, the firm sold tax products to
at least 19 wealthy individuals, according to lawsuits. The most
prominent was late NASCAR driver Dale Earnhardt, according to lawsuits.
Steve Crisp, a spokesman for Earnhardt's former company, Dale Earnhardt
Inc., declined to comment.
To help find clients and implement the complex
transactions, KPMG enlisted bankers, lawyers and investment companies.
First Union initially referred clients to KPMG for the sale of a tax
product called FLIP, or Foreign Leveraged Investment Program. It later
began its own efforts to sell FLIP, the report states.
First Union's fees for promoting improper tax
shelters may have been as much as $10 million, according to Brashier's
complaint. Although a sizable sum, it's small compared with Wachovia's
overall profits -- $1.1 billion in the third quarter of 2003.
Brashier's complaint reads like many of the
lawsuits filed against KPMG, Wachovia and other parties. Described in
court documents as a successful investor inexperienced in tax matters,
he was about to generate profits from the sale of some family-owned
warehouses -- and in turn incur a capital gains tax.
His First Union planner . . .
initially introduced him to Ralph Lovejoy of QA Investments LLC, an
investment firm that would be involved in the transaction. Lovejoy
required Brashier to sign a confidentiality agreement and then explained
the strategy to him, according to Brashier's suit.
Later, Brashier met William "Sandy" Spitz of
KPMG, who was to handle most of the details implementing the strategy,
according to the suit. Spitz, who now works for Wachovia, told Brashier
the investment strategy was not a tax shelter and complied with IRS
regulations, according to the suit. Brashier also was given a legal
opinion from a San Francisco law firm explaining the strategy.
Brashier declined to comment for this article.
Lovejoy and Spitz, both of the Charlotte area,
are defendants in Brashier's suit. Lovejoy declined to comment, and
Spitz did not return calls. XXXXX, who is not named in Brashier's suit
and no longer works at Wachovia, also did not return a call.
A spokesperson for QA Investments, part of
Seattle-based Quellos Group, said the legal claims against the firm were
without merit.
"QA's role was solely to execute the investment
aspect of KPMG's strategy," the spokesperson said.
Other First Union clients describe similar
meetings. In January 2000, Chuck D'Amico, a Charlotte businessman who
was planning to sell a family chemical company, met with Spitz and First
Union employees in a conference room in what is now Two Wachovia Center
in uptown.
Spitz told D'Amico he could avoid paying
capital gains taxes through a "foolproof" IRS loophole, according to
deposition testimony by D'Amico in his suit against First Union. In
return, KPMG would get 5 percent of the gross proceeds from the sale of
his business, according to D'Amico's deposition testimony. First Union's
fee wasn't detailed.
After a second meeting, D'Amico declined to
invest in the tax strategy because he felt it was "speculative and
unethical," according to the deposition. "I'm glad I didn't do it,"
D'Amico told The Observer.
Brashier decided against using FLIP but chose a
similar tax product offered through KPMG called Offshore Portfolio
Investment Strategy, or OPIS. Along with two friends and other family
members, he formed a limited liability corporation called Poinsettia,
which would be a vehicle for his investment.
The object of OPIS was to generate paper losses
to reduce taxes, according to the Senate subcommittee. The shelter
required the purchaser to create a shell corporation and then enter into
a series of complex financial transactions.
According to Brashier's lawsuit, the
transactions involved the purchase of Union Bank of Switzerland stock
and "put" and "call" options to buy UBS stock through limited
partnerships, including one in the Cayman Islands.
It was difficult, if not impossible, to make a
profit through the transactions, according to the lawsuit.
Through the tax strategy, Brashier suffered a
net loss of about $540,000, according to the suit. But these complicated
transactions "generated purported short-term capital losses of more than
$60 million, supposedly usable to offset gains he made from the sale of
his family real estate," the suit states.
Although KPMG and First Union did not express
concerns to clients, they privately had doubts about the tax strategies,
according to the Senate subcommittee report. In a 1999 First Union memo
cited by the report, officials note that Spitz of KPMG wanted the sale
of the shelters to be discreet.
"Clearly, First Union was well-aware that it
was handling products intended to help clients reduce or eliminate their
taxes and was worried about its own high profile from being associated
with tax strategies like FLIP," the report states.
In August 2001, nearly three years after
Brashier signed up for the program, the IRS issued a notice labeling
FLIP and OPIS as abusive tax shelters and began auditing taxpayers who
used them. That sparked more regulatory probes, lawsuits and national
media attention.
In July 2002, the Department of Justice sued
KPMG on behalf of the IRS to obtain information about tax shelters the
firm allegedly had promoted. Last month, the department, in court
documents, accused KPMG of withholding documents in a "concerted pattern
of obstruction and noncompliance."
Meanwhile, the Securities and Exchange
Commission is examining whether First Union's referral arrangement with
KPMG compromised the accounting firm's role as the bank's auditor. SEC
rules say auditor independence is damaged when an auditor has a "direct
or material indirect business relationship" with an audit client,
according to the Senate report.
Wachovia has said it is cooperating with the
investigation, and KPMG remains the company's auditor. KPMG confirmed to
Wachovia that it was "independent" from Wachovia under all applicable
accounting and SEC regulations, the company said in a securities filing.
In a statement, KPMG said it believes it
complied with all independence regulations. It also said the firm's
policy is not to pay referral fees or engage in joint marketing
activities with its audit clients. The SEC declined to comment.
Even if the relationship did not affect KPMG's
independence, the SEC might be worried about the appearance of
impropriety, especially at a time when corporate governance is in the
regulatory spotlight, said Kevin Raedy, associate director of Kenan-Flagler's
accounting master's program.
"The bottom line is one of the things the SEC
is concerned about is confidence in public markets," he said.
Meanwhile, new lawsuits are being filed. Last
month, at least two were filed in Wake County, including one by Peter
Loftin, founder and former CEO of telecommunications company BTI, who
had made $30 million from the sale of a BTI subsidiary. His suit, which
was refiled after a court dismissed an earlier complaint, names KPMG,
Wachovia and other parties as defendants.
Gilreath, Brashier's lawyer, said he may have
the most cases involving KPMG tax strategies of any attorney in the
nation. He filed his first suit in late 2002 and his latest last month.
Some name Wachovia among the defendants; others don't.
The litigation could take a year or two to play
out, said Gilreath, who is being assisted by English McCutchen and John
Freeman. Later this month, hearings are slated on motions related to
some of the cases, including Brashier's.
Some of his clients already have reached
settlements with the IRS, but he would not provide details. Under an IRS
notice, taxpayers who used the shelters can keep 20 percent of their
claimed capital losses.
In more than 35 years in working complex tax
cases, Gilreath said those involving FLIP and OPIS are the most
egregious he has seen: "It's about nothing but greed."
-- Rick Rothacker, Researcher Sara Klemmer
contributed.
In
a case of aiding and abetting a corporate fraud, former KPMG consultant Larry
Alan Rodda pleaded guilty to federal fraud charges Tuesday, admitting he signed
phony contracts with Peregrine Systems intended to boost Peregrine's earnings,
the San Diego Union-Tribute reported.
Richard Rosenthal, KPMG LLP's chief
financial officer since 2002 and the head of the firm's tax operations for two
years before that, has resigned his position, the latest in a series of
departures this year by top executives at the Big Four accounting firm.
KPMG Chairman Gene O'Kelly announced
Mr. Rosenthal's resignation in an e-mail Monday night to the firm's partners.
In the e-mail, a copy of which was reviewed by The Wall Street Journal, Mr.
O'Kelly wrote that Mr. Rosenthal "has informed me of his intent to retire
from the firm. After a 25-year career with the partnership, Rick has decided
to seek an opportunity in the corporate community."
The e-mail didn't specify Mr.
Rosenthal's reason for leaving or whether the 48-year-old had secured a job
outside the firm. Mr. O'Kelly wrote that Mr. Rosenthal is expected to stay at
the firm through the end of the year.
Mr. Rosenthal's resignation comes amid
continuing investigations by the Internal Revenue Service and the Justice
Department into KPMG's tax-shelter operations. As previously reported, a
federal grand jury in Manhattan is conducting a criminal investigation into
KPMG's past activities as a promoter of allegedly abusive tax shelters.
Mr. Rosenthal, who works in KPMG's
Montvale, N.J., office, didn't return phone calls seeking comment. KPMG
spokesman George Ledwith declined to comment and said the firm wouldn't answer
questions about the reasons for Mr. Rosenthal's resignation.
Prior to becoming KPMG's finance chief,
Mr. Rosenthal was KPMG's vice chairman for tax operations from 2000 through
2002, a position in which he was responsible for overseeing the marketing and
development of some of KPMG's most aggressive tax shelters. He first joined
the firm in 1978 after graduating from Arizona State University, starting out
in the firm's Chicago office.
Mr. Rosenthal's name was mentioned
several times in a November 2003 report on KPMG's tax-shelter operations
written by Democratic staff members of the U.S. Senate Permanent Subcommittee
on Investigations. Among other things, the report mentioned Mr. Rosenthal's
participation in overseeing a KPMG tax strategy known as "SC2,"
which the IRS in April declared to be an abusive tax shelter.
Mr. Rosenthal's resignation comes six
months after KPMG announced a shake-up of the firm's upper management,
including the retirement of the firm's No. 2 executive, former Deputy Chairman
Jeffrey Stein. KPMG has made clear that the January shake-up came in response
to IRS and congressional scrutiny of the firm's earlier tax-shelter practices.
The Senate subcommittee's November report had included several references to
e-mail messages tying Mr. Stein to the promotion of controversial shelters. In
addition to replacing Mr. Stein, KPMG in January also replaced its top two tax
executives.
In addition to ceding his post as chief
financial officer, Mr. Rosenthal also stepped down as the firm's chief
administrative officer and relinquished his seat on the firm's management
committee.
Mr. O'Kelly wrote that the firm expects
to announce a new finance chief by Sept. 1. In the interim, Deputy Chairman
Joseph Mauriello, 59, will fill the posts of chief financial officer and chief
administrative officer. Mr. O'Kelly added that Mr. Rosenthal would assist Mr.
Mauriello "until a successor is appointed, and then assist the new
CFO" to ensure an orderly transition.
THE KPMG TAX SHELTER that the IRS last year declared abusive was used
by 29 companies to generate at least $1.7 billion in tax savings,
according to the companies and internal KPMG documents.
The IRS has said the shelter
generated at least $1.7 billion in tax savings for more than two dozen
companies. Previously undisclosed internal documents from KPMG, which
marketed the shelter, list a host of brand-name companies that agreed to
buy it.
The internal KPMG records,
covering the years 1999 through 2001, offer a rare look at the inner
workings of a highly aggressive shelter that KPMG sold under the name
"contested liability acceleration strategy," or CLAS. The
records also provide a look at what nearly all the past year's
government investigations into KPMG and other tax-shelter promoters have
kept a well-guarded secret: the identities of companies that bought
so-called abusive tax shelters.
According to a July 2002 sworn
statement filed by an IRS agent with a federal district court in
Washington, 29 corporations bought CLAS from KPMG, realizing at least
$1.7 billion in tax savings. The statement, based on information KPMG
provided in response to an IRS summons, didn't name the companies.
By that measure, CLAS was more
costly to the federal Treasury than any of the four KPMG tax shelters
that were the subject of hearings held last November by the Senate's
Permanent Subcommittee on Investigations, which focused mainly on
shelters sold to wealthy individuals. As previously reported, a federal
grand jury in Manhattan is investigating KPMG's past tax-shelter
activities. It's not clear what penalties, if any, the IRS may seek from
KPMG in connection with CLAS or other past shelter sales.
The IRS declared the tax shelter
to be abusive in November 2003, after the 29 companies had bought it
from KPMG. Still, "no one purchases a shelter like this without
knowing they're taking significant risks," said Joseph Bankman, a
tax-law professor at Stanford University. "It's a classic case of
getting something for nothing."
By declaring the shelter abusive,
the IRS served notice that companies using CLAS face heightened
disclosure requirements and potential penalties. In some instances,
companies that used the shelter already have resolved IRS tax inquiries
by abandoning the strategy. Others say their discussions with the IRS
are continuing. There is no indication of any criminal investigation
into the corporate users of CLAS.
Some former KPMG tax partners
familiar with CLAS estimate that it generated $20 million in fees for
the firm. Officials at KPMG, the smallest of the Big Four accounting
firms, declined to discuss CLAS for this article.
KPMG created CLAS to help
companies accelerate the timing of tax deductions for settlements of
lawsuits or other claims. Deductions usually aren't allowed until
claimants are paid. One exception under the federal tax code involves
transferring money or other property, under certain limited conditions,
to a "contested liability trust" before the claims are
resolved.
Under the CLAS strategy, a KPMG
client would establish a trust with itself as the beneficiary. It then
transferred noncash assets -- sometimes company stock but usually a kind
of IOU called an intercompany note -- to the trust. The items
represented amounts the client supposedly expected to pay to resolve
claims it was still contesting. The client took corresponding
deductions, reducing taxable income.
In a March 2004 e-mail, a KPMG
attorney told partners and managers that CLAS had been added to the
IRS's list of abusive transactions.Under the IRS's November 2003 notice,
the KPMG shelter had several flaws. For instance, the client continued
to control the trust's assets. To qualify for a deduction, a taxpayer
must relinquish control over the trust's property, the IRS said.
A 1999 internal KPMG synopsis
said the firm charged a fixed fee that approximated 0.4% of the
accelerated deduction, with a minimum fee of $500,000. It said the
optimal CLAS client had at least $150 million of pending claims for
things like shareholder lawsuits, personal-injury claims or
environmental actions. KPMG later relaxed those minimum requirements.
Typically, KPMG salespeople
pitched the shelter to a company's chief financial officer or vice
president for tax. A January 2000 KPMG slide presentation called CLAS
"an aggressive strategy" and told tax partners and managers to
target companies that had "implemented risky strategies in the
past."
The firm's marketing materials
included talking points for salespeople. One slide in the 2000
presentation said: "The true beauty is what is not required --
cash!" The talking points also suggested responses to typical
objections from target companies.
If a prospective client objected
on the grounds that "it's too good to be true," salespeople
were advised to respond: "Three elements are involved in any tax
strategy: Legislation, regulation and court interpretation. Looking at
the legislation alone it is to [sic] good to be true. However,
legislation, regulation and court interpretation combined allow the
strategy to work. KPMG's advantage: We were involved in drafting the
regulations and are acutely aware of the opportunity."
The KPMG partner in charge of
developing and marketing CLAS was Carol Conjura, a former IRS official
based in Washington, according to people who worked with her. Through a
KPMG spokesman, Ms. Conjura declined to comment.
Critics for years have complained
that accounting firms compromise their objectivity when they sell
aggressive tax strategies to audit clients, because they may end up
auditing their own work. KPMG spokesman Thomas Fitzgerald said the firm
"provides tax services to audit clients as permitted by the SEC's
auditor-independence rules and consistent with all applicable
professional and regulatory rules as well as the client's own
policies." He declined to comment further.
Tenet, the nation's
second-largest hospital operator, used the CLAS strategy to accelerate
its deductions for medical-malpractice claims. A Tenet spokesman said
the company, which is also an audit client of KPMG, has "complied
with all the related disclosure obligations required by the IRS"
and has "discontinued utilizing this strategy on a prospective
basis." He said, "It is premature and speculative to determine
if the IRS will deny the tax deductions claimed by Tenet." He
declined to discuss the shelter's effect on KPMG's independence.
At Clear Channel, the nation's
largest radio-station operator, a spokeswoman said, "Had we known
it was going to be classified as a shelter, we wouldn't have bought
it." A Whirlpool spokesman said the appliance maker contacted the
IRS after its November notice and reached a resolution a couple of
months ago; he declined to discuss specifics.
MCI Inc., the telecommunications
concern formerly known as WorldCom, confirmed buying the shelter. A
person familiar with the transaction said WorldCom bought it in 1999 and
used it to accelerate several hundred million dollars in deductions over
a three-year period. This person said the company unwound the shelter
and reversed the deductions in 2002, a year when its losses related to
accounting fraud were so huge that they wiped out the deduction
reversals. The company replaced Arthur Andersen LLP as its outsider
auditor with KPMG in 2002. MCI and KPMG have come under criticism this
year over revelations about an aggressive state-tax shelter that KPMG
sold the company during the late 1990s.
The internal KPMG records
reviewed by the Journal show that Wells
Fargo & Co., a financial-services company audited by KPMG,
signed an agreement to buy CLAS and completed the engagement in 2000. A
Wells Fargo spokeswoman confirmed that "KPMG provided contested
liability-tax services to Wells Fargo in 2000." However, she said,
"Wells Fargo did not implement any strategy that was
disallowed" by the IRS's November notice, adding that "Wells
Fargo was not affected by this notice." She declined to explain
further.
An AstraZeneca spokeswoman said
the drug maker "made the appropriate disclosures in accordance with
the IRS guidance" and resolved the matter with the IRS without
penalty. A Fresenius executive said the health-care company "is in
active discussions with the IRS." AstraZeneca and Fresenius, which
are both KPMG audit clients, said their audit committees had reviewed
the matter.
A Delta spokeswoman said the
company "can't comment on tax periods still under audit." A
person familiar with Delta's transaction said the airline unwound CLAS
shortly after implementing it in 2000. Siemens, Cemex and Qwest, also
KPMG audit clients, declined to comment, as did Washington Mutual,
Lennar and Global Crossing.
We used to sympathize with modern day CPA firms to a certain extent,
and most certainly with Andersen in Houston, by viewing them as victims of
huge and greedy clients like Enron who demanded that their accounting
firms help them in cooking the books and in dreaming up illegal tax
shelters.
What the Frontline and other news accounts now reveal is that the large
CPA firms have not been victims caught in the squeeze. They have
been co-conspirators earning billions in fees in partnerships with some of
the world's largest banks in efforts to defraud the public in stock
dealings and defraud local and state governments of tax revenues.
While the world media focuses on Michael Jackson's sickness, our
supposed watchdogs of fair reporting and fair business dealings have been
robbing us blind.
As professors of accountancy, we must strive in every way to restore
true professionalism, not just the appearance of professionalism, to our
profession. The large have not helped us one in spite of the
contributions that you trickle down to our students and our programs.
They have not helped us one bit because next week we must stand before
our students and perhaps not mention the Frontline broadcast while
hoping that our students were too busy worrying about Michael Jackson's
sex life. Or we must stand in front of our students, put on a
concerned face, and proclaim that every large organization like KPMG has a
few bad apples.
But we are lying to ourselves if we fail to admit to our students that
the top executives in KPMG and the other large CPA firms knew full well
that they were promoting illegal acts while at the same time trying to
sell the public that they are better than any other profession in
protecting the public from financial frauds.
A federal judge ordered KPMG LLP
to turn over documents related to its sales of several tax shelters now
under investigation by the Internal Revenue Service, rejecting the
accounting firm's arguments that producing the records would violate
client-confidentiality obligations.
A KPMG spokesman said the firm
was reviewing the judge's opinion and order and had no comment. The IRS
released a one-sentence statement from Commissioner Mark V. Everson, who
said, "Slowly but surely, we are unmasking the false claim of
privilege made by those who are merely promoting generic abusive tax
products."
The ruling by U.S. District Judge
Thomas F. Hogan of Washington marks the latest twist in the IRS's
two-year civil investigation into KPMG's promotions of various tax
shelters in recent years, some of which the IRS has designated as
abusive transactions. In a December court filing on behalf of the IRS,
the Justice Department accused KPMG of improperly withholding
shelter-related documents from the agency and engaging in improper
delaying tactics. Separately, a federal grand jury is conducting a
criminal investigation into KPMG's former tax-shelter activities.
In a sometimes harshly worded
24-page opinion, Judge Hogan wrote that KPMG had undercut its
client-confidentiality claims by making misleading statements about the
content of many of the documents at issue, citing a report by a
court-appointed magistrate who reviewed the documents. "After
carefully reviewing the entire record of this case, the court comes to
the inescapable conclusion that KPMG has taken steps since the IRS
investigation began that have been designed to hide its tax shelter
activities," Judge Hogan wrote.
Among other findings, the judge
wrote that KPMG had told an IRS investigator that its involvement in one
shelter, called Short Option Strategy, was limited to preparing and
giving advice about tax returns, when in fact KPMG was involved in
developing and marketing the shelter. Other times, the judge wrote,
"KPMG appears to have withheld documents summoned by the IRS by
incorrectly describing the documents to support dubious claims of
privilege."
The documents sought by the IRS
include e-mails from KPMG officials concerning the accounting firm's
dealings with the law firm Brown & Wood, which issued opinion
letters to many KPMG tax-shelter clients; Brown & Wood, of New York,
in 2001 merged with the Chicago law firm Sidley & Austin. Rather
than dealing with privileged client matters, the judge wrote, the
documents instead represented "further evidence suggesting that
Brown & Wood was not engaged in rendering true legal advice, but was
rather a partner with KPMG in its tax shelter marketing strategy."
As part of his ruling, Judge
Hogan postponed deciding whether KPMG must produce copies of the opinion
letters issued by Brown & Wood and its successor firm, Sidley Austin
Brown & Wood LLP. He ordered KPMG to either produce the opinion
letters voluntarily or submit a more detailed log of the documents that
states why each opinion letter shouldn't be produced to the IRS. Sidley
Austin officials couldn't be reached for comment.
The judge also gave KPMG 10 days
to produce the other documents at issue and to identify to the IRS any
participants in tax shelters that it previously had withheld.
U.S. Bankruptcy Judge Arthur
Gonzalez has ordered WorldCom to stop paying its external auditor KMPG
after 14 states announced last week that the Big Four firm gave the
company advice designed to avoid some state taxes ---
http://www.accountingweb.com/item/98927
AccountingWEB.com - Mar-24-2004 - U.S. Bankruptcy Judge Arthur
Gonzalez has ordered WorldCom to stop paying its external auditor KMPG
after 14 states announced
last
week that the Big Four firm gave the company advice designed to
avoid some state taxes.
WorldCom called
the judge’s move a "standard procedural step," which occurs
anytime a party in a bankruptcy proceeding has objections to fees paid
to advisors. A hearing is set for April 13 to discuss the matter, the
Wall Street Journal reported.
Both KPMG and
MCI, which is the name WorldCom is now using, say the states claims are
without merit and expect the telecommunications giant to emerge from
bankruptcy on schedule next month.
"We're very
confident that we'll win on the merits of the motion," MCI said.
Last week, the
Commonwealth of Massachusetts claimed it was denied $89.9 million in tax
revenue because of an aggressive KPMG-promoted tax strategy that helped
WorldCom cut its state tax obligations by hundreds of millions of
dollars in the years before its 2002 bankruptcy filing, the Wall Street
Journal reported.
Thirteen other
states joined the action led by Massachusetts Commissioner of Revenue
Alan LeBovidge, who filed documents last week with the U.S. Bankruptcy
Court for the Southern District of New York. The states call KPMG’s
tax shelter a "sham" and question the accounting firm’s
independence in acting as WorldCom’s external auditor or tax advisor,
the Journal reported.
KPMG disputes
the states’ claims. George Ledwith, KPMG spokesman, told the Journal,
"Our corporate-tax work for WorldCom was performed appropriately,
in accordance with professional standards and all rules and regulations,
and we firmly stand behind it. We are confident that KPMG remains
disinterested as required for all of the company's professional advisers
in its role as WorldCom's external auditor. Any allegation to the
contrary is groundless."
After calling a motion presented by 14 state taxing
authorities a "litigation tactic," a New York judge Wednesday,
June 30, denied the states' request to disqualify KPMG LLP as the
accountant, auditor and tax accountant of MCI Inc.
The states, led by Massachusetts, tried to oust
KPMG in April as MCI was preparing to exit bankruptcy protection. The
states cited a controversial tax plan that the accounting firm designed
for MCI, then known as WorldCom Inc., and said KPMG could not audit its
own tax work.
"Any argument by the states that they have
pursued the disqualification of KPMG to protect the public interest 'rings
hollow' in light of the fact that the very conflict they allege warrants
disqualification was known to them for no less than 10 months before they
decided to file [the motion]," wrote Judge Arthur Gonzalez of the
U.S. Bankruptcy Court for the Southern District of New York.
Throughout the dispute, KPMG and MCI maintained
that the tax plan is legitimate. And even though the company exited
Chapter 11 protection in April, the disqualification motion still carried
serious consequences for the Ashburn, Va.-based telecom.
States have submitted about $2.75 billion in tax
claims against MCI's bankruptcy estate, and disqualification of the
company's adviser and auditor would have strengthened their hand in
negotiations.
A ruling in favor of the states' position also
could have put MCI in the tenuous position of having to find a new auditor
in a post-Sarbanes-Oxley world in which Chinese walls are now supposed to
exist regarding what services such firms can and can't provide.
"There are nonaudit services that auditors
were providing that they cannot provide today," said one attorney not
involved in the case, Morton Pierce of Dewey Ballantine LLP. "Many
companies have adopted a policy that they will not use their auditor for
any non-audit services.
"Given how few major firms are left, any
given company probably has some nonaudit relationships with one or more of
the other firms," Pierce added. "It can be a large
problem."
Gonzalez's ruling helps KPMG immediately. The
states had argued that KPMG should have to sacrifice all its fees during
the bankruptcy case, which totaled well more than $140 million.
Even though the disqualification motion was
denied, the dispute over the tax plan still simmers.
In the 37-page memorandum that accompanied his
ruling, Gonzalez noted that the tax issue could figure in litigation over
claims that the states have against MCI that still need to be resolved.
The Securities and Exchange Commission has
requested documents related to the tax work, though the agency hasn't
indicated that it will take any action. SEC lawyers could not be reached
Wednesday for comment.
Charles Mulford, a professor of accounting at
Georgia Institute of Technology, said the tax plan raises complex issues.
"Where I question any kind of shelter,
whether it's state or federal, is when it is created simply for tax
avoidance and it has no real economic basis," he said. "That's
when questions should be raised."
The tax plan has been a lightning-rod issue in
the MCI case for more than a year. Creditors who were dissatisfied with
their recoveries under MCI's reorganization plan attacked the system in
April 2003. In various motions, the dissenting creditors labeled the
scheme a sham, arguing that it did nothing more than shift MCI's income
from states with high taxes to those with more favorable policies.
To resolve the dispute, MCI increased recoveries
to the dissenting creditors, who in return dropped their objections to the
company's reorganization.
The tax minimization plan surfaced again in
January, however, when Richard Thornburgh, the former U.S. attorney
general who served as MCI's bankruptcy examiner, criticized KPMG at length
in his final report.
"WorldCom likely avoided paying hundreds of
millions of dollars in state taxes in 1998-2001," Thornburgh wrote.
"The cornerstone of this program, which was designed by KPMG Peat
Marwick LLP, was the classification of the 'foresight of top management'
as an intangible asset, which the parent company could license to the
subsidiaries in return for massive royalty charges."
In his order on Wednesday, Gonzalez called the
states "dilatory" for waiting until the eve of MCI's exit from
bankruptcy to protest.
Reports coming out of the US tell us that
Ernst & Young has been selling wealthy US citizens four legal techniques
for reducing their income tax bill, one of which experts claim could be
illegal.
Accountancy Age ---
http://www.financialdirector.co.uk/News/1129611
There is a "moral high ground" when all the largest accounting firms
sold illegal tax shelters to banks like Wachovia and other audit clients
like Worldcom. At least they preyed on tax cheats like big corporations or
wealthy individuals rather than widows and orphans. The same moral
high ground was claimed at Morgan Stanley when it sold illegal derivative
instruments to pension fund managers. The quote is as follows from
http://www.derivativesstrategy.com/magazine/archive/1997/1197fea6.asp
"I sold to cheaters, not widows and orphans.
That was the moral high ground if there was a moral high ground in
derivatives. I sold to cheaters."
Frank Partnoy, Morgan Stanley
Wealthy investors who bought questionable tax
shelters to lower their tax bills are finding that they can't hide from
state and federal regulators. The IRS and California tax regulators are
going to court to obtain client lists from accounting firms or insurers to
identify investors who bought the shelters. The strategy appears to be
working.
Wealthy investors who bought questionable tax
shelters to lower their tax bills are finding that they can’t hide
from state and federal regulators. The Internal Revenue Service and
California tax regulators are going to court to obtain client lists from
accounting firms or insurers to identify investors who bought the
shelters. The strategy appears to be working.
A federal judge on Monday upheld efforts of the
IRS to obtain the names of two tax shelter clients of accounting firm
KPMG, according to the New York Times. And last week, the California
Franchise Tax Board subpoenaed client lists from two major insurance
companies that may have insured questionable tax shelters against
government intervention.
The subpoenas served Friday seek the names and
addresses of all California residents and businesses who were issued
policies or sought coverage for tax liabilities, fiscal events, tax
indemnities or similar contingencies from 1999 to 2002, the San Jose
Mercury News reported.
According to Franchise Tax Board spokeswoman
Denise Azimi, accounting firms that were marketing tax shelters lined up
insurance to convince clients that their money was safe. "It kind of
closed the deal for some of these clients who were sitting on the
fence," she said.
Azimi said the names of the insurance companies
are confidential, though Hartford Insurance and AIG were named in a
November report to the U.S. Senate Government Affairs investigations
subcommittee on tax shelters sold by KPMG in the late 1990s and early
2000s.
The subpoenas are part of an aggressive effort
to crack down on abusive tax shelters in California. The Franchise Tax
Board has mailed 28,000 letters to taxpayers who may have used illegal
tax shelters and the businesses that sell them. The board reminds tax
scheme promoters that anti-shelter legislation signed last year requires
them to turn over client lists by the end of this month.
On the federal level, the IRS issued a summons
to KPMG in the spring of 2002 to obtain the names of clients who bought
the tax shelter known as "Son of Boss." The shelter involved using short
sales of options to create losses on paper to offset taxable income.
The firm did turn over information on dozens of
other investors, but not two clients who sued KPMG last year to keep
their names confidential. They argued that their identities were
protected by "tax practitioner privilege," which has been compared to
attorney-client privilege, but the judge on Monday disagreed.
Another group of investors is trying to keep
their names from the IRS. The group is suing Sidley Austin Brown & Wood
to prevent the law firm from identifying them.
KPMG is the subject of investigations by the
Justice Department, the IRS and a federal grand jury for questionable
tax shelters. Sidley Austin is also being investigated for promoting
illegal tax shelters.
Federal prosecutors investigating
certain tax shelters sold by KPMG LLP have notified about 30 of the
accounting firm's current and former partners and employees that they
are "subjects" of the probe, according to a person familiar with the
matter.
The move signals a broad sweep by
the government, which KPMG has said is investigating certain tax
shelters it formerly sold. In at least a couple of instances, federal
agents have delivered letters in person at KPMG offices, the person
said.
KPMG, the fourth-largest U.S.
accounting firm, said late last month that it intends to cooperate fully
with the U.S. attorney's office in Manhattan that is handling the
investigation. A KPMG spokesman Thursday referred to a prior statement
the firm made saying it has taken "strong actions" to overhaul its tax
practice including leadership changes and improvements to its review
processes.
The U.S. attorney's office in
Manhattan declined to comment.
By identifying individuals as
subjects, prosecutors indicate that they believe these individuals
engaged in suspicious behavior and fall within the scope of the
investigation. A subject falls short of being a "target," which is a
person or firm prosecutors consider a defendant and likely to be
indicted.
While rare for the Justice
Department to contact such a large number of individuals, it isn't
unheard of in major corporate investigations of complex matters. From a
strategic standpoint, it enables authorities to put people on notice and
encourage them to cooperate.
The large number of subjects
identified by prosecutors suggests "that this is a serious investigation
into which they are putting significant manpower," said John Coffee, a
securities and corporate-litigation specialist at Columbia University's
law school in New York. For that reason, he added, "the odds go up that
[prosecutors] will indict someone because they don't like to write off
that much manpower and come up empty-handed."
The prosecutors appear to be
focusing on at least three tax shelters -- known by the acronyms FLIP,
OPIS and Blips -- that were pitched to wealthy clients. Prosecutors, who
recently empanelled a grand jury, are expected to probe for evidence
that individuals at the firm helped clients evade taxes, among other
things.
It is unclear whether authorities
have ruled out identifying the firm itself as a subject. Either way,
criminal tax investigations tend to be lengthy. Prosecutors have in
their arsenal such possible allegations as tax evasion, assisting in the
preparation of false tax returns, conspiracy, mail fraud and obstructing
the IRS. All are felony offenses.
The prosecutors have contacted
representatives of at least one other tax-advice firm, Presidio Advisory
Services LLC, in connection with the probe. Steven Bauer, a lawyer
representing the firm, said his client had been "contacted informally"
by the government, but declined to elaborate beyond saying that his
client is cooperating.
KPMG also is the subject of
probes by the Internal Revenue Service, the Securities and Exchange
Commission and a Senate investigative subcommittee, all involving
aspects of its tax-shelter sales. KPMG has said that it has stopped
selling certain tax strategies and is taking a more conservative
approach in overseeing and marketing others. The firm said it is
cooperating fully with the government inquiries.
From The Wall Street Journal Accounting Educators' Review on
February 27, 2004
TITLE: Audit Firms Face Heavy Fallout From Tax Business
REPORTER: Cassell Bryan-Low
DATE: Feb 25, 2004
PAGE: A1
LINK:
http://online.wsj.com/article/0,,SB107766373003838199,00.html
TOPICS: Accounting Law, Code of Ethics, Code of Professional Conduct, Tax
Avoidance, Tax Evasion, Tax Laws, Tax Regulations, Tax Shelters, Taxation
SUMMARY: The economic conditions of the late-1990s provided significant
incentives for strategies to lower tax liabilities. A number of accounting
firms, including KPMG LLP, capitalized on the market conditions and
increased firm revenue through tax consulting. The legality of some of the
advice offered to tax clients is now being questioned.
QUESTIONS:
1.) Discuss the differences between being an advocate for your client and
being independent of your client? When are Certified Professional
Accountants (CPAs) expected to be independent and when are they expected
to be advocates? Use the Code of Professional Conduct for guidance.
2.) How are aggressive tax strategies different from abusive tax
strategies? Discuss the tax professionals' obligation to tax clients
regarding aggressive tax strategies.
3.) If a CPA gives tax advice to a client that subsequently proves to
be illegal, has the CPA violated the Code of Professional Conduct? Support
your answer.
4.) Why did the economic conditions of the late-1990s provide an
incentive for tax-savings strategies? Briefly discuss tax laws related to
capital gains and capital losses.
5.) Discuss the auditor's responsibility for detecting illegal
activities in the financial statements. Does the auditor have a
responsibility to detect material income tax violations? Support your
answer.
6.) Does providing auditing services to tax clients impair
independence? Support your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
KPMG Boosted Its Profits, Selling Intricate Strategies; Now It Faces
U.S. Probes
There is a Website covering some of the Frontline broadcast
entitled "Tax Me If You Can" at
http://www.pbs.org/wgbh/pages/frontline/shows/tax/
When Jeffrey Stein was named KPMG
LLP's head of tax operations in 1998, he told subordinates to get more
aggressive in pitching tax-minimizing strategies. For emphasis, he
showed a slide of Attila the Hun.
Mr. Stein helped propel
accounting giant KPMG to the forefront of a tax-shelter frenzy ignited
by the late-1990s economic boom and stock-market rally. Eager to join in
the profit binge, KPMG and its rival auditing firms pushed a new
generation of shelters -- often designed to create large paper losses
that a corporation or individual can use to erase unrelated taxable
income.
These latest shelters typically
were more financially complex than earlier models. Produced in huge
volumes, they were marketed with techniques usually associated with
credit cards or home-equity loans.
Inside KPMG, some partners sensed
the firm was playing close to the murky line separating permissible tax
shelters and fraudulent ones. In a September 1998 e-mail to colleagues,
then-KPMG tax partner Mark Watson criticized the way the firm was
advising clients to report one shelter known as OPIS: "When you put the
OPIS transaction together with this 'stealth' reporting approach, the
whole thing stinks." Several months later, he added in another e-mail,
"I believe we are filing misleading, and perhaps false, returns by
taking this reporting position." Mr. Watson left KPMG in 2002 to work
for a commercial bank.
No profession is perfect, especially ours, but
I would like to think that most of us do what is right and not bend to
pressure from the client.
When I became certified, it was only a few
months later that at the company where I worked the man who hired me
suddenly resigned. He told me on a Friday since he hired me.
That Monday the President called me in to his
office. He said he had fired Don and was naming me Vice President of
Finance. I was 26 and clearly not qualified for the job. The next thing
he did was throw something on the desk and tell me to sign it. It was a
audit of the pension fund, without getting into details was blatantly
fraudulent.
I told him I wouldn't sign it. He was shocked.
I said first I couldn't sign it because I wasn't independent, and second
I had seen it. It was an unqualified opinion. I said that, knowing what
I knew I wouldn't issue an unqualified opinion, I would issue and
adverse opinion.
He said, we can solve the independenc thing
right now - you're fired. I said the classic line, you can't fire me - I
quit.
I write this not to pat myself on the back as a
hero, but in the hope that most people in our profession take their
professional responsibility seriously.
The entire field of accounting is not perfect,
and needs improving. But accountants should work to improve it, not
outsiders and especially politicians, hear that Mr. Sarbanes. We need to
clean up our act. But so do all other professions, and this cleaning up
is constant. We need a bath every day of our lives.
Your account was a good one, it's just sad that
it needs to be said.
I wish I could be as hopeful as some of you,
but the profession's head-in-the-sand behavior over the past few years
tells us that wholesale changes are not in store. It seems that the
national firms, smaller practitioners, accounting professors, the AICPA,
the state societies, and state boards are all set to stubbornly stay on
the same course that has demonstrated its self-destructive tendencies so
convincingly of late. It seems likely to me that the next cycle of
accounting scandals will no doubt be even worse than the last. As a CPA,
I see this as deeply disturbing; as an investor in public securities, I
am more skeptical than ever and have diversified accordingly. No wonder
we are now referred to as "the accounting industry," rather than "the
accounting profession." However, there is still the glimmer of hope --
as even though the caption of this post talks about news than can make
one weep, it is refreshing to know that some of us still have the
capacity to weep at news such as this.
AT 26 years of age you can afford to me
independent. Some of those in the profession have amassed vast fortunes
and followers and it's difficult, to say the least, to be so independent
when an "old-buddy type client" needs a favor and partnership profit
sharing depends on earning and getting that fee included in the current
year, if at all. Youth is great because there is little baggage to
carry. As we get old our age bread problems
Still, is the next step nationalization of the
audit departments by the SEC of the big ten, err the big eight, or is it
the big 6- maybe just two of those firms by now?
An observation from Milt Cohen
Chatsworth, Ca. an old timer by now.
February 20 reply from Robin Alexander
There’s a difference between being imperfect
(which we all are) and having a consistent, ongoing, and unrepentant
pattern of what can only be called fraud in our largest and “most
respected” large firms. The drive to make more and more money has
apparently polluted our profession. Interestingly, I resigned my tenured
position at a state U just before the Enron scandal broke. I was glad I
did; how could I have continued to teach basic accounting with a
straight face when an unqualified audit opinion might be on what must be
considered a work of fiction.
Let me say I truly enjoyed reading your
response. This country's founders wrote our original constitution.
Believe it or not, they were human. The IRS collects money for the
government to continue to offer goods and services to some (the needy
and not so needy :-\ ). When are we going to scrutinize where these
dollars are going? We are supporting many Presidents and congressmen and
senators who receive money (and outrageously priced benefits) for
LIFE... even when they are no longer in office... Why is that not a
crime???? And who writes the tax laws? For whose benefit? The lawmakers
are calling the followers crooks?
You have made a good point about information
manipulation! I have read stories about federal agencies paying $50K on
VIP birthday parties... come on!!! There is too much opportunity for
people to do what is 'easy' rather than what is 'right'. Huge
corporations have become so complex that a typical audit or tax team is
truly stretched to get their arms around the 'elephant' at times!!! One
sees/feels a 'trunk', another a 'leg'...you get the picture! And, no ONE
acts truly 'responsible' when a corporation is treated as an entity in
itself! Where are the personal repercussions for management decisions?
How many times have you heard, "I didn't know..."?
It is so hard for some to do what is
appropriate in such a crazy world! Those of us who 'stay out of trouble'
more than likely are the lowest paid professionals out there! Hmmm...
Respectfully,
Cathy Sherwood
February 21, 2004 reply from Sam A. Hicks
[shicks@VT.EDU]
The KPMG Tax Shelter issue has brought focus on
what I believe is a key issue. In the testimony of Mike Hamersley, the
"whistle blower", much is made of the impact of selling the tax shelters
on the independence of the firm for audit purpose. This lead to a
discussion with some colleagues about the do not cross line - Where is
it? Consider the following:
1. CPA tax partner receives a call from an
audit client of the firm asking what would happen if the client follows
a specified series of steps in a merger transaction. The CPA tax partner
response with the answer to the questions. 2. Same, except the CPA tax
Partner suggest that if an alternative set of steps are followed, the
tax results will be more favorable. 3. The CPA tax partner is a part of
a merger and acquisition group that provides full service for all types
of mergers including suggesting the form that the merger should take.
This group provides service to both audit clients and non-audit clients.
The firm promotes it services to all public corporations who might use
the service.
Query? Did CPA firm cross the line?
Have a Good Day!
Sam A. Hicks, PhD CPA
Department of Accounting and Information Systems
Mail Code 0101, 3011 Pamplin Hall Virginia Tech Blacksburg, VA 24061
February 22, 2004 reply from Bob Jensen
Hi Sam,
Mike Hamersley, the KPMG whistle blower, revealed to me how tax
consulting changed from "consulting" to "sales." KPMG formed a
highly secretive tax shelter sales group that was not widely known within
the firm itself (although top KPMG executives purportedly know about the
sales group). Instead of consulting in the old fashioned sense, this
sales group actively promoted the illegal tax shelters like hawkers in a
tent at a county fair. It is analogous to the sales tactics that
leading investment bankers used to package complex and fraudulent
derivatives to delude pension fund managers. The "professionalism"
in those investment banks gave way to outright aggressive and fraudulent
sales tactics. The entire decline in professionalism is wonderfully
revealed by Morgan Stanley whistle blower Frank Partnoy ---
http://www.derivativesstrategy.com/magazine/archive/1997/1197fea6.asp
I think at least one of Parnoy's books should be required reading in
virtually every accounting and finance ethics course.
There is a "moral high ground" when KPMG sold illegal tax shelters to
banks like Wachovia and other audit clients like Worldcom. At least KPMG
preyed on tax cheats like Wachovia and MCI rather than widows and orphans.
The same moral high ground was claimed at Morgan Stanley when it sold
illegal derivative instruments to pension fund managers. The quote is as
follows from
http://www.derivativesstrategy.com/magazine/archive/1997/1197fea6.asp
"I sold to cheaters, not widows and orphans.
That was the moral high ground if there was a moral high ground in
derivatives. I sold to cheaters."
Frank Partnoy, Morgan Stanley
Auditor independence becomes truly jeopardized when we discover the
magnitude of the tax avoidances of KPMG audit clients such as Wachovia.
Wachovia was featured in the Frontline show of taking illegal KPMG tax
shelters to a point where a multimillion refund was claimed. And yet KPMG
certified the multibillion dollar book value of reported earnings of
Wachovia. The following is a quote from
http://www.pbs.org/wgbh/pages/frontline/shows/tax/etc/synopsis.html
**************************
Amazingly, in 2002 -- even though it reported $4 billion in profits --
[Wachovia] reported that it didn't pay any taxes," McIntyre tells
FRONTLINE. "They worked it by sheltering all of their income. They said
they saved $3 billion in taxes over the last three years from leasing --
huge write-offs."
**************************
Which sadly leads us back to the thread (below) about KPMG's current audit
of Worldcom/MCI when KPMG purportedly sold illegal shelters to Woldcom/MCI.
It is a mystery to me why Worldcom/MCI needed such shelters in the first
place since they are not making any money.
KPMG’s “Unusual Twist”
While KPMG's strategy isn't uncommon among corporations with lots of units
in different states, the accounting firm offered an unusual twist: Under
KPMG's direction, WorldCom treated "foresight of top management"
as an intangible asset akin to patents or trademarks.
The potential claims against KPMG represent the most pressing issue
for MCI. The report didn't have an exact tally of state taxes that may
have been avoided, but some estimates range from $100 million to $350
million. Fourteen states likely will file a claim against the company if
they don't reach settlement, said a person familiar with the matter.
The examiner in MCI's Chapter 11 bankruptcy
case issued a report critical of a "highly aggressive" tax strategy KPMG
LLP recommended to MCI to avoid paying hundreds of millions of dollars
in state income taxes, concluding that MCI has grounds to sue KPMG --
its current auditor.
MCI quickly said the company would not sue
KPMG. But officials from the 14 states already exploring how to collect
back taxes from MCI could use the report to fuel their claims against
the telecom company or the accounting firm. KPMG already is under fire
by the U.S. Internal Revenue Service for pushing questionable tax
shelters to wealthy individuals.
In a statement, KPMG said the tax strategy used
by MCI is commonly used by other companies and called the examiner's
conclusions "simply wrong." MCI, the former WorldCom, still uses the
strategy.
The 542-page document is the final report by
Richard Thornburgh, who was appointed by the U.S. Bankruptcy Court to
investigate legal claims against former employees and advisers involved
in the largest accounting fraud in U.S. history. It reserves special ire
for securities firm Salomon Smith Barney, which the report says doled
out more than 950,000 shares from 22 initial and secondary public
offerings to ex-Chief Executive Bernard Ebbers for a profit of $12.8
million. The shares, the report said, "were intended to and did
influence Mr. Ebbers to award" more than $100 million in
investment-banking fees to Salomon, a unit of Citigroup Inc. that is now
known as Citigroup Global Markets Inc.
In the 1996 initial public offering of
McLeodUSA Inc., Mr. Ebbers received 200,000 shares, the third-largest
allocation of any investor and behind only two large mutual-fund
companies. Despite claims by Citigroup in congressional hearings that
Mr. Ebbers was one of its "best customers," the report said he had scant
personal dealings with the firm before the IPO shares were awarded.
Mr. Thornburgh said MCI has grounds to sue both
Citigroup and Mr. Ebbers for damages for breach of fiduciary duty and
good faith. The company's former directors bear some responsibility for
granting Mr. Ebbers more than $400 million in personal loans, the report
said, singling out the former two-person compensation committee. Mr.
Thornburgh added that claims are possible against MCI's former auditor,
Arthur Andersen LLP, and Scott Sullivan, MCI's former chief financial
officer and the alleged mastermind of the accounting fraud. His criminal
trial was postponed Monday to April 7 from Feb. 4.
Reid Weingarten, an attorney for
Mr. Ebbers, said, "There is nothing new to these allegations. And it's a
lot easier to make allegations in a report than it is to prove them in
court." Patrick Dorton, a spokesman for Andersen, said, "The focus
should be on MCI management, who defrauded investors and the auditors at
every turn." Citigroup spokeswoman Leah Johnson said, "The services that
Citigroup provided to WorldCom and its executives were executed in good
faith." She added that Citigroup now separates research from investment
banking and doesn't allocate IPO shares to executives of public
companies, saying Citigroup continues to believe its congressional
testimony describing Mr. Ebbers as a "best customer." An attorney for
Mr. Sullivan couldn't be reached for comment.
The potential claims against KPMG
represent the most pressing issue for MCI. The report didn't have an
exact tally of state taxes that may have been avoided, but some
estimates range from $100 million to $350 million. Fourteen states
likely will file a claim against the company if they don't reach
settlement, said a person familiar with the matter.
While KPMG's strategy isn't
uncommon among corporations with lots of units in different states, the
accounting firm offered an unusual twist: Under KPMG's direction,
WorldCom treated "foresight of top management" as an intangible asset
akin to patents or trademarks. Just as patents might be licensed,
WorldCom licensed its management's insights to its units, which then
paid royalties to the parent, deducting such payments as normal business
expenses on state income-tax returns. This lowered state taxes
substantially, as the royalties totaled more than $20 billion between
1998 to 2001. The report says that neither KPMG nor WorldCom could
adequately explain to the bankruptcy examiner why "management foresight"
should be treated as an intangible asset.
Continued in the article
KPMG Reports That This is the Rest of the Story "KPMG is Subject of DOJ Investigation, KPMG Responds,"
AccountingWeb, February 20, 2004
On Thursday, Big Four accounting firm KPMG LLP
announced that the U.S. Attorney’s Office in the Southern District of
New York "has commenced an investigation in connection with certain
tax strategies" related to KPMG. "It is our understanding that
the investigation is related to tax strategies that are no longer
offered by the firm." The firm’s efforts to market four
questionable tax products was the focus of a two day Senate hearing late
last year. A investigation panel of the Senate Governmental Affairs
Committee took more than a year to examine the role of accounting firms,
law firms, banks and investment advisers in creating and selling tax
avoidance schemes.
The report and testimony focused largely on
one KPMG product known as BLIPS -- Bond Linked Issue Premium Structure.
Marketing began in 1999, and continued until September 2000, when the
IRS listed it as potentially abusive. Senate investigators estimate it
generated $80 million in fees for KPMG from 186 clients. It lost the
U.S. Treasury more than $1.4 billion, the report says.
(See
Below)
In January of 2004 the firm announced new
management to tax services operations and stated that the firm "is
dedicated to leading the effort to return credibility to our profession
and restore investor confidence in the capital markets."
KPMG said in an earlier statement that they no
longer use any of the questioned tax strategies, which “represent an
earlier time at KPMG and a far different regulatory and marketplace
environment.” The firm said it had overhauled its tax products and had
stopped several controversial marketing practices.
KPMG LLP issued the following statement. KPMG
LLP can confirm that the firm has been informed that the United States
Attorney's Office in the Southern District of New York has commenced an
investigation in connection with certain tax strategies.
It is our understanding that the investigation
is related to tax strategies that are no longer offered by the firm.
As previously announced, KPMG has taken strong
actions as part of our ongoing consideration of the firm's tax practices
and procedures, including leadership changes announced last month and
numerous changes in our risk management and review processes.
We have assured the U.S. Attorney's office that
we intend to cooperate fully in this matter.
KPMG Reports That This is the Rest of the Story
"KPMG is Subject of DOJ Investigation, KPMG Responds," AccountingWeb,
February 20, 2004
.... one KPMG
product known as BLIPS -- Bond Linked Issue Premium Structure.........
generated $80 million in fees for KPMG from 186 clients. It lost the
U.S. Treasury more than $1.4 billion, the report says. (See
Above)
In January of 2004 the firm announced new
management to tax services operations and stated that the firm "is
dedicated to leading the effort to return credibility to our
profession....
Bah. No thanks.
KPMG said in an earlier statement that they no
longer use any of the questioned tax strategies, which represent an
earlier time at KPMG .......
Of course not. The tax strategy lifecycle is
only 1 to 5 years, depending on such factors as - frequency of use, -
effectiveness of the secrecy, - magnitude of tax avoidance, - nested,
conceptual complexity, - number of recursive loops (endless loops) and -
what part of the code it is nested under etc.
Tax firms need to quantify the cost, benefit,
and projected life of manufacturing tax schemes. My model is probably
outdated.
The tax strategy lifecycle of course begins in
the big 4 audit firms and specialty tax firms. Why not the Corporation
or CFO's? Because once leaving tax practice, their knowledge has a
half-life of about 1-2 years. Nobody outside the tax practice can
individually maintain their competency, because it is all "relationship"
stuff and mealy lies. There is no logic or reason to it.
The tax strategy lifecycle proceeds from the
firms, to the staffs of senators and congressmen, who create the twisted
and ambiguous wording in the tax laws. http://www.house.gov/rules/jcoc2.htm
Our congressman, Jay Inslee told us, few
congressmen/women actually read most of the bills in the house of
representatives.
There is usually only one copy--a physical
copy, often thousands of pages long and it is bolted to the table on the
floor of the House of Representatives. It is well-known fact that the
Republican majority often inserts changes numerous, obscure, and without
notice or review time.
Here's some nice, ethics CPE for you guys,
Sorry for more mediocre banality,
Todd " a rant a day keeps the clients away"
"Whoops I did it again -B. Spears"
1. Client A, being fully aware of the needs of
society and the importance of governance, nevertheless, forms an intent
to minimize his taxes, and having several taxable entities of moderate
complexity, engages Ernst & Young to create a filing position that saves
him $10,000. (for example read this)
Client B, having a firm intent to minimize his
taxes, and having a small schedule C business, erases his cost of goods
sold and changes it, saving $10,000.
Which is more unethical, and why?
2. Partner in CPA firm hires the dumbest people
he can find, yet still having CPA certificates. He confers at length
with all of his clients, but gives partial information to his staff, and
gives it in a highly disorganized condition, for tax return preparation.
A strict regime of time constraints is also imposed on the staff CPAs.
When the tax returns are completed the Partner
reviewer does not correct most errors in the taxpayer's favor, but
militantly corrects all overtaxation errors.
Thus by a combination of staffing selection and
time constraints he realizes a harvest of tax savings for benefit of
clients. In turn, he achieves above normal economic returns from the
practice.
Does the fact that each particular error
originated with the staff CPA preparer mitigate the ethical
responsibility of the partner in any way?
3. In 1976, the top marginal tax rate in NY
city and state was 15%, and the top Federal tax rate was 70%. Taxpayer A
having real taxable income of $500,000 owed taxes of $350,000. He
decided to underreport his income, reducing the tax by $50,000 and paid
$300,000.
In 1982, after federal and state tax reforms,
teh top Federal rate was 35% and the top NY rate was 8%. Taxpayer B
having true taxable income of $500,000, didn't cheat on his taxes. He
paid a total of $250,000.
Which was unethical and why. (Hint: What is the
guidance from the pope, the mullahs, rabbis, and other spiritual gurus,
on the quantitative issue of marginal rates? And which elder statesman,
in a representative system of government, has such finely calibrated
ethics as to provide this numerical constant? )
4. Taxpayer A, living in the US, having an
income of $100,000 in 1970, and whose government was bombing Cambodia
under an executive order issued in secrecy by a single individual he did
not vote for, paid taxes of $30,000 to his government even though the
government's action was technically illegal and he believed the actions
of the government were morally wrong.
Taxpayer B, under the same circumstances, went
underground, quit working, and didn't file or pay his taxes.
Which was more ethical and why?
"KPMG Didn't Register Strategy," by Cassell Bryan-Low, The Wall
Street Journal, November 17, 2003, Page C1
Former Partner's Memo Says Fees Reaped From
Sales of Tax Shelter Far Outweigh Potential Penalties
KPMG LLP in 1998 decided not to register a new
tax-sheltering strategy for wealthy individuals after a tax partner in a
memo determined the potential penalties were vastly lower than the
potential fees.
The shelter, which was designed to minimize
taxes owed on large capital gains such as from the sale of stock or a
business, was widely marketed and has come under the scrutiny of the
Internal Revenue Service. It was during the late 1990s that sales of tax
shelters boomed as large accounting firms like KPMG and other advisers
stepped up their marketing efforts.
Gregg W. Ritchie, then a KPMG LLP
tax partner who now works for a Los Angeles-based investment firm,
presented the cost-benefit analysis about marketing one of the firm's
tax-shelter strategies, dubbed OPIS, in a three-page memorandum to a
senior tax partner at the accounting firm in May 1998. By his
calculations, the firm would reap fees of $360,000 per shelter sold and
potentially pay only penalties of $31,000 if discovered, according to
the internal note.
Mr. Ritchie recommended that KPMG
avoid registering the strategy with the IRS, and avoid potential
scrutiny, even though he assumed the firm would conclude it met the
agency's definition of a tax shelter and therefore should be registered.
The memo, which was reviewed by The Wall Street Journal, stated that,
"The rewards of a successful marketing of the OPIS product [and the
competitive disadvantages which may result from registration] far exceed
the financial exposure to penalties that may arise."
The directive, addressed to
Jeffrey N. Stein, a former head of tax service and now the firm's deputy
chairman, is becoming a headache itself for KPMG, which currently is
under IRS scrutiny for the sale of OPIS and other questionable tax
strategies. The memo is expected to play a role at a hearing Tuesday by
the Senate's Permanent Subcommittee on Investigations, which has been
reviewing the role of KPMG and other professionals in the mass marketing
of abusive tax shelters. A second day of hearings, planned for Thursday,
will explore the role of lawyers, bankers and other advisers.
Richard Smith, KPMG's current
head of tax services, said Mr. Ritchie's note "reflects an internal
debate back and forth" about complex issues regarding IRS regulations.
And the firm's ultimate decision not to register the shelter "was made
based on an analysis of the law. It wasn't made on the basis of the size
of the penalties" compared with fees. Mr. Ritchie, who left KPMG in
1998, declined to comment. Mr. Stein couldn't be reached for comment
Sunday.
KPMG, in a statement Friday, said
it has made "substantial improvements and changes in KPMG's tax
practices, policies and procedures over the past three years to respond
to the evolving nature of both the tax laws and regulations, and the
needs of our clients. The tax strategies that will be discussed at the
subcommittee hearing represent an earlier time at KPMG and a far
different regulatory and marketplace environment. None of the strategies
-- nor anything like these tax strategies -- is currently being offered
by KPMG."
Continued in the article.
The
Huckster Lobby Fights Back
This illustrates the tack that accounting firms, law firms, and the
leasing industry will take to save their tax sheltering business.
Leasing Industry Which Writes
the Leasing Schemes That Serve No Economic Purpose Other Than Avoid Taxes
Lashes Back at PBS and Others Who Want to End Abusive Tax Shelters ---
http://www.smartpros.com/x42589.xml
Feb. 23, 2004 (SmartPros) — The
Equipment Leasing Association (ELA), a nonprofit association
representing the $218 billion equipment leasing and finance industry,
released a statement in response to a segment on the PBS television show
called "Tax Me If You Can," which aired last week, pointing
out certain statements from the special as "inappropriate" and
"inflammatory."
"We were taken aback by some of the language
used in the Frontline segment and ELA wishes to clarify some of the
statements used," said Michael Fleming, ELA president. "The industry
welcomes a policy discussion around the appropriate role for leasing to
tax-exempts. But, calling a legal business practice a scheme or fraud,
that is inappropriate. Inflammatory statements, such as the ones made in
the television segment, make it difficult for policy makers and an
industry to address a very serious policy subject."
Fleming said the equipment leasing and finance
industry provides significant, much-needed capital and jobs across many
different industries, companies and organizations.
"Calling an industry that contributes so much
'a bunch of hucksters', isn't appropriate," said Fleming. "If current
law doesn't work, then let's have a civil discussion about what would
work. We certainly are willing to address the issues."
Critics of leasing have attempted to depict
some finance leasing to tax-exempt entities negatively to justify
efforts to change longstanding and well-established tax principles
surrounding the leasing industry.
"Leasing levels the economic playing field
between profitable taxable entities and non profitable or tax-exempt
entities with regard to the cost of acquiring equipment," said Fleming.
"Tax depreciation allows an entity to recover the investment made in an
asset. Congress and the courts have affirmatively provided for lessors
to utilize tax depreciation when leasing to taxable corporations as well
as tax-exempt entities."
The current policy debate on lease financing to
tax-exempts has focused increasingly on the nature of the asset, the
geographic location of the asset and the nature of the lessee, as was
the focus of the Frontline segment.
"However, all of these considerations have been
and should remain unimportant under well-established legal and tax
principles," said Fleming. "The appropriate tax treatment of a sale and
lease of a transit facility by a governmental entity in Frankfurt,
Germany, for example, should be no different than the sale and lease of
a transit facility by a governmental entity in Frankfurt, Kentucky."
Said Fleming, contrary to what the PBS story
depicted, the leasing industry is not opposed to the doctrine of
economic substance. The economic substance doctrine is already the law,
established by regulation and court decisions and is enforced through
the IRS. The industry, said Fleming, is opposed to the statutory
codification of the doctrine, not to the doctrine itself, because it
will make the doctrine too rigid and create enforcement headaches.
KPMG’s “Unusual Twist”
While KPMG's strategy isn't uncommon among corporations with lots of units
in different states, the accounting firm offered an unusual twist: Under
KPMG's direction, WorldCom treated "foresight of top management"
as an intangible asset akin to patents or trademarks.
The potential claims against KPMG represent the most pressing issue
for MCI. The report didn't have an exact tally of state taxes that may
have been avoided, but some estimates range from $100 million to $350
million. Fourteen states likely will file a claim against the company if
they don't reach settlement, said a person familiar with the matter.
The examiner in MCI's Chapter 11 bankruptcy
case issued a report critical of a "highly aggressive" tax strategy KPMG
LLP recommended to MCI to avoid paying hundreds of millions of dollars
in state income taxes, concluding that MCI has grounds to sue KPMG --
its current auditor.
MCI quickly said the company would not sue
KPMG. But officials from the 14 states already exploring how to collect
back taxes from MCI could use the report to fuel their claims against
the telecom company or the accounting firm. KPMG already is under fire
by the U.S. Internal Revenue Service for pushing questionable tax
shelters to wealthy individuals.
In a statement, KPMG said the tax strategy used
by MCI is commonly used by other companies and called the examiner's
conclusions "simply wrong." MCI, the former WorldCom, still uses the
strategy.
The 542-page document is the final report by
Richard Thornburgh, who was appointed by the U.S. Bankruptcy Court to
investigate legal claims against former employees and advisers involved
in the largest accounting fraud in U.S. history. It reserves special ire
for securities firm Salomon Smith Barney, which the report says doled
out more than 950,000 shares from 22 initial and secondary public
offerings to ex-Chief Executive Bernard Ebbers for a profit of $12.8
million. The shares, the report said, "were intended to and did
influence Mr. Ebbers to award" more than $100 million in
investment-banking fees to Salomon, a unit of Citigroup Inc. that is now
known as Citigroup Global Markets Inc.
In the 1996 initial public offering of
McLeodUSA Inc., Mr. Ebbers received 200,000 shares, the third-largest
allocation of any investor and behind only two large mutual-fund
companies. Despite claims by Citigroup in congressional hearings that
Mr. Ebbers was one of its "best customers," the report said he had scant
personal dealings with the firm before the IPO shares were awarded.
Mr. Thornburgh said MCI has grounds to sue both
Citigroup and Mr. Ebbers for damages for breach of fiduciary duty and
good faith. The company's former directors bear some responsibility for
granting Mr. Ebbers more than $400 million in personal loans, the report
said, singling out the former two-person compensation committee. Mr.
Thornburgh added that claims are possible against MCI's former auditor,
Arthur Andersen LLP, and Scott Sullivan, MCI's former chief financial
officer and the alleged mastermind of the accounting fraud. His criminal
trial was postponed Monday to April 7 from Feb. 4.
Reid Weingarten, an attorney for
Mr. Ebbers, said, "There is nothing new to these allegations. And it's a
lot easier to make allegations in a report than it is to prove them in
court." Patrick Dorton, a spokesman for Andersen, said, "The focus
should be on MCI management, who defrauded investors and the auditors at
every turn." Citigroup spokeswoman Leah Johnson said, "The services that
Citigroup provided to WorldCom and its executives were executed in good
faith." She added that Citigroup now separates research from investment
banking and doesn't allocate IPO shares to executives of public
companies, saying Citigroup continues to believe its congressional
testimony describing Mr. Ebbers as a "best customer." An attorney for
Mr. Sullivan couldn't be reached for comment.
The potential claims against KPMG
represent the most pressing issue for MCI. The report didn't have an
exact tally of state taxes that may have been avoided, but some
estimates range from $100 million to $350 million. Fourteen states
likely will file a claim against the company if they don't reach
settlement, said a person familiar with the matter.
While KPMG's strategy isn't
uncommon among corporations with lots of units in different states, the
accounting firm offered an unusual twist: Under KPMG's direction,
WorldCom treated "foresight of top management" as an intangible asset
akin to patents or trademarks. Just as patents might be licensed,
WorldCom licensed its management's insights to its units, which then
paid royalties to the parent, deducting such payments as normal business
expenses on state income-tax returns. This lowered state taxes
substantially, as the royalties totaled more than $20 billion between
1998 to 2001. The report says that neither KPMG nor WorldCom could
adequately explain to the bankruptcy examiner why "management foresight"
should be treated as an intangible
asset.
"These Stock Options Just Didn't Add Up," by Grechen Morgensen,
The New York Times, January 30, 2005 ---
Top executives on the receiving end of munificent
pay packages like to argue that their troughs full of stock options have
no relationship to the improprieties that keep erupting across corporate
America.
But an episode last week involving Brocade
Communications, a San Jose, Calif., company that makes switches for
computer storage networks, suggests that every now and again there just
might be a connection after all.
Back in the bubble of 2000, you may recall, Brocade Communications was one
heck of a stock. The shares went public in May 1999 at a split-adjusted
$4.75. By October 2000, the stock had climbed to $133. It closed on Friday
at $5.99.
Last Monday, after the stock market closed, Brocade announced that its
board had appointed a new chief executive to replace Gregory L. Reyes, its
longtime chief; that it would be restating its results for the last six
fiscal years; and that its annual financial report would not be filed on
time to the Securities and Exchange Commission.
Other than that, the company said, everything's going great.
Financial restatements are distressingly common, of course. But Brocade
certainly wins a prize for having to recompute its results for every one
of the six years that it has existed as a public company.
The amounts being restated are considerable. In fiscal 2004, for example,
Brocade's net loss swelled to $32 million from $2 million as a result of
the restatement. For 2003, its loss grew to $147 million from $136
million, and in 2002, its net income rose to $126 million from $60 million
as a result of the new computations.
The restatements, the company said, all had to do with errors in its
option accounting. After a review, the audit committee of Brocade's board
concluded that the company must record additional compensation charges
relating to option grants from 1999 through the third quarter of 2003.
What's more, the committee found "improprieties in connection with
the documentation" of option grants given to a small number of
employees before mid-2002 and concluded that the company's documentation
related to certain option grants before August 2003 was unreliable.
Exactly what went wrong with Brocade's options program is not clear; the
company is not saying.
An analysis last April by Glass Lewis & Company, an institutional
advisory firm, found that Brocade had used unrealistic assumptions in
calculating its option expense in its financial footnotes. The
assumptions, related to the average life of its options and the underlying
volatility in Brocade's stock, wound up understating the true costs of the
grants, Glass Lewis said.
Options have been the drug of choice for years at Brocade, as they have
been at many Silicon Valley businesses. These companies have fought
strenuously against the move last year by accounting rulemakers to require
that the costs of this employee compensation be run through the
profit-and-loss statement. Along with other companies, Brocade signed a
letter to members of Congress in July 2003 that argued against the
expensing of options.
As is also typical at technology companies, Brocade's top management,
especially Mr. Reyes, have been big recipients of options. In last year's
proxy, Brocade noted that 4 percent of the total number of options granted
to its employees in fiscal 2003 went to Mr. Reyes.
Brocade's directors also receive stock options as part of their
compensation: 80,000 options when they join the board and 20,000 options
for each year they remain as members. They also receive annual cash
compensation of at least $25,000.
Under a new plan, which Brocade put to a shareholder vote last year, the
company proposed a system by which a committee of the board would be free
to determine how many options to dispense to directors, when to dispense
them, their vesting provisions and terms. "An inflexible compensation
structure limits our ability to attract and retain qualified
directors," the company noted in its proxy last year. "The board
of directors believes that the amended and restated 1999 Director Option
Plan is necessary so that we can continue to provide meaningful, long-term
equity-based incentives to present and future non-employee
directors."
Shareholders shouted down the plan. Fully two thirds of the shares that
were voted rejected it.
Many analysts who follow Brocade have concluded that Mr. Reyes's hasty
departure was clearly related to the accounting improprieties. But in a
conference call on Monday afternoon, David L. House, a Brocade director
who is a former chief executive of Allegro Networks and a former president
of Nortel
Networks, refused to link the two events. Indeed, he told surprised
listeners that even though Mr. Reyes would no longer run the company, he
would stay on the board and have "a significant and important
role" there.
Mr. Reyes has been the body and soul of Brocade practically since the
company was born. He became its chief executive in July 1998, before the
company went public. He became chairman in May 2001.
But why would Mr. Reyes still have a coveted place on Brocade's board,
given the wall-to-wall restatements that occurred on his watch? Leslie
Davis, a spokeswoman for the company, wrote in an e-mail message:
"Greg has been a key contributor to the success of the company and
will still add great value. Greg will advise on strategic and customer
issues where he can continue to contribute to the success of
Brocade." Ms. Davis declined to make any of the company's directors
available.
AT the end of Brocade's last fiscal year, Mr. Reyes had 1.7 million
options with exercise prices of either $5.53 or $6.54 each. Ms. Davis said
Brocade had not determined whether those options would become immediately
exercisable now that Mr. Reyes has, to use the company's expression,
passed the baton.
Will the company also continue to reimburse Mr. Reyes for the use of his
private plane, as it did when he was chief executive? For fiscal 2002 and
2003, he received $624,000 in such reimbursements. Not determined yet, Ms.
Davis said.
Brocade gets some credit for identifying the stock option improprieties.
And it has instituted more restrictive policies in its option program
recently. But its insistence on keeping Mr. Reyes shows how entrenched the
obeisance to chief executives remains at some companies, even among
directors who have a fiduciary duty to mind the store.
Obviously, shareholders interested in reforming corporate America have a
good deal more work to do.
KMPG was and still is the independent auditor for these "options
that just don't add up."
The Securities and Exchange
Commission recently filed civil fraud charges against Nortel
Networks Corporation and its principal operating subsidiary Nortel
Networks Limited (Nortel) alleging that Nortel engaged in accounting
fraud from 2000 through 2003 to close gaps between its true
performance, its internal targets and Wall Street expectations.
Nortel is a Canadian manufacturer of telecommunications equipment.
Without admitting or denying the
Commission's charges, filed in the U.S. District Court for the
Southern District of New York, Nortel has agreed to settle the
Commission's action by consenting to be permanently enjoined from
violating the antifraud, reporting, books and records and internal
control provisions of the federal securities laws and by paying a
$35 million civil penalty, which the Commission will seek to place
in a Fair Fund for distribution to affected shareholders. Nortel
also has agreed to report periodically to the Commission's staff on
its progress in implementing remedial measures and resolving an
outstanding material weakness over its revenue recognition
procedures.
"This is an important fraud case
involving conduct from 2000 through 2003," said Linda Thomsen,
Director of the Commission's Division of Enforcement. "Since that
time, under new leadership, Nortel has undertaken significant
efforts to address the wrongdoing, remedy the harm and implement a
remediation plan to prevent recurrence of the misconduct."
Christopher Conte, an Associate
Director of the Commission's Division of Enforcement, stated, "The
settlement reached today reflects the seriousness of the company's
past activity. Nortel's fraud was long-running, intentional and
pervasive."
According to the Commission's
complaint, from late 2000 through January 2001, Nortel made changes
to its revenue recognition policies that were not in conformity with
U.S. Generally Accepted Accounting Principles (GAAP). The changes
were made to fraudulently accelerate revenue into 2000 to meet its
publicly announced revenue targets for the fourth quarter of 2000
and for that year. The complaint alleges that Nortel also
selectively reversed certain revenue entries during the 2000
year-end closing process when its acceleration efforts pulled in
more revenue than necessary to meet its targets. These actions, the
complaint alleges, inflated Nortel's fourth quarter and fiscal year
2000 revenues by approximately $1.4 billion.
The complaint further alleges that
Nortel had improperly established, and was improperly maintaining,
over $400 million in excess reserves by the time it announced its
fiscal year 2002 financial results. According to the complaint,
these reserve manipulations erased Nortel's fourth quarter 2002 pro
forma profit and allowed it to report a loss instead so that Nortel
would not show a profit earlier than it had previously forecast to
the market. The complaint alleges that in the first and second
quarters of 2003, Nortel improperly released approximately $500
million in excess reserves to boost its earnings and fabricate a
return to profitability. These efforts turned Nortel's first quarter
2003 loss into a reported profit under GAAP, and largely erased its
second quarter loss while generating a pro forma profit. According
to the complaint, in both quarters Nortel's inflated earnings
allowed it to pay tens of millions of dollars in so called "return
to profitability" bonuses, largely to a select group of senior
managers.
In settling the matter, the
Commission acknowledges Nortel's substantial remedial efforts and
cooperation. After Nortel announced its first restatement, the Audit
Committee of Nortel's Board of Directors launched an independent
investigation which later uncovered the improper accounting.
Nortel's Board took extensive remedial action that included promptly
terminating employees responsible for the wrongdoing, restating its
financial statements four times over four years, replacing its
senior management, and instituting a comprehensive remediation
program designed to ensure proper accounting and reporting
practices. Nortel also shared the results of its independent
investigation with the Commission.
As part of the settlement, Nortel
agrees to report to the Commission staff every quarter until it
fully implements its remediation program, and the company and its
outside auditor agree that the existing material weakness has been
resolved.
The Securities and Exchange
Commission recently filed civil fraud charges against Nortel
Networks Corporation and its principal operating subsidiary Nortel
Networks Limited (Nortel) alleging that Nortel engaged in accounting
fraud from 2000 through 2003 to close gaps between its true
performance, its internal targets and Wall Street expectations.
Nortel is a Canadian manufacturer of telecommunications equipment.
Without admitting or denying the
Commission's charges, filed in the U.S. District Court for the
Southern District of New York, Nortel has agreed to settle the
Commission's action by consenting to be permanently enjoined from
violating the antifraud, reporting, books and records and internal
control provisions of the federal securities laws and by paying a
$35 million civil penalty, which the Commission will seek to place
in a Fair Fund for distribution to affected shareholders. Nortel
also has agreed to report periodically to the Commission's staff on
its progress in implementing remedial measures and resolving an
outstanding material weakness over its revenue recognition
procedures.
"This is an important fraud case
involving conduct from 2000 through 2003," said Linda Thomsen,
Director of the Commission's Division of Enforcement. "Since that
time, under new leadership, Nortel has undertaken significant
efforts to address the wrongdoing, remedy the harm and implement a
remediation plan to prevent recurrence of the misconduct."
Christopher Conte, an Associate
Director of the Commission's Division of Enforcement, stated, "The
settlement reached today reflects the seriousness of the company's
past activity. Nortel's fraud was long-running, intentional and
pervasive."
According to the Commission's
complaint, from late 2000 through January 2001, Nortel made changes
to its revenue recognition policies that were not in conformity with
U.S. Generally Accepted Accounting Principles (GAAP). The changes
were made to fraudulently accelerate revenue into 2000 to meet its
publicly announced revenue targets for the fourth quarter of 2000
and for that year. The complaint alleges that Nortel also
selectively reversed certain revenue entries during the 2000
year-end closing process when its acceleration efforts pulled in
more revenue than necessary to meet its targets. These actions, the
complaint alleges, inflated Nortel's fourth quarter and fiscal year
2000 revenues by approximately $1.4 billion.
The complaint further alleges that
Nortel had improperly established, and was improperly maintaining,
over $400 million in excess reserves by the time it announced its
fiscal year 2002 financial results. According to the complaint,
these reserve manipulations erased Nortel's fourth quarter 2002 pro
forma profit and allowed it to report a loss instead so that Nortel
would not show a profit earlier than it had previously forecast to
the market. The complaint alleges that in the first and second
quarters of 2003, Nortel improperly released approximately $500
million in excess reserves to boost its earnings and fabricate a
return to profitability. These efforts turned Nortel's first quarter
2003 loss into a reported profit under GAAP, and largely erased its
second quarter loss while generating a pro forma profit. According
to the complaint, in both quarters Nortel's inflated earnings
allowed it to pay tens of millions of dollars in so called "return
to profitability" bonuses, largely to a select group of senior
managers.
In settling the matter, the
Commission acknowledges Nortel's substantial remedial efforts and
cooperation. After Nortel announced its first restatement, the Audit
Committee of Nortel's Board of Directors launched an independent
investigation which later uncovered the improper accounting.
Nortel's Board took extensive remedial action that included promptly
terminating employees responsible for the wrongdoing, restating its
financial statements four times over four years, replacing its
senior management, and instituting a comprehensive remediation
program designed to ensure proper accounting and reporting
practices. Nortel also shared the results of its independent
investigation with the Commission.
As part of the settlement, Nortel
agrees to report to the Commission staff every quarter until it
fully implements its remediation program, and the company and its
outside auditor agree that the existing material weakness has been
resolved.
The
case against three former executives at Nortel is coming to an end.
Their actions have been characterized as a “fraud
on the public” by the Canadian prosecutors
during their closing statements. These managers at Nortel Networks
Corporation allegedly used accounting tricks to buoy quarterly
profits and activate various bonuses for themselves.
Linda Nguen quotes prosecutors as saying,
“You cannot just monkey with the accounting.”
The SEC
previously examined the accounting and reporting issues at Nortel,
and we re-examine the relevant Litigation Releases and Complaint to
review the case against these managers. We also note the slow
justice in this case. The fraud occurred over 10 years ago, and
only now have these executives faced a criminal trial for their
deeds.
Nortel’s
shenanigans fall into two groups. The first set of activities dealt
with revenue recognition issues beginning in 2000. Specifically,
the firm employed bill and hold transactions to increase revenues
and earnings. For the most part, generally accepted accounting
principles require inventory to be delivered to the customer before
the corporation can recognize the revenues. There are some
exceptions, and bill and hold transactions may be an exception.
Bill
and hold transactions are governed by
Staff Accounting Bulletin No. 101, and
they must meet several guidelines in order for the revenues to be
considered realized. They are:
The
risks of ownership must have passed to the buyer;
The
customer must have made a fixed commitment to purchase the
goods, preferably in written documentation;
The
buyer, not the seller, must request that the transaction be on a
bill and hold basis. The buyer must have a substantial business
purpose for ordering the goods on a bill and hold basis;
There
must be a fixed schedule for delivery of the goods. The date for
delivery must be reasonable and must be consistent with the
buyer’s business purpose (e.g., storage periods are
customary in the industry);
The
seller must not have retained any specific performance
obligations such that the earning process is not complete;
The
ordered goods must have been segregated from the seller’s
inventory and not be subject to being used to fill other orders;
and
The
equipment [product] must be complete and ready for shipment.
The
SEC (Litigation
Release No. 20036 and
Litigation Release No. 20275
and the related complaint
SEC v. Dunn, Beatty, Gullogly, and Pahapill)
pointed out two major deficiencies in Nortel’s
accounting for these transactions, both violations of the third
criterion. The bill and hold transactions under questions were
requested by Nortel, and not by its customers. Additionally, the
customers of Nortel did not have any particular reason for having
bill and hold transactions; there was no business purpose for these
activities.
The second
accounting scheme involved manipulation of reserves (liabilities).
When more reported income was not necessary to achieve manager
bonuses, no later than 2002, Nortel started accruing a number of
items, thereby recognizing the expenses, and the related current
liabilities. Later, when they desired greater income, the managers
released the reserves by reducing current debts when incurring
various costs, instead of recognizing them as expenses. These
transactions make a mockery out of expense and liability recognition
criteria.
The SEC
linked these accounting shenanigans with the compensation schemes of
Nortel Networks. In particular, not only did Nortel managers
manipulate revenues and expenses to obtain the bonuses, but they
were careful not to exceed the thresholds by very much. In this
way, managers were able to save revenues and incomes for the
proverbial rainy day, and collect bonuses whether the business
climate rained or shined.
In
October 2007 Nortel Networks paid $35 million in fines for these
behaviors (Litigation
Release No. 20333). We still find this
amazing inasmuch as the shareholders are paying these fines. Thus,
shareholders get whacked twice: first by the scoundrels masquerading
as managers, and then by the SEC who is supposed to be giving them
justice! We just don’t understand fines against a company.
Three
top managers of Nortel settled with the SEC (Litigation
Release No. 20546). These three
individuals were vice presidents of the business units involved in
the accounting schemes. They paid fines, disgorgement, and interest
to the tune of $143,481 to $163,031 each. Given their salaries and
given how much they earned via unwarranted bonuses, we wonder
whether these fines were sufficiently high to serve as a
disincentive to other managers.
Continued in article
Worldcom Inc.'s restated financial reports
aren't even at the printer yet, and already new questions are surfacing
about whether investors can trust the independence of the company's latest
auditor, KPMG LLP -- and, thus, the numbers themselves.
I suspect by now, most of you are aware that
after the world's largest accounting scandal ever, our
Denny Beresford
accepted an invitation to join the Board of Directors at Worldcom.
This has been an intense addition to his day job of being on the
accounting faculty at the University of Georgia. Denny has one of
the best, if not the best, reputations for technical skills and integrity
in the profession of accountancy. In the article below, he is quoted
extensively while coming to the defense of the KPMG audit of the restated
financial statements at Worldcom. I might add that Worldcom's
accounting records were a complete mess following Worldcom's deliberate
efforts to deceive the world and Andersen's suspected complicity in the
crime. If Andersen was not in on the conspiracy, then Andersen's
Worldcom audit goes on record as the worst audit in the history of the
world. For more on the Worldcom scandal, go to
http://www.trinity.edu/rjensen/fraud.htm#WorldcomFraud
Worldcom Inc.'s restated financial reports
aren't even at the printer yet, and already new questions are surfacing
about whether investors can trust the independence of the company's
latest auditor, KPMG LLP -- and, thus, the numbers themselves.
The doubts stem from a brewing series of
disputes between state taxing authorities and WorldCom, now doing
business under the name MCI, over an aggressive KPMG tax-avoidance
strategy that the long-distance company used to reduce its state-tax
bills by hundreds of millions of dollars from 1998 until 2001. MCI,
which hopes to exit bankruptcy-court protection in late February, says
it continues to use the strategy. Under it, MCI treated the "foresight
of top management" as an asset valued at billions of dollars. It
licensed this foresight to its subsidiaries in exchange for royalties
that the units deducted as business expenses on state tax forms.
It turns out, of course, that WorldCom
management's foresight wasn't all that good. Bernie Ebbers, the
telecommunications company's former chief executive, didn't foresee
WorldCom morphing into the largest bankruptcy filing in U.S. history or
getting caught overstating profits by $11 billion. At least 14 states
have made known their intention to sue the company if they can't reach
tax settlements, on the grounds that the asset was bogus and the royalty
payments lacked economic substance. Unlike with federal income taxes,
state taxes won't necessarily get wiped out along with MCI's restatement
of companywide profits.
MCI says its board has decided not to sue KPMG
-- and that the decision eliminates any concerns about independence,
even if the company winds up paying back taxes, penalties and interest
to the states. MCI officials say a settlement with state authorities is
likely, but that they don't expect the amount involved to be material.
KPMG, which succeeded the now-defunct Arthur Andersen LLP as MCI's
auditor in 2002, says it stands by its tax advice and remains
independent. "We're fully familiar with the facts and circumstances
here, and we believe no question can be raised about our independence,"
the firm said in a one-sentence statement.
Auditing standards and federal securities rules
long have held that an auditor "should not only be independent in fact;
they should also avoid situations that may lead outsiders to doubt their
independence." Far from resolving the matter, MCI's decision not to sue
has made the controversy messier.
In a report released Monday, MCI's Chapter 11
bankruptcy-court examiner, former U.S. Attorney General Richard
Thornburgh, concluded that KPMG likely rendered negligent and incorrect
tax advice to MCI and that MCI likely would prevail were it to sue to
recover past fees and damages for negligence. KPMG's fees for the tax
strategy in question totaled at least $9.2 million for 1998 and 1999,
the examiner's report said. The report didn't attempt to estimate
potential damages.
Actual or threatened litigation against KPMG
would disqualify the accounting firm from acting as MCI's independent
auditor under the federal rules. Deciding not to sue could be equally
troubling, some auditing specialists say, because it creates the
appearance that the board may be placing MCI stakeholders' financial
interests below KPMG's. It also could lead outsiders to wonder whether
MCI is cutting KPMG a break to avoid delaying its emergence from
bankruptcy court, and whether that might subtly encourage KPMG to go
easy on the company's books in future years.
"If in fact there were problems with prior-year
tax returns, you have a responsibility to creditors and shareholders to
go after that money," says Charles Mulford, an accounting professor at
Georgia Institute of Technology in Atlanta. "You don't decide not to sue
just to be nice, if you have a legitimate claim, or just to maintain the
independence of your auditors."
In conducting its audits of MCI, KPMG also
would be required to review a variety of tax-related accounts, including
any contingent state-tax liabilities. "How is an auditor, who has told
you how to avoid state taxes and get to a tax number, still independent
when it comes to saying whether the number is right or not?" says Lynn
Turner, former chief accountant at the Securities and Exchange
Commission. "I see little leeway for a conclusion other than the
auditors are not independent."
Dennis Beresford, the chairman of MCI's audit
committee and a former chairman of the Financial Accounting Standards
Board, says MCI's board concluded, based on advice from outside
attorneys, that the company doesn't have any claims against KPMG.
Therefore, he says, KPMG shouldn't be disqualified as MCI's auditor. He
calls the tax-avoidance strategy "aggressive." But "like a lot of other
tax-planning type issues, it's not an absolutely black-and-white
matter," he says, explaining that "it was considered to be reasonable
and similar to what a lot of other people were doing to reduce their
taxes in legal ways."
Mr. Beresford says he had anticipated that the
decision to keep KPMG as the company's auditor would be controversial.
"We recognized that we're going to be in the spotlight on issues like
this," he says. Ultimately, he says, MCI takes responsibility for
whatever tax filings it made with state authorities over the years and
doesn't hold KPMG responsible.
He also rejected concerns over whether KPMG
would wind up auditing its own work. "Our financial statements will
include appropriate accounting," he says. He adds that MCI officials
have been in discussions with SEC staff members about KPMG's
independence status, but declines to characterize the SEC's views.
According to people familiar with the talks, SEC staff members have
raised concerns about KPMG's independence but haven't taken a position
on the matter.
Mr. Thornburgh's report didn't express a
position on whether KPMG should remain MCI's auditor. Michael Missal, an
attorney who worked on the report at Mr. Thornburgh's law firm,
Kirkpatrick & Lockhart LLP, says: "While we certainly considered the
auditor-independence issue, we did not believe it was part of our
mandate to draw any conclusions on it. That is an issue left for
others."
Among the people who could have a say in the
matter is Richard Breeden, the former SEC chairman who is overseeing
MCI's affairs. Mr. Breeden, who was appointed by a federal district
judge in 2002 to serve as MCI's corporate monitor, couldn't be reached
for comment Tuesday.
Dennis Beresford, the chairman of MCI's audit
committee and a former chairman of the Financial Accounting Standards
Board, says MCI's board concluded, based on advice from outside
attorneys, that the company doesn't have any claims against KPMG.
Therefore, he says, KPMG shouldn't be disqualified as MCI's auditor.
He calls the tax-avoidance strategy "aggressive." But "like a lot of
other tax-planning type issues, it's not an absolutely black-and-white
matter," he says, explaining that "it was considered to be reasonable
and similar to what a lot of other people were doing to reduce their
taxes in legal ways."
Dunbar's comments:
After reading the report filed by the bankruptcy examiner, I question
the label "aggressive." The tax savings resulted from the "transfer" of
intangibles to Mississippi and DC subsidiaries; the subs charged
royalties to the other members of the WorldCom group; the other members
deducted the royalties, minimizing state tax, BUT Mississippi and DC do
not tax royalty income. Thus, a state tax deduction was generated, but
no state taxable income. The primary asset transferred was "management
foresight." KPMG did not mention this intangible in its tax ruling
requests to either Mississippi or DC, burying it in "certain intangible
assets, such as trade names, trade marks and service marks."
The examiner argues that "management foresight"
is not a Sec. 482 intangible asset because it could not be licensed. His
conclusion is supported by Merck & Co, Inc. v. U.S., 24 Cl. Ct. 73
(1991).
Even if it was an intangible asset, there is an
economic substance argument: "the magnitude of the royalties charged was
breathtaking (p. 33)." The total of $20 billion in royalties paid in
1998-2001 exceeded consolidated net income during that period. The
royalties were payments for the other group members' ability to generate
"excess profits" because of "management foresight."
Beresford's argument that this tax-planning
strategy was similar to what other people were doing simply points out
that market for tax shelters was active in the state area, as well as
the federal area. The examiner in a footnote 27 states that the examiner
"does not view these Royalty Programs to be tax shelters in the sense of
being mass marketed to an array of KPMG customers. Rather, the
Examiner's investigation suggest that the Royalty Programs were part of
the overall restructuring services provided by KPMG to WorldCom and
prepresented tailored tax advice provided to WorldCom only in the
context of those restructurings." I find this conclusion to be at odds
with the examiner's discussion of KPMG's reluctance to cooperate and "a
lack of full cooperation by the Company and KPMG. Requests for
interviews were processed slowly and documents were produced in
piecemeal fashion." Although the examiner concluded that he ultimately
interviewed the key persons and that he received sufficient information
to support his conclusions, I question whether he had sufficient
information to determine that KPMG wasn't marketing this strategy to
other clients. Indeed, KPMG apparently called this strategy a "plain
vanilla" strategy to WorldCom, which implies to me that KPMG considered
this off-the-shelf tax advice.
I worry that if we don't call a spade a spade,
the "aggressive" tax sheltering activity will continue at the state
level. Despite record state deficits, the states appear to be unwilling
to enact any laws that could cause a corporation to avoid doing business
in that state. In the "race to the bottom" for corporate revenues, the
states are trying to outdo each other in offering enticements to
corporations. The fact that additional sheltering is going on at the
state level, over and above the federal level, is evident from the fact
that state tax bases are relatively lower than the federal base (Fox and
Luna, NTJ 2002). Fox and Luna ascribe the deterioration to a combination
of explicit state actions and tax avoidance/evasion by buinesses. They
discuss Geoffrey, Inc v. South Carolina Tax Commission (1993), which
involves the same strategy of placing intangibles in a state that
doesn't tax royalty income.
Thus, the
strategy advised by KPMG may well have been plain vanilla, but the fact
remains that management foresight is not an intangible that can generate
royalties. That is where I think KPMG overstepped the bounds of
"aggressive." What arms-length company would have paid royalties to
WorldCom for its management foresight?
Without getting into private matters I would
just observe that one shouldn't accept at face value everything that is
in the newspaper - or everything that is in an Examiner's report.
Denny
University of Georgia
From The Wall Street
Journal Accounting Educators' Review on January 30, 2004
TITLE: New Issues Are Raised Over Independence of Auditor for MCI
REPORTER: Jonathan Weil
DATE: Jan 28, 2004
PAGE: C1
LINK:
http://online.wsj.com/article/0,,SB107524105381313221,00.html
TOPICS: Audit Quality, Auditing, Auditing Services, Auditor Independence,
Tax Evasion, Tax Laws, Taxation
SUMMARY: The financial reporting difficulties at Worldcom Inc. continue
as the independence of KPMG LLP is questioned. Questions focus on auditor
independence.
QUESTIONS:
1.) What is auditor independence? Be sure to include a discussion of
independence-in-fact and independence-in-appearance in your discussion.
2.) Why is auditor independence important? Should all professionals
(e.g. doctors and lawyers) be independent? Support your answer.
3.) Can accounting firms provide tax services to audit clients without
compromising independence? Support your answer.
4.) Does the relationship between KPMG and MCI constitute a violation
of independence-in-fact? Does the relationship between KPMG and MCI
constitute a violation of independence-in-appearance? Support your answers
with authoritative guidance.
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
Note from Bob Jensen
Especially note Amy Dunbar’s excellent analysis (above) followed by a
troubling reply by Chair of MCI’s Audit Committee, Denny
Beresford. I say “troubling,” because all analysts and academics
have to work with are the media reports, interviews with people closest to
the situation, and reports released by MCI and/or government files made
public. Sometimes we have to wait for the full story to unfold in
court transcripts.
I have always been troubled by quick judgments that auditors cannot be
independent when auditing financial reports when other professionals in
the firm have provided consulting and tax services. I don’t think
this is the real problem of independence in most instances. The real
problem lies in the dependence of the audit firm (especially a local
office) on the enormous audit fees from a giant corporation like
Worldcom/MCI. The risk of losing those fees overshadows virtually
every other threat to auditor independence.
Although
I think Amy’s analysis is brilliant in analyzing the corporate race to
the bottom in tax reporting and the assistance large accounting firms
provided in winning the race to the bottom, I don’t think the threat
that KPMG’s controversial tax consulting jeopardized auditor
independence nearly as much as the huge fixed cost KPMG invested in taking
over a complete mess that Andersen left at the giant Worldcom/MCI.
It will take KPMG years to recoup that fixed cost, and I’m certain
KPMG will do everything in its power to not lose the client. On the
other hand, the Worldcom/MCI audit is now the focal point of world
attention, and I’m virtually certain that KPMG is not about to put its
worldwide reputation for integrity in auditing in harms way by performing
a controversial audit of Worldcom/MCI at this juncture. KPMG
has enough problems resulting from prior legal and SEC pending actions to
add this one to the firm’s enormous legal woes at this point in time.
Hi Mac,
I agree with the 15% rule Mac, but much depends upon whether you are
talking about the local office of a large accounting firm versus the
global firm itself. My best example is the local office of Andersen in
Houston. Enron's auditing revenue in that Andersen office was about $25
million. Although $25 million was a very small proportion of Andersen's
global auditing revenue, it was so much in the local office at Houston
that the Houston professionals doing the audit under David Duncan were
transformed into a much older "profession of the world" in fear of losing
that $25 million.
Also there is something different about consulting revenue vis-à-vis
auditing revenue. The local office in charge of an audit may not even know
many of the consultants on the job since many of an accounting firm's
consultants, especially in information systems, come from offices other
than the office in charge of the audit.
Years ago (I refuse to say how many) I was a lowly staff auditor for
E&Y on an audit of Gates Rubber Company in Denver. We stumbled upon a team
of E&Y data processing consultants from E&Y in the Gates' plant. Our
partner in charge of the Gates audit did not even know there were E&Y
consultants from Cleveland who were hired (I think subcontracted by IBM)
to solve an data processing problem that arose.
Bob Jensen
-----Original Message-----
From: MacEwan Wright, Victoria University Sent: Friday, January 30, 2004
5:21 PM
Subject: Re: Case Questions on Independence of Auditor for MCI
Dear Bob,
Given that, on average, consulting fees used to
represent around 50% of fees from a client, the consulting aspect tended
to reinforce the fee dependency. The old ethical rule in Australia that
15% of all fees could come from one client was probably too large. A 15%
drop in revenue would severely cramp the style of a big practice.
Regards,
Mac Wright
KPMG LLP, the Big Four accounting
firm that has been under intense government scrutiny over the sales of
potentially abusive tax shelters, is shaking up its upper management
ranks, including the departure of its No. 2 executive who helped promote
such vehicles.
KPMG, which told partners Monday
about the changes to three senior positions, is hoping the moves will
expedite settlement discussions with the Internal Revenue Service. The
agency has been examining whether KPMG is liable for penalties as a
promoter of questionable tax shelters. While two of KPMG's rivals --
PricewaterhouseCoopers LLP and
Ernst & Young LLP -- reached settlements months ago in connection
with sales of suspect tax shelters in the late 1990s, KPMG has continued
to wrangle with regulators in federal court in Washington.
The smallest of the Big Four
accounting firms, KPMG had revenue of $3.4 billion for the fiscal year
ended Sept. 30, 2002, of which tax-services revenue contributed $1.2
billion. KPMG's big-name audit clients include Citigroup Inc., General
Electric Co. and Microsoft Corp.
KPMG LLP named two new top tax
partners, continuing recent efforts to show it is overhauling its tax
practice.
The smallest of the Big Four
firms, KPMG has been under intense government scrutiny for its tax work.
The Internal Revenue Service has been examining whether KPMG is liable
for penalties as a promoter of questionable tax shelters. The Senate's
Permanent Subcommittee on Investigations also is probing the firm's mass
marketing of certain tax shelters.
KPMG, which earlier this month
announced it was making several leadership changes, said Wednesday that
James Brasher, 50 years old, is to take over as head of tax services.
John Chopack, 56, will become vice chair of tax services. Both
appointments are effective Feb. 1. (See
related article.)
"This is a first step in
addressing the management changes we announced on Jan. 12," said KPMG
Chairman Eugene O'Kelly. "Jim Brasher and John Chopack bring
unquestioned integrity, business acumen, technical proficiency and
proven operating experience." KPMG also has said it has closed down
certain tax-practice groups, installed more rigorous oversight and
discontinued sales of certain strategies.
KPMG has yet to announce a
successor for its No. 2 executive, Jeffrey Stein, 49, who will step down
at the end of this month. At the recent Senate hearings, e-mail messages
surfaced tying Mr. Stein, a former tax chief at the firm, to the
promotion of tax shelters. KPMG has said a successor to Mr. Stein will
be elected by the board and ratified by a vote of the partnership next
month.
Messrs. Brasher and Chopack
succeed Richard Smith and William Hibbitt, respectively. The firm said
that Mr. Smith is "taking on new responsibilities" in the firm's global
tax operations, and that Mr. Hibbitt "will return to a client service
role."
Mr. Brasher, who became a partner
in 1985, is based in Chicago and is the managing partner in charge of
tax services for the Midwest region. Mr. Chopack, a partner since 1981,
oversees tax-related risk matters for the firm and is based in
Philadelphia.
The Justice Department accused
KPMG LLP of improperly withholding documents from the Internal Revenue
Service to hide tax-sheltering activity, signaling the government's
increasing frustration with what it considers delaying tactics by the
large accounting firm.
KPMG's actions "demonstrate a
concerted pattern of obstruction and non-compliance, threatening the
integrity of the IRS examination process," the Justice Department said
in documents filed Monday in federal court in Washington, D.C., on
behalf of the IRS. The filings stem from a civil investigation by the
IRS into whether KPMG is liable for penalties as a promoter of
potentially abusive tax shelters.
The Justice Department's comments
in the latest court filings come as a further embarrassment for the
accounting firm, one of the largest in the country, in its tax-shelter
dealings. A continuing congressional inquiry has focused on KPMG's mass
marketing of tax strategies, and the firm faces numerous suits filed by
individuals who have alleged bad tax advice in the face of IRS audits.
On that front, KPMG recently
agreed to settle one of the first cases from the wave of suits filed
against the firm alleging improper tax advice, according to people
familiar with the matter. One of these people said KPMG had agreed to
pay just under $10 million to three brothers in Texas who had paid $4.5
million to participate in a KPMG-sponsored transaction that came under
IRS review.
KPMG declined to comment on
whether a settlement has been struck in the case, filed in December 2002
in federal court in the Southern District of Texas. In a statement, the
firm said, "The court ordered the abatement of the trial date for the
case."
It is unclear how such a
resolution would affect the dozen or so other lawsuits alleging fraud
and malpractice, among other things, that KPMG is fighting. The suits
have been filed by wealthy clients mostly in Southeastern states.
Edmundo Ramirez, a lawyer for the Texas brothers, declined to comment on
behalf of his clients.
The IRS via the Justice
Department in July 2002 asked the federal court to enforce at least 25
summonses, the rough equivalent of a subpoena, seeking KPMG records as
part of an investigation into potentially abusive tax shelters. Monday's
filings contain a more-confrontational tone by the Justice Department,
which until now had mostly focused on legal definitions of what
privileges KPMG is entitled to in seeking to not turn over certain
documents.
Senate Panel's Report Says Firm Disregarded
Concerns From Partners on Capital Gains
KPMG LLP disregarded concerns of
some of its own technical tax experts about a product to minimize
capital-gains taxes that the large accounting firm sold to at least 186
wealthy individuals in 1999 and 2000, according to a report released
Tuesday by a Senate panel.
The transaction, known as BLIPS,
generated $50 million in fees and produced more than $1 billion of
questionable tax benefits, according to the report.
The hearings by the Senate's
Permanent Subcommittee on Investigations, and its accompanying 129-page
report, are the results of a yearlong review into the role of KPMG and
other professionals into the mass marketing of potentially abusive tax
shelters. A second day of hearings, planned for Wednesday, will explore
the role of lawyers, bankers and other advisers.
During the development of BLIPS,
the tax partners repeatedly expressed concerns about the legitimacy of
the strategy that the firm ultimately went ahead and sold, according to
internal KPMG e-mails obtained by the panel.
The report names at least two of
the partners who raised concerns internally. One of them, Mark Watson,
who has left the firm, appeared Tuesday before the Senate panel under
subpoena. Responding to a panel question Tuesday about whether the
issues he had concerns about were ever resolved, Mr. Watson said: "Not
to my satisfaction." He added: "I was disappointed with the decision" to
go ahead and market BLIPS, but "a lot of smart partners with a lot of
experience" approved it, and "there was really nothing left for me to
say."
Continued in the article.
Without admitting fault, KPMG
LLP settled a suit connected to the collapse of General American Life
Insurance Co., formerly Missouri's largest insurance company. In a
settlement approved last week, KPMG will pay $18 million to a General
American liquidation fund. AccountingWeb, September 29, 2004 --- http://www.accountingweb.com/item/99836
The
examiner's report cited evidence that KPMG aided and abetted fiduciary
breaches by Mr. Fastow and other Enron officers. KPMG "provided
substantial assistance" to Mr. Fastow by issuing unqualified audit-opinion
letters on the so-called LJM partnerships that he led. Enron's dealings
with those partnerships played a central role in the eventual collapse of
the company.
In the latest wave of allegations
of wrongdoing by major financial and accounting firms in their dealings
with Enron Corp., a federal bankruptcy examiner criticized
Bank of America Corp.,
Royal Bank of Canada,
KPMG LLP and PricewaterhouseCoopers LLP.
The report by examiner Harrison
Goldin also disclosed an internal e-mail written by a Royal Bank of
Canada official in September 2000 that indicates there were suspicions
that Enron was misstating its assets and hiding debt. This memo was
written more than a year before questions began surfacing publicly about
the accuracy of Enron's financial statements. Those questions helped
push the Houston-based energy trader to file for bankruptcy-law
protection in December 2001.
The report by Mr. Goldin was the
latest in a series that have emanated from the Enron bankruptcy
proceedings. Four prior ones were issued by bankruptcy examiner Neal
Batson, who had the principal responsibility to review activities
regarding Enron's financial and accounting activities. Mr. Batson's
previous reports had been very critical of a number of major financial
institutions as well as former top Enron officials and some of the
company's auditors and lawyers.
In his report, Mr. Goldin looked
at 10 transactions involving the Bank of America and Enron. In nine of
the transactions, the examiner didn't find cause to criticize the
company. In the 10th, involving a natural-gas deal, there was enough
evidence to conclude that the bank was involved in "aiding and abetting
certain Enron officers in breaching their fiduciary duties."
A Bank of America spokeswoman
couldn't be reached to comment.
In the case of Royal Bank of
Canada, Mr. Goldin found some alleged misdeeds among the roughly 15
transactions he examined. In some cases, there was evidence that Royal
Bank of Canada "had actual knowledge of wrongful conduct" by Enron
officers, the report said. The examiner's report quoted the September
2000 internal e-mail as saying that information received by the bank
suggested that Enron's asset base "is spurious and that there are other
obligations hidden" in various company-related entities.
A Bank of Canada spokeswoman said
the bank feels it "did absolutely nothing wrong" in its dealings with
Enron. She said that the examiner's report took the September 2000
e-mail as a "quote out of context" that "mischaracterizes the reality"
of the situation.
On Enron accounting issues, much
criticism has focused on the company's longtime outside auditor, Arthur
Andersen LLP. Thursday's report marks the most substantive condemnation
yet of the Enron-related work by PricewaterhouseCoopers and KPMG.
"PwC committed professional
malpractice and was grossly negligent in preparing and providing" two
fairness opinions to Enron's board of directors in 1999 and 2000, the
examiner said. The opinion letters covered transactions between Enron
and various partnerships controlled by its former chief financial
officer, Andrew Fastow.
A PricewaterhouseCoopers
spokesman said that "the examiner's criticisms of PwC have no merit. We
were only engaged to perform valuation work based on unaudited
assumptions provided by Enron management."
The examiner's report cited
evidence that KPMG aided and abetted fiduciary breaches by Mr. Fastow
and other Enron officers. KPMG "provided substantial assistance" to Mr.
Fastow by issuing unqualified audit-opinion letters on the so-called LJM
partnerships that he led. Enron's dealings with those partnerships
played a central role in the eventual collapse of the company.
A KPMG spokesman, in a written
statement, said the examiner's "assertion that KPMG aided and abetted
Mr. Fastow in his breach of duty to Enron is utterly baseless and
irresponsible."
It just gets deeper and deeper for KPMG, the
auditing firm that approved some the Fannie Mae's earnings smoothing with
questionable allowance of hedge accounting for speculations under FAS 133
rules. Fannie's outside auditor, KPMG, certified its results knowing
OFHEO's concerns.
OFHEO alleges that
Fannie didn't qualify for this break (hedge accounting) because it didn't
test whether the derivatives were eligible for such treatment. Now,
OFHEO says Fannie may not use this method (hedge accounting) at all.
Fannie could suffer a $12 billion hit from losses in derivatives, offset
by $5 billion in gains, if OFHEO prevails. But the ijmpact could be
greatly diminished if the SEC rules that Fannie can continue to account
for derivatives this way if it follows the rules more closely.
Paula Dwyer, "Fannie Mae: What's the Damage?" Business
Week, October 11, 2004, Page 36 ---
http://snipurl.com/Oct11Fannie
Bob Jensen's threads on the Fannie Mae and
Freddie Mac scandals are at http://www.trinity.edu/rjensen/caseans/000index.htm
Note that the 2004 scandal is the second time FAS 133 has tripped up
Fannie Mae's auditors.
It just gets deeper and deeper and even deeper
for KPMG.
KPMG LLP, the fourth-largest U.S. accounting
firm, and its former consulting unit, BearingPoint Inc., agreed to a
pair of settlements with a total value of $34 million to resolve their
portions of a class-action lawsuit that accused them of fraudulently
overbilling clients for travel-related expenses.
The preliminary agreements, under which KPMG
and BearingPoint each agreed to settlements valued at $17 million, mark
the latest development in the travel-billings litigation ongoing in a
Texarkana, Ark., state court. Under the terms of Friday's agreements,
BearingPoint and KPMG denied wrongdoing.
In December, PricewaterhouseCoopers LLP agreed
to a $54.5 million settlement in the case, though it denied wrongdoing.
The lawsuit is continuing against the remaining two defendants, Ernst &
Young LLP and the U.S. arm of Cap Gemini Ernst & Young, a French
consulting concern that bought Ernst & Young's consulting business in
2000. A separate civil investigation by the Justice Department into the
accounting and consulting firms' billing practices as government
contractors is continuing.
A third of the combined $34 million settlement,
which was approved Friday by Miller County Circuit Judge Kirk Johnson,
will go to the plaintiffs' attorneys. Class members would have the
option of accepting certificates entitling them to credits toward for
future services. Or they could opt to receive 60% of the certificates'
face value in cash. The certificates' size would vary from client to
client.
Revelations from the Texarkana lawsuit have
shined a light on how some professional-services firms in recent years
have turned reimbursable out-of-pocket expenses, such as bills for
airline tickets and hotel rooms, into profit centers by using their size
during negotiations with travel companies to secure significant rebates
of upfront costs. Unlike discounts that reduce the published fare on,
say, a plane ticket, rebates are paid after travel is completed, usually
in lump-sum checks. When firms retain rebates on client-travel without
disclosing the practice to clients, they run the risk of exposing
themselves to significant legal liability, as Friday's settlements show.
KPMG and the other defendants have acknowledged
retaining undisclosed rebates and commissions from travel companies on
client-related travel. But they deny acting fraudulently, saying they
used the proceeds to offset costs they otherwise would have billed to
clients.
KPMG had continued to administer BearingPoint's
program for client-related travel following BearingPoint's separation
from KPMG in 2000. KPMG said it stopped accepting so-called "back-end"
rebates from travel companies in 2002, shortly after the Texarkana
lawsuit was filed in October 2001.
A BearingPoint spokesman said the company was
"pleased that an agreement has been reached that is beneficial to all
involved, recognizing that it's a liability we inherited for a program
we didn't create." He said the company previously had established
reserves on its balance sheet in anticipation of a settlement and
anticipates "no impact on current or future earnings."
A KPMG spokesman said: "KPMG considers this
settlement a fair and reasonable solution to the litigation. While we
firmly believe that the KPMG travel program operated to our clients'
substantial benefit and that we would prevail at trial, this settlement
will end what promised to be a long and costly litigation."
Whether clients benefited or not, internal KPMG
records on file at the Texarkana courthouse suggest that KPMG operated
its travel division as a profit center and regarded its proceeds from
travel rebates as earnings for the firm.
One of those documents was a 1999 memo by the
firm's travel unit that said the travel unit "will return $17 million to
the firm. As large a profit as any of the firm's most important
clients." Another KPMG document contained a spreadsheet called "earnings
from travel" that showed $19.1 million in such earnings for fiscal 2001
and $17.4 million in such earnings for fiscal 2000.
The plaintiffs leading the Texarkana lawsuit
are Warmack-Muskogee LP, a former PricewaterhouseCoopers client that
operates an Oklahoma shopping mall, and Airis Newark LLC, a former KPMG
client based in Atlanta that builds airport facilities.
"We are extremely pleased with the results that
we were able to obtain for these clients," said Rick Adams, an attorney
for the plaintiffs at the Texarkana, Texas, law firm Patton, Haltom,
Roberts, McWilliams & Greer LLP. "We intend to continue the lawsuit
against Ernst & Young and Cap Gemini."
Continued in article
Pfizer's independent auditors are from the KPMG firm.
Pfizer, the world's largest pharmaceutical
company, pleaded guilty yesterday and agreed to pay $430 million to
resolve criminal and civil charges that it paid doctors to prescribe its
epilepsy drug, Neurontin, to patients with ailments that the drug was not
federally approved to treat.
Of that settlement, $26.64 million will go to a
former company adviser who brought a lawsuit under a federal
"whistleblower" law.
The company encouraged doctors to use Neurontin
in patients with bipolar disorder, a psychological condition, even though
a study had shown that the medicine was no better than a placebo in
treating the disorder. Other disorders for which the company illegally
promoted Neurontin included Lou Gehrig's disease, attention deficit
disorder, restless leg syndrome and drug and alcohol withdrawal seizures.
Although doctors are free to prescribe any
federally approved drug for whatever use they choose, pharmaceutical
companies are not allowed to promote drugs for nonapproved purposes.
Neurontin was initially approved to treat epileptic seizures in patients
who had failed to improve using other treatments, but it has become one of
the biggest-selling drugs in the world, with sales last year of $2.7
billion. Nearly 90 percent of the drug's sales continue to be for ailments
for which the drug is not an approved treatment, according to recent
surveys.
"This illegal and fraudulent promotion
scheme corrupted the information process relied upon by doctors in their
medical decision-making, thereby putting patients at risk," said the
United States attorney in Boston, Michael Sullivan, in a statement
yesterday.
Pfizer, in a statement yesterday, said that the
illegal marketing had been conducted by Warner-Lambert before Pfizer
acquired that company in 2000.
"Pfizer has cooperated fully with the
government to resolve this matter, which did not involve Pfizer practices
or employees," the company said.
Pfizer took a $427 million charge in January
against its fourth-quarter 2003 earnings to pay for the expected
settlement. The government calculated that the company's illegal
promotions brought it $150 million in ill-gotten gains. A standard
multiplier was used to come up with the $430 million fine.
The case is one of many undertaken in recent
years by federal prosecutors in Boston and Philadelphia who are examining
efforts by drug companies to market their drugs for unapproved uses and
pay doctors for prescriptions. And while the pharmaceutical industry
recently adopted voluntary guidelines that have eliminated many of the
gifts and payments once routinely dispensed to doctors, the industry's
aggressive promotions continue.
The SEC is not yet done with Apple: Where were the KPMG
auditors?
"Apple's Former CFO Settles Options Case: Finance
Official Ties CEO Jobs To Stock Backdating Plan," by Carrie Johnson, The
Washington Post, April 25, 2007; Page D01 ---
Click Here
A former chief financial officer of Apple reached a
settlement with the Securities and Exchange Commission yesterday over the
backdating of stock options and said company founder Steve Jobs had
reassured him that the questionable options had been approved by the company
board.
Fred D. Anderson, who left Apple last year after a
board investigation implicated him in improper backdating, agreed yesterday
to pay $3.5 million to settle civil charges.
Chief executive Steve Jobs has not been charged in
the probe. (Alastair Grant - AP)
Complaint: S.E.C. v. Heinen, Anderson
Separately, SEC enforcers charged Nancy R. Heinen,
former general counsel for Apple, with violating anti-fraud laws and
misleading auditors at KPMG
by signing phony minutes for a board meeting that government lawyers say
never occurred.
Heinen, through her lawyer, Miles F. Ehrlich, vowed
to fight the charges. Ehrlich said Heinen's actions were authorized by the
board, "consistent with the interests of the shareholders and consistent
with the rules as she understood them."
Anderson issued an unusual statement defending his
reputation and tying Jobs to the scandal in the strongest terms to date. He
said he warned Jobs in late January 2001 that tinkering with the dates on
which six top officials were awarded 4.8 million stock options could have
accounting and legal disclosure implications. Jobs, Anderson said, told him
not to worry because the board of directors had approved the maneuver.
Regulators said the action allowed Apple to avoid $19 million in expenses.
Late last year, Apple said that Jobs helped pick some favorable dates but
that he "did not appreciate the accounting implications."
Explaining Anderson's motive for issuing the
statement, his lawyer Jerome Roth said: "We thought it was important that
the world understand what we believe occurred here."
Roth said his client, a prominent Silicon Valley
figure and a managing director at the venture capital firm Elevation
Partners, will not be barred from serving as a public-company officer or
board member under the settlement, in which Anderson did not admit
wrongdoing. Roth declined to characterize the current relationship between
Anderson and Jobs.
The SEC charges are the first in the months-long
Apple investigation. Jobs was interviewed by the SEC and federal prosecutors
in San Francisco, but no charges have been filed against him.
Steve Dowling, a spokesman for Apple, declined to
comment on Jobs's conversations with Anderson. Dowling emphasized that the
SEC did not "file any action against Apple or any of its current employees."
Government authorities praised Apple for coming
forward with the backdating problems last year and for sharing information
with investigators. Apple has not publicly released its investigation
report.
Continued in article
"SEC charges former Apple executive in options case:
The SEC accuses Apple's former general counsel of fraudulently backdating stock
options," by Ben Ames, The Washington Post, April 24, 2007 ---
Click Here
The SEC said it did not plan to
pursue any further action against Apple itself, which cooperated with
the government's probe, but it stopped short of saying its investigation
was closed. Commission officials declined to comment on whether possible
charges could still be filed against Jobs or other current officers.
"Options troubles at Apple remain despite SEC case against 2 former
officers," Associated Press, MIT's Technology Review, April
25, 2007 ---
http://www.technologyreview.com/Wire/18587/
That question, frequently heard
during financial scandals earlier this decade, is being asked
again as an increasing number of companies are being probed
about the practice of backdating employee stock options, which
in some cases allowed executives to profit by retroactively
locking in low purchase prices for stock.
For the accounting industry, the
question raises the possibility that the big audit firms didn't
live up to their watchdog role, and presents the Public Company
Accounting Oversight Board, the regulator created in response to
the past scandals, its first big test.
"Whenever the audit firms get caught
in a situation like this, their response is, 'It wasn't in the
scope of our work to find out that these things are going on,' "
said Damon Silvers, associate general counsel at the AFL-CIO and
a member of PCAOB's advisory group.
"But that logic leads an investor to say, 'What are we hiring
them for?' "
. . .
While the Securities and Exchange
Commission has contacted the Big Four accounting firms about
backdating at some companies, the inquiries have been of a
fact-finding nature and are related to specific clients rather
than firmwide auditing practices, according to people familiar
with the matter. Class-action lawsuits filed against companies
and directors involved in the scandal haven't yet targeted
auditors.
Backdating of options appears to have
largely stopped after the passage of the Sarbanes-Oxley
corporate-reform law in 2002, which requires companies to
disclose stock-option grants within two days of their
occurrence.
Backdating practices from earlier
years took a variety of forms and raised different potential
issues for auditors. At UnitedHealth Group Inc., for example,
executives repeatedly received grants at low points ahead of
sharp run-ups in the company's stock. The insurer has said it
may need to restate three years of financial results. Other
companies, such as Microsoft Corp., used a monthly low share
price as an exercise price for options and as a result may have
failed to properly book an expense for them.
At the PCAOB advisory group meeting,
Scott Taub, acting chief accountant at the Securities and
Exchange Commission, said there is a "danger that we end up
lumping together various issues that relate to a grant date of
stock options." Backdating options so an executive can get a
bigger paycheck is "an intentional lie," he said. In other
instances where there might be, for example, a difference of a
day or two in the date when a board approved a grant, there
might not have been an intent to backdate, he added.
"The thing I think that is more
problematic is there have been some allegations that auditors
knew about this and counseled their clients to do it," said
Joseph Carcello, director of research for the
corporate-governance center at the University of Tennessee. "If
that turns out to be true, they will have problems."
A
court-appointed examiner's review of the collapse of Spiegel Inc.
criticizes the catalog retailer's independent auditor, KPMG LLP, for
standing by as its client failed to disclose its worsening financial
condition, according to people familiar with the matter.
The examiner's
214-page report, which is expected to be released publicly as early as
Friday, is likely to fuel the debate that has raged since Enron Corp.
about whether the Big Four auditing firms are tough enough with all of
their clients. KPMG said in a statement Thursday it is "confident that
it acted appropriately at all times and stands behind its actions in the
Spiegel matter." But the role of KPMG, already fighting criticism from
the Securities and Exchange Commission about its alleged passivity at
Xerox Corp., will bring unwanted attention to the fourth-largest
auditing firm in the U.S.
Spiegel of
Downers Grove, Ill., filed for Chapter 11 bankruptcy-court protection in
March. (See article)
The
court-appointed examiner's report stems from Spiegel's failure to file
with the SEC a detailed independent audit of its 2001 books, a so-called
10-K filing or annual report, until the beginning of this year. In a
civil-fraud case partially resolved by Spiegel in March with the SEC,
the regulators alleged that Spiegel violated securities laws by
withholding material information from the public, information that
should have been in the report.
AccountingWEB
US - May-27-2003 - Big Four firm KPMG is being sued by a Lansing,
Michigan branch of United Way after the discovery of a $1.9 million
embezzlement by the branch's former finance chief. "The United Way hired
experts to protect itself," said United Way lawyer, Powell Miller. "We
think if they had done their job properly, this wouldn't have happened."
Employees of
Capital Area United Way discovered the embezzlement, which is estimated
to have occurred over a period of at least seven years. Former vice
president for finance, Jacquelyn Allen-MacGregor, worked for the United
Way for 20 years, during which time she wrote more than 300 checks to
herself on the United Way account, forging the required signatures of
co-signers, then destroying the cancelled checks. The checks were not
posted to the United Way books but instead were recorded as pledges
never received.
In February of
this year, Ms. Allen-MacGregor pleaded guilty to the embezzlement,
saying she used the stolen funds to purchase horses for her business,
Celebration Quarter Horses. This spring the United Way has been able to
recover nearly half of the stolen money by cashing three theft insurance
policies and by selling some of Ms. Allen-MacGregor's assets.
The agency
hopes to recover additional funds from its two accounting firms, KPMG,
which acquired the Lansing area branch of CPA firm Main Hurdman, former
auditor for the Capital Area United Way, and Maner, Costerisan & Ellis.
The United Way is pursuing arbitration with Maner, Costerisan & Ellis
but may pursue action in court at a later date.
The lawsuit
against KPMG claims the audit firms KPMG and Main Hurdman were negligent
and that they should have detected the embezzlement. Main Hurdman
audited the Capital Area United Way from 1985 through 1998. Maner,
Costerisan & Ellis performed the 1999 through 2002 audits.
"We think
if they had done their job properly, this wouldn't have happened," said
Mr. Miller.
KPMG Censored
by SEC: Joins Andersen on the Hot Seat, Albeit a Somewhat Smaller Hot
Plate
The Commission
today censured KPMG LLP, a big-five accounting firm based in New York
City, for engaging in improper professional conduct because it purported
to serve as an independent accounting firm for an audit client at the
same time that it had made substantial financial investments in the
client. The SEC found that KPMG violated the auditor independence rules
by engaging in such conduct. KPMG consented to the SEC's order without
admitting or denying the SEC's findings.
"The SEC's
decision to censure KPMG reflects the seriousness with which the SEC
treats violations of the auditor independence rules, even in the absence
of demonstrated investor harm or deliberate misconduct," said Stephen M.
Cutler, the SEC's Director of Enforcement
In addition to
censuring the firm, the SEC ordered KPMG to undertake certain remedies
designed to prevent and detect future independence violations caused by
financial relationships with, and investments in, the firm's audit
clients.
"This case
illustrates the dangers that flow from a failure to implement adequate
policies and procedures designed to detect and prevent auditor
independence violations," said Paul R. Berger, Associate Director of
Enforcement.
The SEC found
that, from May through December 2000, KPMG held a substantial investment
in the Short-Term Investments Trust (STIT), a money market fund within
the AIM family of funds. According to the SEC's order, KPMG opened the
money market account with an initial deposit of $25 million on May 5,
2000, and at one point the account balance constituted approximately 15%
of the fund's net assets. In the order, the SEC found that KPMG audited
the financial statements of STIT at a time when the firm's independence
was impaired, and that STIT included KPMG's audit report in 16 separate
filings it made with the SEC on November 9, 2000. The SEC further found
that KPMG repeatedly confirmed its putative independence from the AIM
funds it audited, including STIT, during the period in which KPMG was
invested in STIT.
Rule 102(e) of
the SEC's Rules of Practice provided the basis for the SEC's finding in
its administrative order that KPMG engaged in improper professional
practice. According to the SEC, KPMG's independence violation occurred
primarily because the firm lacked adequate policies or procedures to
prevent or detect such violations, and because the steps which KPMG
personnel usually took before initiating investments of the firm's
surplus cash were not taken in this instance.
The SEC also
found that KPMG:
* had no
procedures directing its treasury department personnel to check the
firm's "restricted entity list" to confirm that a proposed investment
was not restricted;
* had no
specific policies or procedures requiring any participation by a KPMG
partner in the investigation and selection of money market investments;
and
* had no
policies or procedures designed to put KPMG audit professionals on
notice of where the firm's cash was invested, or requiring them to check
a listing of the firm's investments, prior to accepting new audit
engagements or confirming the firm's independence from audit clients.
As a result,
the SEC found that there was no system KPMG audit engagement partners
could have used to confirm the firm's independence from its audit
clients.
The SEC
concluded that KPMG's lack of adequate policies and procedures
constituted an extreme departure from the standards of ordinary care,
and resulted in violation of the auditor independence requirements
imposed by the SEC's rules and by Generally Accepted Auditing Standards.
(Rels. 34-45272; IC-25360; AAE Rel. 1491; File No. 3-10676; Press Rel.
2002-4)
KPMG and the auditors agreed to settle the
action without admitting or denying the SEC's findings. As part of the
settlement, KPMG was censured and agreed to pay $10 million to harmed
Gemstar shareholders. This represents the largest payment ever made by an
accounting firm in an SEC action. The auditors, all of whom are certified
public accountants, agreed to suspensions from practicing before the SEC.
SEC as quoted at http://accountingeducation.com/news/news5560.html
KPMG LLP announced that it will sell its
Dispute Advisory Services unit to FTI Consulting Inc. for about $89.1
million. The firm said it will channel resources to build its forensic
practice.
"This proposed transaction will help KPMG meet
marketplace needs in the new regulatory climate by expanding the
services that offer the greatest growth opportunity for a large
accounting firm's Forensic practice -- our Investigative and Integrity
Advisory Services (IIAS), and Forensic Technology Services (FTS) units,"
said Richard Girgenti, national partner in charge of KPMG's Forensic
practice. "Among our priorities is further integrating our Forensic
capabilities in the audit practice."
Girgenti explained that the marketplace has
changed, with the Sarbanes-Oxley Act prohibiting accounting firms from
performing expert-witness work for their audit clients in the United
States, and that many corporate decision-makers are hiring expert
witness services from other sources to avoid any appearance of conflict.
KPMG is under no obligation to separate the DAS
practice, but decided to take that step to "[reflect its] deliberate
decision to lead reform," said Girgenti. He noted that the proposed
transaction does not affect the DAS practices of KPMG member firms in
other countries, where, because of differing regulations, the individual
member firms will continue to serve their clients.
The transaction will include approximately 26
KPMG partners, 125 other billable professionals, plus support staff, who
will join FTI. The transaction does not affect any other KPMG
operations. More than 300 professionals remain in KPMG's Investigative
and Integrity Advisory Services, and Forensic Technology Services units.
The sale transaction is expected to close
during the fourth quarter of 2003.
Beijing, Feb 13, 2003 — KPMG will be the
first international accounting firm to be taken to court in China after
a Chinese investor filed a lawsuit against Jinzhou Port Co Ltd., its
auditor KPMG, and its underwriter GF Securities.
The Shenyang Intermediate People's Court
accepted the case last Sunday.
The case means Chinese investors are gradually
learning to protect their interests via laws and also signals an
'international' case as it involves the B-share markets, industry
experts said.
"There have been no lawsuits against the big
four international accounting companies in China, although some have
been under scrutiny elsewhere after a slew of corporate scandals in the
US involving the big four," a CPA at a Beijing-based accounting company
told XFN.
"But I don't think the investor will win the
case as there are too many of these kinds of cases," the CPA said,
adding if the investor wins, many other investors will sue listed firms
and related companies.
The spokespersons in both KPMG's Beijing and
Hong Kong subsidiaries, which were sued by the investor, were not
available at the moment for comment.
"I think the result of the case is uncertain
but the action is very significant to the legal system and the stock
market development in China," Huang Weimin, a partner of Grandall Legal
Group, told XFN.
Huang said investors should not lose their
confidence in China's legal system, and although there have been
scandals in China's securities markets in the past, many regulations and
laws are improving.
Jinzhou Port was fined 100,000 yuan by the
finance ministry last September for the fraudulent booking of a combined
367.17 million yuan in income between 1996 and 2000.
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
notices.
From The Wall Street Journal Accounting Educators' Review on August 29,
2003
TITLE: KPMG Defends Its Audit Work For Polaroid
REPORTER: James Bandler
DATE: Aug 25, 2003
PAGE: B4
LINK:
http://online.wsj.com/article/0,,SB106176347668457900,00.html
TOPICS: Audit Quality, Audit Report, Auditing, Bankruptcy, Creative
Accounting, Fraudulent Financial Reporting, Accounting
SUMMARY: A court appointed examiner filed a report in U.S. Bankruptcy
Court in Delaware that suggests that KPMG LLP allowed Polaroid Corp. to
use questionable accounting practices to hide financial distress. KPMG LLP
claims that the report is biased and unfounded.
QUESTIONS:
1.) What is the role of the auditor in the historical financial statement
audit? Is the auditor required to provide absolute assurance that the
financial statements are free from material misstatements?
2.) Distinguish between audit risk, business risk, and audit failure.
When should the auditor be held liable to financial statement users? Does
it appear that the situation with Polaroid Corp. is the result of audit
risk, business risk, or audit failure? Support your answer.
3.) Assume that KPMG LLP followed Generally Accepted Auditing Standards
in the audit of Polaroid Inc. Should KPMG LLP be required to defend the
quality of the audit to financial statement users? Do allegations of
substandard audit work result in a loss of reputation and significant cost
to KPMG LLP? How can auditors reduce the possibility of loss of reputation
and the costs of defending audit quality?
4.) What types of audit reports do auditors issue? What is the
difference between a "going concern" note and a qualified opinion? When
should an audit report contain a qualified opinion? When should an audit
report contain a "going concern" note? Does it appear that KPMG LLP issued
the correct audit opinion for Polaroid? Support your answer.
5.) What is materiality? Explain the relation between materiality and
debt covenants.
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
The Right Hand
On January 23, 2003 I opened my mail and found the excellent Year 2002
Annual Report of the KPMG Foundation outlining the many truly wonderful
things KPMG is doing for minority students, education, and accounting
research ---
http://kpmgfoundation.org/faculty.html
The Left Hand
On January 23, 2003 I linked to the electronic version of The
Wall Street Journal
SEC Set to File Civil Action Against KPMG Over
Xerox The Securities and Exchange Commission is set to file civil-fraud
charges against KPMG LLP as early as next week for its role auditing
Xerox Corp., which last year settled SEC accusations of accounting
fraud, people close to the situation said. The expected action by the
SEC would represent the second time in recent years that the SEC has
charged a major accounting firm with fraud. It comes at a crucial
juncture for the accounting industry, which is attempting to rebuild its
credibility and make changes following more than a year of accounting
scandals at major corporations. It also indicates that, while the
political furor over corporate fraud has died down, the fallout may
linger for some time.
The Wall Street Journal, January 23, 2003 ---
http://online.wsj.com/article/0,,SB1043272871733131344,00.html?mod=technology_main_whats_news
Also see
http://www.nytimes.com/2003/01/23/business/23KPMG.html
If the S.E.C. files a complaint, KPMG would
become only the second major accounting firm to face such charges in
recent decades. The first was Arthur Andersen, which settled fraud
charges in connection with its audit of
Waste Management in 2001, the year before it was driven out of
business as a result of the
Enron scandal.
The S.E.C. settled a complaint against Xerox
in April, when the company said it would pay a $10 million fine and
restate its financial results as far back as 1997. The company later
reported that the total amount of the restatement was $6.4 billion,
with the effect of lowering revenues and profits in 1997, 1998 and
1999 but raising them in 2000 and 2001.
KPMG settles Xerox case for $22.475 million in a rare "fraud" action The Securities and Exchange Commission has announced
that KPMG LLP has agreed to settle the SEC's charges against it in connection
with the audits of Xerox Corp. from 1997 through 2000. As part of the
settlement, KPMG consented to the entry of a final judgment in the SEC's civil
litigation against it pending in the U.S. District Court for the Southern
District of New York. The final judgment, which is subject to approval by the
Honorable Denise L. Cote, orders KPMG to pay disgorgement of $9,800,000
(representing its audit fees for the 1997-2000 Xerox audits), prejudgment
interest thereon in the amount of $2,675,000, and a $10,000,000 civil penalty,
for a total payment of $22.475 million. The final judgment also orders KPMG to
undertake a series of reforms designed to prevent future violations of the
securities laws.
Andrew Priest, "KPMG PAYS $22 MILLION TO SETTLE SEC LITIGATION RELATING TO XEROX
AUDITS," AccountingEducation.com, April 21, 2005 ---
http://accountingeducation.com/news/news6095.html
Jensen Comment: The SEC has filed many civil lawsuits against auditing
firms. However, it is rare to actually accuse a CPA firm of outright
fraud. I keep a scrapbook of the legal problems of CPA firms, including
KPMG at
http://www.trinity.edu/rjensen/fraud001.htm#KPMG
On January 23, 2003 I pasted in
the following from the The Wall Street
Journal
SEC Set to File
Civil Action Against KPMG Over Xerox The
Securities and Exchange Commission is set to
file civil-fraud charges against KPMG LLP as
early as next week for its role auditing
Xerox Corp., which last year settled SEC
accusations of accounting fraud, people
close to the situation said. The expected
action by the SEC would represent the second
time in recent years that the SEC has
charged a major accounting firm with fraud.
It comes at a crucial juncture for the
accounting industry, which is attempting to
rebuild its credibility and make changes
following more than a year of accounting
scandals at major corporations. It also
indicates that, while the political furor
over corporate fraud has died down, the
fallout may linger for some time.
The Wall Street Journal, January 23,
2003 ---
http://online.wsj.com/article/0,,SB1043272871733131344,00.html?mod=technology_main_whats_news
Also see
http://www.nytimes.com/2003/01/23/business/23KPMG.html
If the S.E.C.
files a complaint, KPMG would become
only the second major accounting firm to
face such charges in recent decades. The
first was Arthur Andersen, which settled
fraud charges in connection with its
audit of
Waste Management in 2001, the year
before it was driven out of business as
a result of the
Enron scandal.
The S.E.C.
settled a complaint against Xerox in
April, when the company said it would
pay a $10 million fine and restate its
financial results as far back as 1997.
The company later reported that the
total amount of the restatement was $6.4
billion, with the effect of lowering
revenues and profits in 1997, 1998 and
1999 but raising them in 2000 and 2001.
Securities and
Exchange Commission
Washington, D.C.
Litigation
Release No. 17954 / January 29, 2003
Accounting and Auditing Enforcement Release No. 1709 / January 29, 2003
Securities and Exchange Commission v. KPMG LLP, Joseph T. Boyle, Michael
A. Conway, Anthony P. Dolanski and Ronald A. Safran,
Civil Action No. 03 CV 0671 (DLC) (S.D.N.Y.) (January 29, 2003)
SEC Charges
KPMG and Four KPMG Partners with Fraud in Connection with Audits of
Xerox
SEC Seeks
Injunction, Disgorgement and Penalties
On January 29,
2003, the Securities and Exchange Commission filed a civil fraud
injunctive action in the United States District Court for the Southern
District of New York against KPMG LLP and four KPMG partners - including
the head of the firm's department of professional practice - in
connection with KPMG's audits of Xerox Corporation from 1997 through
2000. The complaint charges the firm and four partners with fraud, and
seeks injunctions, disgorgement of all fees and civil money penalties.
The complaint
alleges that KPMG and its partners permitted Xerox to manipulate its
accounting practices to close a $3 billion "gap" between actual
operating results and results reported to the investing public. Year
after year, the defendants falsely represented to the public that their
audits were conducted in accordance with generally accepted auditing
standards (GAAS) and that Xerox's financial reports fairly represented
the company's financial condition and were prepared in accordance with
generally accepted accounting principles (GAAP).
The four
partners named as defendants, all of whom are certified public
accountants, are:
Michael A.
Conway, 59, a resident of Westport, CT, has been KPMG's Senior
Professional Practice Partner and the National Managing Partner of
KPMG's Department of Professional Practice since 1990. He was the
senior engagement partner on the Xerox account from 1983 to 1985. He
again became the lead worldwide Xerox engagement partner for the 2000
audit. Conway also is a member of the KPMG board and is chairman of
the KPMG Audit and Finance Committee.
Joseph T.
Boyle, 59, a resident of New York City, was the "relationship partner"
on the Xerox engagement in 1999 and 2000 and is a managing partner of
the New York office of KPMG and of the Northeast Area Assurance
(Audit) Practice. As the relationship partner, Boyle's chief duty was
serving as liaison between KPMG and the Xerox Board of Directors,
including its Audit Committee.
Anthony P.
Dolanski, 56, a resident of Malvern, PA, was the lead engagement
partner overseeing Xerox's audits from 1995 through 1997. He left KPMG
in 1998. He is currently the chief financial officer of the Internet
Capital Group, a public company.
Ronald A.
Safran, 49, a resident of Darien, CT, was the lead engagement partner
on the 1998 and 1999 Xerox audits. He was removed as engagement
partner at Xerox's request after completing the 1999 audit and was
replaced by Conway. KPMG or its predecessor has employed Safran since
his graduation from college in 1976.
The
Commission's complaint alleges that beginning at least as early as 1997,
Xerox initiated or increased reliance on various accounting devices to
manipulate its equipment revenues and earnings. Most of these "topside
accounting devices" violated GAAP and most improperly increased the
amount of equipment revenue from leased office equipment products which
Xerox recognized in its quarterly and annual financial statements filed
with the Commission and distributed to investors and the public. This
improper revenue recognition had the effect of inflating equipment
revenues and earnings beyond what actual operating results warranted. In
addition, the complaint alleges that the defendants fraudulently
permitted Xerox to manipulate reserves to boost the company's earnings.
Accounting firm KPMG has been reprimanded and fined by the Institute of
Chartered Accountants in Ireland for what the Institute described as an
audit that "in terms of efficiency and competence fell below the standards
to be expected."
http://www.accountingweb.com/item/87371
KPMG-U.S. (August 28, 2002) has been caught in the net of shareholder
lawsuits that will relate to accounting work performed for voice
recognition software company Lernout & Hauspie. The company's auditor,
KPMG-Belgium, will share defendant status with its U.S. counterpart as the
shareholder suits alleging fraud go to trial.
http://www.accountingweb.com/item/89337
KPMG-U.S. has been caught in the net of
shareholder lawsuits that will relate to accounting work performed for
voice recognition software company Lernout & Hauspie. The company's
auditor, KPMG-Belgium, will share defendant status with its U.S.
counterpart as the shareholder suits alleging fraud go to trial. It is
anticipated that shareholders will band together to file a class action
lawsuit alleging that KPMG auditors should have been aware of problems
with the software company's accounts.
U.S. District Court Judge Patti Saris, who
ruled that KPMG-U.S. was eligible to be included in the legal action,
stated that "an escalating pageant of red flags" in the software
company's financial statements "strongly support the inference that
KPMG-U.S. acted with recklessness or actual knowledge" in helping
prepare the 1999 Form 10-K for Lernout & Hauspie. The form was
subsequently found to be fraudulent.
Learnout & Hauspie
filed for Chapter 11 bankruptcy protection in November, 2000 after
restating financial reports for 1998, 1999, and the first half of 2000.
Originally, KPMG issued a clean opinion of the 1998 and 1999 financials,
later
stating that the opinions "could no longer be relied upon."
KPMG has
said that the lawsuit is "completely without me
Big Four firms Ernst & Young and KPMG are being sued by clients for
selling tax shelters that have been found by the Internal Revenue Service
to be illegal tax evasion strategies. Meanwhile shelter participants are
relying on law firms to free them from the burden of paying penalties
should the shelters be found to be illegal.
http://www.accountingweb.com/item/97121
December 2002
Big Four firm KPMG has been named as the defendant in a lawsuit filed by
the Missouri Department of Insurance. The suit, filed in Jackson County
Circuit Court in Kansas City, Missouri, alleges that KPMG contributed to
the 1999 downfall of General American Holding Company.
http://www.accountingweb.com/item/96883
The Commission
today censured KPMG LLP, a big-five accounting firm based in New York
City, for engaging in improper professional conduct because it purported
to serve as an independent accounting firm for an audit client at the
same time that it had made substantial financial investments in the
client. The SEC found that KPMG violated the auditor independence rules
by engaging in such conduct. KPMG consented to the SEC's order without
admitting or denying the SEC's findings.
"The SEC's
decision to censure KPMG reflects the seriousness with which the SEC
treats violations of the auditor independence rules, even in the absence
of demonstrated investor harm or deliberate misconduct," said Stephen M.
Cutler, the SEC's Director of Enforcement
In addition to
censuring the firm, the SEC ordered KPMG to undertake certain remedies
designed to prevent and detect future independence violations caused by
financial relationships with, and investments in, the firm's audit
clients.
"This case
illustrates the dangers that flow from a failure to implement adequate
policies and procedures designed to detect and prevent auditor
independence violations," said Paul R. Berger, Associate Director of
Enforcement.
The SEC found
that, from May through December 2000, KPMG held a substantial investment
in the Short-Term Investments Trust (STIT), a money market fund within
the AIM family of funds. According to the SEC's order, KPMG opened the
money market account with an initial deposit of $25 million on May 5,
2000, and at one point the account balance constituted approximately 15%
of the fund's net assets. In the order, the SEC found that KPMG audited
the financial statements of STIT at a time when the firm's independence
was impaired, and that STIT included KPMG's audit report in 16 separate
filings it made with the SEC on November 9, 2000. The SEC further found
that KPMG repeatedly confirmed its putative independence from the AIM
funds it audited, including STIT, during the period in which KPMG was
invested in STIT.
Rule 102(e) of
the SEC's Rules of Practice provided the basis for the SEC's finding in
its administrative order that KPMG engaged in improper professional
practice. According to the SEC, KPMG's independence violation occurred
primarily because the firm lacked adequate policies or procedures to
prevent or detect such violations, and because the steps which KPMG
personnel usually took before initiating investments of the firm's
surplus cash were not taken in this instance.
The SEC also
found that KPMG:
* had no
procedures directing its treasury department personnel to check the
firm's "restricted entity list" to confirm that a proposed investment
was not restricted;
* had no
specific policies or procedures requiring any participation by a KPMG
partner in the investigation and selection of money market investments;
and
* had no
policies or procedures designed to put KPMG audit professionals on
notice of where the firm's cash was invested, or requiring them to check
a listing of the firm's investments, prior to accepting new audit
engagements or confirming the firm's independence from audit clients.
As a result,
the SEC found that there was no system KPMG audit engagement partners
could have used to confirm the firm's independence from its audit
clients.
The SEC
concluded that KPMG's lack of adequate policies and procedures
constituted an extreme departure from the standards of ordinary care,
and resulted in violation of the auditor independence requirements
imposed by the SEC's rules and by Generally Accepted Auditing Standards.
(Rels. 34-45272; IC-25360; AAE Rel. 1491; File No. 3-10676; Press Rel.
2002-4)
Allegations
that Big Five firm KPMG helped the nation's largest for-profit hospital
chain cheat Medicare and Medicaid will be resolved by a $9 million
settlement by the firm. KPMG this week agreed to settle out of court in
a case that last year slapped their client the Columbia Hospital
Corporation with over $840 million in criminal fines for defrauding
government health care programs.
The case
alleged that KPMG filed false claims on behalf of Basic American Medical
Inc. and later Columbia Hospital Corp. that allowed them to collect on
costs they knew were not allowed. The case revolved around false claims
made from 1990 to 1992, and involved four hospitals in Florida and two
in Kentucky.
"We vigorously
deny that we engaged in any wrongdoing," KPMG spokesman George Ledwith
said. He added that the accounting firm agreed to settle only to avoid
costly litigation and put a 10-year-old dispute behind it.
Accounting firm KPMG has been reprimanded and fined by the Institute of
Chartered Accountants in Ireland for what the Institute described as an
audit that "in terms of efficiency and competence fell below the standards
to be expected."
http://www.accountingweb.com/item/87371
March 12, 2003
Big Four accounting firm KPMG has agreed to pay $125 million as a result
of a class action lawsuit filed by shareholders of Rite Aid, the nation's
third-largest drugstore chain. In addition, KPMG has agreed to pay $75
million to shareholders of Oxford Health Plans after a computer snafu at
Oxford in 1977 resulted in collection and payment delinquencies.
http://www.accountingweb.com/item/97269
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
notices.
KPMG-U.S. (August 28, 2002) has been caught in the net of shareholder
lawsuits that will relate to accounting work performed for voice
recognition software company Lernout & Hauspie. The company's auditor,
KPMG-Belgium, will share defendant status with its U.S. counterpart as the
shareholder suits alleging fraud go to trial.
http://www.accountingweb.com/item/89337
KPMG-U.S. has been caught in the net of
shareholder lawsuits that will relate to accounting work performed for
voice recognition software company Lernout & Hauspie. The company's
auditor, KPMG-Belgium, will share defendant status with its U.S.
counterpart as the shareholder suits alleging fraud go to trial. It is
anticipated that shareholders will band together to file a class action
lawsuit alleging that KPMG auditors should have been aware of problems
with the software company's accounts.
U.S. District Court Judge Patti Saris, who
ruled that KPMG-U.S. was eligible to be included in the legal action,
stated that "an escalating pageant of red flags" in the software
company's financial statements "strongly support the inference that
KPMG-U.S. acted with recklessness or actual knowledge" in helping
prepare the 1999 Form 10-K for Lernout & Hauspie. The form was
subsequently found to be fraudulent.
Learnout & Hauspie
filed for Chapter 11 bankruptcy protection in November, 2000 after
restating financial reports for 1998, 1999, and the first half of 2000.
Originally, KPMG issued a clean opinion of the 1998 and 1999 financials,
later
stating that the opinions "could no longer be relied upon."
KPMG has
said that the lawsuit is "completely without me
Below you
will find my message to a reporter (Sanford Nowlin) regarding the
Lancer/KPMG/Coca Cola mess. The reporter’s original message is
below my message.
What may be of
particular interest to you are Sanford’s links to documents describing
how KPMG has so forcefully dropped Lancer as a client and withdrew KPMG’s
audit opinions of prior years. These are the two links
at the bottom.
This rather dramatic
and forceful dropping of a client is somewhat indicative fears of auditing
firms to stay engaged in risky audits.
The lawsuit,
which you can read in its entirety here, accuses
accounting firm McGladrey of negligent misrepresentation, fraud and
concealment, and demands a jury trial. Damages sought are in excess of $500
million.
“Sadly, the ultimate victims were the
elderly, who lost their preferred Medicare Advantage Plan; valued employees
and families, who lost their jobs and incomes; physicians, who lost provider
networks; shareholders, who lost their investments; Florida Department of
Insurance Regulation [sic], who lost a highly respected Medicare insurer;
and the United States of America, who lost premiums and medical benefits
through Medicare fraud,” the lawsuit reads.
Lawyers representing the plaintiffs
weren’t immediately available for an interview. McGladrey officials declined
to comment on pending litigation.
The suit seems to pin the insolvency
of Physicians United Plan on a complicated financial arrangement with
Pacific Western Finance Corp., or Pacwest, which sold uncollectible accounts
receivables and leased them back to Physicians United as cash equivalents,
according to the lawsuit. That led PUP's owners — Dr.
Sandeep Bajaj and Dr.
Rohini Bajaj — to believe the company was solvent;
if they had known the company was insolvent, they would have been able to
raise the money or slow down the growth, according to the lawsuit. McGladrey,
according to the lawsuit, is responsible because of its financial audits of
PUP.
Continued in article
Jensen Comment
Where are those going concern warnings when you want them the most?
Lawrence Blitz v. AgFeed Industries, Inc., Goldman Kurland &
Mohidin LLP, McGladrey & Pullen LLP,
et al is a securities fraud class action
where investors claim the company’s expansion was “fueled in large part by
fraud.” AgFeed began in the 1990’s as a Chinese manufacturer of animal
nutrition products. It grew rapidly by expanding sales for its animal
nutrition operations through hundreds of independent dealers, and by
acquiring dozens of independent Chinese hog farms in 2007 and 2008 to enter
the hog breeding and production business.
Until 2010, all of AgFeed’s operations
were in China. In September 2010 it acquired M2P2, LLC a large United States
hog producer in Tennessee. AgFeed was listed on NASDAQ in 2007 as the result
of a reverse merger transaction. The lawsuit covers the period from March
16, 2009 through and including September 29, 2011.
The company’s fraudulent strategy,
referred to by company executives in emails as “enlarging by faking”,
involved overstating asset values in the Chinese hog farms it purchased,
overstating accounts receivable in its animal feed division, reducing its
allowance for doubtful accounts to a minimum even when business conditions
indicated customers were less likely to pay, and misrepresenting the value
of equipment, inventory and cost of goods sold in its legacy hog business in
its financial statements which were filed with the SEC.
An excellent,
long read by Dune Lawrence at Bloomberg last
December describes how the fraud was discovered and why the company
eventually delisted its own common stock from NASDAQ to avoid a mandatory
delisting by the exchange. In
July of 2013, the
company filed for
Chapter 11 bankruptcy. Lawrence’s
story provides the background you’ll need to appreciate what I’m going to
talk about next.
There are four aspects of the AgFeed story
that have not been written about in much detail. I will talk more about them
in a series of posts.
Milton Webster, an AgFeed whistleblower,
was a member of the company’s board of directors, an Audit Committee member,
who says he saw problems with the company’s accounting almost immediately
after joining the board on February 24, 2011. He subsequently resigned on
February 14, 2012. It is highly unusual for a board member, especially an
Audit Committee member, to be a fraud whistleblower in a public company.
Goldman Parks Kurland Mohidin LLP
(Goldman) is the CPA firm that provided accounting services to AgFeed from
at least 2007 to November 2010. McGladrey & Pullen LLP (McGladrey) replaced
Goldman as AgFeed’s independent auditor in November 2010 and continued in
that capacity through the end of the period that is subject to the
litigation. Both firms are registered with the PCAOB, have been inspected
and continue to produce audit opinions for public issuers. Two China-based
audit firms that supported Goldman and derive the majority of their revenue
from Goldman are also registered with the PCAOB and have never been
inspected given China’s prohibitions on physical inspections of Chinese
audit firms by US regulators. Both firms continue to support Goldman.
Protiviti, a division of Robert Half
Int’l, provided support to AgFeed’s management in assessing its internal
controls over financial reporting as required by Sarbanes-Oxley. Protiviti
is a creditor of AgFeed in bankruptcy and is being evaluated as a potential
additional defendant in the bankruptcy proceedings by the the debtor and
equity committee for Protiviti’s apparent failure to catch the fraud.
Once trouble started, law firm Latham and
Watkins pitched itself to represent the company, directors, and executives
in the securities and derivative litigation. L&W continues to serve in that
capacity (except the derivative which was wiped out by the bankruptcy) and
also serves as special counsel to the company in bankruptcy. The firm was
eventually hired as counsel to the special investigative committee to
address the various fraud allegations such as a second set of financial
records, inflated asset valuations and undisclosed related-party
transactions. Too many roles and, perhaps, too many conflicts of interest…
I’m going to start with the story of
Milton Webster.
Milton Webster: Whistleblower
Why don’t directors blow the whistle on
fraud more often?
Tom Gorman,
a former SEC official and now a partner at
law firm Dorsey told me, “I suspect that is because they typically have the
authority and the position to do something about the issue. In contrast the
typical whistleblower does not and not infrequently gets fired when trying
to raise the issue.”
The Securities and Exchange Commission
says it’s stepping up scrutiny of corporate accounting and disclosure fraud.
That means going after gatekeepers like auditors, lawyers, and directors
under an aptly named initiative
Operation Broken Gate. The AgFeed case is the
mother lode for an SEC that says it’s ready to rack up some accounting fraud
enforcement points and, perhaps, pursue a more aggressive enforcement
approach to
sparsely utilized Sarbanes-Oxley
provisions like Section 304, compensation clawbacks.
AgFeed has everything a
reinvigorated corporate fraud fighting and broken gate fixing SEC could
want. My recent three part series on this Chinese reverse merger gone bad
and bankrupt was published before the SEC recently filed a complaint against
AgFeed and six executives.
The SEC complaint includes fifteen
allegations that cover a wide range of federal securities laws including
Sarbanes-Oxley law.
I previously wrote about the two audit firms
that missed the fraud, Goldman Parks Kurland Mohidin
LLP and McGladrey & Pullen LLP, defendants in private shareholder class
action litigation alleging malpractice. The SEC’s complaint says AgFeed
executives deceived the auditors, a violation of
Rule 13b2-2 or
Section 303(a) of the Sarbanes-Oxley Act. (The SEC
has, in the interest of strengthening its own case against the executives,
given the audit firms
a big SEC-supported leg up in defending themselves
against private litigation for malpractice.)
The SEC’s complaint “anonymizes” two
trusted advisors, a firm and an individual, and credits them with trying to
do the right thing and warning executives about the potential for fraud. I
wrote about Fred Rittereiser, an advisor to the board that Milton Webster
referred to in his deposition as a “consiglieri”, and not the upstanding,
law abiding kind. I also wrote about Protiviti, a consulting firm with close
ties to the Audit Committee Chairman and, later, AgFeed CEO and Chairman Van
Gothner. Protiviti helped AgFeed management prepare its Sarbanes-Oxley
internal controls assessments starting in 2008, respond in March of 2012 to
initial SEC investigative inquiries and then doubled down in early 2013,
after the fraud was well-known, to be the company’s internal audit service
provider.
The SEC complaint does not even mention
law firm Latham & Watkins, since the agency chose to focus only on the fraud
in the Chinese operations of AgFeed that allegedly occurred from 2008 until
the end of June 2011.
I wrote about Latham & Watkins,
the firm that began representing AgFeed and its officers and directors
shortly they disclosed the Chinese fraud and shareholders sued them. Latham
continues to represent the company and some executives. Latham & Watkins was
hired as counsel to a special investigative committee at the end of 2011 and
the law firm hired consulting firm FTI to act as forensic accountants under
its direction. A derivative suit was eliminated by the bankruptcy in July of
2013. Latham also now serves as special counsel to the company in
bankruptcy.
The SEC complaint
includes a claim against the former Chinese CEO and
CFO and the subsequent US CFO for “failure to reimburse”, a violation of
Section 304(a) of the Sarbanes-Oxley Act of 2002. The Section 304 claim hits
all the highlights of
the law:
“As
a result of the misconduct described above, AgFeed
filed reports that were in material non-compliance with its
financial reporting requirements under the federal securities
laws. AgFeed’s material non-compliance with its financial reporting
requirements resulting from the misconduct required the company
to prepare accounting restatements.” But the SEC admits “the
company prepared a draft restatement but never completed it because on
July 15, 2013, the company filed for protection under the United States
Bankruptcy Code.”
The SEC then makes a calculation of the impact of the
restatement that should have been, if only the AgFeed executives had
completed and filed it.
“Based on the company’s draft
restatement work, the fraud caused AgFeed’s publicly-reported revenues
to be overstated by approximately $239 million over a three-and-a-half
year period. On an annual basis, for 2008, 2009, and 2010, the fraud
caused revenue inflation ranging from approximately 71% to approximately
103% and gross profit inflation ranging from approximately 98% to
approximately 153%.”
On March 7, 2014 AgFeed
filed an 8-K to, among other
things, announce “the Company has not completed, and is not working on, its
financial statements for the years ended 2013, 2012 or 2011, or its restated
financial statements for the year ended December 31, 2010.” The company’s
auditor, McGladrey LLP, also resigned on March 7.
Nearly two
years after it began inspecting McGladrey in 2011, the Public Company
Accounting Oversight Board
published its report saying half of the audits it
checked were deficient.
The PCAOB inspected
16 audits at McGladrey from August 2011 through December of that year and
found problems with eight of the audits, in some cases numerous problems in
a single audit. Many of the problems related to revenue recognition,
allowances for loan losses, accounts receivable, taxes, inventory, and
internal control over financial reporting.
In terms of
the failure rate, McGladrey's 2011 report was a little worse than the
2010 report, where PCAOB inspectors checked 19
audit files and found problems with 9. In one case, follow-up based on the
PCAOB's 2011 inspection finding led to a change in a company's accounting
practices, the PCAOB said.
McGladrey said the
firm has taken actions as appropriate under auditing standards to address
the deficiencies called out by the PCAOB, including performing additional
procedures and adding documentation to its work papers. “We believe the
investments we have made and are continuing to make to audit processes and
quality controls are resulting in improved audit quality,” the firm wrote in
its letter to the PCAOB.
Audit reports
across all major firms showed a marked increase in failure rates from 2009
to 2010 and
showed no improvement for most firms from 2010 to
2011. Crowe Horwath remains the only firm in the Big 4 or second tier of
global firms whose 2011 inspection report is still unpublished.
The PCAOB
recently began offering a first view into 2012 inspection reports for the
largest firms with the publishing of
Deloitte's 2012 inspection results. The firm drew
inspector criticism for 13 of the 52 audits examined for a failure rate of
25 percent, an improvement over rates of 42 percent in 2011 and 45 percent
in 2010.
The PCAOB's
inspection process follows a risk-based approach, so inspectors are
targeting audit files where they consider problems to be most likely. As
such, the board cautions against generalizing failure rates to the entire
collection of audit work.
Accountants have been slow to embrace the
idea that a core function of their job is to identify fraud during company
audits. Part of the problem is it’s not always possible to know who in an
organization is involved in deceptive number-crunching.
Accountants have been slow to embrace the
idea that a core function of their job is to identify fraud during company
audits, and more education and training is needed to hasten the advancement
of this idea. Part of the problem is while standards have evolved to
incorporate fraud detection into the job description, it’s not always
possible to know who in an organization is involved in deceptive
number-crunching, say two accounting experts.
While hard to believe, some CPAs believe
detecting fraud still isn’t one of their core responsibilities, said Brian
Fox, a certified fraud examiner and the founder and president of
Confirmation.com, a cloud-based audit security tool used to prevent
confirmation fraud. “For a long time we said finding fraud wasn’t our
responsibility. Our responsibility was to find material errors in
statements,” Mr. Fox said. “We’ve got great technology today, we don’t need
to be paid to add up numbers. The public is relying on us to make sure
accounting standards are being applied correctly and that management’s
estimates are fairly stated and there is no fraud. They view us as the
public’s watchdog.”
Most auditors are not prepared to search
for and identify the signs of financial fraud, and this lack of preparation
is even more pronounced among staff and senior auditors, where the majority
of the detailed audit work and client conversations take place, Mr. Fox
said, adding this shows resistance remains as to whether this should be the
responsibility of the accountant/auditor. “It’s also a bit of a legacy issue
in not training our folks on ways to find fraud,” he said. “We cover some of
that material but if you ask people in the public who rely on our audited
statements they say it is our responsibility to find fraud. But the CPA
exam, less than 1% focuses on fraud, it’s somewhat surprising, somewhat of a
misalignment.”
Standards requiring auditors to have
responsibility for finding material misstatements in financial statements
and designing audit procedures to detect that fraud have been around for
more than a decade, but John Keyser, national director of assurance services
at assurance, tax and consultant services firm McGladrey, said recent
changes to rules have refined those standards to require additional
procedures and additional inquiries of management and others charged with
governance.
Changes include more fraud awareness
training, and identification of fraud control deficiencies that allow fraud
to occur, he said, along with additional conversation among audit teams
about where fraud could occur and the ways management might try to commit
fraud, with the end result being the designing of policies to protect
against those risks. “There’s been an evolution in required procedures,
refined over time, of additional procedures directed at fraud,” Mr. Keyser
said. He cited the development of the “fraud triangle,” or the three
elements needed for fraud to occur: the opportunity to commit fraud, the
incentive for someone to commit fraud and the ability to rationalize the
fraud. Although auditors are good at identifying the areas where
opportunities to commit fraud exist, it is harder for them to know who in an
organization may have motivation to commit fraud and it is even more
difficult to know who may be capable of rationalizing away such actions, he
said.
“I think there is more of a recognition of
the types of fraud that occur and how those get perpetrated,” Mr. Keyser
said. Auditors need to pay particular attention to year-end statements and
performance targets that may be tied to executive bonuses, as these are
areas where management may fudge the numbers to ensure they receive the most
compensation they can. “Standards are pretty robust, I think, but at the
same time we only can know what we can know. This does not provide absolute
assurance. We can only make educated guesses and evaluate management’s
assumptions to see if they are reasonable. There are limitations.”
The McGladrey accounting firm has settled a lawsuit
that accused the firm of fraud in connection with embezzlement by Miami
Beach Community Health Center CEO Kathryn Abbate.
Although terms of the settlement were not
confidential, the center’s attorney Richard E. Brodsky declined to reveal
the terms.
Abbate was sentenced to six years in prison on
Wednesday for embezzling $7 million over a period of five years.
During that period, accountants working for
McGladrey and CohnReznick audited the center’s accounts.
The center sued both McGladrey and CohnReznick
after learning about Abbate’s theft of funds in August. The center accused
its auditors of failing to detect the embezzlement for years. McGladrey
prepared federal tax returns for the center from 2007 to 2009.
According to the center’s lawsuit, McGladrey fired
its main auditor on the center’s account, Steven D. Schwartz, in January
2011, and Schwartz went to work for CohnReznick.
The lawsuit alleges that Schwartz no longer
performed regular work on the center’s accounts after leaving McGladrey, but
continued to supervise others who did.
The center states in its lawsuit that it was
eventually Schwartz who alerted someone besides Abbate to her embezzlement
in May 2012.
An amended complaint in the lawsuit alleged that
auditors had failed to adequately detect problems with procedures governing
checks and other financial transactions and failed to report those properly
to management and the board of directors.
Continued in article
A Really Bad Audit by
McGladrey & Pullen, LLP The U.S. With Only a Hand Slapping Fine
U.S. Commodity Futures Trading Commission (CFTC) Press Release on
September 22, 2011 ---
http://www.cftc.gov/PressRoom/PressReleases/pr6114-11
CFTC
Charges National Accounting Firm McGladrey & Pullen, LLP, and
Partner David Shane with Failure to Properly Audit One World Capital
Group, a Former Registered Futures Commission Merchant Firm to pay
$900,000 and institute remedial measures, and Shane to pay $100,000
personally to settle CFTC action.
Washington,
DC - The U.S. Commodity Futures Trading Commission (CFTC) today
filed and simultaneously settled an administrative proceeding
against McGladrey & Pullen, LLP (McGladrey), a nationwide public
accounting firm with offices in Chicago, Ill., and a McGladrey
partner, David Shane, a certified public accountant (CPA) licensed
in Illinois.
The
proceeding arises from an audit McGladrey performed in 2006 of One
World Capital Group, LLC (One World), at the time a CFTC-registered
futures commission merchant. The CFTC sued One World in 2007,
alleging that it failed to demonstrate compliance with
capitalization requirements and to maintain required books and
records (see CFTC Press Releases 5427-10, December 18, 2007, and
5786-10, March 4, 2010). One World ceased operation in 2007. Shane
served as the engagement partner for the 2006 audit of One World.
According
to the CFTC order, McGladrey issued an unqualified opinion that One
World’s 2006 financial statements were free from material
misstatements, and a report stating that it had not identified any
deficiencies in One World’s internal controls that it considered to
be material inadequacies. The CFTC order finds that, to the
contrary, the 2006 financial statements were, in fact, materially
misstated and there were material inadequacies in One World’s
internal controls, as well. The order also finds that McGladrey did
not conduct its audit of One World’s financial statements in
accordance with generally accepted auditing standards (GAAS) as
required by the CFTC’s regulations.
In
particular, the order finds that One World’s 2006 financial
statements were materially misstated in various ways including: (1)
the 2006 Statement of Financial Condition states that liabilities
payable to all customers were over $6.9 million, when in fact
information available in One World’s records showed that it may have
owed at least $15 million just to forex customers alone, for whom
One World served as the counterparty; and (2) the 2006 financial
statements materially misstated the nature of One World’s business
by failing to reflect that One World served as the counter party to
its forex customers for over 90 percent of its business, according
to the order.
In
addition, McGladrey failed to report material inadequacies in One
World’s accounting system and internal accounting controls,
including the lack of a customer ledger, and an accounting system
that did not properly identify the number of forex customers or the
amount of customer liabilities, according to the order. These
material inadequacies reasonably could, and did, lead to material
misstatements in One World’s 2006 financial statements, the order
finds.
CFTC
Division of Enforcement Director David Meister stated: “Auditors of
Commission registrants perform a critical gatekeeper role in
protecting the financial integrity of the futures markets and the
investing public. Auditors must understand the business operations
of their clients, and conduct financial audits in accordance with
GAAS. As demonstrated by today's action, the Commission will not
hesitate to impose significant sanctions on auditing firms and hold
individuals personally responsible when they fail to adhere to their
professional obligations as regrettably happened here.”
The CFTC’s
order requires McGladrey to pay a $250,000 civil monetary penalty
and orders Shane to pay a $100,000 civil monetary penalty, for which
he may not be indemnified by the firm. The CFTC’s order also
requires McGladrey to pay $650,000 in restitution to customers of
One World who suffered losses as a result of One World’s fraud. The
order also requires McGladrey and Shane to cease and desist from the
violations found in the order.
Seeking $550m, a trustee for the
money-manager names McGladrey & Pullen for "participating in
wrongdoing," and cites a partner, too. Stephen Taub CFO.com | US
March 24, 2008 The Bloomington, Minn.-based accounting firm of
McGladrey & Pullen, along with the partner in charge of now-defunct
Sentinel Management Group Inc.'s audit, were sued for $550 million
by a Chapter 11 trustee for Sentinel. The trustee charged that
accountancy "itself participated in the wrongdoing committed by a
Sentinel insider," who wasn't named.
The trustee for Northbrook, Ill.-based
money manager Sentinel — which itself had been accused of fraud —
filed the suit in U.S. Bankruptcy Court in Chicago. In addition to
McGladrey & Pullen, the suit named G. Victor Johnson, who had been
the partner in charge, according to a Bloomberg News report.
A representative for the accountancy and
Johnson didn't return a call from CFO.com seeking comment.
Last August, Sentinel froze client
withdrawals from its $1.5-billion short-term investment fund, and
company officials claimed in a letter to clients that because of
subprime mortgage crisis and resulting credit crunch "fear has
overtaken reason," according to an Associated Press report at the
time. Sentinel reportedly told clients that it could not meet their
requests to withdraw cash.
The following week, the Securities and
Exchange Commission filed an emergency action against Sentinel
seeking to halt any improper commingling, misappropriating, and
leveraging of client securities without client consent. The SEC's
complaint alleged that for at least several months Sentinel's
advisory clients suffered undisclosed losses and risks of losses as
a result of several unauthorized practices. The commission said
Sentinel placed at least $460 million of client securities belonging
in segregated customer accounts in Sentinel's house proprietary
account.
According to the AP, the trustee, Frederick
Grede, accused the firm, which audited Sentinel's 2006 financial
statements, of certifying false financial statements and creating
some of the accounting entries that led to Sentinel's financial
misstatements. According to Bloomberg, Grede said McGladrey & Pullen
"ignored blatant violations of federal law" and "failed to satisfy
the most basic standards of the accounting and auditing profession."
The trustee said the firm "assisted in the
creation of a fictitious management agreement" used to siphon $1
million out of Sentinel when it knew no management services were
being provided, according to the wire service. Rather than giving
Sentinel an unqualified opinion for 2006, the trustee said that the
firm should have disclosed violations of law, according to
Bloomberg.
"M&P's failure to either ensure that
Sentinel's financial statements accurately reflected the facts or
refuse to certify materially misstated financial statements, as well
as its failure to report these violations in its audit report and to
authorities, reflects a deliberate disregard of M&P's obligations as
an auditor," Grede reportedly said.
Teaching Case From The Wall Street Journal Weekly Accounting
Review on November 1, 2019
Mattel
Resolves Accounting Probe
By Paul Ziobro | October 29,
2019
Topics:
Accounting Changes and Error Corrections , Accounting for
Income Taxes
Summary:
The article describes an error originating in the third
quarter of 2017 in Mattel’s financial statements. The
company reported a loss and related tax benefit but should
have adjusted that tax benefit with a valuation allowance.
Mattel then reported a loss in the quarter ended December
31, 2017, which was overstated by the same amount. There was
no impact on the full year’s financial statements. The issue
came to light because of a whistleblower letter; the article
also describes a concern raised in regards to
PricewaterhouseCoopers's independence as an auditor because
the firm made recommendations about candidates for the chief
financial officer (CFO) position. The press release related
to this error was issued October 29, 2019 and is available
as exhibit 99.2 to the Form 8-K filed on October 30, 2019.
https://www.sec.gov/Archives/edgar/data/63276/000119312519277846/d788142dex992.htm
Classroom Application:
The article may be used when discussing accounting for
income tax valuation allowances and/or corrections of
errors. The article also may be used in an auditing class to
discuss the independence issues raised by the whistleblower.
Questions:
·Why is the Mattel Inc. chief financial officer (CFO) leaving
his post?
·How did the issues facing Mattel come to light?
·What is an income tax valuation allowance? Cite your source
for this definition.
·What accounting error occurred in Mattel’s financial
statements in the third quarter of 2017?
·When did that accounting error “wash out”? Explain your
answer.
·If the error has “washed out” of the financial statements,
why must Mattel issue restated reports for the third and
fourth quarter of 2017?
·What is the concern with regards to the independence of
auditor Pricewaterhouse Coopers as raised by this
whistleblower?
Toy maker searches for new
CFO and will restate some earnings in resolution that removes roadblock to
refinance debt; stock jumps
Mattel
Inc.
MAT
-0.42%’s chief
financial officer is leaving, and the company is restating some past
earnings after completing an investigation into accounting issues raised in
a whistleblower letter.
The
investigation found shortcomings in the toy maker’s accounting and reporting
procedures but concluded that the actions didn’t amount to fraud.
Shares
of the maker of Barbie dolls and Hot Wheels cars rose more than 20% in
post-market trading as the resolution, coupled with strong third-quarter
earnings, removes a roadblock to the company’s plans to refinance debt due
next year. The whistleblower letter, disclosed in August, abruptly nixed
plans to raise debt at the last minute.
The
investigation found that Mattel understated its net loss by $109 million in
the third quarter of 2017 due to an error calculating its tax valuation
allowance, and then understated fourth-quarter results that year by a
similar amount. The error wasn’t reported to the CEO at the time or the
audit committee.
The
letter also questioned the independence of the lead auditor,
PricewaterhouseCoopers LLP. The investigation found that the lead partner at
the accounting firm violated some independence rules by recommending
candidates for Mattel’s senior finance positions. Mattel said that PwC
replaced its lead partner and other members of its audit team that deals
with the toy maker but will continue as auditor.
Mattel
has launched a search for a new CFO to succeed Joe Euteneuer, who joined the
company in late 2017. He will leave the company after a six-month transition
period.
A
Mattel spokesperson said Mr. Euteneuer was unavailable for comment.
PwC
said in a statement that both the accounting firm and Mattel had concluded
PwC is “objective and impartial.” The firm “takes independence very
seriously and has robust policies and procedures in place to identify and
address potential threats to independence,” the statement said.
Mattel
otherwise reported a sharp jump in profit, as ongoing cost cuts benefited
the bottom line while overall sales rose for the second straight quarter.
In an
interview, Mattel Chief Executive Ynon Kreiz said tariffs had minimal impact
on the El Segundo, Calif.-based company in the latest quarter.
From the CFO Journal's Morning Ledger on September 24 201
Good morning.
Nissan and its former chairman, Carlos Ghosn, have settled civil
charges with the U.S. Securities and Exchange Commission stemming from an
investigation into pay disclosures. Nissan agreed to pay a $15 million civil
penalty to settle charges that it and Mr. Ghosn filed
false financial disclosures
that omitted more than $140 million slated to be paid to Mr. Ghosn in
retirement, the SEC said.
Mr. Ghosn agreed to a $1 million civil penalty and a 10-year prohibition
from serving as an officer or director for a company that files financial
statements with the SEC. “Simply put, Nissan’s disclosures about Ghosn’s
compensation were false,” said Steven Peikin, co-director of the SEC’s
division of enforcement, in a statement. “Through these disclosures, Nissan
advanced Ghosn and Kelly’s deceptions and misled investors, including U.S.
investors.”
In a separate
settlement, PricewaterhouseCoopers is preparing to pay about $8
million to settle claims of improper professional conduct and
violating auditor independence rules,
the SEC said Monday.
The regulator said it also charged Brandon Sprankle, a partner at the Big
Four audit firm, for causing the firm to violate independence rules. The
allegations of improper conduct were in connection to a total of 19
engagements with 15 unidentified companies over a three-year period ending
in 2016, CFO Journal's Mark Maurer reports.
The activity violated a rule issued by the Public Company Accounting
Oversight Board—which regulates U.S. audit firms and is overseen by the
SEC—which required the firm obtain preapproval from an audit client’s audit
committee to perform nonaudit services related to internal controls over
financial reporting.
LONDON — "Big Four" accounting
firms KPMG and PwC have both been handed multi-million-pound fines for
auditing failures, amid growing concerns about
the quality of audits from the major providers.
Auditor KPMG has been fined more
than $6.2 million (£4.8 million) by the US Securities and Exchanges
Commission (SEC) for failing to properly audit an energy company that
grossly overstated the value of its assets.
KPMG issued an unqualified audit
of oil and gas company Miller Energy Resources in 2011, despite the fact
that the company had overvalued various assets bought in Alaska by 100 times
their real worth. The facts presented to auditors "should have raised
serious doubts," the SEC said.
Separately, PwC was also hit with a
£5.1 million fine on Wednesday and "severely reprimanded" by UK watchdog the
Financial Reporting Council, after admitting misconduct when auditing
professional services company RSM Tenon Group in 2011.
Earlier this year, the watchdog
issued a damning
report stating that KPMG, Deloitte and Grant
Thornton were producing below-quality audits. The fines will do little to
dispel fears that auditing standards are slipping, leaving investors
exposed.
Continued in article
Jensen Comment
All the largest CPA firms have been fined in the USA by
the PCAOB for negligence in auditing.
The sad thing is that repeat offenders seemingly shrug off
their relatively small PCAOB fines as being part of the cost of being in the
auditing business. In other words fines and even adverse publicity don't
seem to be working as intended. Civil court actions such as the recent
lawsuits against PwC exceeding a billion dollars are more troublesome for
the firms.
In the public sector the Government Audit Agency (GAO) has
a more disheartening approach. Just declare some enormous "clients" like the
Pentagon and the IRS as incapable of being audited.
From the CFO Journal's Morning Ledger on May 11, 2017
PwC fined over U.K. audit The Financial Reporting
Council, the U.K.’s watchdog for accounting and audit, has fined
PricewaterhouseCoopers LLP and a former partner of the firm for its 2009
audit of Connaught PLC, a FTSE 250 company that went into
administration in 2010. During its investigation, the FRC found misconducted
in three audit areas—mobilization costs, long-term contracts and intangible
assets, Nina Trentmann writes.
PwC will have to
shell out £5 million ($6.4 million), whereas former partner Stephen Harrison
was fined to pay £150,000. The accounting firm was also asked to cover the
FRC’s legal costs and to make an interim payment of £1.5 million. “We are
sorry that our work fell short of professional standards,” a statement
released by PwC read. The FRC declined to comment further.
The fine comes days after the Association of Chartered
Certified Accountants released a report calling for more professional
skepticism on the part of auditors, as reported by Accounting Today.
Jensen Comment
It's somewhat common for auditors to fail to detect fraud. Often the defense is
that the client misled the auditor and well as the public.
This investigation made me recall the somewhat infamous
Koss Case.
Grant Thornton Coughs Up $8.5 Million for Not Detecting
Fraud
"Koss settles claims against former auditor Grant Thornton," by Gary
Spivak, Milwaukee Sentinel Journal, July 5, 2013 --- Click Here
The charity
foundation of multi-billionaire Microsoft founder Bill Gates has sued
Petrobras and accounting giant PwC's Brazil arm over investment losses due
to corruption at the Brazilian oil giant.
The Bill & Melinda
Gates Foundation Foundation, together with WGI Emerging Markets Fund,
alleged in the suit that Petrobras repeatedly misrepresented its operations
and financial situation in raising billions of dollars from investors.
It also alleges
that PwC's Brazil affiliate, PricewaterhouseCoopers Auditores Independentes,
played a key role by attesting to Petrobras financial statements and
ignoring red flags. The suit seeks unspecified damages.
"The depth and
breadth of the fraud within Petrobras is astounding. By Petrobras's own
admission, the kickback scheme infected over $80bn of its contracts,
representing one-third of its total assets," the suit alleged.
"Equally
breathtaking is that the fraud went on for years under PwC's watch, who
repeatedly endorsed the integrity of Petrobras' internal controls and
financial reports. This is a case of institutional corruption, criminal
conspiracy and a massive fraud on the investing public."
Prosecutors in
Brazil say Petrobras executives colluded with construction companies to
massively overbill the state oil giant. The extra money went to kickbacks
and political payoffs company executives, politicians and political parties
that include the ruling Workers' Party.
Portfolio managers
for Gates and WGI probed Petrobras executives on questionable financial
data, but were misled in a "series of materially false and misleading
written and oral statements and/or omissions by Petrobras and/or PwC,"
according to the complaint.
The Gates
litigation follows a class-action suit in New York by a group of investors
against Petrobras. Petrobras has argued that the scandal was the result of
contractors, corrupt politicians and a few employees and should not impugn
the company as a whole.
SUMMARY: Hertz Global Holdings Inc. confirmed
concerns that its accounting issues run even deeper, saying it would restate
its results for 2012 and 2013 as the company continues an investigation into
its financial statements dating back to 2011. The company said it would take
longer to complete the auditing process. "Hertz does not currently expect to
complete the process and file updated financial statements before mid-2015,
and there can be no assurance that the process will be completed at that
time, or that no additional adjustments will be identified," the company
said in a filing.
CLASSROOM APPLICATION: This article is
appropriate for a financial accounting class for the topics of restatements
and accounting errors, or could be used in an auditing class.
QUESTIONS:
1. (Introductory) What are the facts of the Hertz restatements
discussed in the article?
2. (Advanced) What are the reasons for the delays in releasing
financial statements? What additional work must occur? Why?
3. (Advanced) How have these announcements affected Hertz's stock
price? Why? How could the company's stock price be impacted going into the
future?
4. (Advanced) What should the company do in the future to prevent
problems like this?
Reviewed By: Linda Christiansen, Indiana University Southeast
Hertz Global
Holdings Inc. on Friday confirmed concerns that its accounting issues ran
even deeper, saying it would restate its results for 2012 and 2013 as the
company continues an investigation into its financial statements dating back
to 2011.
Previously, the
company had said it would only restate results for 2011, while saying that
it would revise the results for 2012 and 2013.
Hertz shares, down
23% over the past three months through Thursday, fell as much as 14% Friday,
before closing down about 5%.
The company also
disclosed changes to its rental-car fleet strategy and a plan to cut $100
million in costs over the next year.
The company said
its audit committee and management have “concluded that the additional
proposed adjustments arising out of the review are material to the company’s
2012 and 2013 financial statements,” Hertz said in a filing Friday.
As a result, the
company said it would take longer to complete the auditing process. “Hertz
does not currently expect to complete the process and file updated financial
statements before mid-2015, and there can be no assurance that the process
will be completed at that time, or that no additional adjustments will be
identified,” the company said in a filing.
Hertz revealed its
detection of accounting errors in March, which followed its naming of a new
chief financial officer at the end of last year. In June, the company said
it would restate its 2011 results, while warning it may do the same for 2012
and 2013. It withdrew its guidance in August, citing the continuing
challenges and costs associated with the audit.
The company has
since fallen under scrutiny by activists investors such as Jana Partners LLC
and Carl Icahn . Jana, which owns a 7% stake in Hertz, earlier this month
pressed the company to move ahead with its succession planning as the
company seeks a new chief executive. Mark Frissora stepped down from that
role early in September as the company contended with weak results and
accounting issues.
Mr. Icahn, who
disclosed an 8.5% stake in Hertz in August, has said he believes the
company’s shares are undervalued, and that he lacked confidence in
management amid the accounting strife.
Hertz on Friday
also unveiled a new strategy for its U.S. rental car fleet, with an emphasis
on buying more 2015 model-year cars than 2014 models.
The company said it
has implemented a cost-cutting program expected to result in $100 million in
savings by the end of next year, as well.
Hertz said its
total revenue for the period ended Sept. 30 rose about 2% to $3.12 billion.
U.S. car-rental revenue was down slightly to $1.76 billion, while
international car-rental rose about 3% to $795 million.
The company’s
equipment-rental business posted a 3% revenue increase to $415 million.
The government’s audit regulator is scrutinizing
PricewaterhouseCoopers LLP over tax-saving strategies it provided to audit
client Caterpillar Inc., according to people familiar with the matter.
The Public Company Accounting Oversight Board is
looking at whether the practice might create a conflict of interest that
could compromise PwC’s ability to perform a tough audit of the manufacturer,
the people said.
The regulator’s review dates back several months
and follows an April request from Sen. Carl Levin (D., Mich.) for the PCAOB
to look at the matter after he alleged earlier this year that Caterpillar
had deferred or avoided $2.4 billion in taxes under strategies devised by
PwC.
Neither PwC nor Caterpillar have been charged with
any wrongdoing. PwC and Caterpillar have said that PwC’s advice and
Caterpillar’s actions complied with all tax laws.
In April, Sen. Levin sent a letter to the PCAOB
requesting that it “conduct a formal review” of the services that PwC
provided to Caterpillar.
The letter, a copy of which has been reviewed by
The Wall Street Journal, also asks the PCAOB to review whether its rules
should be strengthened to prohibit an auditor from auditing a company’s tax
obligations when those obligations rely on a tax strategy developed by the
same firm.
Accounting firms are required to avoid conflicts of
interest that could raise questions about their objectivity and impartiality
in conducting an audit of a company.
If a firm provides tax strategies to a company for
which it also serves as independent auditor, it could end up auditing its
own work.
Colleen Brennan, a PCAOB spokeswoman, said in the
wake of Sen. Levin’s concerns, the board “is looking further at the nature
of tax services that auditors are performing for their audit clients.” The
PCAOB monitors audit firms’ compliance with independence rules through its
inspections, and those rules “prohibit auditors from marketing aggressive
tax positions to their audit clients,” she said. She didn’t mention PwC or
Caterpillar specifically.
The review came to light Tuesday when Jay Hanson, a
PCAOB member, mentioned it at an accounting conference in New York. He also
didn’t mention PwC or Caterpillar but said members of Congress had asked the
PCAOB to review audit firms’ provision of tax strategies to their clients
and whether that could affect the auditors’ independence.
News of the PCAOB’s review comes less than two
weeks after the release of documents regarding other PwC tax strategies that
reportedly helped hundreds of the world’s largest companies avoid billions
of dollars in taxes by channeling money through the low-tax country of
Luxembourg, according to the International Consortium of Investigative
Journalists.
The PCAOB review predates and is unrelated to the
Luxembourg matter, Mr. Hanson said. PwC has said the Luxembourg documents
were stolen and that its tax advice had complied with applicable laws
Accounting firms PricewaterhouseCoopers and Crowe
Horwath must face a lawsuit accusing them of professional malpractice and
breach of contract for not catching a fraud that led to the 2009 collapse of
Colonial Bank, a federal judge has ruled.
Filed in 2011 by the bank's parent Colonial
BancGroup Inc and its trustee, the lawsuit accused the accounting firms of
making "reckless and grossly inaccurate" reports to the bank's board,
allowing Colonial to conceal a seven-year fraud that drained it of $1.8
billion.
In an opinion on Tuesday, U.S. District Judge Keith
Watkins rejected the auditors' motion to dismiss the complaints, saying the
bank made "plausible" claims that PwC and Crowe breached their contract with
Colonial.
PwC was the public auditor for Montgomery,
Alabama-based Colonial before its collapse, while Crowe provided internal
audit services.
Caroline Nolan, a spokeswoman for PwC, said it
audited Colonial "in full accordance with professional standards" and is
confident it will prevail on the merits of the case, which will now go
forward in district court.
Jan Lippman, a spokeswoman for Crowe, said the
audit firm was hired to help Colonial with internal services but did not
serve as the bank's internal auditor. She said the claims are without merit.
Rufus Dorsey, a lawyer for Colonial, said he was
pleased with the decision.
The fraud, one of the biggest stemming from the
last decade's mortgage crisis, went undetected until a raid by federal
authorities on Aug. 3, 2009. One of the largest U.S. regional banks,
Colonial was seized by regulators and filed for bankruptcy protection later
that month.
PwC and Crowe are facing a similar lawsuit by the
Federal Deposit Insurance Corporation, receiver for the bank. The 2012 FDIC
lawsuit said that PwC and Crowe missed "huge holes" in Colonial's balance
sheet caused by the diversion of money to now bankrupt Taylor Bean &
Whitaker Mortgage Corp.
Lee Farkas, former chairman of Taylor Bean, was
sentenced to 30 years in prison in 2011 for his role in the fraud. Several
other officers of Taylor Bean and Colonial pleaded guilty for their roles in
the scheme.
In Tuesday's opinion, Watkins rejected Crowe's
argument that it had no professional duty to Colonial because it was not the
bank's internal auditor but merely a provider of services, calling that a
"reed thin" distinction.
He also rejected PwC's argument that the negligence
claim against it must be dismissed because Colonial's own negligence played
a role in its fate, saying that is a question of fact for a jury to decide.
The case is: The Colonial BancGroup Inc et al v
PricewaterhouseCoopers et al, U.S. District Court, Alabama Middle District,
No 11-cv-00746 (Reporting by Dena Aubin; Editing by Kevin Drawbaugh and Tom
Brown)
I've always liked the Grumpy Old Accountants blog because it is in the style
of the old Barron's critical commentaries of particular financial statements by
Abe Briloff (who was finally admitted to the Accounting Hall of Fame in
2014). These days its hard to find an accounting academic who pours over a given
company's accounting and auditing reports and raises questions about conformance
with GAAP and GAAS at at technical level. Ed did this when he commenced the
Grumpy Old Accountant's blog and it appears that Tony will carry on with that
fine tradition.
I thought bunnies
were supposed to be cute and cuddly little creatures? Well after
looking at Annie’s, Inc….maybe not. This Company has recently “hit
the trifecta:” a restatement of its financials (2014 10K, p. 54), a
material weakness report on its controls over financial reporting
(2014 10K, pp. 45 and 74), and an auditor resignation (2014 8K dated
June 1)…all in the space of a week. And if this weren’t bad enough,
along comes a class action suit alleging false and/or misleading
financial statements and disclosures.
But should we
really be surprised. No, not really since until this year the
Company avoided scrutiny of its accounting and controls via its
JOBS Act status as an “emerging growth
company”(2014 10K, p. 32). It has been less than a year since I
reminded you in
Garbage In, Garbage Out – Are Accountants Really to Blame? that:
So, did
PricewaterhouseCoopers (PwC) really dump Bernie, Annie’s mascot,
just over a restatement and some internal control weaknesses? After
all, there’s many a PwC client that has committed far greater sins
and still remained a client of the firm (hint: Financial Crisis of
2007 and 2008). Just how could PwC disapprove of
Bernie, Annie’s “Rabbit of Approval?”
This is just the kind of question this grumpy old accountant likes
to tackle.
Management Under Fire
Given recent
allegations made in the class action suit filed in United States
District Court, Northern District of California, and docketed under
3:14-cv-03001, it seems reasonable to first investigate whether
Annie’s management had any incentives to engage in inappropriate
financial reporting behaviors.
Clearly,
management experienced significant pressures to report positive
performance results. The following factors individually and
collectively may have created demands to engage in aggressive
financial reporting:
The Company’s
history of operating losses as evidenced by its retained earnings
deficit (2014 10K, p. 47)
The recent
rapid growth in profitability despite declining gross profit
percentages (2014 10K, p. 34)
Restrictions
imposed by credit agreements (2014 10K, p. 22)
The
steady decline in the Company’s stock
price per share from a high of $51.36 on November 15, 2013 to
its current price of 33.14 (a decline of over 35 percent)
The role of
stock based rewards in management compensation (2014 10K, pp.
63-65)
And all of these
hurdles had to be addressed in a highly competitive market (2014
10K, pp. 9 and 12).
Could the
Company’s operating environment contribute to or facilitate
inappropriate financial reporting by management? The recent
negative report on internal controls over financial reporting would
seem to suggest so. Acknowledging “an insufficient complement of
finance and accounting resources” (2014 10K, p. 74) is a fairly
damning admission for any organization, much less a publicly-traded
company. The statement suggests an environment devoid of controls
and oversight…one just perfect for aggressive financial reporting.
And contrary to managements’ assertions, there is no quick fix to
this problem.
Then, there is
the issue of key officer turnover at Annie’s. Amanda K. Martinez
joined the Company as Executive Vice President in January 2013 (2013
8K dated January 5), was promoted in December 2013 (2013 8K dated
December 9), and resigned without a stated reason in March 2014 just
prior to the end of the fiscal year (2014 8K dated March 26). Also,
the Company’s previous chief financial officer, Kelly J. Kennedy,
resigned effective November 12, 2013 and was succeeded by Zahir
Ibrahim on the following day (2013 8K dated October 16). Such
changes in the C-suite can wreak havoc on internal controls, and
potentially negatively affect financial reporting.
So, is there any quantitative support for my
qualitative concerns about the quality of Annie’s financial
reporting? Absolutely! Let’s first see what the
Beneish Model reveals about the likelihood
of earnings manipulation by the Company’s management.
Go to either of the above sites and do a word search on the phrase "Grumpy
Old." Most the hits will be older blogs that cannot be accessed easily from Tony's
new site since he commenced a new blog after Ed dropped out.
I provide generous quotations of Ed's old blog modules.
Teaching Case
From The Wall Street Journal Weekly Accounting Review on July 25, 2014
SUMMARY: A federal judge said PricewaterhouseCoopers LLP must face
the Federal Deposit Insurance Corp.'s $1 billion lawsuit that alleges the
accounting firm failed to catch the massive fraud that brought down Colonial
Bank, one of the largest bank collapses in U.S. history. Judge W. Keith
Watkins of the U.S. District Court in Montgomery, Ala., said the FDIC's
theory that the auditor's failure to uncover the fraud was "plausible"
enough to allow the suit to survive. The accounting firm's lawyers have
previously argued the FDIC's suit is without merit because Colonial's own
management and largest customer-Taylor Bean-lied to regulators, internal
auditors and to PwC itself.
CLASSROOM APPLICATION: This article could be used when covering the
issues of auditor liability for fraud.
QUESTIONS:
1. (Introductory) What are the facts of this case? Who are the
parties to this lawsuit? What was the judge's ruling?
2. (Advanced) What was the reasoning behind the judge's ruling?
What particular issue was he addressing?
3. (Advanced) What are the rules regarding auditor detection of
fraud? Are auditors responsible to detect fraud?
4. (Advanced) What are fraud examiners? What are their tasks and
responsibilities? How does fraud examination differ from auditing?
5. (Introductory) Who was behind the fraud at Taylor Bean? What was
his scheme? What happened to him? Could he have the same punishment if his
boss had instructed him to do these activities?
Reviewed By: Linda Christiansen, Indiana University Southeast
A federal judge said PricewaterhouseCoopers LLP
must face the Federal Deposit Insurance Corp.'s $1 billion lawsuit that
alleges the accounting firm failed to catch the massive fraud that brought
down Colonial Bank, one of the largest bank collapses in U.S. history.
Judge W. Keith Watkins of the U.S. District Court
in Montgomery, Ala., said Tuesday that the FDIC's theory that the auditor's
failure to uncover the fraud was "plausible" enough to allow the suit to
survive. It was the second legal setback in as many weeks for the accounting
firm.
"FDIC's theory is that the defendants failed to
discover existing fraud at the time of their auditing services, which
permitted the continuation of the fraudulent scheme, albeit through
different means," Judge Watkins wrote in a six-page order. "It is plausible
that the defendant auditors should have reasonably anticipated that a
general fraudulent scheme would continue if their allegedly faulty auditing
services failed to detect existing wrongdoing."
The FDIC, as the receiver for the failed Alabama
bank, sued PwC and fellow accounting firm Crowe Horwath LLP for failing to
detect the long-running fraud at Colonial's largest client, Taylor Bean &
Whitaker Mortgage Corp.
The FDIC lawsuit, which already survived an earlier
legal challenge from the accounting firms, blames the auditors for missing
"huge holes in Colonial's balance sheet" and other serious gaps without ever
detecting the multibillion-dollar fraud at Taylor Bean.
The Taylor Bean fraud "would have been prevented
had PwC and Crowe properly performed their audits in compliance with
applicable professional standards," said the FDIC's lawyers in the suit.
PwC and Crowe Horwath have denied any wrongdoing.
A PwC spokeswoman wasn't immediately available for
comment Wednesday, but the accounting firm's lawyers have previously argued
the FDIC's suit is without merit because Colonial's own management and
largest customer—Taylor Bean—lied to regulators, internal auditors and to
PwC itself. Crowe Horwath spokeswoman Amanda Shawaluk said the firm believes
that all claims against Crowe are totally without merit.
The FDIC has been left with remnants of hundreds of
failed banks in recent years, the result of the wave of bank closures by
regulators in the aftermath of the bursting of the housing bubble. Although
the FDIC transfers a failed bank's deposits to a stronger company—to BB&T
Corp. BBT +0.75% (BBT) in Colonial's case—it is left as a receiver for what
remains.
The collapse of Colonial, which had $25 billion in
assets and $20 billion in deposits, was the biggest bank failure of 2009.
The regulator estimates Colonial's failure will ultimately cost its
insurance fund $5 billion, making it one of the most expensive bank failures
in U.S. history. The FDIC, however, hadn't made a point of targeting the
professional firms who advised the failed banks until filing the original
Colonial lawsuit in 2012.
The mastermind behind the fraud at Taylor Bean was
the company's top executive, 61-year-old Lee Farkas, who is now serving a
30-year prison sentence in North Carolina for orchestrating the seven-year
fraud that pumped a pile of bad loans into what appeared to be billions of
dollars of assets.
His scheme involved Colonial "purchasing" mortgage
loans from Taylor Bean that already had been sold to other investors, such
as Freddie Mac. He wasn't caught until after federal authorities raided
Colonial's and Taylor Bean's offices in August 2009.
Mr. Farkas, whom federal prosecutors described as a
"consummate fraudster," was convicted in the spring of 2011 of
misappropriating about $3 billion and trying to fraudulently obtain more
than $550 million from the government's Troubled Asset Relief Program in a
failed effort to prop up Colonial.
An Alabama federal judge refused Tuesday to dismiss
Federal Deposit Insurance Corp. claims against PricewaterhouseCoopers LLC
and another company over alleged failures in their auditing of Colonial
Bank, saying the agency didn't need to show it could have anticipated the
form that an $899 million mortgage fraud would take.
U.S. District Judge Keith Watkins said the FDIC had
sufficiently pled the claims that auditor negligence enabled double- and
triple-pledging by Taylor Bean & Whitaker Mortgage Corp., a scheme in which
Taylor Bean allegedly kept loan proceeds...
Continued in article
Question
Should Hertz auditor PwC have caught this huge error?
Hertz Global Holdings Inc. HTZ -0.14% said it must
restate results for 2011 and would correct and possibly restate 2012 and
2013 financial statements, according to a regulatory filing Friday that
indicated more widespread accounting problems at the auto-rental company
than had been thought.
Hertz, citing the results of an internal audit,
said its results for 2011, most recently included in its annual report filed
for 2013, "should no longer be relied upon," and that the company must
restate them.
The disclosure follows the company's warning last
month that it may have to restate 2011's results, as well as the detection
of reporting errors in March and its naming of a new chief financial officer
at the end of last year.
Shares of Hertz fell 9% Friday as the company also
warned that its delayed first-quarter results would come in below estimates.
The company said it must correct its 2012 and 2013
financial statements to further reflect the errors in 2011. The results for
those years may also be restated if further adjustments are determined to be
material. The company added that it is reviewing if the issues have had any
impact on results in 2014.
"It will take time to complete this process, and
previously reported information is likely to change, although the actual
size of any adjustments has yet to be determined and some adjustments may
offset others," the company said in its filing with the U.S. Securities and
Exchange Commission.
Hertz said management and the board's audit
committee have determined that "at least one material weakness" was present
in the company's internal financial-reporting controls, and that disclosure
procedures and controls were ineffective at the conclusion of last year.
The company said it is continuing a review that
began when it was preparing its first-quarter report.
The review "recently identified other errors
related to allowances for uncollectable amounts with respect to renter
obligations for damaged vehicles and restoration obligations at the end of
facility leases," Hertz said.
Hertz said the chairman of its audit committee has
discussed the matter with the company's external accountant,
PricewaterhouseCoopers LLP, and that it "expects to receive an adverse
opinion" from the firm on its internal controls over financial reporting as
of Dec. 31.
A representative for PwC wasn't immediately
available for comment.
In March, Hertz identified $46.3 million in
reporting errors that dated back to 2011. At
the time, PwC said, according to Hertz's filing, the car-rental company
fairly presented its results and that the company "maintained, in all
material respects, effective internal control over financial reporting."
PwC's expected shift in opinion on Hertz's
internal controls shouldn't come as a surprise, given the restatement and
revisions, said Charles K. Whitehead, a Cornell University professor who
specializes in corporate and financial law.
"The real question is whether Hertz's managers
and PwC reasonably should have been aware of the problems earlier, and how
those problems were discovered," Mr. Whitehead said.
"Were they uncovered by Hertz and brought to PwC's
attention, or did PwC's review—and potential change of opinion—prompt Hertz
to get ahead of the problem?"
Hertz last month delayed the filing of its
first-quarter financial results after identifying errors relating to
conclusions about the capitalization and timing of depreciation for some
non-fleet assets as well as allowances for doubtful accounts in Brazil,
among other items.
At the time, the company expected to release
results June 9 but said Friday that it doesn't expect to hold its planned
conference call on that date. The company said it would file and report its
first-quarter results when it files the amendment to its annual report.
Hertz earlier this year sought more time to file
its results for 2013, saying it faced "significant issues" after
implementing a system meant to improve financial disclosures.
The delayed report came as the company appointed a
new chief financial officer, former Hilton Worldwide Inc. executive Thomas
Kennedy, who was named to the post following the resignation of Elyse
Douglas.
Hertz on Friday also warned that its attempt to
resolve its accounting issues could delay the separation of its
equipment-rental business, although the plans "remain on track."
In addition, the company said its results for the
first quarter of this year are likely to come in below consensus analyst
estimates, as they will reflect costs associated with the accounting review.
Analysts polled by Thomson Reuters had recently projected per-share earnings
of nine cents and revenue of $2.57 billion for the quarter.
Continued in article
"How Wheels Came Off of Hertz' Accounting," by Tammy Whitehouse,
Compliance Week, June 24, 2014 ---
Click Here
It's an experience almost anyone can
appreciate: your car seems to perform so well for so long—then, suddenly,
all the little things go at once. And you're stuck on the side of the road.
So seems to be the case with $10.7 billion
Hertz, the auto rental company that warned on June 6 of a massive financial
restatement yet to come. In a Form 8-K filing, Hertz warned that its current
quarterly filing would be late and that its financial statements for 2011
should no longer be relied upon. Even worse, the 2012 and 2013 annual
statements might be called into ...
Hertz Global Holdings, a favorite stock in recent
months of some closely-watched hedge funds, disclosed on Friday morning that
its audit committee had concluded that problems with the company’s financial
statements for the last three years must be corrected to reflect mistakes.
Shares of Hertz tumbled by 10.8% in early morning
trading to $27.19. The stock had recently surged as investors of the car
rental company anticipated its split into two companies by next year.
Specifically, the company said its 2011 financial statements were no good
and must be restated, and that its 2012 and 2013 financial statements need
to be fixed.
Hertz’s stock has been popular with prominent hedge
fund investors. As of the end of March, some of its biggest shareholders
included billionaire Larry Robbins’ Glenview Capital Management, billionaire
James Dinan’s York Capital Management, Jeffrey Tannenbaum’s Fir Tree and
billionaire Dan Loeb’s Third Point. It is unclear to what extent those hedge
funds still remain in the stock today.
“The audit committee has directed the company to
conduct a thorough review of the financial records for fiscal years 2011,
2012 and 2013, and this review may require Hertz to make further adjustments
to the 2012 and 2013 financial statements,” Hertz said in a Securities &
Exchange Commission filing. “If these further adjustments to the 2012 and
2013 financial statements are determined to be material adjustments
individually or in the aggregate, Hertz will need to also restate and
withdraw reliance on those financial statements.”
Hertz had already delayed filings its first quarter
financial statements last month after identifying errors related to its
capitalization and timing of depreciation for non-fleet assets, allowances
for doubtful accounts in Brazil and other items. It also found problems
related to allowances for uncollectible amounts with respect to renter
obligations for damaged cars. Previously this year, the company found $46.3
million in out-of-period accounting mistakes in the past three years.
Imagine my surprise when Ben Horowitz, one half of
the venture capital team of
Andreessen Horowitz,
wrote a blog post about dodging a jail term for stock
option backdating that also implicated PwC.
Michelle (note: her name has been changed)
comprehensively understood software accounting, business models, and
best practices, and she was beloved by Wall Street in no small part due
to her honest and straightforward reporting of her previous company’s
business. In my reference checking, at least a dozen investors told me
that they made far more money when the numbers disappointed than when
the company outperformed, because they trusted Michelle when she said
that things were not worse than they appeared and bought on the dips.
Once she came on board, Michelle rapidly
reviewed all of our practices and processes to make sure we were both
compliant and competitive. One area where she thought we were less than
competitive was our stock option granting process. She
reported that her previous company’s practice of setting the stock
option price at the low during the month it was granted yielded a far
more favorable result for employees than ours. She also said that since
it had been designed by the company’s outside legal counsel and approved
by their auditors, it was fully compliant with the law.
I’m not sure why Horowitz bothered to change the
name of the CFO. It’s public knowledge. Sharlene Abrams was CFO of Opsware
and her previous employer was Mercury Interactive.
The S.E.C. claimed in 2007 that Ms. Abrams and
three other former officers committed fraud by backdating stock option
grants and failing to record hundreds of millions of dollars of
compensation expenses. As part of a
settlement with the agency in 2009, Ms. Abrams
was barred from serving as an officer or a director of a public company.
She later
pleaded guilty to tax evasion after a Justice
Department inquiry into the stock options scheme.
Sharlene P. Abrams, the chief financial officer
of Opsware at that time, was forced to resign in 2006 after it emerged
that the S.E.C. was planning an enforcement action against her in
connection to her previous employment at Mercury Interactive, an
enterprise software company.
No one talks about stock options backdating much
anymore. Certainly auditors are rarely mentioned even when someone actually
does. Of all the parties who could have been seriously singed in the options
back dating law enforcement conflagration ignited by Iowa academic Erik Lie,
auditors were left pretty much unscathed.
How did Horowitz, according to his account, avoid
jail? He asked his General Counsel to review an Abrams proposal to
advantageously date options.
According to Horowitz:
I told “Michelle” that a better stock granting
process sounded great, but I needed Jordan Breslow, my General Counsel,
to review it before making a decision. Jordan lived in my hometown of
Berkeley and he certainly belonged there. With hippie sensibilities,
Jordan was nearly allergic to corporate politics, showmanship, or any
behavior that covered the truth. As a result, I knew that what he said
was 100% what he believed and had nothing to do with anything else. I
could trust it.
“Michelle” was surprised, as her
previous company had run this practice for years with full approval from
PricewaterhouseCoopers, its accounting firm. I said:
“That’s all fine and good, but I still need Jordan to review it first.”
Jordan came back with an answer that I did not
expect: “Ben, I’ve gone over the law six times and there’s no way that
this practice is strictly within the bounds of the law. I’m
not sure how PwC justified it, but I recommend against it.” I told “Michelle” that we were not going to implement the
policy and that was that.
Now that the Securities and Exchange Commission and
its
“Operation Broken Gate” initiative has crossed
KPMG’s independence violations off its to-do list, the agency can move on to
the rest of the ones I’ve already identified for them.
One set of facts that should be very easy to wrap
up in shiny paper with a big bow would be the potentially illegal business
relationships between PwC and its audit client Thomson Reuters. I wrote
about them way back in
December of 2012 at Forbes and then in more detail
here.
Through the CIP, Thomson Reuters will
provide PwC US with training and technical support that PwC will use
to work with clients who use Thomson Reuters software solutions in
their corporate tax and accounting departments.
There is a certainly a shared benefit to
teaming up to sell software and consulting services. You can agree
or disagree whether such arrangements should be prohibited, but
under existing rules in the UK and for US listed audit clients of
the global firms, they are prohibited.
I checked and PwC is still listed is a
“Certified Implementer” (CIP) of Thomson
Reuters One Source tax software. In fact, the contact name for the
PwC/Thomson Reuters business alliance is a partner right here in my
hometown of Chicago.
(PwC and Thomson Reuters never responded to my
original requests for comment via Forbes on the Decemeber 2012 report.
I didn’t, therefore, check again this time but if something’s changed
they can give me a holler.)
Thomson Reuters sells its software products all
over the world and they are used by PwC member firms for their clients
in at least the US, UK and now in China. Thomson Reuters is dual listed
on the New York Stock Exchange and the Toronto Stock Exchange. Thomson
Reuters recently changed auditors effective with the 2012 fiscal
year—from the PwC Canada firm to the PwC US firm. That may not seem like
a big deal but it is. The fees, $41 million in 2012, crossed the border
with no disguises or fake passports necessary.
As a result of the
SEC’s recent investigation of KPMG’s
independence violations, the staff is, I hope, now intimately and
thoroughly reacquainted with its
Final Rule: Revision of the Commission’s Auditor Independence
Requirementseffective February 5,
2001. The SEC put everyone on notice as a result of the recent
enforcement action that the perception of auditor independence is as
important, or maybe even more important, than the fact of auditor
independence. That’s especially when it comes to putting your tax
professionals on the job and in the audit client’s cafeteria every day.
The SEC staff has also hopefully memorized
Rule 2-01(b) of Regulation S-X (17 CFR
210.2-01.), amended under the Sarbanes-Oxley Act of 2002 to enhance
auditor independence after the Enron and Arthur Andersen failures.
Spain’s anti-corruption prosecutor accused 61
PricewaterhouseCoopers LLP partners of committing tax crimes, saying they
failed to declare a total of 21 million euros ($28.4 million) in bonus
payments.
The PwC partners categorized the 2002 bonus
payments as part of the price of the sale of a consulting division to IBM
that carried a lower tax rate, the prosecutor said in an e-mailed statement
today. The agency presented a written accusation requesting a criminal
trial, according to the statement.
“The partners omitted to establish in their tax
returns that the sums were payments from work,” the prosecutor said.
PwC “roundly denies” the accusations against its
partners and is convinced that the case will be thrown out once the truth is
recognized, the firm’s Madrid office said in an e-mailed statement today.
“There has been no concealment or fraud,” PwC said.
“All the operations and amounts have been declared and formulated with all
the legal requirements.”
Spain is clamping down on tax evasion as part of
its drive to tackle a budget deficit that risks slipping from its target.
The budget shortfall, excluding municipalities, was 5.27 percent of gross
domestic product in the first seven months of the year, compared with a
full-year target of 6.5 percent.
The prosecutor is seeking jail terms of as much as
14 years and 10 months and fines of more than 102 million euros.
A federal judge on Wednesday rejected
PricewaterhouseCoopers' request to dismiss a $1 billion lawsuit accusing the
auditor of providing bad accounting advice that contributed to the October
2011 collapse of MF Global Holdings Ltd, a brokerage run by former New
Jersey Governor Jon Corzine.
U.S. District Judge Victor Marrero rejected PwC's [PWC.UL]
argument that the MF Global's bankruptcy plan administrator, which brought
the lawsuit, "stands in the shoes" of the company under the "in pari delicto"
legal doctrine, and cannot recover because Corzine and other officials were
also to blame for the collapse.
Marrero has yet to review other PwC arguments for
dismissal, including that the administrator had no authority to sue and did
not show that the accounting advice was a "proximate" cause of MF Global's
bankruptcy.
A PwC spokesman had no immediate comment. The
auditor's lawyer did not immediately respond to a request for comment.
The March 28 lawsuit accused PwC of professional
malpractice for providing "flatly erroneous" advice on how to account for
Corzine's $6.3 billion investment in European sovereign debt.
Marrero said that while MF Global may have provided
information used to formulate that advice, the complaint did not suggest it
had an "active, voluntary" role in the advice or was a "willing participant"
in unlawful conduct related to it.
"Under PwC's reasoning, the in pari delicto
doctrine would insulate an auditor from liability whenever a company pursues
a failed investment strategy after receiving wrongful advice from an
accountant," Marrero wrote. "Such a broad reading of the doctrine would
effectively put an end to all professional malpractice actions against
accountants."
Prior to its Oct. 31, 2011 bankruptcy, MF Global
had struggled with worries about the sovereign debt, margin calls, credit
rating downgrades, and news that money from customer accounts was used to
cover liquidity shortfalls.
Corzine is also a former Goldman Sachs co-chairman.
He is not a defendant in the PwC case but faces other lawsuits over MF
Global from investors, customers and U.S. regulators.
The case is MF Global Holdings Ltd as Plan
Administrator v. PricewaterhouseCoopers LLP, U.S. District Court, Southern
District of New York, No. 14-02197.
PwC US is also
a
“Certified Implementer” of Thomson Reuters
One Source software. That means
PwC consulting professionals implement Thomson Reuters
for third-parties, perhaps at times in joint
engagements with Thomson Reuters. Are there incentives paid? There
must be a joint marketing and training arrangement at least. There
is a certainly a shared benefit to teaming up to sell software and
consulting services. You can agree or disagree whether such
arrangements should be prohibited, but under existing rules in the
UK and for US listed audit clients of the global firms, they are
prohibited.
Why isn’t the SEC
and PCAOB enforcing auditor independence rules prohibiting business
alliances between auditors and their audit clients?
PwC and Thomson
Reuters would not comment for Forbes.com.
Professor Paul
Gillis, a PCAOB SAG member and author of the
China
Accounting Blog, thinks I “jumped the
shark” with this one.
The independence
requirement serves two related, but distinct, public policy
goals. One goal is to foster high quality audits by minimizing
the possibility that any external factors will influence an
auditor’s judgments. The auditor must approach each audit with
professional skepticism and must have the capacity and the
willingness to decide issues in an unbiased and objective
manner, even when the auditor’s decisions may be against the
interests of management of the audit client or against the
interests of the auditor’s own accounting firm.
The other
related goal is to promote investor confidence in the financial
statements of public companies. Investor confidence in the
integrity of publicly available financial information is the
cornerstone of our securities markets. Capital formation depends
on the willingness of investors to invest in the securities of
public companies. Investors are more likely to invest, and
pricing is more likely to be efficient, the greater the
assurance that the financial information disclosed by issuers is
reliable. The federal securities laws contemplate that that
assurance will flow from knowledge that the financial
information has been subjected to rigorous examination by
competent and objective auditors.
The two goals —
objective audits and investor confidence that the audits are
objective — overlap substantially but are not identical. Because objectivity rarely can be observed directly,
investor confidence in auditor independence rests in large
measure on investor perception. For this reason,
the professional literature, such as the AICPA’s Statement on
Auditing Standards (SAS) No. 1, has long emphasized that
auditors “should not only be independent in fact; they should
also avoid situations that may lead outsiders to doubt their
independence.” The Supreme Court has emphasized the importance
of the connection between investor confidence and the appearance
of independence:
The SEC requires
the filing of audited financial statements in order to obviate
the fear of loss from reliance on inaccurate information,
thereby encouraging public investment in the Nation’s
industries. It is therefore not enough that financial
statements be
accurate; the public must also perceivethem
as being accurate. Public faith in the reliability of a
corporation’s financial statements depends upon the public
perception of the outside auditor as an independent
professional. . . . If investors were to view the
auditor as an advocate for the corporate client, the value of
the audit function itself might well be lost.
Apparently, PwC
ad Thomson Reuters believe what happens in China stays in China.
Thomson
Reuters announced it
signed a three-year contract with PwC,
the company’s auditor, to provide use of the Thomson Reuters
ONESOURCE Corporate Tax solution for China. PwC U.K. also uses
this Thomson Reuters software for its tax clients. Business
alliances between a company and its auditor are prohibited under
U.S. law and U.K. auditor regulations. Thomson Reuters,
headquartered in New York, has its shares listed on the Toronto
and New York Stock Exchanges.
Rule 2-01(b) of Regulation S-X (17 CFR
210.2-01.), amended under the Sarbanes-Oxley Act of 2002 to
enhance auditor independence after the Enron and Arthur Andersen
failures, provides the standard used to judge a business
relationship between a company and its auditor or services
provided to an audit client:
Does the
relationship create a mutual or conflicting interest between
the accountant and the audit client?
Does the
relationship result in the accountant acting as management
or an employee of the audit client?
Does the
relationship place the accountant in a position of being an
advocate for the audit client?
For business
relationships specifically, the law allows contracts between a
auditor and its client only if the auditor is a consumer in the
normal course of business and receives no incentives, special
pricing or other advantage that other customers would not
receive.
Questions
Why are US. towns & states, labor unions, and other investors suing
U.K.'s Barclays and other U.K. banks for LIBOR manipulation?
Why do PwC auditors need more caffeine?
Answer
Many of their returns on investments in things like pension funds were
diminished by U.K. bank conspiracies to manipulate LIBOR. And millions
of interest rate swaps based upon LIBOR underlyings (notionals in the
trillions) did not have fair and just settlements. What a huge mess
going on while PwC and other Big Four auditing firms slept!!!
SUMMARY: "Lawyers representing customers of MF Global
Holdings Ltd. added accounting firm PricewaterhouseCoopers LLP to a
civil lawsuit against former executives of the failed securities
firm, saying PwC failed to adequately audit MF Global's internal
controls....PwC said it 'will defend this lawsuit vigorously,' and
that its review of MF Global's internal controls was 'in accordance
with professional standards.' The audit evidence confirmed that MF
Global maintained customer assets in accordance with regulators'
requirements as of the date of PwC's audit, the firm said...."
CLASSROOM APPLICATION: The article may be used in auditing
classes to discuss business risk versus audit risk, engagements to
audit financial reports versus reports on internal controls,
litigation risks in attestation engagements, and internal control
weaknesses.
QUESTIONS:
1. (Introductory) Refer to the related article. What is MF
Global? What internal control issues are associated with its
bankruptcy?
2. (Introductory) Why has PriceWaterhouseCoopers (PwC) been
included as a defendant in a lawsuit "against former executives of
the failed securities firm" MF Global Holdings Ltd?
3. (Introductory) What is the specific claim against the
work done by PwC and the resulting reports issued by the firm?
4. (Advanced) Define the terms business risk and audit
risk.
5. (Advanced) Is there any evidence, as described in this
article, that might have led PwC to increase its assessment of the
business risk associated with its client MF Global? Would such an
assessment impact the firm's assessment of audit risk and,
therefore, audit procedures applied in the engagement? Explain.
6. (Advanced) Is it conceivable that PwC could conclude
that MFGlobal's internal controls were adequate even after having
been "copied on several MF Global internal-audit reports that
indicated there were deficiencies in the firms' internal controls"?
Explain your answer.
7. (Advanced) Is there a difference in responsibility
associated with PwC's audit of MF Global's financial statements as
compared to its report on MF Global's internal controls? Explain
your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Lawyers representing
customers of MF Global Holdings Ltd. MFGLQ -5.56% added accounting
firm PricewaterhouseCoopers LLP to a civil lawsuit against former
executives of the failed securities firm, saying PwC failed to
adequately audit MF Global's internal controls.
The amended suit,
filed in Manhattan federal court Monday, reiterated accusations that
Jon S. Corzine, MF Global's former chief executive, and other
officials at the firm breached their fiduciary duty to MF Global
customers and violated the Commodity Exchange Act. The suit also
added a player with deep pockets to the mix as customers continue to
try to recover an estimated $1.6 billion that went missing from
their accounts when MF Global filed for bankruptcy Oct. 31, 2011.
PwC said it "will
defend this lawsuit vigorously," and that its review of MF Global's
internal controls was "in accordance with professional standards."
The audit evidence confirmed that MF Global maintained customer
assets in accordance with regulators' requirements as of the date of
PwC's audit, the firm said, and both congressional testimony and a
report from the bankruptcy trustee overseeing MF Global "support
this conclusion."
Mr. Corzine is
expected to contest the claims.
The suit, which
seeks class-action status, detailed many of the same findings as a
bankruptcy trustee, James Giddens, in a June report. The trustee has
assigned his claims against former MF Global officers to plaintiffs'
law firms to reduce the legal costs of recovering money.
The latest move
comes as civil regulatory investigations continue. A criminal probe
hasn't resulted in any charges.
About 36,000
customers of MF Global's U.S. brokerage have filed claims with Mr.
Giddens's office. Many have received about 80 cents on the dollar of
cash owed to them, while customers who invested on foreign exchanges
have received only about five cents on the dollar, due to disputes
about how the money should be treated under U.K. bankruptcy law.
"I'm optimistic
we'll recover all the customer money and hopefully a good chunk of
money for the general estate," said Andrew Entwistle, managing
partner at Entwistle & Cappucci, one of the two firms leading the
representation of MF Global's commodities customers.
The complaint
alleges that PwC, as MF Global's auditor, said the firm's internal
controls for safeguarding customer assets were adequate when in fact
they weren't and that PwC should have known they weren't.
The complaint
alleges PwC breached a fiduciary duty to MF Global and its customers
and was negligent in its work at the firm. "If they had made sure
the internal controls were adequate, there never would have been an
invasion of customer funds," said Merrill Davidoff, a managing
principal at Berger & Montague, which also is representing the
commodities customers.
In 2010 and 2011,
according to the complaint, PwC was copied on several MF Global
internal-audit reports that indicated there were deficiencies in the
firm's internal controls.
In 2010, according
to an internal review by MF Global cited in the complaint, there
were five instances in which the firm drew on customer funds to such
a degree that it was "funded by clients."
That isn't
necessarily against federal commodities rules, but it exposed the
firms' clients to risks.
Eric
Schneiderman,the New York Attorney General, filed suit yesterday
against JPMorgan Chase for the sins of Bear Stearns committed prior
to the distressed purchase of Bear Stearns by the bank in 2008.
Schneiderman plays a dual role here, as New York AG and co-head of
the Obama administration Residential Mortgage Backed Securities
Working Group. That task force was peeved, according to Alison
Frankel for Thomson Reuters’ On The Case blog, that Schneiderman
filed the suit Monday, jumping the gun on a joint federal-state
press conference scheduled for Tuesday.
The NYAG complaint
rests heavily on work done by others, in particular law firm
Patterson Belknap Webb & Tyler, journalist Teri Buhl - who has been
following this story since 2010 – and documentary filmmaker Nick
Verbitsky. Patterson Belknap represents monoline mortgage insurers
Ambac, Syncora and Assured Guaranty in their pursuit of Bear Stearns
and now JPM.
Unfortunately, the
NYAG complaint rests a bit too heavily on Patterson Belknap’s Ambac
complaints (first and second amended versions) when discussing the
role and responsibilities of global professional services firm
PricewaterhouseCoopers.
In August 2006,
Bear Stearns’ external auditor, PriceWaterhouseCoopers (“PWC”),
advised Bear Stearns that its failure to promptly review the
loans identified as defaulting or defective was a breach of its
obligations to the securitizations.232 PWC advised Bear Stearns
to begin the “[i]mmediate processing of the buy-out if there is
a clear breach in the PSA agreement to match common industry
practices, the expectation of investors and to comply with the
provisions in the PSA agreement.”
The New York
Attorney General’s complaint repeats an error made by Patterson
Belknap in the Ambac complaints and that was proliferated in many
media reports when the Ambac suit was filed: PwC is not
Bear Stearns external auditor. The error in the
paragraph above and another that says “audit firm” PwC advised Bear
Stearns in August of 2006 that “its failure to promptly evaluate
whether the defaulting loans breached
EMC’s
representations and warranties to the
securitization participants was contrary to “common industry
practices, the expectation of investors and . . . the provisions in
the [deal documents],”” misrepresents PwC’s role and the importance
of its report, misleading the reader. The error wasn’t caught by the
New York Attorney General’s office, potentially affecting its
litigation strategy and the public’s perception of PwC.
The PwC report
prepared for Bear Stearns is entitled, “UPB Break Repurchase Project
– August 31, 2006.”
Alison Frankel obtained a copy of the
first few pages but that’s enough to see that PwC acted as a
consultant to Bear Stearns, not its external auditor. This was not
an audit report. It is the summary of recommendations to a client by
a consultant who was
paid for advice that likely wasn’t followed.
I taped an
episode of the
Keiser Report
last week while in New York. The focus was
Jamie Dimon with a bit of MF Global thrown in for heat. Max Keiser,
the host, asked me, “Why does Jamie Dimon of JPMorgan still have a
job?”
Hard to say.
When I
predicted in January that Dimon would have
his “comeuppance” in 2012, the prognostication was predicated on
backlash from the bank’s involvement, as MF Global’s main banker, in
the failure of that broker/dealer and FCM.
The broker-dealer’s
customers have accused JPMorgan of taking advantage of MF Global’s
weak position to hold onto hundreds of millions of their funds, but
JPMorgan says it was not the culprit. The MF Global story is
one-year old but so far the trustees haven’t directly sued anyone.
The backlash to JPMorgan and Dimon has been practically nil. Jon
Corzine, CEO of MF Global, and his banker Jamie Dimon, have not
suffered the consequences I thought they would.
The customers
have
finally sued PricewaterhouseCoopers, the
MF Global auditor, for its role in the failure. The MF Global
Trustee assigned its claims against several parties to the
customers, partly, I believe, to avoid the conflicts the Trustee has
with PricewaterhouseCoopers, the auditor, and JPMorgan. But JPMorgan
was dropped from the suit and is, for now, not a defendant. I
suspect the bank is negotiating a settlement so it can scratch this
mess off its long list of “litigation to dispose of”.
Because Jamie Dimon
is facing a very long list of regulatory and legal challenges.
JPMorgan took
advantage of the break from MF Global to make more trouble for
itself. The toll for the “London whale” trades is a $5.8 billion
loss, making Dimon’s early dismissal of the issue as a “tempest in a
teapot” quite embarrassing. Initial estimates of the loss hit
first-quarter results but those numbers were wrong. An expedited
internal investigation found that traders mismarked trades to
minimize the reported loss. The quarterly securities filing had to
be formally restated. The “whale” loss has also attracted
shareholder suits from six public pension funds.
Dimon did face
some music at the annual meeting in May. He admitted the “whale”
trades were “poorly constructed, poorly reviewed, poorly executed
and poorly monitored.” But he doesn’t seem to be losing any sleep
over them and, so far,
holds on to his compensation package.
Investors, the board and regulators did not become aware of the
trade price manipulation until August. The SEC and Department of
Justice are still investigating the loss.
Jamie Dimon’s
perceived stellar stewardship of the bank’s stock price – I called
it a “results reprieve” in the Keiser
report interview – has shielded him, and the bank, from serious
compliance and controls complaints in the past. But now several
media outlets are reporting JPM, like all the big banks, is under
investigation for Libor rate manipulation and anti-money laundering
violations, too. JPM is reportedly one of many subpoenaed by New
York, Connecticut and Florida Attorneys General regarding Libor rate
manipulation. JPM is also reportedly the subject of an OCC probe for
suspicious money transfers. JPMorgan Chase, along with other big
banks, will probably pay big money for its “get out of jail card”,
as Barclays did for its Libor scandal and Standard
Chartered did for its settlement
for suspicious transactions with Iran.
Dimon has been
sanguine in the past about the bank’s exposure to mortgage-related
losses and liability for transgressions by its crisis-era
acquisitions Bear Stearns and Washington Mutual.
The Wall Street Journal quoted Dimon
in December saying the bank was “facing fewer mortgage problems than
competitors.” Dimon’s luck on mortgage liability has changed.
New York
Attorney General Eric Schneiderman
filed suit against
the bank regarding the quality, or lack of thereof, of the mortgages
stuffed into securities sold by Bear Stearns prior to its
acquisition. If you think JPM isn’t liable for the sins committed by
a company it bought
“as a favor to the Fed,” take a look at
this lawsuit,
Assured Guaranty vs. Bear Stearns EMC.
Never underestimate
the government’s capacity for incompetence when it comes to
overseeing large financial institutions. The latest example: an
ill-advised consulting contract between Freddie Mac’s outside
auditor and the federal agency in charge of running the company.
Freddie Mac, the
housing financier with a $2.1 trillion balance sheet that was seized
by regulators in 2008, remains under the control of its conservator,
the Federal Housing Finance Agency. Yet its shares and bonds are
still publicly traded. And it continues to file reports with the
Securities and Exchange Commission, which means it must follow the
SEC’s rules.
Some of those
regulations seem to have been ignored when the FHFA hired Freddie
Mac’s auditor, PricewaterhouseCoopers LLP, in May to provide advice
on managing the company. The firm’s work includes consulting
services that are barred under the SEC’s auditor-independence rules,
as far as I can tell. The agency and the accounting firm say they
are following the rules. Their explanations aren’t convincing.
The contract came to
light this week after the housing- finance agency released a copy to
Vern McKinley, a consultant working with the Washington-based
advocacy group Judicial Watch, in response to a Freedom of
Information Act request. The agency hired Pricewaterhouse to create
contingency plans that would be used if the government someday
decides that Freddie Mac, Fannie Mae or any of the Federal Home Loan
Banks should be taken into receivership and liquidated.
(Pricewaterhouse
audits the 12 Federal Home Loan Banks, none of which is in
conservatorship. Fannie Mae’s auditor is Deloitte & Touche LLP.)
Promoting Confidence
The reason for
having auditor-independence rules is to promote confidence in the
integrity of companies’ financial statements. Auditors are supposed
to be watchdogs for the public, not beholden to their clients. To be
sure, the system is a bit of a charade. The client pays the firm for
its audit, so there always are conflicts of interest.
The independence
problem in this instance arises from the FHFA’s connection to
Freddie Mac. In substance, the agency is Freddie Mac. (FMCC) Here’s
how the company explained the relationship in its latest annual
report:
“As our conservator,
FHFA succeeded to all rights, titles, powers and privileges of
Freddie Mac, and of any stockholder, officer or director thereof,
with respect to the company and its assets,” the company said. “FHFA
has delegated certain authority to our board of directors to
oversee, and to management to conduct, day-to-day operations. The
directors serve on behalf of, and exercise authority as directed by,
the conservator.”
With that in mind,
the auditor-independence problems become obvious. There are three
main principles underlying the SEC’s rules: An auditor can’t
function in the role of management. It can’t audit its own work. And
it can’t serve in any advocacy role for an audit client.
The contract, under
which Pricewaterhouse will receive about $757,000, calls for
“providing general advice on receivership preparation, assisting the
FHFA in developing pre- and post-receivership procedures,
implementing those procedures,” and “assisting the FHFA in the
operation and administration of a receivership.”
That means
Pricewaterhouse is giving advice on how to run Freddie Mac, and even
could be called upon to help operate the company at some point. The
contract says the firm’s work includes making recommendations
regarding “valuation services” and “human resources.” The SEC’s
rules list those as services that auditors are prohibited from
providing to audit clients. PR Work
Additionally, the
contract calls for Pricewaterhouse to offer advice on “public
relations,” which is an advocacy role. Other services include making
recommendations on risk management, claims management, asset
management, and securities management.
A Pricewaterhouse
spokesman, Chris Atkins, released this statement: “PwC takes its
auditor independence requirements very seriously. Our acceptance of
the FHFA engagement was in consideration of the SEC’s auditor
independence rules. The scope of services being performed for FHFA
is consistent with those rules.” Asked to explain how, he declined
to comment.
The housing-finance
agency released a statement from its general counsel, Alfred
Pollard. “This is not a contract for PwC to perform work for Freddie
Mac or any other entity regulated by FHFA,” he said. Additionally,
Pollard said “measures are in place to ensure against conflicts of
interest and to maintain independence, including a process that
prevents PwC employees working on this FHFA contract from working on
contracts for a regulated entity.”
Nothing in his
statement addressed the point that the agency, as Freddie Mac’s
conservator, is standing in the company’s shoes, or that
Pricewaterhouse is providing advice on how to manage the company’s
affairs. A Freddie Mac spokeswoman, Sharon McHale, declined to
comment.
The independence
issues here were easily avoidable. There are plenty of firms the
agency could have hired instead. Plus, Pricewaterhouse was the
auditor for Freddie Mac when it was seized in 2008. The company has
never acknowledged anything wrong with its books, even though its
asset values obviously were overstated before it collapsed. There’s
no good reason to hire Pricewaterhouse for this work.
The government's
auditing regulator found deficiencies in 28 audits conducted by
PricewaterhouseCoopers LLP and 12 audits by KPMG LLP in its annual
inspections of the Big Four accounting firms.
The Public Company
Accounting Oversight Board (PCAOB) said many of the deficiencies it
found in its 2010 inspection reports of the two firms, released
Monday, were significant enough that it appeared the firms didn't
obtain sufficient evidence to support their audit opinions. The
regulator hasn't yet issued its yearly reports on its inspections of
the other Big Four firms, Ernst & Young LLP and Deloitte LLP.
The 28 deficient PwC
audits the inspectors found were out of 75 audits and partial audits
reviewed, and were an increase from nine deficient audits found in
the previous year's report. The deficiencies inspectors found in
various audits concerned, among other areas, testing of "fair value"
of the firm's assets, testing of revenue and receivables,
derivatives accounting and asset impairments. In two cases, the
companies involved later restated their financial statements; in a
third case, the company later made "substantial adjustments."
The board didn't
identify the audit clients involved, in accordance with its
practice.
PwC is "focused on
the increase" in the number of deficiencies reported over past
years, and is "working to strengthen and sharpen the firm's audit
quality, including making investments designed to improve our
performance over both the short and long term," Robert Moritz, PwC's
head partner and chairman, said in a statement.
KPMG's 12 deficient
audits were out of 54 audits and partial audits reviewed, and were
an increase from eight deficient audits found the previous year. The
accounting watchdog said the areas in which deficiencies were found
included fair-value testing, receivables testing, goodwill and
testing of loan-loss allowances. None of the deficiencies resulted
in restatements, though one led to a "substantial adjustment" in an
aspect of the company's financial statements.
KPMG "shares a
common objective with the PCAOB" to make sure high-quality audits
are provided, and the board's inspectors "have measurably helped
KPMG as we work to continuously improve our audit performance and
strengthen our system of audit quality control," George Ledwith, a
KPMG spokesman, said in a statement.
The accounting
watchdog conducts annual inspections of the biggest accounting
firms, examining a sample of each firm's audits to assess their
performance and make sure they're complying with auditing standards.
Only part of the report is made public; a section in which the board
assesses the firm's quality controls is sealed and never made public
as long as the firm addresses any criticisms to the board's
satisfaction within a year.
PwC already dmitted its guilt and
already apologized.
"PwC Accused of Breaking Financial Rules Again," Big Four
Blog, December 16, 2011
PwC is being probed
for its reporting of client assets held by Barclays Capital
Securities Ltd. to see if the Big4 firm broke financial rules.
The UK’s Accountancy
and Actuarial Discipline Board is investigating PwC’s reports to the
Financial Services Authority on Barclays’s compliance with rules
about separating client assets from other assets. In January, the
FSA fined Barclays £1.12 million (about $1.7 million) after
concluding that the bank failed to put client money in separated and
protected accounts. At issue was £752 million ($1.16 billion) in
client assets.
PwC told Business
Week that they “will cooperated fully with the AADB investigation
and we will be defending our work vigorously,” adding that “the
focus of the AADB is on cases which raise important issues affecting
the public interest.”
The AADB is also
seeking a fine of £1.5 million against PwC for its role on a
client-money account issue with JPMorgan Chase & Co.’s London
activities. The fine would be the highest ever levied for such a
case.
PwC lawyer Tim
Dutton has previously told a London tribunal that the fine should be
capped at £1 million because the firm has admitted its guilt and
already apologized.
TOPICS: Audit Quality, Audit Report, Auditing, Auditor Changes,
Auditor/Client Disagreements, business combinations, Business Ethics,
Fraudulent Financial Reporting
SUMMARY: The series of events leading to questions about auditing
practices at Olympus that failed to uncover a decades-long coverup of
investment losses is highlighted in this review. The company must submit its
next financial statement filing to the Tokyo Stock Exchange by December 14,
2011 for the period ended September 30, 2011 or face delisting.
CLASSROOM APPLICATION: The review focuses on auditing questions
about sufficient competent evidence, change of auditors, and ability to
provide an audit report given knowledge of the length of time this coverup
has been ongoing.
QUESTIONS:
1. (Introductory) What fraudulent accounting and reporting
practices has Olympus, the Japanese optical equipment maker, admitted to
committing?
2. (Advanced) What services is Mr. Woodford calling for to
investigate the inappropriate payments and accounting practices by Olympus?
Specifically name the type of engagement for which Mr. Woodford thinks that
Olympus should contract with outside accountants.
3. (Introductory) Refer to the related articles. What questions
have been raised about outside accountants' examinations of Olympus's
financial statements for many years?
4. (Advanced) Based only on the discussion in the article, what
evidence did Olympus's auditors rely on to resolve their questions about the
propriety of accounting for mergers and acquisitions? Again, based only on
the WSJ articles, how reliable was that audit evidence?
5. (Advanced) What happened with Olympus's engagement of KPMG AZSA
LLC as its outside auditor? What steps must be taken under U.S. requirements
when a change of auditors occurs?
6. (Introductory) What challenges will Olympus face in meeting the
deadline of December 14 to file its latest financial statements? What will
happen to the company if it cannot do so?
Reviewed By: Judy Beckman, University of Rhode Island
SUMMARY: This review continues coverage from last week of
the accounting scandal at Olympus Corp. The Investigation Report
into Olympus Corporation and its management, written by the "Third
Party Committee" hired by the Board of Directors on October 14,
2011, is available directly online at
http://online.wsj.com/public/resources/documents/third_party_olympus_report_english_summary.pdf
The report provides the clearest description yet of the investment
loss and accounting scandal that has brought the Japanese imaging
equipment maker to the brink of delisting from the Tokyo Stock
Exchange. As described in the opening page of the document, the
Olympus Corporation Board of Directors called for a third party
review because "the shareholders and others doubted that" payments
by Olympus to a financial advisor and acquisitions by Olympus, along
with subsequent recognition of impairment losses on those
investments, were appropriate. The findings in the report
essentially state that Olympus began incurring financial losses on
speculative investments that were originally hoped to bolster
corporate earnings when operating earnings declined due to a
strengthening yen in the late 1980s. "However, in 1990 the bubble
economy burst and the loss incurred on Olympus by the financial
assets management increased" (p. 6). Then, in 1997 to 1998, "when
the unrealized loss was ballooning," Japanese accounting standards
were changed to require fair value reporting of financial assets, as
did those in the U.S. "In that environment, Olympus led by Yamada
and Mori started seeking a measure to avoid the situation where the
substantial amount of unrealized loss would come up to the
surface..." because of this change in accounting standards. The
technique was so common in Japan that it was given a name, "tobashi."
As noted in the WSJ article, the Olympus auditors at the time, KPMG
AZSA LLC "...came across information that indicated the company was
engaged in tabshi, which recently had become illegal in Japan....[T]he
auditor pushed them...to admit to the presence of one [tobashi
scheme] and unwind it, booking a loss of 16.8 billion yen."
CLASSROOM APPLICATION: Questions relate to the accounting
environment under historical cost accounting that allows avoiding
recognition of unrealized losses and to the potential for audit
issues when management is found to have engaged in one unethical or
illegal act.
QUESTIONS:
1. (Introductory) For how long were investment losses
hidden by accounting practices at Olympus Corp?
2. (Advanced) What is the difference between realized and
unrealized investment losses? How are these two types of losses
shown in financial statements under historical cost accounting and
under fair value accounting methods for investments?
3. (Introductory) What accounting change in the late 1990s
led Olympus Corp. management to search for further ways to hide
their investment losses? In your answer, comment on the meaning of
the Japanese term "tobashi."
4. (Introductory) What happened in 1999 when KPMG AZSA
"came across information that indicated the company was engaged in
tobashi, which recently had become illegal in Japan"?
5. (Advanced) Given the result of the KPMG AZSA finding in
1999, what concerns should that raise for any auditor about overall
ability to conduct an audit engagement?
Reviewed By: Judy Beckman, University of Rhode Island
The secret held for
a quarter-century, quietly passed among senior executives. Within
Olympus Corp. the goal was clear. Hide some $1.5 billion in
investment losses from public view.
The toll on Olympus
mounted as time went by. "The core part of the management was
rotten, and that contaminated other parts around it."
So concluded a
200-page reported issued Tuesday, the most complete account yet of a
scandal that routed money through more than a dozen banks, funds and
investment firms around the globe, ultimately leading to the
departure of several top executives and putting the respected
optical-equipment maker on the bubble for a stock delisting.
Starting in the
mid-1980s, Olympus, along with other Japanese exporters, turned to
speculative financial investments as a way to ease the sting of a
surging yen with what they believed would be easy profits.
At Olympus, that
strategy set in motion a chain of events that were the heart of the
company's accounting scandal, according to the report, written by a
six-member outside panel appointed by the company last month.
The document, based
on 189 interviews with current and former Olympus employees and
business partners, also brought into relief the organizational
problems that plague many Japanese companies: lack of transparency,
little regard for shareholder rights and reluctance to challenge
authority.
"The situation was
an epitome of the salaryman mentality in a bad sense," said the
panel, referring to Japan's culture of corporate loyalty.
Olympus on Tuesday
said it "takes very seriously the results" of the investigation and
"is considering further fundamental measures to restore confidence."
The report
identified former Vice President Hisashi Mori, his former boss in
the company's accounting department, Hideo Yamada, and two former
Olympus presidents among a "select few" with knowledge of the
original investment losses, the effort to hide the losses and then
the attempts to account for them through inflated acquisition prices
and advisory fees.
Based on the
report's account, Olympus's financial troubles started with the
Plaza Accord in 1985, an agreement to devalue the U.S. dollar.
The ensuing rise in
the yen dented the company's operating profit, and its president at
the time, Toshiro Shimoyama, decided Olympus should augment its core
business with zaiteku, or financial investments.
Cattles Plc, the
U.K. subprime lender sold this year to creditors including Royal
Bank of Scotland Group Plc, accused PricewaterhouseCoopers Plc of
accounting failures before its shares were suspended in 2009.
Cattles has claims
against PwC tied to the firm’s audits of its finances from 2005
through 2007 that could result in “substantial damages,” according
to an outline of the case by Judge Henry Bernard Eder in London, who
ruled yesterday on preliminary issues. The company said PwC’s audit
led to a “gross misstatement” of the company’s bad debt.
While an official
complaint hasn’t yet been filed, Cattles was awarded some legal
costs against PwC in an evidentiary dispute. Cattles claims groups
of loans that were “ostensibly” set aside for debt collection were
in reality just buckets for bad debt, Eder said in the ruling, which
didn’t address the merits of the case. “Once the misstatements
became clear, the group could not continue trading and became
worthless.”
The company, based
in Batley, England, lent to customers with poor credit histories and
is winding down its loan book after recording an extra 700 million
pounds ($1.12 billion) of writedowns following the audit
irregularities.
Britain’s accounting
regulator has been probing PwC’s handling of the disputed audits
since 2009 and the U.K. Financial Services Authority started an
investigation of Cattles the same year, a person familiar with the
situation said at the time. FSA spokesman Christopher Hamilton
declined to comment in a phone interview today.
Deferred Loans
Cattles alleges PwC
rewrote or deferred loans that were in long-term arrears instead of
listing them as impaired, Eder said. When the problem was
discovered, Cattles said it was forced to report a loss in 2008 of
745 million pounds and restate its earnings from the previous year
to a loss of 98.5 million pounds, from a profit of 165.3 million
pounds.
PwC spokesman David
Jetuah PwC said the firm wasn’t aware of a claim against it and will
vigorously defend its work.
Paul Marriott, a
spokesman for Cattles, declined to say how much the company may seek
in damages.
The financial
troubles at Cattles led to a ruling by the U.K. Supreme Court in
July 2010 that the company’s bondholders can only be repaid once the
subprime lender has honored its debts to banks, including RBS, its
biggest lender.
Continued in article
Jensen Comment
PwC is a former U.S. Big Four auditing firms that is now headquartered
in the United Kingdom
Update October 31:
I’m putting updates over at Forbes.
My latest column is
up at American Banker, “Are Cozy Ties Muzzling S&P on MF Global
Downgrade?”
You may recall the
last time I wrote about MF Global. That story was about the “rogue”
trader that cost them $141 million. In the meantime we’ve seen
another “rogue” trader scandal and PwC has given MF Global clean
opinions on their financial statements and internal controls over
financial reporting since the firm went public in mid-2007.
I’m sure PwC thought
everything was peachy as recently as this past May when the annual
report came out for their year end March 30. Instead we’re seeing
another sudden, unexpected, calamitous, black-swan event that no one
could have predicted let alone warn investors about.
Jensen Comment
I prefer "Yeah right!" to just plain "Right!"
MF Global also has some ocean front property for sale in Arizona that's
been attested to by PwC.
As stock markets
open in New York on Monday, MF Global shares remain halted. The only
news the company has released so far is a one-line press release
confirming the suspension from the Federal Reserve Bank of New York.
Pre-market trading
in MF Global Holdings has been halted since about 6 a.m. ET as news
is expected to be released about Jon Corzine’s ailing brokerage.
Meanwhile, the
global exchange and trading community is moving to lock-down mode on
MF Global as the U.S. broker continues efforts to forge a
restructuring that could include a sale and bankruptcy filing.
The U.S. clearing
unit of ICE said it is limiting MF Global to liquidation of
transactions, while the Singapore Exchange won’t enter into new
trades. Floor traders said Nymex has halted all MF Global-created
trading. Some MF traders are restricted from the entering the floor
of the Chicago Board of Trade, and the Federal Reserve Bank of New
York said it had suspended doing business with MF Global.
The New York Fed
said in its brief statement: “This suspension will continue until MF
Global establishes, to the satisfaction of the New York Fed, that MF
Global is fully capable of discharging the responsibilities set out
in the New York Fed’s policy…or until the New York Fed decides to
terminate MF Global’s status as a primary dealer.”
The Wall Street
Journal reported Sunday night that MF Global is working on a deal to
push its holding company into bankruptcy protection as soon as
Monday, and to sell its assets to Interactive Brokers Group in a
court-supervised auction.
Continued in article
Jensen Comment
Francine may be singing
'99 bottles of negligence on the wall, 99 bottles of negligence,
if one of the bottles should happen to fall, 98 bottles of negligence on
the wall, . . . "
Poor Jon Corzine!
What a pity his firm declared bankruptcy on Halloween. Because he no
more tricks to play, he will be receiving few treats.
Last week Francine
McKenna must have had premonition of what was to come, for she asked
us whether PwC should have issued a going concern opinion. Ok, maybe
she was well connected with all the movers and shakers and was on
top of the news about the firm. Or maybe she read the SEC filings.
At any rate, she has discussed MF Global in “Are Cozy Ties Muzzling
S&P on MF Global Downgrade?” and “MF Global: 99 Problems and PwC
Warned About None of Them.”
To answer the
question, yes, we do think PwC probably should have issued a going
concern opinion. There were plenty of breadcrumbs to reveal the
cupboard was bare.
SAS No. 59 (AU
section 341) seems reasonably clear about the principles. It says in
paragraph 2: “The auditor has a responsibility to evaluate whether
there is substantial doubt about the entity’s ability to continue as
a going concern for a reasonable period of time, not to exceed one
year beyond the date of the financial statements being audited.”
Paragraph 6 goes on to say the auditor should consider such things
as negative trends in key financial metrics, indications of possible
financial difficulties, and external matters that have occurred.
We wonder what is
meant by this pronouncement and what evidence must be present to
conclude that a going concern opinion is appropriate. Might that
include four years (2008-2011) of massive losses, as occurred at MF
Global? Might that include severely negative free cash flows for
three of the last four years? Might that include an exposure to
European sovereign debt that will lead to greater future losses?
Might that include several downgrades in the credit ratings?
Unfortunately, our
experience with Big Four practice suggests a myopic and unreasonable
focus on the ability of the entity to pay its bills for the coming
year is often the primary criteria driving the opinion. Indeed, the
number of going concern opinions is decreasing when they likely
should be increasing.
I put up a column on
Tuesday at Forbes.com that explains, in theory, what I think
happened to MF Global’s missing $600 million in customer assets.
It’s hard to describe the reaction to the story without jumping up
and down and clapping. There’s so much interest in the subject and
so little information being provided by mainstream media.
Here in Chicago,
everyone is mad and no one knows who has the answers.
MF Global’s auditor
is PricewaterhouseCoopers, who inherited the client when Man
Financial, also a client, spun off the brokerage firm in 2007.
Deloitte’s
investigations of claims against MF Global suggest that the defunct
fund’s clients have overstated their claims. According to Deloitte
partner Chris Campbell, a joint administrator of MF Global
Australia, some clients of the brokerage have claimed “significantly
in excess” what the firm really owed them.
“If clients continue
to do that, there will be a shortfall in the full funds of those
claims that are valid, because there’s a finite amount of cash that
needs to be split between them all,” Campbell said of the claims.
In total, Deloitte
believes that clients are owed a total of $313 million. Deloitte
also believes that there is a total of $319 million in funds
available for repaying clients.
If clients’ claims
cannot be reconciled with Deloitte’s investigation, an application
to the Australian Securities and Investments Commission and to a
legal court may be necessary, according to Campbell.
The $319 million
available for repayments consists of $167 million available to MF
Global counterparties and $155 million held for clients in
segregated accounts. $55 million of the total relates to a
derivative that helps traders profit from price fluctuations in
financial markets.
Deloitte was
appointed as the voluntary administrators of MF Global’s Australian
operations. Previously, clients were closed out of market positions
when Deloitte began the administration.
Question
Where did the missing MF Global funds end up?
A legal
loophole in international brokerage regulations means that few, if
any, clients ofMF
Globalare
likely to get their money back. Although
details of the drama are still unfolding,
it appears that MF Global and some of its Wall Street counterparts
have been actively and aggressively circumventing U.S. securities
rules at the expense (quite literally) of their clients.
MF Global's
bankruptcy revelations concerning missing client money suggest that
funds were not inadvertently misplaced or gobbled up in MF’s dying
hours, but were instead appropriated as part of a mass Wall St
manipulation of brokerage rules that allowed for the wholesale
acquisition and sale of client funds through re-hypothecation. A
loophole appears to have allowed MF Global, and many others, to use
its own clients’ funds to finance an enormous $6.2 billion Eurozone
repo bet.
If anyone thought
that you couldn’t have your cake and eat it too in the world of
finance, MF Global shows how you can have your cake, eat it, eat
someone else’s cake and then let your clients pick up the bill. Hard
cheese for many as their dough goes missing.
FINDING FUNDS
Current estimates
for the shortfall in MF Global customer funds have now reached $1.2
billion as revelations break that the use of client money appears
widespread. Up until now the assumption has been that the funds
missing had been misappropriated by MF Global as it desperately
sought to avoid bankruptcy.
Sadly, the truth is
likely to be that MF Global took advantage of an asymmetry in
brokerage borrowing rules that allow firms to legally use client
money to buy assets in their own name - a legal loophole that may
mean that MF Global clients never get their money back.
REPO RECAP
First a quick recap.
By now the story of MF Global’s demise is strikingly familiar. MF
plowed money into an off-balance-sheet maneuver known as a repo, or
sale and repurchase agreement. A repo involves a firm borrowing
money and putting up assets as collateral, assets it promises to
repurchase later. Repos are a common way for firms to generate money
but are not normally off-balance sheet and are instead treated as
“financing” under accountancy rules.
MF Global used a
version of an off-balance-sheet repo called a "repo-to-maturity."
The repo-to-maturity involved borrowing billions of dollars backed
by huge sums of sovereign debt, all of which was due to expire at
the same time as the loan itself. With the collateral and the loans
becoming due simultaneously, MF Global was entitled to treat the
transaction as a “sale” under U.S. GAAP. This allowed the firm to
move $16.5 billion off its balance sheet, most of it debt from
Italy, Spain, Belgium, Portugal and Ireland.
Backed by the
European Financial Stability Facility (EFSF), it was a clever bet
(at least in theory) that certain Eurozone bonds would remain
default free whilst yields would continue to grow. Ultimately,
however, it proved to be MF Global’s downfall as margin calls and
its high level of leverage sucked out capital from the firm. For
more information on the repo used by MF Global please seeBusiness
Law CurrentsMF
Global – Slayed by the Grim Repo?
Puzzling many,
though, were the huge sums involved. How was MF Global able to
“lose” $1.2 billion of its clients’ money and acquire a sovereign
debt position of $6.3 billion – a position more than five times the
firm’s book value, or net worth? The answer it seems lies in its
exploitation of a loophole between UK and U.S. brokerage rules on
the use of clients funds known as “re-hypothecation”.
RE-HYPOTHECATION
By way of
background, hypothecation is when a borrower pledges collateral to
secure a debt. The borrower retains ownership of the collateral but
is “hypothetically” controlled by the creditor, who has a right to
seize possession if the borrower defaults.
In the U.S., this
legal right takes the form of a lien and in the UK generally in the
form of a legal charge. A simple example of a hypothecation is a
mortgage, in which a borrower legally owns the home, but the bank
holds a right to take possession of the property if the borrower
should default.
In investment
banking, assets deposited with a broker will be hypothecated such
that a broker may sell securities if an investor fails to keep up
credit payments or if the securities drop in value and the investor
fails to respond to a margin call (a request for more capital).
Re-hypothecation
occurs when a bank or broker re-uses collateral posted by clients,
such as hedge funds, to back the broker’s own trades and borrowings.
The practice of re-hypothecation runs into the trillions of dollars
and is perfectly legal. It is justified by brokers on the basis that
it is a capital efficient way of financing their operations much to
the chagrin of hedge funds.
U.S. RULES
Under the U.S.
Federal Reserve Board's Regulation T and SEC Rule 15c3-3, a prime
broker may re-hypothecate assets to the value of 140% of the
client's liability to the prime broker. For example, assume a
customer has deposited $500 in securities and has a debt deficit of
$200, resulting in net equity of $300. The broker-dealer can
re-hypothecate up to $280 (140 per cent. x $200) of these assets.
But in the UK, there
is absolutelyno
statutory limiton
the amount that can be re-hypothecated. In fact, brokers are free to
re-hypothecate all and even more than the assets deposited by
clients. Instead it is up to clients to negotiate a limit or
prohibition on re-hypothecation. On the above example a UK broker
could, and frequently would, re-hypothecate 100% of the pledged
securities ($500).
This asymmetry of
rules makes exploiting the more lax UK regime incredibly attractive
to international brokerage firms such as MF Global or Lehman
Brothers which can use European subsidiaries to create pools of
funding for their U.S. operations, without the bother of complying
with U.S. restrictions.
In fact, by
2007, re-hypothecation had grown so large that it accounted for half
of the activity of the shadow banking system. Prior to Lehman
Brothers collapse, theInternational
Monetary Fund(IMF)
calculated that U.S. banks were receiving $4 trillion worth of
funding by re-hypothecation, much of which was sourced from the UK.
With assets being re-hypothecated many times over (known as
“churn”), the original collateral being used may have been as little
as $1 trillion – a quarter of the financial footprint created
through re-hypothecation.
BEWARE THE BRITS:
CIRCUMVENTING U.S. RULES
Keen to get in on
the action, U.S. prime brokers have been making judicious use of
European subsidiaries. Because re-hypothecation is so profitable for
prime brokers, many prime brokerage agreements provide for a U.S.
client’s assets to be transferred to the prime broker’s UK
subsidiary to circumvent U.S. rehypothecation rules.
Under subtle
brokerage contractual provisions, U.S. investors can find that their
assets vanish from the U.S. and appear instead in the UK, despite
contact with an ostensibly American organisation.
Potentially as
simple as having MF Global UK Limited, an English subsidiary, enter
into a prime brokerage agreement with a customer, a U.S. based prime
broker can immediately take advantage of the UK’s unrestricted
re-hypothecation rules.
LEHMAN LESSONS
In fact this is
exactly what Lehman Brothers did through Lehman Brothers
International (Europe) (LBIE), an English subsidiary to which most
U.S. hedge fund assets were transferred. Once transferred to the UK
based company, assets were re-hypothecated many times over, meaning
that when the debt carousel stopped, and Lehman Brothers collapsed,
many U.S. funds found that their assets had simply vanished.
A prime broker need
not even require that an investor (eg hedge fund) sign all
agreements with a European subsidiary to take advantage of the
loophole. In fact, in Lehman’s case many funds signed a prime
brokerage agreement with Lehman Brothers Inc (a U.S. company) but
margin-lending agreements and securities-lending agreements with
LBIE in the UK (normally conducted under a Global Master Securities
Lending Agreement).
These agreements
permitted Lehman to transfer client assets between various
affiliates without the fund’s express consent, despite the fact that
the main agreement had been under U.S. law. As a result of these
peripheral agreements, all or most of its clients’ assets found
their way down to LBIE.
MF
RE-HYPOTHECATION PROVISION
A similar
re-hypothecation provision can be seen in MF Global’s U.S. client
agreements. MF Global’s Customer Agreement for trading in cash
commodities, commodity futures, security futures, options, and
forward contracts, securities, foreign futures and options and
currencies includes the following clause:
“7.Consent
To Loan Or PledgeYou hereby grant us the right, in
accordance with Applicable Law, to borrow, pledge, repledge,transfer,
hypothecate, rehypothecate,loan, or invest any of the
Collateral, including, without limitation, utilizing the
Collateral to purchase or sell securities pursuant to repurchase
agreements [repos] or reverse repurchase agreements with any
party, in each case without notice to you, and we shall have no
obligation to retain a like amount of similar Collateral in our
possession and control.”
In its quarterly
report, MF Global disclosed that by June 2011 it had repledged
(re-hypothecated) $70 million, including securities received under
resale agreements. With these transactions taking place off-balance
sheet it is difficult to pin down the exact entity which was used to
re-hypothecate such large sums of money but regulatory filings and
letters from MF Global’s administrators contain some clues.
According to a
letter from KPMG to MF Global clients, when MF Global collapsed, its
UK subsidiary MF Global UK Limited had over 10,000 accounts. MF
Global disclosed in March 2011 that it had significant credit risk
from its European subsidiary from “counterparties with whom we place
both our own funds or securities andthose
of our clients”.
CAUSTIC
COLLATERAL
Matters get even
worse when we consider what has for the last 6 years counted as
collateral under re-hypothecation rules.
Despite the fact
that there may only be a quarter of the collateral in the world to
back these transactions, successive U.S. governments have softened
the requirements for what can back a re-hypothecation transaction.
Beginning with
Clinton-era liberalisation, rules were eased that had until 2000
limited the use of re-hypothecated funds to U.S. Treasury, state and
municipal obligations. These rules were slowly cut away (from
2000-2005) so that customer money could be used to enter into
repurchase agreements (repos), buy foreign bonds, money market funds
and other assorted securities.
Hence, when MF
Global conceived of its Eurozone repo ruse, client funds were
waiting to be plundered for investment in AA rated European
sovereign debt, despite the fact that many of its hedge fund clients
may have been betting against the performance of those very same
bonds.
OFF BALANCE SHEET
As well as
collateral risk, re-hypothecation creates significant counterparty
risk and its off-balance sheet treatment contains many hidden
nasties. Even without circumventing U.S. limits on re-hypothecation,
the off-balance sheet treatment means that the amount of leverage
(gearing) and systemic risk created in the system by
re-hypothecation is staggering.
Re-hypothecation
transactions are off-balance sheet and are therefore unrestricted by
balance sheet controls. Whereas on balance sheet transactions
necessitate only appearing as an asset/liability on one bank’s
balance sheet and not another, off-balance sheet transactions can,
and frequently do, appear on multiple banks’ financial statements.
What this creates is chains of counterparty risk, where multiple
re-hypothecation borrowers use the same collateral over and over
again. Essentially, it is a chain of debt obligations that is only
as strong as its weakest link.
With collateral
being re-hypothecated to a factor of four (according to IMF
estimates), the actual capital backing banks re-hypothecation
transactions may be as little as 25%. This churning of collateral
means that re-hypothecation transactions have been creating enormous
amounts of liquidity, much of which has no real asset backing.
The lack of
balance sheet recognition of re-hypothecation was noted in
Jefferies’ recent 10Q (emphasis added):
“Note 7.
Collateralized Transactions
We pledge securities in connection with repurchase agreements,
securities lending agreements and other secured arrangements,
including clearing arrangements. The pledge of our securities is
in connection with our mortgage−backed securities, corporate
bond, government and agency securities and equities businesses.
Counterparties generally have the right to sell or repledge the
collateral.Pledged securities that can be sold or
repledged by the counterparty are included within Financial
instruments owned and noted as Securities pledged on our
Consolidated Statements of Financial Condition.We
receive securities as collateral in connection with resale
agreements, securities borrowings and customer margin loans.In
many instances, we are permitted by contract or custom to
rehypothecate securities received as collateral. These
securities maybe used to secure repurchase agreements, enter
into security lending or derivative transactions or cover short
positions.At
August 31, 2011 and November 30, 2010, the approximate fair
value of securities received as collateral by us that may be
sold or repledged was approximately $25.9 billion and $22.3
billion, respectively. At August 31, 2011 and November 30, 2010,
a substantial portion of the securities received by us had been
sold or repledged.
We engage in
securities for securities transactions in which we are the
borrower of securities and provide other securities as
collateral rather than cash.As
no cash is provided under these types of transactions, we, as
borrower, treat these as noncash transactions and do not
recognize assets or liabilities on the Consolidated Statements
of Financial Condition.The
securities pledged as collateral under these transactions are
included within the total amount of Financial instruments owned
and noted as Securities pledged on our Consolidated Statements
of Financial Condition.
According to
Jefferies’ most recent Annual Report it had re-hypothecated $22.3
billion (in fair value) of assets in 2011 including government debt,
asset backed securities, derivatives and corporate equity- that’s
just $15 billion shy of Jefferies total on balance sheet assets of
$37 billion.
HYPER-HYPOTHECATION
With weak collateral
rules and a level of leverage that would make Archimedes tremble,
firms have been piling into re-hypothecation activity with startling
abandon. A review of filings reveals a staggering level of activity
in what may be the world’s largest ever credit bubble.
Math Error on Wall Street Issuance of CDO portfolio bonds laced with a portion of healthy
mortgages and a portion of poisoned mortgages.
The math error is based on an assumption that risk of poison can be
diversified and diluted using a risk diversification formula.
The risk diversification formula is called the
Gaussian copula function
The formula made a fatal assumption that loan defaults would be random
events and not correlated.
When the real estate bubble burst, home values plunged and loan defaults
became correlated and enormous.
Fraud on Wall Street All the happenings on Wall Street were not merely innocent math
errors Banks and investment banks were selling CDO bonds that they knew
were overvalued.
Credit rating agencies knew they were giving AAA high credit ratings to
bonds that would collapse.
The banking industry used powerful friends in government to pass its
default losses on to taxpayers.
Greatest Swindle in the History of the World --- http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout
"For five years,
Li's formula, known as a
Gaussian copula function, looked like an unambiguously
positive breakthrough, a piece of financial technology that
allowed hugely complex risks to be modeled with more ease and
accuracy than ever before. With his brilliant spark of
mathematical legerdemain, Li made it possible for traders to
sell vast quantities of new securities, expanding financial
markets to unimaginable levels.
His method
was adopted by everybody from bond investors and Wall Street
banks to ratings agencies and regulators. And it became so
deeply entrenched—and was making people so much money—that
warnings about its limitations were largely ignored.
Then the model fell apart." The
article goes on to show that correlations are at the heart of the
problem.
"The reason that
ratings agencies and investors felt so safe with the triple-A
tranches was that they believed there was no way hundreds of
homeowners would all default on their loans at the same time.
One person might lose his job, another might fall ill. But those
are individual calamities that don't affect the mortgage pool
much as a whole: Everybody else is still making their payments
on time.
But not all
calamities are individual, and tranching still hadn't solved all
the problems of mortgage-pool risk. Some things, like falling
house prices, affect a large number of people at once. If home
values in your neighborhood decline and you lose some of your
equity, there's a good chance your neighbors will lose theirs as
well. If, as a result, you default on your mortgage, there's a
higher probability they will default, too. That's called
correlation—the degree to which one variable moves in line with
another—and measuring it is an important part of determining how
risky mortgage bonds are."
I would highly recommend reading the
entire thing that gets much more involved with the
actual formula etc.
The
“math error” might truly be have been an error or it might have simply
been a gamble with what was perceived as miniscule odds of total market
failure. Something similar happened in the case of the trillion-dollar
disastrous 1993 collapse of Long Term Capital Management formed by Nobel
Prize winning economists and their doctoral students who took similar
gambles that ignored the “miniscule odds” of world market collapse -- -
http://www.trinity.edu/rjensen/FraudRotten.htm#LTCM
History
(Long Term
Capital Management and CDO Gaussian Coppola failures)
Repeats Itself in Over a Billion Lost in MF Global
"The entire system
has been utterly destroyed by the MF Global collapse," Ann Barnhardt,
founder and CEO of Barnhardt Capital Management, declared last week
in a letter to clients.
Whether that's
hyperbole or not is a matter of opinion, but MF Global's collapse —
and the inability of investigators to find about $1.2 billion in
"missing" customer funds, which is twice the amount previously
thought — has only further undermined confidence among investors and
market participants alike.
Emanuel Derman,
a professor at Columbia University and former Goldman Sachs managing
director, says MF
Global was undone by an over-reliance on short-term funding, which
dried up as revelations of its leveraged bets on European sovereign
debt came to light.
In the accompanying
video, Derman says MF Global was much more like Long Term Capital
Management than Goldman Sachs, where he worked on the risk committee
for then-CEO John Corzine.
As discussed in the
accompanying video, Derman says the "idolatry" of financial models
puts Wall Street firms — if not the entire banking system — at risk
of catastrophe. MF Global was an extreme example of what can happen
when the models — and the people who run them -- behave badly, but
if Barnhardt is even a little bit right, expect more casualties to
emerge.
Jensen Comment
MF Global's auditor (PwC) will now be ensnared, as seems appropriate in
this case, the massive lawsuits that are certain to take place in the
future ---
http://www.trinity.edu/rjensen/Fraud001.htm
Back in
September, Vermont-based
Green Mountain Coffee Roasters put the world on notice
that the SEC was asking some questions about their revenue
recognitions policies. Despite the SEC Q&A, analysts we’re cool with
the company and the GAAP the crunchy accounting group was putting
out.
Also at that
time, the company disclosed that there were some immaterial
accounting errors that were NDB. That was until they dropped a
little
8-K on
everyone last Friday!
Turns out, there was a
whole mess of accounting booboos and the
company will be restating “previously issued financial statements,
including the quarterly data for fiscal years 2009 and 2010 and its
selected financial data for the relevant periods.”
The audit
committee and management have discussed the matters disclosed in
this current report on Form 8-K with PricewaterhouseCoopers LLP, the
Company’s independent registered public accounting firm. The Company
is working diligently to complete the restatement of its financial
statements. The Company expects to file its annual report on
Form 10-K, including the restated financial statements, by no later
than December 9, 2010, the expiration date of the extension period
provided by Rule 12b-25 of the Securities Exchange Act of 1934, as
amended. However, there can be no assurance that the filing will be
made within this period.
Beginning to look like financial
reporting intentional fraud
"GREEN MOUNTAIN COFFEE: A BAD CUP OF JAVA," by Anthony H. Catanach, Jr.
and J.Edward Ketz, Grumpy Old Accountants, July 25, 2011 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/229
The audit
committee and management have discussed the matters disclosed in
this current report on Form 8-K with PricewaterhouseCoopers LLP, the
Company’s independent registered public accounting firm. The Company
is working diligently to complete the restatement of its financial
statements. The Company expects to file its annual report on
Form 10-K, including the restated financial statements, by no later
than December 9, 2010, the expiration date of the extension period
provided by Rule 12b-25 of the Securities Exchange Act of 1934, as
amended. However, there can be no assurance that the filing will be
made within this period.
Chile’s banking
regulator, Superintendencia de Bancos e Instituciones Financieras,
or SBIF, filed charges against PricewaterhouseCoopers (PwC) for
deficiencies in its auditing practices of non-banking credit card
issuers in the country, the regulator said in a statement posted on
its website.
Chilean Securities
and Insurance Supervisor (SVS) Fernando Coloma is in charge of the
case. He explained, “Consumers complained about readjustments made
on their accounts… Having never accepted these modifications, the
changes included quotas and sums which had been defined by the
company and made the debt less manageable. Some consumers remained
unaware of these changes until receiving collection letters or
showing up on DICOM [Chile’s credit rating agency].”
In July 2010, La
Polar had gotten into trouble (123 complaints worth) after the
Chilean National Customer Service (SERNAC) detected that the retail
store had been making changes to its customers’ payment plans
without prior notice, providing false information about its
finances, and failing to abide by due diligence. All in all, La
Polar executives are facing fines up to $714,000 USD and possible
jail time. Charges were levied against them in July 2011.
However, as the
Chilean government traces the root of the issue, it appears the
circle of blame has widened. Bloomberg reported on September 21,
2011 that Chile’s banking regulator, Superintendencia de Bancos e
Instituciones Financieras, or SBIF, would be filing formal charges
against PwC. The company is accused of transferring shares of the
ailing La Polar while knowing the company’s dire financial
situation.
A-ha! I hate
to say I told you so (no I don't) but, uh, I told you so.
In August of 2009, I caught PwC digging around on my site to find
out more about the
Colonial Bank failure, a failure which PwC
itself oversaw and maybe just participated in (if indirectly,
naturally). The year before Colonial's epic failure, PwC auditors
gave the bank the all clear.
"In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the
financial position of The Colonial BancGroup, Inc. and its
subsidiaries at December 31, 2008 and 2007 and the results of their
operations and their cash flows for each of the three years in the
period ended December 31, 2008 in conformity with accounting
principles generally accepted in the United States of America," read
the opinion.
A Quebec Superior
Court judge has ruled that the auditors for a real-estate-investment
company at the centre of a $1.6-billion financial collapse were
negligent, ending a 12-year legal battle by investors in
Montreal-based Castor Holdings Ltd.
“The whole team at
our firm feels incredibly exhilarated,” said Mark Meland of Fishman
Flanz Meland Paquin LLP, one of the lead lawyers acting for the
investors in Castor, which collapsed in 1992.
“It’s a big, big
win.”
Despite the epic
length of the case, which is believed to be the longest trial in
Canadian history, Friday’s ruling is not likely to be the last word.
Prior to the result, both sides said an appeal was expected, no
matter who won.
The Castor
litigation, which is also believed to be the largest auditors’
negligence case in Canada, could end up having broader implications
for the auditing profession across the country.
Many shareholder
lawsuits against auditors don't get very far because of previous
court decisions that auditors can’t be held professionally
responsible for misrepresentations by clients, said Toronto-based
forensic accountant Al Rosen.
Friday's decision
may help bolster the case for auditors' responsibilities in
situations where fraud or other financial irregularities occur, he
said.
“I hope it wakes up
the rest of Canada, but I'm not expecting any immediate change,” he
said. “Perhaps it will encourage lawmakers to pass tougher
legislation.”
Castor was the
creation of German-Canadian businessman Wolfgang Stolzenberg, who is
on the RCMP’s wanted list for alleged fraud and believed to be
living in Germany.
Following the
collapse, a group of investors – including major European banks,
Chrysler Canada Inc.’s pension fund and two Canadian
credit
unions – filed lawsuits totalling
about $1-billion against Coopers & Lybrand, Castor’s auditor,
allegedly it failed to properly audit the company.
Their case has
dragged on for more than 16 years, 12 of them in court, and included
the filing of more than 18,000 exhibits.
In a hefty
752-page decision released Friday, Madam Justice Marie St-Pierre of
the Quebec Superior Court ruled that Coopers & Lybrand failed to
perform its professional services as auditors, in accordance with
generally accepted auditing and
accounting
standards.
She said Coopers &
Lybrand also issued “faulty opinions” concerning Castor’s financial
situation.
Continued in article
Jensen Comment
"The judgment concluded that Castor’s audited financial statements for
1988, 1989 and 1990 were materially misstated and misleading, and that
Coopers & Lybrand periodically issued other faulty opinions on its
financial position from 1988 to 1991."
This judgment reveals how slowly the wheels of justice often move. What
would be the benefit versus cost of restating Castor's financial
statements for 1988, 1989 and 1990?
Are there any pending cases from the 19th Century or the stock market
crash of 1929?
Back in
September, Vermont-based
Green Mountain Coffee Roasters put the world on notice
that the SEC was asking some questions about their revenue
recognitions policies. Despite the SEC Q&A, analysts we’re cool with
the company and the GAAP the crunchy accounting group was putting
out.
Also at that
time, the company disclosed that there were some immaterial
accounting errors that were NDB. That was until they dropped a
little
8-K on
everyone last Friday!
Turns out, there was a
whole mess of accounting booboos and the
company will be restating “previously issued financial statements,
including the quarterly data for fiscal years 2009 and 2010 and its
selected financial data for the relevant periods.”
The audit committee and management have discussed the matters
disclosed in this current report on Form 8-K with
PricewaterhouseCoopers LLP, the Company’s independent registered
public accounting firm. The Company is working diligently to
complete the restatement of its financial statements. The Company
expects to file its annual report on Form 10-K, including the
restated financial statements, by no later than December 9, 2010,
the expiration date of the extension period provided by Rule 12b-25
of the Securities Exchange Act of 1934, as amended. However, there
can be no assurance that the filing will be made within this period.
Beginning to look like financial reporting intentional fraud
"GREEN MOUNTAIN COFFEE: A BAD CUP OF JAVA," by Anthony H. Catanach, Jr.
and J.Edward Ketz, Grumpy Old Accountants, July 25, 2011 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/229
The audit committee and management have discussed the matters
disclosed in this current report on Form 8-K with
PricewaterhouseCoopers LLP, the Company’s independent registered
public accounting firm. The Company is working diligently to
complete the restatement of its financial statements. The Company
expects to file its annual report on Form 10-K, including the
restated financial statements, by no later than December 9, 2010,
the expiration date of the extension period provided by Rule 12b-25
of the Securities Exchange Act of 1934, as amended. However, there
can be no assurance that the filing will be made within this period.
The Office of
Inspector General of the USAID did release the much-anticipated
audit report of Deloitte’s role in the Kabul bank debacle. It’s a 23
page detailed report and a quick synopsis follows:
The OIG contends
that BearingPoint and Deloitte advisers embedded at Afghanistan
Central Bank (DAB) did see several fraud indications at Kabul Bank
for over 2 years before the run on Kabul Bank in early September
2010; but did not aggressively follow up on indications of serious
problems at Kabul Bank.
Further, the OIG
contends that Deloitte advisers did not report fraud indicators at
Kabul Bank to USAID. In addition, the mission did not have a policy
requiring contractors and grantees to report fraud indicators.
Finally, the OIG
contends that USAID/Afghanistan’s management of its task order with
Deloitte was weak; and if senior program managers and technical
experts had been on staff at the mission, USAID could have managed
Deloitte better and ask deeper questions than just accepting them at
face value.
In a reply back to
Timothy Cox, OIG/Afghanistan Director, David McCloud, Acting
Assistant to the Administrator, Office of Afghanistan and Pakistan
Affairs, makes several counter arguments:
That there was no
indications of fraud, waste or abuse by USAID or Deloitte.
Deloitte could not
have stopped the massive fraud that occurred at Kabul Bank.
USAID and Deloitte’s
scope of work and mandate under Component 2 of the Economic Growth
and Governance Initiative task order was to provide trainers and
technical experts to build the capacity
of the Bank
Supervision unit within the Central Bank of the Government of
Afghanistan, Afghanistan Bank, and not for Deloitte itself to
supervise private banks.
USAID agrees that
Deloitte should have aggressively reported evidence of fraud at
Kabul Bank to the Mission.
And then, McCloud
brings up an interesting twist by introducing another Big Four firm,
PwC, which performed an audit of Kabul Bank, but did not bring up
any discrepancies or evidence of fraud, which perhaps delayed any
potential investigations and prevented a true understanding of the
situation.
“The audit performed
by an affiliate of PricewaterhouseCoopers (PwC) was not directly
mentioned in the body of the OIG report but it was a significant
source of information to the Central Bank¡¦s examination staff. The
resulting clean bill of financial health of Kabul Bank issued by PwC
may have acted to delay understanding of the gravity of Kabul Bank’s
true financial condition both among the examination staff and the
international community.
Well team,
despite the
little setback for the PCAOB earlier this week,
Team Peek is not discouraged. In fact, they
were so motivated by the SEC’s little stunt that they thought they’d
churn out three major inspection reports today, just to show
everyone that they get to say what’s what with these accounting
firms (even if it is in an indecipherable combination of vague and
wonky prose).
BDO, Grant Thornton
and PwC all got their papers issued today, which leaves just KPMG as
the last major U.S. firm to not have their report issued. We’ll give
you the quick and dirty on these three but if you want the gory
details, you’ll have to read them in depth yourself (some of us have
lives, you know). We’ll go in alphabetical order so no one gets bent
out of shape.
BDO had eight
issuers mentioned in its report. Issues included not testing the
underlying data used by a specialist, failure to identify a
departure from GAAP before issuing its audit report, loan losses and
“[failure] to perform sufficient procedures to evaluate the
reasonableness of a significant assumption management used to
calculate the gain on the sale of a business,” among others.
http://www.scribd.com/doc/35856583/PCAOB-2010-BDO-Seidman-LLP
GT only had
five issuers listed in their report with problems including two
instances of departures from GAAP that weren’t identified before the
issue of the audit report, testwork related to fair value
determination of illiquid assets and testwork around revenue
recognition.
Steve Chipman got away from the teleprompter
long enough to sign the letter to the PCAOB himself, along with
Trent Gazzaway, the National Managing Partner of Audit Services.
http://www.scribd.com/doc/35856593/PCAOB-2010-Grant-Thornton-LLP
Nine issuers
were noted by the inspectors for P. Dubs. Various issues ranging
from inadequate testing of foreign locations, loan loss issues
(that’s a given) and fair value (another surprise). PwC’s response
made it sound like they actually enjoy the whole inspection process,
“We continue to support the PCAOB and we wish to convey our sincere
appreciation for the professional efforts of the PCAOB staff.”
Wonder if the engagement teams that were inspected feel the same?
http://www.scribd.com/doc/35856619/PCAOB-2010-PricewaterhouseCoopers-LLP
The stories in NYT and WSJ are coming out
because the documents that contain the evidence of the PwC
knowledge of Cassano's contentions in November, pre- the investors
meeting in December, have just been made public by the Financial
Crisis Inquiry Commission. They make for interesting reading for
anyone with the interest, aptitude and patience.
Welcome to
Episode 33 rpm of AIG and PwC and the Big Bad Wolf, Goldman Sachs.
In this episode we attempt to slow things down and stop blaming our
mother, I mean Goldman Sachs, for everything.
Let’s consider
for a moment the unnaturally close, preternatural relationship
between AIG and PwC over the years. The dramas these two have been
through together evoke the classic dysfunctional family, hell bent
on destroying each other before they let anyone or anything destroy
any of them…
“For decades,”
Gretchen Morgenson tells us last Saturday
in the New York Times, “Goldman and AIG had a long and fruitful
relationship, with AIG insuring billions in mortgage-related
securities that Goldman Sachs underwrote. When the mortgage market
started to deteriorate in 2007, however, the relationship went
sour…”
Goldman bought
insurance against an AIG failure from large foreign and domestic
banks, including
Credit Suisse ($310 million),
Morgan Stanley ($243 million) and
JPMorgan Chase
($216 million). Goldman also bought $223 million in insurance on AIG
from a variety of funds overseen by
Pimco, the money management firm.
The Washington Post, May 2005: “The
relationship between PWC and AIG stretches back decades to when
the firm still was called Coopers & Lybrand, before its 1998
merger with Price Waterhouse. Former AIG finance chief Howard I.
Smith, who left the company earlier this year under pressure for
failing to cooperate with regulators, spent almost two decades
as an auditor at Coopers before joining AIG in 1984.
Steven Bensinger, AIG’s new chief financial officer,
also started his career at Coopers &
Lybrand.
In the
lawsuit filed earlier this spring in U.S. District Court in
Manhattan, Petro, the Ohio attorney general, alleges that PWC’s
independence was “impaired” by these long-standing ties and by
nearly $137 million in audit and consulting fees it received
from AIG between 2000 and 2003.”
They also didn’t buy
the excuses AIG made for PwC at the time – that PwC had been kept in
the dark – and claimed there were enough red flags to pin some of
the liability on the auditor.
“In a boost to PWC, AIG in its
release this spring also explicitly told investors that auditors
and board members had been kept in the dark by management about
some AIG accounting maneuvers, including the company’s dealings
with Capco Reinsurance Co. Ltd., a Barbados reinsurance firm,
and Union Excess Reinsurance Co. Ltd.”
In the latest
scandal at AIG, we’ve seen PwC and AIG’s most senior executives such
as former CEO Sullivan and CFO Bensinger attempt to divert attention
from themselves. One example is the accusation against Joseph
Cassano. Mr. Cassano, albeit not the most likeable guy for numerous
reasons, seems to have done everything he could to get it through
the thick heads of PwC, Sullivan and Bensinger that there were
wolves at AIG’s door, even though
Cassano believes even now
that enough time and a suitably stubborn attitude could have fought
them off.
Joseph Cassano
was once portrayed as a villain of our times.
Prosecutors…
interviewed AIG senior management and the company’s external
auditor, and came away thinking Mr. Cassano hadn’t properly
disclosed multi-billion-dollar accounting changes that
drastically cut the size of estimated losses, these people
said…In interviews in 2008, Mr. Ryan told prosecutors he
sometimes couldn’t get straight answers from Mr. Cassano when he
asked him to justify how AIG accounted for the swaps, these
people said…Senior executives at AIG’s parent company voiced
similar misgivings to prosecutors a couple of years ago…However,
Cassano was able to prove that he gave both PwC and Sullivan/Bensinger
enough of a heads up to make their own decision what to tell
investors in December.
{…}
The defense team
rebutted the prosecution’s allegations, presenting a version of
events that portrayed Mr. Cassano as repeatedly disclosing bad
news to his bosses, investors and PwC…its efforts helped focus
prosecutors’ attention on an obscure set of handwritten notes in
their files, found scrawled on the bottom of a printed
spreadsheet…the annotations, which were made by a PwC partner at
a meeting with Mr. Cassano and AIG management a week before the
key December 2007 investor conference…Prosecutors realized the
notes were disastrous to their case… Mr. Cassano had in fact
disclosed the size of the accounting adjustments to both his
bosses and external auditors.
It wasn’t
really news when the
Wall Street Journal wrote about auditors’
“scribbled notes that scuttled the AIG probe” and the
New York Times Deal Book followed with a
“me too” blurb the next day. We’ve known since
late May that the Department of Justice no
longer had a case against Cassano. He had apparently told the
auditors and his bosses everything.
The
investigations went south
when,
“prosecutors found evidence Mr. Cassano did make key
disclosures. They obtained notes written by a PwC auditor
suggesting Mr. Cassano informed the auditor and senior AIG
executives about the adjustment…[and] told AIG shareholders in
November 2007 that AIG would have “more mark downs,” meaning it
would lower the value of its swaps.” So who’s telling the truth?
Why are we seeing more stories now with more color commentary
on the Cassano vindication story? There have
been a number of parallel investigations and inquiries occurring –
criminal, civil and congressional – of the entire AIG/Goldman Sachs
affair as well constant reminders of the financial crisis
conundrums. As
Gretchen Morgenson so aptly put it this
past weekend:
“What did
they know, and when did they know it?” Those are questions
investigators invariably ask when trying to determine who’s
responsible for an offense or a misdeed….a third, equally
important question must be asked: “What did they do once they
knew what they knew?”
All of these
investigations are inevitably producing reams of information – lots
of it in electronic form via emails and electronic records of
conversations, meeting minutes, contracts and calculations. But
this information is being made available to journalists and the
general public on an intermittent and inconsistent basis. As the
information dribbles out in linkable, source-able, quotable form,
the journalists write more stories.
The PwC
documents proving Mr. Cassano’s contentions of good faith were
probably available to the Department of Justice early this year. The
substance of them was made available to some journalists in
April when they started reporting Cassano
would not face charges and then
later in May
when stories were written about charges being dropped. The actual
documents show clearly that PwC knew everything in advance of the
December 2007 AIG investor meeting. They were
recently posted to the FCIC and
House Oversight Committee sites.
The stories have
been out there for a while. The details are now well known. AIG was
under pressure from all sides since late 2006 and PwC stood side by
side with them throughout:
PwC knew
AIG’s recidivist nature very well, including how senior
management had never really exerted sufficient control over
individual managers like Cassano if they were making money for
AIG;
PwC continued to enable AIG’s
“uncontrolled” ways even after the restatements and serious
charges leveled for
accounting manipulations and fraud of the 1999-2005 period.
This potential professional negligence opened the door for
Cassano and the Financial Products Group to construct the AIG
super senior credit default swaps portfolio house of cards.
Every time a
scandal such as this occurs,
earnest journalists believe the auditors
will come under closer scrutiny.
They don’t.
“American
International Group Inc.’s
admission this week that it engaged in improper accounting
practices is putting the nation’s largest independent auditing
firm in the spotlight: PricewaterhouseCoopers LLP…For now, the
Securities and Exchange Commission, which in February subpoenaed
documents from the firm about AIG, isn’t focusing on the
accountants’ actions, people familiar with the matter said.
Instead, SEC investigators, working with New York state
officials, are trying to determine what AIG told its auditors
about deals under scrutiny and whether that information was
truthful, the people said. But at some point, investigators will
press PricewaterhouseCoopers to explain the reasons it missed
the improper accounting, the people added.”
Instead, in
this case, PwC
was reappointed to their jobs with the
help of enabler Arthur Levitt.
PwC, as
auditor also of Goldman Sachs, JP Morgan, Bank of America, Barclays,
Freddie Mac, PIMCO funds, and
two of the Big 3 ratings agencies –
Moody’s (until mid-2008) and Fitch – had a pretty good eye into both
AIG’s and
Goldman Sachs’ counterparty risk and the
ratings roller coaster ride they all were on.
From
Cassano’s FCIC testimony in June 2010:
“In light of the auditors’ heavy involvement in the
fair-market-model evolution generally, and their prior
knowledge of the existence and magnitude of the negative-basis
adjustment in particular, I also found the
material-weakness finding surprising, to say the least. I know
AIG senior management argued strenuously against it.”
I asked
Tucker Warren, spokesperson for the FCIC,
when or if any of the audit firms – EY for Lehman, Deloitte for Bear
Stearns, WaMu, American Home and Merrill Lynch, KPMG for Citigroup,
Fannie Mae, Countrywide, Wachovia, and New Century or PwC for AIG,
Freddie Mac, Goldman Sachs or Bank of America – would testify before
the Commission on the causes of the financial crisis.
Two very interesting cases regarding auditor liability for fraud and
the legal doctrine of "in pari delicto" will be argued in Albany in
front of the New York Court of Appeals on Tuesday September 14th.
Coincidentally, this is the anniversary of the Lehman failure.
I've written about these cases regarding AIG and Refco.
Subject:
Shareholder auditor
liability case against PwC to be argued in NY Sept 14
Grant & Eisenhofer
to argue pivotal case on auditor liability in NY Court of Appeals on
Sept. 14 – underlying suit against PricewaterhouseCoopers stems from
failure to detect bid-rigging fraud at AIG
Francine -
We want to alert you
to a hearing on Tuesday, Sept. 14 before the
N.Y. Court of Appeals in a case with significant implications for
auditor malpractice liability.
The auditor in this
case – PricewaterhouseCoopers – is accused of
failing to detect large-scale fraud at AIG related
to alleged accounting manipulations and sham transactions that go
back to 1999. PwC won dismissal of the suit in the trial court by
arguing that because AIG employees committed the fraud that PwC
failed to spot, AIG was “in pari delicto” with PwC
(translation: at mutual fault) and therefore could not bring a
claim.
Auditors have used
similar defenses to avoid malpractice liability in a number of other
cases, including a suit against Grant Thornton LLP
by the bankruptcy trustee of Refco, Inc., which
will be addressed at the same September 14 hearing. This will mark
the New York high court’s first opportunity to decide whether New
York law recognizes this defense as an outright bar to auditor
malpractice liability. PwC knows well how high the stakes are, and
has engaged former U.S. Solicitor General Paul Clement
(now with King & Spalding) to plead its case.
Making the argument
for investors is Stuart Grant of leading
shareholder and corporate governance law firm Grant &
Eisenhofer, who says the outcome of the hearing will have
significant public policy ramifications. “Corporations hire
accounting firms and pay them huge fees to look for fraud by company
employees. If an auditor can overlook fraud but escape malpractice
liability by blaming the company for committing the fraud in the
first place, then where is the accountability for the auditor? The
company would have no recourse against the auditor, no matter how
egregious the auditor’s conduct.”
The lawsuit against
PwC alleges professional malpractice and negligence over the
accounting firm's audits of AIG during a period of extensive
chicanery at the giant insurer that predated the financial collapse.
Grant & Eisenhofer represents pension fund Teachers’
Retirement System of Louisiana in the shareholders’
derivative suit brought on behalf of AIG in the Delaware courts. In
their underlying case against PwC, the shareholders allege that the
Big Four accounting firm repeatedly failed to detect numerous red
flags indicative of massive fraud, including a $500 million sham
reinsurance transaction with Gen Re Corporation in 2000.
The PwC suit is
drawing intense interest from the accounting industry, with amicus
curiae briefs having been submitted by the American
Institute of Certified Public Accountants and the
Center for Audit Quality in support of PwC. The widely-read
accounting blog re: The Auditors recently posed
the question raised by this case: “Are auditors equally at fault in
the big fraud cases?”
When the plaintiffs
appealed from the Delaware Chancery Court’s dismissal of the claims
against PwC, the Delaware Supreme Court in March 2010 passed the
issue of auditor liability to the New York Court of Appeals for
determination, holding that “a resolution of this appeal depends on
significant and unsettled questions of New York
law…” The Delaware high court certified to the Court of Appeals the
question of whether under New York law corporate shareholders’
derivative claims against an outside auditor for professional
malpractice/negligence are barred under the doctrine of in pari
delicto. The in pari delicto defense prevents a
plaintiff who is also at fault from recovering damages from a
defendant.
Mr. Grant noted that
Tuesday’s hearing will provide the opportunity for the litigants to
ask the high court to declare what New York law is on this issue, as
there has never been a definitive ruling by the Court of Appeals.
“This case has huge
implications for the auditing industry as well as shareholder
derivative litigation,” Mr. Grant said. “What auditors are asking
for is a ‘get-out-of-jail-free’ card that they can play every time
their corporate client sues them for failing to detect fraud by a
corporate manager. But detecting that kind of fraud is exactly what
the client hired them to do. There needs to be some
accountability. If they acted properly, let them have their day in
court where they can prove it, but don’t foreclose the company from
bringing the suit in the first place.”
The case caption is:
Teachers’ Retirement System of Louisiana v.
PricewaterhouseCoopers LLP, No. 119 (N.Y.).
Let us know if you’d
like to speak with Mr. Grant or need any additional details about
the upcoming hearing. If you would like to view a copy of the
Delaware Supreme Court opinion or the plaintiffs’ brief before the
N.Y. Court of Appeals, please let us know.
Summary:
The financial crisis continued to dominate the litigation landscape
in 2009 - although to a lesser degree than in 2008, according to the
annual PwC Securities Litigation Study. Governments worldwide
remained focused on regulatory overhaul, stimulus plans and
investigations into the "who, what, when, where, why, and how" of
alleged wrongdoings related to the crisis.
The affiliates –
Lovelock & Lewes, Price Waterhouse Bangalore, Price Waterhouse & Co.
Bangalore, Price Waterhouse Calcutta, and Price Waterhouse & Co.
Calcutta – must pay $6 million to the SEC, $1.5 million to the PCAOB
and are barred from accepting U.S.-based clients for six months. The
SEC fine is the largest ever levied against a foreign-based
accounting firm in an SEC Enforcement Action and the PCAOB fine is
the largest in the regulator’s history. PW India must also
“establish training programs for its officers and employees on
securities laws and accounting principles; institute new pre-opinion
review controls; revise its audit policies and procedures; and
appoint an independent monitor to ensure these measures are
implemented.” The SEC’s press release stated that the failures “were
not limited to Satyam, but rather indicative of a much larger
quality control failure throughout PW India.”
From the PwC
perspective, meanwhile, the chance for a cheap exit from a major
problem would have been a no-brainer. Consider:
First, an
enforcement ding on the Satyam engagements had to be coming, sooner
or later. From the PCAOB’s order – which PwC agreed not to contest –
the Indian engagement teams on the audits from 2005 through 2008
basically did not:
Adequately
audit the company’s cash positions
Control the
confirmation process on bank balances or accounts receivable
Pursue
indications of inconsistent information or control weaknesses
Follow PwC
global directives on audit execution
Inform or
advise higher-level quality oversight personnel
Document the
work actually done (or not) in the work-papers, until subsequent
back-dating while already under regulatory scrutiny
So a strategic
decision not to defend the indefensible indicates early recognition
of a step toward sustainable credibility.
As for the sanctions
– PwC’s undertakings on future practice quality, staffing, training
and internal oversight are no more than necessary for an enterprise
with aspirations to professionalism; the two-year presence of an
outside monitor only adds one more stranger to the list of foreign
intruders imposed on its Indian practice; and the six-month
restraint on new SEC clients runs only to the settling Indian firms,
so does not inhibit either the global network or its other Indian
affiliates.
And, lastly, the
financial impact of the fines on the massive PwC network is no more
than a dime added to a roll of nickels.
For good measure,
with the week’s news cycle dominated by military activities in Libya
and a threatened government shut-down in Washington, and subsidiary
attention to post-earthquake Japan’s nuclear hazards and Silvio
Berlusconi’s “bunga bunga” trial, the entire story will drop off the
media screen in less than no time.
Predictably, critics
of the accounting profession who are unwilling to settle for less
than the scalps of the Big Four leaders nailed to an enforcer’s door
will make their outrage known.
But they will fail
to acknowledge that both the regulators and PwC itself are only
acting in full accordance with their respective DNA.
So once again, this
settlement points up the challenge to the long-term achievability of
a valuable, sustainable assurance function, to serve the issuers and
users of the financial information of global-scale companies: the
terms of the discourse are revealed as hopelessly inadequate.
“Come on, India’s not as bad as all that. Other side of the earth, if
you like, but we stick to the same old moon.”
E.M. Forster, A
Passage to India, Ch. 3
If any doubts
remained that PricewaterhouseCoopers International Limited, the
international global network “coordinating” firm, does the bidding
of its largest and most powerful member firms – primarily PwC US and
PwC UK – the latest “restructuring” in India should remove them.
From
Livemint.com,
Hindustan Times’ project with the Wall Street Journal:
“The Indian arm
of global consulting and audit firm PricewaterhouseCoopers (PwC)
is ceding control of its prized business process outsourcing (BPO)
unit to PwC US, ending years of battle between the Indian
partners and other PwC network firms.
Because the
Indian arm alone cannot anymore support the envisaged growth of
the BPO business—or “global delivery service” in PwC’s
parlance—over the next few years, it is being transferred to a
joint venture with other PwC network firms, according to
Ambarish Dasgupta, executive director of PricewaterhouseCoopers
Pvt. Ltd, or PwC India.”
In January of
2009, three days after the CEO of Price Waterhouse India’s client
Satyam admitted to a massive fraud,
I predicted the following:
“PwC
Global will pull a
PwC Japan and reorganize
Pricewaterhouse & Co out of existence, forcing “bad” partners
out and creating “clean” firm.
From the
India Times: PwC global CEO Samuel DiPiazza, Jr.,
along with some senior worldwide partners is currently in India
to assess the situation, after widespread reports that Price
Waterhouse’s alleged overlooking of Satyam accounts could impact
the audit firm’s reputation and business in India. It is learnt
that the global partners are actively considering restructuring
the India unit.
Persons close to
the development also said that a damage control exercise is
likely as global partners are also concerned about the likely
impact of the Satyam case on their existing clients. Already,
KPMG and Deloitte, archrivals of PwC, have more auditing clients
than PwC, especially with Indian companies that have presence in
US. The reshuffle could likely include shifting current
leaders to new responsibilities, said the persons who asked not
to be named.”
How can any
self-respecting attorney still argue – and any lucid judge still
believe – that PwC’s global firm is not just a sham legal construct,
an artificial vehicle for the strongest member firms to control and
potentially exploit their weaker ones, all under the guise of
“improving quality and seamless deliver to multinational clients…” ?
PwC UK did the same
thing to its Middle East colleagues recently. Sound familiar?
PricewaterhouseCoopers is ramping up its operations in the
Middle East, with plans to more than double fee income in the
region to $500 million within two years.
Britain’s
biggest professional services firm has identified growth in the
region as one of its top strategic priorities for the next
decade. It is betting that a surge in spending on infrastructure
projects by Arab governments will yield huge consulting fees for
foreign advisory firms.
Its British
division, which generates more than £2 billion a year from
auditing and advisory services, took control of PwC’s Middle
East operations last May. Since then, it has poured millions of
pounds into the practice in an attempt to unseat Ernst & Young
as the dominant accountant in the region.
Putting the best,
fastest growing business seemingly out of reach of Indian legal and
regulatory judgments, sanctions and fines as a result of the Satyam
fraud may be wise. But this ploy assumes that only the Indian firm
and Indian partners will be found culpable.
PwC likely
realizes that its India businesses will not escape far reaching
liability in the Satyam scandal. Assuming the Livemint.com
report is accurate, PwC appears to be moving an Indian jewel out
of the exclusive ownership and control of the Indian firms, and
out of the exclusive legal jurisdiction of the Indian regulators
and courts.
They’ve created
a plausible justification for doing what they did – the Indian
firms could not provide adequate capital to fund the business
and capture the strong demand for future services.
It also
offers some level of assurance that value created by those that
remain will not be a casualty of past acts. This allows them to
stem the
tide of defecting talent.
Finally, it also
opens up the possibility that the full technology outsourcing
business will be folded in eventually. If done now, this would
likely be perceived as way “over the top” and as shifting assets
off shore to protect them from domestic legal exposure.
The legal
maneuverings are even more obvious in light of the long-awaited
ruling by the U.S. Supreme Court affirming dismissal of the Morrison
v. National Australia Bank case. Among other things, the Court’s
opinion will limit securities claims by
investors who bought their shares on foreign exchanges. The Satyam consolidated
class action suit pending in US
District Court, Southern District of New York, alleges claims on
behalf of:
“…[plaintiffs]
who (a) purchased or otherwise acquired Satyam Computer Services
Limited (“Satyam” or “the Company”) American Depositary Shares
(“ADSs”) on the New York Stock Exchange (“NYSE”); and/or (b)
were investors residing in the United States who purchased or
otherwise acquired Satyam common stock on the National Stock
Exchange of India (“NSE”) or the Bombay Stock Exchange (“BSE”)
between January 6, 2004 and January 6, 2009 (the “Class
Period”), and who were damaged by the conduct alleged herein.
This action is also brought on behalf of two sub-classes of
Satyam employees who received and exercised stock options…”
It looks like
the a) plaintiffs will still be good but the b) plaintiffs don’t
fit the new post-NAB test. It may depend which exchange was used
to exercise the Satyam employees’ options, I suppose, but I
wonder if the Court anticipated all scenarios.
PwC’s
attorneys want it
dismissed in full based on forum non
conveniens argments.
The plaintiffs’
attorneys – there are four large firms involved – can still
obtain good results for their clients if they successfully
pierce the sham “corporate” veil of Pricewaterhouse Coopers
International Ltd, the global firm already named in the suit and
force the Global Board of Partners, as representatives of the
largest member firms such as the US and UK, to be held
responsible. Even better, they can avoid the issues of Morrison
v. NAB if they can reel in PwC US (and maybe sue in the UK
against PwC UK) by proving fraud.
Joseph Cassano,
the former head of AIG’s Financial Products Group, testifies
today for the Financial Crisis Inquiry Commission, a bipartisan
commission with a critical non-partisan mission — to examine the
causes of the financial crisis.
[...]
The
Department of Justice cleared Mr. Cassano in May. No criminal
charges will be filed. U.K.’s Serious Fraud Office dropped
probes last month, and the U.S. Securities and Exchange
Commission also closed their investigations too…the
investigations went south
when, “prosecutors found evidence Mr.
Cassano did make key disclosures. They obtained notes written by
a PwC auditor suggesting Mr. Cassano informed the auditor and
senior AIG executives about the adjustment…[and] told AIG
shareholders in November 2007 that AIG would have “more mark
downs,” meaning it would lower the value of its swaps.”
So who’s telling
the truth? Was PwC duped by AIG? Who is looking out for AIG
shareholders and the US taxpayer in this mess?
Based on
my reading of the Audit Committee minutes,
I believe that PwC was aware of weaknesses
in internal controls over the AIGFP super senior credit default
portfolio throughout 2007 and prior. Why were they pussy-footing
around still on January 15, 2008 as to whether these control
weaknesses were a significant deficiency (which would not have
to have been disclosed) or a material weakness (which eventually
was)?
The stories in NYT
and WSJ are coming out because the documents that contain the
evidence of the PwC knowledge of Cassano's contentions in November,
pre- the investors meeting in December, have just been made public
by the Financial Crisis Inquiry Commission. They make for
interesting reading for anyone with the interest, aptitude and
patience.
PWC FOUGHT for
minimal sanctions yesterday after it admitted audit failures in the
case of JP Morgan Securities Limited.
Appearing before a
disciplinary panel, it argued JPMSL shortcomings were to blame as it
omitted to flag up non-segregation of client assets for the seven
years to 2008, not systemic audit failure.
PwC committed an
"honest error" as it "strove to test segregation and reconciliation
of client assets", argued Tim Dutton of law firm Herbert Smith.
Dutton said the
firm's penalty should be in the region of £500,000 to £1m, saying it
would be "appropriate to keep the fine at the lower end due to
mitigating reasons".
"Although the
un-segregated sum of client assets was large, the real risk was
modest," he added, noting no individuals were diversely affected by
the failure.
The Accountancy and
Actuarial Discipline Board's counsel, Simon Browne-Williamson, said
the "crystallisation of risk is irrelevant" and "serious misconduct
will attract serious consequences" whether or not disaster struck.
He argued the
potential for loss of un-segregated funds -at times as much as $23bn
(£14.8bn) - if JPMSL became insolvent was so great that the
strictest penalties must apply.
AADB executive
counsel, Cameron Scott, said in his opinion, the repeated failure to
flag up this infringement of asset rules amounted to institutional
failure.
When questioned by
the panel, Browne-Williamson was unwilling to recommend a sum for
the fine, and Scott said this was because the AADB queried whether
it was "right for the prosecutor to suggest a penalty", calling it
"a very difficult question".
Instead,
Browne-Williamson insisted upon "transparency", saying this was the
best way to restore public confidence in the accounting profession
and fulfil the AADB's mandate.
The Financial
Services Authority fined JPMSL £33.2m for the breach, equivalent to
1% of the average amount of client assets at risk over the eight
years in question.
Browne-Williamson
urged the tribunal to adopt a similar tack, suggesting it might
consider sums such as the £6.5m fees JPMSL paid to PwC during the
period in question.
PwC said: "We
acknowledge that we did not maintain our usual high standards. PwC
takes very seriously its reporting requirements to the FSA. We hope
that the regulatory response will be proportionate to the issue."
Now £15.7 billion
may not seem like much to you if you are, say, Bill Gates or Ben
Bernanke but for PwC UK, it may be the magic number that gets them
into a whole steaming shitpile of trouble.
UK regulators allege
that from 2002 – 2009, PwC client JP Morgan shuffled client money
from its futures and options business into its own accounts, which
is obviously illegal. Whether or not JP Morgan played with client
money illegally is not the issue here, the issue is: will PwC be
liable for signing off on JPM’s activities and failing to catch such
significant shenanigans in a timely manner?
PwC did not simply
audit the firm, they were hired to provide annual client reports
that certified client money was safe in the event of a problem with
the bank. Obviously that wasn’t the case.
The Financial
Reporting Council and the Institute of Chartered Accountants of
England are investigating the matter, and the Financial Services
Authority has already fined P-dubs £33.3 million for co-mingling
client money and bank money. That’s $48.8 million in Dirty Fed Notes
if you are playing along at home.
It’s not just
volcanic ash that comes out of Iceland.
We see today a large
$2 billion lawsuit filed by one of Iceland’s largest banks, now
defunct, naming PricewaterhouseCoopers as one of the defendants.
Glitnir Bank (we see
in Wikipedia that Glitnir is the hall of Forseti, the Norse god of
law and justice, and the seat of justice amongst gods and men),
filed today a legal claim against Jon Asgeir Johannesson and also
PwC for malpractice and negligence in the Supreme Court of the State
of New York.
The suit against Jon
Asgeir Johannesson, formerly its principal 39% shareholder, Larus
Welding, previously Glitnir's Chief Executive, Thorsteinn Jonsson,
its former Chairman, and other former directors, shareholders and
third parties associated with Johannesson, alleges that these
defendants fraudulently and unlawfully drained more than $2 billion
out of the Bank.
Former auditors
PricewaterhouseCoopers are also sued for “facilitating and helping
to conceal the fraudulent transactions engineered by Johannesson and
his associates, which ultimately led to the Bank's collapse in
October 2008.”
The suits shows how
a cabal of businessmen led by Johannesson conspired to
systematically loot Glitnir Bank in order to prop up their own
failing companies; how they seized control of Glitnir, removing or
sidelining experienced Bank employees; and then facilitated and
concealed their diversions from the Bank by overriding Glitner's
financial risk controls, and finally how the transactions cost
Glitnir more than $2billion and contributed significantly to the
Bank's collapse.
There is in
particular a sale of $1billion of Bonds to investors located in New
York and elsewhere in the United States in September 2007, which is
sure to get the attention of the very-aggressive US regulators.
According to
Steinunn Guobjartsdottir, chair of the Glitnir Winding-Up Board,
which conducted the investigation and is making the legal claim,
"There is evidence supporting the allegation that Glitnir Bank was
robbed from the inside."
In terms of PwC, the
suit alleges, “Johannesson and the other individual Defendants could
not have succeeded in their schemes without the complicity of PwC.
PwC knew about Glitnir's irregular related party exposures, reviewed
and signed off on Glitnir financial statements which grossly
misrepresented these exposures, and facilitated Glitnir's fraudulent
fundraising in New York.”
According to
Reuters, “Neither PwC nor Mr Jóhannesson immediately responded to
requests for comment.”
This is serious
stuff, in that the bank’s own senior management is being accused of
fraudulent intent to bankrupt the bank. Iceland’s banking system
with its extraordinary regime of easy credit has negatively impacted
thousands of investors and depositers all over Europe, but there are
now government and non-governmental organizations investigating what
happened and pursuing financial claims.
This Nordic
Drama is just getting started, and likely other lawsuits will follow
both in Europe and in the US. Auditors of Icelandic banks are sure
to get named in these suits as defendants and parties to any
misconduct.
Taking care of
family and close friends first is universal. Whether Irish,
Italian, Kenyan, Mexican, or Tunisian… Legal, regulatory, ethical
and moral lines are often crossed in service to family and those who
are “like a brother to me…”
re:
Satyam in the
New York Times January 9, 2009: “What
started as a marginal gap between actual operating profit and
the one reflected in the books of accounts continued to grow
over the years. It has attained unmanageable proportions as the
size of company operations grew,” he wrote. “It was like riding
a tiger, not knowing how to get off without being eaten.”
Mr. Raju said he
had tried and failed to bridge the gap, including an effort in
December to buy two construction firms in which the company’s
founders held stakes.
The
Times of India, January 8, 2009: The
country’s fourth largest IT company—after TCS,Infosys and
Wipro—was for several years cooking its books by inflating
revenues and profits,thus boosting its cash and bank balances;
showing interest income where none existed; understating
liability; and overstating debtors position (money due to it)….[On
December 16, 2008] Raju announced his ill-fated plan to shell
out $1.6 billion to acquire his sons’ companies, Maytas
Properties and Maytas Infra. It created such a furore that Raju
was forced to backtrack. It now transpires that what was seen as
a move by Raju to bail out his sons was actually a last-ditch
effort to covering his tracks through fictitious cash transfers
and wriggle out of a tight corner...There’s intense
speculation as to what finally triggered Raju’s confession of
wrongdoing. It’s clearly more than coincidence that it came hot
on the heels of investment banker DSP Merrill Lynch’s letter to
the company on Tuesday evening terminating its days-old
agreement with Satyam to advise it on strategic options because
of “material accounting irregularities’’. But the beginning of
the end came when furious investors forced Raju to reverse his
Maytas moves.
Contrast this
scenario of cronyism run amok with the news out of Iceland re:
Glitnir:
From Kevin
LaCroix’s
D&O Diary: In October 2008, in the
midst of the global financial crisis, Iceland’s Financial
Services Authority took
control of Glitner. Glitner
ultimately filed a petition for bankruptcy in the U.S. under Chapter
15 of the Bankruptcy Code. According
to the May 11 complaint, creditors have filed claims exceeding
$26 billion…The May 11 complaint alleges that Jon
Asgeir Johannesson and his
wife, Ingibjorg Stefania Palmadottir , and businesses they owned
or controlled, used improper means to “wrest control” of Glitnir
and to “fraudulently drain over $2 billion out of the Bank to
fill their pockets and prop up their own failing companies.”
According to the complaint, beginning in 2006, Johannesson
“engaged in a scheme” using his “web of companies” to take
control of Glitnir in violation of Icelandic law. By April 2007,
Johannesson and his companies owned about 39% of Glitnir’s
stock. As a result, Johanneson was able to “stack” Glitnir’s
board “with individuals who had connections with companies he
controlled,” and he also “had his inexperienced hand-selected
candidate” replace the existing CEO.
Having
taken control of the Bank, its board and its management,
Johannesson and the other individual defendants “used their
control over the Bank and funds raised in U.S. financial markets
to issue massive ‘loans’ to, and a series of equity transactions
with, companies Johannesson controlled, in an effort to stave
off their eventual collapse,” which “placed the Bank in
extreme financial peril.
There are
obvious similarities between Satyam and Glitnir…
Companies using
loans and investments to related entities to hide distress at
main firm and funnel cash abroad.
Glitnir sold
U.S. investors $1 billion in medium-term notes to finance their
schemes. Satyam’s ADR’s were listed on the NYSE.
Glitnir’s CEO
stacked the bank’s board of directors with “willing accomplices”
in “a sweeping conspiracy” to wrest control of the bank.
Satyam’s Board
filled with Indian elite industry and academic leaders who
didn’t get involved in details.
The
involvement of the board,
Chaudhuri adds, was at the
“strategic level; in companies like Satyam, it is the
owner/promoter/founder who runs the show. It has to do with
the ownership structure.”
Satyam’s
balance sheet included nearly $1.5 billion in non-existent cash
and bank balances, accrued interest and misstatements. It had
also inflated its 2008 second quarter revenues by$122 million,
and actual operating margins were less than a tenth of the
stated $135 million.
Per
Times of London October 25, 2009: Each
of the three big banks — Kaupthing, Landsbanki and Glitnir —
loaned large sums to their biggest shareholders on favourable
terms.It has emerged that at the time of Glitnir’s collapse, the
15 biggest creditors were all connected to FL Group, its largest
shareholder, which was controlled by Jon Asgeir Johannesson, the
boss of collapsed Icelandic retail group Baugur.
And then there is
the most telling similarity between the two companies:
Both Satyam
and Glitnir were audited by PwC.
PwC is now named in
lawsuits in New York by shareholders and creditors of both entities.
Continued in article
"How Dangerous is the Two-Billion Dollar Suit Against PwC Over Iceland's
Glitnir Bank? The Answer is Blowin' in the Wind," by James Peterson, re:
Balance, May 12, 2010 ---
Click Here
It seems as if the British are paying
attention more closely to the audit industry and their complicity in the
financial crisis and other failures than the media, legislators and
regulators in the US.
Well… there was that
blip of interestwhen the Lehman
Bankruptcy Examiner called out Ernst & Young for their malpractice in
that colossal failure.
But the stories mentioning Ernst & Young have
mostly stopped for now. There were a few floating into my inbox the last
few days mentioning
EY’s request for a motion to dismiss in some Lehman litigation.
Let’s hope there’s no judge in New York who
wants to be known as the one who let EY or anyone else involved in that
mess off the hook too early and too easily.
It’s not surprising to me that the dialogue
about auditor failure along with others in the crisis is loudest in the
UK. It was the British –
Prem Sikka, Richard Murphyand
Dennis Howlett – who first took notice of
what I was writing here, three years ago, before anyone else. They were
so surprised to find someone in the US who was free to write so so
critically.
“In a
separate statement, the [Accountant's
Joint Disciplinary Scheme] said the case also gave rise to concerns
about the dominance of the Big Four accountancy firms.
The JDS said it had found it difficult to get
any expert evidence for its investigation because specialists
were confined “almost exclusively” to the Big Four, and because of
conflicts of interest, these were unable to comment.”
It is a dialogue. The audit firm leadership
in the UK actually talk back and speak their mind. In their own voice,
it seems. Sometimes to
comic effect.
There are so many corks popping the UK,
hitting them in the eyes, audit firm leadership is actually trying to
preempt. They’re shaking in their £1000 bespoke leather slip-ons.
Well, not really.
Maybe their bottom lips are quivering a bit
in quiet indignation.
Mr Powell, 54, also has plans to continue to
grow the business, in particular to double the revenues of the [PwC]
consultancy practice against a backdrop of scything cuts in UK and
European government spending.
The response of the affable and
youthful-looking Mr Powell to this mounting in-tray is softly spoken and
mostly diplomatic, although there are flashes of steel, as perhaps
expected from the boss of a firm which counts 90 per cent of the FTSE
100 as its clients in one capacity or another across audit, tax and
consulting.
He tells the Financial Timesin an
interview in his offices overlooking the River Thames that it is “time
to turn up the heat in the organisation”.
However, on regulatory inquiries he wants a
debate. First with Vince Cable, the business secretary, about changing
“ground rules” for auditors and then with investors and regulators about
the desire for more subjectivity in the audit report.
In what context were the “affable and
youthful-looking” Mr. Powell’s comments made, whilst sipping tea in his
“offices overlooking the River Thames” ? PwC is being skewered in the
UK press over its complete and utter lack of competence in the JP Morgan
“billions in client funds in the wrong accounts” debacle.
Didn’t hear about it? It’s a British thing.
Mr Powell’s comments come as PwC’s audit
practice may face a separate inquiry by the Financial Reporting Council,
which oversees auditors, after the Financial Services Authority last
weekrevealed
the firm had failed over a seven-year period to spotthat JPMorgan
had accidentally placed as much
as $23bn (£16bn) of client funds into the wrong bank accounts. PwC has
declined to comment.
His comments also follow government plans to
cut public sector spending on consulting services, an area that
contributes up to 40 per cent of PwC’s £450m consulting and advisory
business. PwC aims to at least double revenues and staff in its
consulting business in the next five years, and has seen “well into
double-digit” growth in its UK consulting practice in the past 11
months, Mr Powell said.
Big Four efforts to aggressively expand their
consulting practices have attracted some controversy, as they had scaled
them back after the Enron crisis amid concerns it could affect the
independence of their audit reports.
Indeed. I must say old chap… Getting a little
squidgy for you?
Ernst and Young, for its part, had a long,
protracted and quite embarrassing run with the Equitable Life
litigation. But as that immortal Brit
once said, “All’s well that ends well.”
Ernst & Young’s statement about the official
disciplinary investigation into its role in theEquitable
Life affair may well lead the casual
reader to think it had come away triumphant…It was still fined £500,000
with costs of £2.4m. But it now crows that the most serious allegations
– that it lacked objectivity and independence – have been thrown out.
The firm also comments that the appeal tribunal took the view that
Equitable and E&Y were right to think it “very unlikely” the insurer
would lose the court case, and that there was no requirement to disclose
a “remote contingency”…It is true that the disaster at Equitable was
primarily the doing of its former executives, and that auditors cannot
be expected to discover all management folly and incompetence. But
shouldn’t any audit firm worth its salt be embarrassed by failing to
spot a scandal of this magnitude?
Ernst & Young apologized to the policy
holders. Apologized.
It’s all behind us now. The audit partner
in question has since retired. Just like Bally’s.
In a statement, Ernst & Young said: “Any
lessons from our audit of Equitable have long been learned and embedded
in our audit systems and procedures. We extend our sympathies to the
policyholders of Equitable Life, who have been impacted by the
near-collapse of the society, following events which lay well outside of
our control and the remit of our role as auditor.”
This fine was handy pocket change for EY and
nothing compared to what they face potentially in the Lehman litigation.
It’s only unfortunate for EY it lasted so long and cost them so much in
solicitor fees.
Will the media, regulators and legislators
wait until the
New Century v. KPMGcase finally comes to
trial? I’d better brace myself for the calls from newbie journalists
all over again.
Or maybe we’ll putter along with updates as
Satyam, Glitnir, Lehman,
Anglo Irishand others play out in the
New York courts.
The Deloitte SAP case in Marin County is
pretty sexy. Michael
Krigsman rightly calls it a game changer
for systems integrators. Who dares to call a spade and spade and accuse
a Big 4 of fraud for the bait and switch which is putting junior folks
on a big SAP engagement when you promised experienced ones?
Here is
Accountancy’s report on the JP Morgan client accounting fiasco. You
will see that PwC was actually engaged to provide some sort of
specific certification in that respect. Whilst trust account
auditing can be tricky, you don’t need to be an audit ‘expert’ to
track GBP 16 billion. A few simple tracing tests ought to do it.
"PwC in
potential inquiry over client money breach: FSA fines JP Morgan
record £33m," by Pat Sweet
PricewaterhouseCoopers could face an inquiry by accounting
regulators over its repeated certification that JP Morgan
Securities Ltd (JPMSL) kept clients' funds separate from its own
- a certification which is now in contention after the bank was
discovered to have breached the rules.
The role of PwC
- also the bank's auditors - in the certification of how the
investment bank handled client funds is now under scrutiny,
following a record £33.3m fine on the bank by the Financial
Services Authority, which discovered that JPMSL had mixed its
own funds with those of clients.
Under the FSA’s
client money rules, firms are required to keep client money
separate from the firm's money in segregated accounts with trust
status. This helps to protect client money in the event of the
firm's insolvency.
The FSA fined
JPMSL after it found to have mixed client funds with its own
cash over a seven year period. Up to £16bn of clients’ money
went into the wrong bank accounts.
The FSA plans to
pass on the details of its investigation to both the Financial
Reporting Council and the ICAEW, which will then determine
whether any further action is necessary, according to the Times.
In addition to
serving as principal auditor, PwC was retained by JP Morgan
Securities Limited to produce an annual client asset returns
report, to confirm that customers’ funds were being effectively
ring-fenced and therefore protected in the event of the bank’s
collapse.
However, PwC
signed off the client report even though JP Morgan was in breach
of the rules.
The money at
risk in this case consisted of funds held by customers of
JPMSL's futures and options business — a sum that varied from
£1.3bn to £15.7bn between 2002 and July 2009, when the breach
came to light.
PricewaterhouseCoopers LLP suffered a defeat on Friday when a
federal appeals court ordered an inquiry into whether the auditor
dealt in good faith with a large Pennsylvania hospital system that
went bankrupt.
The Third Circuit
Court of Appeals in Philadelphia threw out a January 2007 ruling
dismissing claims against PwC by a committee of unsecured creditors
of behalf of the now defunct Allegheny Health, Education and
Research Foundation.
These creditors
accused Coopers & Lybrand LLP, one of PwC's predecessor companies,
of conspiring with AHERF officials in the 1996 and 1997 fiscal years
to hide the increasingly dire financial health of the
Pittsburgh-based system.
AHERF ultimately
sought Chapter 11 protection in July 1998, with about $1.3 billion
of debt, in the largest U.S. nonprofit healthcare collapse. The
system once ran 14 hospitals and two medical schools and employed an
estimated 31,000 people.
It is not clear
whether Friday's ruling will result in more litigation or prompt the
parties to pursue a settlement.
PwC spokesman Steven
Silber said company officials could not be reached for comment.
James Jones, a Pittsburgh-based lawyer for the creditors, declined
immediate comment.
In his 2007 ruling,
U.S. District Judge David Cercone said the creditors could not
recover on AHERF's behalf under a legal doctrine governing cases of
equal fault, concluding AHERF was at least as much at fault as PwC.
But the Third
Circuit asked the Pennsylvania Supreme Court for guidance on that
state's law, including whether an auditor such as PwC could be held
liable for breach of contract, negligence or aiding and abetting a
breach of fiduciary duty.
Writing for a
unanimous three-judge panel of the Third Circuit, Judge Thomas Ambro
adopted the Pennsylvania court's conclusion that an auditor could be
held liable if it had "not dealt materially in good faith with the
client-principal."
This effectively
barred the equal fault defense in cases of "secretive collusion
between officers and auditors to misstate corporate finances to the
corporation's ultimate detriment."
Ambro also directed
the district court to reconsider its finding that misstated
financials could have been a short-term "benefit" to AHERF.
He said that, as a
matter of law, "a knowing, secretive, fraudulent misstatement of
corporate financial information" cannot benefit a company.
The AHERF bankruptcy
generated much litigation and regulatory activity. In 2007, the bond
insurer MBIA Inc (MBI.N) agreed to pay $75 million to settle
regulatory fraud charges over a reinsurance transaction involving
defaulted AHERF debt.
The case is
Official Committee of Unsecured Creditors of Allegheny Health,
Education and Research Foundation v. PricewaterhouseCoopers LLP,
U.S. Third Circuit Court of Appeals, No. 07-1397. (Reporting by
Jonathan Stempel; editing by Steve Orlofsky and Andre Grenon)
Questions
How is bright-line-rule Repo accounting in 2008 like the
bright-line-rule “1% Solution” of a
decade earlier? Answer is suggested below.
How do we
simultaneously award PwC for being the world’s Number 1 financial
management consulting firm and the Number 1 financial auditing firm?
Question is raised below.
First Let’s Talk
About 2010
PwC is the auditor
of Goldman Sachs, and we really don't know if and how long PwC will be
off the hook on Goldman’s 2010 lawsuits. The former Treasury Secretary,
Hank Paulson, was previously the CEO of Goldman. He made it his number
one priority to save Goldman in the Bailout, which in turn made it
necessary to bail out AIG since billions in AIG credit derivative
obligations were owed to Goldman. The net effect was to bail out AIG,
which of course is also audited by PwC.
Ernst &
Young, the audit firm, had a long and lucrative relationship with Lehman
Brothers. Lehman Brothers has paid EY more than $160 million in audit
and other fees since fiscal year 2001. Although this isn’t nearly as
much as
Goldman Sachs and AIG pay PwC– almost
$230 million a year combined in 2008 – it was still a huge amount and
represented a significant client relationship for Ernst & Young Francine McKenna,"Liberté,
Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young,"
re: The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/
Also see
The Continuing Saga of Auditing, Independence, Consulting, and
Professionalism and Fees
"The Great American Financial Sandwich: AIG, PwC, and Goldman Sachs,"
by Francine McKenna, re: The Auditors, February 2, 2010 ---
http://retheauditors.com/2010/02/02/4151/
If and when
shareholders lose money in 2010 because of proven Goldman frauds, it’s
inevitable that Goldman’s shareholders and creditors will file lawsuits
against the PwC auditors as well as Goldman Sachs itself and the credit
agencies that fraudulently gave Goldman’s toxic CDO bonds AAA ratings
when they should’ve been junk. The credit rating agencies in turn will
sue PwC claiming they were misled by Goldman’s golden financial
statement.
The 2010 lawsuit
merry-go-round is barely beginning since the SEC’s lawsuit against
Goldman is hot off the presses. Worse, the Justice Department has yet to
decide whether it will pursue criminal prosecution of Goldman. I doubt
that this will happen since hauling Goldman into criminal court might
greatly upset the Administration’s economic recovery plan and create
massive unemployment and economic disruption.
Thus it’s become a
waiting game for PwC in 2010. Meanwhile PwC can bank hundreds of
millions in a war chest, much of it earned from the administration of
the Lehman Bankruptcy. It’s also not clear that PwC is as culpable for
any Goldman audit failures as much Ernst & Young is culpable, in my
opinion, for the alleged Lehman audit failures ---
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
Goldman and PwC
might well survive the 2010 legal battle like they survived a huge 2000
legal battle:
A History Lesson on
Goldman that Sounds a Bit Like Repo Accounting Issues with the “1%
Solution”
Question
How can you "PUT" away your cares about clear-cut (bright line) rules of
accounting?
Answer
See how AOL did it in conspiracy with Goldman Sachs
With the
AOL-Time Warner deal due to close in just three months, Bertelsmann
needed to reduce its AOL Europe holding -- pronto. But the obvious
buyer, AOL, didn't want to own more than 50% or more of the venture,
either. Going above half might trigger a U.S. accounting rule that would
force AOL to consolidate all the struggling unit's losses on its books
when AOL was already grappling with deteriorating ad revenues and a
declining stock price. Enter Goldman Sachs Group Inc. (GS ) Business
Week has learned that the premier Wall Street bank agreed to buy 1% of
AOL Europe -- half a percent from each parent -- for $215 million. AOL
Europe, in return, agreed to a "put" contract promising Goldman that it
could sell back the 1% by a specific date and at a set price. That
simple transaction solved Bertelsmann's EU problem without trapping AOL
in an accounting conundrum -- a perfect solution.
Goldman's 1%
Solution
In 2000, it cut a questionable deal that smoothed the AOL-Time Warner
merger. Will the SEC take action?
In more
ways than one, the news from the European Union was bad. It was October,
2000, and the EU's executive arm, the European Commission, had just
jolted America Online Inc. with a ruling that its pending acquisition of
Time Warner Inc. (TWX
) could harm competition in Europe's media markets, especially the
emerging online music business. The EC was concerned that AOL was a
50-50 partner with German media giant Bertelsmann in one of Europe's
biggest Internet service providers, AOL Europe. Now the EC was ordering
Bertelsmann to give up control over AOL Europe.
With the AOL-Time Warner deal due to close
in just three months, Bertelsmann needed to reduce its AOL Europe
holding -- pronto. But the obvious buyer, AOL, didn't want to own more
than 50% or more of the venture, either. Going above half might trigger
a U.S. accounting rule that would force AOL to consolidate all the
struggling unit's losses on its books when AOL was already grappling
with deteriorating ad revenues and a declining stock price.
Enter Goldman Sachs Group Inc. (GS )
Business Week has learned that the premier Wall Street bank agreed
to buy 1% of AOL Europe -- half a percent from each parent -- for $215
million. AOL Europe, in return, agreed to a "put" contract promising
Goldman that it could sell back the 1% by a specific date and at a set
price. That simple transaction solved Bertelsmann's EU problem without
trapping AOL in an accounting conundrum -- a perfect solution.
LEGAL HEADACHES
Or so it seemed at the time. But the deal
also may have violated U.S. securities laws. The Securities A: Exchange
Commission and the Justice Dept. have construed some deals involving
promises to buy back assets at a specific time and price as
share-parking arrangements designed to mislead investors. The former
chief executive of AOL Europe says the Goldman deal may have kept up to
$200 million in 2000 losses off of the combined AOL-Time Warner
financials -- enough, he says, that Time Warner might have tried to
change the terms of the $120 billion merger, since AOL wouldn't have
looked as healthy. But as the deal moved toward consummation, the
Goldman arrangement was never disclosed in public documents to AOL or
Time Warner shareholders.
The AOL Europe transaction threatens to
create problems for Goldman Sachs. But it could also prolong the legal
headaches of Time Warner Inc., as the AOL-Time Warner combine is now
called. For the past two years, Time Warner has been in heated
negotiations with the SEC over AOL's accounting for advertising revenues
(BW -- June 7). Just as the SEC is wrapping up that case -- it could
warn Time Warner as early as this summer that it intends to bring civil
fraud charges -- the Goldman transaction raises troubling new questions
about AOL's financial dealings prior to the merger.
The SEC has not brought charges over the 1%
solution, and an SEC spokesman would not comment on whether the agency
is probing the deal. Time Warner spokeswoman Tricia Primrose Wallace
says the company will not comment on any part of the Goldman
arrangement. A lawyer for Stephen M. Case, AOL's chairman and CEO at the
time of the deal, referred questions to Time Warner. Thomas Middelhoff,
who was Bertelsmann's chairman at the time of the deal and negotiated
the AOL Europe joint venture with Case in 1995, says through a spokesman
that the sale of a 0.5% stake was "purely a financial technique" handled
by others. And Lucas van Praag, a Goldman Sachs spokesman, says: "We
handled this entirely appropriately. We don't believe there is anything
untoward here."
The University
of California has joined with Amalgamated Bank to file a lawsuit against
AOL Time Warner Inc., claiming their stakes have lost more than $500
million in value because the media company allegedly lied about its
financial condition.
The University of California, which dropped out of a federal
class-action suit against AOL earlier this month, filed the complaint
Monday in the Superior Court of California in Los Angeles. The
university and co-plaintiff Amalgamated Bank, a New York institution
that manages funds for several dozen union pension funds, are being
represented by Milberg Weiss Bershad Hynes & Lerach.
The plaintiffs allege that AOL Time Warner materially misrepresented its
revenue and subscriber growth after the merger of AOL and Time Warner in
January 2001. In two separate restatements in October and March, AOL
slashed nearly $600 million from previously reported revenue over the
past two years.
The University of California and Amalgamated allege that AOL's
admissions so far have been "too conservative," and that the company may
have overstated results by almost $1 billion.
In a March 28 filing with the Securities and Exchange Commission, AOL
Time Warner said it faces 30 shareholder lawsuits that have been
centralized in the U.S. District Court for the Southern District of New
York. The company said in the filing it intends to defend itself
"vigorously." The lawsuit filed by the University of California and
Amalgamated names several current and former AOL Time Warner executives,
as well as financial-services giants Citigroup and Morgan Stanley.
Citigroup is the parent of Salomon Smith Barney, now called Smith
Barney, which with Morgan Stanley allegedly reaped $135 million in
advisory fees from the AOL and Time Warner merger.
Defendants include Stephen Case, who resigned as chairman in January;
former Chief Executive Gerald Levin, who left the company in May;
current Chairman and Chief Executive Richard Parsons; and Ted Turner,
who recently stepped down as vice chairman.
The lawsuit claims they and more than two dozen other insiders sold off
$779 million in stock just after the merger closed but before the
accounting revelations that would cause the stock price to plummet.
The
suit also names AOL's auditor, Ernst & Young.
The University of California claims it lost $450 million in the value of
its AOL Time Warner shares, which were converted from more than 11.3
million Time Warner shares in the merger. At the end of 2002, the value
of the university's portfolio was at $49.9 billion.
Continued in the article
And so the beat
goes on a decade later with Goldman raking in billions in profits and
PwC thriving like never before in assurance services and consulting.
We see from a recent press release that
PricewaterhouseCoopers has received a “Strong Positive” rating in
Gartner’s Global Finance Management Consulting Services MarketScope
Report, which was published recently on December 21, 2009.
This is the highest possible rating in the
Marketscope, a "Strong Positive" shows a provider who can be considered
"a strong choice for strategic investments" where customers can continue
with planned investments and potential customers can consider this
vendor a strong choice for strategic investments.. The research assesses
the global capabilities of nine leading finance management consulting
service providers on customer experience, market understanding, market
responsiveness, product/service, offering strategy, geographical
capabilities and vertical-industry strategy.
Congratulations to PwC for this select honor.
Jensen Comment
Unfortunately, there is a stiff price to see the contents of this report
(US$1,995), so we can’t say who the other 8 providers are, but very
likely some of the Big Four firms would be on that list, and somewhat
curious why PwC should feature this as a big release on their global
website, but other firms are quite silent on this point.
At times it may be difficult for the
world's largest auditing firm to also be rated as the top firm for
"Global Finance Management Consulting Services." Nobody seems to
question financial consulting since the Andersen destruction gave rise
to new independence rules, notably Sarbanes-Oxley. In the past decade
the Big Four auditing firms, except for Deloitte, shed themselves of
their consulting divisions and then commenced to selectively build them
back up once again. However, more care is being devoted to the
independence bounds of computer systems and tax consulting.
From:
THE Internet Accounting List/Forum for CPAs [mailto:CPAS-L@LISTSERV.LOYOLA.EDU]
On Behalf Of Jim Fuehrmeyer Sent: Friday, January 22, 2010 10:07 AM To: CPAS-L@LISTSERV.LOYOLA.EDU Subject: Re: PricewaterhouseCooopers Gains Top Rating From
Gartner
Despite the
SEC/Sarbanes-Oxley rules that severely limit the non-audit services that
auditors can provide to their audit clients, the re-growth of consulting
should still be a concern.
I think Art
Wyatt’s article on the cultural impact of consulting at Arthur Andersen
that appears in the March 2004 Issue of Accounting Horizons sums
it up best.
It’s required
reading for all my undergraduate CPAs to be.
Jim Fuehrmeyer
JAMES L. FUEHRMEYER,
JR.
Associate Professional Specialist
Department of Accountancy
MENDOZA COLLEGE OF
BUSINESS
UNIVERSITY OF NOTRE DAME 384
Mendoza College of Business
Notre Dame, IN 46556
office: (574) 631-1752 | fax: (574) 631-5255
e:
jfuehrme@nd.edu | w:
http://business.nd.edu
“Gentlemen, not one of you could have
done this on your own. This was a team effort.” Casey
Stengel after the Mets 40-120 season.
Why didn’t the Big 4 audit firms warn that
these obscenely over leveraged institutions threatened our financial
future? Why didn’t the auditors question, push back, or raise
objections to illegal and unethical disclosure gaps? Every one of
the failed or bailed out financial institutions carried
non-qualified, clean audit opinions in their wallets when they
cashed the taxpayers’ check.
Lehman Brothers. Bear Stearns. Washington
Mutual. AIG. Countrywide. New Century. Citigroup. Merrill Lynch. GE
Capital. GMAC. Fannie Mae. Freddie Mac.
The largest four global audit firms –
Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – have
combined revenues of almost $100 billion dollars and employ hundreds
of thousands of people. There’s no hard proof they’re completely
corrupt, but they’ve proven themselves to be demonstrably
self-interested and no longer singularly focused on their public
duty to shareholders.
Something is rotten with the accounting
industry.
America’s public accountants – in
particular, the Big 4 audit firms – aren’t protecting investors. And
no one is holding them accountable.
The crisis that culminated in the
near-collapse of the global financial system is still the subject of
Congressional hearings.
Last month the
Lehman Bankruptcy Examiner’s report told
us that there’s “sufficient evidence exists to support colorable
claims against Ernst & Young LLP for professional malpractice
arising from [their] failure to
follow professional standards of care.”
This weekthe Securities and
Exchange Commission charged Goldman Sachs and one of its vice
presidents with fraud for misleading investors by “misstating and
omitting key facts about a financial product tied to subprime
mortgages.”
That financial product was a structured
collateralized debt obligation (CDO) that hinged on the performance
of subprime residential mortgage-backed securities (RMBS). Goldman
Sachs, according to the SEC, failed to disclose vital information
about the CDO to investors. In particular, John Paulson’s hedge
fund, a Goldman client, played a leading role in the
portfolio
selection process and the hedge fund took a short position against
the CDO, without disclosure to Goldman’s other clients.
In one of the most egregious cases of
auditor complacence during the financial crisis, Pricewaterhouse
Coopers LLP (PwC), the firm that audits both AIG and Goldman Sachs,
sat on the sidelines for almost two years while their clients
disputed the value of credit default swaps (CDS).
There’s been no public explanation of how
PwC presided over the
dispute between AIG and Goldman—a dispute
eventually pushed AIG to accept a bailout – without doing something
decisive to help resolve it. This long-running “difference of
opinion” between two of its most important global clients was
arguably material to at least one of them. Why didn’t PwC force a
resolution sooner based on consistent application of accounting
standards?
PwC was paid a combined $230 million by the
two firms for 2008 and remains the “independent” auditor to both
companies.
Gatekeepers? Or foxes in the hen
house?
The auditor’s role is to be a gatekeeper. A
watchdog. An advocate for shareholders. This is their public duty.
This public trust is subsidized by a
government-sponsored franchise. All companies listed on major stock
exchanges must have an audit opinion.
Audit firms are meant to be shareholders’ first line of defense, and
they are hired by and report to the independent Audit Committee of
the Board of Directors.
And yet the same audit firms that stood by
and watched Bear Stearns and Lehman Brothers fail – Deloitte and
Ernst &Young – are recipients of lucrative government contracts to
audit or monitor the taxpayers’ investment in the bailed out firms.
Deloitte, the Bear Stearns and Merrill Lynch auditor, works for the
US Federal Reserve system. Ernst & Young, Lehman’s auditor, is
working for the US Treasury on the original $700 billion TARP
program and with the Fed on the AIG bailout.
Who are we kidding?
America’s auditors serve themselves.
Focused on “client service” not shareholder advocacy, they’ve
remained above the financial crisis finger-pointing fray. Call it
skillful lobbying or
targeted political contributions… Either
way, regulators and legislators have been afraid of getting on the
auditors’ bad side.
Investment banks, mortgage originators,
commercial banks, and ratings agencies have all been questioned
about their role in the crisis. And the Big 4 public accounting
firms work for all of them.
But when accused of negligence, malpractice
or complicity, the audit firms frequently claim to have been duped.
Do you believe them? The industry is an oligopoly. That’s a $10 word
for what happens when a
market
or
industry is dominated by a small number of
sellers who discuss their strategies in order to achieve common
objectives.
The Sarbanes Oxley Act of 2002 (SOx) was
enacted after the Enron debacle to restore confidence in the audit
profession. Instead, accounting firms reaped huge financial rewards
while enforcing SOx, until the tremendous cost to America’s
businesses forced regulators to lighten up and the auditors to stand
down.
But SOx had another insidious byproduct:
the misplaced belief that after Arthur Andersen’s implosion, the
remaining four global public accounting firms were too important,
and too few, to fail.
This fear of auditor failure precludes any
regulatory or legislative actions that might precipitate the loss of
another large accounting firm. What do you get when there’s no
timely or significant regulatory consequence to repeated auditor
malpractice and incompetence? Moral hazard. “Too few to fail” has
been as detrimental to capital markets as the notion that some
financial institutions are too big to fail. Shareholders are harmed
and investors lose confidence.
Every one of the audit firms is a defendant
in lawsuits for institutions that failed, were taken over, or bailed
out, in addition to several $1 billion plus malpractice, fraud and
Madoff-related lawsuits. Any one of these “catastrophic” matters
could threaten their viability. However, regulators and the
worldwide business community are ignoring this threat or, worse yet,
promoting liability caps. Limiting liability only exacerbates moral
hazard.
Can a crisis caused by “catastrophic”
disruption in audit service delivery be any worse than the one they
never warned us about? Why not face fears head on and start
re-writing the audit blank check – ineffective audit opinions –
before the plaintiffs’ bar does it for us?
This is a great
article by Jennifer hughes in FT, from early in the process that
describes PwC's approach to the (Lehman bankruptcy administration(
engagement.
First, kudos to the Audit Committee (John McCartney, Dubose Ausley and
James Edwards) for unearthing this issue and pursuing it fearlessly to
its terrible end at Huron Consulting.
From The Wall Street Journal Weekly Accounting Review on August 6, 2009
TOPICS: Accounting
Changes and Error Corrections, Advanced Financial Accounting, Mergers
and Acquisitions
SUMMARY: Huron
Consulting Group, Inc., was formed in May 2002 by partners from the
now-defunct Arthur Andersen LLP. "Today, fewer than 10% of the company's
employees came directly from Arthur Andersen." The firm provides
"...financial and legal consulting services, including forensic-style
investigative work...." The firm announced restatement of earnings for
fiscal years 2006, 2007, and 2008 and the first quarter of 2009 due to
inappropriate accounting for payments made to acquire four businesses
between 2005 and 2007. The payments were made after the acquisitions for
earn-outs: additional amounts of cash payments or stock issuances based
on earning specific financial performance targets over a number of years
following the business combinations. However, portions of these earn-out
payments were redistributed to employees remaining with Huron after the
acquisitions based on specific performance measures by these employees
rather than being based on their relative ownership interests in the
firms prior to acquisition by Huron. Consequently, those payments are
deemed to be compensation expense. The amounts restated thus reduce net
income for the periods of restatement and reduce future income amounts,
but do not affect cash flows of the firm. Negative shareholder reaction
to this announcement by a firm which provides consulting services in
this area certainly is not surprising.
CLASSROOM APPLICATION: Accounting
for allocation of a purchase price in a business combination is covered
in this article.
QUESTIONS:
1. (Introductory)
In general, how do we account for assets acquired in business
combinations? How are cash payments and stock issued to selling
shareholders accounted for?
2. (Introductory)
What are contingent payments in a business combination? What are the two
main types of contingent payments and what are their accounting
implications?
3. (Introductory)
Which of the above 2 types of contingent payments were employed in the
Huron acquisition agreements for businesses it acquired over the years
2005 to 2008?
4. (Advanced)
Obtain the SEC 8_k filing by Huron for the restatement announcement,
dated July 31, 2009, and the filing answering subsequent questions and
answers as posted on its web site, dated August 3, 2009 available at
http://www.sec.gov/Archives/edgar/data/1289848/000119312509160844/d8k.htm
and
http://www.sec.gov/Archives/edgar/data/1289848/000128984809000017/exh99-1.htm
respectively. What was the problem which made the original acquisition
accounting improper? What accounting standard establishes requirements
for handling corrections of errors such as this? In your answer, explain
why the company discloses that investors must not rely on the previously
released financial statements.
5. (Advanced)
Refer specifically to the August 3, 2009, filing obtained above. What
were the ultimate journal entries made to correct these errors? Explain
the components of these entries.
6. (Advanced)
The author of this article writes that this error in reporting and
subsequently required restatement "...suggests [that] a closer alliance
between consulting and accounting isn't such a bad idea." What is the
SEC requirement that divides consulting and accounting? Do you think
this problem with reporting would have arisen had the firm been allowed
to perform both auditing, accounting, and consulting services to its
clients? Support your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Financial downturns often expose accounting problems at companies, but
scandals have been noticeably absent in the recent turmoil. Not so
anymore.
Late Friday, Huron Consulting Group Inc. said it would restate the last
three years of financial results, withdraw its 2009 earnings guidance
and lower its outlook for 2009 revenue. The accounting snafu, which has
decimated the company's shares, was all the more surprising because
Huron traces its roots to Arthur Andersen LLP, the accounting firm at
the heart of the last wave of scandals.
A dose of added irony is that Huron makes its money providing financial
and legal consulting services, including forensic-style investigative
work, and tries to help clients avoid these types of mistakes.
"One of their businesses is forensic accounting -- they're experts in
this," says Sean Jackson, an analyst at Avondale Partners in Nashville,
Tenn., who dropped his rating to the equivalent of "hold" from "buy."
"Investors are saying, 'These guys had to know what happened with the
accounting, or they should have known.'"
Investors fear the accounting issues, which will reduce net income by
$57 million for the periods in question, might damage the firm's
credibility. Huron's shares fell 70% on Monday, well below the price of
its initial public offering in 2004. On Tuesday, Huron shares rose four
cents to $13.73.
Huron, based in Chicago, was started in May 2002 by refugees from Arthur
Andersen who fled the firm after it was indicted for its role in the
collapse of Enron Corp. At the time, the group said that it would
specialize in bankruptcy and litigation work, as well as education and
health-care consulting, and that it would work with more than 70 former
clients of Arthur Andersen. Arthur Andersen's guilty verdict was later
overturned, but it was too late to save the firm, which was dismantled.
Today, fewer than 10% of the company's employees came directly from
Andersen, according to a Huron spokeswoman.
Huron on Friday also announced preliminary second-quarter revenue that
was shy of analyst expectations, along with the resignation of Gary
Holdren, its board chairman and chief executive, along with the
resignations of finance chief Gary Burge and chief accounting officer
Wayne Lipski. "No severance expenses are expected to be incurred by the
company as a result of these management changes," Huron's regulatory
filing said.
After its founding by 25 Andersen partners and more than 200 employees,
Huron grew rapidly. It soon had 600 employees and counted firms like
Pfizer, International Business Machines and General Motors as clients.
Growing scrutiny of accounting firms that also did consulting made
Huron's consulting-only business look promising, and shares soared from
below $20 five years ago to nearly $44 before the news on Friday.
That is when Huron dropped its bombshell -- one that suggests a closer
alliance between consulting and accounting isn't always such a bad idea.
Huron is restating financial statements to correct how it accounted for
certain acquisition-related payments to employees of four businesses
that Huron purchased since 2005.
Huron said the employees shared "earn-outs," or financial rewards based
on the performance of acquired units after the transaction was
completed, with junior employees at the units who weren't involved in
the original sale. They also distributed some of the proceeds based on
performance of employees who remained at Huron, not based on the
ownership interests of those employees in the businesses that were sold.
The payments were legal. The problem was how Huron accounted for these
payouts. The compensation should have been booked as a noncash operating
expense of the company. Huron said the payments "were not kickbacks" to
Huron management, but rather went to employees of the acquired
businesses.
The method the company used to book the payments served to increase its
profit. The adjustments reduced the company's net income, earnings per
share and other measures, though it didn't affect its cash flow, assets
or liabilities.
Part of investors' concern is that they aren't entirely sure what
happened at Huron. The company's executives aren't speaking with
analysts, some said on Tuesday.
Employees and big producers now might bolt from Huron, Avondale
Partners' Mr. Jackson says.
"It's still unclear what happened, but it's almost irrelevant at this
point," says Tim McHugh, an analyst at William Blair & Co., who has the
equivalent of a "hold" on the stock, down from a "buy" last week. "The
company's brand has been impaired and turnover of key employees is a
significant risk."
First, kudos to the Audit Committee (John McCartney, Dubose Ausley and
James Edwards) for unearthing this issue and pursuing it fearlessly to
its terrible end.
Second, shame on senior management to succumb to greed and not complying
strictly with accounting standards
Third, shame also on the auditor, PricewaterhouseCoopers for failing to
spot this issue, especially in 2008, when the amount of money kept in
goodwill was $31 million, three times the true net income of Huron of
only $10 million
Fourth, shame on Huron itself for providing accounting, internal audit,
internal controls, Sarbanes, and similar advice to its corporate
clients, while following shady accounting practices. Physician, heal
thyself first.
Finally, our sympathies for all the hard working and honest Huron
consultants who had nothing to do with acquisitions or their accounting,
and are likely as mad as anyone that this could happen to them.
The Continuing Saga of Auditing,
Independence, Consulting, and Professionalism and Fees
"The Great American Financial Sandwich: AIG, PwC, and Goldman Sachs,"
by Francine McKenna, re: The Auditors, February 2, 2010 ---
http://retheauditors.com/2010/02/02/4151/
It may have
been the first time you had ever heard of AIG. As big as it is, it
wasn’t really a household name outside of the financial services
world. And certainly, big as it is, the average businessperson
probably could not describe everything they did and why.
The U.S.
government seized control of American International Group
Inc. — one of the world’s biggest insurers — in an $85 billion
deal that signaled the intensity of its concerns about the
danger a collapse could pose to the financial system.
The step
marks a dramatic turnabout for the federal government, which had
been strongly resisting overtures from AIG for an emergency loan
or some intervention that would prevent the insurer from falling
into bankruptcy. Just last weekend, the government essentially
pulled the plug on Lehman Brothers Holdings
Inc., allowing the big investment bank to go under instead of
giving it financial support. This time, the government decided
AIG truly was too big to fail.
The U.S.
negotiators drove a hard bargain…
Can you
fault the journalists for not having any idea how incomplete and
relatively inaccurate so much of what was written in haste back then
would turn out to be?
The federal bailout
of AIG, which grew to a more than $180 billion commitment, has
attracted controversy and hounded Paulson, Geithner and other
officials who helped orchestrate the troubled insurer’s rescue
in September 2008.
In hearings
last week before Congress, Treasury Secretary Tim Geithner came
under fire for the bailout, given his prior role as Chairman of the
New York Federal Reserve Bank, the chief architect of the deal:
The US treasury
secretary
Timothy Geithner was accused of incompetence, obfuscation
and of making “lame excuses” during a furious hearing on Capitol
Hill over the government’s contentious
bailout of the sprawling insurer AIG.
In an unusually
ill-tempered confrontation, members of Congress from both
parties rounded on Geithner over a decision to use taxpayers’
money to pay out the full $62bn (£38bn) owed by
AIG to
banks such as
Goldman Sachs,
Merrill Lynch,
Barclays
and RBS… The biggest counterparty receiving money from AIG was
Goldman Sachs. Visibly rattled, Geithner was obliged to confirm
to the committee that his chief of staff, Mark Patterson, is a
former Goldman Sachs banker, as is Geithner’s predecessor at
the treasury, Henry Paulson. But he angrily defended those
involved…”
But
if you’ve been reading my stories about AIG and their auditor PwC,
you would have first heard about AIG in 2007. I start with their
earlier accounting issues, restatements, investigations and lawsuits
as a result of, let’s call it, Crisis One,
to differentiate it from Crisis Two – the
$180 billion bailout that became necessary,
suddenly, unexpectedly, as a result of a confluence of unprecedented
economic events and that could not have
been anticipated by
anyone, anywhere, in any way shape of form…
Yeah,
right. If you believe that, Joe Cassano’s got
a great deal for you on a piece of Maiden Lane III. Sounds
quite green and leafy, no?
In
June of 2007, I told you
about former AIG Chairman and founder Maurice Greenberg suing AIG
and PwC as a result of a shareholders derivative suit against him. I
said, “Isn’t it time for PwC to resign as AIG auditor?”
“…which
remains an AIG shareholder—alleges in its
petition [to the SEC] that AIG’s longtime independent auditor
should be forced to resign because an AIG special
litigation committee earlier this year authorized shareholders
to pursue a derivative action against PwC in Delaware Chancery
Court. “AIG’s decision to have the derivative
plaintiffs prosecute the claims against PwC on behalf of AIG
instead of having AIG’s own counsel prosecute the claims cannot
eliminate the conflict that exists,” the Starr petition says.”
In
October of 2007, I told you how PwC was
sued by AIG shareholders who filed an amended complaint because when
AIG management took over the shareholders derivative suit, stepping
into their shoes, they did not comply with their wishes and
decided to not sue PwC.
“…filed in Delaware
Chancery Court on Friday. AIG shareholders previously sued in
2004, naming former Chief Executive Maurice “Hank” Greenberg,
former Chief Financial Officer Howard Smith, PwC and others as
defendants. In the amended complaint, filed on Friday, the
shareholders seek damages from PwC and others…
In June, AIG took
over the shareholders’ lawsuit against Greenberg and Smith,
becoming sole plaintiff in the case and leaving shareholders to
decide whether to pursue claims against some or all of the
remaining defendants, including PwC.
AIG, the largest
U.S. insurer, on Friday restated its claims against Greenberg
and Smith for allegedly breaching the fiduciary duties they owed
the company, while shareholders refiled their claims against
some of the original defendants. AIG “decided not to sue (PwC)
based on the recommendation of a special litigation committee of
AIG’s board of directors” and the company “continues to
have full confidence in the independence of PwC,” a
company spokesman said…
Also
in October 2007, in spite of their role as a defendant in lawsuits
by AIG shareholders, in spite of their longstanding relationship
with the firm that was now in so much trouble,
PwC was reappointed as AIG’s auditor, with
the
endorsement of Arthur Levitt. Levitt had
been hired by AIG to restore good corporate governance to AIG.
The company
interviewed at least three others over the course of a year for
the job, which starts 2008, said AIG spokesman Chris
Winans.
PricewaterhouseCoopers, AIG’s auditor for more than two decades,
had approved financial results from 2000 to 2005 that were
restated amid Spitzer’s probe, lowering earnings by $3.4
billion. AIG investors sued the auditor in a Sept. 28 amended
filing to recover losses from the settlement and restatement.
“Many
companies involved with corporate scandals have changed their
auditors to regain investor trust,” said Lynn Turner,
a former chief accountant at the U.S. Securities and Exchange
Commission. … “disappointed” AIG kept “the auditor who failed
investors by giving a clean bill of health on misleading
financial statements.”
Crisis One litigation is still very much alive. After PwC’s material
weakness determination in early 2008, for the 2007 financials, there
was an attempt to amend the ongoing suits to include a CDO/CDS cause
of action. Research to support this request showed that PwC had
been dealing with
closely related accounting issues
as far back as 2002, centered mostly around
EITF 02-3 valuation issues.
The research revealed deep,
longstanding internal controls issues that were now becoming
painfully apparent.
Between
Crisis One and Crisis Two (i.e., the 2004 and prior accounting
irregularities that ousted Maurice Greenberg, and then the 2007
AIGFP mess), the players on both the AIG management side, and the
PwC engagement team side, were pretty much totally traded out.
On
the PwC side,
Global Relationship Partner Barry Winograd and Engagement Partner
Richard Mayock stepped down after the 2004 audit year and
Tim Ryan and Mike McColgan
took over as Global Relationship Partner and Engagement Partner,
respectively. The AIG Expanded Scope Audit, for 2004 and
prior, was a Herculean effort for PwC, involving a tremendous amount
of interface with AIG’s own internal review, the attorney
investigations led by law firms Paul Weiss and Simpson Thacher, as
well as ongoing regulatory inquiries.
PwC
had to pull out all the stops to come up with enough staff to
complete the task – this was Sarbanes-Oxley prime push period and
resources were constrained and at a premium. Although
Greenberg loudly
disagreed at the time,
sources tell me most of those who had been, and were then, key
members of the engagement team, left the engagement. While the
change-outs at the top were largely political, many of the changes
down in the ranks were people who were completely burned out on AIG,
and unwilling to continue on that engagement.
At
AIG, those managers such as
Cassano not affected by
Crisis One head chopping, were still in place, and the derivatives
business largely missed out on any magnifying glass treatment as a
result of Crisis One. Based on documents obtained during discovery
related to Crisis One, it was clear PwC the firm was really red
faced that they’d “missed it.” When the replacement audit team moved
forward, and then the rumblings of the CDO/CDS mess started being
heard, PwC press releases coming out in February 2008 gave the
impression that the firm’s leaders were not about to be caught
asleep at the wheel again. They threw the “material weakness” flag
quite quickly.
And
then you read the
Washington Post article
about the now revealed 2007 internal AIG emails, and follow the
timeline in 2007. In retrospect, it’s easy to see that by summer
2007 AIG management had a pretty good idea its risk of drawdowns on
the CDS’s is way more likely than the “less than remote”
characterization in the footnote description of prior years’
financial.
How
much of that early realization got on the PwC new engagement team
radar? How many other big things did they
miss or pretend not to see?
An
AIG presentation dated
Nov 2007 was still totally
minimizing any prospective increase in risk.
It
was during 2007 that AIG’s conflicts with Goldman Sachs over
collateral for the CDOs became heated.
I wrote in December, based on reports by
Andrew
Ross Sorkin in his book,
Too Big To Fail:
AIG had publicly
disclosed the existence of a collateral dispute with Goldman
Sachs over CDOs in November of 2007… AIG Chairman of the Board
Bob Willumstad, according to Sorkin, not PwC, originally raised
red flags in January 2008 regarding the growth of the collateral
gap. Willumstad called in PricewaterhouseCoopers to review the
situation and,
“PwC
eventually instructed AIG to revalue every one of the credit
default swaps… and embarrassingly disclosed that it had found a
“material weakness” in [AIG's] accounting methods.”
…AIG “admitted” that
their management may have held back or even lied to the
auditors. AIG
had actually given PwC an out, I said, to keep them close in
the event of litigation or worse…A few pages later, on page 175,
Sorkin describes a Goldman Sachs June 2008 board meeting where
the issue of their collateral dispute with AIG boils over.
“In a
videoconference presentation from New York, a PwC executive (PwC
is Goldman Sach’s auditor, too) updates the board on its dispute
with AIG over how it was valuing or in Wall Street parlance,
“marking-to-market,” its portfolio. Goldman executives
considered AIG was “marking to make-believe” as Blankfein told
the board…the afternoon session proceeded with upbraiding
PricewaterhouseCoopers:
“How
does it work inside PwC if you as a firm represent two
institutions where you’re looking at exactly the same
collatteral and there’s a clear dispute in terms of valuation?”
How does it work,
indeed. Jon Winkelreid, Goldman’s co-president, may or may not
have received an answer that day. Sorkin does not report one. I
have never heard one.
It must be
tough to be PwC, wedged between two powerful, lucrative, and equally
complex clients. The money they’re raking in provides some solace,
I’m sure.
AIG paid PwC a
total of $131 million in audit and other fees in 2008 and $119.5
million in 2007. ”I want to know what these fees were paid for,”
shareholder Kenneth Steiner of Great Neck, New York said. “Why
didn’t anybody know what was going on? What were the accountants
doing? Were they sleeping?”
For
Goldman Sachs, PwC provides not only audit, audit related, and tax
advice, they also provide similar services to other entities managed
by Goldman Sachs subsidiaries. For 2008,
those fees totaled $99.9 million.
PricewaterhouseCoopers
LLP also provides audit and tax services to certain merchant
banking, asset management and similar funds managed by our
subsidiaries. Fees paid to PricewaterhouseCoopers LLP by these
funds for these services were $38.1 million in fiscal 2008 and
$29.5 million in fiscal 2007.
Regardless
of the fact that PwC is making more from AIG right now, both clients
are critical and they’re hanging on to both tightly. So it’s not
surprising, under those circumstances, that PwC tries to minimize
conflict with either unless absolutely necessary. In fact, even
though they may have been taken to the woodshed by both in the past,
they’ve escaped any significant public criticism for staying quietly
and peacefully in the middle, neutral like Switzerland, when it
comes to the disputes and conspiracy theories about the
relationship between the two firms and each with the NY Federal
Reserve Bank.
It
may be that PwC has learned to
play both clients like a fiddle from
professional dancing bears like
Arthur Levitt. As we discussed earlier,
Levitt played a significant role in getting AIG past most of the New
York Attorney General’s scrutiny after their actions against AIG.
Part of that healing process included reappointing PwC as auditor.
But Arthur Levitt is also a
paid advisor to Goldman Sachs.
The Wall Street Journal did not mention his prominent role with AIG
when they published a
fawning homage to Levitt from Lloyd Blankfein.
By tapping
Mr. Liddy as AIG’s next CEO, the government is turning to
someone with deep experience in the insurance industry, having
served as chief executive of Allstate from 1999 to 2006….Mr.
Liddy also has experience pulling apart empires, having helped
dismantle Sears, Roebuck & Co. (from which Allstate was spun
off) in the 1990s. Before joining Sears, Mr. Liddy worked under
Donald Rumsfeld at drug maker G.D. Searle & Co. Mr.
Liddy is on the board at Goldman Sachs Group,
the investment bank that Mr. Paulson led before becoming
Treasury Secretary.
Maybe PwC
didn’t stand a snowball’s chance in hell to be a truly independent,
objective advocate for shareholders by forcing a true and fair
presentation, in all material respects, of the financial position of
either one of these companies and the results of their operations
and their cash flows in conformity with accounting principles
generally accepted in the United States of America. But is there a
truly good excuse for PwC to not have been a preemptive strike
force, a beacon, an early warning system for shareholders of the
financial Armageddon we faced? They had longstanding, thorough,
perfect knowledge of both sets of financial statements.
Why didn’t
PwC speak up, act more strongly to match mismatched valuations
between entities like AIG and Goldman Sachs, raise their hand and
shout fire, or at least warn of suffocating black smoke obscuring
woefully inadequate risk management and of pricing “models” strung
together like so many holiday lights electrical cords, faulty wiring
and all, ready to blow the circuits?
Was it the
fees?
Well,
there’s certainly $230 million plus reasons in 2008 to play nicey-nice
between the two clients. But that explanation would be too simple.
No matter which way
you look at it, the picture that is emerging of the Federal
Reserve, as revealed by the ongoing probes into its AIG bailout,
is singularly unflattering.
The explanations
for its actions can only support one of two interpretations:
that the Fed was a chump, taken by the financiers, or a crony,
and was fully aware that it was not just rescuing AIG, but doing
so in an overly generous way so as to assist financial firms in
a way it hoped would not be widely noticed or understood.
I
wrote similarly about PwC with regard to the
Satyam fraud.
The dilemma for the
PwC Global senior leadership “crisis team” now in India is that
the answer to the burning question, “How could Price
Waterhouse India let this happen at Satyam?” has four
possible answers:
a) Price Waterhouse
India audit technique and “quality” standards demonstrate the
epitome of incompetence and professional negligence,
b) Price Waterhouse
India partners colluded with Satyam management to commit the
fraud,
None of the answers
will win PricewaterhouseCoopers International Limited a prize.
For an
example of incompetence, over and above that which PwC and their
client have already admitted to, let’s talk about one element of
PwC’s audit process at AIG.
From a
source:
Staff Accounting
Bulletin No. 99 talks about that elusive concept of
“materiality.” In its guidelines, SAB 99 says an omission or
misstatement of an item in a financial report is material “…if,
in light of the surrounding circumstances, the magnitude of the
item is such that it is probable that the judgment of a
reasonable person relying upon the report would have been
changed or influenced by the inclusion or correction of the
item.” i.e., qualitative materiality.
The element of
auditor judgment and adequate subjective “professional
skepticism” was lacking, and it allowed the frauds leading to
the 1999-2004 restatements, as well as the head-in-the-sand
failure to identify the impending catastrophe being created in
AIG Financial Products with the CDS / subprime derivative
products. Year after year, the applicable boilerplate footnote
in the financials continued to characterize the risk of ANY
claims on those products, for the Super Senior tranche AIG was
insuring, as “less than remote.” Until, of course, it was too
late.
In workpaper after
workpaper, PwC whizzes past areas that subsequently became
problematic, by relying on the failure of the item to reach the
established level of QUANTITATIVE materiality alone, with
inadequate subjective analysis of the qualitative.
It’s
particularly ironic that, in the AIG/PwC assessment of
“remediation” needs during the Restatement — which resulted in
termination of a number of AIG execs, and demotion or
reassignment of others away from responsibilities for financial
reporting — Joseph Cassano at AIG FP was given a clean bill of
health and allowed to continue unabated down the path toward
disaster. If ever there was a time when “looking under every
rock” for more rattlesnakes was called for, it was during the
2005 Restatement. The fact that PwC failed to get even a sniff
of what was coming a couple of years later from AIG FP — even
after deploying DA&I and dozens of extra auditors to handle the
“Expanded Scope Audit” for 2004 — is very sobering, and brings
into question (as you regularly do) why audits and
investigations are even bothered with.
I
don’t think PwC is a complete dupe for AIG and Goldman Sachs any
more than they were in the
Satyam fraud case in India. I heard
rumors in December 2007
that Goldman Sachs was thinking of dumping PwC. Who knew then how
angry Goldman was at PwC for their client AIG’s intransigence on the
collateral call? But it all worked out, didn’t it? I guess Goldman
decided, “Keep your friends close….and your lackeys closer.”
Koss Corp. collected $8.5
million from Grant Thornton, the accounting firm that audited Koss' books
during a portion of the time that Sujata "Sue" Sachdeva was stealing
millions from the company.
The payment made Wednesday
settles a lawsuit filed in Cook County, Ill., in which Koss charged Grant
Thornton with negligence for not discovering Sachdeva's thievery. Sachdeva's
scheme ran for about 12 years and cost Koss, a maker of headphones, about
$34 million. Her embezzlement, which financed an extravagant lifestyle that
included trips and shopping sprees, intensified in the final years of the
scheme.
Sachdeva, who had been the
company's vice president of finance, is serving an 11-year federal prison
sentence and is expected to be released in August 2020, according to the
Federal Bureau of Prisons.
"I don't think it is
possible to look at the size of the settlement and conclude that Grant
Thornton didn't see some risk if this case came to trial," said Jeremy
Levinson, a Milwaukee attorney not involved in the case. "Every story that
gets written on this case, including this one, is bad for Grant Thornton."
Grant Thornton charged Koss
nearly $700,000 for work it performed from 2004 until it was fired shortly
after Sachdeva was arrested in December 2009, according to records filed
with the U.S. Securities and Exchange Commission. Baker Tilly, the auditing
firm that replaced Grant Thornton, collected $570,679 for its first year of
work — a time when the FBI, auditors and company officials scoured Koss'
books to determine the level of damages she caused.
Tracy Coenen, a Milwaukee
forensic accountant who criticized Koss management on her Fraud Files blog,
said the company should shoulder the blame for not detecting Sachdeva's
crimes earlier.
"Upper management was at
least negligent in not properly overseeing what she was doing and for not
having proper internal controls," Coenen said. Koss "management bears the
bulk of the responsibility, if not all of it."
Continued in article
Grant Thornton
said in a statement that it had met "all of our professional obligations
and that our work complied with professional standards."
See below
"Koss embezzlement ran in spurts,
lawsuit says $478,735 spent over three days in summer 2006" by Cary
Spivak, Milwaukee Journal Sentinel, July 10, 2010 ---
http://www.jsonline.com/business/98152439.html
The $31 million
embezzlement at Koss Corp. included several spurts of rapid-fire
spending, according to a recent court filing - including one
three-day span in 2006 during which nearly $500,000 flew out of the
Milwaukee company's accounts and into the hands of three high-end
retailers and a credit card company.
The lists of checks
and wire transfers shed new light on the scheme for which Sujata
"Sue" Sachdeva, former vice president of finance for Koss, is facing
six federal felony charges. She was arrested by the FBI in December
and has pleaded not guilty.
The list, which
takes up the equivalent of about 10 single-spaced pages, is
contained in a lawsuit that Koss filed last month against Sachdeva
and its former auditor, Grant Thornton LLP.
The list shows that
in addition to expenditures at upscale clothing retailers, Koss
funds also were spent on smaller luxury items such as a personal
trainer and limousine rides. Koss charges that the payments listed
in the lawsuit were used to pay for Sachdeva's personal expenses.
The spending spurts
left some experts wondering how the scheme could have gone unchecked
for at least seven years.
"If they just looked
at a sample of the withdrawals, they would have found it," said Joel
Joyce, a forensic accountant at Reilly, Penner & Benton, referring
to Koss executives or outside auditors. "They might not have caught
it in the first month . . . but my guess is it would not have been
six to seven years."
A case in point was
a flurry of check-writing in the summer of 2006.
On Aug. 1 of that
year, two cashier's checks totaling $154,021 went to Valentina Inc.,
an exclusive Mequon clothing store.
The next day, an
$18,100 cashier's check was cut to Neiman Marcus and a $10,120 check
was made out to Saks Fifth Avenue.
Then, on Aug. 3,
three checks totaling $296,494 were written to American Express, the
credit card company that eventually blew the whistle on Sachdeva
last year.
Total over the
three-day span: $478,735.
The checks to
retailers identified the merchants by their initials, Koss said in
the lawsuit. For example Valentina was V Inc. and Saks Fifth Avenue
was S.F.A Inc.
Tony Chirchirillo,
owner of Valentina, said he saw nothing suspicious about the large
cashier's checks his company received from Sachdeva. He said he
assumed the checks were backed by her own funds.
It's believed that
over a five-year period Sachdeva spent more than $5 million at the
boutique, sources said, although Chirchirillo said that figure
"seemed high."
"I didn't know it
came from Koss," Chirchirillo said, explaining that unlike personal
checks, the cashier's checks did not list whose account the money
was being drawn from. "I was told by an FBI agent that the money
came from Koss. I would not have taken it if it said Koss."
The largest
withdrawals listed in the lawsuit went to upscale retailers and to
American Express, the target of an earlier lawsuit filed by Koss
that contended the credit card company should have raised suspicions
about the expenditures sooner.
The August spurt
wasn't the only one. On Feb. 3, 2006, two cashier's checks were
written to American Express, one for $102,836 and the other for
$101,451.
And from July 11 to
July 17 of 2003, a check for $20,182 was written to Marshall Fields,
a second for $26,420 went to Saks Fifth Avenue, and five checks
totaling $104,738 went to American Express.
The indictment
against Sachdeva charges that she spent most of the embezzled money
on luxury clothing and jewelry, furs, vacations and items for her
Mequon home. More than 22,000 items - some with price tags still
attached - have been seized by federal authorities in connection
with the investigation, including fur coats, designer clothing,
jewelry, art items and hundreds of pairs of shoes.
Among the payments
detailed in the latest lawsuit:
• Carey Limousine
received $16,706 from 2006 to 2008, with the bulk of the money
coming in 2007. The most expensive ride was for $4,460 in September
2007.
• Chris A. Aiello, a
personal trainer, was paid $770 in 2005. Aiello said he trained
Sachdeva two to three times a week, sometimes in a conference room
at Koss headquarters and sometimes at her Mequon home. Normally,
Aiello said, he was paid with personal checks by Sachdeva, although
he recalled that on a handful of occasions Sachdeva told him to get
his money from one of her assistants, Julie Mulvaney. He said he
thinks those few checks came from Koss.
"You question it in
your mind, but you don't say anything," said Aiello, who no longer
trains Sachdeva. "We weren't doing anything illegal."
• Several payments,
including one for $21,000 and another for $14,000, went to
individuals. Ongoing investigations include an effort to determine
what connection, if any, those people had to Sachdeva.
• Mulvaney was paid
a total of $14,000, and another Sachdeva assistant, Tracy Malone,
was paid about $1,800. Both employees were fired by Koss last year,
and attorneys for both women have said they did nothing wrong.
In addition, more
than $145,000 was taken from petty cash, in increments ranging from
$482 to $9,049, according to the Koss list.
"That's a lot of
distributions coming out of petty cash," said Richard Brown, the
retired head of accounting company KPMG's Milwaukee office. "But
petty cash doesn't get a lot of attention."
At the time of the
scheme, Michael Koss held five high-level titles in the company
including chief executive officer and chief financial officer. Koss,
the son of the company's founder, remains CEO but is no longer CFO.
"A CFO should have
been reviewing financial reports that might have raised questions,
which might have included 'Let me see the documents,' " said Brown,
who now teaches accounting. That review would have likely led to
question about why thousands, and in some cases millions, were being
paid to retailers, he said.
The suit, filed in
Cook County, Ill., seeks damages from Grant Thornton and alleges the
national accounting firm failed to spot the fraud and repeatedly
assured Koss that it had adequate internal controls.
Grant Thornton said
in a statement that it had met "all of our professional obligations
and that our work complied with professional standards."
Michael Koss and the
California attorney who filed the lawsuit did not return calls for
comment.
Brown said suits
filed against auditors by companies that are fraud victims often are
settled out of court.
"A full blown civil
lawsuit will bring out a lot of facts potentially embarrassing to
both the company and the accounting firm," Brown said, adding it was
impossible to say which side might prevail in litigation. "Both the
company and the audit firm will suffer continued embarrassing
publicity if the suit goes to completion. It is for this reason that
these types of suits often get settled out of court before a trial
The $31 million
embezzlement at Koss Corp. included several spurts of rapid-fire
spending, according to a recent court filing - including one
three-day span in 2006 during which nearly $500,000 flew out of the
Milwaukee company's accounts and into the hands of three high-end
retailers and a credit card company.
The lists of checks
and wire transfers shed new light on the scheme for which Sujata
"Sue" Sachdeva, former vice president of finance for Koss, is facing
six federal felony charges. She was arrested by the FBI in December
and has pleaded not guilty.
The list, which
takes up the equivalent of about 10 single-spaced pages, is
contained in a lawsuit that Koss filed last month against Sachdeva
and its former auditor, Grant Thornton LLP.
The list shows that
in addition to expenditures at upscale clothing retailers, Koss
funds also were spent on smaller luxury items such as a personal
trainer and limousine rides. Koss charges that the payments listed
in the lawsuit were used to pay for Sachdeva's personal expenses.
The spending spurts
left some experts wondering how the scheme could have gone unchecked
for at least seven years.
"If they just looked
at a sample of the withdrawals, they would have found it," said Joel
Joyce, a forensic accountant at Reilly, Penner & Benton, referring
to Koss executives or outside auditors. "They might not have caught
it in the first month . . . but my guess is it would not have been
six to seven years."
A case in point was
a flurry of check-writing in the summer of 2006.
On Aug. 1 of that
year, two cashier's checks totaling $154,021 went to Valentina Inc.,
an exclusive Mequon clothing store.
The next day, an
$18,100 cashier's check was cut to Neiman Marcus and a $10,120 check
was made out to Saks Fifth Avenue.
Then, on Aug. 3,
three checks totaling $296,494 were written to American Express, the
credit card company that eventually blew the whistle on Sachdeva
last year.
Total over the
three-day span: $478,735.
The checks to
retailers identified the merchants by their initials, Koss said in
the lawsuit. For example Valentina was V Inc. and Saks Fifth Avenue
was S.F.A Inc.
Tony Chirchirillo,
owner of Valentina, said he saw nothing suspicious about the large
cashier's checks his company received from Sachdeva. He said he
assumed the checks were backed by her own funds.
It's believed that
over a five-year period Sachdeva spent more than $5 million at the
boutique, sources said, although Chirchirillo said that figure
"seemed high."
"I didn't know it
came from Koss," Chirchirillo said, explaining that unlike personal
checks, the cashier's checks did not list whose account the money
was being drawn from. "I was told by an FBI agent that the money
came from Koss. I would not have taken it if it said Koss."
The largest
withdrawals listed in the lawsuit went to upscale retailers and to
American Express, the target of an earlier lawsuit filed by Koss
that contended the credit card company should have raised suspicions
about the expenditures sooner.
The August spurt
wasn't the only one. On Feb. 3, 2006, two cashier's checks were
written to American Express, one for $102,836 and the other for
$101,451.
And from July 11 to
July 17 of 2003, a check for $20,182 was written to Marshall Fields,
a second for $26,420 went to Saks Fifth Avenue, and five checks
totaling $104,738 went to American Express.
The indictment
against Sachdeva charges that she spent most of the embezzled money
on luxury clothing and jewelry, furs, vacations and items for her
Mequon home. More than 22,000 items - some with price tags still
attached - have been seized by federal authorities in connection
with the investigation, including fur coats, designer clothing,
jewelry, art items and hundreds of pairs of shoes.
Among the payments
detailed in the latest lawsuit:
• Carey Limousine
received $16,706 from 2006 to 2008, with the bulk of the money
coming in 2007. The most expensive ride was for $4,460 in September
2007.
• Chris A. Aiello, a
personal trainer, was paid $770 in 2005. Aiello said he trained
Sachdeva two to three times a week, sometimes in a conference room
at Koss headquarters and sometimes at her Mequon home. Normally,
Aiello said, he was paid with personal checks by Sachdeva, although
he recalled that on a handful of occasions Sachdeva told him to get
his money from one of her assistants, Julie Mulvaney. He said he
thinks those few checks came from Koss.
"You question it in
your mind, but you don't say anything," said Aiello, who no longer
trains Sachdeva. "We weren't doing anything illegal."
• Several payments,
including one for $21,000 and another for $14,000, went to
individuals. Ongoing investigations include an effort to determine
what connection, if any, those people had to Sachdeva.
• Mulvaney was paid
a total of $14,000, and another Sachdeva assistant, Tracy Malone,
was paid about $1,800. Both employees were fired by Koss last year,
and attorneys for both women have said they did nothing wrong.
In addition, more
than $145,000 was taken from petty cash, in increments ranging from
$482 to $9,049, according to the Koss list.
"That's a lot of
distributions coming out of petty cash," said Richard Brown, the
retired head of accounting company KPMG's Milwaukee office. "But
petty cash doesn't get a lot of attention."
At the time of the
scheme, Michael Koss held five high-level titles in the company
including chief executive officer and chief financial officer. Koss,
the son of the company's founder, remains CEO but is no longer CFO.
"A CFO should have
been reviewing financial reports that might have raised questions,
which might have included 'Let me see the documents,' " said Brown,
who now teaches accounting. That review would have likely led to
question about why thousands, and in some cases millions, were being
paid to retailers, he said.
The suit, filed in
Cook County, Ill., seeks damages from Grant Thornton and alleges the
national accounting firm failed to spot the fraud and repeatedly
assured Koss that it had adequate internal controls.
Grant Thornton said
in a statement that it had met "all of our professional obligations
and that our work complied with professional standards."
Michael Koss and the
California attorney who filed the lawsuit did not return calls for
comment.
Brown said suits
filed against auditors by companies that are fraud victims often are
settled out of court.
"A full blown civil
lawsuit will bring out a lot of facts potentially embarrassing to
both the company and the accounting firm," Brown said, adding it was
impossible to say which side might prevail in litigation. "Both the
company and the audit firm will suffer continued embarrassing
publicity if the suit goes to completion. It is for this reason that
these types of suits often get settled out of court before a trial
takes place."
Audits are not
designed to uncover fraud and Koss did not pay for a separate
opinion on internal controls because they are exempt from that
Sarbanes-Oxley requirement.
But punching
holes in that Swiss-cheese defense is like shooting fish in a
barrel. Leading that horse to water is like feeding him candy taken
from a baby. The reasons why someone other than American Express
should have caught this sooner are as numerous as the
acorns you can steal from a blind pig…
Ok, you get the
gist.
Listing
standards for the NYSE require an internal audit function. NASDAQ,
where Koss was listed, does not. Back in 2003, the
Institute of Internal Auditors (IIA) made recommendations
post- Sarbanes-Oxley that were adopted for the
most part by NYSE, but not completely by NASDAQ. And both the NYSE
and NASD left a few key recommendations hanging.
In addition,
the IIA has never mandated, under its own standards for the internal
audit profession, a
direct reporting of the internal audit
function to the independent Audit Committee. The
SEC did not
adopt this requirement in their final rules, either.
However, Generally
Accepted Auditing Standards (GAAS), the standards an external
auditor such as Grant Thornton operates under when preparing an
opinion on a company’s financial statements – whether a public
company or not, listed on NYSE or NASDAQ, whether exempt or not from
Sarbanes-Oxley – do require the assessment of the internal audit
function when planning an audit.
Grant Thornton
was required to adjust their substantive testing given the number of
risk factors
presented by Koss, based on
SAS 109 (AU 314), Understanding the
Entity and Its Environment and
Assessing the Risks of Material Misstatement. If they had
understood the entity and assessed the risk of material misstatement
fully, they would have been all over those transactions like
_______. (Fill in the blank)
If they had
performed a proper
SAS 99 review (AU 316),Consideration
of Fraud in a Financial Statement Audit, it would have hit’em
smack in the face like a _______ . (Fill in the blank.) Management
oversight of the financial reporting process is severely limited by
Mr. Koss Jr.’s lack of interest, aptitude, and appreciation for
accounting and finance. Koss Jr., the CEO and son of the founder,
held the
titles of COO and CFO, also. Ms. Sachdeva,
the Vice President of Finance and Corporate Secretary who is accused
of the fraud, has been in the
same job since 1992
and during one ten year period
worked remotely from Houston!
When they
finished their review according to
SAS 65 (AU 322),The Auditor’s
Consideration of the Internal Audit Function in an Audit of
Financial Statements, it should have dawned on them: There is
no internal audit function and the flunky-filled Audit Committee is
a sham. I can see it now. The Grant Thornton Milwaukee OMP smacks
head with open palm in a “I could have had a V-8,” moment but more
like, “Holy cheesehead, we’re indigestible gristle-laden, greasy
bratwurst here! We’ll never be able issue an opinion on these
financial statements unless we take these journal entries apart,
one-by-one, and re-verify every stinkin’ last number.”
But I dug in and did
some additional research – at first I was just working the “no
internal auditors” line – and I found a few more interesting
things. And now I have no sympathy for Koss management and,
therefore, its largest shareholder, the Koss family. Granted there
is plenty of basis, in my opinion, for any and all enforcement
actions against Grant Thornton and its audit partners. And
depending on how far back the acts of deliciously deceptive
defalcation go, PricewaterhouseCoopers may also be dragged through
the mud.
Yes.
I can not make
this stuff up and have it come out more music to my ears.
PricewaterhouseCoopers was Koss’s auditor prior to Grant Thornton.
In March of 2004, the
Milwaukee Business Journal reported, “Koss
Corp. has fired the
certified public accounting firm of PricewaterhouseCoopers L.L.P. as
its independent auditors March 15 and retained Grant Thornton L.L.P.
in its place.” The article was
short with the standard disclaimer of no disputes about accounting
policies and practices. But it pointedly pointed out that PwC’s
fees for the audit had increased by almost 50% from 2001 to 2003, to
$90,000 and the selection of the new auditor was made after a
competitive bidding process.
PwC had been Koss’s auditor since 1992!
The focus on
audit fees by Koss’s CEO should have been no surprise to PwC.
Post-Sarbanes-Oxley, Michael J. Koss the son of the founder, was
quoted extensively as part of the very vocal cadre of CEOs who
complained vociferously about paying their auditors one more red
cent. Koss Jr. minced no words regarding PwC in the
Wall Street Journal in August 2002, a
month after the law was passed:
“…Sure,
analysts had predicted a modest fee increase from the smaller
pool of accounting firms left after Arthur Andersen LLP’s
collapse following its June conviction on a criminal-obstruction
charge. But a range of other factors are helping to drive
auditing fees higher — to as much as 25% — with smaller
companies bearing the brunt of the rise.
“The
auditors are making money hand over fist,” says Koss Corp. Chief
Executive Officer Michael Koss. “It’s going to cost shareholders
in the long run.”
He should
know. Auditing fees are up nearly 10% in the past two years at
his Milwaukee-based maker of headphones. The increase has come
primarily from auditors spending more time combing over
financial statements as part of compliance with new disclosure
requirements by the Securities and Exchange Commission. Koss’s
accounting firm, PricewaterhouseCoopers LLP, now shows up at
corporate offices for “mini audits” every quarter, rather than
just once at year-end.”
A year later,
still irate, Mr. Koss Jr. was quoted in
USA Today:
“Jeffrey
Sonnenfeld, associate dean of the Yale School of Management,
said he recently spoke to six CEO conferences over 10 days. When
he asked for a show of hands, 80% said they thought the law was
bad for the U.S. economy.
When pressed
individually, CEOs don’t object to the law or its intentions,
such as forcing executives to refund ill-gotten gains. But
confusion over what the law requires has left companies
vulnerable to experts and consultants, who “frighten boards and
managers” into spending unnecessarily, Sonnenfeld says.
Michael Koss, CEO of stereo headphones maker Koss, says it’s all
but impossible to know what the law requires, so it has become a
black hole where frightened companies throw endless amounts of
money.
Companies
are spending way too much to comply, but the
cost is due to “bad advice, not a bad law,”
Sonnenfeld says.”
It’s
interesting that Koss Jr. has such minimal appreciation for the
work of the external auditor or an internal audit function. By
virtue, I suppose, of his esteemed status as CEO, COO and CFO of
Koss and notwithstanding an undergraduate
degree in anthropology, according to
Business Week, Mr. Koss Jr. has twice
served other Boards as their “financial expert” and Chairman of
their Audit Committees. At
Genius Products,
founded by the Baby Genius DVDs creator, Mr. Koss served in this
capacity from 2004 to 2005. Mr. Koss Jr. has also been a Director,
Chairman of Audit Committee, Member of Compensation Committee and
Member of Nominating & Corporate Governance Committee at
Strattec Security Corp. since 1995.
If I were the
SEC, I might take a look at those two companies…Because
I warned you about the CEOs and CFOs who
are pushing back on Sarbanes-Oxley and every other regulation
intended to shine a light on them as public company executives.
No good will come of
this.
I don’t want
you to shed crocodile tears or pity poor PwC for their long-term,
close relationship with
another blockbuster Indian fraudster. Nor
should you pat them on the back for not being the auditor now. PwC
never really left Koss after they were “fired” as auditor in 2004.
They continued until today to be the trusted “Tax and All Other”
advisor,
making good money filing Koss’s now
totally bogus tax returns.
I
think the auditors were justified, to some extent initially, in
increasing fees substantially post-Sarbanes-Oxley for two reasons:
1)
Uncertainty about what work was required under the law. Given their
new externally regulated status, they were nervous about
interpretation of the vague, poorly drafted law. They had no way to
estimate level of effort necessary to satisfy regulators (PCAOB) and
so over compensated with testing and other procedures and charged
dearly for that.
When are professional service firms justified in charging premium
fees?
-When resources are scarce
-When there is a non-negotiable deadline
-When the task requires new or specialized expertise that may
temporarily be in short supply
SOX had all that.
2)
Fears of substantial litigation exposure if they did not meet
regulators requirements and external legally defensible quality
expectations in what they feared would be inevitable lawsuits.
However, as is their habit, they took it too far, took advantage.
Now, with the excuse of the recession (and some help form Auditing
Standard 7), the clients have the upper hand and are squeezing the
auditors back again on fees.
Interestingly enough, as my friend Jim
Peterson has pointed out, we have yet to see any significant number
of lawsuits using Sarbanes-Oxley as a basis. Jim says only the
first one is now on the docket related to WaMu. Auditor litigation
has increased but still comes from traditional sources - simple
malpractice claims in subprime crisis and Madoff and other frauds
such as Satyam.
Jensen Comment
You may want to compare Francine's above discussion of audit fees with
the following analytical research study:
In most instances the defense of underlying assumptions is based upon
assumptions passed down from previous analytical studies rather than empirical
or even case study evidence. An example is the following conclusion:
We find that audit quality and audit fees both
increase with the auditor’s expected litigation losses from audit failures.
However, when considering the auditor’s acceptance decision, we show that it
is important to carefully identify the component of the litigation
environment that is being investigated. We decompose the liability
environment into three components: (1) the strictness of the legal regime,
defined as the probability that the auditor is sued and found liable in case
of an audit failure, (2) potential damage payments from the auditor to
investors and (3) other litigation costs incurred by the auditor, labeled
litigation frictions, such as attorneys’ fees or loss of reputation. We show
that, in equilibrium, an increase in the potential damage payment actually
leads to a reduction in the client rejection rate. This effect arises
because the resulting higher audit quality increases the value of the
entrepreneur’s investment opportunity, which makes it optimal for the
entrepreneur to increase the audit fee by an amount that is larger than the
increase in the auditor’s expected damage payment. However, for this result
to hold, it is crucial that damage payments be fully recovered by the
investors. We show that an increase in litigation frictions leads to the
opposite result—client rejection rates increase. Finally, since a shift in
the strength of the legal regime affects both the expected damage payments
to investors as well as litigation frictions, the relationship between the
legal regime and rejection rates is nonmonotonic. Specifically, we show that
the relationship is U-shaped, which implies that for both weak and strong
legal liability regimes, rejection rates are higher than those
characterizing more moderate legal liability regimes.
Volker Laux and D. Paul Newman, "Auditor Liability and Client Acceptance
Decisions," The Accounting Review, Vol. 85, No. 1, 2010 pp. 261–285
http://www.trinity.edu/rjensen/TheoryTAR.htm#Analytics
Were AIG losses hidden early on by creative
accounting? PwC is the external auditor of AIG
The American
International Group is rapidly running through $123 billion in
emergency lending provided by the Federal Reserve, raising questions
about how a company claiming to be solvent in September could have
developed such a big hole by October. Some analysts say at least
part of the shortfall must have been there all along,
hidden by irregular accounting.
“You don’t just
suddenly lose $120 billion overnight,” said Donn Vickrey of Gradient
Analytics, an independent securities research firm in Scottsdale,
Ariz.
Mr. Vickrey says he
believes A.I.G. must have already accumulated tens of billions of
dollars worth of losses by mid-September, when it came close to
collapse and received an $85 billion emergency line of credit by the
Fed. That loan was later supplemented by a $38 billion lending
facility.
But losses on that
scale do not show up in the company’s financial filings. Instead,
A.I.G. replenished its capital by issuing $20 billion in stock and
debt in May and reassured investors that it had an ample cushion. It
also said that it was making its accounting more precise.
Mr. Vickrey and
other analysts are examining the company’s disclosures for clues
that the cushion was threadbare and that company officials knew they
had major losses months before the bailout.
Tantalizing support
for this argument comes from what appears to have been a
behind-the-scenes clash at the company over how to value some of its
derivatives contracts. An accountant brought in by the company
because of an earlier scandal was pushed to the sidelines on this
issue, and the company’s outside auditor, PricewaterhouseCoopers,
warned of a material weakness months before the government bailout.
The internal auditor
resigned and is now in seclusion, according to a former colleague.
His account, from a prepared text, was read by Representative Henry
A. Waxman, Democrat of California and chairman of the House
Committee on Oversight and Government Reform, in a hearing this
month.
These accounting
questions are of interest not only because taxpayers are footing the
bill at A.I.G. but also because the post-mortems may point to a
fundamental flaw in the Fed bailout: the money is buoying an insurer
— and its trading partners — whose cash needs could easily exceed
the existing government backstop if the housing sector continues to
deteriorate.
Edward M. Liddy, the
insurance executive brought in by the government to restructure
A.I.G., has already said that although he does not want to seek more
money from the Fed, he may have to do so.
Continuing Risk
Fear that the losses
are bigger and that more surprises are in store is one of the
factors beneath the turmoil in the credit markets, market
participants say.
“When investors
don’t have full and honest information, they tend to sell
everything, both the good and bad assets,” said Janet Tavakoli,
president of Tavakoli Structured Finance, a consulting firm in
Chicago. “It’s really bad for the markets. Things don’t heal until
you take care of that.”
A.I.G. has declined
to provide a detailed account of how it has used the Fed’s money.
The company said it could not provide more information ahead of its
quarterly report, expected next week, the first under new
management. The Fed releases a weekly figure, most recently showing
that $90 billion of the $123 billion available has been drawn down.
A.I.G. has outlined
only broad categories: some is being used to shore up its
securities-lending program, some to make good on its guaranteed
investment contracts, some to pay for day-to-day operations and — of
perhaps greatest interest to watchdogs — tens of billions of dollars
to post collateral with other financial institutions, as required by
A.I.G.’s many derivatives contracts.
No information has
been supplied yet about who these counterparties are, how much
collateral they have received or what additional tripwires may
require even more collateral if the housing market continues to
slide.
Ms. Tavakoli said
she thought that instead of pouring in more and more money, the Fed
should bring A.I.G. together with all its derivatives counterparties
and put a moratorium on the collateral calls. “We did that with ACA,”
she said, referring to ACA Capital Holdings, a bond insurance
company that was restructured in 2007.
Of the two big Fed
loans, the smaller one, the $38 billion supplementary lending
facility, was extended solely to prevent further losses in the
securities-lending business. So far, $18 billion has been drawn down
for that purpose.
First and foremost
it gets to a serious question. Were the initial infusions (into AIG)
by the government just a stop gap measure and will even more be
needed. (The idea of throwing good money after bad comes to mind).
Secondly in class yesterday we talked about information asymmetries
and how accounting can only partially lessen the problem and that
firms can have billions of dollars of losses that investors may not
be aware of even after reading the financial statements. And finally
a student in class is doing a paper on this and what the executives
must have known (or at least should have known) before hand.
If AIG executives knew about these
problems early on, what did the auditor not insist on disclosing?
Sounds like a massive class action lawsuit here for AIG shareholders who
lost their investments.
Britain’s big four
auditing firms have been left exposed to a surge in negligence
claims after the Government refused to limit further the damages
they could face.
Deloitte, Ernst &
Young, KPMG and PricewaterhouseCoopers (PwC) lobbied hard for a cap
on payouts. Senior figures involved in the discussions said that
Lord Mandelson, the Business Secretary, appeared receptive to their
concerns but stopped short of changing the law.
The decision is a
huge blow to the firms — some face lawsuits relating to Bernard
Madoff’s $65 billion fraud — which believe there may not be another
chance for a change in the law for at least two years. They fear
that they will be targeted by investors and liquidators seeking to
recover losses from Madoff-style frauds and big company failures.
At present, auditors
can be held liable for the full amount of losses in the event of a
collapse, even if they are found to be only partly to blame.
In April,
representatives of the companies met Lord Mandelson to plead for new
measures to cap their liability. They warned that British business
could be plunged into chaos if one of them were bankrupted by a
blockbuster lawsuit.
However, an official
of the Department for Business, Innovation and Skills said: “The
2006 Companies Act already allows auditor liability limitation where
companies and their auditors want to take this course.”
Under present
company law, directors can agree to restrict their auditors’
liability if shareholders approve; however, to date, no blue-chip
company has done so. Directors have seen little advantage in
limiting their auditors’ liability, and objections by the US
Securities and Exchange Commission (SEC) have also been a
significant obstacle.
The SEC opposes caps
on the ground that their introduction could lead to secret deals
whereby directors agree to restrict liability in return for auditors
compromising on their oversight of a company’s accounts. The SEC
could attempt to block caps put in place by British companies that
have operations in the United States.
The big four
auditors had hoped to persuade Lord Mandelson to amend the
legislation to address the SEC’s concerns and to encourage companies
to limit their auditors’ liability.
Peter Wyman, a
senior PwC partner, who was involved in the discussions, said that
the Government’s lack of action was disappointing. He said: “The
Government, having legislated to allow proportionate liability for
auditors, is apparently content to have its policy frustrated by a
foreign regulator.”
Auditors are often
hit with negligence claims in the aftermath of a company failure
because they are perceived as having deep pockets and remain
standing while other parties may have disappeared or been declared
insolvent.
In 2005 Ernst &
Young was sued for £700 million by Equitable Life, its former audit
client, after the insurance company almost collapsed. The claim was
dropped but could have bankrupted the firm’s UK arm if it had
succeeded.
This year KPMG was
sued for $1 billion by creditors of New Century, a failed sub-prime
lender, and PwC has faced questions over its audit of Satyam, the
Indian outsourcing company that was hit by a long- running
accounting fraud.
Three of the big
four are also facing numerous lawsuits relating to their auditing of
the feeder funds that channelled investors into Madoff’s Ponzi
scheme.
Investors and
accounting regulators worry that the big four’s dominance of the
audit market is so great that British business would be thrown into
disarray if one of the four were put out of business by a huge court
action. All but two FTSE 100 companies are audited by the four.
Mr Wyman said: “The
failure of a large audit firm would be very damaging to the capital
markets at a time when they are already fragile.”
Arthur Andersen,
formerly one of the world’s five biggest accounting firms, collapsed
in 2002 as a result of its role in the Enron scandal.
Suits you
KPMG A
defendant in a class-action lawsuit in the Southern District of New
York against Tremont, a Bernard Madoff feeder fund
Ernst & Young
Sued by investors in a Luxembourg court with UBS for oversight of a
European Madoff feeder fund
PwC Included
in several lawsuits in Canada claiming damages of up to $2 billion
against Fairfield Sentry, a big Madoff feeder fund
KPMG Sued in
the US for at least $1 billion by creditors of New Century
Financial, a failed sub-prime mortgage lender, which claimed that
KPMG’s auditing was “recklessly and grossly negligent”
Deloitte Sued
by the liquidators of two Bear Stearns-related hedge funds that
collapsed at the start of the credit crunch
Overstock.com (NASDAQ: OSTK) and its
management team led by its CEO and masquerading stock market
reformer Patrick Byrne (pictured on right) continued its pattern of
false and misleading disclosures and departures from Generally
Accepted Accounting Principles (GAAP) in its latest Q1 2009
financial report.
In Q1 2009, Overstock.com reported a net
loss of $2.1 million compared to $4.7 million in Q1 2008 and claimed
an earnings improvement of $2.6 million. However, the company's
reported $2.6 reduction in net losses was aided by a violation of
GAAP (described in more detail below) that reduced losses by $1.9
million and buybacks of Senior Notes issued in 2004 under false
pretenses that reduced losses by another $1.9 million.
After the issuance of the Senior Notes in
November 2004, Overstock.com has twice restated financial reports
for Q1 2003 to Q3 2004 (the accounting periods immediately preceding
the issuance of such notes) because of reported accounting errors
and material weaknesses in internal controls.
While new CFO Steve Chestnut hyped that
"It's been a great Q1," the reality is that Overstock.com’s reported
losses actually widened by $1.2 million after considering violations
of GAAP ($1.9 million) and buying back notes issued under false
pretenses ($1.9 million).
How Overstock.com improperly reported of an
accounting error and created a “cookie jar reserve” to manage future
earnings by improperly deferring recognition of an income
Before we begin, let’s review certain
events starting in January 2008.
In January 2008, the Securities and
Exchange Commission discovered that Overstock.com's revenue
accounting failed to comply with GAAP and SEC disclosure rules, from
the company's inception. This blog detailed how the company provided
the SEC with a flawed and misleading materiality analysis to
convince them that its revenue accounting error was not material.
The company wanted to avoid a restatement of prior affected
financial reports arising from intentional revenue accounting errors
uncovered by the SEC.
Instead, the company used a one-time
cumulative adjustment in its Q4 2007 financial report, apparently to
hide the material impact of such errors on previous affected
individual financial reports. In Q4 2007, Overstock.com reduced
revenues by $13.7 million and increased net losses by $2.1 million
resulting from the one-time cumulative adjustment to correct its
revenue accounting errors.
Q3 2008
On October 24, 2008, Overstock.com's Q3
2008 press release disclosed new customer refund and credit errors
and the company warned investors that all previous financial reports
issued from 2003 to Q2 2008 “should no longer be relied upon.” This
time, Overstock.com restated all financial reports dating back to
2003. In addition, Overstock.com reversed its one-time cumulative
adjustment in Q4 2007 used to correct its revenue accounting errors
and also restated all financial statements to correct those errors,
as I previously recommended.
The company reported that the combined
amount of revenue accounting errors and customer refund and credit
accounting errors resulted in a cumulative reduction in previously
reported revenues of $12.9 million and an increase in accumulated
losses of $10.3 million.
Q4 2008
On January 30, 2009, Overstock.com reported
a $1 million profit and $.04 earnings per share for Q4 2008, after
15 consecutive quarterly losses and it beat mean analysts’ consensus
expectations of negative $0.04 earnings per share. CEO Patrick Byrne
gloated, "After a tough three years, returning to GAAP profitability
is a relief." However, Overstock.com's press release failed to
disclose that its $1 million reported profit resulted from a
one-time gain of $1.8 million relating to payments received from
fulfillment partners for amounts previously underbilled them.
During the earnings call that followed the
press release, CFO Steve Chesnut finally revealed to investors that:
Gross profit dollars were $43.6 million, a
6% decrease. This included a one-time gain of $1.8 million relating
to payments from partners who were under-billed earlier in the year.
Before Q3 2008, Overstock.com failed to
bill its fulfillment partners for offsetting cost reimbursements and
fees resulting from its customer refund and credit errors. After
discovering foul up, Overstock.com
improperly corrected the billing errors by recognizing income in
future periods when such amounts were recovered or on a cash basis
(non-GAAP).
In a blog post, I explained why Statement
of Financial Accounting Standards No. 154 required Overstock.com to
restate affected prior period financial reports to reflect when the
underbilled cost reimbursements and fees were actually earned by the
company (accrual basis or GAAP). In other words, Overstock.com
should have corrected prior financial reports to accurately reflect
when the income was earned from fulfillment partners who were
previously underbilled for cost reimbursements and fees.
If Overstock.com properly followed
accounting rules, it would have reported an $800,000 loss instead of
a $1 million profit, it would have reported sixteen consecutive
losses instead of 15 consecutive losses, and it would have failed to
meet mean analysts’ consensus expectation for earnings per share
(anyone of three materiality yardsticks under SEC Staff Accounting
Bulletin No. 99 that would have triggered a restatement of prior
year’s effected financial reports).
Patrick Byrne responds on a stock market
chat board
In my next blog post, I described how CEO
Patrick M. Byrne tried to explain away Overstock.com’s treatment of
the “one-time gain” in an unsigned post, using an alias, on an
internet stock market chat board. Byrne’s chat board post was later
removed and re-posted with his name attached to it, after I
complained to the SEC. Here is what Patrick Byrne told readers on
the chat board:
Antar's ramblings are gibberish. Show them
to any accountant and they will confirm. He has no clue what he is
talking about.
For example: when one discovers that one
underpaid some suppliers $1 million and overpaid others $1 million.
For those whom one underpaid, one immediately recognizes a $1
million liability, and cleans it up by paying. For those one
overpaid, one does not immediately book an asset of a $1 million
receivable: instead, one books that as the monies flow in. Simple
conservatism demands this (If we went to book the asset the moment
we found it, how much should we book? The whole $1 million? An
estimate of the portion of it we think we'll be able to collect?)
The result is asymmetric treatment. Yet Antar is screaming his head
off about this, while never once addressing this simple principle.
Of course, if we had booked the found asset the moment we found it,
he would have screamed his head off about that. Behind everything
this guy writes, there is a gross obfuscation like this. His purpose
is just to get as much noise out there as he can.
Note: Bold print and italics added by me.
In other words, Overstock.com improperly
used cash basis accounting (non-GAAP) rather than accrual basis
accounting (GAAP) to correct its accounting error. I criticized
Byrne’s response noting that:
… Overstock.com recognized the "one-time of
$1.8 million" using cash-basis accounting when it "received payments
from partners who were under-billed earlier in the year" instead of
accrual basis accounting, which requires income to be recognized
when earned. A public company is not permitted to correct any
accounting error using cash-basis accounting.
Overstock.com tries to justify improper
cash basis accounting in Q4 2008 to correct an accounting error
Overstock.com needed to justify Patrick
Byrne’s stock chat board ramblings. About two weeks later,
Overstock.com filed its fiscal year 2008 10-K report with the SEC
and the company concocted a new excuse to justify using cash basis
accounting to correct its accounting error and avoid restating prior
affected financial reports:
In addition, during Q4 2008, we reduced
Cost of Goods Sold by $1.8 million for billing recoveries from
partners who were underbilled earlier in the year for certain fees
and charges that they were contractually obligated to pay. When the
underbilling was originally discovered, we determined that the
recovery of such amounts was not assured, and that consequently the
potential recoveries constituted a gain contingency. Accordingly, we
determined that the appropriate accounting treatment for the
potential recoveries was to record their benefit only when such
amounts became realizable (i.e., an agreement had been reached with
the partner and the partner had the wherewithal to pay).
Note: Bold print and italics added by me.
Overstock.com improperly claimed that a
"gain contingency" existed by using the rationale that the
collection of all "underbilled...fees and charges...was not
assured....”
Why Overstock.com's accounting for
underbilled "fees and charges" violated GAAP
Overstock.com already earned those "fees
and charges" and its fulfillment partners were "contractually
obligated to pay" such underbilled amounts. There was no question
that Overstock.com was owed money from its fulfillment partners and
that such income was earned in prior periods.
If there was any question as to the
recovery of any amounts owed the company, management should have
made a reasonable estimate of uncollectible amounts (loss
contingency) and booked an appropriate reserve against amounts due
from fulfillment partners to reduce accrued income (See SFAS No. 5
paragraph 1, 2, 8, 22, and 23). It didn’t. Instead, Overstock.com
claimed that the all amounts due the company from underbilling its
fulfillment partners was "not assured" and improperly called such
potential recoveries a "gain contingency" (SFAS No. 5 paragraph 1,
2, and 17).
The only way that Overstock.com could
recognize income from underbilling its fulfillment partners in
future accounting periods is if there was a “significant uncertainty
as to collection” of all underbilled amounts (See SFAS No. 5
paragraph 23)
As it turns out, a large portion of the
underbilled amounts to fulfillment partners was easily recoverable
within a brief period of time. In fact, within 68 days of announcing
underbilling errors, the company already collected a total of “$1.8
million relating to payments from partners who were underbilled
earlier in the year.” Therefore, Overstock.com cannot claim that
there was a "significant uncertainty as to collection" or that
recovery was "not assured."
No gain contingency existed. Overstock.com
already earned "fees and charges" from underbilled fulfillment
partners in prior periods. Rather, a loss contingency existed for a
reasonably estimated amount of uncollectible "fees and charges."
Overstock.com should have restated prior affected financial reports
to properly reflect income earned from fulfillment partners instead
of reflecting such income when amounts were collected in future
quarters. Management should have made a reasonable estimate for
unrecoverable amounts and booked an appropriate reserve against
"fees and charges" owed to it (See SFAS No. 5 Paragraph 22 and 23).
Therefore, Overstock.com overstated its
customer refund and credit accounting error by failing to accrue
fees and charges due from its fulfillment partners as income in the
appropriate accounting periods, less a reasonable reserve for
unrecoverable amounts. By deferring recognition of income until
underbilled amounts were collected, the company effectively created
a "cookie jar" reserve to increase future earnings.
In addition, Overstock.com failed to
disclose any potential “gain contingency” in its Q3 2008 10-Q
report, when it disclosed that it underbilled its fulfillment
partners (See SFAS No. 5 Paragraph 17b). Apparently, Overstock.com
used a backdated rationale for using cash basis accounting to
correct its accounting error in response to my blog posts (here and
here) detailing its violation of GAAP.
PricewaterhouseCoopers warns against using
"conservatism to manage future earnings"
As I detailed above, Patrick Byrne claimed
on an internet chat board that “conservatism demands" waiting until
"monies flow in" from under-billed fulfillment partners to recognize
income, after such an error is discovered by the company. However, a
document from PricewaterhouseCoopers (Overstock.com’s auditors thru
2008) web site cautions against using “conservatism” to manage
future earnings by deferring gains to future accounting periods:
SFAS No. 5 Technical Notes cautions about
using “conservatism” to manage future earnings by deferring gains to
future accounting periods:
"Conservatism...should no[t] connote
deliberate, consistent understatement of net assets and profits."
Emphasis added] CON 5 describes realization in terms of recognition
criteria for revenues and gains, as:"Revenue and gains generally are
not recognized until realized or realizable... when products (goods
or services), merchandise or other assets are exchanged for cash or
claims to cash...[and] when related assets received or held are
readily convertible to known amounts of cash or claims to
cash....Revenues are not recognized until earned ...when the entity
has substantially accomplished what it must do to be entitled to the
benefits represented by the revenues." Almost invariably, gain
contingencies do not meet these revenue recognition criteria.
Note: Bold print and italics added by me.
Overstock.com "substantially accomplished
what it must do to be entitled to the benefits represented by the
revenues" since the fulfillment partners were "contractually
obligated" to pay underbilled amounts. Those underbilled "fees and
charges" were "realizable" as evidenced by the fact that the company
already collected a total of “$1.8 million relating to payments from
partners who were underbilled earlier in the year" within a mere 68
days of announcing its billing errors.
If we follow guidance by Overstock.com's
fiscal year 2008 auditors, the amounts due from underbilling
fulfillment partners cannot be considered a gain contingency, as
claimed by the company. PricewaterhouseCoopers was subsequently
terminated as Overstock.com's auditors and replaced by Grant
Thornton.
Q1 2009
In Q1 2009, even more amounts from
underbilling fulfillment partners were recovered. In addition, the
company disclosed a new accounting error by failing to book a
“refund due of overbillings by a freight carrier for charges from Q4
2008.” See quote from 10-Q report below:
In the first quarter of 2009, we reduced
total cost of goods sold by $1.9 million for billing recoveries from
partners who were underbilled in 2008 for certain fees and charges
that they were contractually obligated to pay, and a refund due of
overbillings by a freight carrier for charges from the fourth
quarter of 2008. When the underbilling and overbillings were
originally discovered, we determined that the recovery of such
amounts was not assured, and that consequently the potential
recoveries constituted a gain contingency. Accordingly, we
determined that the appropriate accounting treatment for the
potential recoveries was to record their benefit only when such
amounts became realizable (i.e., an agreement had been reached with
the other party and the other party had the wherewithal to pay).
Note: Bold print and italics added by me.
Overstock.com continued to improperly
recognize deferred income from previously underbilling fulfillment
partners. The new auditors, Grant Thornton, would be wise to review
Overstock.com's accounting treatment of billing errors and recommend
that its clients restate affected financial reports to comply with
GAAP. Otherwise, they should not give the company a clean audit
opinion for 2009.
Using accounting errors to previous
quarters to boost profits in future quarters
Lee Webb from Stockwatch sums up
Overstock.com's accounting latest trickery:
… Overstock.com managed to turn a
controversial fourth-quarter profit last year after discovering that
it had underbilled its fulfillment partners to the tune of
$1.8-million earlier in the year. Rather than backing that amount
out into the appropriate periods, Overstock.com reported it as
one-time gain and reduced the cost of goods sold for the quarter by
$1.8-million. That bit of accounting turned what would have been an
$800,000 fourth-quarter loss into a $1-million profit.
As it turns out, Overstock.com managed to
find some more money that it used to reduce the cost of goods sold
for the first quarter of 2009, too.
"In Q1 2009, we reduced total cost of goods
sold by $1.9-million for recoveries from partners who were
underbilled in 2008 for certain fees and charges that they were
contractually obligated to pay and a refund due of overbillings by a
freight carrier for charges from Q4 2008," the company disclosed.
"We just keep squeezing the tube of
toothpaste thinner and thinner and finding new stuff to come out,"
Mr. Byrne remarked during the conference call after chief financial
officer Steve Chesnut said that the underbilling and overbilling had
been found "as part of good corporate diligence and governance."
In addition, Overstock.com managed to
record a $1.9-million gain, reported as part of "other income," by
extinguishing $4.9-million worth of its senior convertible notes,
which it bought back at rather hefty discount. If not for the
fortuitous 2008 underbilling recoveries, fourth-quarter overbillings
refund and the paper gain from extinguishing some of its debt,
Overstock.com would have tallied a first-quarter loss of
$5.9-million or approximately 26 cents per share.
So, while Overstock.com did not manage to
conjure up a first-quarter profit by using the same accounting
abracadabra employed in the fourth quarter, it did succeed in
trimming its net loss to $2.1-million.
Bad corporate diligence and governance
During the Q1 2009 earnings conference
call, CFO Steve Chesnut boasted about finding accounting errors:
So just as part of good corporate diligence
and governance we've found these items.
Note: Bold print and italics added by me.
Actually, it was bad corporate diligence
and governance by CEO Patrick Byrne that caused the accounting
errors to happen by focusing on a vicious retaliatory smear campaign
against critics, while he runs his company into the ground with $267
million in accumulated losses to date and never reporting a
profitable year.
Memo to Grant Thornton (Overstock.com's new
auditors)
Overstock.com is a company that has not
produced a single financial report prior to Q3 2008 in compliance
with Generally Accepted Accounting Principles and Securities and
Exchange Commission disclosure rules from its inception, without
having to later correct them, unless such reports were too old to
correct. Two more financial reports (Q4 2008 and Q1 2009) don't
comply with GAAP and need to be restated, too.
To be continued in part 2.
In the mean time, please read:
William K. Wolfrum: "Sam E. Antar: From
Crazy Eddie to Patrick Byrne's Worst Nightmare."
Gary Weiss: "The Whisper Campaign Against
an Overstock.com Whistleblower"
Written by:
Sam E. Antar (former Crazy Eddie CFO and a
convicted felon)
Blog Update:
Investigative journalist and author Gary
Weiss commented on Overstock.com's history of GAAP violations in his
blog:
There are few certainties in this world:
gravity, the speed of light, and, more obviously every quarter, the
utter unreliability of Overstock.com financial statements.
Acclaimed forensic accountant and author
Tracy Coenen notes in her blog:
Don’t laugh too hard at Patrick Byrne’s
explanation of the repeated accounting errors and improper treatment
of those errors, as reported by Lee Webb of Stockwatch:
“We just keep squeezing the tube of
toothpaste thinner and thinner and finding new stuff to come out,”
Mr. Byrne remarked during the conference call after chief financial
officer Steve Chesnut said that the underbilling and overbilling had
been found “as part of good corporate diligence and governance.”
Good corporate diligence and governance? Is
this guy for real? How about having an accounting system that
prevents errors from occurring every quarter?
Of course, Overstock.com management has to
explain away why Sam Antar is finding all these manipulations and
irregularities in their financial reporting. They can stalk and
harass him all they want, call him a criminal all they want, but
there is no explaining it away. The numbers don’t lie. Overstock.com
just always counted on no one being as thorough as Sam.
We were intrigued by a recent quote from
Overstock.com's President.
On December 29, 2009,we saw, "It is nice to
be back with a Big Four accounting firm," said Jonathan Johnson,
President of Overstock.com. "We are pleased to have the resources
and professionalism that KPMG brings as our auditors. We will work
closely with them to timely file our 2009 Form 10-K. In the
meantime, we remain in discussions with the SEC to answer the
staff's questions on the accounting matters that lead to our filing
an unreviewed Form 10-Q for Q3."
As we dug further into this, we found an
interesting situation between client and auditors; and between the
opinions of two different auditors, as you'll see below.
And what makes it curioser is that
Overstock.com has engaged three separate auditors in a space of just
nine months.
From 2001 to 2008, PricewaterhouseCoopers
were the statutory auditors to Overstock.com, but this changed when
the company decided to engage a replacement through a RFP process,
and Grant Thornton was selected in March 2009. Subsequently,
Overstock.com received a letter from the SEC in October 2009
questioning the accounting for a "fulfillment partner overpayment"
(which Overstock.com recovered and recognized $785,000 as income in
2009 as it was received). Apparently earlier PricewaterhouseCoopers
had determined that this amount should not be recognized in fiscal
year 2008, but in 2009. However, the new auditor, Grant Thornton
after further investigation on the receipt of the SEC note,
determined that the amount should have been booked in 2008 and not
in 2009, and that Overstock.com should restate its 2008 financials
to reflect this as an asset
This put Overstock.com in a difficult spot,
with a severe disagreement between two audit opinions. In the
appropriate words of Patrick Byrne, the company's Chairman and CEO,
"Thus, we are in a quandary: one auditing firm won't sign-off on our
Q3 Form 10-Q unless we restate our 2008 Form 10-K, while our
previous auditing firm believes that it is not proper to restate our
2008 Form 10-K. Unfortunately, Grant Thornton's decision-making
could not have been more ill-timed as we ran into SEC filing
deadlines."
In general, Overstock.com agreed with PwC's
recommendation not to account for the amount in 2008 and not with
Grant Thornton's opinion of booking it in 2008.
While all this was going on, Overstock.com
had a make a choice on its Q3-2009 quarterly financials, which they
proceeded to file without required review by an auditor (in
violation of SAS 100). This unusual filing brought on a censure by
NASDAQ, who then finally agreed to grant the company time till May
2010 to refile the earnings.
Meanwhile, Grant Thornton wrote separately
to the SEC outlining its position, and Overstock.com responded to
GT's points in a letter from the President directly to the
shareholders.
Eventually, in November 2009, Overstock.com
dismissed Grant Thornton as its auditor, and Grant Thornton
immediately severed its relationship with the company through a
letter to the SEC.
After a search, on December 29, 2009,
Overstock.com finally hired KPMG to review all its financials,
accounting procedures and determine the final disposition of the
timing for accounting of this issue.
Other bloggers with more knowledge of the
stock and history, are taking a more aggressive position on
Overstock.com's actions, here's a recent post from SeekingAlpha.com:
All this switching around of auditors in
such a short space of time does call into question the company's
stance on alignment with external auditors opinions. Typically,
public companies do try to stay with one acccounting firm over a
long period of time and iron out any differences at a professional
level. This kind of merry-go-rounding seems to suggest that
Overstock.com is looking for the auditor who will agree with the
company's stance rather than an independent third party who will
provide an honest perspective in the best interest of investors,
whose interests they do represent as their fiduciary responsibility.
And that's where it apppears to stand
today, with KPMG having the unenviable task of sorting through all
this confusion, settling issues with the SEC and the NASDAQ, and
putting Overstock.com back in compliance and in some sense of
settlement with previous auditors. GT and PwC seem to have washed
their hands off this, but that's not to say, that a shareholder
lawsuit may spring from the blue, as we have seen in many cases,
that such messy audits have the potential for long tail litigations.
Meanwhile, on the stock market,
Overstock.com ($OSTK)hit a high of $17.65 on October 20, 2009 and
then has been steadily drifting downwards to $13.24 per share today.
At 22.84 million shares outstanding, this is a loss of market
capitalization of $110 million. Other online retailers have had
generally better stock performance during this period, so clearly
the accounting issue is having some level of overhang on stock
performance.
In another very interesting use of
philosophy from the Chairman's letter:
"All things are subject to interpretation;
whichever interpretation prevails at a given time is a function of
power and not truth." - Friedrich Nietzsche
And we hope that in due course, we find the
real truth, and not the interpretation that is biased towards the
powerful.
Now, none of this would be apparent to the
average online shopper who is seeking a real retail bargain on the
"O, O, O, The Big Big O, Overstock.com", but there is always more to
be had beyond the skin than is evident on the surface.
Clearly, this is not going away soon, and
more news is sure to emerge as the company files its audited
financials, and we'll blog as we hear of developments.
We had blogged earlier about Overstock.com,
which had changed three auditors in 2008-2009, from
PricewaterhouseCoopers to Grant Thornton to KPMG, all in a space of
about a year, and been in trouble with Nasdaq for filing unaudited
financials.
See our earlier posts for all the drama
with the company and its erstwhile auditors taking three disparate
viewpoints on restatements, ownership and reporting.
However, over the last few months in 2010,
things seem to have become much better for the company, and the
online retailer seems to have put its heart back into retailing and
put away the distraction of accounting from previous months.
Here’s a chronology of events:
Dec 29, 2009 Overstock.com Engages KPMG as
the company's independent registered public accounting firm of
record for the fiscal year ending December 31, 2009. KPMG will
conduct an integrated audit of the company's 2009 financial
statements, including review of the company's quarterly information
for the periods ending March 31, 2009, June 30, 2009 and September
30, 2009.
KPMG is hired after a lot of back and forth
with previous auditors, Grant Thornton.
March 31, 2010 Overstock.com Reports
Restated FY 2009 Results with Revenue: $876.8M in FY 2009 vs.
$829.9M in FY 2008 (6% increase); Gross margin: 18.8% vs. 17.4% (140
basis point improvement); Gross profit: $164.8M vs. $144.2M (14%
increase); Contribution (non-GAAP measure): $109.2M vs. $86.6M (26%
increase); Net income (loss) attributable to common shares: $7.7M
vs. $(11.1M) ($18.8M increase in net income); and Diluted EPS:
$0.33/share vs. $(0.48)/share ($0.81/share improvement)
Overstock.com ranked for the second year in
a row, number 2 in the NRF/Amex survey of American consumers, behind
only LL Bean and ahead of Amazon, Zappos, eBay, Nordstrom, and many
other fine firms.
Patrick M. Byrne said, “As you may know, at
the end of Q4 we engaged KPMG as our independent auditors, and
announced that we were restating our FY 2008 and Q1, Q2 and Q3 2009
financial statements. I thank you for being patient with us as we
worked through the questions raised by the SEC, the transition to
the KPMG team, and the extra time it took to ensure that our
financial statements are accurate.”
KPMG passed the actual audit of the company
without adverse opinion, saying “In our opinion, the consolidated
financial statements referred to above present fairly, in all
material respects, the financial position of Overstock.com, Inc. and
subsidiaries as of December 31, 2009, and the results of their
operations and their cash flows for the year ended December 31,
2009, in conformity with U.S. generally accepted accounting
principles. Also in our opinion, the related financial statement
schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.”
But they did qualify that Overstock.com’s
internal audit over financial reporting was not up to standards and
provided an adverse opinion on internal controls. The company’s
Audit Committee initiated strong steps to enhance internal audit by
hiring competent professionals and instituting appropriate
processes.
Overstock.com did restate its FY 2008 and
Q1-2009 to Q3-2009 financial statements to account for a number of
auditing issues and concerns.
A nice event, with all the accounting
restatements done and good results to boot compared to FY 2008.
April 5, 2010 Overstock.com Regains
Compliance with NASDAQ Listing Rules, receiving a notice from the
NASDAQ Stock Market that the company is in compliance with the
periodic filing requirement and this matter has been closed.
Earlier, Overstock.com had received a letter on November 19, 2009
from the NASDAQ notifying the company that it had violated NASDAQ
Listing Rule 5250(c)(1) when it filed its Quarterly Report on Form
10-Q for the period ended September 30, 2009 because the filing
wasn't reviewed in accordance with Statement of Auditing Standards
No. 100. In response to a compliance plan submitted by the company,
NASDAQ granted an exception to enable the company to regain
compliance by May 17, 2010.
A close examination
of Overstock.com's (NASDAQ: OSTK) Q1 2010 10-Q report financial
disclosures reveals that the company still failed to remediate
serious material weaknesses in internal controls that have resulted
in three restatements of financial reports in four years to correct
GAAP violations. In addition, a close examination of the company's
financial disclosures reveals serious questions about the quality of
its reported Q1 2010 earnings of $3.7 million and claimed
improvement in financial performance when compared to Q1 2009.
Continuing
Weaknesses in Internal Controls
Each and every
initial financial report for every reporting period issued by
Overstock.com from the company's inception in 1999 to Q3 2009
violated GAAP or some other SEC disclosure rules. Likewise, every
single audit report from 1999 to 2008 was wrong and every single
Sarbanes-Oxley internal control certification signed by management
turned out to be false, too.
In its Q1 2010 10-Q
report, Overstock.com disclosed that the company has not remediated
serious weaknesses in internal controls:
...the Chief
Executive Officer (principal executive officer) and Senior Vice
President, Finance (principal financial officer) concluded that
our disclosure controls and procedures were not effective as of
the end of the period covered by this Quarterly Report on Form
10-Q due to the following material weaknesses:
We lacked a
sufficient number of accounting professionals with the necessary
knowledge, experience and training to adequately account for and
perform adequate supervisory reviews of significant transactions
that resulted in misapplications of GAAP. • Information
technology program change and program development controls were
inadequately designed to prevent changes in our accounting
systems which led to the failure to appropriately capture and
process data. [Snip]
As of March 31,
2010, we had not remediated the material weaknesses.
Based on
Overstock.com's past history of accounting irregularities and
financial reporting violations, we cannot be reasonably assured that
Overstock.com's current Q1 2010 financial report is free of GAAP and
SEC disclosure violations due to continuing reported material
weaknesses in internal controls.
Quality of
Earnings Issues for Q1 2010
In Q1 2010,
Overstock.com reported a net profit of $3.72 million compared to a
net loss of $3.96 million in Q1 2009 or a $7.68 million improvement
in earnings. However, Overstock.com's reported Q1 2010 $3.72 million
profit was helped in large part by a $3.1 million reduction in its
estimated allowance for returns or sales returns reserves when
compared to Q1 2009.
According to
Overstock.com's Q1 2010 10-Q report:
The allowance
for returns was $7.4 million and $11.9 million at March 31, 2010
and December 31, 2009, respectively. The decrease in the sales
returns reserve at March 31, 2010 compared to December 31, 2009
is primarily due to decreased revenues due to seasonality.
It is normal for
sales return reserves to drop from Q4 2009 to Q1 2010 "due to
seasonality" issues such as decreased revenues from an earlier
quarter (Q4 2009) compared to a later quarter (Q1 2010). However, in
many cases such reserves drop due to changes from previous reserve
estimates that artificially increase reported profits in later
periods when such estimates are adjusted.
As the chart
demonstrates, Overstock.com's reduction in allowances for returns
may not be seasonal at all, but instead due to a change of estimate.
As I detailed above, Overstock.com claimed that its reduction in
sales return reserves was "primarily due to...seasonality" and the
company did not claim any other factors such as operating
improvements as a significant reason for the drop in reserves.
After Q4 2008,
Overstock.com's allowance for returns steadily dropped in total
dollars from $16.2 million to $7.4 million in Q1 2010, or a 54%
reduction in reserves. On a relative basis, Overstock.com's
allowance for returns steadily dropped from 6.38% of revenues in Q4
2008 to a mere 2.8% of revenues in Q1 2010, or a 56% drop in
relative reserves.
If Overstock.com's
return allowance had not dropped in dollar amounts from $10.5
million in Q1 2009 to $7.4 million in Q1 2010, the company would
have reported a Q1 2010 profit of only $672k instead of $3.72
million.
In Q1 2010,
Overstock.com's allowance for returns was 2.80% of revenues compared
to 5.65% of revenues in Q1 2009. If we use that same percentage of
revenues in Q1 2010 that Overstock.com used in Q1 2009 (5.65%), the
company's allowance for reserves would have been $14.9 million,
instead of $7.4 million as reported by the company. In such case,
Overstock.com would have reported a Q1 2010 $3.78 million loss
instead of a $3.72 profit.
We have blogged earlier about
PricewaterhouseCoopers, the official auditors of Satyam, the Indian
IT firm, scalded by the scam perpetrated by its Chairman Ramalinga
Raju. Since then, Satyam has been bought by Tech Mahindra and
Deloitte has been hired as the new statutory auditors. All this has
happened in a space of one year, with Ramalinga Raju being arrested
on January 9, 2009, he is reportedly in the hospital now, though his
brother and the Satyam CFO and other key officials are still
imprisoned.
This case continues to twist and turn, and here are some very recent
developments from the Indian press (mainly The Economic Times (www.economictimes.com)
and CNBC-TV18 (www.moneycontrol.com):
First and most recent, the Supreme Court of India today granted bail
to the PricewaterhouseCoopers partner Mr. T Srinivas, on the basis
that the bulky charges (over 55,000 pages) could lead to a
long-drawn trial in the case and the accused was already lodged in
jail for over a year. The judges decided it would be of no use to
keep the accused in jail, where he had been since his arrest on
January 24 2009. Mr. Srinivas has been asked to post bail of about
US$40,000 and two sureties. The court also directed Mr. Srinivas to
appear before the police in the first week of every second month and
not to tamper with the evidence or influence witnesses in the case.
Second, the scam has had larger impact on the PwC Indian firm, with
about 200 professionals leaving PwC India for other firms, mainly
due to adverse reputational impact. This is considered one of the
highest and quickest attritions in Indian professional services.
These 200 employees include the 19 partners who left along with
Dinesh Kanabar, the widely-regarded head of PwC’s tax practice, who
joined rival firm KPMG as deputy CEO in December 2009. These
employees, across all level of professional services, have
apparently moved onto other Big Four firms in India - KPMG, Ernst &
Young and Deloitte. Reportedly, PwC has been trying to control
attrition by attractive bonuses and larger professional roles. Note
that PwC India has 6,500 employees, so this 3% by itself is not an
unusual attrition level, but the rapid outflow in a short amount of
time following a reputational event makes it all the more critical.
Third, recall that PwC India had made serious changes to the top
management of the Indian firm, also bringing in Gautam Banerjee as
the new Chairman from PwC Singapore in December 2009.
Fourth, in a recent interview with Dennis Nally PwC Chairman with
CNBC-TV18 India TV, he acknowledged that the Satyam scam had hurt
the PwC brand, saying, “Without question the firm has had real
challenges in India but that has not changed my outlook and view on
the importance of India economy to global economic picture….It is
going to take sustained performance and nothing short of that.
Everything we do is a matter of focus. …If we do that and we do that
consistently over a period of time the PwC brand in India will be as
strong and as good as it has been in the past and where we want it
to be into the future.”
So this case moves on, leaving behind tons of collateral damage for
all concerned. We can all ask how the auditors could have missed
lining up company statements against bank statements to see whether
the cash reported was really in the bank. Relying upon company
management, however convincing they may be, should not have
precluded independent investigation. That’s true auditing, isn’t it
- an unbiased, critical and dispassionate view coupled with focus on
the truth and unstinting efforts to show accurate financial
information. Till the entire story comes out, we’ll never know what
really happened, but deep inquiry at the right time could have
prevented this crisis and taken it out at the bud.
We recently
published our extensive financial analysis on the Big Four Firms (read
here, download
here), and with some recent revenue
announcements by the next set of firms, here is a brief overview of
The Next Four, the second set of international but smaller
accounting firms.
As you can see below, these are large complex organizations in their
own right, and likely to place in the global Fortune 500 as
independent entities. They are multi-billion dollar, multi-firm,
transnational enterprises, with presence in 100+ countries, and
providing a wide variety of accounting, tax and advisory services.
In another industry, they would be good contenders for top
positions, but the sheer size of each of the Big Four firms totally
dwarfs their presence in the accounting & tax firm sector. Consider
that the combined revenue of these four firms (~$16 billion) is less
than the revenue of the smallest of the Big Four firms (KPMG at $20
billion).
To recap:
First,
PricewaterhouseCoopers, still the largest firm in the industry
Second,
Deloitte, just a bit behind PwC
Third, Ernst &
Young
Fourth, KPMG,
the smallest of the Big Four firms
Fifth, and a distant follower to KPMG
is BDO International, which had total combined fee income for
all BDO Member Firms of US$ 5.026 billion for the year ended 30
September 2009, a creditable year over year increase of 1.7 % in
euro terms but a decrease of 2.3 % in US dollars terms. In local
currency terms, excluding the effect of all currency movements,
revenues actually increased 4.5%, with the appreciating US
dollar reducing this by about 7% when results were reported in
US dollars from 2008 to 2009.
Europe and North America both decreased combined fee income, but
Asia Pacific, Middle East and Sub Saharan Africa regions each
had an increase of some 20% in Euro terms. Latin America grew by
almost 10% in Euro terms.
Audit & Accounting grew by 4.5%, Tax fell by 3.9% and Advisory
services fell by 10%. The total number of people increased from
44,002 in 2008 to 46,035 in 2009, while the network’s offices
grew from 1,095 to 1,138 over the same period.
In recent news BDO Seidman, the US member firm, simply became
BDO.
Sixth, and jumping over Grant Thornton
to take that sixth spot is RSM International with 2009 worldwide
revenues of US$3.87 billion, up a solid 8% from 2008. Of this
global revenue, Americas have US$2.65 billion, Europe has US$837
million, Asia Pacific has US$349 million; and Africa & Middle
East with a small figure of US$36.8 million. RSM International
has 32,492 people, comprised of 3,150 partners, 23,262
professional and 6,080 administrative staff in 736 offices in 76
countries.
There were some bright spots for RSMI which led to this
increase. In 2009, Singapore and China revenues rose 31% and 17%
respectively, with good showings from Philippines, New Zealand,
Indonesia and Malaysia. Revenues in Belgium shot up 69% due to a
local merger while member firms in Malta and Portugal also grew
by over 25 percent each. RSM Tenon, the newly merged UK member
firm, increased the UK firm revenues to US$406 million.
RSMI’s 8% increase in revenue was a key factor in displacing
Grant Thornton from sixth place, as Grant Thornton’s revenue
went the other way, dropping by 9%.
Seventh, and just behind RSM
International is Grant Thornton International (losing that sixth
spot), with combined global revenues of $3.6 billion from its 96
member firms for the year ended 30 September 2009. Revenues for
2009 were flat in local currency terms from 2008, but declined
9% in US dollar terms from 2008.
Assurance revenues at $1.6 billion (46%
of total revenues) increased 5% in local currency terms but
dropped 4% in US dollar terms against 2008. Tax revenues of $763
million (~25% of total) were flat to 2008 in local currency
terms but were down 9% in US dollar terms. Specialist advisory
services revenues were $884 million (25% of global dollar
revenues), down 5% in local currency but down 16% in US dollar
terms
Latin America and the Caribbean had
solid local currency growth of 13%. Europe, Middle East & Africa
revenues were flat at local currency terms. Greece (up 11%),
Poland (12%) and Belgium (19%) were top performers. 2009 North
American revenues were down 1% from 2008. Asia Pacific revenues
were up by 14% at constant exchange rates, helped by a 23%
increase in revenues by the India member firm.
Grant Thornton’s 9% drop in revenue led
to its displacement as the sixth largest accounting firm in the
world. An unexpected surprise indeed.
In Eighth place is Baker Tilly
International with 145 member firms in 110 countries and 2,800+
partners and 25,000 people. Baker Tilly’s revenues for fiscal
year 2008 were US$2.95 billion, up 18% from 2007. We could not
find Baker Tilly’s 2009 revenues, but presume they were higher
than 2008.
According to the recently published
rankings of 40 accounting organizations from the International
Accounting Bulletin's annual world survey, average network
revenues dropped 6% to $122 billion and average association
revenues increased only 3% to $20.8 billion. The Bulletin says
that this is a nearly a 20% revenue turnaround for networks with
some of the largest firms affected, corroborating our earlier
analysis of the Big 4 firms. Only two firms in the top 10 - RSM
International and Baker Tilly were able to increase their
revenues from 2008 to 2009.
The Bulletin further noted that Audit
demand was affected by severe fee reductions, as high as 40% in
come cases. Tax demand suffered as clients generally paid less
tax, affecting the appetite for tax planning advice. But the
most impacted was corporate finance with 2009 being the worst
year for M&A deals since 2004. Restructuring services were in
good demand. Most firms noted heavy investment in Asia-Pacific,
with Asia Pacific, the Middle East and Latin America reporting
solid growth.
The IAB predicts, as we did in our
analysis, “If the networks’ recent growth trends continue,
Deloitte will overtake PwC this year.”
Note that the revenues for the Big Four
firms fell 7% from $101 billion in 2008 to $94 billion in 2009.
In 2009, it is interesting to note that the total global
revenues of all the other 36+ large accounting firms combined
were only $26 billion ($122 billion minus $94 billion). And the
6% drop in the industry is largely defined by the 7% drop in the
mega Big Four firms (PricewaterhouseCoopers, Deloitte, Ernst &
Young and KPMG).
The IAB’s analyis is in sync with our
findings, and the big surprise is clearly RSMI’s move to the
sixth spot, swapping places with Grant Thornton. We shall look
out to next year where there are two close races: Deloitte
versus PricewaterhouseCoopers to be the largest accounting firm
on the planet and RSMI versus Grant Thornton for sixth and
seventh spots.
PwC Auditors Apparently Let This Massive and Long-Term Accounting
Fraud Go Undetected Price Waterhouse, auditor to Satyam Computer
Services Ltd. (500376.BY), Wednesday said it is examining the contents
of Satyam Chairman B. Ramalinga Raju's statement in which he said
Satyam's accounts were falsified. "We have learnt of the disclosure made
by the chairman of Satyam Computer Services and are currently examining
the contents of the statement. We are not commenting further on this
subject due to issues of client confidentiality," Price Waterhouse said
in an e-mailed statement.
"Price Waterhouse: Currently Examining Satyam Chmn's Statement," Lloyds,
January 7, 2008 ---
http://www.lloyds.com/dj/DowJonesArticle.aspx?id=416525
Earlier in the day, Satyam Chairman Raju resigned, admitting to
falsifying company accounts and inflating revenue and profit figures
over several years.
The Continuing Saga of Auditing,
Independence, Consulting, and Professionalism and Fees
"The Great American Financial Sandwich: AIG, PwC, and Goldman Sachs,"
by Francine McKenna, re: The Auditors, February 2, 2010 ---
http://retheauditors.com/2010/02/02/4151/
PricewaterhouseCoopers LLP’s Indian
affiliate, the auditor of Satyam Computer Services Ltd., said two
partners were arrested by police as authorities extended the
nation’s largest fraud inquiry.
Srinivas Talluri and S. Gopalakrishnan were
remanded to judicial custody on charges of “conspiracy and co-
participation,” A. Shivanarayana, a police spokesman in Andhra
Pradesh state, said from the province’s capital Hyderabad, where
Satyam is based. Price Waterhouse said in an e-mailed statement it
didn’t know why two partners were detained.
Seven years after the implosion of Enron
Corp. led to the dissolution of accounting firm Arthur Andersen LLP,
the Satyam case has put PricewaterhouseCoopers in the spotlight.
Indian police, fraud squad, markets regulator and accounting body
have started investigations after Satyam founder Ramalinga Raju said
Jan. 7 that he had fabricated $1 billion of assets.
“Over the last fortnight, the firm has
fully cooperated in all inquiries and has provided the documents
called for by the Indian authorities,” Price Waterhouse said today
in a statement from New Delhi. “We greatly regret that two Price
Waterhouse partners have been detained today for further
questioning.”
PricewaterhouseCoopers LLP may also face
scrutiny in the U.S. after Satyam’s New York-listed equities lost 82
percent of their market value in two weeks. The U.S. Securities and
Exchange Commission is investigating whether Satyam misled investors
and officials from the SEC plan to coordinate inquiries with
counterparts in India.
Fudged Accounts
The auditing firm said Jan. 15 that its
reports could no longer be relied on after former chairman Raju said
he’d fudged the accounts. The Institute of Chartered Accountants of
India, a statutory body which oversees auditors, will report on its
investigation into Price Waterhouse on Feb. 11.
Prosecutors allege Satyam padded employee
numbers to siphon off cash and forged documents to support fake bank
deposits.
Satyam had about 33 billion rupees ($674
million) of “fictitious and non-existent” accounts, public
prosecutor K. Ajay Kumar told a hearing on Jan. 22. The company had
about 40,000 employees, compared with the 53,000 claimed by Satyam,
he said.
India’s biggest corporate fraud
investigation is being led by teams from the Andhra Pradesh state
police’s criminal investigation department, the markets regulator,
the independent accounting body and the government’s serious fraud
office.
Separate Entity
Satyam’s state-appointed board has almost
arranged funds to help tide over a cash crunch till the end of
March, the company said yesterday. The board has hired KPMG and
Deloitte Touche Tohmatsu to restate the accounts.
Satyam is struggling to raise cash to pay
salaries after Raju said he had falsified accounts for several
years. It is also battling to stop off customers from joining State
Farm Mutual Automobile Insurance Co. in canceling contracts.
Price Waterhouse has offices in nine Indian
cities, according to the firm’s Web site. The Indian operation is a
separate legal identity from PricewaterhouseCoopers International
Ltd., according to the Web site.
The auditor’s clients include Maruti Suzuki
India Ltd., maker of half the cars in the country, and the local
units of Colgate-Palmolive Co., the world’s largest toothpaste
maker.
PricewaterhouseCoopers LLP has a “vigorous
global network” allowing member firms to “operate simultaneously as
the most local and the most global of businesses,” the firm says on
its Web site. The site also includes a disclaimer that each member
firm “is a separate and independent legal entity.”
Larsen & Toubro
Larsen & Toubro Ltd., India’s biggest
engineering company, yesterday tripled its stake in Satyam to give
it greater say in the rescue of the software exporter.
The disgraced former chairman of Satyam
Computer Services Ltd., B. Ramalinga Raju, used salary payments to
13,000 fictitious employees to siphon millions of dollars from the
Indian outsourcer for land purchases, prosecutors said Thursday.
Prosecutors in the southern Indian city of
Hyderabad, where the technology-outsourcing firm is based, told a
criminal court that Satyam has only about 40,000 employees instead
of the 53,000 it claims.
Prosecutors claimed the money, in the form
of salaries paid to ghost employees, came to around $4 million a
month. The money was diverted through front companies and through
accounts belonging to one of Mr. Raju's brothers and his mother to
buy thousands of acres of land, the prosecutors said.
Prosecutors said they are investigating but
didn't allege that Mr. Raju's mother or brother were involved. They
didn't offer further details on how the alleged diversion of funds
took place.
Prosecutors made the claims in a hearing
Thursday where the state police for the state of Andhra Pradesh
asked for more time to interrogate Mr. Raju and Satyam's former
chief financial officer, Srinivas Vadlamani, who is also in custody.
"The funds of Satyam have been diverted to
many other companies," K. Ajay Kumar, assistant prosecutor, told a
packed courtroom. Investigators need more time with Mr. Raju and Mr.
Vadlamani to figure out where the money has gone, Mr. Kumar said.
Continued in article
PwC Auditors Apparently Let This Massive and Long-Term Accounting
Fraud Go Undetected Price Waterhouse, auditor to Satyam Computer
Services Ltd. (500376.BY), Wednesday said it is examining the contents
of Satyam Chairman B. Ramalinga Raju's statement in which he said
Satyam's accounts were falsified. "We have learnt of the disclosure made
by the chairman of Satyam Computer Services and are currently examining
the contents of the statement. We are not commenting further on this
subject due to issues of client confidentiality," Price Waterhouse said
in an e-mailed statement.
"Price Waterhouse: Currently Examining Satyam Chmn's Statement," Lloyds,
January 7, 2008 ---
http://www.lloyds.com/dj/DowJonesArticle.aspx?id=416525
Earlier in the day, Satyam Chairman Raju resigned, admitting to
falsifying company accounts and inflating revenue and profit figures
over several years.
Satyam Computer Services, a leading Indian
outsourcing company that serves more than a third of the Fortune 500
companies, significantly inflated its earnings and assets for years,
the chairman and co-founder said Wednesday, roiling Indian stock
markets and throwing the industry into turmoil.
The chairman, Ramalinga Raju, resigned
after revealing that he had systematically falsified accounts as the
company expanded from a handful of employees into a back-office
giant with a work force of 53,000 and operations in 66 countries.
Mr. Raju said Wednesday that 50.4 billion
rupees, or $1.04 billion, of the 53.6 billion rupees in cash and
bank loans the company listed as assets for its second quarter,
which ended in September, were nonexistent.
Revenue for the quarter was 20 percent
lower than the 27 billion rupees reported, and the company’s
operating margin was a fraction of what it declared, he said
Wednesday in a letter to directors that was distributed by the
Bombay Stock Exchange.
Satyam serves as the back office for some
of the largest banks, manufacturers, health care and media companies
in the world, handling everything from computer systems to customer
service. Clients have included General Electric, General Motors,
Nestlé and the United States government. In some cases, Satyam is
even responsible for clients’ finances and accounting.
The revelations could cause a major
shake-up in India’s enormous outsourcing industry, analysts said,
and may force many large companies to investigate and perhaps revamp
their back offices.
“This development is going to have a major
impact on Satyam’s business with its clients,” said analysts with
Religare Hichens Harrison on Wednesday. In the short term “we will
see lot of Satyam’s clients migrating to competition like Infosys,
TCS and Wipro,” they said. Satyam is the fourth-largest outsourcing
firm after the three named.
In the four-and-a-half page letter
distributed by the Bombay stock exchange, Mr. Raju described a small
discrepancy that grew beyond his control. “What started as a
marginal gap between actual operating profit and the one reflected
in the books of accounts continued to grow over the years. It has
attained unmanageable proportions as the size of company operations
grew,” he wrote. “It was like riding a tiger, not knowing how to get
off without being eaten.”
Mr. Raju said he had tried and failed to
bridge the gap, including an effort in December to buy two
construction firms in which the company’s founders held stakes.
Speaking of a “deep regret” and a “tremendous burden,” Mr. Raju said
that neither he nor the co-founder and managing director, B. Rama
Raju, had “taken one rupee/dollar from the company.” He said the
board had no knowledge of the situation, nor did his or the managing
director’s families.
The size and scope of the fraud raises
questions about regulatory oversight in India and beyond. In
addition to India, Satyam has been listed on the New York Stock
Exchange since 2001, and on Euronext since January of 2008. The
company has been audited by PricewaterhouseCoopers since its listing
on the New York Stock exchange.
Satyam has been under close scrutiny in
recent months, after an October report that the company had been
banned from World Bank contracts for installing spy software on some
World Bank computers. Satyam denied the accusation but in December,
the World Bank confirmed without elaboration on the cause that
Satyam had been banned. Also in December, Satyam’s investors
revolted after the company proposed buying two firms with ties to
Mr. Raju’s sons.
On Dec. 30, analysts with Forrester
Research warned that corporations that rely on Satyam might
ultimately need to stop doing business with the company. “Firms
should take the initial steps of reviewing the exit clauses in their
current Satyam contracts,” in case management or direction of the
company changed, Forrester said.
The scandal raised questions over
accounting standards in India as a whole, as observers asked whether
similar problems might lie buried elsewhere. The risk premium for
Indian companies will rise in investors’ eyes, said Nilesh Jasani,
India strategist at Credit Suisse.
R. K. Gupta, managing director at Taurus
Asset Management in New Delhi, told Reuters: “If a company’s
chairman himself says they built fictitious assets, who do you
believe here?” The fraud has “put a question mark on the entire
corporate governance system in India,” he said.
Continued in article
The huge accounting scandal at Satyam Computer
Services Ltd., one of India's biggest information-technology firms, could lead
to an overhaul of corporate-governance standards in the country and force
changes in how Indian companies do business. Although some leading Indian
companies have become international powerhouses in recent years, the general
standard of corporate ethics and accounting have traditionally been poor in
India.
Jackie Range and Joann S. Lublin, "Spotlight on India's Corporate Governance,"
The Wall Street Journal, January 8, 2008 ---
http://online.wsj.com/article_email/SB123134607361061165-lMyQjAxMDI5MzAxNzMwNDc2Wj.html
Brace yourself. Fill your coffee cup.
Grab a bagel or two.
This is going to be a long one.
US and Indian regulators and investigators
are focusing on the wrong thing when investigating the Satyam
scandal. It’s not the spectacular audit failure that’s most
important. That’s just the inevitable unraveling of something
bigger. They need to look at the money flowing between Satyam and PW
India. Don’t be surprised if you find that money going outside of
India to PwC entities in the US or UK or shells set up in offshore
locations.
Follow the money. The level of
incestuousness between Satyam, PW India, PwC in other parts of the
world, and the Indian government may be greater than anyone
initially suspected. Otherwise, how could Satyam, an acknowledged
second-tier player in the Indian and global outsourcing arena end up
with
185 of the Fortune 500 as clients? Did PW
India facilitate, play tour guide, provide “due diligence” for sole-
or limited- sourced procurement efforts by PwC’s clients all over
the world and collect “referral” and “facilitation” fees, for
themselves and on behalf of key players in the PwC global
organization from both Satyam and their own fellow PwC partners? Was
anything paid to Indian government officials implying an FCPA
exposure, too?
We’ve already seen reports of PW partners
perhaps enabling and supporting the inflated staffing numbers and
global payrolls utilized by Satyam to add credibility to their
business strategy and to funnel money out of the company. But did
those funds go to only Satyam management?
“The Central Bureau of
Investigation (CBI) has established that the Raju brothers were
funnelling around Rs12 crore every month from Satyam through
hawala
(money brokers, often used in money laundering operations.)
Satyam sent the amount as salaries for over 10,000 fictitious
employees abroad…
“They were showing on their books
the transfer of Rs12 crore every month as salaries. The transfer
for one year was Rs144 crore. This went on for seven years since
2002," the CBI official said. Investigators established
that in the last seven years, around Rs1,008 crore may have been
transferred abroad. The money may be parked in the US,
England, Mauritius and southeast Asian countries.”
I contend that the relationship PwC had
with Satyam, its audit client, was not the ideal client relationship
under the professional standards auditors are bound to abide by. As
a trusted source and former partner with a major firm that was
active in this arena during the time in question told me:
“If half of what we think is
possible here is true, then PwC had a “perverse” view of what
their professional responsibilities and obligations were.
Instead of putting the client, the shareholders of their audit
client Satyam and other audit clients involved here, first they
put their own self interest as individuals and as profit making
members of a government-sanctioned oligopoly first. They did not
uphold the professional standards shareholders expect of any
audit professional in any country in any part of the world.”
I told you back in May how
PricewaterhouseCoopers used Satyam to jump start the reemergence of
their US consulting practice. PwC highlighted their strategic
relationship with Satyam during a meeting with industry analysts
last year. Satyam and their involvement with PwC client Idearc was
featured in one of only two case studies intended to demonstrate
PwC’s resurgent capabilities as a systems integrator. Satyam’s role
as a technical team member and, eventually, as the third-party IT
outsourcer of choice for PwC’s client Idearc allowed PwC serve this
client in areas where they were forbidden to do so under their 2002
non-compete agreement with IBM.
The relationship between PwC and Satyam,
whether implicit or explicit, was promoted at the July 2008 industry
analyst meeting and documented in
a report of the meeting prepared by
Gartner. Whether backed up by actual
contractual and/or project management relationships that tie Satyam
to PwC legally in the project for Idearc, a Verizon spin off, or
not, just the act of using Satyam to market the consulting practice
violates the independence standards audit firms are bound to
uphold.
Why?
Satyam was PwC’s audit client.
And we all know now that a massive fraud has been perpetrated on
Satyam shareholders with the complicity, according to the Indian
authorities, of two PwC partners, if not the whole firm in India,
the US and at a global level.
After the post came out in May there was
enormous interest, in India, in the UK, from my fellow bloggers.
But not from the mainstream US or UK media.
They say things like, “Much as I’d like to
devote a lot of resource to it, I believe my readers have gone a
little cold on it and are worrying about things closer to home…” Or
they seem strangely, curiously, to be avoiding the story completely.
A well known US journalist, one who has been very good on stories
of the accounting firms in the past in my opinion, was quite adamant
that the story would take too much “time and money” to pin down
since there was no way he could print it without several more
examples of a similar relationship as PwC seemed to have with Satyam
regarding Idearc.
Conversation with famous journalist ended,
“Let me know if you find any more examples and I’ll think about it.”
Yeah. If I have the sources and put in the
effort, (given my vast and various resources and funding,) I’m going
to send them to you.
Not.
And, so, I do have the sources and, so, I
have put in the effort.
The purpose of describing in detail
the Satyam clients who also had
a”trusted advisor” relationship with PwC,
that continued these relationships
after the purchase of PwC Consulting by IBM,
and often involved long, expensive IT
transformations and SAP implementations,
is to support the consideration of the
following scenario:
1) The strategic importance of Satyam as a
systems integration partner and technical resource caused global PwC
leadership to overlook, look the other way, or not take action on
reports of poor quality or lack of independence by Price Waterhouse
India partners.
2) PwC leadership – US, global, and
Indian- enabled and promoted complicity in the fraud called
“India’s Enron” for the sake of the global consulting business
strategy, in particular the growth of their outsourcing practice.
4) The PW India Audit partners acted as
willing, but subordinate, actors, nothing more than “bagmen,” in
a much larger plan to collect other incentives for PwC US, PwC UK
and the PW India consulting practice as a result of PwC US and UK
steering their “trusted advisor” clients to Satyam as an IT
outsourcing vendor. They probably even collected actual engagement
fees as the Indian outsourcing “go-to guys” from unknowing PwC
partners in the US and UK, acting as facilitators, tour guides,
providers of “due diligence” for sole- or limited- sourced
procurement efforts by PwC’s clients all over the world. PwC US even
planned to send a senior partner, Bob
Lattimore, to India to keep an eye on this
money-train by acting as ”the on site US Partner responsible for
working with PwC India as one of our key providers/partners for
Global Strategic Sourcing activities.”
5)
As late as mid-2008, Satyam, for all the
support and huge clients handed to them as a result of PwC
relationships, was still not one of the top three outsourcers in
India. Many of the companies who did choose Satyam, chose a
relatively unknown second-tier Indian firm over
known non-Indian firms
such as Accenture, ACS, EDS, IBM, and SAIC.
You have to wonder how Satyam could have come so far so fast any
other way than with an inside track. A bought and paid for inside
track.
6) PwC International Limited and PwC US
leadership have been much more active in lobbying the Indian
government in this case and in working through the Satyam scandal
issues personally, on site. This is quite contrary to their typical
approach to stay clear and above it all, given the standard defense
of no “manage and control” regarding international member firms. PwC
US and Global management are definitely in "red alert"
damage control and containment mode. It’s painfully obvious,
wracked with
poor PR and communications examples, and
unfortunately poorly coordinated with the Indian firm’s efforts to
save their own skins first.
7) PwC US, UK, and Global leadership
actually want the PW India audit partners to stay in jail and have
been shielding them from media and any opportunity to share their
side of the story. Why? Because what they know about what happened
can incriminate others at a very high level both in PwC, in Satyam,
and in the Indian government. The potential ripple effects on the
Indian and global outsourcing/consulting business are significant.
The Satyam scandal lowered confidence in Indian corporate governance
and management practices. There is a tacit desire on the part of
everyone involved to prevent any more light from shining on the
questionable business practices no one wants to admit to openly.
Although PwC is the newly designated auditor
of the Bailout Program, appearances of conflict of interest just keep increasing
since a huge and controversial recipient of Bailout funds is not only a PwC
client, the recipient has now been convicted of accounting fraud dating back to
Year 2000.
Will government bailout money be used
to pay AIG's court settlements?
"A federal judge has ruled that
shareholders of American International Group Inc. lost more than $500
million as a result of a scheme to manipulate the financial statements
of the world's largest insurance company," AccountingWeb,
November 3, 2008 ---
http://accounting.smartpros.com/x63720.xml
A federal judge has ruled that shareholders
of American International Group Inc. lost more than $500 million as
a result of a scheme to manipulate the financial statements of the
world's largest insurance company.
The ruling Friday by Judge Christopher
Droney means five former insurance executives convicted of the
scheme could face up to life in prison under advisory sentencing
guidelines.
Four former executives of General Re Corp.
and a former executive of AIG were convicted in February of
conspiracy, securities fraud, mail fraud and making false statements
to the Securities and Exchange Commission.
Prosecutors filed court papers citing a
study by its expert, concluding the fraud-related losses to AIG
shareholders totaled $1.2 billion to $1.4 billion.
They cited another methodology by the
expert that put the losses at $544 million to $597 million, but said
either method is reasonable.
Droney rejected the higher estimate, but
said the lower range was reasonable. That finding and a
determination that the fraud affected more than 250 victims will
increase the advisory guideline sentence range.
The guideline range and a sentencing date
have not been set yet.
The defendants challenged the estimate,
saying there was no loss to investors. The defendants are
Christopher Garand, Ronald Ferguson, Elizabeth Monrad, Robert Graham
and Christian Milton.
Ferguson has said in court papers that he
anticipated the government will advocate a loss amount that leads to
a recommendation for life in prison. But prosecutors made no such
recommendation, simply concluding that the defendants should receive
a "substantial" prison sentence.
A report by the probation department
recommended sentences of 14 years to more than 17 years for each
defendant.
Prosecutors said the defendants
participated in a scheme in which AIG paid Gen Re as part of a
secret side agreement to take out reinsurance policies with AIG in
2000 and 2001, propping up its stock price and inflating reserves by
$500 million.
Reinsurance policies are backups purchased
by insurance companies to completely or partly insure the risk they
have assumed for their customers.
General Re is part of Berkshire Hathaway
Inc., which is led by billionaire investor Warren Buffett of Omaha,
Neb.
Jensen Comment Just for the record
--- I’m not the only one raising concerns about independence of the Bailout
consultant and auditor, I provide reference to the following published in
CFO.com:
I am very troubled that the
government has chosen PwC as one of the firms to help with the internal
controls on the $700b bail out which included AIG. PWC just recently
agreed to one of the largest settlements in the public accounting
history over a class-action law suit because of their carelessness in
auditing AIG. What happened to the Sarbanes-Oxley requirements? Where
were the auditors, controllers and CFO?s of these companies requiring
the bailout? Something is fundamentally wrong. I fully agree with Lynn
Turner, former CFO and former chief accountant of the SEC on the recent
quote:
When you look at the past and see where auditors didn't get the job done
right, there were indicators that they didn't pay attention to,".
"Auditors are going to need to take off the blinders."
I was a former PwC employee and always thought highly of the caliber of
training and values they taught me. In the last decade or so, however,
public accounting firms are more worried about the bottom line than the
significant value the profession can bring to troubled companies.
I hope there are no conflicts
of interest, such as independence issues, of PwC, and Ernst and
Young auditing the USA Federal Treasury while also consulting on
accounting and internal control areas. The latter is indicated in
the article. The auditing is not.
Though some research indicates that the Government Accountability
Office (GA) audits the Federal Treasury. Now the million dollar
question: who audits the GAO?
All of the
comments published may be dysfunctional at this point to our profession
at this moment. I will not deliberately continue my search for evidence
that other people in the world are raising the same concerns about
independence of the Bailout auditor and consultant.
Auditing has a huge image problem since
all of the failed and failing banks (with Washington Mutual perhaps
being the worst-case illustration) had clean audit reports prior to
failing and wiping out shareholder equity. Even if the CPA Profession
finds reasons and excuses for those clean opinions, the image of
independence and value added by an audit is badly tarnished at this
point. Paying those same auditing firms giving those clean opinions for
failed banks millions of dollars in the government’s subsequent bailing
out of PwC and E&Y banking clients seemingly adds to the tarnish at this
point in time.
Although AIG, that is now dependent upon billions
in the government's Bailout Program in order to survive, AIG will have
to come up with another $500 million from somewhere following the
judge's October 31, 2008 ruling establishing the amount owing for its
accounting fraud dating back to Year 2000.
Under censure from the SEC for compromising its independence AIG
accounting fraud, Ernst & Young agreed to
pay up $1.5 million to clients of AIG in 2007.
From The Wall Street Journal
Accounting Weekly Review on March 30, 2007
SUMMARY: Ernst
& Young (E&Y) "was censured by the
Securities and Exchange Commission
(SEC) and will pay $1.5 million to
settle charges that it compromised
its independence through work it did
in 2001 for clients American
International Group Inc. and PNC
Financial Services Group.
"Regulators claimed AIG hired E&Y to
develop and promote an
accounting-driven financial product
to help public companies shift
troubled or volatile assets off
their books using special-purpose
entities created by AIG." PNC
accounted incorrectly for its
special purpose entities according
to the SEC, who also said that
"PNC's accounting errors weren't
detected because E&Y auditors didn't
scrutinize important corporate
transactions, relying on advice
given by other E&Y partners.
QUESTIONS:
1.) What are "special purpose
entities" or "variable interest
entities"? For what business
purposes may they be developed?
2.) What new interpretation
addresses issues in accounting for
variable interest entities?
3.) What issues led to the
development of the new accounting
requirements in this area? What
business failure is associated with
improper accounting for and
disclosures about variable interest
entities?
4.) For what invalid business
purposes do regulators claim that
AIG used special purpose entities
(now called variable interest
entities)? Why would Ernst & Young
be asked to develop these entities?
5.) What audit services issue arose
because of the combination of
consulting work and auditing work
done by one public accounting firm
(E&Y)? What laws are now in place to
prohibit the relationships giving
rise to this conflict of interest?
It appears that, when they were appointed by the 2008 Bailout Program
as consultants and auditors, both PwC
and E&W had already settled the
AIG lawsuits. This is not the case for AIG itself that must come up with
more cash.
Jim Mahar writes as follows in his Finance Professor Blog on October
30, 2008
The American International Group is rapidly
running through $123 billion in emergency lending provided by the
Federal Reserve, raising questions about how a company claiming to be
solvent in September could have developed such a big hole by
October.....Mr. Vickrey says he believes A.I.G. must have already
accumulated tens of billions of dollars worth of losses by
mid-September, when it came close to collapse and received an $85
billion emergency line of credit by the Fed. That loan was later
supplemented by a $38 billion lending facility.
But losses on that scale do not show up in the company’s financial
filings. Instead, A.I.G. replenished its capital by issuing $20 billion
in stock and debt in May and reassured investors that it had an ample
cushion....Mr. Vickery and other analysts are examining the company’s
disclosures for clues that the cushion was threadbare and that company
officials knew they had major losses months before....
Professor Mahar Comment Several reasons for including this one.
First and foremost it gets to a serious question. Were the initial
infusions by the government just a stop gap measure and will even more
be needed. (The idea of throwing good money after bad comes to mind).
Secondly in class yesterday we talked
about information asymmetries and how accounting can only partially
lessen the problem and that firms can have billions of dollars of losses
that investors may not be aware of even after reading the financial
statements. And finally a student
in class is doing a paper on this and what the executives must have
known (or at least should have known) before hand.
PwC'a auditors either ignored or missed the warning signs of
accounting fraud at AIG For years, PricewaterhouseCoopers LLP gave a
clean bill of financial health to American International Group Inc.,
only to watch the insurance giant disclose a long list of accounting
problems this spring. But in checking for trouble, PwC might have asked
the audit committee of AIG's board of directors, which is supposed to
supervise the outside accountant's work. For two years, the committee
said that it couldn't vouch for AIG's accounting. In 2001 and 2002, the
five-member directors committee, which included such figures as former
U.S. trade representative Carla A. Hills and, in 2002, former National
Association of Securities Dealers chairman and chief executive Frank G.
Zarb, reported in an annual corporate filing that the committee's
oversight did "not provide an independent basis to determine that
management has maintained appropriate accounting and financial reporting
principles." Further, the committee said, it couldn't assure that the
audit had been carried out according to normal standards or even that
PwC was in fact "independent." While the distancing statement by the
audit committee is not unprecedented, the AIG committee's statement is
one of the strongest he has seen, said Itzhak Sharav, an accounting
professor at Columbia University. "Their statement, the phrasing, all of
it seems to be to get the reader to understand that they're going out of
their way to emphasize the possibility of problems that are undisclosed
and undiscovered, and they want no part of it." Language in audit
committee reports ran the gamut . . .
"Accountants Missed AIG Group's Red Flags," SmartPros, May 31,
2005 ---
http://accounting.smartpros.com/x48436.xml
"PwC Sets Accord in Tyco Case: Pact for $225 Million Settles Claims
Involving Auditing Malpractice," by David Reilly and Jennifer Levitz, The
Wall Street Journal, July 7, 2007 ---
Click Here
Accounting titan PricewaterhouseCoopers LLP
agreed to pay $225 million to settle audit-malpractice claims
arising from the criminal misdeeds of top executives at Tyco
International Ltd., marking the largest single legal payout ever
made by that firm and one of the biggest ever by an auditor.
The settlement applies to claims from both
Tyco investors, who had filed a class-action lawsuit against the
accounting firm in federal court in New Hampshire, and Tyco itself.
The agreement was disclosed Friday by PwC, Tyco and the class-action
investors.
Tyco's involvement in the PwC deal followed
on its agreement in May to settle for $2.98 billion claims brought
against it by the same class-action plaintiffs -- removing a cloud
of liability that shadowed the conglomerate as it split into three
publicly traded companies. As part of that agreement, Tyco allowed
investors to pursue its own claims against PricewaterhouseCoopers,
while Tyco would pursue claims on behalf of shareholders against
former executives, including former Chief Executive L. Dennis
Kozlowski.
Attorneys for Tyco investors said the
settlement marked a victory for shareholders. The $225 million
payout "sends a message to accounting firms" and will act as a
"deterrent to future situations like this," according to Jay
Eisenhofer of Grant & Eisenhofer PA, who represented investors in
the case. Tyco declined to comment beyond saying that the agreement
had been filed.
The PwC settlement ranks among the top 10
legal payouts made by accounting firms related to work on behalf of
one company. Ernst & Young LLP's $335 million settlement in 1999
related to work for Cendant Corp. remains the biggest-ever payout by
an auditor.
As a percentage of the overall settlement
reached by the company and other parties -- an important metric
looked at by accounting firms -- the PwC deal represented a payout
on its end of about 7% of the total. That is generally in line with
payouts by accounting firms, which tend to range from 5% to 15% of
total payouts.
While the Tyco case was one of several
corporate scandals that rocked markets earlier this decade, it is
somewhat unusual in that the malfeasance revolved around
compensation issues involving top executives. That contrasted with
the kind of bankruptcy-inducing fraud seen in many other scandals
such as those at Enron Corp. and WorldCom Inc. In June of 2005, a
jury convicted Mr. Kozlowski, and Mark Swartz, Tyco's former chief
financial officer, of grand larceny, conspiracy and securities
fraud. Both are serving prison sentences in New York.
While PwC stood by its work, the firm's
position was potentially undermined when the Securities and Exchange
Commission in 2003 barred Richard P. Scalzo, the firm's lead partner
on Tyco's audits from 1997 to 2001, from audits of publicly listed
companies. The SEC didn't accuse him of deliberately covering up
faulty accounting at Tyco, but said he was "reckless" for not
heeding warning signs regarding the integrity of the company's
management. Mr. Scalzo didn't admit or deny wrongdoing.
Although the PwC settlement with Tyco will
have to be approved by class-action investors, and some could drop
out to pursue claims individually, the deal mostly brings to a close
one of the biggest legal issues for PwC. Other high-profile cases
the firm has outstanding are suits related to its work for insurance
titan American International Group Inc. and computer maker Dell Inc.
IBM and PwC Settle With Government International Business Machines Corp. and
PricewaterhouseCoopers LLP have agreed to pay nearly $5.3 million combined to
settle allegations that they made improper payments on government technology
contracts, the Justice Department said Thursday. PhysOrg, August 16, 2007 ---
http://physorg.com/news106499155.html
Jensen Comment
The sad part about this is the promises made by PwC to abide by ethics and
professionalism after the scandals at the end of the last century.
IBM Misleads Investors The Securities and Exchange Commission has
announced a settled enforcement action against International Business
Machines Corporation for making materially misleading statements in a
chart concerning the impact that the company's decision to expense
employee stock options would have on its first quarter 2005 (1Q05) and
fiscal year 2005 (FY05) financial results. The misleading chart caused
analysts to lower their earnings per share (EPS) estimates for the
company. Linda Chatman Thomsen, Director of the SEC's Division of
Enforcement, said, "Information regarding a company's earnings is one of
the most important factors that many investors consider in making an
investment decision, and it is essential that the information companies
provide be clear and accurate."
Andrew Priest, AccountingEducation.com, June 15, 2007 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=145059
The external independent
auditor for IBM is PricewaterhouseCoopers (PwC)
SUMMARY: Videogame maker Electronic Arts, Inc., has
initiated a hostile takeover bid for Take-Two
Interactive Software, the "creator of the
crooks-beat-the-cops franchise, Grand Theft Auto...."
Despite open investigations "...including an undisclosed
number of grand-jury subpoenas from the New York County
district attorney examining almost every aspect of the
videogame company," its stock price has reacted to the
potential takeover to now equal "...roughly where it was
when the subpoenas first started to fly two years ago."
The article goes on to refer to two studies by
university faculty finding evidence of investor
reactions to restatements and to outside investigations
in general.
CLASSROOM APPLICATION: The below questions ask
students to compare the results from larger scale
studies, as cited in the article, to the specific cases
in which stock prices may not have reacted as negatively
as might be expected. The article therefore could be
used in a business statistics course as well as
accounting courses covering disclosure requirements such
as intermediate accounting and financial statement
analysis courses.
QUESTIONS:
1. (Introductory) Why should a company's stock
price react negatively to open investigations by the
Securities and Exchange Commission or other regulatory
agency?
2. (Advanced) What accounting and reporting
standards require disclosure of regulatory
investigations? Why might managers have discretion over
when such disclosure must be made?
3. (Introductory) What evidence is offered in
the article that investors "...are simply 'too generous'
in their assessment of regulatory risk?"
4. (Introductory) What evidence is offered
that, on average, investors do react negatively to
announcements of regulatory issues at companies in which
they invest?
5. (Advanced) Explain the difference between
the overall results of the two research studies
mentioned in the article and the specific examples cited
by the author of cases in which stock prices do not
strongly reflect negative impact from open regulatory
investigations.
Reviewed By: Judy Beckman, University of Rhode Island
From the looks of its stock price, you
would never know that Take-Two Interactive Software is at the center
of multiple open investigations, including an undisclosed number of
grand-jury subpoenas from the New York County district attorney
examining almost every aspect of the videogame company.
Even with the unresolved risks, the creator
of the crooks-beat-the-cops franchise, Grand Theft Auto, recently
received an unwanted takeover bid from Electronic Arts. The hostile
offer propelled Take-Two's stock to roughly where it was when the
subpoenas first started to fly two years ago.
Then there is Bally Technologies. Its stock
is trading at a considerable premium to where it was in 2005, when
the maker of slot machines disclosed that the Securities and
Exchange Commission was investigating its revenue-recognition
practices.
When it comes to government investigations,
"investors are dangerously complacent," says John Gavin, president
of Disclosure Insight, a research firm that analyzes SEC filings
with a focus on uncovering investigations before they are publicly
disclosed. Too often, he says, they are simply "too generous" in
their assessment of regulatory risk.
He says that is because management often
gives little in the way of facts while analysts don't probe "because
they're afraid" of getting frozen out by the company.
But buyer beware: While it may seem that
investigations no longer matter, there is plenty of research -- and
more than a few examples -- to show that many if not most still tend
not to bode well for investors, assuming investors know about them
in the first place.
As Mr. Gavin has found, many companies
avoid disclosing investigations until long after they are under way.
To break the code, he files Freedom of Information Act requests with
various government entities. His findings are available without
charge on his company's Web site.
The reality: There isn't a rule that says a
company must disclose investigations until they are deemed, by the
company, as material. "They are the judge," says Mr. Gavin, who
acknowledges that "inasmuch as investigations matter, in fairness
sometimes they truly don't. They might be a tiny matter -- something
where the SEC just goes away."
On the other hand, Mr. Gavin adds, "Dell
sat on its revenue-recognition investigation for a year and then
disclosed it."
Dell, for its part, says it waited to
disclose the investigation until the inquiry became "more focused."
And even then, a spokesman says, it was announced before it
officially turned "formal," the time at which the SEC can begin
issuing subpoenas.
Even after last year's announcement of a
restatement, which at less than $100 million amounted to a fraction
of sales, Dell's stock has been an underperformer as the company has
tried to reinvent itself.
But restatements, which would appear to put
overly aggressive accounting in the past, don't necessarily
establish a clean slate in the eyes of investors.
According to a Treasury Department
restatements report this past week by University of Kansas associate
professor of accounting Susan Scholz, while there are some
indications of apathy by investors, "returns are statistically
negative for restatements involving fraud" in every year but 2004.
Restatements, alone, aren't as ominous for
investors as outside investigations. From "the first revelation of
misconduct" until an investigation is resolved, stocks of target
companies tend to fall by an average of 40%, says Jonathan Karpoff,
a finance professor at the University of Washington, who co-authored
a study on the topic.
The reason, he says, is a loss of
reputation, which on one level is an intangible, but on the other
can be seen as a direct hit to the business.
Lenders, for example, might be reluctant to
lend to companies that have been tagged as having inadequate
internal controls. "And in some cases," he says, investigations can
"be the cause of losing customers."
Mr. Karpoff's study also shows that about
90% of companies under regulatory fire tend to lose their top
executives by the time the investigation has been settled.
The Public Company Accounting
Oversight Board, in an inspection report released Friday, cited
PricewaterhouseCoopers LLP for deficiencies in some of its audits of
public companies.
The PCAOB noted the firm had
failed in some cases to catch or address errors in the way companies
applied accounting rules or lacked sufficient evidence to back up
some of its decisions. The PCAOB singled out for criticism nine
audits done by PricewaterhouseCoopers, saying in a number of the
cases the firm failed to adequately check the value of revenue,
inventory and accounts receivable at companies whose books it was
approving. The board's inspections entail reviews of a sampling of
audits, not every audit done by a firm.
In keeping with the board's
policies, the report doesn't identify the companies that had their
audits cited. In addition, only a portion of the report is made
public. A section that includes criticisms related to an accounting
firm's quality-control systems is kept secret and never made public
if a firm is able to show that it has corrected the problems cited
within 12 months of the report's issuance.
In a comment letter included
in the PCAOB report, PricewaterhouseCoopers said, "We have addressed
each of the specific findings raised in the report and, where
necessary, performed additional procedures or enhanced the related
audit documentation." A spokesman for PricewaterhouseCoopers issued
a statement saying that the firm believes it is "performing quality
audits" and that it "will incorporate the board's findings" into the
firm's practices.
The board's inspection
reports are the only public assessment of audit firms' work
available to investors and the corporate audit committees, which
hire, fire and negotiate how much to pay the accounting firms.
The report is the second this
year that the PCAOB has issued for a Big Four accounting firm
covering inspections conducted last year of the firms' audits of
companies' 2004 financial results. Earlier this month the agency
issued its 2005 report for Deloitte & Touche LLP.
The PCAOB, which has been
criticized for the length of time it is taking to issue annual
reports, has yet to issue 2005 inspection reports for Ernst & Young
LLP or KPMG LLP, the other two members of the Big Four. The board
has until the end of the year to do so.
The PCAOB must issue an
annual inspection report for any accounting firm that audits 100 or
more public companies. Firms that audit fewer than 100 public
companies are inspected every three years, although the PCAOB on
Friday said it would look to amend this rule.
PricewaterhouseCoopers'
response to its PCAOB report was in contrast to that of Deloitte,
which included strong rebuttals of many of the board's findings.
In a case that illustrates what used to be common practice before
Sarbanes-Oxley became law, Big Four accounting firm PricewaterhouseCoopers
agreed to pay $50 million to settle a class action suit involving its former
audit client Raytheon. http://www.accountingweb.com/item/99230
Dell to Restate Results for 4 Years as Audit Ends Dell Inc said on Thursday it would restate four
years of financial results, reducing net income for the period by as
much as $150 million, after a lengthy audit found that top executives
sought accounting adjustments to reach quarterly performance goals. Dell
said it expects the restatements to also reduce revenue by 1 percent or
less per year for the period under review.
"Dell to Restate Results for 4 Years as Audit Ends ," The New York
Times, August 16, 2007 ---
http://www.nytimes.com/reuters/business/business-dell-accounting.html?_r=1&oref=slogin
Creative Accounting by Creative Michael Dell Dell said yesterday that the Securities and
Exchange Commission had started a formal investigation into its
accounting practices, but provided no other details of the inquiry that
began in August. As a result, the computer company said it was delaying
the release of its third-quarter financial results until the end of the
month. It had planned to announce them today after the markets closed.
The company said the delay was not because of the new status of the
investigation, but rather because of the difficulty of answering
government queries, conducting its own inquiry and quickly compiling
complex financial information.
Damon Darlin, "Dell Accounting Inquiry Made Formal by S.E.C.," The
New York Times, November 16, 2006 ---
http://www.nytimes.com/2006/11/16/technology/16dell.html?_r=1&ref=business&oref=slogin
"Dell to restate more than 4 years of earnings, says company
manipulated results to meet goals," MIT's Technology Review,
August 17, 2007 ---
http://www.technologyreview.com/Wire/19268/
From The Wall Street Journal Accounting Weekly Review on
August 24, 2007
SUMMARY: 'Dell Inc. said it would restate more than four years of
its financial results, after a massive internal investigation found
that unidentified senior executives and other employees manipulated
company accounts to hit quarterly performance goals." In August 2005
the SEC informed Dell, Inc. that it was investigating the company's
accounting and financial reporting practices. Dell disclosed the
investigation in August 2006 with little discussion of details even
as the investigation progressed through March 2007, "but a company
SEC filing disclosed that the investigation uncovered issues about
the way Dell recognizes revenue from selling other companies'
software, amortizes revenue from some extended warranties, and
accounts for reimbursement agreements with vendors." The results of
the investigation indicate that various reserve and
accrued-liability accounts were created or improperly
adjusted-usually at the close of the quarter to give the appearance
that quarterly financial goals were met.
CLASSROOM APPLICATION: The article can be used to help students
consider materiality issues in terms of both dollar amounts and the
nature of the item in question, indicating the problem tone set by
executives at Dell because of their actions. Demonstrating
understanding the accounting for risky accounts--accruals for
warranties and revenue accounts--and combining that understanding
with ideas on devising audit steps also is required.
QUESTIONS:
1.) Define the term "materiality". What points about Dell Inc.'s
accounting issues indicate that the items in question are material?
What points indicate that the issues are not material?
2.) In what areas must Dell Inc. restate its results?
3.) Define the terms "reserve accounts" and "accrued liability
accounts." How do you think these accounts are used in relation to
the topics of revenue recognition from sales of other companies'
software and revenue from extended warranties?
4.) How might an executive or manager use the accounts described
above to meet quarterly financial goals? In your answer, also
comment on the types of goals that an executive would want to meet.
5.) Dell, Inc. engaged a law firm and an accounting firm who used
special software to evaluate more than five million documents and
then conduct extensive interviews to undertake investigation into
these accounting matters. Describe one analysis procedure and one
interview that you might conduct if you were part of the accounting
firm's team undertaking this investigation.
Reviewed By: Judy Beckman, University of Rhode Island
Four PricewaterhouseCoopers auditors arrested in Tokyo on criminal charges Four certified public accountants at a Japanese unit of
the PricewaterhouseCoopers Group were arrested Tuesday for allegedly
collaborating with former executives at Kanebo Ltd. to falsify accounting
reports. The special investigation department of the Tokyo District Public
Prosecutor's Office also searched the offices of ChuoAoyama
PricewaterhouseCoopers in Chiyoda Ward, Tokyo, and the suspects' homes jointly
with the Securities and Exchange Surveillance Commission, prosecutors said.
Pursuing criminal responsibility of certified public accountants in connection
with window-dressing is unusual, and the arrests have blemished the credibility
of those assigned auditing responsibilities, observers say. The accountants
under arrest were identified as Kuniaki Sato, 63, Seiichiro Tokumi, 58,
Kazutoshi Kanda, 55, and Kazuya Miyamura, 48. The Japan Times, Sept. 14, 2005
This article was forwarded to me by Miklos A. Vasarhelyi
[miklosv@andromeda.rutgers.edu]
Here are some of Francine's posts on the Kanebo
fraud:.
"Audit Quality and Auditor
Reputation: Evidence from Japan," by Douglas J. Skinner The
University of Chicago - Booth School of Business and Suraj Srinivasan ,
Harvard Business School, SSRN, Revised April 7, 2010 ---
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1557231
Abstract:
We study events surrounding ChuoAoyama’s failed audit of Kanebo, a large
Japanese cosmetics company whose management engaged in a massive
accounting fraud. ChuoAoyama was PwC’s Japanese affiliate and one of
Japan’s “Big Four” audit firms. In May 2006, the Japanese Financial
Services Agency (FSA) suspended ChuoAoyama’s operations for two months
as punishment for its role in the accounting fraud at Kanebo. This
action was unprecedented, and followed a sequence of events that
seriously damaged ChuoAoyama’s reputation for audit quality. We use
these events to provide evidence on the importance of auditors’
reputation for audit quality in a setting where litigation plays
essentially no role. We find that ChuoAoyama’s audit clients switched
away from the firm as questions about its audit quality became more
pronounced but before it was clear that the firm would be wound up,
consistent with the importance of auditors’ reputation for delivering
quality.
Doral Financiali Settles Financial Fraud Charges The Securities and Exchange Commission on
September 19, 2006 filed financial fraud charges against Doral Financial
Corporation, alleging that the NYSE-listed Puerto Rican bank holding
company overstated income by 100 percent on a pre-tax, cumulative basis
between 2000 and 2004. The Commission further alleges that by
overstating its income by $921 million over the period, the company
reported an apparent 28-quarter streak of “record earnings” that
facilitated the placement of over $1 billion of debt and equity. Since
Doral Financial’s accounting and disclosure problems began to surface in
early 2005, the market price of the company’s common stock plummeted
from almost $50 to under $10, reducing the company’s market value by
over $4 billion. Without admitting or denying the Commission’s
allegations, Doral Financial has consented to the entry of a court order
enjoining it from violating the antifraud, reporting, books and records
and internal control provisions of the federal securities laws and
ordering that it pay a $25 million civil penalty. The settlement
reflects the significant cooperation provided by Doral in the
Commission’s investigation.
"DORAL FINANCIAL SETTLES FINANCIAL FRAUD CHARGES WITH SEC AND AGREES TO
PAY $25 MILLION PENALTY," AccountingEducation.com, September 28,
2006 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=143606
The independent auditor for Doral Financial is PricewaterhouseCoopers
LLP (PwC) ---
Click Here for Doral's 10-K
PwC's charges to Doral increased from $2.2 million in 2004 to $5.6
million in 2006.
LUBBOCK, Tex. Oct. 10 (AP) — A former
executive who admitted to embezzling millions of dollars from
Patterson-UTI Energy Inc., the oil and gas drilling company, was
sentenced to 25 years in prison Tuesday.
The executive, Jonathan D. Nelson, 36, was
accused of using a bogus invoice scheme to take more than $77
million from the company, a large operator of land-based oil and gas
drilling rigs.
The authorities said he spent the money on
an airplane, an airfield, a cattle ranch, a truck stop, homes and
vehicles.
Mr. Nelson was also fined $200,000 and
ordered to pay restitution of about $77 million minus the money that
has been recouped from the sale of assets purchased with the stolen
money.
“We are at a crossroads in America where
malfeasance in corporate America has reached an all-time high,”
Judge Sam R. Cummings of United States District Court said in
comments to Mr. Nelson. “This type of conduct simply cannot be
tolerated in our society.”
The independent external auditor was Pricewaterhouse Coopers ---
Click Here
Fees Incurred in Fees Incurred in Fiscal Year Fiscal Year
Description
2004
2003
Audit fees
$ 419,000 $ 323,000
Audit-related fees
1,141,000 180,000
Tax fees
573,000 81,000
All other fees
19,000 31,000
Totals $2,152,000
$615,000
Tyco Fraud Update
First a quote from 2004
PricewaterhouseCoopers also fell prone to faulty risk assessments. In July, the
SEC forced Tyco, the industrial conglomerate, to restate its profits, which it
inflated by $1.15 billion, pretax, from 1998 to 2001. The next month, the SEC
barred the lead partner on the firm's Tyco audits from auditing publicly
registered companies. His alleged offense: fraudulently representing to
investors that his firm had conducted a proper audit. The SEC in its complaint
said that the auditor, Richard Scalzo, who settled without admitting or denying
the allegations, saw warning signs about top Tyco executives' integrity but
never expanded his team's audit procedures.
"Behind Wave of Corporate Fraud: A Change in How Auditors Work: 'Risk Based'
Model Narrowed Focus of Their Procedures, Leaving Room for Trouble,' " by
Jonathan Weil, The Wall Street Journal, March 25, 2004, Page A1
You can read a longer part of the above article below in this document.
Jensen Comment: Dennis Kozlowski is eligible
for parole in eight years on a 25-year sentence. This is far to lenient
and once again shows how white collar crime is punished much too lightly ---
http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays
But at least Dennis is not going to do his 8/25 in Club Fed (of course in Club
Fed he would probably not get such an early parole opportunity.
There aren't any $6,000 shower curtains in
New York state prisons, where Tyco felons Dennis Kozlowski and Mark
Swartz will be enjoying all or part of the next 25 years. The former
CEO and CFO were sentenced yesterday for their roles in looting $600
million from their company and paying off one or more directors to
avert their eyes. They won't become eligible for parole until about
seven years.
Thus concludes one of the sorrier chapters
in U.S. business history. And while it took a while -- the first
Tyco trial ended in mistrial -- the outcome strikes us as just. Not
because of their greed -- there's no law against lavish living yet
-- but because of their crimes. Messrs. Kozlowski and Swartz were
convicted in June on 22 counts of grand larceny and conspiracy. The
verdicts were a victory for Manhattan District Attorney Robert
Morgenthau, who last week survived a tough primary challenge.
Of all the fin de siècle corporate
scandals, the Tyco heist has always seemed the most audacious, a
case of stealing money in plain sight. If you want to liven up the
conversation at a business lunch, mention former Enron CEO Jeffrey
Skilling and Chairman Ken Lay and whether they were complicit in the
fraud for which several former executives have been convicted. There
are still those who believe former WorldCom CEO Bernard Ebbers was
unaware of the fraud that was taking place under his nose, despite
his conviction. The Tyco scandal didn't inspire such ambiguities.
Messrs. Kozlowski and Swartz aren't headed
for Club Fed by the way; under New York correctional policy,
criminals with their sentences usually serve their time in
maximum-security prisons. In addition, they were ordered to pay
restitution and fines of $175 million. A case of justice in plain
sight.
By Jonathan Soble 551 words 10 May 2006
03:57 Reuters News English (c) 2006 Reuters Limited
(Adds establishment of new PWC affiliate in
Japan)
TOKYO, May 10 (Reuters) - Japan's financial
regulator imposed a two-month business suspension on accounting firm
Chuo Aoyama PricewaterhouseCoopers on Wednesday over its role in a
book-keeping fraud at cosmetics and textiles maker Kanebo Ltd.
In the unprecedented sanction, the
Financial Services Agency (FSA) barred Chuo Aoyama, part of global
accounting firm PricewaterhouseCoopers, from auditing corporate
accounts under Japan's securities and commercial laws for two months
beginning July 1.
Three Chuo Aoyama accountants charged in
connection with the Kanebo fraud have admitted helping the firm hide
losses as part of a nine-year effort to disguise its financial
decline. Kanebo has since been broken up in a state-led
restructuring, and rival Kao Corp. bought its cosmetics business
earlier this year.
In imposing the penalty, the FSA's first
against one of Japan's "big four" accounting houses, the agency said
the firm's failure to prevent the fraud was a result of "serious
deficiencies" in its internal controls.
The suspension will not disrupt earnings
reporting by Chuo Aoyama clients for the business year that ended in
March, which some firms have not completed. Auditing of certain
companies, such as those that close their books later than the
normal March 31 cut-off, will also be allowed during the suspension,
the FSA said.
But the auditors' clients -- a group that
includes some of Japan's biggest companies -- could abandon it for
rivals in coming reporting periods.
In a statement PWC said it would assist
ChuoAoyama in its reform efforts but at the same time establish a
new independent affiliated firm in Japan that would "adopt
international best practices in accounting and auditing."
Toray Industries Inc., Japan's top
synthetic-fibre maker, said at an earnings briefing held before the
FSA's announcement that it would consider dropping Chuo Aoyama if
the authorities penalised the firm.
Nippon Mining Holdings Inc., another
client, said it was happy with Chuo Aoyama's work but might consider
switching if a sanction impaired its ability to function.
The punishment comes as legislators
consider proposed legal changes that would make auditors criminally
responsible for fraud at client firms.
Accounting problems became an issue in
Japan during the long bad-debt mess at the nation's banks.
Book-keeping scandals at Kanebo and more recently at Internet firm
Livedoor Co. have brought auditors under further scrutiny.
Kanebo, which sought restructuring help
from the government-backed Industrial Revitalisation Corp. last
year, declared about $2 billion in non-existent profits between the
1995/96 and 2003/04 business years, a period when it fell into
negative net worth.
Kanebo said in April 2005 it had inflated
profits by exaggerating sales numbers, under-reporting business
costs and improperly removing unprofitable subsidiaries from its
balance sheet.
Unable to sustain the fiction, Kanebo
finally declared a net loss of 358 billion yen ($3.22 billion) in
2003/04.
Its actual loss that year was in fact only
142 billion yen, Kanebo said later in admitting the long-running
fraud. The remaining 216 billion yen in red ink represented
undeclared losses from previous years. (Additional reporting by
Yoshiyasu Shida)
A Little Like Dirty Pooling Accounting Tyco Undervalues Acquired Assets and Overvalues Acquired Liabilities:
Tyco International Ltd. said Monday it has agreed to
pay the Securities and Exchange Commission $50 million to settle charges related
to allegations of accounting fraud by the high-tech conglomerate's prior
management. The regulatory agency had accused Tyco of inflating operating
earnings, undervaluing acquired assets, overvaluing acquired liabilities and
using improper accounting rules, company spokeswoman Sheri Woodruff said. 'The
accounting practices violated federal securities laws,'' she said. "Tyco to Pay S.E.C. $50 Million on Accounting Charges," The New York Times,
April 17, 2006 ---
http://www.nytimes.com/aponline/business/AP-Tyco-SEC-Fine.html?_r=1&oref=slogin
April 17, 2006 reply from Saeed Roohani
Bob,
Assuming improper accounting practices by
Tyco negatively impacted investors and creditors in the capital
markets, why SEC gets the $50 M? Shouldn't SEC give at least some of
it back to the people potentially hurt by such practices? Or damage
to investors should only come from auditors' pocket?
Saeed Roohani
April 18, 2006 reply from Bob Jensen
Hi Saeed,
In a case like this it is difficult to identify particular
victims and the extent of the damage of this one small set of
accounting misdeeds in the complex and interactive multivariate
world of information.
The damage is also highly dispersed even if you confine the scope
to just existing shareholders in Tyco at the particular time of the
financial reports.
One has to look at motives. I'm guessing that one motive was to
provide overstated future ROIs from acquisitions in order to justify
the huge compensation packages that the CEO (Kozlowski) and the CFO
(Schwarz) were requesting from Tyco's Board of Directors for
superior acquisition performance. Suppose that they got $125 million
extra in compensation. The amount of damage for to each shareholder
for each share of stock is rather minor since there were so many
shares outstanding.
Also, in spite of the illegal accounting, Kozlowski's
acquisitions were and still are darn profitable for Tyco. I have a
close friend (and neighbor) in New Hampshire, a former NH State
Trooper, who became Koslowski's personal body guard. To this day my
friend, Jack, swears that Kozlowski did a great job for Tyco in
spite of possibly "stealing" some of Tyco's money. Many shareholders
wish Kozlowski was still in command even if he did steal a small
portion of the huge amount he made for Tyco. He had a skill at
negotiating some great acquisition deals in spite of trying to take
a bit more credit for the future ROIs than was justified under
purchase accounting instead of virtual pooling accounting.
I actually think Dennis Kozlowski was simply trying to get a bit
larger commission (than authorized by the Board) for some of his
good acquisition deals.
Would you rather have a smart crook or an unimaginative bean
counter managing your company? (Just kidding)
PricewaterhouseCoopers today issued the following statement in
response to sanction announced in Japan against ChuoAoyama
PricewaterhouseCoopers.
PricewaterhouseCoopers regrets the actions of the former ChuoAoyama
partners in connection with the Kanebo fraud and will respect fully
the requirements and the intent of the order by the Financial
Services Agency.
ChuoAoyama
is committed to its previously announced reform plan.
PricewaterhouseCoopers will continue to assist ChuoAoyama in the
implementation of its programme to improve audit quality and will
assist ChuoAoyama in managing through this difficult period.
In
addition:
-- A
permanent new and independent audit firm is being created in
Japan that will be a member of the PricewaterhouseCoopers global
network.
-- This
new member firm will operate under a new management and
governance structure, and will be of a sufficiently large scale
to serve its clients. It will adopt international best practices
in accounting and auditing to create a new distinctive firm that
will meet high standards of audit quality.
--
During its development, the new firm will have a high level of
oversight by PwC.
PricewaterhouseCoopers expects to be able to provide additional
details with respect to this new firm within the next week.
PwC'a auditors either ignored or missed the warning signs of accounting
fraud at AIG For years, PricewaterhouseCoopers LLP gave a clean bill
of financial health to American International Group Inc., only to watch the
insurance giant disclose a long list of accounting problems this spring. But in
checking for trouble, PwC might have asked the audit committee of AIG's board of
directors, which is supposed to supervise the outside accountant's work. For two
years, the committee said that it couldn't vouch for AIG's accounting. In 2001
and 2002, the five-member directors committee, which included such figures as
former U.S. trade representative Carla A. Hills and, in 2002, former National
Association of Securities Dealers chairman and chief executive Frank G. Zarb,
reported in an annual corporate filing that the committee's oversight did "not
provide an independent basis to determine that management has maintained
appropriate accounting and financial reporting principles." Further, the
committee said, it couldn't assure that the audit had been carried out according
to normal standards or even that PwC was in fact "independent." While the
distancing statement by the audit committee is not unprecedented, the AIG
committee's statement is one of the strongest he has seen, said Itzhak Sharav,
an accounting professor at Columbia University. "Their statement, the phrasing,
all of it seems to be to get the reader to understand that they're going out of
their way to emphasize the possibility of problems that are undisclosed and
undiscovered, and they want no part of it." Language in audit committee reports
ran the gamut . . .
"Accountants Missed AIG Group's Red Flags," SmartPros, May 31, 2005 ---
http://accounting.smartpros.com/x48436.xml
The latest huge Enron-type scandal: Where was the external auditor,
PwC, when all this was going on? Among AIG's admissions: It used insurers in Bermuda and
Barbados that were secretly under its control to bolster its financial results,
including shifting some liabilities off its books. Amid the wave of financial
scandals that have toppled corporate executives in recent years, AIG's woes
stand out. Unlike Enron, WorldCom and HealthSouth -- all highfliers that rose to
prominence in the 1990s -- AIG has been a solid blue-chip for decades. Its stock
is in the Dow Jones Industrial Average, and its longtime chief, Maurice R.
"Hank" Greenberg, was a globe-trotting icon of American business. Civil and
criminal probes already have forced the departure of the 79-year-old Mr.
Greenberg after nearly four decades at AIG's helm. Investigators are closely
examining the actions of Mr. Greenberg and several other top AIG officials who
have quit or been ousted in recent days, including its former chief financial
officer; the architect of its offshore operations in Bermuda; and its
reinsurance operations chief. In addition, the Securities and Exchange
Commission could eventually bring civil-fraud charges against the company or
executives.
Ian McDonald, Theo Francis, and Deborah Solomon, "AIG Admits 'Improper'
Accounting : Broad Range of Problems Could Cut $1.77 Billion Of Insurer's
Net Worth A Widening Criminal Probe," The Wall Street Journal, March 31,
2005; Page A1---
http://online.wsj.com/article/0,,SB111218569681893050,00.html?mod=todays_us_page_one
Underwriting losses: AIG said it improperly
characterized losses on insurance policies -- known as underwriting
losses -- as another type of loss, through a series of transactions
with Capco Reinsurance Co. of Barbados. It said Capco should have
been treated as a subsidiary of AIG, a change that will force AIG to
restate $200 million of the other losses as underwriting losses from
its auto-warranty business. AIG long has prided itself on having
among the lowest underwriting losses in the industry -- a closely
watched figure.
• Investment income: Through a string of
transactions with unnamed outside companies, AIG said it booked a
total of $300 million in gains on its bond portfolio from 2001
through 2003 without actually selling the bonds. If it had waited to
book the income until it sold the bonds, the income would have come
later and been counted as "realized capital gains." That category of
income is sometimes treated suspiciously by investors because
insurance companies have considerable discretion over when they sell
securities in their portfolio.
• Bad debts: The company suggested that
money owed to AIG by other companies for property-casualty insurance
policies might not be collectible. The company said that could
result in an after-tax charge of $300 million.
• Commission costs: Potential problems with
AIG's accounting for the up-front commissions it pays to insurance
agents and similar items might force it to take an after-tax charge
of up to $370 million, the company said.
• Compensation costs: AIG also will begin
recording an expense on its books for compensation paid to its
employees by Starr International, the private company run by current
and former executives. Starr has spent tens of millions of dollars
on a deferred-compensation program for a hand-picked group of AIG
employees in recent years.
The probe that spurred the AIG admissions
stemmed from a broader investigation of "nontraditional insurance,"
an industry niche that had grown rapidly in the 1990s. In
particular, regulators have been concerned about a product called
"finite-risk reinsurance."
Reinsurance is a decades-old business that
sells insurance to insurance companies to cover bigger-than-expected
claims, thereby spreading the losses for policies they sell to
individuals and companies. Finite-risk reinsurance blends elements
of insurance and loans.
Regulators had become concerned that some
insurers were using the policies to improperly bolster their
financial results. Their concern: For a contract to count as
insurance, it has to transfer risk to the insurer selling the
policy. Some finite-risk policies appeared to be more akin to loans
than insurance policies -- yet the buyers used favorable insurance
accounting.
In December, the SEC opened a broad probe
into at least 12 insurance and reinsurance companies, including
General Re, ACE Ltd., Chubb Corp. and Swiss Reinsurance Co. All four
companies have said they are cooperating with the inquiry.
Key to the inquiry is how the finite-risk
transactions were structured and treated on the financial statements
of the companies or their clients, these people said. Following the
SEC request for information, General Re lawyers combed through their
finite-risk insurance deals and turned up roughly a dozen
transactions where it wasn't clear that enough risk had been
transferred to treat them as insurance. Among those deals was the
AIG deal. General Re lawyers quickly alerted the SEC and the New
York attorney general's office, which resulted in the current probe.
The catalogue of problems AIG unveiled
yesterday was detailed to law-enforcement and regulatory authorities
in meetings with the company's outside lawyers in recent days. The
company also has fired three senior executives for refusing to
cooperate with investigators, including former chief financial
officer Howard I. Smith and Michael Murphy, a Bermuda-based AIG
executive.
Given its level of cooperation so far, the
company almost certainly will be able to reach a civil settlement
with authorities, people familiar with the probes said. One of these
people compared AIG's cooperation to the approach taken by Michael
Cherkasky, the chief executive of Marsh & McLennan Cos. After Mr.
Spitzer accused Marsh's insurance brokerage of bid-rigging, its
board forced out then-CEO Jeffrey Greenberg, Mr. Greenberg's son and
a former AIG executive. Mr. Cherkasky, the head of Marsh's
investigative unit, became the new chief.
When he came in, a criminal indictment of
the company remained a possibility. But Mr. Cherkasky cleaned house
among the company's high ranks, then made sure the firm's internal
investigation and cooperation with regulators were the top priority.
He often personally participated in talks with regulators.
What do we have auditors for? Still, "at a certain point, if auditors can
only find out about [improper accounting]
if management tells them about it, then what do we have auditors for?"
said Lynn E. Turner, a former SEC chief accountant and managing director
of research for proxy-advisory concern Glass Lewis & Co. "The reason we
have auditors is to give investors confidence that an outside third
party has looked at them and found things that might turn out to be big
errors."
Theo Francis and Diya Gullapalli, "Pricewaterhouse's Squeeze Play:
AIG Says It Misled Auditor, As Greenberg Cites Review Clearing Internal
Controls," The Wall Street Journal, May 3, 2005, Page C3 ---
http://online.wsj.com/article/0,,SB111508622792022942,00.html?mod=todays_us_money_and_investing
I can understand why his CEO refused to
listen, but why wasn't PwC willing to listen to a CFO whistleblower?
Nov. 24, 2003 (Detroit Free Press) — Jeffrey
Boyer, Kmart's former chief financial officer, didn't publicly blow the
whistle about the Troy retailer's worsening financial condition in
mid-2001.
Like corporate whistle-blower Sherron Watkins
at Enron , he approached his boss with his concerns. But unlike Watkins,
Boyer was fired after raising issues about Kmart's financial reporting
under Chuck Conaway, Kmart's former CEO and chairman, according to a
civil lawsuit filed this week.
Boyer's six-month tenure at Kmart has been the
center of considerable interest in the aftermath of the company's
bankruptcy, the largest in U.S. retail history. His testimony has been
sought by numerous investigators and regulators. Boyer has not made any
public comments.
But, based on court documents, it's clear he
clashed with Kmart's leadership. He even raised the issue of bankruptcy
as early as August 2001 -- five months before the company filed its
bankruptcy petition.
Conaway fired Boyer in November 2001, claiming
that he was "concerned with his decision-making capability and
particularly his state of emotional health," according to the lawsuit.
Boyer, however, was told that he was being fired because supposedly he
was "not a team player."
Boyer is about the only executive who was on
Conaway's executive team who isn't facing allegations of wrongdoing. He
was witness to most of the questionable financial practices detailed in
the 116-page lawsuit filed Tuesday by the Kmart Creditor Trust in
Oakland County Circuit Court.
And that makes him an ideal witness for the
host of federal and other investigations that have ensnared Kmart since
its Jan. 22, 2002, bankruptcy filing. The company emerged from
bankruptcy on May 6 as Kmart Holding Corp.
"I think his data that he would supply to
whatever source would be significant," said Joseph Whall, managing
director of Auburn Hills-based forensic accounting firm the Whall Group.
"It is extremely helpful to an investigation to
have an insider at an executive position that is openly discussing
wrongdoing," Whall said. "He's offering a highway to a critical danger
zone."
Boyer has been a key witness in several ongoing
investigations of Kmart's finances including those by a federal grand
jury, a congressional committee investigating corporate scandals, the
U.S. Securities and Exchange Commission and Kmart's own bankruptcy
lawyers.
And his legal bills are mounting. His role in
the investigations has added up to about $329,799 in legal fees. Boyer
has filed a claim for $1.27 million in Chicago bankruptcy court against
Kmart, saying the retailer has not lived up to its obligations under his
Nov. 23, 2001, separation agreement.
The bill had not been paid as of Thursday.
"Boyer has testified truthfully and endeavored
to assist Kmart in these legal proceedings," his lawyer, Seth Gould,
wrote in the claim. "As a result of such involvement, however, Boyer has
personally incurred hundreds of thousands of dollars in legal expenses."
Neither Boyer nor Gould would comment on
Thursday.
Boyer, who is now executive vice president and
chief financial officer for Michaels Stores Inc. of Irving, Texas, was
prominently mentioned throughout the civil lawsuit.
The lawsuit details how Boyer kept questioning
things like how Kmart was accounting for vendor allowances, which
companies pay retailers for space in the stores. The vendor allowances
were the basis for securities fraud charges brought and recently dropped
against two other former Kmart executives.
Boyer had also asked Kmart's auditors at
PricewaterhouseCoopers in several cases to look into various accounting
issues and was unsatisfied with the firm's work, according to the
lawsuit.
Large CPA firms are in a settlement mood Deloitte & Touche LLP is expected to announce today
it will pay a $50 million fine to settle Securities and Exchange Commission
civil charges that it failed to prevent massive fraud at cable company
Adelphia Communications Corp. In another case, the now-largely defunct
accounting firm Arthur Andersen LLP agreed to a $65 million settlement in a
class-action suit by investors in WorldCom Inc. over losses from stocks and
bonds of the once-highflying telecommunications company now known as MCI
Inc. These follow a $22.4 million settlement the SEC reached last week with
KPMG LLP related to its audits of Xerox Corp. from 1997 through 2000, and a
$48 million settlement by
PricewaterhouseCoopers LLP last month to end
class-action litigation over its audit of Safety-Kleen Corp., an
industrial-waste-services company that filed for bankruptcy-court protection
in 2000.
Diya Gullapalli, "Deloitte to Be Latest to Settle In Accounting Scandals,"
The Wall Street Journal, April 26, 2005; Page A3 ---
http://online.wsj.com/article/0,,SB111444033641815994,00.html?mod=todays_us_page_one
A former PricewaterhouseCoopers LLC employee has
instigated a class-action suit against the Big Four firm claiming unfair
pension practices, Pension and Investments reported.
In the suit filed in federal district court in
East St. Louis was amended on Jan. 28 and charges PwC and its partners
with coming up with “a brazen, unlawful scheme ... to game the tax and
pension laws in order to improperly pad the partners' retirement benefits
and take-home pay at the expense of both rank-and-file PwC employees and
the public,” Pension and Investments reported.
The suit was brought by former employee Timothy
D. Laurent and contends that the firm, which has been known for it's
creative cash-balance pension funds, intentionally broke age- and
income-discrimination provisions of federal law.
By “engaging in multiple layers of
deception,” the suit alleges, PwC and its partners reduced “benefits
to the paid rank-and-file employees down to the bare minimum thought
need(ed) to keep the shelter afloat.”
While federal pension law shields employers from
liability for the investment performance of participants' 401(k) plan
options, it does not apply to defined benefit plans, Pension and
Investments reported, meaning that a ruling in favor of Laurent and other
participants could cost the firm hundreds of millions of dollars.
MBIA
Inc. will restate more than six years of its financial statements in a
move acknowledging that it wrongly used a complex insurance transaction in
1998 to reduce losses on bonds it insured, the company said.
The announcement makes MBIA the
second major insurer this year to announce a restatement tied to faulty
accounting for complex insurance products they themselves used, following
in the heels of Bermuda-based RenaissanceRe
Holdings Ltd.
This is the bad news about PwC performance Eastman Kodak Co. said it will restate its
previously reported results for 2004 and 2003, lowering earnings, because of
accounting errors in pensions, income taxes and other areas. Kodak
said it expects to report results by March 31 and has applied for an
automatic extension of time to file the results, which were due yesterday.
Kodak said its auditor, PricewaterhouseCoopers, will, as expected, give an
adverse opinion on its internal financial-reporting controls. Kodak said it
has concluded it has a "material weakness" involving its
accounting for retirement benefits as well as for income taxes.
William M. Bulkeley, "Kodak to Restate Results for '03, '04,"
The Wall Street Journal, March 17, 2005; Page A6 --- http://online.wsj.com/article/0,,SB111101010575381521,00.html?mod=todays_us_page_one
Jensen Comment: The external independent auditor for Kodak is
PricewaterhouseCoopers (PwC)
This is the good news about PwC
performance
Eastman Kodak Co. released preliminary fourth-quarter results in line with
expectations, but said its auditors are expected to issue an "adverse
opinion" citing "material weaknesses" in its internal
financial controls for 2004.Kodak joins a growing list of corporations
reporting such problems under new Sarbanes-Oxley rules that went into effect
in November. Earlier this month, SunTrust Banks Inc., Atlanta, said it will
disclose a material weakness in its annual report. Last month Toys
"R" Us Inc. disclosed that it was working to resolve unspecified
internal-control issues.
"Kodak to Get Auditors'
Adverse View," by William M. Bulkeley and Robert Tomsho, The Wall
Street Journal, January 27, 2005, Page A# --- http://online.wsj.com/article/0,,SB110674149783836535,00.html
A federal magistrate judge in Ohio has concluded
that PricewaterhouseCoopers withheld evidence in an accounting fraud trial
brought by an audit client.
"Judge Rules that PricewaterhouseCoopers Withheld Evidence," AccountingWeb,
January 14, 2005 --- http://www.accountingweb.com/item/100381
A federal magistrate judge in Ohio has concluded
that PricewaterhouseCoopers withheld evidence in an accounting fraud trial
brought by an audit client. According to The New York Times, United States
Magistrate Judge Patricia A. Hemann recommended a default judgment against
the accounting firm for failing to turn over evidence sought by Telxon
Corporation, which makes bar code readers. Hemann's report, completed in
July, was unsealed Thursday and provided to The New York Times by a lawyer
in the case.
The newspaper reported that the firm found
multiple versions of documents in different places very late in the
proceedings. "In some cases, it is difficult to avoid the
conclusion" that PricewaterhouseCoopers "engaged in deliberate
fraud," Hemann wrote. She also wrote that "there is strong
evidence that documents have been destroyed, placing plaintiffs and Telxon
in a situation which cannot be remedied."
The judge's recommendation goes to U.S. District
Court Judge Kathleen O'Malley, who will order that the lawsuit proceed to
consider damages if she adopts the magistrate judge's report, according to
Jeffrey Zwerling, who represents shareholders. “Our experts tell us we
have damages for that period of $139 million,” he said.
According to court papers, both sides battled for
months over whether PricewaterhouseCoopers was required to produce certain
papers related to its audit work at Telxon. The magistrate judge's report
stemmed from motions filed by both Telxon and shareholders that the
accounting firm should be sanctioned for failing to follow discovery
rules.
"PricewaterhouseCoopers respectfully
disagrees with the magistrate judge's report and recommendation,” the
firm said in a statement. “We have filed extensive objections with the
district court judge to the magistrate judge's recommendation. We
acknowledge an error in discovering and producing documents in the
litigation later than that should have occurred. At the same time we
believe that our objections to the magistrate judge's recommendation are
well founded."
Even if the district court judge rejects the
magistrate judge's findings, they may hurt the firm's reputation, said
Arthur W. Bowman, editor of Bowman First Alert, an accounting industry
newsletter. "What the big four, the final four, use for
differentiation now is, they are higher quality than the
competition," Bowman said. "PricewaterhouseCoopers is one of
those using that kind of strategy, and this kind of occurrence will
destroy that."
Shareholders filed suit against Telxon after a
restatement of earnings in 1998. The company settled the shareholder
lawsuit last year, then filed a lawsuit against PricewaterhouseCoopers on
the claim that the firm did not follow generally accepted accounting
principles when it conducted its audits. Shareholders filed a separate
lawsuit contending the firm approved improper financial statements.
Conclusion: According to a press release dated October
27, 2005, PricewaterhouseCoopers LLP ("PwC") has agreed to pay $27.9
million to settle all claims asserted against it by class members who
purchased Telxon Corp. ("Telxon") securities during the period from June
29, 1998 through February 23, 1999.
http://securities.stanford.edu/1007/TLXN98/
May 23, 2003
PricewaterhouseCoopers Agrees to Pay $1M
May 23, 2003 (Associated Press) —
PricewaterhouseCoopers, the nation's largest accounting firm, has agreed
to pay $1 million to settle federal regulators' allegations that it
engaged in improper professional conduct in its audit work -- the second
time in less than a year it has been cited for that alleged infraction.
PricewaterhouseCoopers neither admitted nor
denied wrongdoing in the settlement that the Securities and Exchange
Commission announced Thursday. As it did last July in a similar accord
with the SEC, in which it paid $5 million, the firm also agreed to be
censured and to make changes in how it operates. That case involved
audits of 16 companies from 1996 to 2001.
At issue in the new case is
PricewaterhouseCoopers' 1997 audit of SmarTalk TeleServices Inc., a
provider of pre-paid phone cards and wireless services which the SEC
says is now bankrupt. Because the auditing firm failed to adequately
account for a $25 million reserve fund, SmarTalk filed with the SEC an
annual report "which contained materially false and misleading financial
statements," the agency said.
Spokesmen for New York-based
PricewaterhouseCoopers didn't immediately return a telephone call
seeking comment.
Nearly a year after now-fallen Arthur Andersen
LLC was convicted on obstruction of justice charges for destroying reams
of Enron audit documents, alleged violations by other big firms in the
scandal-tainted accounting industry continue to be cited.
In January the SEC sued another Big Four
accounting firm, KPMG LLP, alleging that it fraudulently allowed Xerox
Corp. to manipulate accounting practices to fill a $3 billion gap,
thereby satisfying investors about its financial performance. The agency
is seeking injunctions, repayment of auditing fees and unspecified civil
penalties. KPMG has defended its 1997-2000 audits of Xerox's financial
statements and has called the SEC's accusations unfounded.
Antonia Chion, an associate enforcement
director at the SEC, called the latest PricewaterhouseCoopers action an
example of the agency's "intention to adopt a new enforcement model -
one that holds an accounting firm responsible for the actions of its
partners."
"It also highlights the firm's failure to
maintain the integrity of its audit working papers," Chion said in a
statement.
Under the settlement, PricewaterhouseCoopers
agreed to establish new policies for preserving documents and to hire an
independent consultant to review its computer software system.
The SEC also alleged that Philip Hirsch, who
had been the lead audit partner for SmarTalk, engaged in improper
professional conduct. Hirsch, who neither admitted nor denied the
allegations, consented in a settlement to be barred from auditing
publicly traded companies for at least a year, with the right to apply
for reinstatement after that.
In the July 2002 case, the SEC alleged that
PricewaterhouseCoopers broke rules meant to ensure that auditors remain
independent from the companies whose books they oversee.
As a result of the rule violations, the SEC
found that 16 clients of the accounting firm submitted financial
statements from 1996 to 2001 that didn't comply with federal securities
laws. The violations were said to be related to PricewaterhouseCooper's
approval of clients' accounting treatment of costs that included the
accounting firm's own consulting fees.
Also, the SEC said that PricewaterhouseCoopers
entered into improper fee arrangements with the audit clients, in which
the companies hired PricewaterhouseCoopers' investment bankers to
provide financial advice for a fee that depended on the success of the
transaction the company was pursuing.
The new board created by Congress last year to
ovesee the accounting industry, which has the power to discipline
accountants, recently decided it also will establish new standards for
auditors governing quality control, professional ethics and their
independence from audit clients. The SEC on Wednesday formally approved
the appointment of William J. McDonough, president and chief executive
of the Federal Reserve Bank of New York, as chairman of the oversight
board.
April 25, 2003
Amerco Inc., the parent company of U-Haul International, itself hauled Big
Four accounting firm PricewaterhouseCoopers into federal court in Arizona
last week charging that the Big Four accounting firm was to blame for
Amerco's dire financial situation.
http://www.accountingweb.com/item/97460
Yawn!
Corporate America's Funniest (read that most boring) Home Video The Wall Street Journal, October 29,
2003
20-minute video of an extravagant birthday party for the wife of former
Tyco CEO L. Dennis Kozlowski depicts what many consider the height of
corporate excess. Three videos can be downloaded from links below:
Full:
Part 2):
http://play.rbn.com/?dowjones/wsj/demand/wsj_vid/tyco3_hi.rm
This is a Roman Orgy without the orgy. Actually everybody looks
pretty boring and bored. Neither video shows the life-sized naked
woman birthday cake. And the sculpture of David peeing vodka was
edited out of the flicks. The cake and the sculpture were not shown
to the jury in the Kozlowski trial. Just why these were edited out
is a mystery to me since they depict the sickness of this former Tyco CEO
more than the tame stuff on the jury's videos where all the bored actors
in togas wore underwear. What's left on the tape isn't worth
watching except to witness a boring waste of $2 million in corporate
dough. I've attended funeral parties (e.g., for my friend John
Bacon) in Pilots Grill in Bangor, Maine where the guests had more fun.
Bottom Line Conclusion: Success of a corporate party is defined as
what it cost rather than what it bought.
Has anybody read whether any partners from PwC attended the birthday
bash?
An enormous mystery for the Manhattan prosecutors has been how much
Tyco’s auditors knew about the about allegedly improper bonuses paid to
Kozlowski and other executives along with the improper spending of
corporate funds for personal expenses such as Kozlowski’s $65,000 New
England golf club membership ---
http://www.yourlawyer.com/practice/printnews.htm?story_id=2104
-----Original Message-----
From: Patricia Doherty
[mailto:pdoherty@BU.EDU]
Sent: Wednesday, October 29, 2003 9:20 AM
Subject: Re: Corporate America's Most Boring Home Video
I suppose one interesting fact that emerged is
the fact that his mistress planned his wife’s birthday party.
Remarkable what some people will put up with for money. They deserve
each other.
"If not this, then what?
If not now, then when?
If not you, then who?"
Patricia A. Doherty
Instructor in Accounting
Coordinator, Managerial Accounting
Boston University School of Management
595 Commonwealth Avenue
Boston, MA 02215
Question
First there's a problem of simply accepting something by word of mouth.
Second there is a problem of accepting the word of mouth of an executive
with an obvious conflict of interest. Is this acceptable auditing
procedure?
"Tyco Auditor Raised, Dropped Bonus Disclosure, Witness Says,"
by Chad Bray, The Wall Street Journal, February 18, 2005, Page C3 ---
http://snipurl.com/TycoFeb18
NEW YORK -- Tyco International Ltd.'s former head
of finance testified yesterday that the company's lead auditor initially
raised concerns that Tyco didn't disclose millions of dollars in
relocation-loan forgiveness and other payments to top executives L. Dennis
Kozlowski and Mark H. Swartz in 2000.
However, Mark D. Foley, the conglomerate's former
senior vice president of finance, said PricewaterhouseCoopers partner
Richard Scalzo dropped his objections after Mr. Foley told him that Mr.
Swartz had consulted outside lawyers who concurred the bonuses didn't need
to be in the proxy because they were associated with relocation loans. Mr.
Foley said he had raised similar concerns to Mr. Swartz, Tyco's then-chief
financial officer.
"Rick was OK" with it, Mr. Foley said
in response to a question by Assistant District Attorney Marc Scholl.
Prosecutors claim that Messrs. Swartz and
Kozlowski, Tyco's former chief executive, granted themselves millions of
dollars in unauthorized bonuses and other compensation, including $48
million in loan forgiveness and other payments in connection with the
initial public offering of its optical-fiber unit Tycom in 2000.
Messrs. Kozlowski, 58 years old, and Swartz, 44,
are on trial in New York state court. They have denied wrongdoing. Their
first trial ended in a mistrial in April. Tyco has its headquarters in
Bermuda, but now operates out of West Windsor, N.J.
Scalzo Knew That Executives Got Payments, but Didn't Check If Board Had
Given Approval
In essence, that has been a key defense claim
in the continuing criminal trial of two former Tyco International Ltd.
executives. To rebut charges that the executives took unauthorized
bonuses and loans, defense attorneys have repeatedly stressed that the
disputed transactions were reviewed by the company's outside auditor,
PricewaterhouseCoopers LLP.
Wednesday, prosecutors called a key witness to
try to counter that defense, Pricewaterhouse partner Richard Scalzo. Mr.
Scalzo, who oversaw Tyco's books from 1993 to 2002, testified that he
reviewed the accounting for some of the disputed bonuses and loans, but
never checked to see whether they were approved by the company's board
or compensation committee.
"That wasn't part of our auditing procedure,"
Mr. Scalzo said at one point in response to a prosecutor's question as
to why Pricewaterhouse didn't determine whether loans taken out by the
defendants had been approved by the board.
Former Tyco Chief Executive L. Dennis Kozlowski
and former Chief Financial Officer Mark Swartz are on trial in state
court in Manhattan, charged with improperly using Tyco funds to enrich
themselves and others. Each faces as much as 30 years in prison. They
have denied wrongdoing.
In cross-examining prior witnesses, defense
attorneys have repeatedly referred to so-called management
representation letters sent by Tyco executives to Pricewaterhouse, in
which the disputed bonuses were mentioned. Prosecutors have claimed the
defendants stole the bonuses without board knowledge, but the defense
has countered that the letters to Pricewaterhouse are evidence the
defendants weren't trying to hide anything.
Wednesday, Mr. Scalzo testified that
Pricewaterhouse asked Tyco management to include representations of how
it was handling the accounting for two of the bonuses paid to
executives, supposedly related to the success of the initial public
offering of the company's Tycom optical-fiber unit and the sale of its
ADT Automotive unit.
In the letter, which was signed by Mr.
Kozlowski and Mr. Swartz, Tyco said it considers management bonuses
associated with those transactions as "direct and incremental costs" in
those deals. Mr. Scalzo testified that he concurred with the accounting
treatment for the bonuses, but never checked to see if they were
authorized. "Based on the work we performed and the representation of
management, I concurred with the accounting position," he said.
Later, Mr. Scalzo said he contacted Mark Foley,
then-head of Tyco's finance department, after reviewing a draft of the
company's coming proxy and finding it didn't reflect the full Tycom
bonus. He said Mr. Foley told him that Tyco's attorneys had said the
bonus didn't need to be disclosed in the proxy. Mr. Scalzo said he told
Mr. Foley the treatment was "unusual," but he considered it the end of
the matter.
"It's a legal issue, not an accounting issue,"
Mr. Scalzo said.
Judge Michael Obus, who is presiding over the
case, ruled Wednesday that Mr. Scalzo wouldn't be allowed to testify
about a settlement and cooperation agreement he reached with the
Securities and Exchange Commission last year. In August, the SEC
permanently barred Mr. Scalzo from public-company accounting and
auditing. At the time, he didn't admit or deny the SEC's claims of
improper professional conduct in auditing Tyco's financial reports from
1998 through 2001.
Wednesday, Mr. Scalzo testified that
Pricewaterhouse asked Tyco management during three separate auditing
years to disclose noninterest-bearing loans made by Tyco to employees,
including top executives. On each occasion, Tyco management responded
that the loans didn't need to be disclosed. Relocation loans provided by
Tyco to its employees were noninterest-bearing.
"I consider Mark Swartz part of Tyco
management," said Mr. Scalzo in response to a question from prosecutors
about whether he discussed not disclosing the loans with Mr. Swartz. He
later said that Mr. Swartz responded to him in writing through the
management-representation letter attached to each year's audit.
Mr. Scalzo also testified that the auditors
didn't review whether the board approved loans to top executives as part
of its audit of the Bermuda conglomerate's financials. Instead, auditors
reviewed a list of loans outstanding to determine if the executive was
still employed by the company and would be able to repay the loan.
Meanwhile, Mr. Scalzo said that conducting an
annual audit of Tyco was a massive undertaking with teams of auditors
working in more than 100 countries and multiple teams working in the
U.S. As a result, the auditors prioritized which matters were reviewed
and who reviewed them. "We didn't look at every single piece of paper,
every single account, every single transaction," the auditor said.
AccountingWEB US - Mar-6-2003 -
Last week VTech Holdings Ltd filed a $400 million lawsuit against
PricewaterhouseCoopers (PwC) stemming from VTech’s acquisition of a
business unit of Lucent Technologies in 2000. VTech alleges that PwC
concealed information about the unit’s financial condition.
According to the suit, filed in a Manhattan
federal court, PricewaterhouseCoopers allegedly convinced VTech to pay
$113.3 million for the Lucent unit in order to impress its "bigger
paying client." PwC was acting as an advisor for Lucent at the time of
the transaction.
"We see no basis for any lawsuit against us,"
said Steven Silber, a spokesperson for PwC.
VTech, a Hong Kong-based company, designs,
manufactures, markets and sells electronic learning and
telecommunication products. It paid $113 million for the consumer
telephone assets of Lucent, an AT&T spin-off. The acquisition
doubled VTech’s consumer telecommunications business and gave it an
exclusive 10-year right to use the AT&T brand name in the U.S. and
Canada.
Continued in the article.
Amerco Inc., the parent company of U-Haul International, itself hauled
Big Four accounting firm PricewaterhouseCoopers into federal court in
Arizona last week charging that the Big Four accounting firm was to blame
for Amerco's dire financial situation.
http://www.accountingweb.com/item/97460
PricewaterhouseCoopers accused of lax audits of Gazprom
Welcome to the
first issue of BusinessWeek Online's European Insider. This weekly
newsletter contains highlights of news, analysis, commentary, and
regular columns that cover Europe specifically, as well as other stories
with wide international impact.
Angry investors
are accusing PricewaterhouseCoopers of lax audits of Gazprom. Did the
accounting firm ignore the energy giant's insider dealing and shady
asset transfers?
SPEs and Off Balance Sheet Financing Advice
from PwC
"U Haul's Parent Citing Faulty Advice Sues Its Old Auditor," Reuters,
REUTERS April 22, 2003
Amerco Inc., the
parent of U-Haul International, said yesterday that it had sued its
former auditor PricewaterhouseCoopers for more than $2.5 billion in
damages.
In the suit, Amerco accused
PricewaterhouseCoopers of providing financial advice that it said was
flawed and led it to the brink of bankruptcy.
The suit, filed on Friday in the
Federal District Court
for
Arizona
, contends PricewaterhouseCoopers's advice, coupled with delays in
disclosing an error once it was discovered, caused events that put
Amerco in "serious jeopardy."
Amerco said the delay forced it to postpone
filing financial statements with regulators and put it in danger of
being delisted from the Nasdaq stock market. Amerco, which named a new
finance chief last week, avoided bankruptcy by reaching an agreement
with lenders last month.
"They gave us bad advice for seven straight
years," Amerco's general counsel, Gary Klinefelter, said in an interview
yesterday. "We're in the business of renting out trucks and trailers,
and they're in the business of giving out accounting advice."
A spokesman for PricewaterhouseCoopers, David
Nestor, said the lawsuit appeared to be an effort by Amerco's management
to shift blame away from itself.
"The primary responsibility for the accuracy of
financial statements lies with the company," Mr. Nestor said. "Once it
became apparent that there was an error in Amerco's, we worked with them
to get their financial statements correct, which is, of course, the
important thing."
The dispute centers on financing arrangements
known as special purpose entities that Amerco set up in the mid-1990's.
These were created to help expand the company's self-storage business
without weighing down its balance sheet with debt.
Mr. Klinefelter said the idea for the special
purpose entities, a term that has gained notoriety since they played a
crucial role in
Enron's collapse, came from PricewaterhouseCoopers, which guided the
deals.
Amerco said in the lawsuit that it had been
assured by PricewaterhouseCoopers that the special purpose entities
could be excluded from its financial statements under federal accounting
rules. But last year, after the Enron debacle put the spotlight on these
arrangements, PricewaterhouseCoopers re-examined the accounting and
realized that Amerco's financial statements had to be restated to
include those entities, Amerco said.
In August 2003,
Pricewaterhouse Coopers agreed to pay more than $50 million to settle a
suit by MicroStrategy investors who alleged that the firm defrauded them
when it approved MicroStrategy's financial reports. The PwC
engagement partner was banned from future audits of corporations listed
with the SEC.
Lucent admitted it had incorrectly accounted for $679 million in revenue
in its fiscal 2000 fourth quarter.
Lucent Technologies Inc. said Thursday night that it had settled
massive shareholder litigation for a total of $568 million in cash,
stock and warrants, in one of the largest such settlements in history.
The size of the settlement shows
the amount of risk that Lucent, one of the country's most widely held
stocks, faced from at least 54 shareowner lawsuits. People involved in
the case said that the Murray Hill, N.J., company faced a potential
bankruptcy situation if it had gone to trial and lost.
The settlement also shows that
Lucent is trying to put its woes behind it. Just last month, the company
settled a civil case with the Securities and Exchange Commission without
admitting or denying any wrongdoing, though Lucent vowed not to violate
securities laws in the future. The SEC had been investigating Lucent's
sales practices for over two years. "The clouds have been put behind
us," said Kathleen Fitzgerald, Lucent's spokeswoman.
The main thrust of the
shareholder suits claimed that the large telecommunications-maker
engaged in financial fraud and aggressive sales practices to sustain its
growth during the height of the telecom boom, from the time of its
fourth-quarter 1999 financial results until December 2000. Then, Lucent
admitted it had incorrectly accounted for $679 million in revenue in its
fiscal 2000 fourth quarter.
The settlement will pay the
estimated five million holders of Lucent stock between Oct. 26, 1999,
and Dec. 21, 2000, a mix of both cash and stock totaling $315 million.
According to the company, it will have discretion to issue these
shareholders either stock or cash.
Lucent said its insurers agreed
to pay another $148 million in cash, and Lucent also will issue 200
million stock warrants to shareowners, with a strike price of $2.75 and
a three-year expiration. The company estimates the current value of
those warrants at $100 million. The company said it would contribute
another $5 million for administration of the claims process. While the
company hopes to recover some of its portion of the settlement from
insurers, Lucent said it expects to take a charge in the second quarter
of $420 million, or 11 cents a share.
Attorneys for the plaintiffs, led
by New York firm Milberg Weiss Bershad Hynes & Lerach LLP, also will
collect a sizable amount for their work in the case. Partner David
Bershad said the attorneys expect to seek fees of as much as 20% of the
total settlement, and the attorneys would take the same proportion of
cash, stock and warrants that shareholders get. That would mean fees of
as much as $115 million. Both the settlement and the attorneys' fees
require court approval.
Mr. Bershad said in an interview
Thursday night that he believed the plaintiffs' cases posed "a serious
threat" to Lucent.
The Securities
and Exchange Commission is expected to announce as early as Wednesday
that PricewaterhouseCoopers LLP has agreed to pay $5 million to settle
three separate enforcement actions alleging violation of independence
standards and improper accounting.
The agreements
will outline accounting violations involving two audit clients: Pinnacle
Holdings Inc., and Avon Products Inc. A third case involves independence
violations by the firm's broker-dealer, PwC Securities.
In a letter dated Wednesday, PricewaterhouseCoopers Chairman Dennis
Nally disclosed to the firms' partners that the SEC settlement was
imminent and that the firm, without admitting or denying the
allegations, had agreed to pay a fine and make improvements to audit
procedures.
"Despite the potential for unfavorable publicity, we believe that
settling these issues now is in the best interest of our firm and our
clients," Mr. Nally wrote.
PricewaterhouseCoopers spokesman David Nestor said the firm doesn't
"comment on SEC matters." An SEC spokeswoman said the agency doesn't
confirm or deny investigations.
The SEC believes the settlements are highly significant because they
demonstrate how consulting-fee arrangements allegedly led directly to
the audit clients' improper accounting, according to a person with
knowledge of the settlement. In the late 1990s, when former SEC Chairman
Arthur Levitt was pushing to limit accounting firms from cross-selling
some consulting services to audit clients, the accounting profession
argued such restrictions weren't necessary because there had never been
an example of an audit tainted by consulting arrangements.
"This is one of those cases," this person said.
The SEC is expected to allege that Pinnacle Holdings, Sarasota, Fla.,
with the approval of PricewaterhouseCoopers, improperly wrote off the
cost of the auditor's continuing consulting services as part of a
merger-related reserve.
In August 2000, Pinnacle Holdings, an operator of communications towers,
disclosed in SEC filings that the commission had begun a formal
investigation into whether PricewaterhouseCoopers compromised its
independence as Pinnacle's auditor by providing certain unspecified
nonaudit services. In December 2001, Pinnacle announced a settlement
with the SEC relating to Pinnacle's original accounting for an August
1999 acquisition of certain assets from
Motorola Inc. Pinnacle restated its accounting for that transaction
in filings made in April and May 2001 to reflect those changes in
accounting. Since then, Pinnacle has changed its auditing firm to Ernst
& Young LLP.
The SEC also is expected to allege that Avon Products should have
written off the consulting cost of the accounting firm's work on a
nonoperating management system project, but instead kept a portion of
the cost on its books as an asset, said a person with knowledge of the
situation.
Avon, a New York cosmetics company, has been responding to a two-year,
formal SEC investigation that concerns a special charge reported by Avon
in the first quarter of 1999 that included the write off of costs
associated with a management-software system, the company has said in
SEC filings. The balance of the project's development costs had been
carried as an asset until the third quarter of 2001, when Avon recorded
a pretax charge of $23.9 to write off the carrying value of costs
related to that project.
In SEC filings, the company has said, "as part of a resolution of the
investigation or at the conclusion of a contested proceeding, there may
be a finding that Avon knew or should have known in the first quarter of
1999 that it was not probable that [the software project] would be
implemented and therefore, the entire [software project] asset should
have been written off as abandoned at that time."
In the matter of PwC Securities, Mr. Nally's letter said, "the SEC found
that PricewaterhouseCoopers violated independence rules due to
contingent fee arrangements entered into by PwC Securities with fourteen
of the firm's" audit clients. The SEC order states "that the SEC is not
alleging that the financial statements of any of the clients were
misstated," according to the PricewaterhouseCoopers letter. As a result
of the contingent fee arrangements, the firm disciplined three
supervisors, the letter said. In 2001, the firm sold a significant
portion of the broker-dealer business.
Hi Justin,
I think it was the auditor of American Express at the time which was PW
which is now PwC. Shortly thereafter American Express changed to
Ernst and Whinny.
Allied was not a quoted company therefore was
not subject to the SEC requirement of filing audited reports by an
independent auditor. But American Express was subject to these
requirements. In the investigation on the Allied fraud attention tended
to focus on American Express and their procedures. Points (a) and (b)
below deal with the obvious weaknesses here. It is important however to
examine the accounting and auditing points in this case from the
perspective of the lenders - the banks, brokers and export companies
involved. Points (d) to (f) deal with these and the lessons in this case
for accountants, managers and regulatory agencies.
a) There was clearly staff collusion in the
fraud on a massive scale. Rumours from staff and information on the
scale of the fraud were ignored and dismissed as "too fantastic". An
employee of American Express told Miller that tank number 6006 contained
sea water. This was not properly followed up. After the fraud was
discovered and the discharge valve released on this tank sea water
poured out for 12 days
b) American Express' internal auditors and at
one point their external auditors (who did an inventory check at the
tank farm on a specially requested investigation by head office) were
too willing to accept facile explanations of disturbing evidence. On
finding water in the samples, they accepted the explanation that this
was from broken steam pipes. Expert advice from an independent chemical
analyst was not sought. Samples were actually sent to Allied's own
chemist.
c) The independence of the American Express
auditors and the weekly checkers was compromised by accepting and being
guided to what Allied wanted checked
Bob Jensen
-----Original Message-----
From: Justin Mock
[mailto:justinmock@hotmail.com]
Sent: Tuesday, February 03, 2004 6:20 PM
To: Jensen, Robert Subject: Salad Oil Swindle
Hello Dr. Jensen,
I'm a college student working on a series of
fraud case studies as an independent study project at Miami University
and have stumbled upon your site and its many resources. Most of your
material is current, but I thought you might be able to help me with one
query that has thus far gone unanswered.
I simply can not find who the auditors were of
Allied Crude Vegetable Oil Refining of Salad Oil Swindle fame. Any idea?
Thanks for any information.
Justin Mock
Helpers for Courses on Fraud and
Forensic Accounting
The
Securities and Exchange Commission plans to launch computer software
this year to spot accounting anomalies, including potential fraud,
in the financial statements that companies file with the agency.
The
software would scan a firm’s financial disclosures, assess risk
factors and generate a score based on a model developed by the
agency, Craig Lewis, the SEC’s chief economist, said in a recent
speech. The score would be used to identify outliers within a peer
group.
“It is a
model that allows us to discern whether a registrant’s financial
statements stick out from the pack,” said Lewis, who also heads the
agency’s risk, strategy and financial innovation division.
The
software is scheduled to be available in nine months.
The effort
is the most recent sign of the agency’s commitment to beef up its
technological prowess as it tries to better police Wall Street and
avoid oversight lapses such as the ones that allowed Bernard
Madoff’s Ponzi scheme to go undetected for years.
The SEC has
acknowledged that it lags behind the industries it regulates when it
comes to technology, in part because of a tight budget that is
subject to the whims of Congress. While nearly all financial
regulators operate on fees collected from the industries they
oversee, the SEC’s funding is decided by lawmakers on a year-to-year
basis. Uncertainty about the budget makes it difficult to commit to
technology or upgrade it.
The SEC
took that into account when it embarked on its most ambitious
technological endeavor in recent history — a software package that
will stream real-time trade data from the exchanges into the
agency’s headquarters. Rather than build the technology from scratch
at great expense, the agency purchased it from a New Jersey firm
called Tradeworx. The project, called Market Information Data
Analytics, or MIDAS, is in the final testing phases.
The new
software is based on a model that the SEC has used to evaluate hedge
fund returns and identify fraud, mostly by looking for performance
that was inconsistent with a fund’s investment strategy. The agency
has brought seven cases based on information culled from that
project since 2011.
“This
success has only fed our ambition for what we can do with
sophisticated data-driven monitoring programs,” Lewis said. The goal
is to make use of the “veritable treasure trove of information” that
the SEC regularly receives from companies.
The new
software would focus on accounting anomalies.
Under the
2002 Sarbanes-Oxley law, the SEC must examine the financial filings
from public companies every three years. But only recently have all
companies been required to file those forms in a digital format with
computer-readable tags that make it easy to search for and compare
items of data, either for a single firm over time or across
companies.
The
new software would search for unusual accounting by looking at
various risk factors such as frequent changes in auditors or delays
in the release of earnings. But it would not be used solely to
detect fraud. It could also pinpoint areas in which companies can
improve the quality of their financial disclosures, Lewis said.
The mechanics of a
fraud investigation and associated ramifications for business
professionals are the theme of The Guide to Investigating Business
Fraud, the latest book publication from the American Institute of
Certified Public Accountants’ Specialized Publications Group.
Authored by a team
of seasoned professionals from Ernst & Young’s Fraud Investigation
and Dispute Services (FIDS) Practice, the guide delivers practical,
actionable guidance on fraud investigations from the discovery phase
through resolution and remediation.
“The decade’s
high-profile scandals, with the Bernard Madoff Ponzi scheme being
the most recent, underscore exactly how critical it is for CPAs and
the business owners, controllers and managers they advise to
understand what to do when fraud hits, how a fraud investigation
works, and how to avoid problems during the investigation,” said
Arleen Thomas, AICPA senior vice president – member competency and
development. “This book provides a very clear framework.”
Thomas added that a
June report by the Federal Bureau of Investigation, in which the FBI
disclosed that it had opened more than 100 new cases involving
corrupt business practices in the previous 18 months, emphasizes the
need for the new guidance.
Ernst & Young
Principal Ruby Sharma, the main editor and a contributing author,
notes the book, which collects the knowledge of 18 firm
contributors, took over two years to develop.
“This book is the
result of many professionals’ hard work and draws upon their
extensive experience,” she said. “This book is for forensic
accountants, litigation attorneys, corporate boards and management,
audit committees, students of accounting and anybody interested in
understanding the risk of fraud and its multiple implications."
In 14 chapters
arranged to track the time sequence of an investigation and all
anchored to a central case study, The Guide to Investigating
Business Fraud answers four basic questions:
How do fraud experts
examine and work a fraud case? How do you reason and make decisions
at critical times during the investigation? How do you evaluate a
case and interact with colleagues? How do you handle preventive
anti-fraud programs?
In addition to
Sharma, the editors are Michael H. Sherrod, senior manager, Richard
Corgel, executive director; and Steven J. Kuzma, Americas Fraud
Investigation and Dispute Services chief operating officer.
The Guide to
Investigating Business Fraud is available from CPA2Biz (
www.cpa2biz.com
). The cost is $79 for AICPA members and $98.75 for non-members.
Jensen Comment
This book is weak on derivatives accounting but stronger on economics,
finance, and law.
Chapter 1 has a short summary of ancient history.
Question
Can any of you identify the mystery "Fraud Girl" who will be writing a weekly
(Sunday) column for Simoleon Sense?
Hint
She seems to have a Chicago connection and seems very well informed about the
blog posts of Francine McKenna. http://retheauditors.com/
But I really do know know who is the mystery "Fraud Girl."
I’m exceptionally proud to introduce you to Fraud
Girl, our new Sunday columnist. She will write about all things corp
governance, fraud, accounting, and business ethics. To give you some
background (and although I can not reveal her identity). Fraud girl recently
visited me in Chicago for the Harry Markopolos presentation to the local
CFA. We were incredibly lucky to meet with Mr. Markopolos and enjoyed 3
hours of drinks and accounting talk. Needless to say Fraud Girl was leading
the conversation and I was trying to keep up. After a brainstorm session I
persuaded her to write for us and teach us about wall street screw-ups.
So watch out, shes smart, witty, and passionate
about making the world a better place. I think Sundays just got a lot
better…
Regulators, Ignore the Masses — It’s Your Responsibility
Men in general judge more by the sense of
sight than by the sense of touch, because everyone can see but only
a few can test feeling. Everyone sees what you seem to be, few know
what you really are; and those few do not dare take a stand against
the general opinion, supported by the majesty of the government. In
the actions of all men, and especially of princes who are not
subject to a court of appeal, we must always look to the end. Let a
prince, therefore, win victories and uphold his state; his methods
will always be considered worthy, and everyone will praise them,
because the masses are always impressed by the superficial
appearance of things, and by the outcome of an enterprise. And the
world consists of nothing but the masses; the few have no influence
when the many feel secure.
-Niccolo Machiavelli,
The Prince
Why are Machiavelli’s words so astonishingly
prophetic? How does a 500 year old quote explain contagion, bubbles, and
Ponzi schemes? Do financial decision makers consciously overlook reality or
do they merely postpone due diligence? That is the purpose of this series —
to analyze financial fraud(s) and question business ethics.
Recent accounting scandals i.e. Worldcom, Enron,
Madoff, reveal a variety of methods for boosting short term performance at
the expense of long run shareholder value. WorldCom recorded bogus revenue,
Enron boosted their operating income through improper classifications, and
Madoff ran the largest Ponzi scheme in history. Sure these scandals were
unethical, deceived the public, and made a ton of money. But what is the
most striking similarity? Each of these companies was seen as the golden
goose egg; an indestructible force that could never fail. Of course, the key
word is “seen”, regulators, attorneys, financial analysts, and auditors
failed to see reality. But why?
Fiduciaries are entrusted with protecting the
public and shareholders from crooks like Skilling, Pavlo, and Schrushy. An
average shareholder lacks the knowledge and expertise of a prominent
regulator, right? Shareholders don’t perform the company’s annual audit,
review all legal documentation, or communicate with top executives. No,
shareholders base their decisions off information that is “accurate” and
“meticulously examined”.
Unfortunately in each of these instances regulators
failed to take a stand against consensus and became another ignorant face in
the crowd. “Everyone sees what you seem to be, few know what you really are;
and those few do not dare take a stand against the general opinion”. Who are
the few that really know who these companies are? The answer should be
evident. What isn’t clear is why these cowardly few are in charge of
overseeing our financial markets.
When Auditors Look The Other Way
A week ago, I came across this article:
Ernst & Young defends its Lehman work in letter to clients.
I chuckled as I was reading it, remembering Roxie Hart
from the play Chicago shouting the words “Not Guilty” to anyone who would
listen. Like Roxie, the audit team pleaded that the media was inaccurate. In
recording Lehman’s Repo 105 transactions, they claimed compliance with GAAP
and believed the financial statements were ‘fairly represented’. But, fair
reporting is more than complying with GAAP. Often auditors are “compliant”
while cooking the books (a mystery that still eludes me). In this case, the
auditors blatantly covered their eyes and closed their ears to what they
must have known was deliberate misrepresentation of Lehman Brother’s
financial statements.
We will explore the Lehman Brothers fiasco in next
week’s post…but here’s the condensed version. Days prior to quarter end,
Lehman Brothers used “Repo 105” transactions, which allowed them to lend
assets to others in exchange for short-term cash. They borrowed around $50
Billion; none of which appeared on their balance sheet. Lehman instead
reported the debt as sales. They used the borrowed cash to pay down other
debt. This reduced both their total liabilities and total assets, thereby
lowering their leverage ratio.
This was allegedly in compliance with SFAS 140,
Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities that allowed Lehman to move the $50 Billion
of assets from its balance sheet. As long as they followed the rules,
auditors could stamp [the] financial statements with a “Fairly Represented”
approval and issue an unqualified opinion.
Clearly in this case complying was unethical and
probably illegal.
Howard Schilit, the author of Financial Shenanigans:
How to Detect Accounting Gimmicks & Fraud in Financial Reports,
once said, “You [the auditor] work for the investor, even though you are
paid by someone else”. He insists that auditors should look beyond the
checklists and guidelines and should instead question everything. Auditors
are the first line of defense against fraud and the shareholders are
dependent upon the quality of their services. So I ask again, with respect
to Lehman Brothers, were the auditors working for the investors or where
they in the pockets of senior management?
What can we do?
An admired value investor believes in a similar
tactic for confirming the honesty of companies. It’s known as “killing the
company”, where in his words, “we think of all the ways the company can die,
whether it’s stupid management or overleveraged balance sheets. If we can’t
figure out a way to kill the company, then you have the beginning of a good
investment”. Auditors must think like this, they must kill the company, and
question everything. If you can’t kill a company, then (and only then) are
the financial statements truly a fair representation of the firms
operations.
There was no “killing” going on when the lead
auditing partner said that his team did not approve Lehman’s Accounting
Policy regarding Repo 105s but was in some way comfortable enough with them
to audit their financial statements. This engagement team failed in looking
beyond SFAS 140 and should have realized what every law firm (aside from one
firm in London) was stating; that the accounting methods Lehman Brothers
used to record Repo 105s were a deliberate attempt to defraud the public.
So I repeat: Ignoring reality is not an option.
Ignoring the crowd, however, is an obligation.
“The
greatest past users of deception…are highly individualistic and
competitive; they would not easily fit into a large
organization…and tend to work by themselves. They are often
convinced of the superiority of their own opinions. They do in
some ways fit the supposed character of the lonely, eccentric
bohemian artist, only the art they practice is different. This
is apparently the only common denominator for great
practitioners of deception such as Churchill, Hitler, Dayan, and
T.E. Lawrence”
-Michael I. Handel (58)
Welcome
Back.
Last week
we wrapped up Part II of the Fraud by Hindsight case. We noted that
hindsight bias is a major concern in securities litigation & fraud
cases. We explained how fraud by hindsight leads judges to
misinterpret relevant facts and such let financial criminals off the
hook.
This week
we will analyze the work of Paul Ekman, a professor at the
University of California who has spent approximately 50 years
analyzing human emotions and nonverbal communication. Ekman’s work
is featured in the television show “Lie to Me”. One of his most
popular books, Telling Lies: Clues to Deceit in the Marketplace,
Politics, and Marriage, describes “how lies vary in form and how
they can differ from other types of misinformation that can reveal
untruths”. He claims that although ‘professional lie hunters’ can
learn how to recognize a lie, the so-called ‘natural liars’ can
still fool them.
So the
question is:
Can most
financial felons be classified as ‘natural liars’? If so, is it at
all possible to catch them via their body language, voice, and
facial expressions?
To
test this, I examined (a clip from) the February 2002 testimony of
former Enron CEO Jeff Skilling to see if I could spot any deception
clues. In his testimony, Skilling pleads that his resignation from
Enron was solely for personal reasons and that he had no knowledge
that Enron was on the brink of collapse. In order to not be misled
by Skilling’s words, I watched the testimony without sound and
focused solely on his facial expressions and body movements. Ekman
noted, “most people pay most attention to the least trustworthy
sources – words and facial expressions – and so are easily misled”
(81). In trying to be coherent with Ekman’s beliefs, this is what I
found on Jeff Skilling:
"Happy, sad, angry or astonished?" PhysOrg, July 3, 2007 ---
An advertisement for a new perfume is hanging in
the departure lounge of an airport. Thousands of people walk past it every
day. Some stop and stare in astonishment, others walk by, clearly amused.
And then there are those who seem puzzled when they look at the poster.
With the help of a small video camera, the system
automatically localizes the faces of everyone who walks past the
advertisement. And nothing escapes its watchful eye: Does the passerby look
happy, surprised, sad or even angry?
The system for rapid facial analysis is being
developed by researchers at the Fraunhofer Institute for Integrated Circuits
IIS in Erlangen. Highly complex algorithms immediately localize human faces
in the image, differentiate between men and women and analyze their
expressions.
“The special feature of our facial analysis
software is that it operates in real time,” says Dr. Christian Küblbeck,
project manager at the IIS. “What’s more, it is able to localize and analyze
a large number of faces simultaneously.” The most important facial
characteristics used by the system are the contours of the face, the eyes,
the eyebrows and the nose. First of all, the system has to go through a
training phase in which it is presented with huge quantities of data
containing images of faces. In normal operation, the computer compares
30,000 facial characteristics with the information that it has previously
learned.
“On a standard PC, the calculations are carried out
so quickly that mood changes can be tracked live,” explains Küblbeck.
However, we do not need to worry about an invasion of our privacy, as the
software analyzes the data on a purely statistical basis.
The software package is not only of interest to
advertising psychologists; there are numerous potential applications for the
system. It can be used, for example, to test the user-friendliness of
computer software programs. The system monitors the facial expressions of
the user in order to determine which aspects of the program arouse a
particularly strong reaction. Alternatively, it can assess the reactions of
the users of learning software, in order to establish the extent to which
they are put under stress or challenged by the task they are performing. The
system could also be used to check the levels of concentration of car
drivers.
"Happy, sad, angry or astonished?" PhysOrg, July 3, 2007 ---
An advertisement for a new perfume is hanging in
the departure lounge of an airport. Thousands of people walk past it every
day. Some stop and stare in astonishment, others walk by, clearly amused.
And then there are those who seem puzzled when they look at the poster.
With the help of a small video camera, the system
automatically localizes the faces of everyone who walks past the
advertisement. And nothing escapes its watchful eye: Does the passerby look
happy, surprised, sad or even angry?
The system for rapid facial analysis is being
developed by researchers at the Fraunhofer Institute for Integrated Circuits
IIS in Erlangen. Highly complex algorithms immediately localize human faces
in the image, differentiate between men and women and analyze their
expressions.
“The special feature of our facial analysis
software is that it operates in real time,” says Dr. Christian Küblbeck,
project manager at the IIS. “What’s more, it is able to localize and analyze
a large number of faces simultaneously.” The most important facial
characteristics used by the system are the contours of the face, the eyes,
the eyebrows and the nose. First of all, the system has to go through a
training phase in which it is presented with huge quantities of data
containing images of faces. In normal operation, the computer compares
30,000 facial characteristics with the information that it has previously
learned.
“On a standard PC, the calculations are carried out
so quickly that mood changes can be tracked live,” explains Küblbeck.
However, we do not need to worry about an invasion of our privacy, as the
software analyzes the data on a purely statistical basis.
The software package is not only of interest to
advertising psychologists; there are numerous potential applications for the
system. It can be used, for example, to test the user-friendliness of
computer software programs. The system monitors the facial expressions of
the user in order to determine which aspects of the program arouse a
particularly strong reaction. Alternatively, it can assess the reactions of
the users of learning software, in order to establish the extent to which
they are put under stress or challenged by the task they are performing. The
system could also be used to check the levels of concentration of car
drivers.
Questions
Has the art and science of reading faces ever been part of an auditing
curriculum?
Have there been any accountics studies of Ekman's theories as applied to
auditing behavioral experiments? (I can imagine that some accounting doctoral students have not experimented
along these lines?)
Ekman's work on facial expressions had its starting
point in the work of psychologist
Silvan Tomkins.[Ekman
showed that contrary to the belief of some
anthropologists including
Margaret Mead, facial expressions of emotion are
not culturally determined, but universal across human cultures and
thus
biological in origin. Expressions he found to be
universal included those indicating
anger,
disgust,
fear,
joy,
sadness, and
surprise. Findings on
contempt are less
clear, though there is at least some preliminary evidence that this emotion
and its expression are universally recognized.]
In a research project along with Dr. Maureen
O'Sullivan, called the
Wizards Project (previously named the
Diogenes Project), Ekman reported on facial "microexpressions"
which could be used to assist in lie detection. After testing a total of
15,000 [EDIT: This value conflicts with the 20,000 figure given in the
article on Microexpressions] people from all walks of life, he found only 50
people that had the ability to spot deception without any formal training.
These naturals are also known as "Truth Wizards", or wizards of
deception detection from demeanor.
He developed the
Facial Action Coding System (FACS) to taxonomize
every conceivable human facial expression. Ekman conducted and published
research on a wide variety of topics in the general area of non-verbal
behavior. His work on lying, for example, was not limited to the face, but
also to observation of the rest of the body.
In his profession he also uses verbal signs of
lying. When interviewed about the Monica Lewinsky scandal, he mentioned that
he could detect that former President
Bill Clinton was lying because he used
distancing language.
Ekman has contributed much to the study of social
aspects of lying, why we lie,
and why we are often unconcerned with detecting lies.
He is currently on the Editorial Board of Greater Good magazine,
published by the
Greater Good Science Center of the
University of California, Berkeley. His
contributions include the interpretation of scientific research into the
roots of compassion, altruism, and peaceful human relationships. Ekman is
also working with Computer Vision researcher
Dimitris Metaxas on designing a visual
lie-detector.
Research Papers Worth
Reading On Deceit, Body Language, Influence etc.. (with
links to pdfs)
Facial Expression Of Emotion. – In M.Lewis
and J Haviland-Jones (eds) Handbook of emotions, 2nd
edition. Pp. 236-249. New York: Guilford Publications,
Inc. Keltner, D. & Ekman, P. (2000)
A Few Can Catch A Liar. - Psychological
Science, 10, 263-266. Ekman, P., O’Sullivan, M., Frank,
M. (1999)
Deception, Lying And Demeanor.- In States
of Mind: American and Post-Soviet Perspectives on
Contemporary Issues in Psychology . D.F. Halpern and
A.E.Voiskounsky (Eds.) Pp. 93-105. New York: Oxford
University Press.
Lying And Deception. – In N.L. Stein, P.A.
Ornstein, B. Tversky & C. Brainerd (Eds.) Memory for
everyday and emotional events. Hillsdale, NJ: Lawrence
Erlbaum Associates, 333-347.
Lies That Fail.- In M. Lewis & C. Saarni
(Eds.) Lying and deception in everyday life. Pp.
184-200. New York: Guilford Press.
Who Can Catch A Liar. -American
Psychologist, 1991, 46, 913-120.
Hazards In Detecting Deceit. In D. Raskin,
(Ed.) Psychological Methods for Investigation and
Evidence. New York: Springer. 1989. (pp 297-332)
Earlier this week Wired reported that a Brooklyn
lawyer wanted to use fMRI brain scans to prove that his client was telling
the truth. The case itself is an average employer-employee dispute, but
using brains scans to tell whether someone is lying—which a few, small
studies have suggested might be useful—would set a precedent for
neuroscience in the courtroom. Plus, I'm pretty sure they did something like
this on Star Trek once.
But why go to all the trouble of scanning someone's
brain when you can just count how many times the person blinks? A study
published this month in Psychology, Crime & Law found that when people were
lying they blinked significantly less than when they were telling the truth.
The authors suggest that lying requires more thinking and that this
increased cognitive load could account for the reduction in blinking.
For the study, 13 participants "stole" an exam
paper while 13 others did not. All 26 were questioned and the ones who had
committed the mock theft blinked less when questioned about it than when
questioned about other, unrelated issues. The innocent 13 didn't blink any
more or less. Incidentally, the blinking was measured by electrodes, not
observation.
But the authors aren't arguing that the blink
method should be used in the courtroom. In fact, they think it might not
work. Because the stakes in the study were low--no one was going to get into
any trouble--it's unclear whether the results would translate to, say, a
murder investigation. Maybe you blink less when being questioned about a
murder even if you're innocent, just because you would naturally be nervous.
Or maybe you're guilty but your contacts are bothering you. Who knows?
By the way, the lawyer's request to introduce the
brain scanning evidence in court was rejected, but lawyers in another case
plan to give it a shot later this month.
(The abstract of the study, conducted by Sharon
Leal and Aldert Vrij, can be found here. The company that administers the
lie-detection brain scans is called Cephos and their confident slogan is
"The Science Behind the Truth.")
"The New Face of Emoticons: Warping photos could help text-based
communications become more expressive," by Duncan Graham-Rowe, MIT's
Technology Review, March 27, 2007 ---
http://www.technologyreview.com/Infotech/18438/
Computer scientists at the University of Pittsburgh
have developed a way to make e-mails, instant messaging, and texts just a
bit more personalized. Their software will allow people to use images of
their own faces instead of the more traditional emoticons to communicate
their mood. By automatically warping their facial features, people can use a
photo to depict any one of a range of different animated emotional
expressions, such as happy, sad, angry, or surprised.
All that is needed is a single photo of the person,
preferably with a neutral expression, says Xin Li, who developed the system,
called Face Alive Icons. "The user can upload the image from their camera
phone," he says. Then, by keying in familiar text symbols, such as ":)" for
a smile, the user automatically contorts the face to reflect his or her
desired expression.
"Already, people use avatars on message boards and
in other settings," says Sheryl Brahnam, an assistant professor of computer
information systems at MissouriStateUniversity, in Springfield. In many
respects, she says, this system bridges the gap between emoticons and
avatars.
This is not the first time that someone has tried
to use photos in this way, says Li, who now works for Google in New York
City. "But the traditional approach is to just send the image itself," he
says. "The problem is, the size will be too big, particularly for
low-bandwidth applications like PDAs and cell phones." Other approaches
involve having to capture a different photo of the person for each unique
emoticon, which only further increases the demand for bandwidth.
Li's solution is not to send the picture each time
it is used, but to store a profile of the face on the recipient device. This
profile consists of a decomposition of the original photo. Every time the
user sends an emoticon, the face is reassembled on the recipient's device in
such a way as to show the appropriate expression.
To make this possible, Li first created generic
computational models for each type of expression. Working with Shi-Kuo
Chang, a professor of computer science at the University of Pittsburgh, and
Chieh-Chih Chang, at the Industrial Technology Research Institute, in
Taiwan, Li created the models using a learning program to analyze the
expressions in a database of facial expressions and extract features unique
to each expression. Each of the resulting models acts like a set of
instructions telling the program how to warp, or animate, a neutral face
into each particular expression.
Once the photo has been captured, the user has to
click on key areas to help the program identify key features of the face.
The program can then decompose the image into sets of features that change
and those that will remain unaffected by the warping process.
Finally, these "pieces" make up a profile that,
although it has to be sent to each of a user's contacts, must only be sent
once. This approach means that an unlimited number of expressions can be
added to the system without increasing the file size or requiring any
additional pictures to be taken.
Li says that preliminary evaluations carried out on
eight subjects viewing hundreds of faces showed that the warped expressions
are easily identifiable. The results of the evaluations are published in the
current edition of the Journal of Visual Languages and Computing.
Last week we discussed the credit rating
agencies and their roles the financial crisis. These agencies provided false
ratings on credit they knew was faulty prior to the crisis. In defense,
these agencies (as well as Warren Buffet) said that they did not foresee the
crisis to be as severe as it was and therefore could not be blamed for
making mistakes in their predictions. This week’s post focuses on
foreseeability and the extent to which firms are liable for incorrect
predictions.
Like credit agencies, Wall Street firms have
been accused of knowing the dangers in the market prior to its collapse. I
came across this post (Black
Swans*, Fraud by hindsight, and Mortgage-Backed Securities)
via the Wall Street Law Blog that discusses how
firms could assert that they can’t be blamed for events they couldn’t
foresee. It’s a doctrine known as Fraud by Hindsight (“FBH”) where
defendants claim “that there is no fraud if the alleged deceit can only be
discerned after the fact”. This claim has been used in numerous securities
fraud lawsuits and surprisingly it has worked in the defendant’s favor on
most occasions.
Many Wall Street firms say they “could not
foresee the collapse of the housing market, and therefore any allegations of
fraud are merely impermissible claims of fraud by hindsight”. Was Wall
Street able to foresee the housing market crash prior to its collapse?
According to the writers at WSL Blog, they did foresee it saying, “From 1895
through 1996 home price appreciation very closely corresponded to the rate
of inflation (roughly 3% per year). From 1995 through 2006 alone – even
after adjusting for inflation – housing prices rose by more than 70%”. Wall
Street must (or should) have foreseen a drastic change in the market when
rises in housing costs were so abnormal. By claiming FBH, however, firms can
inevitably “get away with murder”.
What exactly is FBH and how is it used in
court? The case below from Northwestern University Law Review details the
psychology and legalities behind FBH while attempting to show how the FBH
doctrine is being used as a means to dismiss cases rather than to control
the influence of Wall Street’s foreseeability claims.
Link Provided to Download "Fraud by Hindsight" (Registration Required)
I’ve broken down the case into two parts. The
first part provides two theories on hindsight in securities litigation: The
Debiasing Hypothesis & The Case Management Hypothesis. The Debiasing
Hypothesis provides that FBH is being used in court as a way to control the
influence of ‘hindsight bias’. This bias says that people “overstate the
predictability of outcomes” and “tend to view what has happened as having
been inevitable but also view it as having appeared ‘relatively inevitable’
before it happened”. The Debiasing Hypothesis tries to prove that FBH aids
judges in “weeding out” the biases so that they can focus on the allegations
at hand.
The Case Management Hypothesis states that FBH
is a claim used by judges to easily dismiss cases that they deem too
complicated or confusing. According to the analysis, “…academics have
complained that these [securities fraud] suits settle without regard to
merit and do little to deter real fraud, operating instead as a needless
tax on capital raising. Federal judges, faced with overwhelming caseloads,
must allocate their limited resources. Securities lawsuits that are often
complex, lengthy, and perceived to be extortionate are unlikely to be a
high priority. Judges might thus embrace any doctrine [i.e. FBH
doctrine] that allows them to dispose of these cases quickly” (782-783). The
case attempts to prove that FBH is primarily used for case management
purposes rather than for controlling hindsight bias.
The psychological aspects behind hindsight
bias are discussed thoroughly in this case. Here are a few excerpts from the
case regarding this bias:
(1)“Studies show that judges are vulnerable
to the bias, and that mere awareness of the phenomenon does not ameliorate
its influence on judgment. The failure to develop a doctrine that
addresses the underlying problem of judging in hindsight means that the
adverse consequences of the hindsight bias remain a part of securities
litigation. Judges are not accurately sorting fraud from mistake, thereby
undermining the system, even as they seek to improve it” (777).
(2) “Judges assert that a company’s
announcement of bad results, by itself, does not mean that a prior
optimistic statement was fraudulent. This seems to be an effort to divert
attention away from the bad outcome and toward the circumstances that gave
rise to that outcome, which is exactly the problem that hindsight bias
raises. That is, if people overweigh the fact of a bad outcome in
hindsight, then the cure is to reconstruct the situation as people saw it
beforehand. Thus, the development of the FBH doctrine suggests a
judicial understanding of the biasing effect of judging in hindsight and of
a means to address the problem” (781).
(3) “Once a bad event occurs, the evaluation
of a warning that was given earlier will be biased. In terms of evaluating a
decision-maker’s failure to heed a warning, knowledge that the warned-of
outcome occurred will increase the salience of the warning in the
evaluator’s mind and bias her in the direction of finding fault with the
failure to heed the warning. In effect, the hindsight bias becomes an
‘I-told-you-so’ bias.” (793).
(4) “In foresight, managers might reasonably
believe that the contingency as too unlikely to merit disclosure, whereas in
hindsight it seems obvious a reasonable investor would have wanted to know
it. Likewise, as to warning a company actually made, in foresight most
investors might reasonably ignore them, whereas in hindsight they seem
profoundly important. If defendants are allowed to defend themselves by
arguing that a reasonable investor would have attended closely to these
warnings, then the hindsight bias might benefit defendants” (794).
Next week we’ll explore the second part of the
case and discuss the importance of utilizing FBH as a means of deterring the
hindsight bias. We’ll see how the case proves that FBH is not being used for
this purpose and is instead used as a mechanism to dismiss cases that simply
do not want to be heard.
The link below is a book review of Michael Lewis’s
latest book ‘The Big Short’. The book is clearly based on an article that
Bob uncovered about 9 months ago. The mechanism underpinning the ‘short’ is
better explained in the NYRB essay and, presumably, in the book itself. It
seems that the ‘mezzanine’ tranches (BBB rated) of a series of MBS were
packaged, rated AAA and then issued in another MBS. Dubious this might be,
but fraud it will not be. It lacks the central element of mens rea. In the
face of an accusation of fraud the accused will generally resort to the
defence of incompetence or inadequacy – a dangerous thing when facing civil
action as well – but better than being seen to have acted ‘knowingly’.
No-one knew the property markets would collapse. Many people, including me*,
thought that it was inevitable – but we did not know it.
*When I was first told of the ‘low doc’ loan
concept by an investment manager, I could hardly believe it. He, on the
other hand, described the packager of such products as very clever. The
investor in question failed badly due to an over-exposure to MBS. Funny
that.
Last week we discussed the first part of the “Fraud
by Hindsight” study. As we learned, the FBH doctrine is utilized in
securities litigation cases. In learning about the FBH doctrine we reviewed
the Debiasing Hypothesis and the Case Management Hypothesis. According to
the Debiasing Hypothesis, FBH is used as a tool to “weed out” hindsight bias
in order to focus on legal issues at hand. The Case Management Hypothesis,
on the other hand declares that FBH is used to dismiss securities fraud
cases in order to facilitate judicial control over them. This week we will
strive to analyze how Fraud By Hindsight has evolved, meaning, how the
courts apply the doctrine (in real life), which differs markedly from the
doctrine’s theoretical meaning.
History
The first mention of FBH was in 1978 with Judge
Friendly in the case Denny v. Barber. The plaintiff in this case claimed
that the bank had “engaged in unsound lending practices, maintained
insufficient loan loss reserves, delayed writing off bad loans, and
undertook speculative investments” (796). Sound familiar? Anyway — the
plaintiff plead that the bank failed to disclose these problems in earlier
reports and instead issued reports with optimistic projections. Judge
Friendly claimed FBH stating that there were a number of “intervening
events” during that period (i.e. increasing prices in petroleum and the City
of New York’s financial crisis) that were outside the control of managers
and it was therefore insufficient to claim that the defendant should have
known better when out-of-the-ordinary incidents have occurred. The end
result of the case provided that “hindsight alone might not constitute a
sufficient demonstration that the defendants made some predictive decision
with knowledge of its falsity or something close to it” (797). Friendly
established that FBH is possible, but that in this case the underlying
circumstances did not justify a judgment against the bank.
The second relevant mention of FBH was in 1990 with
Judge Easterbrook in the case DiLeo v. Ernst & Young. Like the prior case,
DiLeo involved problems with loans where the plaintiff plead that the bank
and E&Y had known but failed to disclose that a substantial portion of the
bank’s loans were uncollectible. This case was different, in that there were
no “intervening events” that could have blind sighted managers from issuing
more accurate future projections. Still, Easterbrook claimed FBH and said,
“the fact that the loans turned out badly does not mean that the defendant
knew (or should have known) that this was going to happen” (799-800).
Easterbrook believed that the plaintiff must be able to separate the true
fraud from the underlying hindsight evidence in order to prove their case.
Easterbrook’s articulation of the FBH doctrine set
the stage for all future securities class action cases. As the authors
state, the phrase was cited only about twice per year before DiLeo but it
increased to an average of twenty-seven times per year afterwards.
Unfortunately, the courts found Easterbrook’s perception of the phrase to be
more compelling. Instead of providing that the hindsight might play a role
determining if fraud has occurred, Easterbrook claimed that there simply is
no “fraud by hindsight”. This allows the courts to adjudicate cases solely
on complaint, therefore supporting the Case Management Hypothesis.
The results of many tests provided in this case
proved that courts were using the doctrine as a means to dismiss cases. Of
all the tests, I found one to be most interesting: The Stage of the
Proceedings. The results of the test shows that “over 90 percent of FBH
applications involve judgments on the pleadings” (814) stage rather than at
summary judgment. In the preliminary (pleading) stages, the knowledge of
information is not provided, meaning that it is less likely that hindsight
bias will affect their decisions. The more the judge delves into the case,
the more they are susceptible to the hindsight bias. If the judge is
utilizing the FBH doctrine mostly during the pleading stages where hindsight
bias is “weak”, then the Debiasing Hypothesis is not valid.
The authors point out the problems with utilizing
the FBH doctrine in this way:
“The problem, however, is that the remedy is
applied at the pleadings stage, not the summary judgment stage. At the
pleadings stage, a bad outcome truly is relevant to the likelihood of fraud.
At this stage, the Federal Rules do not ask the courts to make a judgment on
the merits, and hence the remedy of foreclosing further litigation is
inappropriate. By foreclosing further proceedings, courts are not saying
that they do not trust their own judgment, but that they do not trust the
process of civil discovery to identity whether fraud occurred” (815).
Because cases are being dismissed so early in the
litigation process, courts are not allowing for the discovery of fraud that
may be apparent even though hindsight is a factor in the case.
By gathering this and other evidence, the case
concludes that judges utilize FBH as a case management tool. They cited that
the development of the FBH doctrine could be described as “naïve cynicism”.
Though judges understand that hindsight bias must be taken into
consideration, they express the belief that the problem does not affect
their own judgment. The courts are relying on their own intuitions and
gathering the necessary facts to prove fraud by hindsight. The authors note
a paradox here saying, “Judges simultaneously claim that human judgment
cannot be trusted, and yet they rely on their own judgment”.
The problem is that the naively cynical (FBH)
approach has led to securities fraud cases to be governed by moods. The
authors say that “In the 1980s and 1990s, as concern with frivolous
securities litigation rose, courts and Congress simply made it more
difficult for plaintiffs to file suit. In the post-Enron era, this
skepticism about private enforcement of securities fraud might have abated
somewhat, leading to lesser pleading requirements” (825).
Recap & Implications
Overall the case proves that the courts have not
yet been able to establish a sensible mechanism for sorting fraud from
mistake. It therefore allows cases that really involve fraud to potentially
be dismissed. In cases since DiLeo, the win rate for defendants in FBH cases
is 70 percent, as compared with 47 percent in those cases that did not
mention it. The mere declaration of “Fraud by Hindsight” gives the defendant
an automatic advantage over the plaintiff. Now, the defendant may in fact be
innocent – but the current processes are not able to determine who is or
isn’t guilty. Remember, judges spend much of their time in these cases
separating the hindsight bias from the fraud. This task can become very
complex and time consuming.
In sum, the increasing use of FBH has been
beneficial for (1) judges because they don’t have to listen to these
complicated cases and (2) defendant’s because they are likely to win the
case by using the doctrine. The only ones who don’t benefit from doctrine
are the plaintiff’s who may truly have been victims of fraud. It is crucial
that the judiciary revise the way the FBH is interpreted in order to protect
the innocent and convict the guilty.
Have any ideas on how to fix the FBH problem? Send
me an email at fraudgirl @ simoleonsense.com.
The
link below is a book review of Michael Lewis’s latest book ‘The Big
Short’. The book is clearly based on an article that Bob uncovered
about 9 months ago. The mechanism underpinning the ‘short’ is better
explained in the NYRB essay and, presumably, in the book itself. It
seems that the ‘mezzanine’ tranches (BBB rated) of a series of MBS
were packaged, rated AAA and then issued in another MBS. Dubious
this might be, but fraud it will not be. It lacks the central
element of mens rea. In the face of an accusation of fraud the
accused will generally resort to the defence of incompetence or
inadequacy – a dangerous thing when facing civil action as well –
but better than being seen to have acted ‘knowingly’. No-one knew
the property markets would collapse. Many people, including me*,
thought that it was inevitable – but we did not know it.
*When I was
first told of the ‘low doc’ loan concept by an investment manager, I
could hardly believe it. He, on the other hand, described the
packager of such products as very clever. The investor in question
failed badly due to an over-exposure to MBS. Funny that.
"A Model Curriculum for Education in
Fraud and Forensic Accounting," by Mary-Jo Kranacher, Bonnie W.
Morris, Timothy A. Pearson, and Richard A. Riley, Jr., Issues in
Accounting Education, November 2008. pp. 505-518 (Not Free)
---
Click Here
There are other articles on fraud and
forensic accounting in this November edition of IAE:
Incorporating Forensic Accounting
and Litigation Advisory Services Into the Classroom Lester E.
Heitger and Dan L. Heitger, Issues in Accounting Education
23(4), 561 (2008) (12 pages)]
West Virginia University: Forensic
Accounting and Fraud Investigation (FAFI) A. Scott Fleming, Timothy
A. Pearson, and Richard A. Riley, Jr., Issues in Accounting
Education 23(4), 573 (2008) (8 pages)
The Model Curriculum in Fraud and
Forensic Accounting and Economic Crime Programs at Utica College
George E. Curtis, Issues in Accounting Education 23(4), 581
(2008) (12 pages)
Forensic Accounting and FAU: An
Executive Graduate Program George R. Young, Issues in Accounting
Education 23(4), 593 (2008) (7 pages)
The Saint Xavier University Graduate
Program in Financial Fraud Examination and Management William J.
Kresse, Issues in Accounting Education 23(4), 601 (2008) (8
pages)
Also see
"Strain, Differential Association, and Coercion: Insights from the
Criminology Literature on Causes of Accountant's Misconduct," by James
J. Donegan and Michele W. Ganon, Accounting and the Public Interest
8(1), 1 (2008) (20 pages)
Accountancy used to be boring – and safe.
But today it’s neither. Have the ‘big four’ firms become too cosy with the
system they’re supposed to be keeping in check?
In the summer of 2015, seven years after the
financial crisis and with no end in sight to the ensuing economic stagnation
for millions of citizens, I visited a new club. Nestled among the hedge-fund
managers on Grosvenor Street in Mayfair, Number Twenty had recently been
opened by accountancy firm KPMG.
It was, said the firm’s then UK chairman Simon Collins in the fluent
corporate-speak favoured by today’s top accountants, “a West End space” for
clients “to meet, mingle and touch down”. The cost of the 15-year lease on
the five-story building was undisclosed, but would have been many tens of
millions of pounds. It was evidently a price worth paying to look after the
right people.
Inside, Number Twenty is
patrolled by a small army of attractive, sharply uniformed serving staff. On
one floor are dining rooms and cabinets stocked with fine wines. On another,
a cocktail bar leads out on to a roof terrace. Gazing down on the refreshed
executives are neo-pop art portraits of the men whose initials form today’s
KPMG: Piet Klynveld (an early 20th-century Amsterdam accountant), William
Barclay Peat and James Marwick (Victorian Scottish accountants) and Reinhard
Goerdeler (a German concentration-camp survivor who built his country’s
leading accountancy firm).
KPMG’s
founders had made their names forging a worldwide profession charged with
accounting for business. They had been the watchdogs of capitalism who had
exposed its excesses. Their 21st-century successors, by contrast, had been
found badly wanting. They had allowed a series of US subprime mortgage
companies to fuel the financial crisis from which the world was still
reeling.
“What do
they say about hubris and nemesis?” pondered the unconvinced insider who had
taken me into the club. There was certainly hubris at Number Twenty. But by
shaping the world in which they operate, the accountants have ensured that
they are unlikely to face their own downfall. As the world stumbles from one
crisis to the next, its economy precarious and its core financial markets
inadequately reformed, it won’t be the accountants who pay the price of
their failure to hold capitalism to account. It will once again be the
millions who lose their jobs and their livelihoods. Such is the triumph of
the bean counters.
The demise of sound accounting
became a critical cause of the early 21st-century financial crisis. Auditing
limited companies, made mandatory in Britain around a hundred years earlier,
was intended as a check on the so-called “principal/agent problem” inherent
in the corporate form of business. As Adam Smith once pointed out, “managers
of other people’s money” could not be trusted to be as prudent with it as
they were with their own. When late-20th-century bankers began gambling with
eye-watering amounts of other people’s money, good accounting became more
important than ever. But the bean counters now had more commercial
priorities and – with limited liability of their own – less fear for the
consequences of failure. “Negligence and profusion,” as Smith foretold, duly
ensued.
After the
fall of Lehman Brothers brought economies to their knees in 2008, it was
apparent that Ernst & Young’s audits of that bank had been all but
worthless. Similar failures on the other side of the Atlantic proved that
balance sheets everywhere were full of dross signed off as gold. The
chairman of HBOS, arguably Britain’s most dubious lender of the boom years,
explained to a subsequent parliamentary enquiry: “I met alone with the
auditors – the two main partners – at least once a year, and, in our
meeting, they could air anything that they found difficult. Although we had
interesting discussions – they were very helpful about the business – there
were never any issues raised.
SUMMARY: SEC administrative law judge Cameron Elliot has ruled that
"the Chinese units of the Big Four accounting firms [plus a fifth
China-based accounting firm, Dahua CPA, formerly associated with the
accounting firm BDO] should be suspended from auditing US-traded companies
for six months....[The] ruling...doesn't take effect immediately, and the
firms might appeal the ruling, first to the [SEC] itself, then to the
federal courts....The SEC had sought audit work papers from the firms to
assist its investigations of some of the 130-plus Chinese companies trading
on U.S. markets....But the Chinese firms refused...They said their hands
were tied, as Chinese law treats the information in such audit documents as
akin to 'state secrets'..." and thus could not cooperate with the SEC
"without the Chinese government's blessing." The ruling could significantly
affect audits of U.S. multinational companies because the Big Four use
Chinese affiliates to assist in those engagements.
CLASSROOM APPLICATION: The article may be used in an auditing,
international accounting, or international business course. The related
article was covered in this review; that review includes links to other
articles as well.
QUESTIONS:
1. (Advanced) Why is it important for the U.S. and China to have
audit oversight and cross-border enforcement cooperation? What problems have
arisen in this area?
2. (Introductory) Why does the U.S./Chinese agreement described in
the related article not resolve ongoing issues in audit oversight and
cross-border enforcement cooperation?
3. (Advanced) What is the impact on an audit report when the
auditor relies on the work of an affiliate or another auditor? What do you
think will happen to U.S. audit firms' work and their reports if Judge
Elliot's ruling stands?
Reviewed By: Judy Beckman, University of Rhode Island
The Chinese units of the Big Four accounting firms
should be suspended from auditing U.S.-traded companies for six months, a
judge ruled, a move that could complicate the audits of dozens of Chinese
companies and some U.S.-based multinationals.
he audit firms, plus a fifth China-based accounting
firm, broke U.S. law when they refused to turn over documents about some of
their clients to the Securities and Exchange Commission to aid the
commission in investigating those U.S.-traded Chinese companies for possible
fraud, ruled Cameron Elliot, an SEC administrative law judge.
Judge Elliot's ruling Wednesday doesn't take effect
immediately, and the firms can appeal the ruling, first to the commission
itself, then to the federal courts. But if the ruling stands, it could
temporarily leave more than 100 Chinese companies that trade on U.S. markets
without an auditor. It also could throw a monkey wrench into the audits of
U.S. multinational companies that have significant operations in China,
because the Chinese affiliates of the Big Four—PricewaterhouseCoopers,
Deloitte Touche Tohmatsu, KPMG and Ernst & Young—often help their U.S.
sister firms complete those audits.
Without audited financial statements, a company
can't sell securities in the U.S. or stay listed on U.S. exchanges.
"This is a body blow to the Big Four," said Paul
Gillis, a Beijing-based professor at Peking University's Guanghua School of
Management. "It's really quite a harsh ruling."
The ruling will be inconvenient for the companies
those Chinese firms audit, said Jacob S. Frenkel, a former SEC enforcement
attorney now in private practice. It is a middle ground, he said. The judge
could have gone further and permanently barred the Chinese firms from
issuing audit reports on U.S.-traded companies, as the SEC had requested and
as the accounting industry had feared.
In a joint statement, the Big Four firms in China
called the judge's decision "regrettable" and said they would appeal. "In
the meantime the firms can and will continue to serve all their clients
without interruption."
The SEC said it was gratified by the ruling and
that it upholds the commission's authority to obtain records that are
"critical to our ability to investigate potential securities law violations
and protect investors."
Officials at China's Ministry of Finance and the
China Securities Regulatory Commission said they didn't have an immediate
comment.
The fifth firm, Dahua CPA, was censured by Judge
Elliot but not suspended. Dahua was an affiliate of another large accounting
firm, BDO, until last April, but the two are no longer affiliated.
The SEC had sought audit work papers from the firms
to assist its investigations of some of the 130-plus Chinese companies
trading on U.S. markets that have encountered accounting and disclosure
questions in the past few years. Many of those companies have their
independent audits performed by the Chinese affiliates of the Big Four, and
the SEC had wanted to know more about what the auditors had found about the
companies. (All the major accounting firms are international networks made
up of individual, free-standing firms in each country in which they do
business.)
But the Chinese firms refused to turn over the
documents. They said their hands were tied, as Chinese law treats the
information in such audit documents as akin to "state secrets." The firms
said their auditors could be thrown in jail if they cooperated with the SEC
without the Chinese government's blessing.
That led the SEC to file an administrative
proceeding against the five firms in December 2012, arguing that U.S. law
compels the firms to cooperate with such requests.
The judge agreed, saying the firms "have failed to
recognize the wrongful nature of their conduct" and showed "gall" in
complaining that complying with the SEC's demands would hurt them. The firms
knew when they registered with U.S. regulators and built their businesses in
China that they might ultimately be put between a rock and a hard place in
providing documents, the judge said.
The judge wasn't deterred by an agreement last year
between the U.S. and Chinese governments that somewhat alleviated the
stalemate over documents, by allowing some documents from the audit firms to
come to the U.S. after they were funneled through Chinese regulators. Since
July, documents the SEC had sought relating to at least six companies have
either been provided to U.S. regulators or were "in the pipeline" to be
provided, the audit firms said in filings in November and December.
The five Chinese firms involved in the case have a
total of 103 U.S.-traded companies that they audit or in which they played a
substantial role in the audit, according to their 2013 annual reports filed
with U.S. regulators. The companies might have to make other arrangements
for audits if their firm is suspended during the period when their yearly
audit is being performed.
Companies in Britain could be forced to
switch accountants to break up the cozy relationships between the
"Big Four" and their clients, blamed for masking weaknesses exposed
by the financial crisis.
The "Big Four" - KPMGKPMG.UL, PwC PWC.UL,
Ernst & Young ERNY.UL and Deloitte DLTE.UL - check the books of
nearly all listed companies in Britain and around the world, and
have often served the same clients for decades.
The UK's Competition Commission proposed
that companies put out their audit work to tender every five to
seven years, and change accounting firms every seven to 14 years -
roughly in line with changes being discussed at the European Union
level.
Investors would also play a role in
selecting an auditor, according to plans put forward by the
commission, which published preliminary findings from a probe it
began in 2011.
The industry was put under scrutiny after
auditor "complacency" was blamed by UK lawmakers for deepening the
financial crisis.
The Competition Commission found that 31
percent of the top 100 companies in the UK and a fifth of the next
250 firms had had the same auditor for over 20 years.
Competition in the UK is restricted by
factors that make it hard for companies to switch accountants, the
Competition Commission found, and there is a tendency for auditors
to focus on satisfying management rather than shareholder needs, it
said.
The findings add weight to a draft European
Union law which contains plans for boosting competition in the
27-country bloc's audit market which would override UK changes.
The United States is also mulling auditor
rotation as the sector faces questions for giving banks a clean bill
of health just before governments had to step in and rescue them in
the 2007-09 financial crisis.
Critics have said the Big Four should
separate out their audit and advisory units, a step the draft EU law
looks at.
"The real issue we have identified is
stickiness in the market," Laura Carstensen, who chaired the probe,
told Reuters. "The question of break-up was not on our list."
There was "significant dissatisfaction"
among big investors, the commission said, but changing the "long
standing and entrenched" system would take time.
Its proposals go further than a recent
change introduced by Britain's Financial Reporting Council (FRC),
which requires companies to consider changing accountants every
decade. The FRC said it was pleased the Commission was looking at
taking more steps to enhance competitiveness and switching.
PIRC, which represents pension funds and
fund managers, said mandatory rotation was the best way to ensure
auditor independence and large shareholders increasingly favored
this.
The commission also proposes banning "Big
Four only" clauses, meaning banks could not insist on a borrower
using one of the four top audit firms.
"GROSSLY UNDERESTIMATED"
The Big Four insist there is strong
competition and point to downward pressure on fees and some recent
switchings of auditors among big companies.
PwC said the Competition Commission had
"grossly underestimated" the critical role the audit committees at
client firms play in protecting shareholder interests.
Ernst & Young said it was pleased the
watchdog found no collusion, abuses or excess profits but rejected
accusations that the audit market was not serving shareholders, as
did Deloitte and KPMG.
"In addition, we believe that competition
between audit firms is healthy and robust and that the evidence
supports this," E&Y said.
But second tier audit firms, such as
Mazars, BDO and Grant Thornton, welcomed the findings after having
argued it would not be worthwhile expanding unless there was some
intervention to help prise open the market.
Jensen Comment
I doubt that the U.K. has the jurisdiction to trust-bust these large
international auditing firms. However, the U.K. may be the first to
force audit firm rotation in auditing. The U.K. has more problems than
just audit firms. Among all the giant banks in the world, the U.K. has
some of the most criminally-inclined banks that money launder for Iran
and the large drug cartels. And then there's the massive LIBOR scandal
that will cost U.K. banks billions in fines. If we start putting bankers
in prison, the place to start is the U.K.
The U.K. could force its big companies to give more audit work to
smaller firms. But this may have negative repercussions on the cost of
capital for those firms to say nothing of the formidable startup costs
for any small firm to take on giant companies like giant banks and
insurance companies headquartered in the U.K.
A simpler solution would be for the U.K. to become more litigious and
make the large auditing firms more vulnerable to billion-dollar audit
negligence tort cases. The costs will, of course, be passed on the U.K.
clients, but if this is what the U.K. wants in order to have more
professional and independent audits then this is the route that I would
recommend.
As a parting question, do the Brits spell skeptical as sceptical?
I do know that they spell judgment as judgement.
The accountants who service publicly traded
companies are likely to have something to be thankful for this year:
shareholders are not filing federal securities fraud lawsuits
against them.
Just 10 years ago, public company
accountants were in the cross hairs of shareholders, regulators and
prosecutors. A criminal indictment destroyed
Enron’s auditor, Arthur Andersen. Congress
created a new regulator, the
Public Company Accounting Oversight Board,
to oversee the profession. And in dozens of lawsuits in the years
afterward, shareholders named accountants as co-defendants when
alleging accounting fraud.
But things have changed. According to NERA
Economic Consulting, which tracks shareholder litigation and
reported on the decline in accounting firm defendants in
its midyear report in July,
not one
accounting firm has been named a defendant so far this year. One of
the study’s co-authors, Ron I. Miller, confirmed that the trend has
continued at least through November.
That prompts the question, why don’t
shareholders sue accountants anymore?
“To the extent that firms have been burned
for a lot of money, they have some pretty strong incentives to try
to behave,” Mr. Miller said. “That’s the hopeful side of the legal
system: You hope that if you put in penalties, that those penalties
change people’s actions.”
The less positive alternative, he added, is
that public companies “have gotten better at hiding it.”
From 2005 to 2009, according to the NERA
report, 12 percent of securities class action cases included
accounting firm co-defendants. The range of federal securities fraud
class action cases filed per year in that period was 132 to 244.
The absence of accounting firm defendants
this year can probably be explained at least in part by court
decisions; the Supreme Court has issued rulings, as in
Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc.
in 2008, making it more difficult to recover
damages from third parties in fraud cases.
So perhaps more shareholder suits would
take aim at accountants, if the plaintiffs believed that their
claims would survive a defendant’s motion to dismiss. And it is
possible that plaintiffs will add accounting firm as defendants to
existing cases in the future, if claimants get information to
support such claims.
Over all, fewer shareholder class action
lawsuits are based on allegations of accounting fraud, as opposed to
other types of fraud. The NERA midyear report found that in the
first six months of 2012, about 25 percent of complaints in
securities class action cases included allegations of accounting
fraud, down from nearly 40 percent in all of 2011.
Perhaps the Sarbanes-Oxley Act, the
legislative response to the accounting scandals of the early 2000s,
actually worked, Mr. Miller said.
“There’s been a lot of complaining about
SOX, and certainly the compliance costs are high for smaller
publicly traded companies,” he said, but accounting fraud “is to a
large extent what SOX was intended to stop.”
Public company accountants still have
potential civil liability to worry about, said Joseph A. Grundfest,
a former commissioner of the
Securities and Exchange Commission
who
teaches at Stanford Law School. Regulators, he said, are
investigating potential misconduct involving accounting firms.
Crowe Horwath, the last of the top eight
accounting firms to have its 2010 audit inspection report published,
took the same lashing as its counterparts with a significant
increase in the number of audits criticized by inspectors.
Two years after 2010 inspections were
performed, the Public Company Accounting Oversight Board published
its report on Crowe's audit work finding fault with eight of the 13
audits selected for inspection. By comparison, inspectors criticized
only two of the 13 Crowe Horwath audits that they inspected in 2009,
and only one audit in 2008. The PCAOB had no comment on why it took
two years to publish the report.
Crowe's 2010 report outlines the same
audit-by-audit summary of inspectors' concerns found in other
reports, focusing on many of the same issues that cropped up across
all firms in 2010. Among the eight audits criticized, most comments
revolve around allowances for loan losses, impairments, and
over-reliance on third-party pricing services for establishing fair
values.
The PCAOB report says deficiencies included
failures to identify or properly address financial statement
misstatements, including failures to comply with disclosure
requirements, as well as failures to perform certain audit
procedures. Inspectors noted that in some cases, the failure stems
from inadequate documentation. The report says Crowe issued a
revised opinion on one audit report after inspectors unearthed
problems with the audit of internal control over financial
reporting.
The firm says in its response to the
inspection findings that it is committed to quality auditing and has
designed its quality control and monitoring systems to drive
improvement. Crowe says it took actions to address each matter
raised in the inspection report, including providing more
documentation in audit files to more completely describe procedures,
evidence, and conclusions. “We remain committed to continual
improvement in our audit practice and making responsive changes in
areas identified by the PCAOB for improvement, and look forward to
further dialogue towards the shared goal of audit quality,” the firm
wrote.
Among the top eight audit firms that are
inspected annually by the PCAOB, inspection findings jumped
dramatically from 2009 to 2010. The ratio of failed audits to the
total number of audits inspected more than doubled at some firms,
like Crowe. The eight major firms that are inspected annually
include Ernst & Young, KPMG, PwC, Deloitte & Touche, Grant Thornton,
BDO USA, McGladrey & Pullen, and Crowe.
Sunbeam. WorldCom. HealthSouth. A decade
ago investors knew what those companies had in common: top
executives who cooked the books. After their phony accounting was
exposed, most went to jail–and hundreds of billions of dollars of
shareholder wealth evaporated.
The Securities & Exchange Commission
remains quite busy. In fiscal 2011 the agency brought a record 735
enforcement actions. But those looking to see the next Jeff Skilling
or Richard Scrushy frog-marched in front of television cameras will
be sorely disappointed. Only 89 of those actions targeted fraudulent
or misleading accounting and disclosures by public companies, the
fewest, by far, in a decade.
So what happened? Call it the Bernie Madoff
effect. Embarrassed that it missed the Ponzi King’s $65 billion
scheme, the SEC reorganized its enforcement division, eliminating an
accounting-fraud task force and adding new units to pursue crooked
investment advisors and asset managers, market manipulations and
violations of the Foreign Corrupt Practices Act. Since then
Pfizer,
Oracle,
Aon,
Johnson & Johnson and Tyson Foods have all
paid fines to settle foreign-payoff charges.
That’s all fine and good. But remember
this: Foreign-payola charges (absent alleged accounting abuses) have
minimal effect on a company’s stock. Accounting fraud risks massive
market disruption. Groupon, Zynga and Green Mountain Coffee Roasters
are all down at least 75% in the past year, amid doubts about their
accounting and prospects. And those examples don’t even carry
allegations of illegality.
Is a stretched SEC neglecting accounting
fraud? In a statement to FORBES, SEC Enforcement Director Robert
Khuzami argued that the task force was no longer needed because
accounting expertise exists throughout the agency, and the number
and severity of earnings restatements (a flag for possible
accounting fraud) has declined dramatically since the mid-2000s. He
added: “In a world of limited resources, we must prioritize our
efforts. … The reorganization helped to focus us on where the fraud
is and not where the fraud isn’t, while allowing us to remain fully
capable of addressing cases of accounting and disclosure fraud.”
Accounting experts agree that the
Sarbanes-Oxley Act of 2002, Congress’ response to Enron, has reduced
abuses. But they worry the SEC is risking those gains. “The SEC
enforcement of Sarbanes-Oxley has been minimal,” says Jack
Ciesielski, a CPA who sells accounting alerts to stock analysts.
“Sarbanes-Oxley may have bought us some peace for our time, but
without vigilance through long-term enforcement, it can’t last.”
Anyway, it’s not like all numbers games
have ceased. Public company CFOs, responding to a survey last year
by Duke and Emory business profs, estimated that 18% of companies
manipulate their earnings, by an average of 10%, in any given
year–to influence stock prices, hit earnings benchmarks and secure
executive bonuses. Most of this finagling goes undetected.
Sarbox aimed to limit accounting
shenanigans by requiring companies to set up internal accounting
controls and CEOs and CFOs to personally “certify” financial
statements, risking civil and even criminal penalties if they
knowingly signed off on bogus numbers.
In addition, public auditors were required
to flag any “material weaknesses” in a company’s internal controls,
presumably providing an early warning to companies, investors and
the SEC.
How’s that working? A study by two
University of Connecticut accounting professors found auditors have
waved the weakness flag in advance of a small and declining share of
earnings restatements–just 25% in 2008 and 14% in 2009, the last
year studied. There was no auditor warning before Lehman Brothers’
2008 collapse, even though a bankruptcy examiner later concluded it
used improper accounting gimmicks to dress up its balance sheet. And
no warning before Citigroup lowballed its subprime mortgage exposure
in 2007. (It paid a $75 million SEC fine.)
For several years battles have
raged in several courtrooms concerning whether accounting firms have
a legal obligation to pay junior accountants overtime. We are
sympathetic to the position of the accounting firms, but worry about
the soundness of their legal reasoning and conclusions. Do
accounting firms have to be consistent in different domains? For
example, does the logic in legal briefs and oral arguments have to
be congruent with ethical principles and auditing standards?
There are a number of accounting
overtime cases, including Campbell and Sobek v. PwC (California) and
Litchfield v. KPMG (Washington). Essentially the facts in these
cases are the same. Plaintiffs are unlicensed employees of a Big
Four firm in the attestation unit or division who serve as
associates or senior associates. They worked long hours but were
not paid overtime; the plaintiffs seek damages in the amount of the
unpaid overtime work.
On September 20, in Ho v. Ernst &
Young, the court partially certified a class of junior tax
accountants at E&Y in California. These overtime cases now include
other areas of accounting besides attestation.
We are sympathetic to the position
of the large accounting firms because these firms generally have
been open and honest with potential recruits. While they do promise
busy periods involving long hours with no overtime pay, they
historically have held out the prospect of other rewards (e.g.,
bonuses, extra vacation time, etc.). If these cases pivoted about
contracts, they would be a slam dunk in favor of the large
accounting firms. Recruits cannot claim they did not know what
awaited them.
Further, if the plaintiffs
prevail, it is easy to conclude that the Big Four will most likely
change the pay model in the future. The base compensation will be
significantly reduced so that the base pay plus estimated overtime
will equal the current levels. If the plaintiffs prevail, they and
their attorneys will be the only ones to benefit.
Be that as it may, we have read
some of the legal filings and are disturbed by the defense counsel
arguments.
Federal
and state labor laws require overtime pay, but allow for various
exemptions. One exemption
is for “professionals,” but unlicensed accountants may not be viewed
as “professional.” Only licensed CPAs can perform audits, so the
license appears to be a demarcation whether this exemption can be
applied.
Defense attorneys in many of these
cases utilize the administrative exemption, which essentially states
the firm does not have to pay overtime if the employees have duties
and responsibilities that require them to exercise discretion and
independent judgment. This is a peculiar thing to argue for a
junior accountant working on an attest function, because he or she
does not have the authority to issue an audit opinion. How much
discretion and judgment can these individuals exercise without
simultaneously having the authority to form and write audit
opinions?
Former New York Governor and
Attorney General Eliot Spitzer took aim at corporate influence in
politics and blamed accountants, as well as lawyers and bankers, for
allowing companies and their CEOs to get away with dodgy valuations
and overblown compensation.
During a speech Tuesday at the New
York University School of Law, sponsored by the American
Constitution Society for Law and Policy, Spitzer derided the Obama
administration’s increasing acquiescence to corporate America,
including the recent extension of the Bush-era tax cuts.
“We have created a class in our
society of what I call facilitators,” said Spitzer. “Facilitators —
and we’re all part of it — lawyers, investment bankers and
accountants. Our purpose is to be hired to justify the actions that
are being taken by CEOs and others to run their businesses, and over
time what has happened is that we have lost our backbone. We have
lost our willingness to stand up and say, ‘Stop.’ There are a bunch
of reasons for this. I’ve been in private practice and I know how
those pressures are. We don’t like to look at our clients and say,
‘No, you can’t do that. I’m not writing an opinion letter that
justifies that valuation.’ We don’t like to write a letter to the
CEO saying, ‘No, you don’t deserve a 50 percent bonus.’ Those things
don’t happen very often because we succumb to the pressures of our
clients.”
Continued in article
Jensen Comment
Aside from his adulterous use of a prostitution ring, Spitzer has had
some integrity lapses himself such as lying about campaign
contributions, using campaign donations to pay for prostitutes, and the
hiding of bribes ---
http://en.wikipedia.org/wiki/Eliot_Spitzer#Scandal_and_resignation .
As Attorney General and Governor of New York, he did take some unusual
measures to combat corruption in state government, including orders to
state police to conduct surveillances of some top legislators.
Be that as it may, Spitzer is a top Harvard Law School
graduate and in total seems to be dedicated, as a liberal
Democrat, to fighting corruption in the private as well as the public
sectors. Since the Kennedy era it seems more difficult for the public to
forget sex scandals --- in part because of the changed practice of the
media in no longer hiding those scandals from the public. Many of the
affairs of John and Bobby Kennedy were suppressed by the press until
after they were dead. Spitzer will probably never rise again to high
office, but he will continue to be a force using his media jobs to
hammer at corruption. It would, however, be better if he accompanied his
future articles with more examples and facts.
Spitzer earned his reputation as a crime fighter by
taking on the Gambino mob in the NYC area. Now he wants to take on the
Big Four mob and the Wall Street mob. He's got guts.
What Watson failed to realize was
that the word "leg," by itself, wasn't actually an answer to the
question. This is common sense for people, because "leg" is an
anatomical part, not an anatomical oddity, though Watson did realize
that legs were involved somehow. What happened here might have been
something more profound than a simple bug. David Ferrucci, Watson's
project leader, attributed the failure to the difficulty of the word
"oddity" in the question. To understand what might be odd, you have
to compare it to what isn't odd—that is to say, what's common sense.
A problem with Watson's approach is that if some sentence appears in
its database, it can't tell whether someone put it there just
because it's true, or because someone felt it was so unusual that it
needed to be said.
A computer that lacks common
sense, unfortunately, isn't an oddity. Maybe it should be.
Henry Lieberman is a
research
scientist who works on artificial intelligence at the Media
Laboratory at MIT.
An audit firm that lacks common sense,
unfortunately, isn't an oddity. Maybe it should be. In the context of Repo 105/108 auditing of
Lehman and C12 Capital Management auditing at Barclays where common
sense should've prevailed but did not prevail in order to facilitate
accounting deception. What happened to the common sense auditors?
---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
PCAOB advisory
group head calls for investigations into audit firms
Auditor rotation, annual reports recommended (Adds PCAOB comment)
"UPDATE 1-US urged to probe auditors' role in credit crisis," by Dena
Aubin, Reuters, March 16, 2011 ---
http://www.reuters.com/article/2011/03/16/pcaob-auditors-idUSN1611473820110316
Audit firms that failed to flag risks ahead
of the financial crisis have not been held to account and an
in-depth investigation is needed, an advisory group to the U.S.
auditor watchdog agency said on Wednesday.
Regulators in Europe and the United Kingdom
are probing the role of auditors in the 2008 crisis, but the United
States has lagged and needs to do more, said Barbara Roper, head of
a working group for the Public Company Accounting Oversight Board.
"Auditors failed to perform their basic
watchdog function in the financial crisis," Roper said at a PCAOB
advisory group meeting in Washington. "There's a need to figure out
why they failed to perform that function and what can be done to fix
that problem."
The PCAOB was created after the Enron and
WorldCom accounting scandals to police audit firms. It oversees the
work of the Big Four auditors -- Deloitte, KPMG, Ernst & Young and
PricewaterhouseCoopers -- and other auditors of public companies.
While auditors did not cause the financial
crisis, they gave stamps of approval to many companies' financial
statements just months before they failed, said Roper, director of
investor protection for the Consumer Federation of America.
She said the PCAOB should look at examples
of companies that failed or had to be bailed out and find out what
went wrong with the audits and why.
Lehman Brothers (LEHMQ.PK), American
International Group (AIG.N), Citigroup (C.N), Fannie Mae (FNMA.OB),
and Freddie Mac (FMCC.OB), among others, received unqualified audit
opinions on their financial statements months before their collapse
or bailouts, Roper said.
"If the auditors were performing as they
should and this is the result we get, then there's a problem with
the system," she said.
AUDITOR ROTATION RECOMMENDED
Audit firms also lack the basic independent
governance that most public companies around the globe have, Lynn
Turner, head of a PCAOB working group on audit firm governance, said
at the meeting in Washington.
He said these firms need more transparency.
They should have to file annual financial statements with the PCAOB,
including information about how they control quality globally,
Turner said.
PCAOB members said they will consider all
the recommendations and report back on what they decide.
Asked for his response to the
recommendations, PCAOB chair James Doty told Reuters that the PCAOB
had identified areas where audits performed during the credit crisis
needed to be stronger in a report released in September. Some of the
problem audits are being investigated and disciplinary actions may
result, he said.
"All of these activities, including what we
heard from the investor advisory group today, will give us insights
into the root causes of problems we identify and will inform our
initiatives to strengthen investor protection," he said.
Because the Big Four audit firms are
private, they are not required to file public financial statements,
though they do report their revenues annually.
Without seeing their financial statements,
however, it will be difficult for the PCAOB to properly regulate
them, said Turner, a former chief accountant for the Securities and
Exchange Commission.
The PCAOB also should require companies to
rotate auditors periodically to break up cozy relationships between
some companies and their auditors, he said.
Audit partners, but not audit firms, have
to be rotated every five years currently.
The UK accounting firms’ response to the
“pressure” on their industry post-crisis has been sharp, quick, and
on message.
But the “pressure” itself feels like a
strategy orchestrated by the audit firms to force legislators to
grant their wishes under the mistaken assumption they’re
“regulating” the industry.
Let me break it down for you.
There’s been
much more noise made by legislators and regulators in the UK
regarding the auditors’ role in the financial crisis than in the US.
Banks failed there, too. The government bailed them out, although it
looked more like nationalization. The difference is they’re not
afraid to admit it.
Mainstream media publications such as the
Financial Times and the Guardian
have been
full of stories about the auditors and what they did, and did not
do, to warn of the crisis or mitigate the impact to investors.
But the firms’ master plan hit a speedbump
at end of November. The leaders of the largest audit firms –
Ian Powell, chairman of PwC UK,
John Connolly, Senior Partner and Chief
Executive of Deloitte’s UK firm and Global MD of its international
firm, John
Griffith-Jones, Chairman of KPMG’s
Europe, Middle East and Africa region and Chairman of KPMG UK, and
Scott Halliday, UK & Ireland Managing
Partner for Ernst & Young – appeared before the House of Lord’s
Economic Affairs Committee and let their cat out of the bag.
The auditors admitted they did not
issue “going concern” warnings
for any of
the large banks that were eventually nationalized because they were
assured during private, confidential meetings with government
officials – Lord Myners in particular – that the government would
bail out the banks if needed.
The admission was “astonishing” said one
member of the Committee, Lord Lawson.
Accountancy Age, November 23, 2010:
Debate focused on the use of “going concern” guidance, issued by
auditors if they believe a company will survive the next year.
Auditors said they did not change their going
concern guidance because they were told the government would
bail out the banks.
“Going concern [means] that a business
can pay its debts as they fall due. You meant something thing
quite different, you meant that the government would dip into
its pockets and give the company money and then it can pay it
debts and you gave an unqualified report on that basis,” Lipsey
said.
I found the admission to be quite
astonishing myself.
I reprinted it on my site,
based here in
the United States, and some in the US also found it rather
astonishing.
Questions
Did auditing firms not warn that banks were failing "going concern"
auditing rules based upon ill-advised speculation that governments would
bail out failing banks?
Did auditors not object to greatly underestimated
loan loss reserves based upon speculation that governments would
bail out failing banks?
Since well over a thousand banks failed in the U.S.
immediately following the subprime scandal., this was not a very good
alleged speculation on the part of CPA firm auditors..
Leaders of the four largest global
accounting firms –
Ian Powell, chairman of PwC UK,
John Connolly, Senior Partner and Chief
Executive of Deloitte’s UK firm and Global MD of its international
firm, John
Griffith-Jones, Chairman of KPMG’s Europe,
Middle East and Africa region and Chairman of KPMG UK, and
Scott Halliday,
UK & Ireland Managing Partner for Ernst & Young – appeared before
the UK’s House of Lords Economic Affairs Committee yesterday to
discuss competition and their role in the financial crisis.
“I don’t see that is on the
horizon at all,” Connolly said.
The European Union’s executive
European Commission has also opened a public consultation into
ways to boost competition in the sector, such as by having
smaller firms working jointly with one of the Big Four so there
is a “substitute on the bench.”
“Having a single auditor
results in the best communication with the board and with
management and results in the highest quality audit,” said Scott
Halliday, an E&Y managing partner.
The Lord’s Committee was more
interested in questioning the auditors about the issue of
“going concern” opinions
and, in particular, why there were none for the banks that failed,
were bailed out, or were nationalized.
The answer the Lord’s received
was, in one word, “Astonishing!”
Accountancy Age, November 23, 2010:
Debate focused on
the use of “going concern” guidance, issued by auditors if they
believe a company will survive the next year. Auditors said they did not change their going
concern guidance because they were told the government would
bail out the banks.
“Going concern [means] that a
business can pay its debts as they fall due. You meant something
thing quite different, you meant that the government would dip
into its pockets and give the company money and then it can pay
it debts and you gave an unqualified report on that basis,”
Lipsey said.
The leadership of the Big 4 audit
firms in the UK has admitted that
they did not issue “going concern” opinions
because they were told by government officials, confidentially, that
the banks would be bailed out.
The Herald of Scotland,
November 24, 2010: John
Connolly, chief executive of Deloitte auditor to Royal Bank of
Scotland, said the UK’s big four accountancy firms initiated
“detailed discussions” with then City minister Lord Paul Myners
in late 2008 soon after the collapse of Lehman Brothers prompted
money markets to gum up.
Ian Powell, chairman of
PricewaterhouseCoopers, said there had been talks the previous
year.
Debate centred on whether the
banks’ accounts could be signed off as “going concerns”. All
banks got a clean bill of health even though they ended up
needing vast amounts of taxpayer support.
Mr. Connolly said: “In the
circumstances we were in, it was recognised that the banks would
only be ‘going concerns’ if there was support forthcoming.”
“The consequences of reaching the conclusion that a bank was
actually going to go belly up were huge.” John Connolly,
Deloitte
He said that the firms held
meetings in December 2008 and January 2009 with Lord Myners, a
former director of NatWest who was appointed Financial Services
Secretary to the Treasury in October 2008.
What is the recourse for
shareholders and other stakeholders who lost everything if the
government was the one who prevented them from hearing any warning?
The
New York Court of Appeals decided on
October 21, 2010, by a vote of 4-3, to “decline to alter our
precedent relating to in pari delicto and imputation and the adverse
interest exception, as we would have to do to bring about the
expansion of third-party liability sought by plaintiffs here.”
The decision is flawed, misguided and
strongly biased towards corporate interests rather than shareholder
and investor interests.
Imputation – a fundamental principle
that has outlived its usefulness and that defies common sense and
fairness – has been reaffirmed in cases of third-party advisor
negligence or collusion.
“A fraud that by its nature will
benefit the corporation is not “adverse” to the corporation’s
interests, even if it was actually motivated by the agent’s
desire for personal gain (Price, 62 NY at 384). Thus,
“[s]hould the ‘agent act[] both for himself and for the
principal,’ . . . application of the [adverse interest]
exception would be precluded” (Capital Wireless Corp. v
Deloitte & Touche, 216 AD2d 663, 666 [3d Dept 1995]
[quoting Matter of Crazy Eddie Sec. Litig., 802 F Supp
804, 817 (EDNY 1992)]; see also Center, 66 NY2d at 785
[the adverse interest exception "cannot be invoked merely
because . . . .(the agent) is not acting primarily for his
principal"]). [*12]
New York law thus articulates the
adverse interest exception in a way that is consistent with
fundamental principles of agency. To allow a
corporation to avoid the consequences of corporate acts simply
because an employee performed them with his personal profit in
mind would enable the corporation to disclaim, at its
convenience, virtually every act its officers undertake.
“[C]orporate officers, even in the most upright
enterprises, can always be said, in some meaningful sense, to
act for their own interests” (Grede v McGladrey & Pullen LLP,
421 BR 879, 886 [ND Ill 2008]). A corporate insider’s personal
interests — as an officer, employee, or shareholder of the
company — are often deliberately aligned with the
corporation’s interests by way of, for example, stock options or
bonuses, the value of which depends upon the corporation’s
financial performance.
And this is ok?
A majority of the New York Court of Appeals
bought the self-serving, selfish and unjust arguments of the
defendants and their flunky amicus brief toadies supporting criminal
corporate fraudsters and, get this, the shareholders of the
accounting firms (!!). The New York Court of Appeals abandoned the
shareholders and creditors of Refco and AIG for criminals and
incompetents.
I could not have imagined more contemptible
excuses for judicial cowardice if I were writing this decision for a
novel of corporate cronyism to the extreme in a Utopian nirvana for
capitalist parasites.
“In particular, why should the
interests of innocent stakeholders of corporate fraudsters trump
those of innocent stakeholders of the outside professionals who
are the defendants in these cases?
…In a sense, plaintiffs’ proposals may
be viewed as creating a double standard whereby the
innocent stakeholders of the corporation’s outside professionals
are held responsible for the sins of their errant agents while
the innocent stakeholders of the corporation itself are not
charged with knowledge of their wrongdoing agents. And, of course, the corporation’s agents [*19]would
almost invariably play the dominant role in the fraud and
therefore would be more culpable than the outside professional’s
agents who allegedly aided and abetted the insiders or did not
detect the fraud at all or soon enough. The owners
and creditors of KPMG and PwC may be said to be at least as
“innocent” as Refco’s unsecured creditors and AIG’s
stockholders.“
The doctrine’s full name is in pari
delicto potior est conditio defendentis, meaning “in a case of
equal or mutual fault, the position of the [defending party] is the
better one” (Baena, 453 F3d at 6 n 5 [internal quotation marks
omitted]).
I have some other names for it:
Immunity from
Prosecution for the “Duped” theory
Incompetent Professional
service providers Defense
Regulators are
taking auditors to task over their rigor around some of the
accounting issues that proved especially volatile through the
economic crisis.
The Public Company Accounting Oversight Board
has
published a report summarizing its
observations after inspecting audits performed while credit market
seized and the economy plunged into depression. The report says
auditors generally didn’t adhere adequately to PCAOB standards when
it came to some of the toughest areas in financial reporting through
the credit crisis – namely fair value measurements, goodwill
impairments, indefinite-lived intangible assets and other long-lived
assets, allowances for loan losses, off-balance-sheet structures,
revenue recognition, inventory and income taxes.
The report
says firms have made some headway in responding to the increased
risks that erupted with the economic crisis, but it also implores
them to keep at it. Through future inspection cycles, the PCAOB says
it will continue to focus on whether firms have adequately addressed
quality control deficiencies that have been pointed out the past few
years. The board is especially interested in how firms are focusing
on audit risks raised by the ongoing effects of economic strife.
The PCAOB also
reveals in the report that it has referred a number of audit
deficiencies to its enforcement office for further investigation,
including cases involving financial services firms. However, the
board is prohibited from discussing investigations until cases are
settled in private.
The secrecy of the PCAOB’s enforcement process
is becoming increasingly frustrating to the board, in fact. Calling
it “the most pressing issue” facing his office, Claudius B. Modesti,
director of enforcement, joined the board in
calling on Congress to amend the
Sarbanes-Oxley Act to allow the PCAOB to conduct its enforcement
proceedings publicly.
In a recent
speech, Mostesti said the concealed enforcement process denies
investors information about allegations of misconduct and gives
those who are accused an incentive to draw out the process to stall
any public disclosures. That drains PCAOB resources and constrains
the board from using the disciplinary process as a deterrent, he
said.
In addition to
enforcement measures, the PCAOB also reveals in its report that it
will take its findings into account as it conducts future
inspections and considers new audit rules or new guidance for
auditors. The board said audit committees should use the report in
the meantime to guide dialogue with its financial reporting
management and its external auditor.
Internally,
for example, audit committees might want to check with management on
how the company handles the hot-button accounting areas that the
PCAOB identifies as problematic, how the company documents its
decisions and what type of information it provides to auditors, the
board said.
The report
also suggests audit committees talk with their auditors about how
the auditor is assessing audit risk in the areas raised by the PCAOB,
what strategy the auditor is following to address those risks, and
the results of audit procedures that are performed in relation to
those risks.
PCAOB Acting Chairman Daniel L. Goelzer said
in a
statement, “These inspection observations
underscore the need for auditors to be diligent in assessing and
responding to emerging areas of risk when economic and business
conditions change.”
The
House – Senate Wall Street Reform and Consumer Protection
Act Conference reconvened on Tuesday, June 15 and
Compliance Week says a version of the
Specter Bill – to repeal the Supreme Court’s Stoneridge decision –
will not be included in whatever comes out of the process.
Bruce Carton in Compliance Week: As this
process gets underway, auditors, lawyers, bankers and other
advisers to public companies are quietly breathing a sigh of
relief that one of the items no longer on the table is an
amendment proposed by Sen. Arlen Specter that would have
overturned the U.S. Supreme Court’s 2008 ruling in Stoneridge
Investment Partners, LLC v. Scientific-Atlanta, Inc.,
thereby permitting “aiding and abetting” liability for a
company’s auditors and others. The final version of the
financial reform bill that passed the Senate did not include the
Specter amendment.
However,
a coalition of state regulators, public
pension funds, professors, consumers and investors and the attorneys
who advise them, are still working to put something back in the bill
as an amendment to restore the right of investors to defend
themselves and hold white collar criminals accountable.
Their email
to me states:
The
amendment brought by Senators Arlen
Specter (D-PA), Jack Reed (D-RI), Dick Durbin (D-IL) and many
other senior Democrats would have enacted one simple change in
current anti-investor law – law that was “legislated” by a
conservative Supreme Court rather than the U.S. Congress. The
reform would have restored the right of pension funds and other
investors to hold accountable in courts those who knowingly aid
and abet securities fraud.
This
legal right of investors, which for fifty years helped white
collar crime victims recover their losses while also deterring
future fraud enablers, was stripped from shareholders and
bondholders by the radical Stoneridge Supreme Court
decision of 2008, which expanded upon an earlier misguided Court
decision in order to throw out thousands of remaining
meritorious fraud claims brought by retirement funds and
individual investors against investment banks and others who
helped design the Enron fraud – the largest financial crime in
U.S. history.
Earlier
this Spring, a Federal appeals court cited the “Supremes” and
threw out the legitimate claims of ripped-off shareholders and
bondholders in the billion dollar Refco, Inc. derivatives
fraud. In Refco, a now criminally convicted corporate lawyer
had worked with Refco’s senior execs to execute fake
transactions as a paper trail leading to falsified financial
statements that were issued to investors and the public.
I
have consistently disagreed with the Big 4’s claim that auditor
liability caps are necessary to
avoid losing one of the remaning firms to catastrophic
litigation. I have lamented the fact
that the auditors don’t get sued often enough for my tastes and,
when they do, they often settle. I’ve also said that they don’t
deserve our pity, as they are less than transparent regarding
their true financial capacity to address ongoing litigation…
“The
Treasury Department established the Advisory Committee on the
Auditing Profession to examine the sustainability of a strong
and vibrant auditing profession.”
John P. Coffey, the Co-Managing
Partner of Bernstein Litowitz Berger & Grossmann LLP… agrees
with what I have been saying on this blog all last year.
It is with
this perspective that I address one of the questions the
Committee is considering, namely, whether there ought to be a
cap on auditor liability. I respectfully submit that the case
for such a cap has not been made…
…the fact
that, in today’s environment, auditors are rarely named as
defendants in these actions. In a three-year period immediately
before the PSLRA was enacted – April 1992 through April 1995 –
auditors were named as defendants in 81 of 446 private
securities class actions filed, for an average of 27 suits per
year, or 18% of all private securities class actions. As the
reforms of the PSLRA and the concomitant jurisprudence took
hold, that number dropped precipitously. Auditors were named as
defendants in only five suits in 2005, and only two cases in
each of 2006 and 2007.
The number
for 2007 is especially telling because approximately one out of
every eleven companies with U.S.-listed securities – almost 1200
companies in all – filed financial restatements in 2007 to
correct material accounting errors. Further, an analysis of
securities actions filed in 2006 and 2007 demonstrates a
significant decline in the number of cases alleging GAAP
violations, appearing to suggest “a movement away from the focus
in recent years on the validity of financial results and
accounting treatment.”
Refco Inc.’s tax accountant, Ernst &
Young, and a company law firm may have helped the defunct
futures trader defraud investors, according to an examiner’s
report unsealed today.
Ernst & Young, the second-biggest U.S. accounting firm, and
Mayer Brown Rowe & Maw, a Chicago-based law firm, might face
claims by Refco for aiding and abetting the fraud, examiner Joshua
Hochberg said in a report filed in
U.S. Bankruptcy Court in New York. Grant Thornton, the sixth
biggest U.S. accounting firm, might face claims of professional
negligence for work it did before Refco’s bankruptcy, Hochberg
said.
Contrast
that seemingly slam-dunk assessment with this report on August 22,
2009:
Two
accounting firms and a law firm won dismissal of a lawsuit on
behalf of former Refco Inc currency trading customers who lost
more than $500 million when the defunct futures and commodities
broker went bankrupt.
U.S.
District Judge Gerard Lynch on Tuesday said Marc Kirschner, a
trustee representing the customers, failed to show that Ernst &
Young LLP [ERNY.UL], Grant Thornton LLP and the law firm Mayer
Brown LLP knew of or substantially assisted in the fraudulent
diversion of assets that led to Refco’s demise.
The
Manhattan federal judge, however, gave permission for Kirschner
to file a new complaint. Citing the trustee’s access to a
“substantial trove” of Refco documents, Lynch said: “It is far
from clear that repleading would be futile.”
In his
35-page opinion, Lynch said Grant Thornton’s work gave it “a
complete picture of how Refco and the Refco fraud, functioned.”
He also
said Mayer Brown “actively participated in carrying out Refco’s
fraudulent misstatement of its financial position,” while Ernst
performed to work for Refco “despite apprehending the scope of
the fraud.”
Question
Will the big auditing firms survive the explosion in lawsuits stemming
from questionable audits of failed firms in the wake of the 2008
economic collapse?
The
leadership of the Big 4 audit firms – Deloitte, Ernst & Young, KPMG
and PricewaterhouseCoopers – are scared witless. The auditors prefer
to be Switzerland. That is, they prefer to remain neutral. They
don’t like the kind of attention that Ernst & Young is getting.
They like the soft, managed,
scripted kind of attention for
Davos,
diversity,
charitable endeavors and support of
higher education.
Until
the
Lehman Bankruptcy Examiner’ Report was
issued on March 11th, the auditors had experienced a “good
crisis.” No serious scrutiny of their behavior, no testimony
before the various investigative committees of the US Congress and
only a few lawsuits that had not yet come to trial.
“Speaking at a meeting of accountants from
across the world at the Mansion House yesterday,
Paul Boyle
said: ‘So far at least, auditing has had a good crisis.’
Detractors, Boyle added, had been vague in their complaints and
had misunderstood the role of auditor, on the one hand, and
corporate governance and financial services supervision, on the
other. These statements are notable because Boyle is clearly
sticking up for the profession. If he had thought the opposite
he would presumably not addressed the subject during the speech.
This is active backing for auditors.”
So much for
that.
The Lehman
Bankruptcy Examiner threw the word “fraud” into the financial crisis
conversation.
The words
“auditor malpractice’” followed.
It’s
quite likely EY will be called before the US House
Oversight Committee to testify about the
Lehman bankruptcy. David Einhorn, a member of the much maligned
“short club,” will probably be called to
testify, too.
I
criticized Ernst & Young in mid-2008 for not questioning
Lehman’s CFO revolving door. Lehman had
chosen another non-CPA CFO, the second one in less than three years.
I was following the lead of another
Cassandra,
David Einhorn. Einhorn is now being heralded because he questioned
Lehman’s accounting, in spite of being ridiculed and damned for it
at the time. He’s getting almost as much applause as the
“whistleblower” du jour,
Matthew Lee.
Einhorn has also recently been vindicated in
another case where he called foul and
faced harsh criticism.
The
SEC’s watchdog found that the agency failed to properly pursue
serious allegations made against Allied Capital, a public
company that invests in small to midsize businesses. But after
heavy lobbying by Allied Capital, the agency aggressively
pursued the hedge fund manager who had challenged the value of
Allied’s investments…The case…began in 2002, when a hedge fund
manager named David Einhorn explained in a speech that he bet
against Allied Capital’s stock by short-selling it because he
thought Allied overvalued its holdings.
Other investors proceeded to short Allied’s stock, which
declined sharply in value.
About the same time, Einhorn began contacting the SEC by phone
and letter to explain his skepticism about Allied Capital’s
accounting techniques. Allied also worked behind the scenes to
urge the SEC to investigate whether Einhorn was engaging in
illegal behavior to undermine the company’s shares, according to
the inspector general’s report.
Without any specific evidence of wrongdoing, Allied met with SEC
investigators in June 2002 to urge them to investigate Einhorn.
Shortly thereafter, the SEC opened a probe, questioning Einhorn
about his trading activities, subpoenaing documents, and seeking
his telephone records and a list of clients. Soon after
investigators started looking at Einhorn, they concluded that he
had done nothing wrong.
Sources tell me that the SEC Inspector General’s report on the
Allied Capital investigation paints an even worse picture of the SEC
than those involved ever expected. For example, it was the SEC
lawyer who grilled Einhorn that later became a lobbyist for Allied
and was the one who hired private investigators to steal Greenlight
Capital’s phone records. Allied Capital’s auditor is
KPMG. They are
not yet accused of any wrongdoing,
but the report also discusses the
mis-valuations that Allied was originally
accused of by Greenlight.
Maybe it’s
time to start listening to the “shorts” and the contrarians.
Many
ask me if Ernst & Young will fail because of Lehman. I
have answered that in previous posts.
In short,
not immediately.
Maybe E&Y
won’t be the first of the remaining Big 4 to fail. The leadership
of the Big 4 are terrified because any one of them could be thrust
into the harsh spotlight the way Ernst & Young has been. At any
time.
Because
they’re all on the brink.
Take
KPMG. When the
New Century Trustee v. KPMG US and KPMG International
lawsuit comes to trial, you can bet the media will suddenly remember
there’s an auditor smoking gun there, too. Mr. Missal, the New
Century bankruptcy examiner, found emails that uncovered the same
kind of disregard for KPMG’s experts and their risk and quality
gurus that we saw in Arthur Andersen’s handling of Enron. New
Century is more like Enron for that reason than EY/Lehman is. So
far. That we know of.
Depending on how well
Steven Thomas tries it, the media will be
all over the “KPMG will fail” scenario. Losing the case carries a
$1 billion dollar price tag for KPMG. There’s also significant
implications for the global network business model in addition to
the enormous costs of KPMG defending themselves in the meantime.
Arthur Andersen’s partner ignored his own expert’s advice in
Enron. KPMG is accused of doing the same
in New Century. All for the sake of keeping a lucrative client. EY
may have done the same to hold onto Lehman. Certainly the
long, lucrative relationship between EY and Lehman
paints a similar picture of mercenary
motivation.
When EY’s
Lehman audit team ran into the growing use of Repo 105 transactions,
or the declining market value of the CDOs, or the Archstone REIT or
any of the other problematic accounting issues mentioned in the
Examiner’s report, one of four scenarios took place:
The
audit team didn’t ask for advice from their technical GAAP and
SEC reporting/disclosure specialists at EY headquarters. The
team went along and did what had always been done in the past:
They acquiesced to Lehman CFOs. After all it was the Lehman
CFO Goldfarb, an EY alumni who designed the transactions and
approved the accounting treatments. When Sarbanes-Oxley
outlawed the revolving door of audit partners moving into high
level positions at clients, Dick Fuld chose non-accountants who
didn’t know better, would not question and weren’t interested in
accounting.
Or…The
audit team asked for advice from their technical GAAP and SEC
reporting/disclosure specialists at EY headquarters. The
headquarters specialists blessed the existing treatment. After
all it was Lehman CFOs who were EY alumni who had designed the
transactions and approved the accounting treatments.
Or…The
audit team asked for advice from their technical GAAP and SEC
reporting/disclosure specialists at EY headquarters. The audit
team received advice that the problematic issues represented
unacceptable treatments according to current standards. And/or
the experts suggested disclosures to clarify Lehman’s position.
When this answer was brought to the audit partners they
dismissed it and acquiesced to the Lehman executives. That’s
similar the KPMG/New Century scenario.
Or…The
audit team asked for advice from their technical GAAP and SEC
reporting/disclosure specialists at EY headquarters. The audit
team received advice that the problematic issues represented
unacceptable accounting treatments according to standards. When
this answer was brought to the audit partners they raised the
issue with Lehman executives, encouraged them to stop
manipulating the balance sheet without disclosures using Repo
105 or to write down assets such as Archstone or the CDOs and
were rebuffed. Lehman executives threatened to fire them and
replace them with another firm like KPMG and EY backed down. We
may never know if this happened unless or until EY partners are
forced to settle charges and flip on the Lehman executives.
Or
take the massive Satyam fraud-related litigation facing
PricewaterhouseCoopers. When the courts in the Southern District of
New York decide that
PwC’s motions to dismiss are denied,
PricewaterhouseCoopers will face a flood of lawsuits that will dwarf
New Century v. KPMG. The publicity over EY/Lehman should make it
difficult for the court to accept any lame excuses from PwC. PwC’s
argument is that the case should be tried in India but they are
fighting in India to have the case dismissed.
New
York courts will now hear age discrimination litigation that names
PwC as a defendant because the courts agreed that
decisions about PwC partnership are made in New York. That
same theory can certainly be applied when it comes to PwC global
leadership (elected to represent the interests of the owners of its
largest member firms) and their control over a global client like
Satyam. Satyam is a PwC client that was listed on the New York Stock
Exchange. The global leadership exerted control over member firm
India because it has significant strategic
importance to the global leadership.
The global leadership exerted that control
using the PwC International Limited legal construct.
I asked
PCAOB spokesperson Colleen Brennan if there was more to come. What
about the Price Waterhouse India partners that were jailed?
The order says formal investigation started Jan 8,
2009. It is now 14 months later and the outcome is that they
wouldn’t talk to you. What took so long? Generally speaking the
investigative process requires getting relevant audit work
papers and other documents and scheduling the testimony of
witnesses. Particularly in cases where witnesses are located
abroad, which is the case here, the staff works with the
witnesses and their counsel regarding an appropriate location
for the testimony. Depending on the location, different
planning goes into scheduling the testimony. Under the Board’s
rules, witnesses are allowed to have counsel present during
their testimony. In this instance, the auditors obtained new
counsel during the investigative process which led to a
postponement of the original testimony.
Is this it on your Satyam activities? What else is
PCAOB doing to address the Satyam matter? The order mentions that
the Board issued an order of formal investigation relating to
the audits of Satyam. We cannot comment further.
What are next steps for PCAOB on Satyam? The disciplinary
proceedings as to these respondents are complete. The Board
does not comment one way or another about the specifics of its
investigative inventory. (We cannot confirm that we have an
ongoing investigation because Section 105(b)(5)(A) of the
Act. This is the first case where we barred someone only for
non-cooperation with Enforcement.)
Has the Board charged any other Lovelock & Lewes
personnel, or Lovelock & Lewes, the firm, in connection with the
Satyam audit? We
cannot comment on whether others have been or will be charged.
These orders only address the conduct of Messrs. Ravindernath
and Prasad.
Are the Board’s investigation and disciplinary
proceedings in connection with this matter completed? These disciplinary
proceedings are completed as to Messrs. Ravindernath and
Prasad. The Board does not comment one way or another about the
specifics of its nonpublic investigative inventory, or about any
proceedings that may be in litigation before the Board, which
are non-public as required by the Sarbanes-Oxley Act.
What prompted the Board to investigate the audits
and reviews of Satyam’s financial statements? The orders disclose that
Satyam filed a Form 6-K with the SEC on January 7, 2009, that
its chairman had revealed that he had inflated key financial
results, and the Board issued an order of formal investigation
on January 8, 2009.
Is the SEC also investigating this matter? Do you
expect the SEC also to take enforcement action against Satyam
management, or the auditors in this matter? As a matter of policy, the
Board does not comment on SEC investigations.
Each of the
largest global audit firms could take a hit of $1 billion if forced
to. They would find a way to come up with the cash. But they don’t
want to. A $1 billion dollar settlement would make a significant
impact on any of the firms. A settlement or judgment, especially of
that size, would make it very difficult to stay in business even if
the firm remained technically viable.
But there
are several $1 billion claims out there. All four of the largest
firms are suffocating under the weight of the potential claims and
the cost to defend them as well as the distraction from normal
business activities and the impact on morale.
The Big 4
feels the pain on a rotating basis, only for a short for a while,
and only whenever a painful exposé such as the Lehman bankruptcy
report surfaces or a case gets closer to trial. Then the media moves
on. Very few cases against the auditors went to trial in the past.
There are many reasons for this. But the sheer volume of cases
filed given number of scandals, frauds and failures, is giving
plaintiff’s lawyers and regulatory enforcement more practice than
ever before. The plaintiff’s lawyers, in particular are talking to
each other, sharing information and getting better at their
arguments with each filing.
The tide’s
gone out and left the audit firms high and dry.
Which
case will be the showcase trial of the new millennium? Which billion
dollar case will
make it to the jury first? Which case will
force legislators and regulators to admit the business model for
public accounting is irreparably broken?
"Audit Quality and Auditor
Reputation: Evidence from Japan," by Douglas J. Skinner The
University of Chicago - Booth School of Business and Suraj Srinivasan ,
Harvard Business School, SSRN, Revised April 7, 2010 ---
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1557231
Abstract:
We study events surrounding ChuoAoyama’s failed audit of Kanebo, a
large Japanese cosmetics company whose management engaged in a
massive accounting fraud. ChuoAoyama was PwC’s Japanese affiliate
and one of Japan’s “Big Four” audit firms. In May 2006, the Japanese
Financial Services Agency (FSA) suspended ChuoAoyama’s operations
for two months as punishment for its role in the accounting fraud at
Kanebo. This action was unprecedented, and followed a sequence of
events that seriously damaged ChuoAoyama’s reputation for audit
quality. We use these events to provide evidence on the importance
of auditors’ reputation for audit quality in a setting where
litigation plays essentially no role. We find that ChuoAoyama’s
audit clients switched away from the firm as questions about its
audit quality became more pronounced but before it was clear that
the firm would be wound up, consistent with the importance of
auditors’ reputation for delivering quality.
Student Term Paper and/or Debate Idea One idea for a student term paper or student debate would be to
compare consumer product protection legislation and tort litigation with
auditing firm legislation (e.g,, Sarbox) and malpractice insurance
costs. This is relevant at the moment because of the pending 2010
Consumer Product Safety Improvement Act versus questions whether
auditing firms will recover from pending lawsuits of thousands of bank
failures ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
This is now especially
important debate for financial auditing firms who are possibly at risk
of imploding like Andersen due to regulation and litigation risks.
One thing I would like to learn more
about is the cost of auditing firm malpractice insurance compared
between different nations such as the U.S. versus Canada versus Japan
versus Germany.
One issue of great concern is how
regulation and tort liability can easily put small businesses and small
auditing firms out of business even before lawsuits due to the mere cost
of meeting regulation requirements and the exploding cost of malpractice
insurance.
A second issue extends these question to
large businesses and international auditing firms.
Students can also be assigned to debate
the pros and cons of regulation and liability protection "relief."
One important point to consider is the
2006 Texas amendment to its constitution that limits punitive damages in
medical malpractice lawsuits without limiting damages for loss of income
in medical malpractice awards. Before this amendment may medical
specialists dropped high risk services due to the high cost of
malpractice insurance. For example, my wife's great female OB/GYN
surgeon in San Antonio dropped OB services completely in 2003 because
insurance coverage and Medicaid payments did not even cover the
malpractice insurance cost for her OB services. After Texas amended its
constitution, malpractice insurance costs dropped significantly. This
great GYN surgeon once again added OB to her services after 2006.
Years ago while we were still living in
San Antonio, Texas my wife had two of her 12 spine surgeries performed
by a surgeon from the South Texas Spinal Clinic. When it came
time for next surgery her surgeon turned her away saying that the Clinic
no longer accepted any Medicare patients (she was then covered under
Medicare Disability Insurance before retirement age). Purportedly the
soaring costs, especially malpractice insurance, made complicated
Medicare surgeries, on average, big money losers in for spinal surgeons
in Texas. We subsequently moved to New Hampshire where Erika had two
spine surgeries from Dr. Levi at the Concord Hospital. Erika later
became so bent over that we afterwards sought out one of the very few
specialists in the nation who can perform a "Pedicle Subtraction
Osteotomity for Severe Fixed Sagittal Imbalance."
She went into a Boston hospital bent over like the Hunchback of
Notre Dame and came out walking Marine-drill erect in 2007 (but with no
relief from her chronic pain). She has hundreds of thousands of dollars
worth of metal attached to her spine from neck to hips. But since it is
jointed in three places, she can pick up a paper towel off the floor.
---
http://www.trinity.edu/rjensen/Erika2007.htm
Out of curiosity in November 2009, I phoned the South Texas Spinal
Clinic and discovered it once again is accepting Medicare patients even
though Erika has no intention of returning to that Clinic. Ostensibly a
major factor in deciding to once again take on Medicare patients is the
decline in malpractice insurance costs due largely to a change in the
Texas Constitution. Interestingly, decreases in
malpractice insurance costs have been a major factor in increasing
competition for physician specialists in Texas:
Four years
after Texas voters approved a constitutional amendment limiting
awards in
medical malpracticelawsuits, doctors
are responding as supporters predicted, arriving from all parts of
the country to swell the ranks of specialists at Texas
hospitalsand bring professional health
care to some long-underserved rural areas. “It was hard to believe
at first; we thought it was a spike,” said Dr. Donald W. Patrick,
executive director of the medical board and a neurosurgeon and
lawyer. But Dr. Patrick said the trend — licenses up 18 percent
since 2003, when the damage caps were enacted — has held, with an
even sharper jump of 30 percent in the last fiscal year, compared
with the year before. Ralph Blumenthal, "More Doctors in Texas After Malpractice
Caps," The New York Times, October 5, 2007 ---
http://www.nytimes.com/2007/10/05/us/05doctors.html
Under financial stress hospitals in
Massachusetts have had to take huge budget cuts. Rather than spread
those cuts across the board to all departments, some hospitals have
decided to concentrate on dropping the most money-losing departments.
You probably can guess the leading candidate for being eliminated ---
the obstetrics department.
My neighbor down the road has a second
home up here in the White Mountains. However, he still practices
cardiology in a Boston suburb. He says that Mass. hospital obstetrics
departments are leading candidates for elimination, in large measure,
because of the high cost of malpractice insurance covering obstetrics
services relative to insurance payment caps in Mass.
Lawyers file cookie-cutter lawsuits
against doctors, nurses, and hospitals for every defective baby
irrespective of the facts in any given case. The reason is the tendency
of sympathetic juries to make multimillion dollar awards to a mother of
a defective baby irrespective of the facts in the case. Many juries feel
that fat cat insurance companies owe it to the unlucky woman (and her
lucky lawyers) who must nurture and raise a severely handicapped child.
Juries make such awards even when the doctors, nurses, and hospitals
performed perfectly under the circumstances. Paul Newman showed us how
to love it when lawyers beat the medical system in favor of the "poor
and powerless" in The Verdict ---
http://www.youtube.com/watch?v=zVZFlBJftgg
But so-called "fat cat" insurance
companies adjust rates based upon financial risks. The rates became so
high for obstetrics that across most of the U.S. (less so in states like
Texas that cap punitive damages) thousands of gynecologists dropped the
obstetrics part of their services. And under then Governor Mitt Romney's
Universal Healthcare in Massachusetts some strained hospitals dropped
obstetrics services.
Canadian
Malpractice Insurance Takes Profit Out Of Coverage," by Jane Akre, Injury
Board, July 28, 2009 ---
Click Here
The
St. Petersburg Times
takes a look at the cost of insurance
in Canada for health care providers.
A neurosurgeon in Miami pays about
$237,000 for medical malpractice insurance. The same professional in
Toronto pays about $29,200, reports Susan Taylor Martin.
These are just some factors to consider
in the debate about the pros and cons of providing some relief from
killer regulations and lawsuits for high risk product manufacturing and
high risk services.
One thing I would like to learn more
about is the cost of auditing firm malpractice insurance compared
between different nations such as the U.S. versus Canada versus Japan
versus Germany.
This is now an important debate for
financial auditing firms who are possibly at risk of imploding like
Andersen due to regulation and litigation risks.
The phrase in pari delicto
sounds like something dirty to me. Maybe I’m still preoccupied with
the
accusation
that I’m producing accounting pornography.
“…the etymology of the term [pornography] is: “Etymology:
Greek pornographos, adjective, writing about prostitutes, from
porn prostitute + graphein to write; akin to Greek pernanai to
sell, porosjourney “
That implies accounting porn is writing about accounting
prostitutes. That being the case, then Francine McKenna, Sam
Antar, Tracy Coenen and Bob Jensen all engage in accounting
porn. They write about the corporate executives and audit firm
partners that prostitute their accounting reports in the search
for fictitious profits and all too real unearned bonuses. In
other words, accounting fraud is accounting prostitution…”
In pari delicto,
for those of you not lawyers or legal argument junkies like me,
is “Latin for “in equal fault”.
It’s a legal term used to indicate that two persons or
entities are equally at fault, whether we’re talking about a
crime or
tort. The phrase is most commonly used by
courts when relief is being denied to both
parties in a
civil action because of wrongdoing by both
parties. The phrase means, in essence, that since both parties are
equally at fault, the court will not involve itself in resolving one
side’s claim over the other, and whoever possesses whatever is in
dispute may continue to do so in the absence of a superior claim.”
There are two active cases where this
doctrine and defense is being employed by auditors trying to avoid
liability for fraud.
In Teachers’ Retirement System of
Louisiana v. PricewaterhouseCoopers LLP, No. 454, 2009 (Del.
March 4, 2010), one of many AIG suits that PwC is involved in
directly or indirectly, the Delaware Supreme Court used a
procedure provided for under the New York Rules of Court to
certify a question of law to New York’s highest court, the New York
Court of Appeals.This matter involves an
appeal from the Delaware Court of Chancery regarding the oft-cited AIG
case which denied a motion to dismiss claims against the top
officials of AIG for breach of fiduciary duty based on Delaware law.
However, the claims against the auditor, PwC, were dismissed based
on New York law. The Plaintiff’s are appealing the Chancery Court’
decision regarding PwC. (Summary borrowed for accuracy from Francis
Pileggi at
Delaware Litigation.com who alerted me to this most
unusual move by the Chancery Court.)
The Court of Chancery held that the claims against PwC
were governed by New York law, and that based on the allegations
of the Complaint, AIG’s senior officers did not “totally
abandon[]” AIG’s interests—as would be required under New York
law to establish the “adverse interest” exception to
imputation. Accordingly, the Court of Chancery held that the
wrongdoing of AIG’s senior officers is imputed to AIG.3 The
Court of Chancery concluded that, once the wrongdoing
was imputed to AIG, AIG’s claims against PwC were barred by New
York’s in pari delicto doctrine and by the related Wagoner line
of standing cases in the United States Court of Appeals for the
Second Circuit.
This Court hereby certifies the following question to the
New York Court of Appeals:
Would the doctrine of in pari delicto bar a derivative
claim under New York law where a corporation sues its
outside auditor for professional malpractice or negligence based
on the auditor’s failure to detect fraud committed by the
corporation; and, the outside auditor did not knowingly
participate in the corporation’s fraud, but instead, failed to
satisfy professional
standards in its
audits of the corporation’s financial statements?
The other case where the in
pari delicto defense has tied the litigation into
knots and caused some stops and starts is in Kirschner v.
KPMG LLP et al., case number 09-2020, in the U.S. Court of
Appeals for the Second Circuit which is about the
Refco fraud. The
Second Circuit certified the questions
about an exception to the in pari delicto defense. Now they have two high profile cases against
auditors to consider. From
Law360.com:
Not one to go down easy, the bankruptcy trustee for
Refco Inc. brought his suit implicating
Mayer Brown LLP,
KPMG LLP and other corporate giants in the massive Refco
fraud to a federal appeals court…The U.S. Court of Appeals for
the Second Circuit found Monday that trustee Marc S. Kirschner’s
fight to revive his claims against the clutch of corporate
insiders raised critical unresolved questions concerning the
bankruptcy trustee’s standing under New York law to sue third
parties for Refco’s fraud.
The trustee alleges outside counsel Mayer Brown, auditors
Ernst & Young LLP, [Grant Thornton]
PricewaterhouseCoopersLLP, Banc of America Securities LLC
and several other insiders are liable for defrauding Refco’s
creditors, namely by helping the defunct brokerage conceal
hundreds of millions of dollars in uncollectible debt.
Ms. Vance wrote an article entitled, In
Pari Delicto, Reconsidered, in which
she posited–as none had before–that the in pari delicto
doctrine is being inappropriately used by federal
courts to supplant traditional tort law defenses that derive from
state, not federal, law.
The way I see it, the in pari delicto
doctrine is being used like a pair of needle nosed
pliers by audit firm defense lawyers to diffuse a bomb – huge
liability for some of the biggest frauds in history. The in pari delicto doctrine attempts to pull the
auditors’ tails from the fire by excusing any of their guilty acts
due to the approval of those acts by potentially equally guilty
executives. The law allows these executives to continue to “stand in
the shoes” of the shareholder plaintiffs even after their guilt has
been determined. The theory is that the executives perpetrated the
fraud for the benefit of the corporation and never “totally
abandoned” it, as would be required for the “adverse interest”
exception.
Auditors who should otherwise be tested on
their fulfillment of their public duty are instead getting reprieves
because courts have been unwilling to impose the
“adverse interest” exception as
expansively as they have the in pari delicto
defense itself. How can executives who are successfully sued, been
subject to regulatory sanctions or, in the case of the Refco executives,
plead guilty to criminal activities, still be considered
representatives of the corporation’s interests? They should forfeit
the right to stand in the shoes of the corporation’s shareholders in
derivative suits and therefore to shield other potentially guilty or
negligent parties.
The situation gets complicated in a
bankruptcy case such as Refco since, traditionally according to
Section 541 of a decision called
In re PSA, Inc, “property of the
bankruptcy estate consists of all legal or equitable interests of
the debtor, including causes of action, as of the commencement of
the bankruptcy case. A bankruptcy estate’s causes of action,
therefore, as well as the attendant defenses thereto, transfer to
the bankruptcy trustee frozen and fixed as they existed at
the commencement of the bankruptcy case. As a result, an “innocent”
bankruptcy trustee “stands in the shoes” of the pre-petition debtor
and may be unable to prevail on estate causes of action where the
pre-bankruptcy debtor participated or was complicit in the wrongful
acts upon which the estate attempts to sue.”
A trustee in bankruptcy must have
standing to sue anyone on behalf of
the creditors and other injured parties. Unfortunately, this habit
of allowing guilty parties to continue to drive the bankruptcy bus
by having the
actions of the guilty officers “imputed” to the corporation
and, therefore, in bankruptcy to the trustee
potentially threatens the trustee’s ability to sue
“co-conspirators.”
It’s just nuts.
Akin Gump summarizes critics of this line
of reasoning this way:
The purpose of the in pari delicto defense,
they argue, is to prevent a party who is complicit in wrongdoing
from prevailing against their joint actors. In their view, the
intercession of an innocent trustee whose duty it is to maximize
the value of the estate for the debtor’s creditors purges the
taint of the debtor’s wrongdoing, and that to hold otherwise
would simply elevate the legal fiction of section 541 over the
purpose of the in pari delicto defense.
Ms. Vance reminds us in her
treatise that
in pari delicto was
ushered into modern bankruptcy jurisprudence as a part of the
deepening insolvency
discussion. I’ve written about deepening insolvency many times as it
relates to the auditors who, by continuing to provide false and
negligent clean audit opinions, allow a company to go deeper and
deeper into debt and ruin, thereby significantly diminishing any
remaining value for stakeholders once the gig is up.
The deepening insolvency
arguments have been
shot down by no less than
Judge Posner whose pernicious pragmatism
forces him to engage in the self-delusion that helping companies
remain “viable” via fraud doesn’t hurt anyone. This fantasy
presupposes the company to be a person and not the embodiment of the
goals and objectives, hopes and dreams, faith and trust of the
shareholders, employees, creditors, and community that count on it
to continue legally and honorably instead. I suppose a
Supreme Court that allows corporations to donate money to political
campaigns in an exercise of their
inalienable constitutional rights would not find this idea so
strange.
2009 was a difficult year overall for the Big Four accounting firms:
Deloitte, Ernst & Young (E&Y), KPMG and PricewaterhouseCoopers
(PwC), as their financial performance was affected by tough external
conditions, slow global economic growth, cost-conscious clients and
sluggish merger and acquisition activity.
After an extraordinary period of continuous revenue growth from the
early 2000s to 2008, combined revenue for the four firms in fiscal
2009 did fall by 7% from fiscal 2008 in US dollar terms. Revenue
decreases in US dollar percentage terms ranged from negative 5% for
Deloitte to negative 7% each for Ernst & Young and
PricewaterhouseCoopers to negative 11% for KPMG.
The large fall in US dollar terms was also driven by the
appreciating US dollar during the period. Despite this, the combined
revenues of the Big Four firms was an astonishing $94 billion, with
PwC retaining its leadership position as the largest accounting firm
on the planet by narrowly beating Deloitte.
The Americas region represents about 40% of global revenues for the
Big Four firms, but its share has been falling over the years, due
to the preponderance of mature markets. Contrary perhaps to common
belief, Europe, Middle East and Africa has the highest percentage of
total revenues for the Big Four firms at 45%. Asia Pacific, while
being the smallest region at 15% of revenues, has posted the highest
growth rates, owing to the strong upswing in many emerging Asian
economies.
The Audit service line accounts for almost 50% of total revenues and
has been generally holding at this level across the years. Tax
services experienced strong growth in 2006 to 2008, in sync with
global merger and acquisition transactions activity. Advisory
services has been the fastest growing service line as the firms
extend their services into risk management and business consulting.
The Big Four firms cumulatively employ more than 600,000
professionals globally, with a total of 34,000 partners overseeing a
steep pyramid of about 470,000 professionals.
Despite the world’s worst financial crisis for over 70 years, the
Big Four firms turned in quite a creditable performance, with
revenues falling only by a small percentage in local currency terms.
For 2010 and beyond, we will likely see a return back to revenue
growth, though it is debatable whether a string of double-digit
growth over multiple years will be seen for the next few years. 2010
will also be an interesting year to watch for any changes in Big
Four rankings, with a close race between Deloitte and
PricewaterhouseCoopers for the leadership position.
________________________________________
REVENUE PERFORMANCE
2009 Reverses Multi-year Revenue Growth Trend
2009 was a difficult year overall for the Big Four accounting firms:
Deloitte, Ernst & Young (E&Y), KPMG and PricewaterhouseCoopers
(PwC), as their financial performance was affected by tough external
conditions, slow global economic growth, cost-conscious clients and
sluggish merger and acquisition activity. After an extraordinary
period of continuous revenue growth from the early 2000s to 2008,
mostly at a double-digit percentage rate, combined revenue for the
four firms in fiscal 2009 did fall by 7% from fiscal 2008 in US
dollar terms.
Quite apart from operating considerations, the large fall in US
dollar terms was also driven by the appreciating US dollar during
the period. The decrease in local currency terms was at a much lower
level, ranging from negative 3% to positive 1%.
Despite the decrease in revenues, these large accounting firms
posted some big numbers in 2009, their combined revenues was an
eye-popping $94 billion, dropping from an all-time record level of
over a $100 billion in 2008. Revenue decreases in US dollar
percentage terms also differed across firms, ranging from negative
5% for Deloitte to negative 7% each for Ernst & Young and
PricewaterhouseCoopers to negative 11% for KPMG. In local currency
terms, revenue decreases were more modest, from positive 1.0% for
Deloitte, 0.2% for PricewaterhouseCoopers to negative 0.2% for Ernst
& Young and negative 2.6% for KPMG.
The difference across firms was driven by the intrinsic nature of
the firm itself and varying compositions of service lines and
geographies and a small effect due to fiscal years which spanned
different calendar months. Deloitte’s fiscal 2009 ended on May 31,
2009, E&Y and PwC’s fiscal 2009 ended on June 30, 2009 and KPMG was
the last to close out the fiscal year on September 30, 2009. In
2009, this small difference in fiscal year-ends would have had a
relatively higher impact, for example, KPMG’s fiscal year 2009
coincided exactly with meltdown in financial markets as Lehman
Brother collapsed in September 2008. Other Big Four firms had three
to five fewer months of this negative impact.
Fluctuations in the US dollar also contributed to the higher level
of percentage drops. The US dollar appreciated strongly from
mid-2008 to mid-2009 against a basket of foreign currencies, after
staying weak in the prior twelve months. This had an unfavorable
effect, as depreciating local currencies, where the firms earned
revenue, were converted into US dollars, in which the firms reported
their annual results. In general, decreases expressed in US dollar
terms were about 7% lower than decreases expressed in local currency
terms.
PricewaterhouseCoopers retained its first place as the largest
accounting firm on the planet with revenues of $26.2 billion,
narrowly beating Deloitte, a very close second with revenues of
$26.1 billion. Ernst & Young took the third spot at $21.4 billion,
and KPMG maintained its position as the smallest of the Big Four
firms at $20.1 billion of revenues. Deloitte proved to the most
resilient firm to the tough economy, with its revenue falling only
4.9% in US dollar terms, while close rival PricewaterhouseCoopers’
revenues decreased 7.1%. This enabled Deloitte to close the gap
against PwC in 2008 to be at almost at par in 2009. In 2010, it will
be interesting to see who will gain the leadership spot, as a
relatively stronger performance by Deloitte could well edge it past
PwC.
The Big Four firms have had an astonishing run up in total revenues
over the last six years. In 2004, combined firm revenues were only
$60 billion, but by 2008, this had moved up at a compounded annual
growth rate of 14% to exceed $100 billion. Some of this gain was
from the collapse of Andersen, as Andersen’s $10 billion or so of
revenues in 2002 was generally redistributed over the remaining four
firms. Beyond this, the global financial boom in the middle of the
decade, combined with assertive penetration into emerging economies
provided the engine for revenue increases.
This positive trend rapidly reversed in 2009, the first time in six
years, as economies all over the world came to an abrupt halt in
mid-2008, with many countries going into recessions, and ultimately
affecting the seemingly unstoppable growth in Big Four firm
revenues. Even with this drop in 2009, the six year compounded
annual growth rate from 2004 to 2009 was 9%, a remarkable
achievement, given that these multi-billion dollar enterprises had
to grow their size by nearly 60% from a high starting point by
either finding new revenue opportunities or penetrating current
clients.
Despite being auditors for the world’s public companies who are
required to report extensive details on their financials, the Big
Four firms provide only very high level financial information with
minimum commentary, with consequent impact on the depth of possible
analysis in our study.
________________________________________
2009 FIRM PERFORMANCE
We blogged on each firm’s 2009 financial performance as they
sequentially reported on The Big Four Blog, and we encourage our
readers to read those analyses to obtain a flavor of the timing and
our immediate response.
Ernst & Young was the first to report its 2009 financials, and with
Deloitte following (on a much delayed schedule) it became clear that
the year was turning out to be quite challenging on the revenue
line. PwC followed suit, showing flat revenue growth on a local
currency basis. KPMG was the last to report in December 2009, and
its revenues fell the most among all the four firms. Additional data
points from the UK member firms, where the Big Four firms have to
provide more detailed information, proved that the pressure on the
top line was also leading to lower bottom lines and decreased
profits per partner.
In 2009, while revenues fell drastically in developed markets, all
firms generally noted that emerging markets were more resilient
against slowdowns, and revenues rose in many developing countries.
The appreciating US dollar caused the percentage drop in US dollars
to exceed the more modest drops in local currency. In general the
firms’ results met our expectations, though KPMG’s sharp fall was
quite surprising. In addition, Ernst & Young changed their method of
reporting in 2009, choosing to report combined, rather than
consolidated revenues, which led to a lower level of reported
revenues.
PricewaterhouseCoopers’s FY 2009 global revenues for the year ending
June 30, 2009 was US$26.2 billion, a 7.1% decline from the US$28.2
billion in FY 2008 in US dollar terms. However, on local currency
terms FY 2009 revenues were actually higher than FY 2008 by a modest
0.2%. This performance enabled PwC to remain the largest accounting
firm on the planet.
In terms of service lines, Assurance grew 2.0% in local currency
terms to $13.1 billion, but in terms of US dollars, revenues
actually fell by 4.8% from $13.8 billion in 2008. PwC attributed
this to market-leading strength of the business and its continued
focus on improved customer service and very competitive pricing. Tax
services fell by 0.3% in local currency terms to $6.9 billion, but
fell 7.5% in US dollar terms from $7.5 billion in 2008. Tax was
impacted by the worldwide decline in corporate deals and
restructuring work. Advisory services fell by 2.9% in local currency
terms to $6.1 billion, but fell 11.4% in US dollar terms from $6.9
billion in 2008. This service line was the hardest hit by the global
slowdown, as M&A and IPOs dried up and private equity firms slowed,
while bankruptcy and restructuring work provided some offset.
In terms of geographies, Asia revenues rose about 4% to $3.7 billion
in local currency terms but falling about 5% in US dollar terms from
$4.0 billion in 2008. Revenues in the smaller regions of Middle East
& Africa (up 9.1%) and South & Central America (up 13.3%) also rose
strongly in local currency terms, showing strong growth in emerging
markets. In the developed world, revenues in both Europe and North
America declined, and since these account for 85% of total PwC
revenues, they essentially drove the results for the firm. Revenue
growth was high in a number of PwC member firms around the world,
with particularly good results in Japan, Russia, Spain, Sweden and
Canada.
________________________________________
Deloitte Touche Tohmatsu, the global firm, reported fiscal 2009
revenues for the year ending May 31, 2009 of US$26.1 billion, an
increase in local currency terms of 1%, but a drop of 4.9% in US
dollar terms from 2008.
By service line, Consulting (Advisory) was the fastest grower at
7.3% in local currency terms; and in US dollar terms, revenue
increased 2% from $6.3 billion in 2008 to $6.5 billion in 2009.
Audit was relatively flat against 2008 in local currency terms; in
US dollar terms, Audit shrank by 6.4% from $12.7 billion to $11.9
billion. Tax was also relatively flat against 2008 in local currency
terms; in US dollar terms, Tax revenues decreased by 5.5% from $6.0
billion to $5.7 billion. Financial Advisory Services revenue fell
6.1% in local currency terms, but in US dollar terms, fell by 13.8%
from $2.4 billion in 2008 to $2.0 billion in 2009.
In terms of geography, Americas dropped 1.3% in local currency terms
and 3.7% in US dollar terms from $12.9 billion in 2008 to $12.5
billion in 2009. Europe, Middle East and Africa rose 2% in local
currency terms but dropped 9.0% in US dollar terms from $11.3
billion in 2008 to $10.2 billion in 2009. Asia Pacific grew 4.7% in
US dollar terms from $3.2 billion in 2008 to $3.4 billion in 2009.
The Asia Pacific region had local currency growth of 7.6% and was
the fastest-growing region for the fifth consecutive year. India’s
revenues grew 29.9%, Australia grew 11.5% and Japan grew 11.3% in
local currency terms.
Africa, the Middle East, and Latin America and the Caribbean posted
high growth rates of 21.3%, 15.6% and 13.7% respectively, in local
currency.
Despite this remarkable performance, Deloitte was unable to beat PwC
to be the largest Big Four firm in the world. Its 2009 revenues of
$26.1 billion were behind PwC’s 2009 revenues of $26.2 billion by
only $100 million or 0.4%. We had indicated in our earlier analysis
that a 4.5% decrease in Deloitte’s revenues in US dollar terms would
make it the largest among the Big Four firms. However, Deloitte’s
overall revenues actually dropped by 4.9% from 2008 to 2009,
narrowing, but not completely closing the gap against PwC. By
showing remarkable performance in 2009, arguably one of the toughest
environments in recent memory, Deloitte has shown that it is a
strong contender for the leadership position.
________________________________________
Ernst & Young’s combined worldwide 2009 revenues for the year ending
30 June 2009 were US$21.4 billion, decreasing a modest 0.2% in local
currency terms from the comparable period in FY 2008 of US$23.0
billion in global revenues. In US dollar terms, the revenue actually
declined 6.8% from 2008 to 2009.
Assurance Services with FY 2009 revenues of $10.1 billion offset
price pressure with market-share gains, and revenues declined only
0.7% in local currency terms, but 6.3% in US dollar terms. Global
Tax Services with FY 2009 revenues of $5.8 billion was up 1.8% in
local currency terms due to increased tax enforcement, but dropped
5.2% in US dollar terms. Advisory Services with FY 2009 revenues of
$3.6 billion was up 1.5% in local currency terms due to sustained
demand for risk management and performance improvement, but dropped
6.0% from $3.8 billion in 2008 in US dollar terms.
Transaction Advisory Services with FY 2009 revenues of $1.9 billion,
had a 6.9% decrease in local currency terms due to fall in M&A
volumes, but revenues decreased a large 14.8% in US dollar terms
from $2.2 billion in 2008.
Across E&Y’s five geographic areas, Japan grew at 7.5% in local
currency terms, due to the acquisition of 1,000 professionals from
accountancy firm Misuzu; and revenues increased 20% in US dollar
terms. The Europe, Middle East, India and Africa (EMEIA) area grew
1.8% in local currency terms, but declined 9.7% in US dollar terms.
Oceania decreased 0.4% in local currency terms, but declined a
dramatic 15.9% in US dollar terms. The Far East decreased 2.7% in
local currency terms and 5.9% in US dollar terms. The Americas area
decreased 3.2% in local currency terms, but 5.5% in US dollar terms.
There were some bright spots however, with many of the emerging
markets achieving strong revenue growth, including the Middle East
at 18.6%, India at 13.1% and Brazil at 8.0%.
Ernst & Young made a key change to their reporting of revenues in
2009, electing to show combined, not consolidated revenues by
eliminating intra-firm billings. E&Y restated its 2008 revenues down
from $24.5 billion as originally reported to $23.0 billion reported
as restated in 2009. The reason provided for this change was, “In
line with our globalization efforts to harmonize policies across
member firms, revenues for 2009 and 2008 related to member firm
billings to other member firms have been eliminated from the
financial information presented here. This financial information
represents combined not consolidated revenues, and includes expenses
billed to clients.”
________________________________________
KPMG reported 2009 combined revenues for the fiscal year ending 30
September 2009 of US$20.1 billion versus US$22.7 billion for the
prior 2008 fiscal year. This was an 11.4% decline in US dollars
terms and a 2.6% decline in local currency terms, which was the
highest drop among all Big Four firms.
By service line, Audit 2009 revenues were $10.0 billion versus $10.7
billion in 2008, down 6.9% in US dollar terms but a 0.5% increase in
local currency terms. In the global financial services industry,
Audit services' revenues actually grew 7%.
Tax services revenues in 2009 were $4.1 billion versus $4.7 billion
in 2008, a 13.4% decrease in US dollar terms and a 4.3% decrease in
local currency terms. But certain practices within Tax did very
well: Transfer Pricing grew 5.3%, Indirect Tax grew 8% and
International Executive Services grew 7.8%, all in local currency
terms.
Advisory services revenues of $6.1 billion in 2009 decreased versus
$7.3 billion in 2008, by a large 16.6% in US dollars terms and 6.6%
decline in local currency terms. However, Advisory in China and the
Middle East posted double-digit growth.
By geography, Americas Region had 2009 revenue of US$6.3 billion
versus US$7.2 billion in 2008, decreasing 12% in US dollar terms and
8.6% in local currency terms. Bright spots included Brazil with 5%
revenue growth, Mexico with 8.2% growth, Venezuela grew 22.9% and
Chile's revenues rose 22.7%, all in local currency terms.
In Europe, Middle East and Africa, combined KPMG member firm 2009
revenues were $10.7 billion versus $12.4 billion in 2008, dropping
13.5% in U.S. dollars terms and 0.6% in local currency terms. Middle
East and South Asia was the fastest growing sub-region in Europe;
and KPMG in Africa had a 9.3% growth in local currency terms.
In Asia Pacific, combined 2009 revenues of $3.1 billion decreased
1.1% in US dollars terms but grew a substantial 3.9% in local
currency terms. Some countries posted spectacular results: Korea had
19.4% growth, Vietnam and Cambodia each had 17.5% growth, and Japan
had 7.2% growth, all in local currency terms. KPMG said that Asia
Pacific member firms are beginning to see an increasing number of
M&A transactions especially in China and Korea.
Revenues in the BRIC countries as a group grew 4.3%. Middle East and
South Asia was the fastest growing practice with a 25% growth rate.
KPMG’s BRIC headcount increased by 11.5% this year, with BRIC
headcount nearly quadrupling in the past ten years.
________________________________________
REVENUE BY GEOGRAPHY
The distribution of revenues by geography shows some very
interesting insights. Contrary perhaps to common belief, Europe
(including generally Europe, Middle East and Africa), rather than
the Americas region (including Canada, the US and South America),
has the highest percentage of total revenues for the Big Four firms,
averaging 45% of total worldwide revenues. Americas average about
40% and the Asia Pacific countries (including India, South Asia,
China, North Asia and Australia) have the remaining 15% of the
revenue share.
The Americas
The Americas represent about 40% of global revenues, but its share
has been falling over the years. From 2004 to 2009, there has been a
noticeable drop of about 3% in the Americas region’s share of the
total revenue for all the firms. In 2005, 43% of combined firm
revenues were reported from the Americas region, whereas in 2009, it
had dropped to only 40% of total firm revenues.
There also appears to be large variation across firms in the amount
of revenue from this geographic region as a percentage of their
global revenues. For example, Deloitte at the high end, sources 48%
of its revenues from the Americas and KPMG at the low end has only
31% of its revenues from the Americas. Ernst & Young and PwC each
have about 40% of their total revenues from the Americas, in line
with the total firm average.
While Latin America, and particularly Brazil and Mexico have
provided good growth opportunities for growth in recent years, the
predominance of the mature markets of USA and Canada with slower
growth has generally limited the expansion of Big Four firms in the
Americas region. The 3% revenue share loss has generally gone to
Asia Pacific, where emerging markets such as China, India, Korea and
Vietnam have grown at disproportionately higher rates.
Europe
Europe, surprisingly, is the largest region by revenue for all Big
Four firms. The Big Four firms typically combine Europe, comprising
the developed countries of Western Europe, the up and coming markets
of Eastern Europe with Middle Eastern and African nations for a
giant EMEA region. Europe represents about 45% of global revenues,
and as we see across the years, this total percentage has remained
remarkably flat from 2004 to 2009. In 2004, 46% of combined firm
revenues were reported from the Europe region, and in 2009, the same
percentage 46% of total firm revenues came from Europe.
________________________________________
As in Americas, each firm has a different percentage of European
revenues as a share of the total revenues. KPMG at the high end
sources 53% of its revenues from Europe (KPMG Europe being a key
contributor) while Deloitte at the low end has only 40% of its
revenues from Europe, this situation being a total polar opposite of
the Americas. Ernst & Young and PwC each have 45% of their total
revenues from Europe, in line with the total firm average.
This diverse European region comprises both of mature markets such
as the United Kingdom, France, Italy and Germany, as well as fast
growing Eastern European nations - Poland, Russia, Czech Republic,
Hungary and Romania. The Big Four firms have had spectacular growth
in Eastern Europe as these high growth economies have matured into
capitalistic markets, requiring sophisticated audit, tax and
transaction services.
The Big Four firms have had tremendous growth in Russia in
particular as part of their BRIC initiatives. Europe also comprises
the rapidly rising countries of the Middle East – including Dubai,
Abu Dhabi, Kuwait, Saudi Arabia and Israel; as also the larger
economies of the African continent – South Africa, Egypt and Nigeria
for example. In the Middle East and Africa, the Big Four firms have
capitalized on their historical small presence and posted very high
annual growth numbers for the last few years, albeit from a smaller
base.
Asia Pacific
Asia Pacific, while being the smallest region, has posted the
highest growth rates of all regions. This diverse region comprises a
few mature markets such as Japan and Australia, but mainly covers
fast growth emerging markets such as China, India, Vietnam, Korea
and Singapore. The Asia Pacific region has been in an economic boom
for most of this decade, and their demand for Big Four firm
professional services have multiplied. All the firms have grown at
exceedingly high rates each year since 2004, with the result that
combined revenues have doubled from $7 billion in 2004 to $14
billion in 2009.
Asia represents about 15% of global revenues for all the firms, and
as we see across the years, this total percentage has increased
steadily from 2004 to 2009. In 2004, 12% of combined firm revenues
were reported from Asia, and in 2009, it had sharply increased to
15% of total firm revenues. This share gain came at the expense of
the Americas region, which correspondingly lost its share of the
pie.
________________________________________
BRIC
The BRIC countries – Brazil, Russia, India and China – have been
unquestionably the shining stars in the growth story in recent
years. Though the firms do not report individual country revenues,
there is typically some commentary on the annual report on the
spectacular increases in these countries.
For example, Ernst & Young reported in 2009 that revenues in India
had increased 13% and in Brazil by 8%; and KPMG said that their
headcount in the BRIC countries had nearly quadrupled in the past
ten years.
________________________________________
REVENUE BY SERVICE LINE
The Big Four firms offer a wide variety of professional and
financial services, with newer Advisory services adding to their
more traditional and deep-rooted Audit (Assurance) and Tax Services.
Firms vary in their structure and definition of these broad service
lines, typically though about half the revenues are sourced from
Audit, and the balance is shared between Tax and Advisory Services.
Audit
The audit service line, the largest in all firms, accounts for
almost 50% of total revenues and generally holding this percentage
level across the years. Typically Audit services is a steady
business, as publicly traded clients renew auditor services each
year with some increase in annual fees. Most companies prefer to
maintain their auditors for a long time, providing stability to the
auditors’ top line. The Audit service line experienced sharp growth
in total revenues in 2005 to 2007, but this has slowed down sharply
in the 2008-2009 years.
From 2008 to 2009, revenue for the Audit service line for the
combined firms shrank by 6% in US dollar terms, which was better
than the negative 7% in Tax service line and negative 9% in
Advisory, which demonstrated the somewhat anti-recessionary nature
of this service line. Audit fees came under pressure in 2009, but
firms maintained their focus on client service and market share
gains to mitigate any losses in revenue.
________________________________________
Tax
The tax service line, forms about a quarter of the Big Four firm
revenue and generally holding this percentage level across the
years. Tax revenue are reasonably steady, as they derive revenue
from add-on services provided to audit clients, in addition to tax
services provided for transactions, complicated tax restructurings
and other projects.
Tax had a very strong growth in 2006 to 2008, in line with large
scale global merger and acquisition transactions activity, but had a
sharp decline in 2009.
________________________________________
Advisory
The Advisory service line, forms the last quarter of the Big Four
firm revenue and includes the broader non-Audit and non-Tax services
such as Transaction Advisory, Risk Management, and Business
Consulting services; and demarcations generally vary across the
firms. Owing to this catch-all nature of this category, there are
many drivers of top line results, merger and acquisition activity
being a principal factor.
Advisory services have been one of the fastest growers in the Big
Four firms as the firms extend their services beyond assurance and
taxation through penetration into current clients or through
referrals from other firms who may be conflicted out at their
clients. Advisory services have generally increased their share of
revenues. In 2004, they had 22% of total revenues and this had
sharply increased to 28% in 2009. Despite this sharp growth,
Advisory services had the sharpest decline of 9% from 2008 to 2009,
as clients slowed down transaction and restructuring activities all
over the world.
________________________________________
FIRM EMPLOYMENT ANALYSIS
The Big Four firms cumulatively employ more than 600,000
professionals all over the world, including partners, audit, tax and
advisory professionals and administrative staff. This staggering
number has been consistently on the rise since 2004, when cumulative
employment was around 435,000 professionals.
Thus in six years, the number of people working at just these four
firms has been around 175,000. Despite the reduction in revenues,
net employment grew by more than 10,000 professionals from 2008 to
2009, with notably Deloitte and PwC adding to their workforce. The
growth rate in employment of people dropped sharply to 2% in 2009.
Typical annual attrition rate at Big Four firms was running about
15% prior to 2008, so for example in 2008, the Big Four firms
cumulatively would have made about 140,000 new hires to account for
the loss of professionals and the additional growth. This works out
to about 550 hires for each business day of the year.
Even in 2009, assuming attrition rates had dropped to 10%, new hires
in 2009 would be about 70,000 equating to about 275 hires each day.
Truly, Big Four firms are huge seekers of talent with
correspondingly very busy recruiters even in a period of deep
recession.
Elevation to partner at a Big Four firm is a tough and long process
as every professional who has ever worked at one knows. Partners
form an elite class within these large partnerships, and only one in
about 20 people belongs to this exclusive club. In 2009, we estimate
there were only about 34,000 partners in all the Big Four firms,
overseeing a steep pyramid of about 470,000 professionals, thus the
typical partner being responsible for about 14 professionals in
2009.
In 2004, the professional to partner ratio was only 11, thus
partners are taking on more responsibilities in terms of
professional management and development over the years.
Another metric that is closely watched is revenue per partner, in
2004, each partner was holding up $2.1 million in revenue, and this
had crept up to $2.8 million by 2009, after peaking at $3.0 million
in 2008. In other words, each partner was expected to bring in and
manage client revenues of nearly $3 million in recent years to
justify his or her position in the highest levels of the firms.
Clearly, making partner is only the beginning of a series of
demanding client development and professional responsibilities down
the road.
________________________________________
ERNST & YOUNG RESTATES REVENUE
Ernst & Young changed their revenue reporting methodology in 2009,
by reporting “…combined not consolidated revenues, and including
expenses billed to clients in line with globalization efforts to
harmonize policies across member firms”. Under the prior
consolidation method in 2008, Ernst & Young’s global revenues were
$24.5 billion which were revised down to $23.0 billion under the new
combined method of reporting. Ernst & Young restated only 2008 under
this methodology but did not restate prior years, thus our analysis
is affected by this reporting constraint.
________________________________________
CONCLUSION
The 2007 to 2009 recession has been the world’s worst financial
crisis for over 70 years, and despite such turbulence, the Big Four
firms turned in quite a creditable performance, with revenues
falling by single digits in local currency terms from 2008 to 2009.
Since March 2009, global financial markets have seen a marked
improvement in equity values, and general business conditions are
decidedly in much better shape in December 2009 than earlier in the
year.
Leading economic indicators in developed nations are on the uptrend
and emerging market countries have posted multiple quarters of
positive GDP growth. Clearly as we stand at the beginning of 2010,
there is an optimistic outlook among leading executives, and all
economies are decidedly on a growth pattern in the coming year. All
these are positive indicators favor Big Four firm revenue growth, as
the firms participate in an increasing level of financial activities
pursued by their clients, whether it be tax restructuring or
compliance, transfer pricing, mergers and acquisitions, strategic
growth, risk management, IFRS conversions or audit compliance.
Having likely captured the worst of 2009’s impact in fiscal year
2009, we believe that fiscal year 2010, staring mid-2009 to
mid-2010, will lead to positive revenue growth due to several key
factors:
An inherent improvement in underlying client fundamentals, with
greater emphasis on implementing strategies their own top line
growth
Improved equity markets which are potentially poised to do better
in 2010
A low revenue base for easy comparison
A depreciating US dollar, which has started sliding against major
currencies in mid-2009
More efficient Big Four firms, which have undergone internal
restructurings and much better positioned to take advantage of
growth prospects
Higher penetration into emerging markets with better growth
profiles
We think KPMG in particular will have the strongest fiscal 2010,
since its fiscal 2009 ended in September 2009, and captured much of
the crisis; and further its 2010 revenues will be compared to a much
lower base.
The Big Four firms dominate their space and are unlikely to face any
emerging competitors for a long time, and while regulation and audit
litigation do pose operating and financial risks, it is unlikely
that any of these single items will be of sufficient magnitude to
generally upset the status quo.
For 2010 and beyond, we will likely see a return back to revenue
growth, though it is debatable whether a string of double-digit
growth over multiple years will be seen for the next few years. The
Big Four firms have participated extensively in the explosive growth
in the emerging markets, and further it will be harder to grow at
high levels from an already huge revenue baseline, now exceeding $20
billion for each firm.
2010 will also be an interesting year to watch for any changes in
Big Four rankings, with a close race between Deloitte and
PricewaterhouseCoopers for the leadership position.
Overstock.com (NASDAQ: OSTK) and its
management team led by its CEO and masquerading stock market
reformer Patrick Byrne (pictured on right) continued its pattern of
false and misleading disclosures and departures from Generally
Accepted Accounting Principles (GAAP) in its latest Q1 2009
financial report.
In Q1 2009, Overstock.com reported a net
loss of $2.1 million compared to $4.7 million in Q1 2008 and claimed
an earnings improvement of $2.6 million. However, the company's
reported $2.6 reduction in net losses was aided by a violation of
GAAP (described in more detail below) that reduced losses by $1.9
million and buybacks of Senior Notes issued in 2004 under false
pretenses that reduced losses by another $1.9 million.
After the issuance of the Senior Notes in
November 2004, Overstock.com has twice restated financial reports
for Q1 2003 to Q3 2004 (the accounting periods immediately preceding
the issuance of such notes) because of reported accounting errors
and material weaknesses in internal controls.
While new CFO Steve Chestnut hyped that
"It's been a great Q1," the reality is that Overstock.com’s reported
losses actually widened by $1.2 million after considering violations
of GAAP ($1.9 million) and buying back notes issued under false
pretenses ($1.9 million).
How Overstock.com improperly reported of an
accounting error and created a “cookie jar reserve” to manage future
earnings by improperly deferring recognition of an income
Before we begin, let’s review certain
events starting in January 2008.
In January 2008, the Securities and
Exchange Commission discovered that Overstock.com's revenue
accounting failed to comply with GAAP and SEC disclosure rules, from
the company's inception. This blog detailed how the company provided
the SEC with a flawed and misleading materiality analysis to
convince them that its revenue accounting error was not material.
The company wanted to avoid a restatement of prior affected
financial reports arising from intentional revenue accounting errors
uncovered by the SEC.
Instead, the company used a one-time
cumulative adjustment in its Q4 2007 financial report, apparently to
hide the material impact of such errors on previous affected
individual financial reports. In Q4 2007, Overstock.com reduced
revenues by $13.7 million and increased net losses by $2.1 million
resulting from the one-time cumulative adjustment to correct its
revenue accounting errors.
Q3 2008
On October 24, 2008, Overstock.com's Q3
2008 press release disclosed new customer refund and credit errors
and the company warned investors that all previous financial reports
issued from 2003 to Q2 2008 “should no longer be relied upon.” This
time, Overstock.com restated all financial reports dating back to
2003. In addition, Overstock.com reversed its one-time cumulative
adjustment in Q4 2007 used to correct its revenue accounting errors
and also restated all financial statements to correct those errors,
as I previously recommended.
The company reported that the combined
amount of revenue accounting errors and customer refund and credit
accounting errors resulted in a cumulative reduction in previously
reported revenues of $12.9 million and an increase in accumulated
losses of $10.3 million.
Q4 2008
On January 30, 2009, Overstock.com reported
a $1 million profit and $.04 earnings per share for Q4 2008, after
15 consecutive quarterly losses and it beat mean analysts’ consensus
expectations of negative $0.04 earnings per share. CEO Patrick Byrne
gloated, "After a tough three years, returning to GAAP profitability
is a relief." However, Overstock.com's press release failed to
disclose that its $1 million reported profit resulted from a
one-time gain of $1.8 million relating to payments received from
fulfillment partners for amounts previously underbilled them.
During the earnings call that followed the
press release, CFO Steve Chesnut finally revealed to investors that:
Gross profit dollars were $43.6 million, a
6% decrease. This included a one-time gain of $1.8 million relating
to payments from partners who were under-billed earlier in the year.
Before Q3 2008, Overstock.com failed to
bill its fulfillment partners for offsetting cost reimbursements and
fees resulting from its customer refund and credit errors. After
discovering foul up, Overstock.com
improperly corrected the billing errors by recognizing income in
future periods when such amounts were recovered or on a cash basis
(non-GAAP).
In a blog post, I explained why Statement
of Financial Accounting Standards No. 154 required Overstock.com to
restate affected prior period financial reports to reflect when the
underbilled cost reimbursements and fees were actually earned by the
company (accrual basis or GAAP). In other words, Overstock.com
should have corrected prior financial reports to accurately reflect
when the income was earned from fulfillment partners who were
previously underbilled for cost reimbursements and fees.
If Overstock.com properly followed
accounting rules, it would have reported an $800,000 loss instead of
a $1 million profit, it would have reported sixteen consecutive
losses instead of 15 consecutive losses, and it would have failed to
meet mean analysts’ consensus expectation for earnings per share
(anyone of three materiality yardsticks under SEC Staff Accounting
Bulletin No. 99 that would have triggered a restatement of prior
year’s effected financial reports).
Patrick Byrne responds on a stock market
chat board
In my next blog post, I described how CEO
Patrick M. Byrne tried to explain away Overstock.com’s treatment of
the “one-time gain” in an unsigned post, using an alias, on an
internet stock market chat board. Byrne’s chat board post was later
removed and re-posted with his name attached to it, after I
complained to the SEC. Here is what Patrick Byrne told readers on
the chat board:
Antar's ramblings are gibberish. Show them
to any accountant and they will confirm. He has no clue what he is
talking about.
For example: when one discovers that one
underpaid some suppliers $1 million and overpaid others $1 million.
For those whom one underpaid, one immediately recognizes a $1
million liability, and cleans it up by paying. For those one
overpaid, one does not immediately book an asset of a $1 million
receivable: instead, one books that as the monies flow in. Simple
conservatism demands this (If we went to book the asset the moment
we found it, how much should we book? The whole $1 million? An
estimate of the portion of it we think we'll be able to collect?)
The result is asymmetric treatment. Yet Antar is screaming his head
off about this, while never once addressing this simple principle.
Of course, if we had booked the found asset the moment we found it,
he would have screamed his head off about that. Behind everything
this guy writes, there is a gross obfuscation like this. His purpose
is just to get as much noise out there as he can.
Note: Bold print and italics added by me.
In other words, Overstock.com improperly
used cash basis accounting (non-GAAP) rather than accrual basis
accounting (GAAP) to correct its accounting error. I criticized
Byrne’s response noting that:
… Overstock.com recognized the "one-time of
$1.8 million" using cash-basis accounting when it "received payments
from partners who were under-billed earlier in the year" instead of
accrual basis accounting, which requires income to be recognized
when earned. A public company is not permitted to correct any
accounting error using cash-basis accounting.
Overstock.com tries to justify improper
cash basis accounting in Q4 2008 to correct an accounting error
Overstock.com needed to justify Patrick
Byrne’s stock chat board ramblings. About two weeks later,
Overstock.com filed its fiscal year 2008 10-K report with the SEC
and the company concocted a new excuse to justify using cash basis
accounting to correct its accounting error and avoid restating prior
affected financial reports:
In addition, during Q4 2008, we reduced
Cost of Goods Sold by $1.8 million for billing recoveries from
partners who were underbilled earlier in the year for certain fees
and charges that they were contractually obligated to pay. When the
underbilling was originally discovered, we determined that the
recovery of such amounts was not assured, and that consequently the
potential recoveries constituted a gain contingency. Accordingly, we
determined that the appropriate accounting treatment for the
potential recoveries was to record their benefit only when such
amounts became realizable (i.e., an agreement had been reached with
the partner and the partner had the wherewithal to pay).
Note: Bold print and italics added by me.
Overstock.com improperly claimed that a
"gain contingency" existed by using the rationale that the
collection of all "underbilled...fees and charges...was not
assured....”
Why Overstock.com's accounting for
underbilled "fees and charges" violated GAAP
Overstock.com already earned those "fees
and charges" and its fulfillment partners were "contractually
obligated to pay" such underbilled amounts. There was no question
that Overstock.com was owed money from its fulfillment partners and
that such income was earned in prior periods.
If there was any question as to the
recovery of any amounts owed the company, management should have
made a reasonable estimate of uncollectible amounts (loss
contingency) and booked an appropriate reserve against amounts due
from fulfillment partners to reduce accrued income (See SFAS No. 5
paragraph 1, 2, 8, 22, and 23). It didn’t. Instead, Overstock.com
claimed that the all amounts due the company from underbilling its
fulfillment partners was "not assured" and improperly called such
potential recoveries a "gain contingency" (SFAS No. 5 paragraph 1,
2, and 17).
The only way that Overstock.com could
recognize income from underbilling its fulfillment partners in
future accounting periods is if there was a “significant uncertainty
as to collection” of all underbilled amounts (See SFAS No. 5
paragraph 23)
As it turns out, a large portion of the
underbilled amounts to fulfillment partners was easily recoverable
within a brief period of time. In fact, within 68 days of announcing
underbilling errors, the company already collected a total of “$1.8
million relating to payments from partners who were underbilled
earlier in the year.” Therefore, Overstock.com cannot claim that
there was a "significant uncertainty as to collection" or that
recovery was "not assured."
No gain contingency existed. Overstock.com
already earned "fees and charges" from underbilled fulfillment
partners in prior periods. Rather, a loss contingency existed for a
reasonably estimated amount of uncollectible "fees and charges."
Overstock.com should have restated prior affected financial reports
to properly reflect income earned from fulfillment partners instead
of reflecting such income when amounts were collected in future
quarters. Management should have made a reasonable estimate for
unrecoverable amounts and booked an appropriate reserve against
"fees and charges" owed to it (See SFAS No. 5 Paragraph 22 and 23).
Therefore, Overstock.com overstated its
customer refund and credit accounting error by failing to accrue
fees and charges due from its fulfillment partners as income in the
appropriate accounting periods, less a reasonable reserve for
unrecoverable amounts. By deferring recognition of income until
underbilled amounts were collected, the company effectively created
a "cookie jar" reserve to increase future earnings.
In addition, Overstock.com failed to
disclose any potential “gain contingency” in its Q3 2008 10-Q
report, when it disclosed that it underbilled its fulfillment
partners (See SFAS No. 5 Paragraph 17b). Apparently, Overstock.com
used a backdated rationale for using cash basis accounting to
correct its accounting error in response to my blog posts (here and
here) detailing its violation of GAAP.
PricewaterhouseCoopers warns against using
"conservatism to manage future earnings"
As I detailed above, Patrick Byrne claimed
on an internet chat board that “conservatism demands" waiting until
"monies flow in" from under-billed fulfillment partners to recognize
income, after such an error is discovered by the company. However, a
document from PricewaterhouseCoopers (Overstock.com’s auditors thru
2008) web site cautions against using “conservatism” to manage
future earnings by deferring gains to future accounting periods:
SFAS No. 5 Technical Notes cautions about
using “conservatism” to manage future earnings by deferring gains to
future accounting periods:
"Conservatism...should no[t] connote
deliberate, consistent understatement of net assets and profits."
Emphasis added] CON 5 describes realization in terms of recognition
criteria for revenues and gains, as:"Revenue and gains generally are
not recognized until realized or realizable... when products (goods
or services), merchandise or other assets are exchanged for cash or
claims to cash...[and] when related assets received or held are
readily convertible to known amounts of cash or claims to
cash....Revenues are not recognized until earned ...when the entity
has substantially accomplished what it must do to be entitled to the
benefits represented by the revenues." Almost invariably, gain
contingencies do not meet these revenue recognition criteria.
Note: Bold print and italics added by me.
Overstock.com "substantially accomplished
what it must do to be entitled to the benefits represented by the
revenues" since the fulfillment partners were "contractually
obligated" to pay underbilled amounts. Those underbilled "fees and
charges" were "realizable" as evidenced by the fact that the company
already collected a total of “$1.8 million relating to payments from
partners who were underbilled earlier in the year" within a mere 68
days of announcing its billing errors.
If we follow guidance by Overstock.com's
fiscal year 2008 auditors, the amounts due from underbilling
fulfillment partners cannot be considered a gain contingency, as
claimed by the company. PricewaterhouseCoopers was subsequently
terminated as Overstock.com's auditors and replaced by Grant
Thornton.
Q1 2009
In Q1 2009, even more amounts from
underbilling fulfillment partners were recovered. In addition, the
company disclosed a new accounting error by failing to book a
“refund due of overbillings by a freight carrier for charges from Q4
2008.” See quote from 10-Q report below:
In the first quarter of 2009, we reduced
total cost of goods sold by $1.9 million for billing recoveries from
partners who were underbilled in 2008 for certain fees and charges
that they were contractually obligated to pay, and a refund due of
overbillings by a freight carrier for charges from the fourth
quarter of 2008. When the underbilling and overbillings were
originally discovered, we determined that the recovery of such
amounts was not assured, and that consequently the potential
recoveries constituted a gain contingency. Accordingly, we
determined that the appropriate accounting treatment for the
potential recoveries was to record their benefit only when such
amounts became realizable (i.e., an agreement had been reached with
the other party and the other party had the wherewithal to pay).
Note: Bold print and italics added by me.
Overstock.com continued to improperly
recognize deferred income from previously underbilling fulfillment
partners. The new auditors, Grant Thornton, would be wise to review
Overstock.com's accounting treatment of billing errors and recommend
that its clients restate affected financial reports to comply with
GAAP. Otherwise, they should not give the company a clean audit
opinion for 2009.
Using accounting errors to previous
quarters to boost profits in future quarters
Lee Webb from Stockwatch sums up
Overstock.com's accounting latest trickery:
… Overstock.com managed to turn a
controversial fourth-quarter profit last year after discovering that
it had underbilled its fulfillment partners to the tune of
$1.8-million earlier in the year. Rather than backing that amount
out into the appropriate periods, Overstock.com reported it as
one-time gain and reduced the cost of goods sold for the quarter by
$1.8-million. That bit of accounting turned what would have been an
$800,000 fourth-quarter loss into a $1-million profit.
As it turns out, Overstock.com managed to
find some more money that it used to reduce the cost of goods sold
for the first quarter of 2009, too.
"In Q1 2009, we reduced total cost of goods
sold by $1.9-million for recoveries from partners who were
underbilled in 2008 for certain fees and charges that they were
contractually obligated to pay and a refund due of overbillings by a
freight carrier for charges from Q4 2008," the company disclosed.
"We just keep squeezing the tube of
toothpaste thinner and thinner and finding new stuff to come out,"
Mr. Byrne remarked during the conference call after chief financial
officer Steve Chesnut said that the underbilling and overbilling had
been found "as part of good corporate diligence and governance."
In addition, Overstock.com managed to
record a $1.9-million gain, reported as part of "other income," by
extinguishing $4.9-million worth of its senior convertible notes,
which it bought back at rather hefty discount. If not for the
fortuitous 2008 underbilling recoveries, fourth-quarter overbillings
refund and the paper gain from extinguishing some of its debt,
Overstock.com would have tallied a first-quarter loss of
$5.9-million or approximately 26 cents per share.
So, while Overstock.com did not manage to
conjure up a first-quarter profit by using the same accounting
abracadabra employed in the fourth quarter, it did succeed in
trimming its net loss to $2.1-million.
Bad corporate diligence and governance
During the Q1 2009 earnings conference
call, CFO Steve Chesnut boasted about finding accounting errors:
So just as part of good corporate diligence
and governance we've found these items.
Note: Bold print and italics added by me.
Actually, it was bad corporate diligence
and governance by CEO Patrick Byrne that caused the accounting
errors to happen by focusing on a vicious retaliatory smear campaign
against critics, while he runs his company into the ground with $267
million in accumulated losses to date and never reporting a
profitable year.
Memo to Grant Thornton (Overstock.com's new
auditors)
Overstock.com is a company that has not
produced a single financial report prior to Q3 2008 in compliance
with Generally Accepted Accounting Principles and Securities and
Exchange Commission disclosure rules from its inception, without
having to later correct them, unless such reports were too old to
correct. Two more financial reports (Q4 2008 and Q1 2009) don't
comply with GAAP and need to be restated, too.
To be continued in part 2.
In the mean time, please read:
William K. Wolfrum: "Sam E. Antar: From
Crazy Eddie to Patrick Byrne's Worst Nightmare."
Gary Weiss: "The Whisper Campaign Against
an Overstock.com Whistleblower"
Written by:
Sam E. Antar (former Crazy Eddie CFO and a
convicted felon)
Blog Update:
Investigative journalist and author Gary
Weiss commented on Overstock.com's history of GAAP violations in his
blog:
There are few certainties in this world:
gravity, the speed of light, and, more obviously every quarter, the
utter unreliability of Overstock.com financial statements.
Acclaimed forensic accountant and author
Tracy Coenen notes in her blog:
Don’t laugh too hard at Patrick Byrne’s
explanation of the repeated accounting errors and improper treatment
of those errors, as reported by Lee Webb of Stockwatch:
“We just keep squeezing the tube of
toothpaste thinner and thinner and finding new stuff to come out,”
Mr. Byrne remarked during the conference call after chief financial
officer Steve Chesnut said that the underbilling and overbilling had
been found “as part of good corporate diligence and governance.”
Good corporate diligence and governance? Is
this guy for real? How about having an accounting system that
prevents errors from occurring every quarter?
Of course, Overstock.com management has to
explain away why Sam Antar is finding all these manipulations and
irregularities in their financial reporting. They can stalk and
harass him all they want, call him a criminal all they want, but
there is no explaining it away. The numbers don’t lie. Overstock.com
just always counted on no one being as thorough as Sam.
We were intrigued by
a recent quote from Overstock.com's President.
On December 29,
2009,we saw, "It is nice to be back with a Big Four accounting
firm," said Jonathan Johnson, President of Overstock.com. "We are
pleased to have the resources and professionalism that KPMG brings
as our auditors. We will work closely with them to timely file our
2009 Form 10-K. In the meantime, we remain in discussions with the
SEC to answer the staff's questions on the accounting matters that
lead to our filing an unreviewed Form 10-Q for Q3."
As we dug further
into this, we found an interesting situation between client and
auditors; and between the opinions of two different auditors, as
you'll see below.
And what makes it
curioser is that Overstock.com has engaged three separate auditors
in a space of just nine months.
From 2001 to 2008,
PricewaterhouseCoopers were the statutory auditors to Overstock.com,
but this changed when the company decided to engage a replacement
through a RFP process, and Grant Thornton was selected in March
2009. Subsequently, Overstock.com received a letter from the SEC in
October 2009 questioning the accounting for a "fulfillment partner
overpayment" (which Overstock.com recovered and recognized $785,000
as income in 2009 as it was received). Apparently earlier
PricewaterhouseCoopers had determined that this amount should not be
recognized in fiscal year 2008, but in 2009. However, the new
auditor, Grant Thornton after further investigation on the receipt
of the SEC note, determined that the amount should have been booked
in 2008 and not in 2009, and that Overstock.com should restate its
2008 financials to reflect this as an asset
This put
Overstock.com in a difficult spot, with a severe disagreement
between two audit opinions. In the appropriate words of Patrick
Byrne, the company's Chairman and CEO, "Thus, we are in a quandary:
one auditing firm won't sign-off on our Q3 Form 10-Q unless we
restate our 2008 Form 10-K, while our previous auditing firm
believes that it is not proper to restate our 2008 Form 10-K.
Unfortunately, Grant Thornton's decision-making could not have been
more ill-timed as we ran into SEC filing deadlines."
In general,
Overstock.com agreed with PwC's recommendation not to account for
the amount in 2008 and not with Grant Thornton's opinion of booking
it in 2008.
While all this was
going on, Overstock.com had a make a choice on its Q3-2009 quarterly
financials, which they proceeded to file without required review by
an auditor (in violation of SAS 100). This unusual filing brought on
a censure by NASDAQ, who then finally agreed to grant the company
time till May 2010 to refile the earnings.
Meanwhile, Grant
Thornton wrote separately to the SEC outlining its position, and
Overstock.com responded to GT's points in a letter from the
President directly to the shareholders.
Eventually, in
November 2009, Overstock.com dismissed Grant Thornton as its
auditor, and Grant Thornton immediately severed its relationship
with the company through a letter to the SEC.
After a search, on
December 29, 2009, Overstock.com finally hired KPMG to review all
its financials, accounting procedures and determine the final
disposition of the timing for accounting of this issue.
Other bloggers with
more knowledge of the stock and history, are taking a more
aggressive position on Overstock.com's actions, here's a recent post
from SeekingAlpha.com:
All this switching
around of auditors in such a short space of time does call into
question the company's stance on alignment with external auditors
opinions. Typically, public companies do try to stay with one
acccounting firm over a long period of time and iron out any
differences at a professional level. This kind of merry-go-rounding
seems to suggest that Overstock.com is looking for the auditor who
will agree with the company's stance rather than an independent
third party who will provide an honest perspective in the best
interest of investors, whose interests they do represent as their
fiduciary responsibility.
And that's where it
apppears to stand today, with KPMG having the unenviable task of
sorting through all this confusion, settling issues with the SEC and
the NASDAQ, and putting Overstock.com back in compliance and in some
sense of settlement with previous auditors. GT and PwC seem to have
washed their hands off this, but that's not to say, that a
shareholder lawsuit may spring from the blue, as we have seen in
many cases, that such messy audits have the potential for long tail
litigations.
Meanwhile, on the
stock market, Overstock.com ($OSTK)hit a high of $17.65 on October
20, 2009 and then has been steadily drifting downwards to $13.24 per
share today. At 22.84 million shares outstanding, this is a loss of
market capitalization of $110 million. Other online retailers have
had generally better stock performance during this period, so
clearly the accounting issue is having some level of overhang on
stock performance.
In another very
interesting use of philosophy from the Chairman's letter:
"All things are
subject to interpretation; whichever interpretation prevails at a
given time is a function of power and not truth." - Friedrich
Nietzsche
And we hope that in
due course, we find the real truth, and not the interpretation that
is biased towards the powerful.
Now, none of this
would be apparent to the average online shopper who is seeking a
real retail bargain on the "O, O, O, The Big Big O, Overstock.com",
but there is always more to be had beyond the skin than is evident
on the surface.
Clearly, this
is not going away soon, and more news is sure to emerge as the
company files its audited financials, and we'll blog as we hear of
developments.
So Much Auditor Litigation Makes For Strange Bedfellows
Francine McKenna's Great Blog, October 12, 2009 ---
Click Here
Includes a clip from the old risqué movie Bob,Carol, Ted, and Alice
Every one of the Big 4 (and the next tier) has a
handful of lawsuits on their desk related to their
audits of the banks and other financial institutions that failed, were taken
over in the dead of night, or bailed out by their respective central banks.
That’s in addition to the various fraud and Madoff related suits. It may or
may not have been better for them to have
warned us with “going concern” opinions earlier. We’ll
let the judges and juries decide, if any of the cases are actually tried.
Most often they settle and the audit firm pays, but
not as much as you would think.
Deloitte has been party to settlements, left and
right, lately, but they’re no more prone to settlements. After all, per
Adam Savett of Risk Metrics (by way of
Kevin La Croix of D&O Diary), “jury
trials in securities class action lawsuits are extremely rare” :
“As reported on the Securities
Litigation Watch blog (here),
only 21 cases (prior to Vivendi) have gone trial
since the 1995 enactment of the PSLRA.
Only seven of the 21 cases (including the
Household International case) that have gone to a verdict involved
conduct that occurred after the PSLRA was enacted.”
What’s interesting about the current flood of
lawsuits is the heightened probability Deloitte - and the rest of the Big 4
- will end up on both sides of lawsuits with their former and current audit
clients.
Deloitte is a co-defendant with Bank of America (in
place of Merrill Lynch) on lawsuits stemming from Bank of America’s
“Deal From Hell” to buy Merrill Lynch for $50
billion, arranged in 48 hours, and agreed to on September 15 of last year.
In January of this year, Merrill Lynch announced settlement of a
suit filed in October 2007 related to the earlier
period where Merrill Lynch experienced significant losses due to write downs
of CDOs and other subprime related assets. Deloitte was a
defendant and may also have to contribute
to that $475 million settlement. Kevin La Croix described it as,
”…unquestionably the largest
subprime subprime securities lawsuit settlements so far, and [ ]
certainly suggest[s] the enormous stakes that may be involved in the
mass of subprime and credit crisis-related litigation cases that remain
pending.”
Britain’s big four
auditing firms have been left exposed to a surge in negligence
claims after the Government refused to limit further the damages
they could face.
Deloitte, Ernst &
Young, KPMG and PricewaterhouseCoopers (PwC) lobbied hard for a cap
on payouts. Senior figures involved in the discussions said that
Lord Mandelson, the Business Secretary, appeared receptive to their
concerns but stopped short of changing the law.
The decision is a
huge blow to the firms — some face lawsuits relating to Bernard
Madoff’s $65 billion fraud — which believe there may not be another
chance for a change in the law for at least two years. They fear
that they will be targeted by investors and liquidators seeking to
recover losses from Madoff-style frauds and big company failures.
At present, auditors
can be held liable for the full amount of losses in the event of a
collapse, even if they are found to be only partly to blame.
In April,
representatives of the companies met Lord Mandelson to plead for new
measures to cap their liability. They warned that British business
could be plunged into chaos if one of them were bankrupted by a
blockbuster lawsuit.
However, an official
of the Department for Business, Innovation and Skills said: “The
2006 Companies Act already allows auditor liability limitation where
companies and their auditors want to take this course.”
Under present
company law, directors can agree to restrict their auditors’
liability if shareholders approve; however, to date, no blue-chip
company has done so. Directors have seen little advantage in
limiting their auditors’ liability, and objections by the US
Securities and Exchange Commission (SEC) have also been a
significant obstacle.
The SEC opposes caps
on the ground that their introduction could lead to secret deals
whereby directors agree to restrict liability in return for auditors
compromising on their oversight of a company’s accounts. The SEC
could attempt to block caps put in place by British companies that
have operations in the United States.
The big four
auditors had hoped to persuade Lord Mandelson to amend the
legislation to address the SEC’s concerns and to encourage companies
to limit their auditors’ liability.
Peter Wyman, a
senior PwC partner, who was involved in the discussions, said that
the Government’s lack of action was disappointing. He said: “The
Government, having legislated to allow proportionate liability for
auditors, is apparently content to have its policy frustrated by a
foreign regulator.”
Auditors are often
hit with negligence claims in the aftermath of a company failure
because they are perceived as having deep pockets and remain
standing while other parties may have disappeared or been declared
insolvent.
In 2005 Ernst &
Young was sued for £700 million by Equitable Life, its former audit
client, after the insurance company almost collapsed. The claim was
dropped but could have bankrupted the firm’s UK arm if it had
succeeded.
This year KPMG was
sued for $1 billion by creditors of New Century, a failed sub-prime
lender, and PwC has faced questions over its audit of Satyam, the
Indian outsourcing company that was hit by a long- running
accounting fraud.
Three of the big
four are also facing numerous lawsuits relating to their auditing of
the feeder funds that channelled investors into Madoff’s Ponzi
scheme.
Investors and
accounting regulators worry that the big four’s dominance of the
audit market is so great that British business would be thrown into
disarray if one of the four were put out of business by a huge court
action. All but two FTSE 100 companies are audited by the four.
Mr Wyman said: “The
failure of a large audit firm would be very damaging to the capital
markets at a time when they are already fragile.”
Arthur Andersen,
formerly one of the world’s five biggest accounting firms, collapsed
in 2002 as a result of its role in the Enron scandal.
Suits you
KPMG A
defendant in a class-action lawsuit in the Southern District of New
York against Tremont, a Bernard Madoff feeder fund
Ernst & Young
Sued by investors in a Luxembourg court with UBS for oversight of a
European Madoff feeder fund
PwC Included
in several lawsuits in Canada claiming damages of up to $2 billion
against Fairfield Sentry, a big Madoff feeder fund
KPMG Sued in
the US for at least $1 billion by creditors of New Century
Financial, a failed sub-prime mortgage lender, which claimed that
KPMG’s auditing was “recklessly and grossly negligent”
Deloitte Sued
by the liquidators of two Bear Stearns-related hedge funds that
collapsed at the start of the credit crunch
Questions
Where were the auditors when auditing those risky investments and bad
debt reserves of the ailing banks? Answer: Not sure.
Where will the auditors be in after the shareholders in the failing
banks lose all or almost all in the meltdowns? Answer: In court, because the shareholders are the fall guys not being
bailed out in when banks declare bankruptcy or are bought out cheap just
before declaring bankruptcy. Shareholder will
understandably turn to the deep pocket auditors.
Ever since Arthur
Andersen left the market after its scandalous role in the fall of
Enron, people have been asking how long it will be before another
big firm follows suit. The (UK) Financial Reporting Council (FRC)
has been trying ever since to make sure that the Big Four will be
protected if found guilty of similar negligence. The introduction of
limited liability should help, but given the accelerating meltdown
of the global financial system, will it be enough?
As always, and as
was the case with Arthur Andersen, it will be events in America that
determine the fate of the Big Four. This summer the U.S. Treasury's
Advisory Committee of the Auditing Profession met in Washington and
heard that between them the six largest firms had 27 outstanding
litigation proceedings against them with damage exposure above $1
billion, seven of which exceed $10 billion. It is impossible to buy
insurance that will cover such catastrophic liability and any one of
them, if successful, could prove a fatal blow.
That U.S. Treasury
committee met again last week to discuss the viability of limited
liability for auditors in the U.S., but the 21-strong panel decided
against it. With that, the hope of some silver bullet solution to
the Big Four's problems expired. Committee member Lynn Turner,
formerly a chief accountant to the Securities and Exchange
Commission (SEC), was plainly baffled such an idea had even been
seriously suggested.
"Do you believe that
an auditor found to have been aware of financial reporting problems
but never reporting them to the public should be the subject of
liability caps or some type of litigation reform protecting them?"
he asked. Turner summed the situation up nicely when he described
the big accounting firms as a "federally mandated and authorized
cartel" which was "too big to [be allowed to] fail".
When Arthur Andersen
went down six years ago, Turner had never been quite able to believe
that the firm's bad behavior had really been all that anomalous.
"It's beyond Andersen," he told CBS Frontline that same year, "it's
something that's embedded in the system at this time. This notion
that everything is fine in the system just because you can't see it
is totally off-base."
The credibility of
the markets
Looking at recent
economic events, Turner's suspicions that the credibility of the
markets were at stake has plainly proved prescient. So too may his
belief that unethical accounting was not so much a case of a few bad
apples, but a bad barrel.
Consider some of the
recent and outstanding claims against the biggest six firms. In
Miami last August a jury ordered BDO Seidman to pay $521 million in
damages for its negligence in a Portuguese bank audit; almost as
much as the firm's estimated revenue for that year. In the U.S.,
banks and the shareholders of banks are perfectly prepared to go
after auditors, and when they win they tend to win big. Note than
when Her Majesty's Treasury hired the BDO's valuation partner Andrew
Caldwell for the controversial Northern Rock valuation, they hired
the man and not the firm. The firms are already worried enough about
litigation.
KPMG provides a
clear example of how the credit crunch might cull the Big Four. The
firm was already looking vulnerable before it hit: there was the
2005 'deferred prosecution' agreement with the New York Attorney's
Office, the damning German probe into the Siemens bribery scandal, a
lawsuit from superconductor company Vitesse for 'audit failures' and
a minor fine from the UK's Joint Disciplinary Scheme (JDS) for
allowing fraud to occur at Independent Insurance (it may only have
been half a million, but it was the JDS' biggest fine to date). But
when the subprime problems of U.S. lender New Century enter the
picture, the damages involved escalate drastically.
A U.S. Justice
Department report has already concluded that KPMG either helped
perpetrate the fraud at the mortgager or deliberately ignored it.
Class-action lawsuits are already pending. Only weeks before the
report was published the U.S. Supreme Court's Stone Ridge ruling
immunized third party advisers like accountants and bankers from the
disgruntled shareholders of other entities, but that may be not much
of a shield. Of course, New Century might not be KPMG's biggest
problem. That's probably the Federal National Mortgage Association,
or Fannie Mae.
Fannie Mae initiated
litigation way back in 2006, and is trying to reclaim more than $2
billion from its old auditors. That's on top of the $400 million
KPMG agreed to pay the SEC to settle the regulator's fraud
allegations. Its defense so far has been one of complete innocence,
asserting that Fannie Mae successfully hid all evidence of anything
untoward. Now that the FBI is investigating the mortgage lender,
such a position will have to be abandoned if incriminating evidence
turns up. Ostensibly, the Federal investigation relates to Fannie
Mae's relationship with ratings agencies, but you never know what
will fall out of the closet.
So KPMG is in a spot
of bother, but it's not alone. Ernst and Young will almost
inevitably see itself in court over the demise of its audit client
Lehman Brothers. Similarly, PricewaterhouseCoopers is surely going
to feel some heat for its auditing of what was once the world's
largest insurance company, AIG, assuming the Northern Rock
Shareholders Group doesn't take a pop at it first.
Continued in article
THE MAIN
PROBLEM WITH OUR BROKEN AUDITING MODEL IS THAT IT ENCOURAGES CLIENTS TO
BECOME BULLIES JUST TO HAVE THEIR OWN WAYS!
The most serious
problem in the U.S. audit model is that clients are becoming bigger and
bigger due to non-enforcement of anti-trust laws. For example, the
merger of Mobile and Exxon created an even larger single client. The
merger of Bear Stearns and JP Morgan created a much larger client. The
number of potential clients is shrinking while the size of the clients
is exploding.
As these giants
merge to become bigger giants, it gets to a point where their auditors
cannot afford to lose a giant client producing upwards of $100 million
in audit revenue each year. Real independence of audits breaks down
because a giant client can become a bully with its audit firm fearful of
losing giant clients.
Enron was an
extreme but not necessarily an outlier. It will most likely be alleged
in court over the next few years that giant Wall Street banks bullied
their auditors into going along with understating financial risk before
the 2008 banking meltdown. We certainly witnessed the understating of
financial risk in 2007 and 2008.
A summary is provided below with Bob Jensen's comments
in blue.
September 26, 2008
HP-1158
Fact
Sheet: Final Report of the Advisory Committee on the Auditing Profession
The U.S. Treasury
Department's Advisory Committee on the Auditing Profession adopted a Final
Report containing more than 30 recommendations to improve the sustainability
of the public company auditing profession. The report is separated into
three sections by principal areas of focus.
Human
Capital
recommendations focused on improving accounting education and strengthening
human capital, including:
Implementation of
accounting education curricula and content that continuously evolves to
reflect current market developments to help prepare new entrants to the
profession.
This is motherhood and apple pie, but keep in mind that the financial
accounting part of the curriculum is 95% driven by the CPA examination.
To change the curriculum all NASBA has to do is change the CPA Exam,
which I will now have to do since all FASB standards will be trashed in
favor of IFRS standards because Chris Cox abused his authority as Chair
of the SEC ---
http://www.trinity.edu/rjensen/theory01.htm#MethodsForSetting
Ensuring an adequate
supply of qualified accounting faculty through public and private sector
funding to meet future demands and help prepare students to execute high
quality audits.
This is an enormous failure because virtually all doctoral programs
wanted to become mathematics programs more than accounting programs ---
http://www.trinity.edu/rjensen/theory01.htm#DoctoralPrograms
Development and
maintenance of demographic data on the accounting profession so that the
profession can understand the human capital situation and its impact on
the profession's future and sustainability.
The AICPA keeps a pretty good database for this.
Study of the future of
education for the accounting profession, including the potential for
graduate schools of accounting, to determine the best way to educate
students to deal with the challenging financial reporting and auditing
environment.
The AICPA is so concerned about the shortage of auditing and tax
professors that it just now created a fund to provide five years of full
ride funding to each of 30 doctoral students who will commit to auditing
and tax specialties Requests for applications and additional
information may be obtained online from the AICPA Foundation at
ADSprogram@AICPA.org. or by calling 919-402-4524
Firm
Structure and Finances
recommendations focused on enhancing auditing firm governance, transparency,
responsibility, communications, and audit quality, including:
Creation of a national
center at the Public Company Accounting Oversight Board to provide a
forum for auditing firms and other market participants to share their
fraud detection experiences in order to improve audit quality.
Probably a good idea, but I doubt that firms will devote a whole lot of
hours making this a success.
Granting accountants
licensed in one state with reciprocity to practice in other states to
foster a more efficient operation of the capital markets given the
multi-state operations of many public companies and multi-state
practices of many auditing firms.
This has some real problems. For example, most but not all states now
require five-years (150 semester credits) to sit for the CPA
examination, but there are some states that only require four years.
Should students will four-year degrees become licensed in states that
have tougher standards? Also there’s a huge problem with varying
experience requirements among states. And there are societal problems.
Florida does not want all the semi-retired CPAs from NY to set up shop
in Florida.
Exploration of the
feasibility of appointing independent members with full voting power to
firm boards and/or advisory boards to improve the governance and
transparency of auditing firms.
Probably a good idea, but there are problems with confidentiality of
client information.
Enhancement of
disclosure requirements regarding public company auditor changes will
improve transparency and enhance investor confidence.
There has been progress here with SEC rules, but more could be
accomplished. It’s hard to separate reasons from excuses.
Enhancements to make
the auditor's standard reporting model more useful to investors by
including more relevant information, such as key accounting estimates
and judgments.
The estimation process is so complex, that “more relevant information”
might only add trees in front of somebody already lost in the forest.
Mandating the
engagement partner's signature on the auditor's report to improve
accountability among auditing firms.
A good idea, but not as important as rotating the engagement partner
more frequently, including bringing in new engagement partners from
other offices.
Requirement for
larger auditing firms to produce a public annual report with relevant
firm information and file on a confidential basis with the PCAOB audited
financial statements to improve transparency at auditing firms.
Yes, yes, yes.
The
Concentration and Competition
recommendations focused on ways to increase audit market competition and
auditor choice, including:
Having the PCAOB
monitor potential sources of catastrophic risk at auditing firms to
prevent reduced auditor choice and significant market disruptions.
At the moment really large clients like Bank of America can create a
catastrophe by dropping their auditing firm. The audit model is
basically broken since audit firms are chosen by and paid by executives
of firms that they audit. I’m not saying that government auditors would
be an improvement, because we all know that industries pretty much get
control of the government agencies that regulate them. But there should
be some type of “accounting court” for resolving auditor-client
conflicts in confidentiality. This was first proposed in a big way by a
managing partner of Arthur Andersen named Leonard Spacek ---
http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/leonard-paul-spacek/ Especially note
---
http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
Creation of a
mechanism for the preservation and rehabilitation of troubled larger
public company auditing firms to prevent reduced auditor choice and
significant market disruptions. Especially note
---
http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
Development and
publication of key indicators of audit quality and effectiveness to
promote competition and choice in the industry based on audit quality.
The PCAOB is doing a pretty good job in this department. For example it
has found deficiencies in some of the audits of public accounting firms
of all sizes, including the recent PCAOB fine of $1 million for Deloitte
---
http://www.pcaobus.org/Inspections/index.aspx
Promotion of the
understanding of and compliance with auditor independence requirements
to enhance investor confidence in the quality of audit processes and
audits.
Academics have been clamoring about this for years, but it’s almost
impossible to make significant progress beyond the litigation threat. At
the moment, the risk of being sued in the U.S. is probably the biggest
factor keeping auditing firms professional and honest, but there are
many failures ---
http://www.trinity.edu/rjensen/Fraud001.htm
It should be noted that most of the litigation of CPA firms centers on
mistakes, incompetence, and cost-saving practices that were not a good
idea such as substituting substantive testing with analytical reviews.
There have been some, but very few, outright frauds and collusions of
auditors in frauds.
Adoption of annual
shareholder ratification of public company auditors by all public
companies to enhance the audit committee's oversight to ensure that the
auditor is suitable for the company's size and financial reporting
needs.
Shareholder ratifications are a pile of crap since most of the shares
are held by enormous funds (pension funds, mutual funds, etc.). The
ideal that Main Street will thereby have a huge input into the choice of
an auditor is nonsense. Most individuals don’t know one auditor from
another. And for huge clients there are only about six choices anyway.
Enhancement of
collaboration and coordination between the PCAOB and its foreign
counterparts so that investors can be confident that auditing firms of
all sizes are contributing effectively to audit quality.
Sounds great but this is motherhood and apple pie that’s difficult to
implement effectively in practice. Mostly it sounds good on paper.
Closing
Comment
What’s really needed is an Accounting Court much like operates in The
Netherlands, although it will be much more difficult to operate in the U.S.
because of the much greater size of the U.S. I still like Spacek’s basic
idea of an Accounting Court. Especially
note ---
http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
The main
advantage of an Accounting Court is that auditors could get more backing
from experts when confronting clients on some sticky issues, and clients
would have a more difficult time bullying their auditors.
THE MAIN
PROBLEM WITH OUR BROKEN AUDITING MODEL IS THAT IT ENCOURAGES CLIENTS TO
BECOME BULLIES JUST TO HAVE THEIR OWN WAYS!
The most serious
problem in the U.S. audit model is that clients are becoming bigger and
bigger due to non-enforcement of anti-trust laws. For example, the
merger of Mobile and Exxon created an even larger single client. The
merger of Bear Stearns and JP Morgan created a much larger client. The
number of potential clients is shrinking while the size of the clients
is exploding.
As these giants
merge to become bigger giants, it gets to a point where their auditors
cannot afford to lose a giant client producing upwards of $100 million
in audit revenue each year. Real independence of audits breaks down
because executives running virtually any giant client can become a bully
with its audit firm.
Enron was an
extreme but not necessarily an outlier. It will most likely be alleged
in court over the next few years that giant Wall Street banks bullied
their auditors into going along with understating financial risk before
the 2008 banking meltdown. We certainly witnessed the understating of
financial risk in 2007 and 2008.
"The thing I think that is more problematic is there
have been some allegations that auditors knew about this and counseled their
clients to do it," said Joseph Carcello, director of research for the
corporate-governance center at the University of Tennessee. "If that turns out
to be true, they will have problems."
Bernard Madoff, former Nasdaq Stock Market chairman and
founder of Bernard L. Madoff Investment Securities LLC, was arrested and charged
with securities fraud Thursday in what federal prosecutors called a Ponzi scheme
that could involve losses of more than $50 billion.
It is bigger than Enron, bigger than Boesky and bigger than
Tyco
According to
RealMoney.com columnist Doug Kass,
general partner and investment manager of hedge fund Seabreeze
Partners Short LP and Seabreeze Partners Short Offshore Fund,
Ltd., today's late-breaking report of an alleged massive fraud
at a well known investment firm could be "the biggest story of
the year." In his view,
it is bigger
than Enron, bigger than Boesky and bigger than Tyco.
It attacks at the core of investor confidence --
because, if true, and this could happen ... investors
might think that almost anything imaginable could happen
to the money they have entrusted to their fiduciaries.
Bernard Madoff,
founder and president of Bernard Madoff Investment
Securities, a market-maker for hedge funds and banks,
was charged by federal prosecutors in a $50 billion
fraud at his advisory business.
Madoff, 70,
was arrested today at 8:30 a.m. by the FBI and appeared
before U.S. Magistrate Judge Douglas Eaton in Manhattan
federal court. Charged in a criminal complaint with a
single count of securities fraud, he was granted release
on a $10 million bond guaranteed by his wife and secured
by his apartment. Madoff’s wife was present in the
courtroom.
"It’s all just
one big lie," Madoff told his employees on Dec. 10,
according to a statement by prosecutors. The firm,
Madoff allegedly said, is "basically, a giant Ponzi
scheme." He was also sued by the Securities and Exchange
Commission.
Madoff’s New
York-based firm was the 23rd largest market maker on
Nasdaq in October, handling a daily average of about 50
million shares a day, exchange data show. The firm
specialized in handling orders from online brokers in
some of the largest U.S. companies, including General
Electric Co (GE). and Citigroup Inc. (C).
...
SEC Complaint
The SEC in its
complaint, also filed today in Manhattan federal court,
accused Madoff of a "multi-billion dollar Ponzi scheme
that he perpetrated on advisory clients of his firm."
The SEC said
it’s seeking emergency relief for investors, including
an asset freeze and the appointment of a receiver for
the firm. Ira Sorkin, another defense lawyer for Madoff,
couldn’t be immediately reached for comment.
...
Madoff, who
owned more than 75 percent of his firm, and his brother
Peter are the only two individuals listed on regulatory
records as "direct owners and executive officers."
Peter Madoff
was a board member of the St. Louis brokerage firm A.G.
Edwards Inc. from 2001 through last year, when it was
sold to Wachovia Corp (WB).
$17.1 Billion
The Madoff
firm had about $17.1 billion in assets under management
as of Nov. 17, according to NASD records. At least 50
percent of its clients were hedge funds, and others
included banks and wealthy individuals, according to the
records.
...
Madoff’s Web
site advertises the "high ethical standards" of the
firm.
"In an era of
faceless organizations owned by other equally faceless
organizations, Bernard L. Madoff Investment Securities
LLC harks back to an earlier era in the financial world:
The owner’s name is on the door," according to the Web
site. "Clients know that Bernard Madoff has a personal
interest in maintaining the unblemished record of value,
fair-dealing, and high ethical standards that has always
been the firm’s hallmark."
...
"These guys
were one of the original, if not the original, third
market makers," said Joseph Saluzzi, the co-head of
equity trading at Themis Trading LLC in Chatham, New
Jersey. "They had a great business and they were good
with their clients. They were around for a long time.
He’s a well-respected guy in the industry."
The case is
U.S. v. Madoff, 08-MAG-02735, U.S. District Court for
the Southern District of New York (Manhattan)
What was the auditing firm of Bernard Madoff Investment
Securities, the auditor who gave a clean opinion, that's been
insolvent for years? Apparently, Mr Madoff said the business had
been insolvent for years and, from having $17 billion of assets
under management at the beginning of 2008, the SEC said: “It appears
that virtually all assets of the advisory business are gone”. It has
now emerged that Friehling & Horowitz, the auditor that signed off
the annual financial statement for the investment advisory business
for 2006, is under investigation by the district attorney in New
York’s Rockland County, a northern suburb of New York City.
"The $50bn scam: How Bernard Madoff allegedly cheated investors," London
Times, December 15, 2008 ---
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5345751.ece
It was at the Manhattan apartment that Mr
Madoff apparently confessed that the business was in fact a “giant
Ponzi scheme” and that the firm had been insolvent for years.
To cap it all, Mr Madoff told his sons he
was going to give himself up, but only after giving out the $200 -
$300 million money he had left to “employees, family and friends”.
All the company’s remaining assets have now
been frozen in the hope of repaying some of the companies,
individuals and charities that have been unfortunate enough to
invest in the business.
However, with the fraud believed to exceed
$50 billion, whatever recompense investors could receive will be a
drop in the ocean.
The three-person auditing firm that
apparently certified the books of Bernard Madoff Investment
Securities, the shuttered home of an alleged multibillion-dollar
Ponzi scheme, is drawing new scrutiny.
Already under investigation by local
prosecutors for its potential role in the scandal, the firm,
Friehling & Horowitz, is now also being investigated by the American
Institute of Certified Public Accountants, the prestigious body that
sets U.S. auditing standards for private companies.
The problem: The auditing firm has been
telling the AICPA for 15 years that it doesn't conduct audits.
The AICPA, which has more than 350,000
individual members, monitors most firms that audit private
companies. (Public-company auditors are overseen, as the name
suggests, by the Public Company Accounting Oversight Board, which
was created in 2003 in response to accounting scandals involving
WorldCom and Enron.)
Some 33,000 firms enroll in the AICPA's
peer review program, in which experienced auditors assess each
firm's audit quality every year. Forty-four states require
accountants to undergo reviews to maintain their licenses to
practice.
Friehling & Horowitz is enrolled in the
program but hasn't submitted to a review since 1993, says AICPA
spokesman Bill Roberts. That's because the firm has been informing
the AICPA -- every year, in writing -- for 15 years that it doesn't
perform audits.
Meanwhile, Friehling & Horowitz has
reportedly done just that for Madoff. For example, the firm's name
and signature appears on the "statement of financial condition" for
Madoff Securities dated Oct. 31, 2006. "The plain fact is that this
group hasn't submitted for peer review and appears to have done an
audit," Roberts says. AICPA has now launched an "ethics
investigation," he says.
As it happens, New York is one of only six
states that does not require accounting firms to be peer-reviewed.
But on the heels of the Madoff revelations, on Tuesday, the New York
State senate passed legislation that requires such a process. (The
bill now awaits Gov. David Paterson's signature.) "We've not been
regulated in the fashion we should've inside the state," says David
Moynihan, president-elect of the New York State Society of Certified
Public Accountants.
David Friehling, the only active accountant
at Friehling & Horowitz, according to the AICPA, might seem like an
odd person to flout the institute's rules. He has been active in
affiliated groups: Friehling is the immediate past president of the
Rockland County chapter of the New York State Society of Certified
Public Accountants and sits on the chapter's executive board.
Friehling, who didn't return calls seeking
comment, is rarely seen at his office, according to press reports.
The 49-year-old, whose firm is based 30 miles north of Manhattan in
New City, N.Y., operates out of a 13-by-18-foot office in a small
plaza.
A woman who works nearby told Bloomberg
News that a man who dresses casually and drives a Lexus appears
periodically at Friehling & Horowitz's office for about 10 to 15
minutes at a stretch and then leaves. (State automobile records
indicate that Friehling owns a Lexus RX.) The Rockland County
District Attorney's Office has opened an investigation to see if the
firm committed any state crimes.
People who know Friehling, through the
state accounting chapter and through the Jewish Community Center in
Rockland County (where he's a board member) were reluctant to
discuss him. Most members of both boards wouldn't comment except to
say they were surprised by Friehling's connection to Madoff.
"He's nothing but the nicest guy in the
world," says David Kirschtel, chief executive of JCC Rockland. "I've
never had any negative dealings with him."
When he was Director of the SEC, Arthur
Levitt and his Chief SEC Accountant gave the large auditing firms
considerable trouble (unlike SEC Chairman Harvey Pitt). But to my
knowledge Levitt was pretty much hands off on free-wheeling Wall Street
financial institutions and is now probably given too much credence in
terms of cleaning up the mess after Chris Cox was the disastrous head of
the SEC ---
http://www.trinity.edu/rjensen/2008Bailout.htm#SEC
Leavitt was easily duped by his close
friend Bernie Madoff, probably not separating church and state when
Levitt was head of the SEC and Madoff was committing fraud (for over 28
years of phony stock trades in his investment fund that Levitt, Pitt,
and Cox left unregulated to the point of not even requiring audits by
registered auditing firms).
From The Wall Street Journal
Accounting Weekly Review on January 23, 2009
TOPICS: Auditing, Fraudulent Financial Reporting,
SEC, Securities and Exchange Commission
SUMMARY: These letters to the editor express a
range of opinions on another op-ed piece by Arthur
Levitt Jr., former Chairman of the SEC. In Levitt's
January 5 Op-Ed piece, he stated that he "never saw an
instance where credible information about misconduct was
not followed up by the agency."
CLASSROOM APPLICATION: Understanding the role of
the SEC and the skill set needed to fulfill its mission
are the primary uses of this article.
QUESTIONS:
1. (Introductory) Who is Arthur Levitt?
Summarize his recent opinion-page piece that led to
these letters in response.
2. (Introductory) What concerns the CPA, Kevin
Rosenberg, who describes the types of audit and
accounting firms associated with recent financial
reporting frauds and failures?
3. (Advanced) One op-ed writer, Paul L.
Comstock, argues that "the SEC can only do so much to
protect without paralyzing our capital markets." But
does Eunice Bet-Mansour, Ph.D., necessarily call for a
greater quantity of regulatory steps to avoid another
Ponzi scheme or fraud such as that committed by Mr.
Madoff?
4. (Advanced) What level of skill set does Dr.
Bet-Mansour say is needed among SEC staffers? What level
of education provides this analytical skill set? In your
answer, consider the level of education held by Harry
Markopoulos.
Reviewed By: Judy Beckman, University of Rhode Island
Never mind showbusiness, there's
no business like the accountancy business. Accountancy firms have a
licence to print money because they enjoy access to a
state-guaranteed market for auditing. Companies, hospitals, schools,
charities, universities, trade unions and housing associations have
to submit to an audit, even though the auditor might issue duff
reports. Anyone refusing their services faces a prison sentence.
Major company audits are the most
lucrative and that market is dominated by just four global auditing
firms. PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young have
global revenues of over $80 billion (£41bn) a year, which is
exceeded by the gross domestic product of only 54 nation states.
These firms dominate the structures that make accounting and
auditing rules.
Following the Enron and WorldCom
debacles and the demise of Arthur Andersen, the auditing market has
become further concentrated in those four firms. Many major
companies looking for global coverage find that the auditor choice
is very restricted.
In the US, the big four audit 95%
of public companies with market capitalisations of over $750m. A US
study focusing on 1,300 companies, showed that the fees charged by
the big auditing firms have
increased by 345% in the five years to
2006. Median total auditor costs rose to $2.7m, from $1.4m in 2001.
A major reason for the increase is said to be the (SOX)
Sarbanes-Oxley Act (pdf)
2002, which was introduced after audit failures at Enron and
WorldCom.
In the UK, the big four firms
audit 97% of FTSE 350 companies. In 2001, the average FTSE 100
company audit fee was £1.89m. By
2006,
the figure had increased to £3.7m. The rise in audit fees continues
to exceed the rates of inflation. For example, Northern Rock's fees
have increased from £1.8m in 2006 to £2.4m in 2007.
The firms cite the Sarbanes-Oxley
Act and international accounting and auditing standards to justify
higher fees. They are silent on the fact that their own audits of
Enron and WorldCom arguably prompted the Sarbanes-Oxley Act, or that
the big four firms finance and dominate the setting of international
accounting and auditing standards. These standards rarely say
anything about the public accountability of auditing firms. Most
firms refuse to reveal their profits.
The massive hike in audit fees has
not given us better audits.
Carlyle Capital Corporation collapsed
within days of receiving a clean bill of health form its auditors.
Bear Stearns was bailed out within a few
days of receiving another clean bill of health. In the current
financial crisis, all major banks received a clean bill of health
even though they engaged in massive off balance sheet accounting and
around
$1.2tn of toxic debts may
have been hidden. But perhaps ineffective auditors suit the
corporate barons.
In market economies, producers of
shoddy goods and services are allowed to go to the wall. Governments
impose higher standards of care on them to improve quality. But
entirely the opposite has happened in the auditing industry.
Auditing firms have secured
liability concessions (pdf)
to shield them from the consequences of own their failures.
Charlie McCreevy, the EU
commissioner for the internal market and services, an accountant, is
keen to give them more. He favours an artificial "cap" on auditor
liability. The commissioner has failed to provide any evidence to
show that the liability shield provided to producers of poor quality
goods and services somehow encourages them to improve the quality of
their products.
Accountancy firms, EU
commissioners and regulators routinely preach competition to
everyone else, but go soft when it comes to dealing with auditing
firms. They could restrict the number of FTSE companies that any
auditing firm can audit and thus create for space for medium-sized
firms to advance. They could insist that some quoted companies
should have joint audits and thus again create space for
medium-sized firms. They could insist on compulsory retendering or
company audits and rotation of auditors. They could invite new
players to the audit market. The Securities Exchange Commission or
the Financial Services Authority could take charge of audits of
banks and financial institutions. None of these proposals are on the
radar of the corporate dominated UK accounting regulator, the
Financial Reporting Council.
It advocates market led solutions,
which raises the question of why the markets have not resolved the
problems already, and exerted pressures for better audits.
As a society, we continue to give
auditing firms state-guaranteed markets, monopolies, lucrative fees
and liability concessions. None of it has given us, or is likely to
give us better audits, company accounts, corporate governance or
freedom from frauds and fiddles. Without effective independent
regulation, public accountability and demanding liability laws, the
industry cannot provide value for money.
Seeking $550m, a trustee for the
money-manager names McGladrey & Pullen for "participating in
wrongdoing," and cites a partner, too. Stephen Taub CFO.com | US
March 24, 2008 The Bloomington, Minn.-based accounting firm of
McGladrey & Pullen, along with the partner in charge of now-defunct
Sentinel Management Group Inc.'s audit, were sued for $550 million
by a Chapter 11 trustee for Sentinel. The trustee charged that
accountancy "itself participated in the wrongdoing committed by a
Sentinel insider," who wasn't named.
The trustee for Northbrook, Ill.-based
money manager Sentinel — which itself had been accused of fraud —
filed the suit in U.S. Bankruptcy Court in Chicago. In addition to
McGladrey & Pullen, the suit named G. Victor Johnson, who had been
the partner in charge, according to a Bloomberg News report.
A representative for the accountancy and
Johnson didn't return a call from CFO.com seeking comment.
Last August, Sentinel froze client
withdrawals from its $1.5-billion short-term investment fund, and
company officials claimed in a letter to clients that because of
subprime mortgage crisis and resulting credit crunch "fear has
overtaken reason," according to an Associated Press report at the
time. Sentinel reportedly told clients that it could not meet their
requests to withdraw cash.
The following week, the Securities and
Exchange Commission filed an emergency action against Sentinel
seeking to halt any improper commingling, misappropriating, and
leveraging of client securities without client consent. The SEC's
complaint alleged that for at least several months Sentinel's
advisory clients suffered undisclosed losses and risks of losses as
a result of several unauthorized practices. The commission said
Sentinel placed at least $460 million of client securities belonging
in segregated customer accounts in Sentinel's house proprietary
account.
According to the AP, the trustee, Frederick
Grede, accused the firm, which audited Sentinel's 2006 financial
statements, of certifying false financial statements and creating
some of the accounting entries that led to Sentinel's financial
misstatements. According to Bloomberg, Grede said McGladrey & Pullen
"ignored blatant violations of federal law" and "failed to satisfy
the most basic standards of the accounting and auditing profession."
The trustee said the firm "assisted in the
creation of a fictitious management agreement" used to siphon $1
million out of Sentinel when it knew no management services were
being provided, according to the wire service. Rather than giving
Sentinel an unqualified opinion for 2006, the trustee said that the
firm should have disclosed violations of law, according to
Bloomberg.
"M&P's failure to either ensure that
Sentinel's financial statements accurately reflected the facts or
refuse to certify materially misstated financial statements, as well
as its failure to report these violations in its audit report and to
authorities, reflects a deliberate disregard of M&P's obligations as
an auditor," Grede reportedly said.
That question, frequently heard during
financial scandals earlier this decade, is being asked again as an
increasing number of companies are being probed about the practice
of backdating employee stock options, which in some cases allowed
executives to profit by retroactively locking in low purchase prices
for stock.
For the accounting industry, the question
raises the possibility that the big audit firms didn't live up to
their watchdog role, and presents the Public Company Accounting
Oversight Board, the regulator created in response to the past
scandals, its first big test.
"Whenever the audit firms get caught in a
situation like this, their response is, 'It wasn't in the scope of
our work to find out that these things are going on,' " said Damon
Silvers, associate general counsel at the AFL-CIO and a member of
PCAOB's advisory group. "But that logic leads an investor to say,
'What are we hiring them for?' "
Others, including accounting professionals,
aren't so certain bookkeepers are part of the problem. "We're still
trying to figure out what the auditors needed to be doing about
this," said Ann Yerger, executive director of the Council of
Institutional Investors, a trade group. "We're hearing lots of
things about breakdowns all through the professional-advisor chains.
But we can't expect audit firms to look at everything."
One pressing issue: Should an auditor have
had reason to doubt the veracity of legal documents showing the
grant date of an option? If not, it is tough for many observers to
see how auditors could be held responsible for not spotting false
grant dates.
"I don't blame the auditors for this," said
Nell Minow, editor of The Corporate Library, a governance research
company. "My question is, 'Where were the compensation committees?'
"
To sort out the issue, the PCAOB advisory
group -- comprising investor advocates, accounting experts and
members of firms -- last week suggested the agency provide guidance
to accounting firms on backdating of stock options. A spokeswoman
for the board said, "We are looking to see what action they may be
able to take."
To date, more than 40 companies have been
put under the microscope by authorities over the timing of options
issued to top executives. Federal authorities are investigating
whether companies that retroactively applied the grant date of
options violated securities laws, failed to properly disclose
compensation and in some cases improperly stated financial results.
A number of companies have said they will restate financial
statements because compensation costs related to backdated options
in questions weren't properly booked.
All of the Big Four accounting firms --
PricewaterhouseCoopers LLP, Deloitte & Touche LLP, KPMG LLP and
Ernst & Young LLP -- have had clients implicated. None of these top
accounting firms apparently spotted anything wrong at the companies
involved. One firm, Deloitte & Touche, has been directly accused of
wrongdoing in relation to options backdating. A former client,
Micrel Inc., has sued the firm in state court in California for its
alleged blessing of a variation of backdating. Deloitte is fighting
that suit.
The big accounting firms haven't said
whether they believe there was a problem on their end. Speaking at
the PCAOB advisory group's recent meeting, Vincent P. Colman, U.S.
national office professional practice leader at
PricewaterhouseCoopers, said his firm was taking the issue
"seriously," but more time is needed "to work this through" both
"forensically" and to insure this is "not going to happen going
forward."
Robert J. Kueppers, deputy chief executive
at Deloitte, said in an interview: "It is one of the most
challenging things, to sort out the difference in these [backdating]
practices. At the end of the day, auditors are principally concerned
that investors are getting financial statements that are not
materially misstated, but we also have responsibilities in the event
that there are potential illegal acts."
While the Securities and Exchange
Commission has contacted the Big Four accounting firms about
backdating at some companies, the inquiries have been of a
fact-finding nature and are related to specific clients rather than
firmwide auditing practices, according to people familiar with the
matter. Class-action lawsuits filed against companies and directors
involved in the scandal haven't yet targeted auditors.
Backdating of options appears to have
largely stopped after the passage of the Sarbanes-Oxley
corporate-reform law in 2002, which requires companies to disclose
stock-option grants within two days of their occurrence.
Backdating practices from earlier years
took a variety of forms and raised different potential issues for
auditors. At UnitedHealth Group Inc., for example, executives
repeatedly received grants at low points ahead of sharp run-ups in
the company's stock. The insurer has said it may need to restate
three years of financial results. Other companies, such as Microsoft
Corp., used a monthly low share price as an exercise price for
options and as a result may have failed to properly book an expense
for them.
At the PCAOB advisory group meeting, Scott
Taub, acting chief accountant at the Securities and Exchange
Commission, said there is a "danger that we end up lumping together
various issues that relate to a grant date of stock options."
Backdating options so an executive can get a bigger paycheck is "an
intentional lie," he said. In other instances where there might be,
for example, a difference of a day or two in the date when a board
approved a grant, there might not have been an intent to backdate,
he added.
"The thing I think that is more
problematic is there have been some allegations that auditors knew
about this and counseled their clients to do it," said Joseph
Carcello, director of research for the corporate-governance center
at the University of Tennessee. "If that turns out to be true, they
will have problems."
Fear in the European Union (EU) of the
potential collapse of one of the Big Four accounting firms surfaced
this week when a briefing document, prepared for members of the EU
delegation meeting in Beijing with Chinese officials on accounting
and auditing issues, was shown to XFN-Asia. “The audit firms wish to
have a limit of their liability, at least to acts for which they can
be held directly responsible for. There is a particular fear that
the next corporate scandal would reduce the Big Four to Big Three,”
it said, according to AFX News Limited.
The audit giants have been lobbying member
states for legislation that will limit their liability to
shareholder claims. A study currently underway in the EU of the
economic consequences of the liability issue will be concluded by
September of this year, AFX News says.
“Towards the end of the year, I intend to
be in a position to assess the options and decide what can be done,”
the position paper said as a proposed response to a question about a
collapse of any of the Big Four.
While the Big Four prepare for limited
liability in the EU, China, a market in which they are all seeking a
larger presence, is subjecting their audits to close examination and
at times, public rebuke.
Last week, Ernst & Young (E&Y) was forced
to retract data on nonperforming loans in China’s banking sector.
E&Y estimated that China’s bank held $900 billion in bad loans, a
number it later said was “factually erroneous” and “embarrassing.”
But the official Chinese estimate of $164 billion is not accepted by
most analysts, the Wall Street Journal says. “There are hidden NPLs
there,” Mei Yan, a bank analyst at Moody’s Investor Services told
the Journal. She said that Beijing’s estimates were based on a very
narrow definition of a bad loan.
Deloitte and Touche has been sued in China
for failing to expose falsified accounts in its audits of Guandong
Kelon Electrical Holdings Co., AFX News says.
Japan’s Financial Services Agency (FSA) has
been inspecting local affiliates of each of the Big Four firms and
will issue a report in late June on the strength and independence of
the firms, according to the Washington Post. Government officials in
Japan, the Post reports, have indicated that they lack confidence in
the ability of local Japanese firms to uncover fraud in their
clients.
Chuo Aoyama PwC, a local affiliate of
Pricewaterhousecoopers (PwC), was banned from auditing for two
months by the FSA last week. While PwC said that it would support
the affiliate, it announced that it would form a new Japanese
auditing firm that will compete with Chuo Aoyama, that it hopes will
be running by July, the Post says.
PwC Settles for a hefty $41.9 million for "overbilling" PricewaterhouseCoopers LLP agreed to pay $41.9
million to settle charges it overbilled government agencies for travel
expenses, the Justice Department said. The department alleged the
company failed to disclose rebates it received from credit-card
companies, airlines, hotels and rental-car agencies and didn't reduce
reimbursement claims accordingly. PricewaterhouseCoopers didn't admit to
any wrongdoing and said the policy that gave rise to the matter was
changed in 2001. In late 2003, PricewaterhouseCoopers settled its share
of a class-action lawsuit filed in state court in Arkansas that accused
the company of overbilling corporate clients for travel-related
expenses.
"Pricewaterhouse Settles Charges," The Wall Street Journal, July
12, 2005; Page C12 ---
http://online.wsj.com/article/0,,SB112111341898682519,00.html?mod=todays_us_money_and_investing
Jensen Comment: PwC is not the only large firm of keeping travel
rebates secret from clients. You can read more about this question
of ethics below.
While many filings in the Texarkana case are
under seal, one internal PricewaterhouseCoopers document from October 1999
estimated the firm's annual credits from travel rebates at $45 million,
mostly from postflight rebates on airline tickets. As an example, the
court record contains a December 1999 contract under which Budget Rent A
Car Corp. agreed to pay PricewaterhouseCoopers a rebate equal to 3% of all
rental revenue that Budget received from the firm, if annual sales to
PricewaterhouseCoopers topped $15 million. The plaintiff in the Texarkana
case has alleged that some of the firms' airline rebates topped 40% of the
plane tickets' purchase prices. Jonathon Weil, The Wall Street Journal, September 23,
2003 ---
http://online.wsj.com/article/0,,SB106452493527358700,00.html?mod=todays%255Fus%255Fmoneyfront%255Fhs
Note from Bob Jensen: This is a
classic problem of ethics. The issue is not so much what the largest
accounting firms are/were doing before they got caught (I guess most have
stopped doing it now). It’s more of a matter of keeping it secret
from their clients, potential clients, and the public in general.
For example, many (most) of us get frequent flier miles when we bill our
airline tickets to universities and other organizations that pay our air
fares. However, it's no big secret that we get those frequent flier
miles. Some of us also get credit card rebates if we pay with credit
cards such as Discover Card. This is a bit more of a gray area, but
if the price is the same no matter how we pay the bill, I guess we can
hold our head high and declare that we are not ripping off anybody as long
a another form of payment would not reduce the bill. However, what
the large accounting firms have been doing around the world for travel
billings is a much more controversial matter of ethics.
The above article
notes how the Justice Department is investigating this rip off (my words)
in more than just one of the large accounting firms. What gets me
about the above revelation of the magnitude of this scheme is the
hypocritical aspect in which large accounting firms are now preaching
virtue but still show signs of practicing vice after all the scandals.
Sometimes it seems they are not really listening to Art Wyatt's advice
quoted above.
In August the PCAOB released the
first set of reviews of audit firms as mandated by the
Sarbanes/Oxley Act, comprising an examination of 16 engagements from
each of the Big 4 audit firms. While fault was found with each firm
(with E&Y being a clear negative outlier), the errors were
relatively minor, either being immaterial departures from GAAP, or
the failure to perform certain tests. But in no case was the
previously determined audit opinion affected by the review, a not
surprising result given that the samples were taken from engagements
that had already gone through the firms own review processes. The
PCAOB stated in advance that the 2004 reviews would not be as
comprehensive or thorough as ones it will conduct in the future.
Thus in 2005 the Big 4 (who are required to be reviewed annually)
will see some 500 of their engagements reviewed, while the PCAOB
will also begin the required triennial review of smaller audit
firms, with some 150 subject to examination.
Given this ambitious agenda, it is
time to stop and consider what the best use that the PCAOB can make
of the power is granted to it to conduct reviews of the audit
industry. The reviews are conducted by auditors drawn from the same
firms as the ones they are reviewing, trained in the same
traditional methodologies and one has to fear that this will lead to
a failure in imagination and innovation in how the PCAOB conceives
of the role of the review process.
Thus, evidently the PCAOB feels
that the main instrument it should rely on are sample engagement
audits, which will then help pinpoint failures in the audit firm’s
procedures and policies. The engagement focused approach can
certainly lead to some useful information about how the audit firms
are operating, but how much is learned clearly depends on how the
sample is chosen. Engagements that are subject of firm review are
that are inherently problematic and high risk, but it is a good
question whether the majority of audit failures are with such
engagements since they are already subject to closer scrutiny. An
astute manager might feel that the best candidates for fraud are
precisely in those quiet, routine accounts that are considered too
dull for an auditor to worry too much about—consider that the
misrepresentation of expenses as assets at WorldCom far exceeded the
total liability at Enron with its sexy SPEs.
Inspecting engagements will help
firm do those engagements better, but the approach is not explicitly
designed to improve the 95% of audits that will not be inspected,
and provides no protection for the industry if one of those
unexamined engagements ends in a spectacular failure. By contrast,
consider the basis of Section 404 of the Sarbanes/Oxley Act which
requires managers to certify as to the effectiveness of the
company’s controls over the preparation of financial reports with
the auditor then attesting to the certification. A glaring absence
in the Sarbanes/Oxley regulatory framework is a 404 type requirement
on audit firms themselves with regard to the controls on their audit
engagements. The PCAOB can potentially fill that gap by focusing its
review on the audit firms control systems rather than almost
exclusively on actual engagements. The point is to help the firm
improve how it does an audit in the first place rather than to catch
a badly done one. The preventive rather than corrective approach
underlies Total Quality Control and there is no reason why those
principles long used in American manufacturing cannot be applied to
auditing.
A justification for an inspection
regime is to serve as a deterrent to badly conducted audits, an
approach that may appeal to a public burned by the Andersen
meltdown. But deterrent only works if it is credible and one has to
seriously question whether the Big 4 firms are now too large to
fail, meaning that the PCAOB is constrained in how hard it can come
down on these audit firms even when a review finds a serious flaw in
an engagement. If the PCAOB realistically cannot de-register one of
the Big 4, or even publicly reveal enough information that could
lead to a crippling lawsuit, then what is gained from these
inspections? It is equivalent to an audit in which both the auditor
and the manager knows that at the end of the day a qualified opinion
will not be issued. In these circumstances a better approach may be
to act explicitly like an internal rather than an external auditor,
focusing on improving the audit process and helping prevent problems
rather than catching errors that have already occurred.
Another credibility problem with
the inspection regime proposed by the PCAOB is whether, given the
staff and resources at the PCAOB’s disposal, expanding the sample
size almost tenfold will result in more or less thorough reviews of
each engagement than the rather shallow examinations in 2004. What
is noteworthy about the proposed review process is that it is little
different in substance from the old and reviled peer review system
that it replaced, despite the fact that the PCAOB has far more legal
authority to demand access and cooperation from the firm and its
documentation than the peer reviewers ever did. That is an
indication of the fundamental problem with the PCAOB approach, that
it is simply trying to do the old peer reviews better rather than
starting from scratch and asking what is the optimal method of
assuring auditing.
Such a reengineering approach would
surely begin with technology, which when allied with the new
requirements for comprehensive documentation by both firm and
auditor (“if it isn’t in writing, it doesn’t exist.”) can
potentially lead to the creation of a vast depository of digitized
audits. Sophisticated audit tools can then be applied against this
dataset to provide real time monitoring of audit procedures and to
develop models of emerging audit failures.
[1]
This approach would also enable the PCAOB to take advantage of a
major new capability that it potentially has, the ability to
benchmark across audit firms and to find both discrepancies and best
practices. What the PCAOB ideally needs is a monitoring system, as
real time as possible, incorporating a large set of business rules
based on statistical analysis that calls attention not to unhealthy
high audit risk firms but to profiles of audit failure, and which
would issue alarms as audit failures are occurring rather than after
an opinion has been issued.
Finally, recall that an auditor
checks whether a firm has prepared income in accordance with GAAP,
but the auditor is not responsible for developing GAAP itself. By
contrast, the PCAOB both audits auditors and now also has the duty
to develop audit standards. This suggests that reviews have to
provide a mechanism to understand and improve the way in which
auditing takes place, something which cannot happen if the reviews
use traditional methodologies to perpetuate the current system. The
PCAOB needs to rethink how a properly configured audit review
system, imaginatively using the latest information technology, can
be part of a systematic continuous improvement process that leads to
audits that better serve the needs of financial markets and
shareholders.
[1] Further details
on the application of continuous auditing methodology to the
audit review process can be found in “Restoring Auditor
Credibility: Tertiary Monitoring and Logging of Continuous
Assurance Systems” Michael Alles, Alex Kogan, Miklos
Vasarhelyi. International Journal of Accounting Information
Systems, Vol. 5, No. 2, pp. 183-202, June 2004.
A new state audit concludes that the accounting
firm chosen by the Roslyn school district as its fiscal watchdog was hired
without competitive bidding, had a blatant conflict of interest in the
sale of financial software to the district, grossly neglected basic duties
like reviewing canceled checks and failed to catch rampant
multimillion-dollar corruption - even after a whistleblower's tip on
thefts of $223,000
The withering critique could have implications
far beyond Roslyn. The accounting firm, Miller, Lilly & Pearce of East
Setauket, has also been the independent auditor for 54 other school
systems in New York State, including more than a third of Long Island's
districts and three upstate, and for several local governments and
nonprofit groups.
State Comptroller Alan G. Hevesi, who released
his staff's report at a news conference here Thursday, said he had no
evidence of major problems in other schools but was alerting all 701
districts across the state.
So far in Roslyn's growing scandal, three people
have been arrested and charged with defrauding the district of more than
$2.3 million, though investigators predict the ultimate amount could be
several times that. Those arrested are the fired school superintendent,
Frank Tassone; the former business manager, Pamela Gluckin; and her niece,
a former accounting clerk, Debra Rigano.
The accountants hired to detect and prevent fraud
utterly failed, Comptroller Hevesi said.
"The work of Miller, Lilly & Pearce was
so appallingly inadequate that it would shock anyone associated with the
auditing profession and certainly the taxpayers who depend on the firm to
safeguard their money," he said. "This is just an awful
performance by this auditor. They are unprofessional.
"The fraud was so pervasive that it would
have taken significant effort not to uncover it. Even a rudimentary review
of disbursements and canceled checks would have revealed many instances of
wrongdoing."
KPMG LLP, the fourth-largest U.S. accounting
firm, and its former consulting unit, BearingPoint Inc., agreed to a
pair of settlements with a total value of $34 million to resolve their
portions of a class-action lawsuit that accused them of fraudulently
overbilling clients for travel-related expenses.
The preliminary agreements, under which KPMG
and BearingPoint each agreed to settlements valued at $17 million, mark
the latest development in the travel-billings litigation ongoing in a
Texarkana, Ark., state court. Under the terms of Friday's agreements,
BearingPoint and KPMG denied wrongdoing.
In December, PricewaterhouseCoopers LLP agreed
to a $54.5 million settlement in the case, though it denied wrongdoing.
The lawsuit is continuing against the remaining two defendants, Ernst &
Young LLP and the U.S. arm of Cap Gemini Ernst & Young, a French
consulting concern that bought Ernst & Young's consulting business in
2000. A separate civil investigation by the Justice Department into the
accounting and consulting firms' billing practices as government
contractors is continuing.
A third of the combined $34 million settlement,
which was approved Friday by Miller County Circuit Judge Kirk Johnson,
will go to the plaintiffs' attorneys. Class members would have the
option of accepting certificates entitling them to credits toward for
future services. Or they could opt to receive 60% of the certificates'
face value in cash. The certificates' size would vary from client to
client.
Revelations from the Texarkana lawsuit have
shined a light on how some professional-services firms in recent years
have turned reimbursable out-of-pocket expenses, such as bills for
airline tickets and hotel rooms, into profit centers by using their size
during negotiations with travel companies to secure significant rebates
of upfront costs. Unlike discounts that reduce the published fare on,
say, a plane ticket, rebates are paid after travel is completed, usually
in lump-sum checks. When firms retain rebates on client-travel without
disclosing the practice to clients, they run the risk of exposing
themselves to significant legal liability, as Friday's settlements show.
KPMG and the other defendants have acknowledged
retaining undisclosed rebates and commissions from travel companies on
client-related travel. But they deny acting fraudulently, saying they
used the proceeds to offset costs they otherwise would have billed to
clients.
KPMG had continued to administer BearingPoint's
program for client-related travel following BearingPoint's separation
from KPMG in 2000. KPMG said it stopped accepting so-called "back-end"
rebates from travel companies in 2002, shortly after the Texarkana
lawsuit was filed in October 2001.
A BearingPoint spokesman said the company was
"pleased that an agreement has been reached that is beneficial to all
involved, recognizing that it's a liability we inherited for a program
we didn't create." He said the company previously had established
reserves on its balance sheet in anticipation of a settlement and
anticipates "no impact on current or future earnings."
A KPMG spokesman said: "KPMG considers this
settlement a fair and reasonable solution to the litigation. While we
firmly believe that the KPMG travel program operated to our clients'
substantial benefit and that we would prevail at trial, this settlement
will end what promised to be a long and costly litigation."
Whether clients benefited or not, internal KPMG
records on file at the Texarkana courthouse suggest that KPMG operated
its travel division as a profit center and regarded its proceeds from
travel rebates as earnings for the firm.
One of those documents was a 1999 memo by the
firm's travel unit that said the travel unit "will return $17 million to
the firm. As large a profit as any of the firm's most important
clients." Another KPMG document contained a spreadsheet called "earnings
from travel" that showed $19.1 million in such earnings for fiscal 2001
and $17.4 million in such earnings for fiscal 2000.
The plaintiffs leading the Texarkana lawsuit
are Warmack-Muskogee LP, a former PricewaterhouseCoopers client that
operates an Oklahoma shopping mall, and Airis Newark LLC, a former KPMG
client based in Atlanta that builds airport facilities.
"We are extremely pleased with the results that
we were able to obtain for these clients," said Rick Adams, an attorney
for the plaintiffs at the Texarkana, Texas, law firm Patton, Haltom,
Roberts, McWilliams & Greer LLP. "We intend to continue the lawsuit
against Ernst & Young and Cap Gemini."
A Justice Department investigation that started
two years ago with questions about PricewaterhouseCoopers LLP's
travel-related billing practices as a government contractor also is
focusing on possible overbillings by the other Big Four accounting
firms, as well as several other companies.
Some details of the probe's scope are contained
in a previously unreported November 2002 memorandum that the Justice
Department filed with a Texarkana, Ark., state circuit court in
connection with a separate civil lawsuit into travel-related billing
practices. The lawsuit accuses PricewaterhouseCoopers, Ernst & Young LLP
and KPMG LLP of fraudulently padding the travel-related expenses they
billed to clients by hundreds of millions of dollars over a 10-year
period starting in 1991.
In its memo to the court, the Justice
Department said it is investigating each of the suit's defendants,
"focusing on whether they have submitted false claims to the government,
because they have failed to credit government contracts with amounts
they have received as rebates from travel providers."
The Texarkana lawsuit originally was filed in
October 2001 by closely held shopping-mall operator Warmack-Muskogee LP
and had proceeded without publicity until reported last week in The Wall
Street Journal. It alleges that the accounting firms systematically
billed their clients for the full face amount of certain travel
expenses, including airline tickets, hotel rooms and car-rental
expenses, while pocketing undisclosed rebates they received under
contracts with various travel-service providers.
The defendants have acknowledged retaining
rebates on various travel expenses for which they had billed clients at
their pre-rebate amounts. However, they deny that their conduct was
fraudulent, saying that the proceeds offset amounts that otherwise would
have been billed to clients. They say they have discontinued the
practice.
Other defendants in the Texarkana lawsuit
include the U.S. unit of Cap Gemini Ernst & Young, a French consulting
company that purchased Ernst & Young's consulting practice in 2000, and
BearingPoint Inc., a former KPMG unit previously known as KPMG
Consulting Inc. that now is an independent public company. The Justice
Department memo further disclosed that the defendants "are aware of" the
investigation, which "concerns the same issues presented in the"
Texarkana civil lawsuit, and that the government had obtained documents
from each of the defendants in the Texarkana case through subpoenas.
According to a person familiar with the
investigation, the Justice Department's overbilling probe also includes
the travel-related billing practices of Deloitte & Touche LLP, as well
as four other large government contractors. This person declined to
identify the other four contractors under investigation, but said they
are not professional-services firms. Federal contracts, this person
explained, typically state that government contractors will bill the
government for actual travel costs -- often referred to as
"out-of-pocket" or "incurred" costs -- which the government interprets
to mean the amount that a contractor actually paid for, say, an airline
ticket, including any rebates.
Three of the nation's four biggest accounting
firms have been accused in a lawsuit of fraudulently overbilling clients
by hundreds of millions of dollars for travel-related expenses, and the
Justice Department has been conducting an investigation of the billing
practices of at least one of the firms, PricewaterhouseCoopers LLP.
Documents describing the government's
investigation are contained in the previously unpublicized lawsuit filed
here in October 2001 that could pose both a public-relations
embarrassment and a big legal challenge to the firms. The industry has
been under intense scrutiny for its audit work following the 2001
collapse of Enron Corp., which brought down another big accounting firm,
Arthur Andersen LLP, and for its perceived lack of oversight at other
companies, including Tyco International Ltd., Xerox Corp. and others.
The suit, pending in an Arkansas state circuit
court, accuses PricewaterhouseCoopers, KPMG LLP and Ernst & Young LLP of
padding the travel-related expenses they billed thousands of clients
over a 10-year period dating back to 1991.
The suit alleges that the firms systematically
billed their clients for the full face amount of certain travel
expenses, including airline tickets, hotel rooms and car-rental
expenses, while pocketing undisclosed rebates and volume discounts they
received under contracts with various airline, car-rental, lodging and
other companies. At times, the rebates retained by the various firms
were for up to 40% of the purchase price of travel-related services, the
suit has alleged, citing internal firm documents filed with the court.
The lawsuit shines a light on how some
professional-services firms, including law firms and medical practices,
in recent years have turned reimbursable out-of-pocket expenses, such as
bills for travel and meals, into profit centers, which itself isn't
illegal or improper. As big accounting, law and other firms have grown
over the past decade, they increasingly have used their size in
negotiations with travel companies, credit-card companies and others to
secure significant rebates of upfront costs. Such rebates don't generate
disputes between firms and their clients when fully disclosed. But any
that aren't fully disclosed, as alleged in the Texarkana suit, could
open firms up to potential liability.
The suit, filed by closely held
Warmack-Muskogee Limited Partnership, a shopping-mall operator, also
accuses the accounting firms of colluding with each other to secure
favorable deals with various travel vendors. It also alleges the firms
operated under an agreement not to disclose the existence of the rebates
to clients or credit clients fully for the rebates.
The defendants in the suit, all of which deny
the lawsuit's allegations, have filed motions seeking to dismiss the
case as groundless and to defeat requests that the lawsuit be certified
as a class action, the class for which could include a majority of the
nation's publicly held corporations. Still, the lawsuit, for which no
trial date has been set, already has proved costly to the firms. In an
affidavit last month, a PricewaterhouseCoopers partner estimated the
firm's partners and staff had spent 125,000 hours, valued at $10.3
million at the firm's billing rates, gathering and analyzing information
to be produced for discovery. KPMG in a July court filing estimated that
its discovery expenses could approach $26 million.
Ernst &
Young was awarded $98.8 million of undisclosed rebates on airline
tickets from 1995 through 2000, mostly on client-related travel for
which the accounting firm billed clients at full fare, internal Ernst
records show.
The rebates are at the crux of a civil lawsuit here in a state circuit
court, in which Ernst & Young LLP, KPMG LLP and PricewaterhouseCoopers
LLP are accused of fraudulently overbilling clients for travel expenses
by hundreds of millions of dollars since the early 1990s. The tallies
are the first precise annual airline-rebate figures to emerge in the
case for any of the three accounting firms.
Ernst and the other defendants,
in the lawsuit brought by closely held shopping-mall operator
Warmack-Muskogee LP, have acknowledged retaining large rebates from
travel companies without disclosing their existence to clients. But they
deny that their conduct was fraudulent, saying they used the proceeds to
offset costs they otherwise would have billed to clients through higher
hourly rates. Confidentiality provisions in the firms' contracts,
standard in the airline industry, barred parties from disclosing the
contracts' existence or terms.
Court records show that Ernst had
rebate agreements with three airlines: American Airlines' parent
AMR Corp.,
Continental Airlines, and
Delta Air Lines. The airline rebates soared to $36.7 million in
2000, compared with $21.2 million in 1999 and $5.2 million in 1995,
reflecting a trend among major accounting firms to structure their
volume discounts with select airlines as rebates rather than upfront
price reductions.
A May 2001 chart by Ernst's
travel department shows the firm estimated that its 2001 rebates would
be $39.8 million to $44 million, including at least $21.2 million from
AMR and $8.3 million from Continental.
Of Ernst's three "preferred
carriers," two -- AMR and Continental -- are audit clients of the firm.
Some investors say the large dollar figures, combined with a reference
in one Ernst document to the firm's arrangements with AMR, Continental
and seven other travel companies as "strategic partnering
relationships," raise questions about how such payments mesh with
Securities and Exchange Commission requirements that auditors be
independent. The reference was contained in a 2001 presentation
outlining the travel department's goals and objectives for the following
year.
Audit firms generally aren't
allowed to have partnership arrangements with clients in which the
auditor would appear to be a client's advocate, rather than a watchdog
for the public. SEC rules bar auditors from having direct business
relationships with audit clients, with one exception: if the auditor is
acting as "a consumer in the normal course of business."
The rules don't clearly spell out
the full range of business relationships that would fall under that
category. Ernst says its relationships with AMR and Continental
qualified for the exception. Generally, auditors can buy goods and
services from audit clients at volume discounts, if the prices are fair
market and negotiations are arm's length. Ernst, American and
Continental say theirs were. Ernst's terms with American and Continental
were similar to those with Delta, which wasn't an audit client.
In a January 2000 e-mail to an
Ernst consultant, Ernst's travel director explained that, within the
airline industry, "point-of-sale discounts are the industry norm, not
back-end rebates." Many large professional-services firms tended to
prefer back-end rebates, however. A September 2000 presentation by
Ernst's travel department said "the back-end rebate structure is
consistent with practices in other large professional-services firms,"
including the other four major accounting firms and investment banks
Credit Suisse First Boston and Morgan Stanley. It also said an outside
consulting firm, Caldwell Associates, had deemed the competitiveness of
Ernst's travel contracts "to be above average," compared with those of
the other four major accounting firms.
In a statement, Ernst says:
"There is no independence rule of any sort that would prohibit our
receipt of rebates for volume travel in the normal course of business.
As is the case with any large airline customer, we receive discounts on
tickets purchased from American based on the volume of our business. ...
It is entirely unrelated to our audit work for the airline."
PricewaterhouseCoopers LLP's practice of
retaining undisclosed rebates on client-related travel expenses
generated internal dissent within the accounting firm, some of whose
partners complained it was improper to keep the payments rather than
passing them on to clients, internal records of the firm show.
The records, including internal e-mails and
slide-show presentations to top executives of the firm, were filed this
year with a Texarkana, Ark., state circuit court as exhibits to a
deposition of PricewaterhouseCoopers Chairman Dennis Nally. The
deposition of Mr. Nally was conducted in February in connection with a
continuing lawsuit against PricewaterhouseCoopers and four other
accounting and consulting firms that accuses them of fraudulently
overbilling clients for travel-related expenses by hundreds of millions
of dollars.
Attorneys alleging that PricewaterhouseCoopers
LLP overbilled its clients for travel expenses have released a flurry of
the accounting firm's e-mails, including one from April 2000 in which
the head of its ethics department described the firm's practices as "a
bit greedy."
The e-mails and other internal records, filed
Friday with a state circuit court here, mark the broadest display yet of
evidentiary material in the lawsuit by a closely held shopping-mall
operator, Warmack-Muskogee LP, against three of the nation's Big Four
accounting firms. The records include complaints by more than a dozen
PricewaterhouseCoopers partners and other personnel about the firm's
billing practices, as well as case logs for three separate internal
ethics-department investigations into the practices since 1999. The firm
halted the practices in question in October 2001.
PricewaterhouseCoopers has acknowledged that it
retained rebates on various travel expenses for which the firm had
billed clients at their prerebate prices, including rebates from
airlines, hotels, rental-car companies and credit-card issuers. It also
has acknowledged that it didn't disclose the rebates to clients and that
most of its partners had been unaware of them. The firm, however, has
denied Warmack-Muskogee's allegations that the rebate arrangements
constituted fraud, saying the proceeds offset amounts it otherwise would
have billed to clients through higher hourly rates.
In her April 2000 e-mail, the top partner in
PricewaterhouseCoopers's ethics department, Boston-based Barbara Kipp,
scolded Albert Thiess, the New York-based partner responsible for
overseeing the firm's infrastructure, including its travel department.
"Al, in general, while I appreciate the importance of managing as tight
a fiscal ship as we can, I somehow feel that we are being a bit greedy
here," she wrote. "I think that, in most of our clients' and
partners'/staff's minds, when we say [in our engagement letters] that
'we will bill you for our out-of-pocket expenses, including travel ...',
they don't contemplate true overhead types of items being included in
that cost."
Continued in the article.
The GAO issued a report on the effects of consolidation in the auditing
profession, resulting in the Big Four firms which audit the majority of
public companies. The GAO has issued a supplemental report, providing
views of CEOs and CFOs on the consolidation of the industry.
http://www.accountingweb.com/item/98020
From the CFO Journal's Morning Ledger on
April 12, 2019
The
U.K.’s audit regulator is investigating the audits of financial statements
of Interserve PLC, an outsourcing firm that last month sold itself to
its lenders to avoid collapse.
The Financial Reporting Council on Thursday said it would
probe the audits for 2015, 2016 and 2017under its Audit
Enforcement Practice. The audits were conducted by Grant Thornton UK
LLP, one of the country’s major audit firms.
Grant
Thornton is already under investigation by the FRC for its work for
Patisserie Holdings PLC, a U.K. cafe chain that discovered alleged
financial fraud in the fall and went into administration in January. Grant
Thornton confirmed the FRC’s investigation and vowed it would “of course
fully cooperate” with the regulator.
The new
probe comes at a time of increased scrutiny over the U.K. audit sector amid
various corporate failures, including that of construction giant
Carillion PLC in 2018.
U.K.
lawmakers last week called for a breakup of the audit and consulting
business units of the Big Four accounting firms into separate legal
entities. Under the changes, audit work would no longer be subsidized by the
firms’ other business, a step aimed at avoiding conflicts of interest.
By allowing a poorly rated
partner to continue auditing a public company without sufficient supervision
and oversight, “Grant Thornton prioritized the career of its partner and the
retention of that partner’s clients over the interest of investors, with
serious negative consequences,” Andrew J. Ceresney, director of the
Securities and Exchange Commission’s division of enforcement, said in a
Wednesday conference call with reporters following the announcement that the
accounting firm had reached a $4.5 million settlement with the SEC.
In the case, Grant Thornton
and two of its former partners, Melissa Koeppel, 54, and Jeffrey Robinson,
63, agreed to settle allegations “that they ignored red flags and fraud
risks while conducting deficient audits of two publicly traded companies
that wound up facing SEC enforcement actions for improper accounting and
other violations,” according to an SEC press release.
Robinson has since retired
from Grant Thornton, while Koeppel remains with the firm but in a
non-auditing, non-partner role.
Grant Thornton
admitted wrongdoing and agreed to forfeit about $1.5 million in audit fees
and interest, pay a $3 million penalty, and
hire an independent consultant to review a number of its procedures.
“We are pleased to have
these several years-old matters resolved and we maintain a strong commitment
to continually improving the quality of our work,” Grant Thornton stated.
The admission by the firm
follows a similar acknowledgement of wrongdoing by BDO in a September
settlement with the SEC. The commission has of late been stressing the need
to extract admissions of guilt in its settlements with companies hit with
enforcement actions.
Grant Thornton Partner Obtains Full Membership in Club Fed
A former partner at Grant Thornton was sentenced to 4-1/2 years in prison on
Wednesday for stealing nearly $4 million from the accounting firm. Craig Haber,
60, had pleaded guilty in August to a charge of mail fraud stemming from what
prosecutors say was an eight-year scheme to divert client payments to a personal
bank account ---
http://in.reuters.com/article/2014/03/12/grantthornton-theft-idINL2N0M92EV20140312
Until this article I thought the PCAOB thought the worst audit
firms were in the Big Four
Turns out Grant Thornton has the worst record with 65% audit "failures" as
defined by the PCAOB for 2012
The Public Company Accounting Oversight
Board gave a failing grade to Grant Thornton on 65 percent of audits
inspected in 2012,
the highest failure rate ever registered in a single inspection report by a
major firm.
The PCAOB found fault with 22 of the 34
Grant Thornton audits scrutinized, a notable jump from the 15 of 35 audits,
or 43 percent, with problems
in 2011. In the four years that
the PCAOB has provided data in its reports on how many audits it inspects,
only Crowe Horwath has registered a failure rate above 60 percent, hitting
62 percent in 2011 and 2010.
s the PCAOB has hammered firms to get
tougher on internal control over financial reporting, inspectors found
internal control problems in 19 of Grant Thornton's 22 problem audits in
2012, or 86 percent. In a letter attached to the inspection report, Grant
Thornton acknowledged the disturbing figures. “The volume of findings in
this report is concerning and of great importance to our dedicated
professionals,” wrote CEO Stephen Chipman along with Trent Gazzaway,
national managing partner of audit services.
Chipman and Gazzaway also note,
however, that the report addresses 2011 financial statements that were
audited in 2012 and inspected in 2013. The firm revised its audit
methodology and training around internal control in the summer of 2012 based
on
concerns raised by the PCAOB about
the quality of internal control auditing across the profession. “Those
changes were in effect during our audits of 2012 financial statements
(conducted in 2013), and we believe have been effective at improving audit
quality in this important area,” they wrote.
Beyond internal control, the PCAOB also
called out 10 audits where the firm failed to comply with standards on
assessing the risks of material misstatements, and nine cases where the firm
had difficulty with auditing fair value measurements. Seven audits also
contained problems with auditing accounting estimates.
Over the latter part of 2013, the PCOAB
published reports for all four Big 4 firms, with their failure rates ranging
from a low of 25 percent for Deloitte to a high of 48 percent for EY. Among
major firms, 2012 reports are still outstanding for McGladrey, BDO USA, and
Crowe Horwath.
Jensen Comment
When are large auditing firms going to take the PCAOB criticisms seriously?
Kenton District Judge Patricia Summe on Friday issued
a judgment of more than $100 million in favor of William J. Yung and his family.
Yung is the owner of the Crestview Hills-based
hotelier Columbia Sussex. The defendant in the case is Grant Thornton LLP, one
of the world’s largest accounting firms.
Kenton County Circuit Court Clerk William Middleton
said the judgment is believed to be the largest ever in the county and one of
the largest in the state.
Grant Thornton was ordered to pay William and Martha
Yung $4.68 million in compensatory damages and $55 million in punitive damages,
as well as pre-judgment interest on $900,000 at a rate of 12 percent from June
11, 2007, through Friday’s ruling.
Grant Thornton was also ordered to pay the 1994
William J. Yung Family Trust $14.6 million in compensatory damages and $25
million in punitive damages.
Kevin Murphy of the Fort Mitchell law firm of Graydon
Head & Ritchey sued Grant Thornton on behalf of the Yung family. Murphy said
Grant Thornton’s tax advice cost the family millions of dollars in excessive
tax, penalties and interest, which carried a negative impact to the family’s
business interests.
Continued in
article
Jensen Comment
This award is almost certain to be reduced on appeal, but how much is a real
question.
Koss hired
one of the best accounting firms in the world, Grant Thornton, and
should have been able to rely on Thornton’s audits to uncover
wrongdoing, Avenatti said. The suit against the auditing firm says
auditors assigned to Koss were not properly trained.
The lawsuit
lists hundreds of checks that Sachdeva ordered drawn on company
accounts to pay for her personal expenses. She disguised the
recipients — upscale retailers such as Neiman Marcus, Saks Fifth
Avenue and Marshall Fields — by using just the initials. But the
suit says Grant Thornton could have ascertained the true identity of
the recipients by inspecting the reverse side of the checks, which
showed the full name.
Koss Corp. receives $8.5M in
settlement with former auditor Koss Corporation announced it has settled the
claims between Koss and its former auditor, Grant Thornton, in the lawsuit
pending in the Circuit Court of Cook County, Illinois. As part of the
settlement, the parties provided mutual releases that resolved all claims
involved in the litigation between Koss and its directors against Grant
Thornton. Pursuant to the settlement, Koss received gross proceeds of $8.5M
on July 3.
Jensen Comment
Grant Thornton failed to detect former Koss Corp. executive's $34 million
embezzlement. Normally external auditors rested easy when such frauds did not
materially affect the financial statements or they had strong cases that they
were deceived by the client in a way that they were not responsible to detect
such fraud in a financial statement audit.
Both the SEC and the PCAOB are beginning to make
waves about having audit firms more responsible for detecting major frauds like
the SAC fraud. If one of the Big Four had been the auditor of the Madoff Fund I
think the audit firm probably would not have gotten off with zero liability for
negligence. Times are changing since Andy Fastow pilfered around $60 million
from his employer (Enron).
Audits are not
designed to uncover fraud and Koss did not pay for a separate
opinion on internal controls because they are exempt from that
Sarbanes-Oxley requirement.
But punching
holes in that Swiss-cheese defense is like shooting fish in a
barrel. Leading that horse to water is like feeding him candy taken
from a baby. The reasons why someone other than American Express
should have caught this sooner are as numerous as the
acorns you can steal from a blind pig…
Ok, you get the
gist.
Listing
standards for the NYSE require an internal audit function. NASDAQ,
where Koss was listed, does not. Back in 2003, the
Institute of Internal Auditors (IIA) made recommendations
post- Sarbanes-Oxley that were adopted for the
most part by NYSE, but not completely by NASDAQ. And both the NYSE
and NASD left a few key recommendations hanging.
In addition,
the IIA has never mandated, under its own standards for the internal
audit profession, a
direct reporting of the internal audit
function to the independent Audit Committee. The
SEC did not
adopt this requirement in their final rules, either.
However, Generally
Accepted Auditing Standards (GAAS), the standards an external
auditor such as Grant Thornton operates under when preparing an
opinion on a company’s financial statements – whether a public
company or not, listed on NYSE or NASDAQ, whether exempt or not from
Sarbanes-Oxley – do require the assessment of the internal audit
function when planning an audit.
Grant Thornton
was required to adjust their substantive testing given the number of
risk factors
presented by Koss, based on
SAS 109 (AU 314), Understanding the
Entity and Its Environment and
Assessing the Risks of Material Misstatement. If they had
understood the entity and assessed the risk of material misstatement
fully, they would have been all over those transactions like
_______. (Fill in the blank)
If they had
performed a proper
SAS 99 review (AU 316),Consideration
of Fraud in a Financial Statement Audit, it would have hit’em
smack in the face like a _______ . (Fill in the blank.) Management
oversight of the financial reporting process is severely limited by
Mr. Koss Jr.’s lack of interest, aptitude, and appreciation for
accounting and finance. Koss Jr., the CEO and son of the founder,
held the
titles of COO and CFO, also. Ms. Sachdeva,
the Vice President of Finance and Corporate Secretary who is accused
of the fraud, has been in the
same job since 1992
and during one ten year period
worked remotely from Houston!
When they
finished their review according to
SAS 65 (AU 322),The Auditor’s
Consideration of the Internal Audit Function in an Audit of
Financial Statements, it should have dawned on them: There is
no internal audit function and the flunky-filled Audit Committee is
a sham. I can see it now. The Grant Thornton Milwaukee OMP smacks
head with open palm in a “I could have had a V-8,” moment but more
like, “Holy cheesehead, we’re indigestible gristle-laden, greasy
bratwurst here! We’ll never be able issue an opinion on these
financial statements unless we take these journal entries apart,
one-by-one, and re-verify every stinkin’ last number.”
But I dug in and did
some additional research – at first I was just working the “no
internal auditors” line – and I found a few more interesting
things. And now I have no sympathy for Koss management and,
therefore, its largest shareholder, the Koss family. Granted there
is plenty of basis, in my opinion, for any and all enforcement
actions against Grant Thornton and its audit partners. And
depending on how far back the acts of deliciously deceptive
defalcation go, PricewaterhouseCoopers may also be dragged through
the mud.
Yes.
I can not make
this stuff up and have it come out more music to my ears.
PricewaterhouseCoopers was Koss’s auditor prior to Grant Thornton.
In March of 2004, the
Milwaukee Business Journal reported, “Koss
Corp. has fired the
certified public accounting firm of PricewaterhouseCoopers L.L.P. as
its independent auditors March 15 and retained Grant Thornton L.L.P.
in its place.” The article was
short with the standard disclaimer of no disputes about accounting
policies and practices. But it pointedly pointed out that PwC’s
fees for the audit had increased by almost 50% from 2001 to 2003, to
$90,000 and the selection of the new auditor was made after a
competitive bidding process.
PwC had been Koss’s auditor since 1992!
The focus on
audit fees by Koss’s CEO should have been no surprise to PwC.
Post-Sarbanes-Oxley, Michael J. Koss the son of the founder, was
quoted extensively as part of the very vocal cadre of CEOs who
complained vociferously about paying their auditors one more red
cent. Koss Jr. minced no words regarding PwC in the
Wall Street Journal in August 2002, a
month after the law was passed:
“…Sure,
analysts had predicted a modest fee increase from the smaller
pool of accounting firms left after Arthur Andersen LLP’s
collapse following its June conviction on a criminal-obstruction
charge. But a range of other factors are helping to drive
auditing fees higher — to as much as 25% — with smaller
companies bearing the brunt of the rise.
“The
auditors are making money hand over fist,” says Koss Corp. Chief
Executive Officer Michael Koss. “It’s going to cost shareholders
in the long run.”
He should
know. Auditing fees are up nearly 10% in the past two years at
his Milwaukee-based maker of headphones. The increase has come
primarily from auditors spending more time combing over
financial statements as part of compliance with new disclosure
requirements by the Securities and Exchange Commission. Koss’s
accounting firm, PricewaterhouseCoopers LLP, now shows up at
corporate offices for “mini audits” every quarter, rather than
just once at year-end.”
A year later,
still irate, Mr. Koss Jr. was quoted in
USA Today:
“Jeffrey
Sonnenfeld, associate dean of the Yale School of Management,
said he recently spoke to six CEO conferences over 10 days. When
he asked for a show of hands, 80% said they thought the law was
bad for the U.S. economy.
When pressed
individually, CEOs don’t object to the law or its intentions,
such as forcing executives to refund ill-gotten gains. But
confusion over what the law requires has left companies
vulnerable to experts and consultants, who “frighten boards and
managers” into spending unnecessarily, Sonnenfeld says.
Michael Koss, CEO of stereo headphones maker Koss, says it’s all
but impossible to know what the law requires, so it has become a
black hole where frightened companies throw endless amounts of
money.
Companies
are spending way too much to comply, but the
cost is due to “bad advice, not a bad law,”
Sonnenfeld says.”
It’s
interesting that Koss Jr. has such minimal appreciation for the
work of the external auditor or an internal audit function. By
virtue, I suppose, of his esteemed status as CEO, COO and CFO of
Koss and notwithstanding an undergraduate
degree in anthropology, according to
Business Week, Mr. Koss Jr. has twice
served other Boards as their “financial expert” and Chairman of
their Audit Committees. At
Genius Products,
founded by the Baby Genius DVDs creator, Mr. Koss served in this
capacity from 2004 to 2005. Mr. Koss Jr. has also been a Director,
Chairman of Audit Committee, Member of Compensation Committee and
Member of Nominating & Corporate Governance Committee at
Strattec Security Corp. since 1995.
If I were the
SEC, I might take a look at those two companies…Because
I warned you about the CEOs and CFOs who
are pushing back on Sarbanes-Oxley and every other regulation
intended to shine a light on them as public company executives.
No good will come of
this.
I don’t want
you to shed crocodile tears or pity poor PwC for their long-term,
close relationship with
another blockbuster Indian fraudster. Nor
should you pat them on the back for not being the auditor now. PwC
never really left Koss after they were “fired” as auditor in 2004.
They continued until today to be the trusted “Tax and All Other”
advisor,
making good money filing Koss’s now
totally bogus tax returns.
Jensen Comment
You may want to compare Francine's above discussion of audit fees with
the following analytical research study:
In most instances the defense of
underlying assumptions is based upon assumptions passed down from
previous analytical studies rather than empirical or even case study
evidence. An example is the following conclusion:
We find
that audit quality and audit fees both increase with the
auditor’s expected litigation losses from audit failures.
However, when considering the auditor’s acceptance decision, we
show that it is important to carefully identify the component of
the litigation environment that is being investigated. We
decompose the liability environment into three components: (1)
the strictness of the legal regime, defined as the probability
that the auditor is sued and found liable in case of an audit
failure, (2) potential damage payments from the auditor to
investors and (3) other litigation costs incurred by the
auditor, labeled litigation frictions, such as attorneys’ fees
or loss of reputation. We show that,
in equilibrium, an increase in
the potential damage payment actually leads to a reduction in
the client rejection rate. This effect arises because the
resulting higher audit quality increases the value of the
entrepreneur’s investment opportunity, which makes it optimal
for the entrepreneur to increase the audit fee by an amount that
is larger than the increase in the auditor’s expected damage
payment. However, for this result to hold, it is crucial that
damage payments be fully recovered by the investors. We show
that an increase in litigation frictions leads to the opposite
result—client rejection rates increase. Finally, since a shift
in the strength of the legal regime affects both the expected
damage payments to investors as well as litigation frictions,
the relationship between the legal regime and rejection rates is
nonmonotonic. Specifically, we show that the relationship is
U-shaped, which implies that for both weak and strong legal
liability regimes, rejection rates are higher than those
characterizing more moderate legal liability regimes.
Volker Laux and D. Paul Newman, "Auditor Liability and Client
Acceptance Decisions," The Accounting Review, Vol. 85,
No. 1, 2010 pp. 261–285
http://www.trinity.edu/rjensen/TheoryTAR.htm#Analytics
Teaching Case About a Former
Grant Thornton Client CLASSROOM APPLICATION: The article may be used in an
auditing or accounting class. Auditing questions relate to the
responsibility for financial statements versus the audit report, issues
delaying issuance of financial statements and audit reports, and auditor
changes. Accounting questions relate to eliminations as done for
consolidation of financial statements in order to avoid double counting
of assets.
From The Wall Street Journal Accounting Weekly Review on July
15, 2011
SUMMARY: "Three Louisiana public pension funds say
they are assembling a team of experts to examine the books and
financial statements of a New York hedge-fund firm [Fletcher Asset
Management] they invested with after the firm responded to
redemption requests with promissory notes rather than cash....The
executive directors of the Louisiana pension funds said the
response...'gives rise to questions regarding the liquidity' of the
Fletcher fund...'and the accuracy of the financial statements'...."
The article states that the financial statements "were issued by two
independent auditing firms." The related article provides a few more
details on accounting issues with respect to the hedge fund and the
reported amounts of assets under management after including "feeder
funds." "Fletcher reports it has more than $500 million of assets
under management....Yet its primary investment vehicle held just
$187.8 million of securities...and these made up 95% of the firm's
market investments....This would translate to a 2009 year-end total
for the firm's market investments of about $198 million, more than
half of it the Louisiana pension funds' money....A lawyer who
supervises Fletcher's SEC filings said it 'should be appropriate' to
include the value of each feeder fund in the asset total...because
each fund is actively managed and can invest in outside securities,
said the lawyer...Mr. Fletcher gave an example: If investors put $2
in one Fletcher fund, and this fund borrowed $1, and then put the
money in a second Fletcher fun, that would make $5 the firm managed,
he said."
CLASSROOM APPLICATION: The article may be used in
an auditing or accounting class. Auditing questions relate to the
responsibility for financial statements versus the audit report,
issues delaying issuance of financial statements and audit reports,
and auditor changes. Accounting questions relate to eliminations as
done for consolidation of financial statements in order to avoid
double counting of assets.
QUESTIONS:
1. (Introductory) Summarize the agreement, as described in
the main article and the related one, offered to Louisiana pension
fund managers by Fletcher Asset Management.
2. (Introductory) What is so unusual about the agreement
that would lead some who reviewed its documentation--at the request
of the WSJ-to say they "had never seen such an arrangement"?
3. (Introductory) What action are the three Louisiana
pension funds now jointly undertaking? What "experts" do you believe
they will hire?
4. (Advanced) For what report is an outside auditor
responsible? Who is responsible for issuing financial statements?
Explain a common misperception about these responsibilities and note
how that misperception is evident in this article.
5. (Advanced) What factors may lead to delayed issuance of
financial statements and a related audit report? In your answer,
note any examples of these factors described in the articles.
6. (Introductory) Refer to the related article. What
difference leads to measuring assets under management at $500
million according to Fletch Asset Management's reporting and $200
million under "a more orthodox way of measuring assets under
management"? Given the different measurements of assets under
management, how substantial is the total of the three Louisiana
pension funds' investment in the Fletcher Asset Management funds?
7. (Advanced) How do consolidation accounting procedures
help to resolve the problem of double counting evidenced in the
calculation and discussion to the question above?
8. (Advanced) Refer to the statement by "a lawyer who
supervises Fletcher's SEC filings" that "'it should be appropriate'
to include the value of each feeder fund in the asset
total...because each fund is actively managed and can invest in
outside securities...." What criteria would you offer to decide on
whether to separately count an investment fund's holdings in total
assets under management? Support your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Three
Louisiana public pension funds say they are assembling a team of
experts to examine the books and financial statements of a New York
hedge-fund firm they invested with after the firm responded to
redemption requests with promissory notes rather than cash.
Separately,
the Securities and Exchange Commission has opened a probe into the
fund firm, Fletcher Asset Management, according to a person familiar
with the matter. It isn't clear what the regulator is looking at.
A
spokeswoman for Fletcher didn't immediately respond to a request for
comment. An SEC spokeswoman declined to comment.
In a joint
statement Tuesday, the executive directors of the Louisiana pension
funds said the response they received to their redemption requests
"gives rise to questions regarding the liquidity" of the Fletcher
fund in which they invested "and the accuracy of the financial
statements" issued by two independent auditing firms.
A
representative for one audit firm,
Grant Thornton LLP, which no longer has the Fletcher account,
declined to comment. Representatives for a second, EisnerAmper, on
Tuesday didn't respond to requests for comment.
The three
pension systems separately invested a total of $100 million with
Fletcher in 2008. They were offered a minimum return of 12% a year.
In March, two funds put in redemption requests for a total of about
$32 million.
The
statement from the pension-fund executives said the investments have
accrued the expected return as verified by the auditors. But the
firm's decision to pay the redemption in notes in lieu of immediate
cash prompted them to take a deeper look at Fletcher's books, the
statement said.
Previously,
Fletcher in a statement told The Wall Street Journal it wasn't
required to distribute redemptions in cash and that it made the
payments in accordance with its agreement with the pension funds.
In their
statement Tuesday, executives from the three pension funds said
Fletcher Asset Management has fully cooperated during the
"preliminary assessments conducted by the retirement systems."
A Wall
Street Journal article last week highlighted a number of unusual
practices at the firm, including the 12% offered to the pension
funds. In the arrangement, the return is backed by the holdings of
other investors. Fletcher hasn't delivered its 2009 audit for the
fund in which the Louisiana pension funds are invested.
Alphonse
Fletcher Jr., a former Wall Street trader who founded the
asset-management firm in 1991, said in interviews earlier this year
that his firm fully and clearly discloses its practices and has
acted in accordance with its legal obligations to the pension funds.
Fletcher
recently told investors that its 2009 audit has been delayed because
the firm needs to "finalize the valuation of one of the fund's
investments," according to pension-fund records. On Monday, Fletcher
said in a statement the audit is expected by the end of July.
The
pension-fund executives said in their statement that Fletcher
initially indicated the redemption requests two of the funds made
would be "accommodated" at the end of a 60-day notice period.
"Just prior
to the expiration" of that notice period, the executives wrote,
Fletcher informed the pension boards "that they would receive the
requested distribution, but the cash distribution would first
require an orderly liquidation of assets held by" the fund. The note
gives Fletcher as long as two years to accomplish the liquidation,
according to the pension funds' statement, which said the note is
payable at 5% interest a year.
Mr.
Fletcher, 45 years old, made a splash on Wall Street in the 1990s
when he opened his own firm, which reported 300%-a-year returns.
Questions about his finances have arisen in a suit he filed earlier
this year in state court in New York against the board of the famed
Dakota co-operative apartment complex alongside New York's Central
Park, where he owns several apartments. Mr. Fletcher accused the
co-op board of unfairly rejecting his request to buy an additional
apartment and alleged racial discrimination. The case is pending.
Tuesday's
statement came as Louisiana state officials and lawmakers called for
a possible revamp of public-pension investment rules and a review of
the Fletcher investment.
In an
interview after the Journal's article last week, Louisiana
Legislative Auditor Daryl Purpera said he would meet with key
lawmakers to discuss legislation for new, more-strict investment
guidelines for public pension funds across the state.
State
officials and lawmakers said one proposal might be to consolidate
investment decisions for large and smaller public pension funds.
Another
option, they said, would be to set uniform investment guidelines for
pension funds in the state.
At present,
they say, pension boards in Louisiana typically set investment
guidelines and review investments independently, including the three
boards with Fletcher investments—Firefighters' Retirement System of
Louisiana, Municipal Employees' Retirement System of Louisiana, and
the New Orleans Firefighters' Pension and Relief Fund.
"Koss suit against former
auditor (Grant Thornton) to proceed," by Doris Hajewski, Journal
Sentinel, June 22, 2011 ---
http://www.jsonline.com/business/124389194.html
Thank you Caleb Newquist for the heads up.
Koss
Corp.'s lawsuit against the company's former auditor, Grant
Thornton, will move forward in Cook County, Ill., according to a
ruling from a judge in Chicago this week.
Koss
accuses Grant Thornton of gross negligence for not uncovering the
$34 million embezzlement by its former vice president of finance.
Sujata "Sue" Sachdeva is serving an 11-year sentence in federal
prison for the crime, which came to light in December 2009 when
American Express notified Koss of the fraud.
Grant
Thornton had sought to have the Cook County action dismissed.
In other
litigation related to the embezzlement, a fairness hearing is
scheduled Friday in Milwaukee County on a proposed settlement for a
derivative lawsuit against the Koss board of directors, Sachdeva and
Grant Thornton. The agreement, reached in May, calls for the
dismissal with prejudice of claims against individual Koss
directors. Claims against Grant Thornton and Sachdeva would be
dismissed without prejudice, meaning they could be refiled
The suit
didn't seek money for shareholders but asked the court to order
corporate governance reforms at the company and for any money paid
by defendants in that case to be paid to Koss.
Koss also
has suits pending against firms that were involved in payments using
embezzled money.
A Maricopa
County court is considering Koss' request for reconsideration of the
dismissal of its complaint against American Express. Koss claims
Amex should have notified the company sooner when it discovered
Sachdeva was using company money to pay her bills.
In another
suit pending in Milwaukee County Circuit Court, Koss claims that
Park Bank was lax in issuing checks to Sachdeva from company
accounts and not detecting the fraud.
"Audit Overseer Faults BDO, Grant Thornton: The PCAOB says BDO
had trouble testing revenue-recognition controls, while Grant Thornton did not
adequately identify GAAP errors. Both firms complain that the board criticized
judgment calls," by Marie Leone, CFO.com, July 13, 2009 ---
http://www.cfo.com/article.cfm/14026057/c_2984368/?f=archives
Annual inspection reports for BDO Seidman and Grant
Thornton, released last Thursday by the Public Company Accounting Oversight
Board, criticized some of the audit testing procedures and practices at the
two large accounting firms.
The review of BDO focused mainly on issues related
to testing controls around revenue recognition, while Grant Thornton was
chastised for not identifying or sufficiently addressing errors in clients'
application of generally accepted accounting principles with respect to
pension plans, acquisitions, and auction-rate securities.
With regard to BDO, the inspection staff reviewed
seven of the company's audits performed from August 2008 through January
2009 as a representation of the firm's work.
The report highlighted several deficiencies tied to
what it said were failures by BDO to perform audit procedures, or perform
them sufficiently. According to the reports, the shortcomings were usually
based on a lack of documentation and persuasive evidence to back up audit
opinions. For example, the board said, BDO did not test the operating
effectiveness of technology systems that a client used to aggregate revenue
totals for its financial statements. The systems were used by the client
company for billing and transaction-processing purposes.
The inspection team also reported that BDO's audit
of a new client failed to "appropriately test" the company's recognition of
revenue practices. Specifically, the audit firm noted that sales increased
in the last month of the year but it failed to get an adequate explanation
from management. Also, the report concluded that BDO reduced its
"substantive" revenue testing of two other clients, although more thorough
testing was needed.
And while BDO identified so-called "channel
stuffing" as a risk of material misstatement due to fraud, at another
client, its testing related to whether the client engaged in the act was not
adequate, said the inspectors. (Channel stuffing is the practice of
accelerating revenue recognition by coaxing distributors to hold excess
inventory.)
Other alleged problem spots for BDO included a
failure to design and perform sufficient audit procedures to test: journal
entries and other adjustments for evidence of possible material misstatement
due to fraud; valuation of accrued liabilities related to contra-revenue
accounts; a liability for estimated sales returns in connection with an
acquisition; and assumptions related to a client's goodwill impairment of a
significant business unit.
In response to the inspection report, BDO performed
additional procedures or supplemented its work papers as necessary. It also
noted in a letter that was attached to the report that none of the clients
cited had to restate their financial results.
In the letter, BDO acknowledged the importance of
the inspection exercise, commenting that "an inherent part of our audit
practice involves continuous improvement." However, the firm also said the
report does not "lend itself to a portrayal of the overall high quality of
our audit practice," since it reviews only a tiny sampling of audits. What's
more, BDO pointed out that many of the issues reviewed "typically involved
many decisions that may be subject to different reasonable interpretations."
Deficiencies highlighted in the inspection report
on Grant Thornton, meanwhile, included failures to "identify or
appropriately address errors" in clients' application of GAAP. In addition,
inadequacies were said to have been found with respect to performing
necessary audit procedures, or lacking adequate evidence to support audit
opinions. The Grant Thornton inspections were performed at on eight audits
conducted between July 2008 and December 2008.
In five audits, the PCAOB said inspectors found
deficiencies in testing benefit plan measurements and disclosures. In four
of those audits, Grant Thornton was said to have failed to test the
existence and valuation of assets held in the issuer's defined-benefit
pension plan. In one audit, the board said, the accounting firm failed to
test the valuation of real estate and hedge fund investments and a
guaranteed investment contract held by the client's defined-benefit pension
plan.
One client amended three of its post-retirement
benefit plans to eliminate certain benefits, and Grant Thornton "failed to
evaluate whether the issuer's accounting" was appropriate, said the report.
In another audit, the accounting firm allegedly did not perform sufficient
procedures to evaluate whether the assumptions related to the discount rate
and long-term rate of return on plan assets — provided by the client's
actuary — were reasonable.
In a separate audit, a client acquired a public
company that was described as having six reporting units. The client
recorded the fair values of the net assets of each reporting unit according
to the valuations provided by a specialist. But according to the inspection
report, Grant Thornton did not audit the acquisition transaction
sufficiently.
In particular, the firm neglected to evaluate which
of the fair-value estimates represented the "best estimate" with regard to
two units that were hit with an economic penalty for having a lower total
fair value than their net assets, the inspectors said. They also concluded
that Grant Thornton did not do a sufficient auditing job when it failed to
note whether it was appropriate for the specialist to use liquidation values
for two other units.
Federal Regulators Fine Grant Thornton $300,000 Over Audit of Failed
Bank Federal bank regulators have fined the
accounting firm Grant Thornton LLP $300,000 for what they called
"reckless conduct" in its audit of First National Bank of Keystone, a
West Virginia institution whose collapse in 1999 was one of the
costliest U.S. bank failures in the past decade.
Marcy Gordon, "Federal Regulators Fine Grant Thornton $300,000 Over
Audit of Failed Bank, SmartPros, December 11, 2006 ---
http://accounting.smartpros.com/x55776.xml
Grant Thornton LLP said it will challenge
recent Treasury Department (DoT) findings and penalties stemming from
the firm’s audit of a bank that collapsed in 1999. The Office of the
Comptroller of the Currency, the Treasury agency that regulates
nationally chartered banks, on Friday announced the telling $300,000
fine against the Chicago-based CPA firm that audited First National Bank
of Keystone in 1998.
"Grant Thornton to Fight Claim of “Reckless” Audit," AccountingWeb,
December 12, 2006 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=102894
Nothing like admitting defeat before the charges are filed The chief executive of Refco Inc.'s outside
auditor, Grant Thornton LLP, said the accounting firm has ample
resources to withstand the government probes and investor lawsuits it
will face as a result of the brokerage firm's meltdown last week. In his
first interview since Refco's scandal broke a week ago, Grant Thornton's
Edward Nusbaum said the firm is well capitalized and has outside
liability insurance it can tap if necessary to cover legal expenses,
including potential settlements. "We anticipate the legal costs will be
expensive, as they are in every case," Mr. Nusbaum said. "But Grant
Thornton is very sound financially, and we anticipate any legal costs
will be absorbed by the firm. We have insurance, if it is needed."
Jonathan Weil, "Grant Thornton Expects to Weather Scandal of Client,"
The Wall Street Journal, October 17, 2005; Page C1 ---
http://online.wsj.com/article/SB112951490246670395.html?mod=todays_us_money_and_investing
A Who Done it?: Grant Thornton's Case of the Unknown Debt Some of the IPO underwriters had previous
experience with Refco. Two of those three firms, CSFB and Bank of
America, also played lead roles, along with Deutsche Bank AG, in
arranging an $800 million term loan for the Lee buyout, as well as a
related $600 million debt sale, according to Thomson Financial. Bank of
America, Deutsche Bank and Sandler O'Neill & Partners, a smaller firm
that specializes in financial services, all were advisers on the Lee
firm's investment in Refco . . . Those companies' extensive experience
with Refco, together with the fees they collected, is sure to be
scrutinized in court claims brought by aggrieved investors. The role of
Refco's outside auditors Grant Thornton LLP in failing to discover the
chief executive's debt sooner will come under the microscope. For now,
the Wall Street firms aren't publicly discussing the matter, but some
people familiar with their executives' thinking say they believe both
they and the auditors were duped. A Grant Thornton spokesman said in a
statement issued yesterday, "We are continuing our investigation related
to the matters reported by Refco." The accounting firm likely will argue
that its auditors were lied to, people familiar with the matter said.
Executives at Thomas H. Lee won't discuss the matter publicly, but
people familiar with its thinking say the buyout shop relied on
underwriters and two auditing firms when it made the investment.
Randall Stith, Robin Sidel, and Kara Scannell, "From Wall Street Pros To
Auditors, Who Knew? Refco Disclosures Raise 'Due Diligence' Issues; Why
Thomas Lee Invested," The Wall Street Journal, October 12, 2005;
Page C3 ---
http://online.wsj.com/article/SB112908133517166268.html?mod=todays_us_money_and_investing
The question ex post when fraud is discovered is
always: How high were the "red flags?"
In court, the plaintiffs and the auditors generally
filter down to a dispute over the auditor's failure to discover or take
action on known "red flags" that signaled fraud or poor internal
controls. In the Refco case, the fraud was both financial
(stealing money) and an enormous GAAP violation ($430 million unbooked
loan).
“The odds are high that the auditors were
hoodwinked, but it’s an open question as to the size of any red
flags which were missed,” Christopher Bebel, a former U.S.
securities and Exchange Commission (SEC) attorney told Reuters. “The
plaintiffs [in the shareholder lawsuits] are going to argue that
these deficiencies which existed at Refco . . . served as red flags
and a more thorough investigation was warranted once these flags
were discovered,” he said. But these same disclosures can provide a
way out for the auditors and underwriters, he added.
Refco said in its August SEC filing that
its auditors had warned it in February of deficiencies in internal
controls due to inadequate resources at its finance department,
Reuters reports.
In fact, a new hire in the finance
department, Peter F. James, initially questioned the interest spike
from Liberty, according to a report Monday in the New York Times.
James brought it to the attention of the company’s chief financial
officer, Gerald M. Sherer, who had joined Refco in January.
Answering James’ questions led to the discovery of the
unacknowledged debt and subsequent collapse of the company.
GTI is standing by its U.S member firm,
Global Chief Executive David McDonnell announced on Thursday,
according to Reuters. “There is absolutely no question of separation
and I don’t believe there will be,” McDonnell said. GTI broke with
its Italian arm in the wake of the Parmalat scandal in 2003. “We
separated from our Italian unit because they were unable, unwilling
to cooperate with us,” said McDonnell, who said that he believed
Grant Thornton LLP was investigating the problems at Refco
thoroughly, Reuters reports.
Accounting frauds are here to stay. When
the prophet said "the heart is deceitful above all things," he
included the hearts of corporate managers. Whatever one's religious
beliefs, one has to admit that the empirical evidence in the world
of corporate accounting confirms Jeremiah's insight. Managers don't
employ accounting; they bend, twist, and distort it to display the
set of numbers that helps them look good. Who cares about truth?
The Public Company
Accounting Oversight Board (PCAOB) has found deficiencies in five
audits conducted by Grant Thornton. Grant Thornton failed "to
identify or appropriately address errors in the issuer's application
of GAAP," said the PCAOB, which acts as an audit watchdog and
annually inspects accounting firms with more than 100 public-company
clients.
Grant Thornton
also did not perform certain audit tests to back up its opinions,
the April 4 report said.
"In some cases, the
deficiencies identified were of such significance that it appeared
to the inspection team that the firm, at the time it issued its
audit report, had not obtained sufficient competent evidential
matter to support its opinion on the issuer's financial statements,"
the report said.
Grant Thornton
failed to test the effectiveness of controls, data that had been
provided to actuaries, and assumptions made by management, CFO.com
reported. The inspection report does not name the audited companies,
instead referring to them as Issuer A, B, etc. The inspection,
conducted between April and December of last year, involved 14 of
the firm's 50 offices.
Accountancy Age
reported that the firm failed to adequately test the revenue and
cost of revenue cycles and that it failed to test certain factors
that the issuer had used in determining the fair value of stock
options, for example.
In response, Grant
Thornton said that it had performed additional procedures or added
to its documentation after the inspections had ended, but, "None of
the findings resulted in a change in our original overall audit
conclusions or affected our reports on issuers' financial
statements."
In addition the firm
said, "We have already developed additional guidance, updated our
policies where applicable, implemented expanded monitoring in some
key areas and enhanced our training programs to address topics
covered by the PCAOB's comments."
Oct. 21, 2005 (International Herald
Tribune) — In the year before Refco sold shares to the public and
then made the fourth-largest bankruptcy filing in U.S. history,
insiders at the company received more than $1 billion in cash,
according to Refco's financial statements.
Also, one insider, Robert Trosten, received
$45 million when he left his post as chief financial officer a year
ago, according to an arbitration hearing this year.
Mystery still surrounds the collapse this
month of Refco, a decades-old Wall Street firm that conducted
billions of dollars in trades in commodities, currencies and U.S.
Treasury securities for more than 200,000 client accounts last year.
But investors and customers who are facing losses in Refco's
bankruptcy will certainly want to understand how insiders could
drain $1.124 billion from the company's coffers in the year or so
leading up to its demise.
To some degree, the money that insiders
took out is not surprising, given that Refco's executives sold a big
stake in the company to Thomas H. Lee Partners, a private equity
firm in Boston, in August 2004.
Most of the money that insiders received
$1.057 billion was paid upon the completion of that deal. Two Refco
insiders were on the receiving end of those payouts: Phillip
Bennett, the former chief executive who has been charged with
defrauding investors by concealing a $435 million loan he arranged
with the firm, and Tone Grant, Refco's longtime chief executive
before Bennett.
Bennett has denied the securities fraud
charges but has declined to comment further. Grant could not be
reached for comment Wednesday.
Creditors of Refco will almost certainly
try to recover what they can from payments made by the company to
its top executives in the months leading up to its demise.
While compensation like salaries is
typically not recoverable, payments made in the sale of a company or
dividends paid to its owners are fair game if the company is
insolvent, said Denis Cronin, a specialist in bankruptcy law at the
New York firm Cronin & Vris.
The $1.057 billion came in two chunks,
according to the Refco prospectus. First, Bennett and Grant appear
to have shared in a $550 million cash payment in the transaction
with Thomas Lee Partners. Then, Bennett appears to have received
$507 million more from the deal.
Bennett did not cash out of Refco
completely. At the time of the Lee deal, he agreed to roll over an
equity stake in Refco worth $383 million, the prospectus said.
-- Gretchen Morgenson and Jenny Anderson,
The New York Times
For the 373 partners of Grant Thornton LLP,
the U.S.'s No. 5 accounting firm by revenue, these should be heady
times. Revenue climbed about 30% last year to $635 million, and the
firm picked up more than 1,000 new clients.
Only one thing is missing: large, publicly
held audit clients. For 2004, Grant Thornton served as the
independent auditor for just one Fortune 500 company, W.W. Grainger
Inc. That's down from two during 2003, before Countrywide Financial
Corp. switched to KPMG LLP, the smallest of the Big Four with $4.1
billion of revenue. Then, in March, Grant Thornton Chief Executive
Officer Ed Nusbaum got the bad news. Grainger was switching to Ernst
& Young LLP.
"There's this perception that somehow the
Big Four are better than we are, and that's just simply not true,"
Mr. Nusbaum says. "It's a very difficult perception issue that has
to be broken."
If ever the opportunity seemed ripe to
shatter that image, it would be now. The corporate-accounting
scandals of the past four years have damaged the Big Four's
reputations, class-action lawyers are suing them over billions in
shareholder losses, and criminal probes are pending over some of
their tax-shelter sales.
Instead, even though Grant has tried its
hardest with an elaborate marketing plan, the Big Four's grip on the
audits of the world's largest companies keeps tightening. KPMG,
Ernst, PricewaterhouseCoopers LLP and Deloitte & Touche LLP now
audit all but about a dozen of the companies in the Fortune 500.
Many investors and corporate executives
complain that the accounting industry has become too concentrated,
leaving companies with too few choices for the important job of
auditing. But the obstacles are many for Grant and other second-tier
firms as they seek to move up.
First, there is size, a reason cited by
Grainger and Countrywide in their moves: Grant's roughly 3,900
staffers stacked up against about 18,300 at KPMG last year. Then,
too, the smaller firms aren't without their own warts: They face
lawsuits over allegedly botched audits and some of their tax-shelter
sales also are under federal scrutiny.
Most notably, Grant's former Italian arm,
Grant Thornton SpA, made headlines in recent years as an auditor for
dairy company Parmalat SpA, which filed for bankruptcy-court
protection amid $18.5 billion in missing funds. Grant says it, too,
was a victim of the fraud.
The Internal Revenue Service, as part of a
crackdown on abusive tax shelters, has been pressing an action against
one of the country's biggest accounting firms, Grant Thornton, to force
it to disclose the names of clients it advised to shelter millions of
taxable dollars in Roth I.R.A.'s via shell corporations. How such a
shelter worked and how it was promoted is vividly detailed in a lawsuit
brought by a former Silicon Valley executive against Grant Thornton over
the shelter he was sold.
Federal prosecutors are planning a fresh
indictment in a case that involves tax shelters sold by the
accounting firm Ernst & Young, according to defense lawyers in the
case.
Four current and former partners of
Ernst & Young were indicted last May in connection with their tax
shelter work from 1998 through 2004. The firm itself, which has not
been charged, has been under investigation since 2004 by federal
prosecutors in Manhattan, who have been looking into its creation
and sale of aggressive shelters.
It was not clear whether a superseding
indictment — which would include previous charges as well as new
ones — would be focused on additional Ernst & Young employees,
either former or current; on the firm itself; or on other firms or
individuals.
Defense lawyers for two of the Ernst &
Young defendants said that Deborah E. Landis, the federal prosecutor
overseeing the case, told a hearing in a Federal District Court in
Manhattan yesterday that the government expected to file a
superseding indictment around mid-December. Any decision to file new
charges requires approval of the Justice Department.
Yesterday’s hearing, before Judge Sidney
H. Stein of United States District Court in Manhattan, was held to
discuss the schedule of court events for the four Ernst & Young
defendants. No trial date has been set.
Asked about an impending new indictment,
a spokesman for Ernst & Young declined last night to comment.
A San Francisco nonprofit that went out of
business after failing to account for $19 million in donations is suing
its auditor.
The suit, filed by PipeVine's court-appointed
receiver, seeks unspecified damages as a "result of the acts,
omissions and breach of duty by defendant Grant Thornton,” according to
the San Francisco Business Times. The complaint go on to say that "in
its oral and/or written reports or statements, defendant Grant Thornton
made untrue and/or misleadingly incomplete representations or failed to
state material facts." PipeVine was a spinoff organization of United
Way of the Bay Area, which was audited by Grant Thornton. It became a
stand-alone organization in 2000 and annually processed more than $100
million in donations. It closed operations in 2003 after it was discovered
that some donations directed to charities actually went to PipeVine's
day-to-day operations.
Grant Thornton, in an e-mail to the San Francisco
Business Times, said the suit “is without merit and will be vigorously
fought.” The firm argues that it recommended that PipeVine's management
investigate the fact that PipeVine was overspending donations collected
for charities. That was in January 2003. The firm later suspended audit
work after meeting with the board of directors.
Continued in article
Grant Thornton is Being Sued Separately
"Jury Finds Parmalat Defrauded Citigroup," by Eric Dash, The New
York Times, October 20, 2008 ---
Click Here
A New Jersey jury
found that Parmalat, the Italian food and dairy company, had defrauded
Citigroup and awarded the bank $364.2 million in damages.
The 6-to-1
verdict cleared Citigroup of any wrongdoing after a five-month civil
trial that delved into complex, off-balance-sheet accounting that
enabled Parmalat to artificially raise its earnings.
The verdict was
returned on Monday in New Jersey Superior Court in Hackensack.
For Citigroup,
the decision will most likely be the last in several accounting scandals
that entangled it earlier this decade. The bank previously reached
settlements over its roles in Enron and WorldCom. But more litigation is
coming.
The bank is
expected to face billions of dollars in legal claims over its role in
the subprime mortgage market and is engaged in another battle with Wells
Fargo over the takeover of the Wachovia Corporation.
Parmalat’s new
management, including its chief executive, Enrico Bondi, had sought up
to $2.2 billion in damages from Citigroup, contending its bankers
designed a series of complex transactions that helped Parmalat “mask
their systemic looting of the company” while collecting tens of millions
in fees. The Italian company collapsed in 2003 under billions of dollars
of debt.
Citigroup said it
was a victim of Parmalat’s fraud and countersued for damages. On Monday,
Citigroup said it was delighted that a jury had vindicated its position.
“We have said from the beginning that we have done nothing wrong,” the
bank said. “Citi was the largest victim of the Parmalat fraud and not
part of it.”
Officials from
Parmalat could not be reached, but the company is expected to appeal the
decision.
Citigroup was the
first financial services firm to go to trial in the United States over
Parmalat’s accusations. Parmalat is pursuing separate claims against the
Bank of America andGrant Thornton, the
accounting firm,
in Manhattan federal
court. That case is expected to go to trial next year; both companies
have denied any wrongdoing.
In-Substance Defeasance Controversy Arises
Once Again
Defeasance OBSF was
invented over 20 years ago in order to report a $132 million gain on
$515 million in bond debt. An SPE was formed in a bank
' s trust department (although the term SPE was not
used in those days). The bond debt was transferred to the SPE and
the trustee purchased risk-free government bonds that, at the future
maturity date of the bonds, would exactly pay off the balance due on the
bonds as well as pay the periodic interest payments over the life of the
bonds.
At the time of the
bond transfer, Exxon captured the $132 million gain that arose because
the bond interest rate on the debt was lower than current market
interest rates. The economic wisdom of defeasance is open to
question, but its cosmetic impact on balance sheets became popular in
some companies until defeasance rules were changed first by FAS 76
and later by FAS 125.
Exxon removed the $515 million in debt from its
consolidated balance sheet even though it was technically still the
primary obligor of the debt placed in the hands of the SPE trustee.
Although there should be no further risk when the in substance
defeasance is accomplished with risk-free government bond investments,
FAS 125 in 1996 ended this approach to debt extinguishment. FASB
Statement No. 125 requires derecognition of a liability if and only if
either (a) the debtor pays the creditor and is relieved of its
obligation for the liability or (b) the debtor is legally released from
being the primary obligor under the liability. Thus, a liability is not
considered extinguished by an in-substance defeasance.
From The Wall Street Journal Accounting Educators' Reviews on
January 16, 2004
TITLE: Investors Missed Red Flags, Debt at Parmalat
REPORTER: Henny Sender, David Reilly, and Michael Schroeder
DATE: Jan 08, 2004
PAGE: C1
LINK:
http://online.wsj.com/article/0,,SB107348886029654700,00.html
TOPICS: Auditing, Debt, Financial Accounting, Financial Analysis,
Fraudulent Financial Reporting
SUMMARY: The article describes several points apparent from Parmalat's
financial statements that, in hindsight, give reason to have questioned
the company's actions. Discussion questions relate to appropriate audit
steps that should have been taken in relation to these items. As well,
financial reporting for in-substance defeasance of debt is apparently
referred to in the article and is discussed in two questions.
QUESTIONS:
1.) Describe the signals that investors are purported to have missed
according to the article's three authors.
2.) Suppose you were the principal auditor on the Parmalat account for
Deloitte & Touche. Would you have noted some of the factors you listed as
answers to question #1 above? If so, how would you have made that
assessment?
3.) Why do the authors argue that it should have been seen as strange
that the company kept issuing new debt given the cash balances that were
shown on the financial statements?
4.) Define the term "in-substance defeasance" of debt. Compare that
definition to the debt purportedly repurchased by Parmalat and described
in this article. How did reducing the total amount of debt shown on its
balance sheet help Parmalat's management in committing this alleged fraud?
5.) Is it acceptable to remove defeased debt from a balance sheet under
USGAAP? If not, then how could the authors write that, "at the time,
accountants and S&P said that [the accounting for Parmalat's debt] was
strange, but that technically there was nothing wrong with it"? (Hint: in
your answer, consider what basis of accounting Parmalat is using.)
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
The case in Parma is
one of several against former executives and others accused of
contributing to the alleged fraud that concealed Parmalat’s
mounting debt.
Eric Sylvers, "Parmalat’s Founder and Bankers Are Charged,"
The New York Times, July 25, 2007 ---
Click Here
Parmalat's Tonna Reaches Out to the Public
Fausto Tonna, the self-confessed mastermind of the accounting shenanigans
that crippled Parmalat, is attempting a new role: Mr. Nice Guy.
Fausto Tonna, self-confessed
mastermind of the accounting shenanigans that crippled Parmalat SpA,
admits he has a problem with anger management. During a perp walk earlier
this year, he turned to a bunch of journalists and shouted: "I wish
you and your families a slow and painful death."
Recently sprung from nine months in
detention, Mr. Tonna, who once smashed a glass door to bits, is attempting
a new role: Mr. Nice Guy.
Between bites of tortelli at a
trattoria near his home in this northern Italian village, he oozes charm
as he pours two glasses of sparkling wine and seeks some forgiveness for
his role in Europe's biggest-ever fraud. "It makes me vomit,"
the former chief financial officer says, admitting to a decade of cooking
the books at the Italian dairy giant. "But I don't want to go down in
history as the culprit."
Italian prosecutors have fingered
Mr. Tonna, 53 years old, as one of the two chief villains in a nearly $19
billion scam that bankrupted Parmalat a year ago, alleging that he and
founder Calisto Tanzi engineered fake deals that fed the fraud. They have
requested Mr. Tonna's indictment on charges of market manipulation and are
investigating him for false accounting and fraud.
Like many an embattled executive,
he is going public with his story. But in sharp contrast to Martha
Stewart, Kenneth Lay of Enron Corp. and other white-collar suspects who
fought to the bitter end, Mr. Tonna is baldly admitting guilt, with the
caveat that he worked for an even bigger alleged crook.
"The most disgusting part of
my job was finding justifications for fixing the accounts," the
barrel-chested finance man confides in his husky voice. In early 2003,
when Mr. Tanzi needed more than $5 million to buy out a niece's 2% stake
in Parmalat's holding company, "he told me to transfer the money out
of the company and into a bank account and I did," Mr. Tonna says,
adding that he then had to cover up the deal.
Mr. Tonna's strategy of mea culpas
has a certain twisted logic in Italy. He doesn't aim to put prosecutors
off the scent but to win pardon from the public, so he can return to a
semblance of normal life while his case crawls through Italy's convoluted
justice system. In Italy, suspects' public comments aren't necessarily
used against them in a court of law. Mr. Tonna has a potentially rich vein
of sympathy to tap, as Italians have grown disenchanted with the courts.
Justice moves slowly: A first trial in the Parmalat case isn't likely
until late 2005, and a lengthy appeals process means definitive verdicts
will take years.
The disillusionment is a turnabout
from the early 1990s, when the "Clean Hands" probes made heroes
of prosecutors who uncovered vast corruption among politicians and
businessmen. Many of those investigations fizzled, while several trials
are dragging on. One suspect from the time -- Prime Minister Silvio
Berlusconi -- has spent his political career blasting Italian prosecutors.
A verdict earlier this month cleared Mr. Berlusconi of the final charges
against him, partly because the statute of limitations expired on a
bribery charge, further fueling popular misgivings about the justice
system.
Continued in article
From The Wall Street Journal Accounting Educators' Review on
January 30, 2004
SUMMARY: PricewaterhouseCoopers LLP was engaged to investigate the true
financial position of Parmalat SpA. The report issued by
PricewaterhouseCoopers reveals significant understatement of liabilities
and significant overstatement of net income. Questions focus on the
accounting and auditing issues related to the fraudulent financial
reporting by Parmalat.
QUESTIONS:
1.) Briefly describe the discrepancies between Parmalat's reported
financial information and the financial information contained in the
report by PricewaterhouseCoopers.
2.) How much was debt misstated? Describe the normal accounting
treatment for a debt transaction. Discuss potential ways of underreporting
total debt. What management assertion(s) is(are) violated? Describe audit
procedures that are designed to uncover an understatement of debt.
3.) How much are revenues misstated? Describe an accounting scheme that
would lead to overstatement of revenues. What management assertion(s)
is(are) violated? Describe audit procedures that are designed to uncover
an overstatement of revenue.
4.) How much is earnings before interest, taxes, depreciation, and
amortization (ebitda) misstated? Given the revenue misstatement, describe
an accounting scheme that would lead to the reported ebitda misstatement.
What management assertion(s) is(are) violated? Describe audit procedures
that are designed to uncover the reported misstatement.
5.) The article reports, "The company also was crediting to its assets
receivables . . . that now turn out to be worthless . . . ." Comment on
this statement.
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
David Reilly and Alessandra Galloni, "Facing Lawsuits, Parmalat Auditor
Stresses Its Disunity: Deloitte Presented Global Face, But Says
Arms Acted Alone; E-Mail Trail Between Units: A Liability Threat
for Industry," The Wall Street Journal, April 28, 2005;
Page A1 ---
http://online.wsj.com/article/0,,SB111464808089519005,00.html?mod=todays_us_page_oneThe Big Four accounting firms -- Deloitte,
PricewaterhouseCoopers, KPMG and Ernst & Young -- have long claimed in
court cases that their units are independent and can't be held liable
for each other's sins. U.S. courts to date have backed that argument.
The firms say the distinction is important -- allowing them to boost the
efficiency of the global economy by spreading uniform standards of
accounting around the world, without worrying that one unit's missteps
will sink the entire enterprise. But Deloitte e-mails seized by Italian
prosecutors and reviewed by The Wall Street Journal, along with
documents filed in the court cases, show how the realities of auditing
global companies increasingly conflict with the legal contention that an
accounting firm's units are separate. The auditing profession -- which
plays a central role in business by checking up on companies' books --
has become ever-more global as the firms' clients have expanded around
the world. But that's creating new problems as auditors face allegations
that they bear liability for the wave of business scandals in recent
years.
Bob Jensen's threads on Deloitte's legal woes are at
http://www.trinity.edu/rjensen/fraud001.htm#Deloitte
Four Banks Charged in Parmalat Failure A Milan judge has ordered Citigroup, UBS,
Morgan Stanley and Deutsche Bank to stand trial for market-rigging in
connection with dairy firm Parmalat's collapse, judicial sources said.
Judge Cesare Tacconi also ordered 13 individuals to face trial on the
same charges, at the end of preliminary hearings into the case, the
sources told Reuters on Wednesday. Reuters, June 13, 2007 ---
Click Here
Parmalat's external auditor was Grant Thornton
"7 Detained as Parmalat Investigation Is Widened," by John Taglibue,
The New York Times, January 1, 2004
Police in Bologna, near Parmalat's headquarters
outside Parma in north-central Italy, were holding two former chief
financial officers, Fausto Tonna and Luciano del Soldato, as well as a
company lawyer and two of its auditors from the firm Grant Thornton.
The police were also seeking the head of Parmalat's operations in
Venezuela, Giovanni Bonici, though his lawyers said he was out of the
country but would turn himself in to the authorities upon his return.
The police are holding the men at the request
of magistrates who are investigating the circumstances of the failure of
Parmalat, which sought protection from creditors earlier this month.
Earlier on Wednesday, a representative of the
United States Securities and Exchange Commission met with the
magistrates as well as with the new chairman of Parmalat, Enrico Bondi,
to discuss efforts to salvage some of the company's assets, which
include dairy products, fruit juices and baked goods, and to devise a
strategy for discovering what individuals or institutions might have
made themselves culpable of defrauding investors by masking the
company's true state.
The move appeared to push the investigation to
a new level. The magistrates had focused until now on the investigation
of the founder and former chairman, Calisto Tanzi, who was arrested on
Saturday and has been undergoing questioning by the magistrates.
Among those detained by the police are a lawyer
and close associate of Mr. Tanzi, Gian Paolo Zini; the chairman of the
Italian unit of the auditors Grant
Thornton, Lorenzo Penca; and one of the accounting firm's partners,
Maurizio Bianchi. Mr. Penca announced that he had resigned as chairman
before turning himself in to the police.
Fresh from having its name
dragged through the mud over its Italian affiliate's audit work for
Parmalat SpA, Chicago accounting firm Grant Thornton LLP now faces a
full-fledged auditing scandal of its own.
In an order Tuesday initiating
disciplinary proceedings against the firm and others, the Securities and
Exchange Commission accused Grant Thornton and a partner in its Detroit
office of aiding and abetting securities-fraud violations by former
audit client MCA Financial Corp., a defunct mortgage-banking company.
The events underlying the SEC's
allegations date back to 1998. Five of MCA's former officers have
pleaded guilty to criminal charges over a wide-ranging book-cooking
scheme. In a prepared statement, Grant Thornton spokesman John Vita
suggested that Grant Thornton shouldn't be blamed for signing off on
MCA's fraudulent financial statements.
"The SEC stated in its complaint
filed April 24, 2002, against MCA Financial Corporation that MCA's
management had engaged in a carefully concealed fraud that included
providing false information and lying to our personnel," he said. "For
80 years, we have adhered to the highest standards of professionalism,
and we will vigorously defend ourselves against these charges."
The SEC's action comes amid a
wave of negative publicity for Grant Thornton and its global network of
accounting firms, which operate under the name Grant Thornton
International. This month, the international network moved to expel the
Italian affiliate, two of whose partners have been arrested in
connection with the Italian government's investigation of fraudulent
dealings at Parmalat, the troubled dairy concern.
In the U.S., Grant Thornton
continues to wrestle with the Internal Revenue Service and Justice
Department, which have been investigating aggressive tax shelters sold
by the firm to wealthy individuals. The firm has said it isn't engaged
in the promotion of abusive tax shelters.
U.S. auditing firms are roaring
tigers compared to Chinese auditing firms Chinese Firms Need to Open Up Books
Question
What do Trojan Horse viruses, listed Chinese companies in the U.S., and
many for-profit universities have in common?
Answer
They all entered by way of the back door. Trojan viruses are known for
the the sneaky way they gain
back door entry into computer systems. Many for-profit universities
bought regional accreditation (especially from the lax
Northwest Acceditation Commission) by purchasing small, failing, and
nearly bankrupt non-profit colleges that had shaky lingering
accreditation due mostly to laxness of the accrediting agencies). And
here's how Chinese companies entered into U.S. capital markets by way of
the back door:
In
the U.S., Chinese companies have used reverse mergers to gain access
to the benefits of public listing without having gone through the
rigorous regulatory process of an initial public offering. Further,
Chinese companies listed in Hong Kong and other worldwide markets
are allowed to use auditors from mainland China in producing
financial statements for submission in fulfillment of listing
requirements. However, China has no agreement with international
regulators to allow supervision over the audit function in the
country. "In testimony to U.S. lawmakers this past April, James
Doty, the PCAOB's chairman, called the group's inability to inspect
the work of registered firms in China 'a gaping hole in investor
protection.'"
See below
Teaching Case
From The Wall Street Journal Accounting Weekly Review on June 24,
2011
TOPICS: International Accounting, International
Auditing, Mergers and Acquisitions, Public Accounting,
Sarbanes-Oxley Act, SEC, Securities and Exchange Commission
SUMMARY: In the U.S., Chinese companies have used
reverse mergers to gain access to the benefits of public listing
without having gone through the rigorous regulatory process of an
initial public offering. Further, Chinese companies listed in Hong
Kong and other worldwide markets are allowed to use auditors from
mainland China in producing financial statements for submission in
fulfillment of listing requirements. However, China has no agreement
with international regulators to allow supervision over the audit
function in the country. "In testimony to U.S. lawmakers this past
April, James Doty, the PCAOB's chairman, called the group's
inability to inspect the work of registered firms in China 'a gaping
hole in investor protection.'"
CLASSROOM APPLICATION: The article may be used in
an auditing class to relate the role of the PCAOB and the audit
function to investor confidence in financial markets. It also may be
used in an international accounting class to discuss current issues
faced in globalization of financial markets.
QUESTIONS:
1. (Advanced) What is the Public Company Accounting
Oversight Board (PCAOB)?
2. (Advanced) What role does the PCAOB play that provides
critical support to the Securities and Exchange Commission (SEC) and
other regulators over U.S. markets?
3. (Introductory) What is the difference between the role
the PCAOB fills with respect to U.S. publicly-traded companies and
the role it can play regarding Chinese companies listed in the U.S.?
4. (Advanced) What is a "reverse merger"? How can this
transaction avoid difficult requirements associated with an initial
public offering (IPO)?
5. (Introductory) How do stock markets react to the
uncertainty created by the current situation for Chinese companies
with shares listed outside of their home country? What does it mean
to say that these companies should "open their books" to resolve
this uncertainty?
6. (Introductory) Refer to the related video. Who will get
"left behind" as China moves to higher value added production as its
economic focus? How does that possibility compare to the situation
we face in the U.S.?
Reviewed By: Judy Beckman, University of Rhode Island
Poor access
to information is a major culprit in the selloff of China's
overseas-listed companies. If China hopes to limit the damage, it
needs to open up.
The
Securities and Exchange Commission is investigating accounting and
disclosure issues at a number of U.S.-listed Chinese companies that
acquired backdoor listings through so-called reverse mergers, and
even top-name Chinese companies are inviting new scrutiny. Renren
Inc., a social-networking site that launched its shares to much
fanfare in early May, now trades at about half its IPO price. Renren
itself stirred controversy when it lowered the growth rate of its
user base without explanation in its IPO prospectus and the head of
its audit committee resigned just before the listing.
Shares of
Toronto-listed Sino-Forest Corp. have plunged 80% since late May
after a short seller alleged problems in the forestry company's
accounting, which the company denies. Hong Kong-listed Chinese
companies, too, are drawing new scrutiny over their accounting.
Not all
Chinese companies are shady. But investors are right to ask: How do
you know which aren't?
One answer
is access to information. Auditors need it to be sure a company's
business is as good as management says it is. So do regulators who
oversee the auditors.
In the case
of Chinese companies, however, there are no arrangements that allow
the Public Company Accounting Oversight Board, the U.S. government's
accounting regulator, to inspect the work of accountants in China.
So the PCAOB can't really know whether that work is reliable. Using
U.S. accountants doesn't help because they outsource the real work
to accountants in China anyway.
In
testimony to U.S. lawmakers this past April, James Doty, the PCAOB's
chairman, called the group's inability to inspect the work of
registered firms in China "a gaping hole in investor protection."
The limited
ability of Hong Kong regulators to access information on Chinese
companies has long been a risk factor for the city's stock market,
the primary venue through which foreign investors buy a piece of
China. That ability suffered a new blow late last year when the
local exchange agreed to let mainland Chinese companies listed in
the territory use mainland auditors. As part of the new arrangement,
Hong Kong's Securities and Futures Commission secured a promise that
it would be able to examine records of auditors for companies it
wants to investigate.
"Clearly
the test will be when we have a live case to go through," Martin
Wheatley, the outgoing head of the SFC, recently said in an
interview. That hasn't yet happened.
Concerns
about the transparency of Chinese companies put one Hong Kong-listed
stock through the wringer last week. On Tuesday, Standard & Poor's
withdrew its ratings for long-term corporate debt of a major Chinese
packaging manufacturer, Nine Dragons Paper (Holdings) Ltd., after
its analyst complained of being unable to get senior management to
answer questions about the company's business. The stock plunged
more than 17% after S&P's move, though it regained much of the loss
the next day, when Nine Dragons said it was willing to cooperate
with S&P and respond to requests for information.
Continued in article
Jensen Comment
Sometimes we think it might be nice to send these listed Chinese
companies out the back door on the horse they road in on, but then we
must face the reality that China is our banker that keeps the
deficit-ridden United States afloat. It's wise to send your banker back
out on the horse he rode in on.
It would seem that listed
Chinese companies would have audits conducted by large international CPA
firms in order to attract investors suspicious of Chinese accounting and
auditing. Capital market efficiency is not entirely dead.
Miscellaneous Corporate and
Accounting Firm Fraud
From The Wall Street Journal
Accounting Weekly Review on April 23, 2009
SUMMARY: The
World Bank's Independent Evaluation Group produced a report in
fall 2008, which cited the bank's fraud-detection procedures in
its main program providing aid to poor countries as a material
weakness. This $40 billion program is called the International
Development Association (IDA). "[World] Bank staffers said that
the IDA program faces particularly difficult challenges because
corruption is often a problem in especially poor
countries....Generally, the IDA received good marks and the
results 'should overall be considered a quite respectable
outcome,' the report said."
CLASSROOM APPLICATION: The
application of internal control procedures, and their
independent testing, outside of corporations can be an
eye-opener for students.
QUESTIONS:
1. (Introductory)
What is the World Bank?
2. (Introductory)
Who issued a report on the internal controls in place in World
Bank programs? Why was this review of internal controls
undertaken?
3. (Advanced)
Describe a corporate function similar to the group that
undertook the review described in answer to question 2 above.
4. (Advanced)
Which World Bank program has been found to have material
weaknesses in control systems? What system has been found as a
material weakness?
5. (Advanced)
Define the terms "material weakness" and "significant
deficiency" in relation to audits of corporate internal control
systems.
6. (Advanced)
Do you think that the meaning of these terms in the report on
World Bank programs is the same as the definitions you have
provided? Why or why not?
Reviewed By: Judy Beckman, University of Rhode Island
The World Bank's fraud-detection procedures
in its main aid program to poor countries were labeled a "material
weakness" in an internal report, adding to the bank's woes in
handling corruption issues.
The bank's Independent Evaluation Group
gave it the lowest possible rating for fraud-detection procedures in
the $40 billion aid program, called the International Development
Association. That could hurt contributions to the effort, which
gives grants and interest-free loans to the world's 78 poorest
countries.
The 690-page report, the first for the
program, was completed last fall. Since then it has been the subject
of lengthy discussions between World Bank management and the
independent evaluation unit over whether the single designation of
"material weakness," the lowest of four ratings, was justified. None
of the program's other marks were as low; six other areas were
labeled "significant deficiencies."
"The bank's traditional control systems
weren't designed to address fraud and corruption," one of the
report's authors, Ian Hume, said in an interview. "They were
designed for efficiency and equity -- the cheapest possible price."
That increases the risk that corruption could occur in the use of
IDA grants, he said.
The World Bank has been pilloried by
critics for years for not taking corruption seriously enough, and
some staffers worried that the report's publication was being
delayed for political reasons. The U.S., in particular, pushed for
its publication, said bank staffers.
"We have had a tough but cordial
interaction with [World Bank] management along the way," said Cheryl
Gray, director of the evaluation group.
The report was published on the unit's Web
site late Wednesday, but not publicized. Its presence was noted by a
small icon on the bottom right of the page. Ms. Gray says that the
group didn't intend to bury the report and said the unit didn't put
out a press release because the report was "technical and jargony."
After an inquiry from The Wall Street Journal, it was given greater
prominence on the Web site. Ms. Gray said she had planned to make
the change anyway.
The report concluded that the World Bank
"has until recently had few if any specific tools" to directly
address fraud and corruption "at all stages in the lending cycle."
An advisory panel that backed the "material weakness" designation
wrote that fraud and corruption issues "involve a considerable
reputation risk, involving at least a potential loss of confidence
by various stakeholders."
The Obama administration recently asked
Congress to approve a three-year, $3.7 billion contribution to the
bank's IDA program. A Democratic congressional staffer said it was
too early to tell whether the report would make passage more
difficult. Overall, the World Bank won commitments in December 2007
for $41.6 billion in funding for IDA over three years.
Bank staffers said that the IDA program
faces particularly difficult challenges because corruption is often
a problem in especially poor countries. "We operate in some of the
most difficult and challenging environments in the world," Fayez
Choudhury, the World Bank's controller, said in an interview. "We
are always looking to up our game."
The bank's management pressed to get the
fraud-and-corruption designation improved by a notch to "significant
deficiency." It argued that the evaluation group didn't take into
account steps it had taken over the past year to improve its
controls.
"The bank is firmly committed to
mainstreaming governance and anticorruption efforts into its
development work," said a management statement. It listed a number
of improvements including the creation of an independent advisory
board. The bank said it is trying to better integrate fraud
prevention and corruption prevention generally into its operations.
The report doesn't examine cases of actual
corruption, though it notes there have been several instances that
have received publicity, including health-clinic contracts in India.
Rather, it looks at the systems and procedures in place to identify
and prevent corruption.
The report uses standards similar to those
applied to corporate controls. Generally, the IDA received good
marks and the results "should overall be considered a quite
respectable outcome," the report said.
For decades, the World Bank largely ignored
corruption, figuring that some graft was the price of doing business
in poor countries. Starting in 1996, however, former World Bank
President James Wolfensohn focused more attention on the issue, as
did his successor, Paul Wolfowitz, who held up loans to some poor
countries because of concerns about corruption. That led to charges
that the bank was enforcing corruption rules selectively.
After Mr. Wolfowitz came under fire earlier
for showing favoritism to his girlfriend, a bank employee, some
developing nations dismissed the bank's efforts as hypocritical. Mr.
Wolfowitz resigned in 2007 and the World Bank's current president,
Robert Zoellick , has been trying to depoliticize the corruption
issue, especially by beefing up the Department of Institutional
Integrity, the main antifraud unit at the bank.
Reviews of other institutions have also
turned up designations of "material weakness." A U.S. Treasury
"accountability report" for the year ended Sept. 30, 2008, for
instance, found four such designations, including three involving
the Internal Revenue Service's modernization, computer security and
accounting, and one involving government-wide financial statements.
Companies
increasingly take people for a ride. They issue glossy
brochures and mount PR campaigns to tell us that they
believe in "corporate social responsibility". In
reality, too many are trying to find new ways of picking
our pockets.
Customers are
routinely fleeced through price-fixing cartels. Major
construction companies are
just the latest example. Allegations of price fixing
relate to companies selling dairy products,
chocolates,
gas and electricity,
water,
travel,
video games,
glass,
rubber products,
company audits
and almost everything else. Such
is the lust for higher profits that there have even been
suspected cartels for
coffins, literally a last
chance for corporate barons to get their hands on our
money.
Companies and
their advisers sell us the fiction of free markets. Yet
their impulse is to build cartels, fix prices, make
excessive profits and generally fleece customers. Many
continue to announce record profits. The
official UK statistics showed
that towards the end of 2007 the rate of return for
manufacturing firms rose to 9.7% from 8.8%. Service
companies' profitability eased to 21.2% from a record
high of 21.4%. The rate of return for North Sea oil
companies rose to 32.5% from 30.1%. Supermarkets and
energy companies have declared record profits. One can
only wonder how much of this is derived from cartels and
price fixing. The artificially higher prices also
contribute to a higher rate of inflation which hits the
poorest sections of the community particularly hard.
Cartels cannot be
operated without the active involvement of company
executives and their advisers. A key economic incentive
for cartels is profit-related executive remuneration.
Higher profits give them higher remuneration. Capitalism
does not provide any moral guidance as to how much
profit or remuneration is enough. Markets, stockbrokers
and analysts also generate pressures on companies to
constantly produce higher profits. Companies respond by
lowering wages to labour, reneging on pension
obligations, dodging taxes and cooking the books.
Markets take a short-term view and ask no questions
about the social consequences of executive greed.
The usual UK response
to price fixing is to fine companies, and many simply
treat this as another cost, which is likely to be passed
on to the customer. This will never deter them.
Governments talk about being tough on crime and causes
of crime, but they don't seem to include corporate
barons who are effectively picking peoples' pockets.
Governments need
to get tough. In addition to fines on companies, the
relevant executives need to be fined. In the first
instance, they should also be required to personally
compensate the fleeced customers. Executives
participating in cartels should automatically receive a
lifetime ban on becoming company directors. There should
be prison sentences for company directors designing and
operating cartels. That already is possible in the US.
Australia's new Labour government has recently said that
it will impose
jail terms on executives
involved in cartels or price fixing. The same should
happen in the UK too. All correspondence and contracts
relating to the cartels should be publicly available so
that we can all see how corporations develop strategies
to pick our pockets and choose whether to boycott their
products and services.
Is there a political party willing to
take up the challenge?
Companies had to restate financial reports in
record numbers in 2004. But that wasn't necessarily a bad thing.
Error-driven restatements were up 28% to 414 last
year, according to data to be released today by Huron Consulting Group LLC,
a financial advisory firm. But investors shouldn't necessarily be alarmed by
the big increase because, the report's authors say, the jump may partly
reflect that more errors are being caught now than in years past, not that
more are occurring.
One big reason more would be caught are the
requirements of the 2002 Sarbanes-Oxley corporate-governance act, under
which a company's outside auditor and its top brass must annually certify
the soundness of internal financial-reporting controls. The certification
procedure kicked in for the first time at many companies this past November.
The intense focus on public companies to
"thoroughly document, test and take responsibility for the
effectiveness of their company's safeguards for quality financial reporting
has resulted in an unprecedented period of scrutiny," says Joseph J.
Floyd, a managing director of Huron and author of the report.
The Huron study covers error-driven restatements
involving either an annual report or quarterly financial statement. The
previous record for such restatements was in 2002, when a then-record 330
restatements occurred. In 2003, the number leveled off to 323 restatements.
Errors involving improper booking of revenue were
behind 16.4% of the restatements last year, followed closely by mistakes
involving accounting for stock options, other stock instruments and earnings
per share. Another source of errors was accounting for reserves for accounts
receivable, inventory, restructuring and other loss contingencies.
Beefed up regulation also drove last year's surfeit
of restatements. During its inspections of audit firms earlier last year,
the new Public Company Accounting Oversight Board found problems with debt
classification on one of the balance sheets it was examining, and that
discovery prompted the regulators to cast a broader net. Ultimately, about
25 companies restated their financial reports as a result. Also, the
Securities and Exchange Commission changed its reporting requirements to
make error-driven restatements easier to spot.
The crop of companies in 2004 that completed
restatements include Cardinal Health Inc., El Paso Corp. and SunTrust Banks
Inc. Of companies restating results last year, about 15% were "repeat
filers," which Huron defines as companies that have reported erroneous
financial information on more than one occasion since 1997. In this
category: Tyco International Ltd.
Manufacturing companies filed about one-third of
the restatements last year, with finance, insurance and real-estate
companies accounting for 17% of redos. Companies in a range of other
industries, including transportation, communications and sanitary services,
comprised 13% of restatements; and software companies made up 12%.
While companies with more than $1 billion in
revenue accounted for 19% of restatements in both 2003 and 2004, the number
of small companies that restated declined last year. Companies with less
than $100 million of revenue comprised 39% of restatements last year, down
from 49% in 2003.
Huron also noted a continued rise in the number of
companies restating more than one year of financials in a single filing. For
the fifth consecutive year, the number of filers reporting errors in at
least three prior annual periods rose to nearly 40% of the annual reports
restated. For example, Bally Total Fitness Holding Corp. announced that it
would restate eight years of financial reports, from 1996 to 2003, to record
a liability for certain membership contracts sold by a subsidiary before
Bally acquired it.
Expect more high-profile restatements in the months
ahead. For example, Fannie Mae and Krispy Kreme Doughnuts Inc. recently
announced that they would restate financial results for certain years past.
Bernard Madoff, former Nasdaq Stock Market chairman and
founder of Bernard L. Madoff Investment Securities LLC, was arrested and charged
with securities fraud Thursday in what federal prosecutors called a Ponzi scheme
that could involve losses of more than $50 billion.
It is bigger than Enron, bigger than Boesky and bigger than
Tyco
According to
RealMoney.com columnist Doug Kass,
general partner and investment manager of hedge fund Seabreeze
Partners Short LP and Seabreeze Partners Short Offshore Fund,
Ltd., today's late-breaking report of an alleged massive fraud
at a well known investment firm could be "the biggest story of
the year." In his view,
it is bigger
than Enron, bigger than Boesky and bigger than Tyco.
It attacks at the core of investor confidence --
because, if true, and this could happen ... investors
might think that almost anything imaginable could happen
to the money they have entrusted to their fiduciaries.
Bernard Madoff,
founder and president of Bernard Madoff Investment
Securities, a market-maker for hedge funds and banks,
was charged by federal prosecutors in a $50 billion
fraud at his advisory business.
Madoff, 70,
was arrested today at 8:30 a.m. by the FBI and appeared
before U.S. Magistrate Judge Douglas Eaton in Manhattan
federal court. Charged in a criminal complaint with a
single count of securities fraud, he was granted release
on a $10 million bond guaranteed by his wife and secured
by his apartment. Madoff’s wife was present in the
courtroom.
"It’s all just
one big lie," Madoff told his employees on Dec. 10,
according to a statement by prosecutors. The firm,
Madoff allegedly said, is "basically, a giant Ponzi
scheme." He was also sued by the Securities and Exchange
Commission.
Madoff’s New
York-based firm was the 23rd largest market maker on
Nasdaq in October, handling a daily average of about 50
million shares a day, exchange data show. The firm
specialized in handling orders from online brokers in
some of the largest U.S. companies, including General
Electric Co (GE). and Citigroup Inc. (C).
...
SEC Complaint
The SEC in its
complaint, also filed today in Manhattan federal court,
accused Madoff of a "multi-billion dollar Ponzi scheme
that he perpetrated on advisory clients of his firm."
The SEC said
it’s seeking emergency relief for investors, including
an asset freeze and the appointment of a receiver for
the firm. Ira Sorkin, another defense lawyer for Madoff,
couldn’t be immediately reached for comment.
...
Madoff, who
owned more than 75 percent of his firm, and his brother
Peter are the only two individuals listed on regulatory
records as "direct owners and executive officers."
Peter Madoff
was a board member of the St. Louis brokerage firm A.G.
Edwards Inc. from 2001 through last year, when it was
sold to Wachovia Corp (WB).
$17.1 Billion
The Madoff
firm had about $17.1 billion in assets under management
as of Nov. 17, according to NASD records. At least 50
percent of its clients were hedge funds, and others
included banks and wealthy individuals, according to the
records.
...
Madoff’s Web
site advertises the "high ethical standards" of the
firm.
"In an era of
faceless organizations owned by other equally faceless
organizations, Bernard L. Madoff Investment Securities
LLC harks back to an earlier era in the financial world:
The owner’s name is on the door," according to the Web
site. "Clients know that Bernard Madoff has a personal
interest in maintaining the unblemished record of value,
fair-dealing, and high ethical standards that has always
been the firm’s hallmark."
...
"These guys
were one of the original, if not the original, third
market makers," said Joseph Saluzzi, the co-head of
equity trading at Themis Trading LLC in Chatham, New
Jersey. "They had a great business and they were good
with their clients. They were around for a long time.
He’s a well-respected guy in the industry."
The case is
U.S. v. Madoff, 08-MAG-02735, U.S. District Court for
the Southern District of New York (Manhattan)
What was the auditing firm of Bernard Madoff Investment
Securities, the auditor who gave a clean opinion, that's been
insolvent for years? Apparently, Mr Madoff said the business had
been insolvent for years and, from having $17 billion of assets
under management at the beginning of 2008, the SEC said: “It appears
that virtually all assets of the advisory business are gone”. It has
now emerged that Friehling & Horowitz, the auditor that signed off
the annual financial statement for the investment advisory business
for 2006, is under investigation by the district attorney in New
York’s Rockland County, a northern suburb of New York City.
"The $50bn scam: How Bernard Madoff allegedly cheated investors," London
Times, December 15, 2008 ---
http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5345751.ece
It was at the Manhattan apartment that Mr
Madoff apparently confessed that the business was in fact a “giant
Ponzi scheme” and that the firm had been insolvent for years.
To cap it all, Mr Madoff told his sons he
was going to give himself up, but only after giving out the $200 -
$300 million money he had left to “employees, family and friends”.
All the company’s remaining assets have now
been frozen in the hope of repaying some of the companies,
individuals and charities that have been unfortunate enough to
invest in the business.
However, with the fraud believed to exceed
$50 billion, whatever recompense investors could receive will be a
drop in the ocean.
Questions about accounting at IBM
resulted in analysts expressing worries about the value of Big Blue's
stock, and the resulting ripple sent the Dow Jones industrial average down
1.6 percent on Tuesday. IBM share prices dropped to below $100 on Tuesday
after a report in Friday's New York Times raised the issue of how
the earnings on a $300 million gain were reported to shareholders.
http://www.accountingweb.com/item/72700
Questions about
accounting at IBM resulted in analysts expressing worries about the
value of Big Blue's stock, and the resulting ripple sent the Dow Jones
industrial average down 1.6 percent on Tuesday. IBM share prices
dropped to below $100 on Tuesday after a report in Friday's New
York Times raised the issue of how the earnings on a $300 million
gain were reported to shareholders. IBM stock has lost more than 8% in
two days.
According to
The New York Times, IBM booked the $300 million gain on the sale of
an optical unit in December. The New York Times stated that IBM
should have accounted for the sale as a one time gain. Instead, the
paper
reported, IBM referred to the company's fourth-quarter profits in a
recent conference call, indicating profits had grown due to increased
productivity and higher sales of certain products.
IBM claims the
company disclosed the sale adequately in two press releases in December.
"IBM's accounting is conservative and fully compliant with all
regulatory standards," said Carol Makovich, a company spokeswoman.
A Wall Street
investment firm, Prudential Securities, questioned the firm's complex
accounting procedures and suggested that such complexities would weigh
on IBM's share price. Prudential analyst, Kimberly Alexy,
said that long-standing concerns about IBM's earnings "engineering"
would hurt the stock in the coming year.
Chief financial
officers and comptrollers at such companies may be under duress and
persistent pressure to look the other way - though published studies
suggest that, regrettably, they are often involved. Outside directors
likely have no clue about any shenanigans. But there are plenty of
instances where someone aware of the fraud stepped forward. "Most frauds
are not found by fraud investigations," says Dan Jackson, president of
Jackson and Rhodes, a Dallas-based accounting firm. "It's usually
because of a disgruntled employee, a dissatisfied vendor or someone with
a conscience."
These days,
just the suggestion that a company may have accounting irregularities is
enough to drive down its stock price, notes Robert Willens, an
accounting analyst at Lehman Brothers. He cites the case of Tyco
International, a well-managed company that makes home-security and
alarms systems but which was rumored to have accounting problems by the
Tice Report, a markets newsletter published by short-seller David Tice.
After Tice raised suspicions, the company lost one-third of its value,
although the Securities and Exchange Commission later gave it a clean
bill of health.
"It doesn't
seem to matter whether it's the SEC or some newsletter, everyone seems
willing to sell a stock now even if there's just a hint of questionable
practices," Willens says. "Nobody wants to own the next Cendant or
Sunbeam."
Despite the
1995 law -- which critics concede has eliminated some meritless suits --
shareholder actions have thrived in part because the Internet has given
law firms the power to reach masses of disgruntled investors willing to
join a class of plaintiffs in the hopes of getting a big settlement.
Internet chat rooms are filled with company gossip provided by investors
-- gossip that's sometimes used by lawyers to bolster a claim.
Meanwhile,
public companies, especially high-flying high-tech firms, are under more
pressure than ever from Wall Street to meet profit expectations so
exacting that companies falling short by even a penny a share can see
their stock price crash. As companies strain to meet quarterly
projections, some have found themselves embroiled in public battles with
government regulators or their own auditors over accounting methods,
leaving them open to shareholder suits.
More than half
the record 332 class-action lawsuits filed last year on behalf of
shareholders claimed companies had committed some kind of accounting
fraud. Faced with the prospect of a lengthy trial, most firms chose to
settle for amounts that were on the average double what they were five
years ago, observers say.
Tyco spent $US8 billion in its
past three fiscal years on more than 700 acquisitions that were
never announced to the public. The >story is at
http://au.news.yahoo.com/020205/2/3vlo.html
The auditing firm was PricewaterhouseCoopers.
In August 2003, Pricewaterhouse Coopers agreed to
pay more than $50 million to settle a suit by MicroStrategy investors who
alleged that the firm defrauded them when it approved MicroStrategy's
financial reports. The PwC engagement partner was banned from future
audits of corporations listed with the SEC.
This series of articles is
based on interviews with Michael Saylor and more than 100 people who
have known, watched or worked with him. It is also based on court
documents, MicroStrategy memos and internal e-mails.
Part I Tycoon: Michael Saylor had a vision that was not just about
software. For a while, everyone wanted to be a part of it.
Part II Damage control: Forced by outside accountants to revise
MicroStrategy's books, Saylor and his board struggle to keep the
company afloat.
Part III Facing the SEC: Saylor maintained that Microstrategy's
mistakes had been negligible. But unless he admitted some fault, his
problems were going to be worse.
Part IV (Wednesday) Aftermath: "I made the mistake of being passionate and
idealistic. ... That was my sin."
One item of special interest is
the fact that the Big Five accounting firm Pricewaterhouse Coopers (PwC)
did nothing to re-state some really bad accounting until that bad
accounting was made public in a Forbes article. The following
quotation is from Part II of the above Washington Post series:
"We believe it
would be appropriate for us to retract the previously audited financial
statement of December 1999," Dirks said, according to a source familiar
with that conversation. He suggested that MicroStrategy issue a press
release announcing it would be restating its revenue figures from the
previous quarter.
Dirks focused
on a large deal that MicroStrategy had struck the previous fall with NCR
Corp, a computer equipment and services firm. MicroStrategy sold $27.5
million worth of software and services to NCR for NCR to "resell" to its
own customers. As part of the transaction, MicroStrategy agreed to pay
$25 million in stock and cash to NCR for one of its business units and a
data warehousing system. Some stock analysts saw the deal as a virtual
revenue wash, but MicroStrategy still issued a press release on Oct. 4,
1999, hailing its "52.5 million agreement with NCR." MicroStrategy
recorded $17.5 million in sales from the NCR deal in the quarter that
ended that Sept. 30. NRC accounted for the deal in the following
quarter.
Without that
$17.5 million, MicroStrategy's revenue for the third quarter would have
dropped nearly 20 percent from the previous quarter, instead of growing
by 20 percent. It would have reported a loss of 14 cents a share instead
of a profit of 9 cents. And it would have fallen well below Wall
Street's expectations, making it unlikely its stock price would have
risen as much as it did the following month, when Saylor and a group of
company insiders sold shares at a collective value of $82 million.
The firm's
accountants had approved MicroStrategy's financial statements until as
late as Jan. 26, 2000. They were acting now, they privately told
MicroStrategy officials, in response to the Forbes article, which had
examined the NCR deal in detail. Citing an ongoing client relationship
with MicroStrategy, Pricewaterhouse refused to respond to several
written questions for these articles. Dirks and Martin also declined to
comment through Pricewaterhouse spokesman Steven Silber.
"Wait," Saylor
said to Dirks and Martin, his voice cracking, "you guys signed off on
this." If MicroStrategy issued a press release, he said, "there will be
a collapse of confidence and trust in our company that will cause great
collateral damage."
Everyone agreed
to talk again the next morning. Lynch bought cigarettes, and neither he
nor Saylor slept that night.
At midnight
Washington time, Saylor and Lynch called the Arlington home of
MicroStrategy's chief counsel, Jonathan Klein. This set off a flurry of
sleep-jangling calls between Klein, other MicroStrategy attorneys,
executives and members of the company's board of directors.
On the Road
Again
Late on
Tuesday, Lynch returned to Washington to join a group of MicroStrategy
accountants, lawyers and board members who were meeting with
Pricewaterhouse. Saylor continued his roadshow, except for a trip back
to Washington where he announced that he would spend $100 million of his
own money to start a free online university, a plan that was previewed
on the front page of The Washington Post.
Back on the
road, Saylor would call Klein in Washington after every pitch for
updates. The meetings centered on small computations, arcane rules and
subjective analyses, but Saylor told his executives they were really
about something else: "Whether we live, or whether everything will end."
Lynch slept a
total of eight hours over those five days. The numbers they discussed
fluctuated widely.
On Sunday,
March 19, at 4 p.m., MicroStrategy's board of directors, made up of many
of the prominent local businessmen Saylor had cultivated during his
rise, convened around a large table in a 14th-floor conference room of
the company's Tysons Corner offices. In addition to Saylor, Terkowitz
and Ingari, the board included Worldcom Corp. Vice Chairman John
Sidgmore, who had joined the board a week before, entrepreneur Jonathan
Ledecky; and MicroStrategy co-founder Sanju Bansal. The board voted to
issue an accounting restatement the next day.
At the end of
the day, they were joined by top company executives, lawyers and a
crisis public relations team that was brought in from New York. "It will
be a PR victory for us if our stock doesn't drop 100 points tomorrow,"
Ledecky said.
But Saylor grew
more frustrated by what he was hearing. He became especially agitated
with Ralph Ferrara, a securities law expert from the Washington office
of Debevoise & Plimpton who spoke to the board about the accounting
problems. As Ferrara was making a point about the possible ramifications
of the restatement, Saylor cut him off, according to two sources who
were in the room. Saylor told Ferrara that none of the information he
was providing was new to him.
"If you know
all this," Ferrara snapped back, "then you've ruined your company."
Stunned, Saylor
remained silent for several minutes while Ferrara continued, sources
recalled. Saylor, who does not remember this specific exchange, said he
never acted in any way that would have "ruined the company," and if
Ferrara had accused him of it, he would have responded immediately.
After Ferrara
continued for a few minutes, the sources said, Saylor began banging his
palm on the table in boredom. He said Ferrara was lingering on
unimportant detail and he told him to move on to the next item.
"Michael, my D and O [directors and officers] insurance only covers me
up to $15 million," Ledecky said, glaring at Saylor. "After that, they
come after my own assets. So I want to hear this." Saylor's eyes bulged,
he went silent again and Ferrara continued.
Saylor recalls
the tension in that meeting to be a result of "our company heading into
a horrifically difficult period." Up until six days before, he added,
"everyone told me I was doing a perfect job."
As midnight
approached on March 19, Saylor called his family to inform them of the
announcement to come. He spoke longest to his mother, Phyllis Saylor,
the dominant figure in Michael's life. She doted on her son, and friends
said Saylor often credited her with instilling a belief that he could
"do great and enormous things."
"There's gonna
be a lot of bad publicity," Saylor explained to his mother, who had
recently accompanied her son to the White House millennium party.
"People will write bad things about me."
Of course,
alleged fraud often melds with incompetence or arrogance. Think Oxford
Health
(Nasdaq: OXHP) or Columbia/HCA
(NYSE: COL). And sometimes the alleged fraud is considerably less
obvious, even after the fact. It often relates to the slippery issue of
disclosure, of what management knew and when, and whether they benefited
from delays in telling other investors the news or from
misrepresentations of that news.
There are two
common legal pegs here. The first is accounting fraud owing to
misrepresentations or omissions in financial statements (cited in 67% of
recent cases). Often, the accounting fraud is said to have masked poor
results so that the company could float an important equity or debt
offering. The second peg is trading by insiders during the class period
(cited in 59% of recent cases). Top executives are often alleged to have
fudged the truth since they may have held lucrative options packages
that would have been hurt by poor earnings results. Or more typically,
they might have sold some of their own shares before the bad news got
out.
Let me just
make a few quick points about these more complex, disclosure-related
cases. First, major U.S. companies routinely engage in
selective
disclosure, so there's no reason for investors to give corporate
managers the benefit of the doubt. Second, companies with poor
disclosure practices often have weak corporate boards, which suggests
the likelihood that the all-important audit committee, which ought to
catch genuine fraud, will fail to do its job.
Third, because
of points one and two, there's good reason for investors to believe that
fraud is possible and thus no good reason to put undue obstacles in the
way of securities fraud cases. Except for the most obviously frivolous
lawsuits (which judges will dismiss with prejudice), it's simply
difficult to determine that fraud has not been committed before full
discovery occurs. Though discovery is often seen as a fishing
expedition, you don't catch fish unless they're in the pond.
Fourth, despite
the "safe harbor" provision of the 1995 Securities Litigation Reform Act
that protects forward-looking statements made in conjunction with proper
cautionary language, some forward guidance is so reckless as to be
unsupported by a company's business. That kind of garbage should
continue to be open to litigation.
To take some
obvious examples, Boston Chicken
(Nasdaq: BOST) stated repeatedly that based on its thorough economic
review, it did not need to set aside any
reserves for losses on its loans to its area developers of Boston
Market or Einstein Bagel
(Nasdaq: ENBX) stores. When the chickens
came
home to roost over this ridiculous accounting judgment (and thus
misleading disclosure), Boston Chicken ended up setting aside hundreds
of millions of dollars in reserves for loan losses and the write down of
other assets. By then, shareholders had been carved up.
Then there was
the case of LaserSight
(Nasdaq: LASE), a firm that manufactures and sells laser equipment
used in photorefractive keractectomy (PRK) eye surgery. Its stock
plummeted in 1996 after its wildly optimistic forward guidance proved to
be a complete joke.
It's important
to remember that our economic system absolutely depends on a vibrant
atmosphere for civil suits against corporate wrongdoers. That's because
the SEC has its hands full. Excluding notable exceptions, often brought
to its attention by short-sellers, the SEC just doesn't evaluate the
reliability of federal filings by public companies. Moreover, the Wall
Street analyst community has repeatedly shown an inability, or perhaps
disinterest, in doing the kind of serious research that would uncover
potential problems. For example, Oxford Health's collapse came while all
the analysts remained fundamentally bullish. Boston Chicken and Einstein
Bagel imploded despite a sea of positive analyst comments. In addition,
while auditors sometimes find junky accounting, they also sign off on
lots of garbage.
What reasonable
people should want from the securities laws is for investors to have a
fair chance to go after a company that's committed fraud while companies
have a fair shot at fending off truly unwarranted lawsuits. The new
securities reform act that recently passed the U.S. Senate 79 to 21, and
seems likely to be approved by the House in July, is a hasty attempt to
revamp the Reform Act of '95 before the fundamental legal issues
pertaining to that Act have really been determined by the courts. But it
may reconcile these twin goals by strengthening both sides in the
struggle.
The Accounting Fraud Beat
(This article has some great examples.)
"Asset misappropriation comes in many forms: Enemies Within," by
Joseph T. Wells, The Journal of Accountancy, December 2001 ---
http://www.aicpa.org/pubs/jofa/dec2001/wells.htm
Sometimes, the
truth isn’t very pretty. Consider, for example, the American
workforce. Although regarded by many as the finest in the world, it has
a dark side. According to estimates, a third of American workers have
stolen on the job. Many of these thefts are immaterial to the financial
statements, but not all are—especially to small businesses.
Regardless of
the amounts, CPAs are being asked to play an increasingly important role
in helping organizations prevent and detect internal fraud and theft.
Responding to these demands requires the auditor to have a thorough
understanding of asset misappropriation. CPAs with unaudited clients can
provide additional services by suggesting a periodic examination of the
cash account only.
Although “internal
theft” and “employee fraud” are commonly used, a more encompassing
term is “asset misappropriation.” For our purposes, asset
misappropriation means more than theft or embezzlement. An employee who
wrongly uses company equipment (for example, computers and software) for
his or her own personal benefit has not stolen the property, but has
misappropriated it.
Employees—from
executives to rank-and-file workers—can be very imaginative in the
ways they scam their companies. But in a study of 2,608 cases of
occupational fraud and abuse, we learned that asset misappropriation can
be subdivided into specific types; the most prevalent are skimming and
fraudulent disbursements.
BDO Seidman LLP,
the accounting firm, settled investor claims over a $285 million loan that
was made to LeNature's Inc. before the drink maker went bankrupt in 2006,
according to a court filing.
Terms of the
settlement were not disclosed in the Monday filing in New York State Supreme
Court in Manhattan.
BDO Seidman, based
in New York, prepared LeNature's financial statements, and Wachovia Capital
Markets arranged the loan. Normandy Hill Master Fund LP, which bought some
of the debt on the secondary market, sued Wachovia, BDO Seidman and others
in June 2010.
"It has been
resolved, and the parties are pleased to put it behind them," Aaron
Mitchell, an attorney for the plaintiffs, said on Thursday.
Timothy Hoeffner,
an attorney representing BDO Seidman, could not be reached for comment on
the settlement.
Wachovia Capital
Markets, now a part of Wells Fargo & Co., said in court documents filed in
February that it settled claims against it in the lawsuit, without
disclosing terms.
LeNature's, based
in Latrobe, made bottled water, tea and other flavored drinks. Gregory J.
Podlucky, the company's founder, and others were indicted in September 2009
on charges that they duped creditors out of more than $800 million by
overstating company revenue. Podlucky pleaded guilty in May 2011 and was
sentenced to 20 years in prison in October.
Audit firm BDO USA was charged Wednesday by the
Securities and Exchange Commission with issuing false and misleading audit
opinions about staffing services company General Employment Enterprises.
The SEC also charged five BDO partners for their
roles in allegedly deficient audits, and the regulator brought fraud charges
against the client company’s then-chairman and majority shareholder, Stephen
Pence. Mr. Pence is also a former U.S. attorney and a former lieutenant
governor of Kentucky.
According to the SEC, BDO was informed by the
company during a 2009 audit that $2.3 million invested in a 90-day
certificate of deposit wasn’t repaid by the bank upon its maturity date. A
bank employee, meanwhile, informed BDO that there was no record of a CD
being purchased from the bank, the SEC said. The $2.3 million represented
about half of the company’s assets and most of its cash, the SEC said.
The SEC charged that General Employment then
received a series of deposits totaling $2.3 million from three entities not
affiliated with the bank—one of which allegedly was owned by Mr. Pence.
BDO didn’t receive reasonable and coherent
explanations for why the sum went missing and later was received, the SEC
said, and though BDO issued a letter to the company about the conflict and
called for an independent investigation, BDO days later withdrew its demand
and issued what the SEC deemed unqualified opinions on the financial
statements included in General Employment’s 2009 and 2010 annual reports.
A Circuit Court
jury in Miami decided on Monday that the accounting firm BDO Seidman should
pay the late philanthropist/aviation pioneer George Batchelor's estate and
foundation $91 million for ``fraudulently'' concealing false information
about a company in which Batchelor had invested.
The award consists
of $55 million in punitive and $36 million in compensatory damages.
Steven Thomas of
the Venice, Calif., firm Thomas, Alexander & Forrester, is lead Batchelor
attorney. He said he thought that the punitive damage award was so hefty
because ``BDO, right up to the end, denied it had a public duty -- and
public is literally their middle name: CPA.''
A lawsuit filed in
2002 -- the year that Batchelor died at age 81 -- alleged that BDO Seidman
covered up erroneous financial statements during an audit of Grand Court
Lifestyles, a Boca Raton owner/manager of ``senior'' communities. Batchelor
had invested in Grand Court, which filed for bankruptcy in 2000.
The jury decided
that BDO owed the estate $34.4 million and the foundation $2.3 million in
compensatory damages.
Thomas said that
the entire award ``goes into the Foundation, which means dozens of
organizations in Miami that are funded by the Foundation may be getting
additional monies.''
Batchelor, who
founded Arrow Air and Batch Air, had given an estimated $100 million to
South Florida causes that benefited children, animals, the environment and
medical facilities before he died. The foundation continues supporting many
of those charities.
In a written
statement, the accounting firm said it ``strongly'' disagreed with the
verdict and planned to appeal.
NEW YORK, Feb 4
(Reuters Legal) - Federal prosecutors who ignited a legal firestorm five
years ago for pressuring the accounting firm KPMG to stop paying its former
employees' legal fees are facing the same accusations in another
high-profile tax-fraud case.
BDO Seidman case
has similarities to KPMG
The defendant in
this case, Denis Field, ex-CEO of BDO Seidman, the world's fifth largest
accounting firm, claims Manhattan prosecutors intimidated his former firm
into curtailing and eventually cutting off payments to his lawyers. In
recently filed court papers, he claims that the government deprived him of
his constitutional right to counsel and seeks dismissal of the case. Field
alleges that among other tactics, prosecutors threatened to indict the firm
if it kept funding his defense. During a hearing on Thursday, U.S. Judge
William Pauley III of the Southern District of New York, who is presiding
over the case, closely questioned prosecutors about the accusations. A
ruling is expected soon.
The controversy
touches on the common arrangement among U.S. companies of paying the legal
fees of executives. It raises the question of whether a government attempt
to meddle with this practice amounts to depriving a defendant of his or her
lawyer -- which could constitute a violation of the right to counsel under
the 6th Amendment.
The Field
prosecution, in which he is charged with creating phony tax shelters, is
strikingly similar to the KPMG matter. That case was thrown out in 2007
after U.S. Judge Lewis Kaplan found that prosecutors had improperly
"coerced" KPMG into cutting off the legal fees of 13 former KPMG partners
and employees. "KPMG refused to pay because the government held the
proverbial gun to its head," Kaplan wrote.
Two of the
prosecutors called out by Judge Kaplan -- Stanley Okula and Shirah Neiman --
have also been involved in the Field case, a fact that is prominently noted
by Field's lawyers in their motion to dismiss. "The reason for the
government's conduct is obvious -- as with KPMG, the prosecutors believed
BDO 'should not pay the fees' of allegedly culpable individuals," Field's
lawyers argue. They cited the KPMG case no fewer than 50 times in their
brief. Okula and Neiman declined comment, as did a spokesperson for the
Manhattan U.S. Attorney's office.
The Public Company Accounting Oversight Board
has issued its latest
inspection report on BDO USA and found several
audit failures and deficiencies.
The PCAOB reviewed 31 audits and found significant
deficiencies with audits of eight companies in the board’s 2010 inspection
of the firm.
“The inspection team identified matters that it
considered to be deficiencies in the performance of the audit work it
reviewed,” said the PCAOB report. “Those deficiencies included failures by
the firm to identify, or to address appropriately, financial statement
misstatements, including failures to comply with disclosure requirements, as
well as failures by the firm to perform, or to perform sufficiently, certain
necessary audit procedures. In some cases, the conclusion that the firm
failed to perform a procedure was based on the absence of documentation and
the absence of persuasive other evidence, even if the firm claimed to have
performed the procedure.”
Continued in article
This is not the first time BDO has been in trouble with the PCAO
Nearly two years after Texas financier Allen
Stanford was indicted in an alleged massive Ponzi scheme, investors have just
filed a $10 billion proposed class action suit against his auditor—the giant
accounting firm BDO. The suit—filed Thursday in federal court in Dallas—says BDO
did not only aid and abet the $7 billion dollar fraud…it was a “co-conspirator.”
“BDO’s cozy relationship with the Stanford Financial Group was steeped in
conflicts of interest and required ongoing deceptive and duplicitous
manipulation of the facts to allow the Ponzi scheme’s exponential growth for
over a decade,” the complaint says. “The result of this deception is the loss of
thousands of investors’ life savings.”
Convicted Ponzi schemer
R. Allen Stanford was sentenced Thursday to 110 years in federal prison for his
$7 billion fraud. Stanford victimized thousands of individual investors to fund
a lifestyle of private jets and island vacation homes. Now the question is
whether there will be anything left at all for these victims once authorities in
jurisdictions around the world finish sifting through the wreckage.
Stanford "stole more
than millions. He stole our lives as we knew them," said victim Angela Shaw,
according to Reuters. Certificates of deposit issued by a Stanford bank in
Antigua promised sky-high returns but succeeded only in destroying the savings
of middle-class retirees. More than three years after U.S. law enforcement shut
down the Stanford outfit, victims have recovered nothing.
A receiver appointed by
a federal court, Ralph Janvey, has collected $220 million from the remains of
Stanford's businesses but has already used up close to $60 million in fees for
himself and other lawyers, accountants and professionals, plus another $52
million to wind down the Stanford operation.
And then there's the
Securities and Exchange Commission, which didn't charge Stanford for years even
after its own examiners raised red flags as early as the 1990s. The SEC has
lately pursued a bizarre attempt at blame-shifting, trying to get the Securities
Investor Protection Corporation to cover investor losses. Even the SEC must know
that SIPC doesn't guarantee paper issued by banks in Antigua—or anywhere else
for that matter.
SEC enforcers should
instead focus on catching the next Allen Stanford. Careful investors should
expect that they won't.
Well team,
despite the
little setback for the PCAOB earlier this week,
Team Peek is not discouraged. In fact, they were so motivated by the SEC’s
little stunt that they thought they’d churn out three major inspection
reports today, just to show everyone that they get to say what’s what with
these accounting firms (even if it is in an indecipherable combination of
vague and wonky prose).
BDO, Grant Thornton
and PwC all got their papers issued today, which leaves just KPMG as the
last major U.S. firm to not have their report issued. We’ll give you the
quick and dirty on these three but if you want the gory details, you’ll have
to read them in depth yourself (some of us have lives, you know). We’ll go
in alphabetical order so no one gets bent out of shape.
BDO had eight
issuers mentioned in its report. Issues included not testing the underlying
data used by a specialist, failure to identify a departure from GAAP before
issuing its audit report, loan losses and “[failure] to perform sufficient
procedures to evaluate the reasonableness of a significant assumption
management used to calculate the gain on the sale of a business,” among
others.
http://www.scribd.com/doc/35856583/PCAOB-2010-BDO-Seidman-LLP
GT only had
five issuers listed in their report with problems including two instances of
departures from GAAP that weren’t identified before the issue of the audit
report, testwork related to fair value determination of illiquid assets and
testwork around revenue recognition.
Steve Chipman got away from the teleprompter long
enough to sign the letter to the PCAOB himself, along with Trent Gazzaway,
the National Managing Partner of Audit Services.
http://www.scribd.com/doc/35856593/PCAOB-2010-Grant-Thornton-LLP
Nine issuers
were noted by the inspectors for P. Dubs. Various issues ranging from
inadequate testing of foreign locations, loan loss issues (that’s a given)
and fair value (another surprise). PwC’s response made it sound like they
actually enjoy the whole inspection process, “We continue to support the
PCAOB and we wish to convey our sincere appreciation for the professional
efforts of the PCAOB staff.” Wonder if the engagement teams that were
inspected feel the same?
http://www.scribd.com/doc/35856619/PCAOB-2010-PricewaterhouseCoopers-LLP
It was a
screwy sequence of events, for sure. Every
time I wrote about the case I had to carefully
consider how to present all the twists and turns, ins and outs and complex
machinations the court forced both sides to endure.
The 20-page
opinion was written by Judge Vance E. Salter. Judges Gerald B. Cope and
Linda Ann Wells concurred. Salter said Rodriguez’s trial-planning
decision was based on good intentions for efficiency purposes.
“These
objectives are much harder to achieve, however, in a complex case,”
Salter said.
Rodriguez
ordered the first phase of the trial to determine whether BDO Seidman
had committed gross negligence, but Salter noted that was two months
before the jury considered issues of causation, reliance and comparative
fault.
One potential
negative for the plaintiffs in the retrial is the likely judge. Miami-Dade
Circuit Judge John Schlesinger, the judge who rendered the verdict for the
defense in the
BDO International phase of the case, has taken
over Judge Jose Rodriguez’s civil division and will hear the retrial. I
was not impressed with Judge Schlesinger’s
level of interest or aptitude during the BDO International trial for this
“complex case brought by plaintiffs not in privity with the accounting
firm/defendant.”
From
Leagle’s posting of
the opinion: The salutary objectives of
judicial economy (no phase II damages trial is required if the jury
returns a defense verdict in phase I), and the reduction of a longer
case into more digestible “phases,” often support bifurcation and the
exercise of that discretion. These objectives are much harder to
achieve, however, in
a complex case brought by plaintiffs not in privity with the accounting
firm/defendant. In such
a case, liability ultimately turns on specific demonstrations of
knowledge, intent, and reliance.The evidence pertaining to those issues is
inextricably intertwined with the claims and affirmative defenses on
issues of comparative fault, causation, and gross negligence.
Bankest’s attorney
Steven Thomas is optimistic about a retrial. Me? Not so much. This isn’t
because I doubt Mr. Thomas’ ability to kick tail as he did in the original
trial. This isn’t because the case doesn’t have sufficient merit.
From
Michael Rapoport at DJ/Wall Street Journal:
Steven Thomas, an attorney for Espirito Santo,
said he was looking forward to a retrial. “The evidence of BDO Seidman’s
failures of even the most basic auditing procedures is so overwhelming
that we expect a new jury will reach the same conclusion as the original
jury,” he said in a statement.
My doubts
about the efficacy of a new trial are based on the
disappointing, frustrating and completely unsatisfying way the court and the
judges in this case have proceeded. Some of the additional comments raised
by the Appeals Court do not bode well for this plaintiff’s chances next time
around. This is in spite of the fact they
made a point of saying they would stop at the
prejudice imposed by the trifurcation issue and say no more that would
prejudice a new trial.
Because of the
prejudice inherent in the premature, first-phase gross negligence
finding, we do not address in detail other aspects of the trial. Our
conclusion regarding the “trifurcation” issue renders moot or pretermits
our consideration of most of the other parts of the jury’s verdicts and
the remaining points on appeal and cross-appeal.
There are two other
issues raised by the Appeals Court that may prove problematic to the
plaintiffs in a retrial.
"Audit Overseer Faults BDO, Grant Thornton: The PCAOB says BDO
had trouble testing revenue-recognition controls, while Grant Thornton did not
adequately identify GAAP errors. Both firms complain that the board criticized
judgment calls," by Marie Leone, CFO.com, July 13, 2009 ---
http://www.cfo.com/article.cfm/14026057/c_2984368/?f=archives
Annual inspection reports for BDO Seidman and Grant
Thornton, released last Thursday by the Public Company Accounting Oversight
Board, criticized some of the audit testing procedures and practices at the
two large accounting firms.
The review of BDO focused mainly on issues related
to testing controls around revenue recognition, while Grant Thornton was
chastised for not identifying or sufficiently addressing errors in clients'
application of generally accepted accounting principles with respect to
pension plans, acquisitions, and auction-rate securities.
With regard to BDO, the inspection staff reviewed
seven of the company's audits performed from August 2008 through January
2009 as a representation of the firm's work.
The report highlighted several deficiencies tied to
what it said were failures by BDO to perform audit procedures, or perform
them sufficiently. According to the reports, the shortcomings were usually
based on a lack of documentation and persuasive evidence to back up audit
opinions. For example, the board said, BDO did not test the operating
effectiveness of technology systems that a client used to aggregate revenue
totals for its financial statements. The systems were used by the client
company for billing and transaction-processing purposes.
The inspection team also reported that BDO's audit
of a new client failed to "appropriately test" the company's recognition of
revenue practices. Specifically, the audit firm noted that sales increased
in the last month of the year but it failed to get an adequate explanation
from management. Also, the report concluded that BDO reduced its
"substantive" revenue testing of two other clients, although more thorough
testing was needed.
And while BDO identified so-called "channel
stuffing" as a risk of material misstatement due to fraud, at another
client, its testing related to whether the client engaged in the act was not
adequate, said the inspectors. (Channel stuffing is the practice of
accelerating revenue recognition by coaxing distributors to hold excess
inventory.)
Other alleged problem spots for BDO included a
failure to design and perform sufficient audit procedures to test: journal
entries and other adjustments for evidence of possible material misstatement
due to fraud; valuation of accrued liabilities related to contra-revenue
accounts; a liability for estimated sales returns in connection with an
acquisition; and assumptions related to a client's goodwill impairment of a
significant business unit.
In response to the inspection report, BDO performed
additional procedures or supplemented its work papers as necessary. It also
noted in a letter that was attached to the report that none of the clients
cited had to restate their financial results.
In the letter, BDO acknowledged the importance of
the inspection exercise, commenting that "an inherent part of our audit
practice involves continuous improvement." However, the firm also said the
report does not "lend itself to a portrayal of the overall high quality of
our audit practice," since it reviews only a tiny sampling of audits. What's
more, BDO pointed out that many of the issues reviewed "typically involved
many decisions that may be subject to different reasonable interpretations."
Deficiencies highlighted in the inspection report
on Grant Thornton, meanwhile, included failures to "identify or
appropriately address errors" in clients' application of GAAP. In addition,
inadequacies were said to have been found with respect to performing
necessary audit procedures, or lacking adequate evidence to support audit
opinions. The Grant Thornton inspections were performed at on eight audits
conducted between July 2008 and December 2008.
In five audits, the PCAOB said inspectors found
deficiencies in testing benefit plan measurements and disclosures. In four
of those audits, Grant Thornton was said to have failed to test the
existence and valuation of assets held in the issuer's defined-benefit
pension plan. In one audit, the board said, the accounting firm failed to
test the valuation of real estate and hedge fund investments and a
guaranteed investment contract held by the client's defined-benefit pension
plan.
One client amended three of its post-retirement
benefit plans to eliminate certain benefits, and Grant Thornton "failed to
evaluate whether the issuer's accounting" was appropriate, said the report.
In another audit, the accounting firm allegedly did not perform sufficient
procedures to evaluate whether the assumptions related to the discount rate
and long-term rate of return on plan assets — provided by the client's
actuary — were reasonable.
In a separate audit, a client acquired a public
company that was described as having six reporting units. The client
recorded the fair values of the net assets of each reporting unit according
to the valuations provided by a specialist. But according to the inspection
report, Grant Thornton did not audit the acquisition transaction
sufficiently.
In particular, the firm neglected to evaluate which
of the fair-value estimates represented the "best estimate" with regard to
two units that were hit with an economic penalty for having a lower total
fair value than their net assets, the inspectors said. They also concluded
that Grant Thornton did not do a sufficient auditing job when it failed to
note whether it was appropriate for the specialist to use liquidation values
for two other units.
Y PATRICK DANNER
pdanner@MiamiHerald.com
640 words
17 June 2009
The Miami Herald
A1
3
English
(c) Copyright 2009, The Miami Herald. All Rights Reserved.
BDO International is not liable for $351 million in punitive damages
that a Miami jury awarded a Portuguese bank in 2007, a Miami-Dade
Circuit judge has ruled.
Banco Espirito Santo was awarded $170 million for its losses and
$351 million in punitive damages for the negligence of accounting
firm BDO Seidman. The reason: BDO failed to uncover fraud at a
now-defunct financial services firm in which the bank held a stake.
Still left to be decided is whether BDO International is on the hook
for the $170 million award, too.
TRIAL UNDER WAY
In a trial now under way in Miami-Dade Circuit, Banco Espirito Santo
had wanted a new jury to hold BDO International responsible for the
2007 award, as well. The bank alleged BDO International was grossly
negligent in failing to ensure Chicago-based BDO Seidman performed
proper audits of factoring firm E.S. Bankest.
Belgium-based BDO International was part of the earlier trial, but
was dismissed from the case after a judge found the bank presented
no evidence establishing its claim against BDO International. An
appeals court disagreed and ordered that a jury must decide whether
BDO International was responsible for ensuring the quality of BDO
Seidman's audits.
Article continues
QUESTION FOR JURY
Still left for the jury to decide is whether BDO International
should be responsible for the $170 million in losses sustained by
the bank because of the fraud. The bank alleges BDO International is
liable for the verdict because BDO Seidman is an agent of BDO
International. BDO Seidman has appealed the verdict.
On Tuesday, BDO International completed the presentation of its
case. Closing arguments in the trial, which started two weeks ago,
may happen on Wednesday.
Document MHLD000020090617e56h0000o
From The Wall Street Journal Accounting Weekly
Review on June 18, 2009
TOPICS: Ethics,
Public Accounting, Public Accounting Firms, Tax Evasion, Tax Shelters,
Taxation
SUMMARY: "Seven
people including the former chief executive and chairman of accounting firm
BDO Seidman LLP have been charged criminally in an allegedly fraudulent
tax-shelter scheme that generated billions of dollars in false tax losses
for clients." The remaining six include three former Jenkens & Gilchrist PC
lawyers--one of which is Paul Daugerdas, former head of the law firm's
Chicago office who joined the firm bringing in the revenue from these
tax-structured transactions--and two former investment-bank employees. The
investment bank wasn't named in the indictment but "a person familiar with
the matter" said it was Deutsche Bank AG.
CLASSROOM APPLICATION: Ethics,
including the need to stand up against others' unethical actions, can be
discussed with this article.
QUESTIONS:
1. (Introductory)
What is tax evasion? Differentiate it from tax avoidance.
2. (Advanced)
What types of firms have been charged in this "27-count federal indictment,
which includes charges of conspiracy and tax evasion"? How must these types
of firms work together to structure tax-beneficial transactions?
3. (Introductory)
Refer to the related articles. Summarize the description of the types of
transactions questioned by the IRS and leading to the indictment.
4. (Advanced)
Are there ways in which structured transactions can be legitimate tax
shelters? What are some general requirements that must be met for a
transaction to be considered legitimate?
5. (Introductory)
Refer again to the related articles. What were the Jenkens & Gilchrist
partners' concerns about the risk of the transactions and services
structured and sold by the Chicago office partner Mr. Daugerdas? What
factors did they allow to override their concerns?
6. (Introductory)
Place yourself in the position of partner in the law firm of Jenkens &
Gilchrist. Consider the issues discussed at the board meetings in offering a
position to Mr. Daugerdas and in dealing with the beginning lawsuits from
clients facing IRS scrutiny. How would you react in each of these meetings?
7. (Advanced)
What is the affiliation of the accounting firm BDO Seidman in these
transactions? How could the accounting firm and its partner be held
responsible for a transaction designed by another firm--a law firm, not an
accounting firm, at that?
Reviewed By: Judy Beckman, University of Rhode Island
Adrian Dicker, a United
Kingdom chartered accountant and former vice chairman and board
member at a major international accounting firm, has pleaded guilty
to conspiring with certain tax shelter promoters to defraud the
United States in connection with tax shelter transactions involving
clients of the accounting firm and the law firm Jenkens & Gilchrist
(J&G), the Justice Department and Internal Revenue Service (IRS)
announced. In the hearing before U.S. Magistrate Judge Theodore H.
Katz in the Southern District of New York, Dicker, who is a resident
of Princeton Junction, NJ, also pleaded guilty to tax evasion in
connection with a multi-million dollar tax shelter that Dicker
helped sell to a client of the accounting firm.
According to the
information and the guilty plea, between 1995 and 2000, Dicker was a
partner in the New York office of the accounting firm which he
identified during his guilty plea as BDO Seidman. From early 1999
through October 2000, Dicker was on the firm's Board of Directors,
and through October 2003 he served as a retired partner director.
From 1998 until 2000, Dicker was one of the leaders of the firm's
"Tax Solutions Group" (TSG), a group led by the firm's chief
executive officer, Dicker, and another New York-based tax partner.
The activities of the TSG were devoted to designing, marketing, and
implementing high-fee tax strategies for wealthy clients, including
tax shelter transactions.
According to the
information and the guilty plea, Dicker and the other two TSG
managers used a bonus structure that handsomely rewarded the
accounting firm personnel involved in the design, marketing, and
implementation of the TSG's transactions, including: the individual
who referred the client to TSG personnel; the TSG member who pitched
and closed the sale; other TSG members; and TSG management. From
July 1999, Dicker, the CEO, and the other TSG manager earned and
shared equally 30 percent of the net profits of the TSG. Dicker
earned approximately $6.7 million in net TSG profits, as well as
salary and bonuses between 1998 and 2000. In addition, the CEO of
the firm doled out additional bonuses from the profits earned as a
result of the sale of the tax shelter products. Moreover, the firm
made the sale of the tax shelter products a focal point of its
aggressive "value added" product promotion activities, using a "Tax
$ells" logo and other marketing hype to induce employees to generate
additional tax shelter sales.
According to the
information and the guilty plea, while serving as a manager of the
TSG, Dicker, along with other TSG partners, engaged in the design,
marketing, and implementation of two different tax shelter
transactions with the Chicago office of the law firm of Jenkens &
Gilchrist, as well as an international bank with its U.S.
headquarters in New York. As a member of TSG and the accounting
firm's tax opinion committee - which reviewed the tax opinions
issued in connection with tax shelter transactions sold by the
accounting firm and J&G - Dicker knew that the tax shelter
transactions he helped vet and sell would be respected and allowed
by the IRS only if the client had a substantial non-tax business
purpose for entering the transaction, and the client had a
reasonable possibility of making a profit through the transaction.
Dicker and his co-conspirators knew and understood that the clients
entering into the tax shelter transactions being marketed and sold
with J&G had neither a substantial non-tax business purpose nor a
reasonable possibility of earning a profit, given the large amount
of fees being charged by the accounting firm and J&G to enter the
transaction. Those fees were set by the co-conspirators as a
percentage of the tax loss being sought by the tax shelter clients.
Dicker also knew that the clients who purchased the tax shelter had
no non-tax business reasons for entering into the transactions and
their pre-planned steps.
According to the
information and the guilty plea, in order to make it appear that the
tax shelter clients of Dicker, other TSG members, and J&G had the
requisite business purpose and possibility of profit, Dicker and his
co-conspirators reviewed and approved the use of a legal opinion
letter issued by J&G that contained false and fraudulent
representations purportedly made by the clients about their
motivations for entering into the transactions. In addition, Dicker
and his co-conspirators created and used, or approved of the
creation and use of, other documents in the transactions that were
false, fraudulent, and misleading in order to paint a picture for
the IRS that was patently untrue - that is, that the clients had a
legitimate non-tax business purpose for entering the transaction and
executing the preplanned steps of the transaction. Dicker also
admitted during his plea that TSG members created and placed into
client files certain paperwork that falsely conveyed fabricated
business purposes and rationales for clients entering into the
shelters. The false paperwork was created to mislead and defraud the
IRS.
Continued
in article
Lurking in the shadows behind the public spotlight on
Andersen and Enron has been a criminal case against
BDO Seidman for failing to report that a client had
misappropriated investor funds. Legal steps this week follow a settlement
in April with a goal of removing all criminal charges against the firm.
http://www.accountingweb.com/item/84264/ee2eE47/3825
BDO Seidman snags guilty verdict National CPA firm BDO Seidman LLP has been found
grossly negligent by a Florida jury for failing to find fraud in an audit that
resulted in costing a Portuguese Bank $170 million. The verdict opens up the
opportunity for the bank to pursue punitive damages that could exceed $500
million.
"BDO Seidman snags guilty verdict," AccountingWeb, June 26, 2007 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=103667
From the CFO Journal's Morning Ledger on January 7, 2021
Watchdog Finds Deloitte
Failed to Challenge Autonomy’s Accounting
The
U.K. accounting watchdog on Wednesday said Deloitte LLP and two former partners were “culpable of
serious and serial failures” in their audits of Autonomy Corp., wrapping up a yearslong
investigationafter
findings of misconduct
From the CFO Journal's Morning Ledger on
March 1, 2018
Deloitte’s $150 million mortgage
headache
Accounting firm Deloitte
& Touche LLP agreed
Wednesday
to pay $149.5 million to settle U.S. Justice Department allegations that it
failed to head off a huge fraud at a mortgage company Taylor
Bean & Whitaker Mortgage Corp. that
collapsed during the financial crisis, writes the WSJ’s Michael Rapoport.
HONG KONG—Deloitte Touche Tohmatsu Ltd., the
auditor of Tianhe Chemicals Group Ltd., has resigned from auditing the
embattled Chinese chemicals firm.
Tianhe, which went public in Hong Kong in June of
last year in a US$748 million initial public offering, faced criticism a few
months later from the group Anonymous Analytics, which calls itself an
advocate for corporate transparency but doesn’t disclose who its members
are.
In September of last year, Anonymous Analytics
released a report alleging that Tianhe had kept two sets of financial books
-- one for investors and one for Chinese authorities -- and that the company
overstated sales of a chemical agent called anti-mar used in products such
as smartphones.
The activist group said it wouldn’t profit from the
report, although a disclaimer noted that, while it holds “no direct or
indirect interest” in Tianhe, its consultants, affiliates or clients may
have a short position in the stock.
Tianhe, the Hong Kong-listed company which counts
Morgan Stanley ’s private-equity arm among its investors, has repeatedly
denied the Anonymous allegations, calling them false and groundless. Morgan
Stanley was one of the lead banks on Tianhe’s IPO.
Spokespeople for Tianhe, Deloitte and Morgan
Stanley declined to comment.
Tianhe said late Thursday its board had on Tuesday
informed Deloitte it wouldn’t accept a draft report the auditor had
prepared, in which the auditor refrained from expressing an opinion on
Tianhe’s financials.
“In these circumstances, Deloitte is of the view
that, for all practical purposes, the audit has come to an end,” Tianhe
said, adding that Deloitte gave a formal notice of its resignation as
auditor to the board and the audit committee on Wednesday. Tianhe said it
will try to find a new auditor.
Trading in Tianhe’s shares has been halted at the
company’s request since March. Tianhe at the time said it needed more time
to provide further information to its auditors concerning its 2014 annual
results, which haven’t been released.
In August, Tianhe said in a filing to the Hong Kong
stock exchange that “there are three areas where the Auditor considers that
its concerns have not been fully addressed” and which were delaying the
publication of the 2014 results. Tianhe said in the filing its audit
committee had conducted an investigation into the issues cited by Deloitte.
In December 2011, the non-partisan organization
Public Campaign criticized CSC for spending $4.39 million on
lobbying and not paying any taxes during 2008–2010, instead getting
$305 million in tax rebates, despite making a profit of $1.67 billion.
In February 2011, the
SEC launched a fraud investigation into CSC’s accounting practices
in Denmark and Australian business. CSC's CFO Mike Mancuso confirmed
that accounting errors and intentional misconduct by certain personnel
in Australia prompted SEC regulators to turn their gaze to Australia.
Mancuso also stated that the alleged misconduct includes $19 million in
both intentional accounting irregularities and unintentional accounting
errors.
The company has been accused of breaching human rights by arranging
several illegal
rendition flights for the
CIA between 2003 and 2006, which also has led to criticism of
shareholders of the company, including the governments of Norway and
Britain.
The company has engaged in a high number of activities, that have
resulted in legal action against it. These are:
1) Millions of visas allowing foreigners to enter Britain are being
issued by them rather than British Diplomats.
2) As one of the Obamacare contractor hired by the Internal Revenue Service
to modernize its tax-filing system. They told the IRS it would meet a
January 2006 deadline, but failed to do so, leaving the IRS with no system
capable of detecting fraud. It failure to meet the delivery deadline for
developing an automated refund fraud detection system cost the IRS between
$200 million and $300 million.
The Securities and Exchange Commission on Friday
reached a $190 million settlement with Computer Sciences Corp. in connection
with accounting fraud charges against the information-technology services
provider.
The agency had reached a tentative settlement with
Computer Sciences worth the same amount in December, but recent media
reports suggested that infighting at the agency could result in a lower
fine.
The Wall Street Journal said this week that
Chairwoman Mary Jo White’s agenda at the SEC has been thwarted by bickering
among its five members, and the New York Times reported late last month that
divisions within the agency had disrupted the case against Computer
Sciences.
A representative from the SEC declined to comment,
and CSC neither admitted nor denied the findings.
According to the commission, CSC manipulated
financial results and concealed problems about the company’s largest
contract, with the U.K.’s National Health Service, on which it was set to
lose money on account of missed deadlines.
To avoid a resulting hit to its earnings, Robert
Sutcliffe, CSC’s finance director for the multibillion-dollar contract,
allegedly added items to CSC’s accounting models that artificially increased
its profits.
With then-Chief Executive Michael Laphen’s
approval, CSC continued to avoid the financial effect of its delays by
basing its models on contract amendments it was proposing to the NHS, and
that the NHS was rejecting, rather than on the actual contract, the SEC
said.
By basing its models on a negotiated contract
rather than the actual contract, CSC artificially avoided recording
significant reductions in its earnings in 2010 and 2011, according to the
SEC.
Continued in article
CSC 2014 Independent Auditors Report
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM
To the Board of Directors and Stockholders of
Computer Sciences Corporation
Falls Church, Virginia
We
have audited the accompanying consolidated balance sheets of Computer
Sciences Corporation and subsidiaries (the "Company") as of March 28, 2014
and March 29, 2013, and the related consolidated statements of operations,
comprehensive income (loss), cash flows, and changes in equity for each of
the three fiscal years in the period ended March 28, 2014. Our audits also
included the financial statement schedule listed in the Index at Item 15.
These financial statements and financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express
an opinion on the financial statements and financial statement schedule
based on our audits.
We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. W e believe that
our audits provide a reasonable basis for our opinion.
In
our opinion, such consolidated financial statements present fairly , in all
material respects, the financial position of Computer Sciences
Corporation and subsidiaries as of March 28, 2014 and March 29, 2013, and
the results of their operations and their cash flows for each of the three
fiscal years in the period ended March 28, 2014, in conformity with
accounting principles generally accepted in the United States of America.
Also, in our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly , in all material respects, the information set forth
therein.
We
have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the Company's internal control
over financial reporting as of March 28, 2014, based on the criteria
established in Internal Control - Integrated Framework (1992) issued by the
Committee of Sponsoring Organizations of the Treadway Commission and our
report dated May 22, 2014 expressed an unqualified opinion on the Company's
internal control over financial reporting.
/s/
DELOITTE & TOUCHE LLP
McLean, Virginia
May 22, 2014
Auditing: Paying More for Less
From the CFO Journal's Morning Ledger on June 3, 2015
PCAOB Inspections That Tend to Be Critical of Both Large and Small Auditing
Firms in the USA ---
http://pcaobus.org/Inspections/Pages/default.aspx
There are many complaints, but a common finding is that audit firms are too
eager to replace detail testing with dubious analytical reviews. Other complains
include such things as poor supervision of inexperienced auditors.
After a decade of regulating the audit of public
companies in the United States, only one thing is certain about the quality
of audits: that even today, nobody is quite sure how good audits actually
are.
The Public Company Accounting Oversight Board,
formed under the Sarbanes-Oxley Act, continues to adjust its approach to
regulating the audit profession, especially the method by which it inspects
audits to determine where problems exist that auditors need to fix. That has
sent auditors on an odyssey—especially in the last five years—to determine
what will satisfy regulators and the public. How can auditors deliver a
tough but fair audit at a cost that clients are willing to pay?
“If I’m sitting in Congress or at the Securities
and Exchange Commission and I want to see if the auditing profession is
getting better or worse, could I figure it out?” asks Joe Carcello,
executive director of the corporate governance center at the University of
Tennessee and a past member of.
The remainder of the article is for subscribers only (subscriptions are
very expensive to Compliance Week)
The Financial Reporting Council (FRC) has launched
a formal disciplinary complaint against Big Four firm Deloitte, as well as
partner John Clennett, and Hugh Bevan, the former financial director (FD) of
Aero Inventory
The complaint was issued in connection with the
2009 collapse of Aero Inventory plc and its subsidiary Aero Inventory UK.
The FRC alleges that Deloitte’s conduct, as well as
the conduct of the firm’s audit engagement partner (Clennett) and Aero
Inventory FD (Bevan), “fell significantly short” of expected standards.
The FRC complaint said the three parties – all of
whom are ICAEW members – had “failed to act in accordance with the
fundamental principles” of the ICAEW’s guide to professional ethics, and
code of ethics, as part of working with “professional competence and due
care”.
An independent tribunal will now be appointed to
hear the complaint, though a date has yet to be set.
Aero Inventory, a listed wholesaler of aircraft
parts, was placed in administration in November 2009, after suspending
shares when issues concerning the valuation of stock became apparent.
While Deloitte had audited the company’s accounts
for a number of years, the firm refused to sign off accounts in 2009, due to
a disagreement over stock valuations with Aero Inventory’s management.
In late 2014, Deloitte launched an appeal against a
record FRC fine of £14m, issued in connection with the firm’s role as
adviser to MG Rover Group, which collapsed in 2005. A decision has yet to be
reached on that appeal.
An Ontario judge has ordered Deloitte & Touche to
pay $33-million in interest payments to creditors of defunct theatre company
Livent Inc., bringing the auditing firm’s total payments in the long-running
negligence case to $118-million.
The interest payments were the final issue to be
determined by Ontario Superior Court Justice Arthur Gans in a lawsuit
between Livent’s lenders and Deloitte. He ruled in April that Deloitte must
pay $85-million in damages to creditors because auditors were negligent in
their review of Livent’s 1997 financial statements, but said at the time he
would hear further submissions on how to calculate interest on the payment.
An Ontario judge has awarded $85-million in damages
to the creditors of long-defunct theatre company Livent Inc., ruling the
firm’s auditors at Deloitte & Touche were negligent in their reviews of the
company’s 1997 financial statements.
The critical ruling, released late Friday, marks a
rare victory for creditors in a lawsuit against its auditors.
But my how times have
changed…the “Paper Tiger” has become “Tony
the Tiger,” and
that is
just grrrrreat!
What am I talking
about? Well, it has been a really bad month for the global
accounting firms (GAFS). First, Deloitte gained notoriety
by receiving one of the largest civil penalties ever imposed
by the Public Company Accounting Oversight Board (PCAOB).
In addition to a $2 million civil penalty, the PCAOB also
censured the firm for allowing former partner Christopher
Anderson to continue to “practice” while he was
suspended by the PCAOB. According
to the PCAOB:
Remember, this is the guy who
“violated PCAOB standards in auditing Navistar Financial
Corporation’s FY 2003 financial statements” and authorized
an unqualified opinion (page 3, PCAOB Release No.
105-2008-003).
And what makes this particularly
interesting is that Mr. Anderson had his CPA license
suspended by the Illinois Department of Financial &
Professional Regulation (see https://www.idfpr.com/LicenseLookUp/disc.asp)
beginning on June 30, 2009. The Wisconsin Department of
Regulation & Licensing also
suspended his license
for one year until November 1, 2009 (license expired
December 14, 2011). Michigan’s Department of Licensing and
Regulatory Affairs was much kinder to Anderson, only
fining him $500 (license
expired December 31, 2011). Isn’t
it amazing that none of these state regulatory agencies saw
fit to actually revoke his CPA license outright? And
despite all of this adverse regulatory action, Deloitte kept
Mr. Anderson on the payroll doing “audit related work”…I
wonder if they got $2 million worth of value?
Next, on November 6,
2013, the PCAOB took a bold and much needed step by creating
a
Center for Economic Analysis
“to study the role and relevance of
the audit in capital formation and investor protection.”
This move suggests a failure by the
Center for Audit Quality
(CAQ) to provide meaningful
or relevant research into improving audit quality. I am
shocked…you mean the GAFS’ blatant attempt to use the CAQ to
direct academic research away from real audit quality
problems has failed? Do you really believe that CAQ- (i.e.,
GAFS) funded research performed by accounting academics can
be unbiased? Not if you want to get more CAQ research
funding in the future!
Think I am being too
critical? Well, just take a look at the quality of the
“unbiased research” coming out the CAQ, specifically the
descriptive study titled
An Analysis of Alleged Auditor Deficiencies in SEC Fraud
Investigations: 1998-2010. If one
really wanted to analyze audit deficiencies with the goal of
improving audit quality, why would one restrict the sample
to 87 “old” cases of alleged fraudulent reporting reported
by the Securities and Exchange Commission (SEC), and ignore
more recent PCAOB disciplinary orders since 2005? And what
significant insights does this “research” yield? According
to a recent article by
Tammy Whitehouse,
the study suggests “that auditors faced SEC disciplinary
actions primarily related to audits of smaller companies.”
As for the study’s contribution, according to one of the
authors:
The implications? If the
multinationals aren’t the problem, then neither are the GAFS,
right? So, was this real research or a CAQ promotion? Now
you can see why the PCAOB’s new Center for Economic Analysis
is a terrific development. And it just has to irritate the
GAFS and CAQ. By the way, the
CAQ’s Newsroom
seems to have missed the PCAOB’s terrific news…I wonder why?
Then, on November 13th, PCAOB
Chairman James Doty took another giant step toward GAFS’
transparency and audit quality when he announced at the
PCAOB’s recent Standing Advisory Group meeting that it will
propose a rule on December 4th
requiring public companies to reveal the name of their lead
engagement audit partner as part of the annual reporting
process. Francine McKenna provides a compelling
argument as to why “we
deserve to know audit partner names.” As
Francine seems to suggest, would things have been different
had the GAFS’ partners been required to sign their audit
opinions? Maybe we should ask Linda McGowan (PwC, MF
Global), Chris Anderson (Deloitte, Navistar Financial
Corporation), Scott London (KPMG, Sketchers), or Jeffrey S.
Anderson (E&Y, Medicis)…
Finally, on Friday
November 22nd, the PCAOB again
publicly reprimanded Deloitte for
its failure to adequately address quality control problems
related to its audit practice by releasing the previously
nonpublic portions of the PCAOB’s April 16, 2009 inspection
report. And as usual, we see that this audit “emperor has
no clothes.” Is an audit being done in name only? The
PCAOB raised the following serious audit quality concerns in
its report (PCAOB Release No. 104-2009-051A):
Did Deloitte perform
appropriate procedures to audit significant estimates,
including evaluating the reasonableness of management's
assumptions and testing the data supporting the
estimates (page 10).
How appropriate was
Deloitte's approach in using the work of specialists and
data provided by service organizations when auditing
significant management estimates (page 11).
Specifically, the PCAOB raised questions about
Deloitte’s testing of controls and data, audit
documentation, etc.
Did Deloitte fail to
obtain sufficient competent evidential matter, at the
time it issued its audit report, to support its audit
opinions, specifically as it related to the exercise of
due care, professional skepticism, supervision and
review (page 12).
What’s really depressing
about the these audit quality problems, is that they were
almost exactly the same as those noted in the PCAOB’s
May 19, 2008
report (pages 12 through 16). Also, problematic is the
waning interest of the popular press in these PCAOB report
releases, suggesting that GAFS’ strategy to downplay and
even ignore the PCAOB just may be working.
SUMMARY: In London, Big Four accounting and auditing firm Deloitte
was fined 14 million pounds ($22 million) for "failing to manage conflicts
of interest in advice it gave to MG Rover Group...." London's Financial
Reporting Council alleged that Deloitte "failed to consider the public
interest in a series of transactions."
CLASSROOM APPLICATION: The article may be discussed in an ethics or
auditing class to discuss conflicts of interests in services provided by
public accounting firms.
QUESTIONS:
1. (Introductory) From the article and/or other outside sources,
describe the work for which Deloitte is accused of "failing to manage
conflicts of interest" and therefore violating the public interest in its
work.
2. (Introductory) What is the public interest? What are conflicts
of interest?
3. (Advanced) Why do accounting firms have a duty to consider the
public interest in the work they do?
4. (Advanced) What self-regulatory mechanisms are used by the
public accounting profession to ensure this obligation is upheld?
Reviewed By: Judy Beckman, University of Rhode Island
Accountancy firm Deloitte was fined £14 million
($22 million) on Monday for failing to manage conflicts of interest in
advice it gave to MG Rover Group and its owners before the British auto
maker entered administration in 2005.
A tribunal handed down the fine after upholding 13
allegations made by regulatory body the Financial Reporting Council against
Deloitte and one of its former partners, Maghsoud Einollahi The FRC's
allegations centered around Deloitte's failure to consider the public
interest in a series of transactions between the auto maker, its owners and
associated companies, and to address the potential conflicts of interest
between the parties.
A Deloitte spokeswoman said the firm is
disappointed with the outcome and disagrees with the tribunal's main
conclusions. It has 28 days to appeal the decision but the spokeswoman
declined to comment on whether it would take action.
The tribunal also issued "a severe reprimand" to
Deloitte, and presented Mr. Einollahi with a £250,000 fine and three-year
ban from working in the profession. A spokesman at Freshfields, the law firm
representing Deloitte and Mr. Einollahi, declined to comment.
The FRC said the tribunal's decision should "send a
strong and clear message to all members of the accountancy profession about
their responsibility to act in the public interest and comply with their
code of ethics."
MG Rover collapsed in 2005, five years after a
group of four businessmen bought the loss-making auto maker for £10.
Deloitte was auditor for MG Rover while also acting as corporate finance
adviser to companies controlled by or affiliated with the businessmen.
The fine came as Deloitte and other auditing firms
face pressure from regulators to sharpen their standards and act with
greater independence in questioning clients' activities.
SUMMARY: In London, Big Four accounting and auditing firm Deloitte
was fined 14 million pounds ($22 million) for "failing to manage conflicts
of interest in advice it gave to MG Rover Group...." London's Financial
Reporting Council alleged that Deloitte "failed to consider the public
interest in a series of transactions."
CLASSROOM APPLICATION: The article may be discussed in an ethics or
auditing class to discuss conflicts of interests in services provided by
public accounting firms.
QUESTIONS:
1. (Introductory) From the article and/or other outside sources,
describe the work for which Deloitte is accused of "failing to manage
conflicts of interest" and therefore violating the public interest in its
work.
2. (Introductory) What is the public interest? What are conflicts
of interest?
3. (Advanced) Why do accounting firms have a duty to consider the
public interest in the work they do?
4. (Advanced) What self-regulatory mechanisms are used by the
public accounting profession to ensure this obligation is upheld?
Reviewed By: Judy Beckman, University of Rhode Island
Accountancy firm Deloitte was fined £14 million
($22 million) on Monday for failing to manage conflicts of interest in
advice it gave to MG Rover Group and its owners before the British auto
maker entered administration in 2005.
A tribunal handed down the fine after upholding 13
allegations made by regulatory body the Financial Reporting Council against
Deloitte and one of its former partners, Maghsoud Einollahi The FRC's
allegations centered around Deloitte's failure to consider the public
interest in a series of transactions between the auto maker, its owners and
associated companies, and to address the potential conflicts of interest
between the parties.
A Deloitte spokeswoman said the firm is
disappointed with the outcome and disagrees with the tribunal's main
conclusions. It has 28 days to appeal the decision but the spokeswoman
declined to comment on whether it would take action.
The tribunal also issued "a severe reprimand" to
Deloitte, and presented Mr. Einollahi with a £250,000 fine and three-year
ban from working in the profession. A spokesman at Freshfields, the law firm
representing Deloitte and Mr. Einollahi, declined to comment.
The FRC said the tribunal's decision should "send a
strong and clear message to all members of the accountancy profession about
their responsibility to act in the public interest and comply with their
code of ethics."
MG Rover collapsed in 2005, five years after a
group of four businessmen bought the loss-making auto maker for £10.
Deloitte was auditor for MG Rover while also acting as corporate finance
adviser to companies controlled by or affiliated with the businessmen.
The fine came as Deloitte and other auditing firms
face pressure from regulators to sharpen their standards and act with
greater independence in questioning clients' activities.
Deloitte & Touche LLP on Monday dodged claims that
it allowed insiders at USA Commercial Mortgage Co. to steal from the
now-bankrupt mortgage company and defraud investors when the Ninth Circuit
affirmed a lower court ruling for the auditing giant.
A three-judge panel affirmed a summary judgment
ruling for the mortgage company’s erstwhile external auditor, ruling that
the lower court was correct to file that under the Nevada’s so-called sole
actor rule, only the mortgage company is at fault for the fraud of its
owners CEO...
The full articles from Law360 are not free (except for a free trial)
Francine wishing that the courts would
bring Deloitte to its knees (litigation, Bear Sterns, JP Morgan, audit,
auditing, Deloitte, lawsuits, Independence, Litigation, PCAOB)
Hewlett-Packard said on Tuesday that it had taken
an $8.8 billion accounting charge, after discovering “serious accounting
improprieties” and “outright misrepresentations” at Autonomy, a British
software maker that it bought for $10 billion last year.
It is a major setback for H.P., which has been
struggling to turn around its operations and remake its business.
The charge essentially wiped out its profit. In the
latest quarter, H.P. reported a net loss of $6.9 billion, compared with a
$200 million profit in the period a year earlier. The company said the
improprieties and misrepresentations took place just before the acquisition,
and accounted for the majority of the charges in the quarter, more than $5
billion.
Shares in H.P. plummeted nearly 11 percent in early
afternoon trading on Tuesday, to less than $12.
Hewlett-Packard bought Autonomy in the summer of
2011 in an attempt to bolster its presence in the enterprise software market
and catch up with rivals like I.B.M. The takeover was the brainchild of Léo
Apotheker, H.P.’s chief executive at the time, and was criticized within
Silicon Valley as a hugely expensive blunder.
Mr. Apotheker resigned a month later. The
management shake-up came about one year after Mark Hurd was forced to step
down as the head of H.P. after questions were raised about his relationship
with a female contract employee.
“I’m both stunned and disappointed to learn of
Autonomy’s alleged accounting improprieties,” Mr. Apotheker said in a
statement. “The developments are a shock to the many who believed in the
company, myself included. ”
Since then, H.P. has tried to revive the company
and to move past the controversies. Last year, Meg Whitman, a former head of
eBay, took over as chief executive and began rethinking the product lineup
and global marketing strategy.
But the efforts have been slow to take hold.
In the previous fiscal quarter, the company
announced that it would take an $8 billion charge related to its 2008
acquisition of Electronic Data Systems, as well as added costs related to
layoffs. Then Ms. Whitman told Wall Street analysts in October that revenue
and profit would be significantly lower, adding that it would take several
years to complete a turnaround.
“We have much more work to do,” Ms. Whitman said at
the time.
Hewlett-Packard continues to face weakness in its
core businesses. Revenue for the full fiscal year dropped 5 percent, to
$120.4 billion, with the personal computer, printing, enterprise and service
businesses all losing ground. Earnings dropped 23 percent, to $8 billion,
over the same period.
“As we discussed during our securities analyst
meeting last month, fiscal 2012 was the first year in a multiyear journey to
turn H.P. around,” Ms. Whitman said in a statement. “We’re starting to see
progress in key areas, such as new product releases and customer wins.”
The strategic troubles have weighed on the stock.
Shares of H.P. have dropped to less than $12 from nearly $30 at their high
this year.
The latest developments could present another
setback for Ms. Whitman’s efforts.
When the company assessed Autonomy before the
acquisitions, the financial results appeared to pass muster. Ms. Whitman
said H.P.’s board at the time – which remains the same now, except for the
addition of the activist investor Ralph V. Whitworth – relied on Deloitte’s
auditing of Autonomy’s financial statements. As part of the due diligence
process for the deal, H.P. also hired KPMG to audit Deloitte’s work.
Neither Deloitte nor KPMG caught the accounting
discrepancies. Deloitte said in a statement that it could not comment on the
matter, citing client confidentiality. “We will cooperate with the relevant
authorities with any investigations into these allegations,” the accounting
firm said.
Hewlett-Packard said it first began looking into
potential accounting problems in the spring, after a senior Autonomy
executive came forward. H.P. then hired a third-party forensic accounting
firm, PricewaterhouseCoopers, to conduct an investigation covering Autonomy
sales between the third quarter 2009 and the second quarter 2011, just
before the acquisition.
The company said it discovered several accounting
irregularities, which disguised Autonomy’s actual costs and the nature of
the its products. Autonomy makes software that finds patterns, data that is
used by companies and governments.
H.P. said that Autonomy, in some instances, sold
hardware like servers, which has higher associated costs. But the company
booked these as software sales. It had the effect of underplaying the
company’s expenses and inflating the margins.
“They used low-end hardware sales, but put out that
it was a pure software company,” said John Schultz, the general counsel of
H.P. Computer hardware typically has a much smaller profit margin than
software. “They put this into their growth calculation.”
An H.P. official, who spoke on background because
of ongoing inquiries by regulators, said the hardware was sold at a 10
percent loss. The loss was disguised as a marketing expense, and the amount
registered as a marketing expense appeared to increase over time, the
official said.
H.P. also contends that Autonomy relied on
value-added resellers, middlemen who sold software on behalf of the company.
Those middlemen reported sales to customers that didn’t actually exist,
according to H.P.
H.P. also claims that that Autonomy was taking
licensing revenue upfront, before receiving the money. That improper
assignment of sales inflated the company’s gross profit margins.pfront,
before receiving the money. It had the effect, the company said, of
significantly bolstering Autonomy’s gross margin.
INDEPENDENT AUDITOR’S REPORT TO THE MEMBERS OF
AUTONOMY CORPORATION PLC
"Analysts Had Questioned Autonomy’s Accounting Years Ago," by Holly
Ellyatt and Deepanshu Bagchee, CNBC, November 21, 2012 ---
http://www.cnbc.com/id/49914072
Hewlett Packard’s surprising announcement of
accounting irregularities at Autonomy caught the market by surprise on
Tuesday and led to a nearly 12 percent decline in the company’s stock. But
Autonomy’s accounting had been questioned by analysts years ago.
Paul Morland, technology research analyst at
broking and advisory house Peel Hunt, told CNBC that he had noticed three
red flags in Autonomy’s accounts in the years leading up to the HP [HPQ
11.71 ] acquisition: poor cash conversion, an inflated organic growth rate,
and the categorizing of hardware sales as software.
Indeed, Morland said that in the six reports he had
produced since 2008 in which he had mentioned Autonomy, the U.K.-based maker
of data analysis software, he had mostly recommended selling the stock.
“There were periods when I wasn’t a seller,” he
told CNBC on Wednesday, saying that his work as an analyst meant he had to
be mindful of what the share price was discounting at the particular time of
analysis — but his opinion changed in 2008.
“Sometime in 2009, I began to find out about the
things we’ve been talking about and I moved towards a more negative stance.
… I had a ‘sell’ recommendation on the stock for most of the three years
leading up to the deal.”
HP Chief Executive Meg Whitman, who was a director
at the company at the time of the deal, said the board had relied on
accounting firm Deloitte for vetting Autonomy's financials and that KPMG was
subsequently hired to audit Deloitte.
HP had many other advisers as well: boutique
investment bank Perella Weinberg Partners to serve as its lead adviser,
along with Barclays. Banking advisers on both sides of the deal were paid
$68.8 million, according to data from Thomson Reuters/Freeman Consulting.
Barclays pocketed the biggest banker fee of the
transaction at $18.1 million and Perella was paid $12 million. The company's
legal advisers included Gibson, Dunn & Crutcher; Freshfields Bruckhaus
Deringer; Drinker Biddle & Reath; and Skadden, Arps, Slate, Meagher & Flom,
which advised the board.
On Autonomy's side of the table were
Frank Quattrone's
Qatalyst Partners, which specializes in tech deals and which picked up $11.6
million.
UBS, Goldman Sachs, Citigroup, JPMorgan Chase and
Bank of America were also advising Autonomy and were paid $5.4 million each.
Slaughter & May and Morgan Lewis served as the company's legal advisers.
Continued in article
Jensen Question Where have AECMers encountered the name "Frank Quattrone" in the past?
When Autonomy Corp. was starting up in this
historic university town, founder Mike Lynch stuck a sign on an office door
that read "Authorized Personnel Only." Behind the door, he told visitors,
were 500 engineers working on "hush-hush" projects.
The door, in fact, led to a broom closet, Mr. Lynch
recounted in a 2010 speech. By then, Autonomy had grown from its founding in
1996 to one of Europe's largest and fastest-growing software companies.
Hewlett-Packard Co. HPQ +2.35% bought it in October 2011 for more than $11
billion.
Now, following allegations last week by H-P that
Autonomy made "outright misrepresentations" to inflate its financial
results, U.S. authorities are trying to establish whether much of the
company's business may also have been a facade. Meanwhile, questions are
mounting about how H-P failed to uncover the alleged irregularities ahead of
buying Autonomy, particularly as some outside analysts raised concerns about
Autonomy's accounting for years.
In May, H-P fired Mr. Lynch, citing poor
performance by his unit. Last week, the company wrote down the value of
Autonomy by $8.8 billion, blaming more than half the charge on what it said
was Autonomy's misleading accounting.
Mr. Lynch has come out swinging, denouncing H-P's
assertions as "completely and utterly wrong." In an interview Monday, he
defended Autonomy's practices and said that many of the allegations stem
from the difference between U.S. accounting standards and the international
ones Autonomy followed. He said it mostly amounted to "a lot of nitty-gritty
about small amounts of revenue on certain deals." He said every sale valued
at more than $100,000 would have been reviewed by Autonomy's auditors.
"H-P made a series of assertions without providing
any evidence. We'd like to see some evidence," Mr. Lynch said. "Where's the
beef in this?" he added.
Interviews in California and England with former
Autonomy employees, business partners and attorneys close to the case paint
a picture of a hard-driving sales culture shaped by Mr. Lynch's desire for
rapid growth. They describe him as a domineering figure, who on at least a
few occasions berated employees he believed weren't measuring up.
Along the way, these people say, Autonomy used
aggressive accounting practices to make sure revenue from software licensing
kept growing—thereby boosting the British company's valuation. The firm
recognized revenue upfront that under U.S. accounting rules would have been
deferred, and struck "round-trip transactions"—deals where Autonomy agreed
to buy a client's products or services while at the same time the client
purchased Autonomy software, according to these people.
"The rules aren't that complicated," said Dan
Mahoney of accounting research business CFRA, who covered Autonomy until it
was acquired. He said that Autonomy had the hallmarks of a company that
recognized revenue too aggressively. He said neither U.S. nor international
accounting rules would allow companies to recognize not-yet collected
revenue from customers that might be at risk not to pay, which he said
appears to be the case in some of Autonomy's transactions.
A person familiar with H-P's investigation said the
company is confident the deals are improper even under the international
accounting standards Mr. Lynch cites. "We've looked at this very closely,"
this person said.
In a statement issued Saturday, H-P said its
"ongoing investigation into the activities of certain former Autonomy
employees has uncovered numerous transactions clearly designed to inflate
the underlying financial metrics of the company before its acquisition"
including several using the tactics and techniques described in this
article.
Autonomy's practices are being reviewed at H-P's
urging by the U.S. Securities and Exchange Commission and the Federal Bureau
of Investigation. Meg Whitman, H-P's CEO, said she expects the process will
prompt a "multiyear journey through the courts" in both the U.S. and the
U.K.
On Monday, Mr. Lynch said he hasn't been formally
notified of any lawsuits or investigations.
Mr. Lynch was raised in England, the son of a
firefighter. He went on to study engineering at Cambridge University and
obtain a Ph.D. in mathematical computing.
Autonomy, founded at a startup incubator in
Cambridge, developed a computer program to sift through documents, Web
pages, presentations, videos, phone conversations and emails. The technology
could understand words' meanings and find data accordingly, Mr. Lynch has
said. A search within a company's servers for "profanity," for instance,
would turn up results featuring a variety of swear words, not just the term
itself.
Dow Jones & Co., publisher of The Wall Street
Journal, has used Autonomy's search software on its consumer websites.
Mr. Lynch was as effective at selling and marketing
as he was at software development, recall former employees, customers and
business partners. "It was a very sales-oriented culture with a very
business-savvy CEO," contrary to the norm in Cambridge, says Simon
Galbraith, the founder and CEO of Red Gate Software Ltd., which is based
across the street from Autonomy.
Mr. Lynch named Autonomy's conference rooms after
references from James Bond movies—one of the big ones was called "GoldenEye"—and
found ways to mention the spy in speeches or presentations. He drove an
Aston Martin, a quintessential Bond car.
In another touch worthy of Ian Fleming, Autonomy
stocked piranhas for a while in the office fish tank. At times, Autonomy's
culture was combative as a Bond movie and at other times demeaning, former
employees say.
One former marketing employee was sent outside the
Cambridge office to collect cigarette butts from the ground, according to
two people familiar with the incident. Another former marketing employee
recalled being asked to buy Sushovan Hussain, Autonomy's finance chief,
underwear during a company trip to Miami, because he had failed to pack a
sufficient supply. Turnover on the sales and marketing staffs was high. A
spokeswoman for Mr. Hussain acknowledged the incident had happened, but said
the CFO was simply late for a meeting and had lost his luggage.
On Monday, Mr. Lynch said many people thrived on
Autonomy's aggressive atmosphere, while others did not.
According to legal filings and former employees,
senior members of Autonomy's management sometimes would swoop in at the last
minute and complete deals—an arrangement that, in some cases, cut
salespeople's commissions and in other cases allowed the senior executives
to negotiate other arrangements with clients.
A spokeswoman for Mr. Lynch said the deal-making
didn't result in cut commissions.
At times, Autonomy salespeople appeared to close
deals by offering to buy customers' products. In July 2009, Autonomy sold $9
million in software to New York-based data provider VMS Information,
according to ex-VMS Chief Executive Peter Wengryn and three former Autonomy
employees. At the same time, Autonomy agreed to buy about $13 million worth
of licenses for data from VMS, say Mr. Wengryn and the ex-Autonomy
employees.
The story was first told to me late last year, and
like a lot of stories of financial impropriety inside a huge company, it was
almost impossible to nail down. Hewlett-Packard‘s Autonomy division, my
source told me, was vaporware writ large: An $11 billion software company
with an overhyped flagship product that was literally being given away
because customers didn’t have a use for it.
Today, Meg Whitman admitted as much. H-P announced
it was writing off 80% of the purchase price for Autonomy and accused “some
former members of Autonomy’s management team” of using “accounting
improprieties, misrepresentations and disclosure failures” to hide the
software company’s true performance and value.
In the release, H-P identified one of the oldest
accounting tricks in the book, a variation on the one “Chainsaw Al” Dunlap
used to accelerate revenue at Sunbeam — by getting customers to “buy”
products now, under terms that really just borrowed from the future.
I spoke to my source again this morning and he
detailed what he saw at H-P, from his position deep within the
300,000-employee company.
“What I saw was exactly what Meg Whitman wrote in
her internal memo to employees,” my source said. “There was really sketchy
accounting going on.”
Autonomy was founded as Cambridge Neurodynamics in
1991 by Michael Lynch, a Cambridge-educated computer scientist, according to
this flattering profile by the Guardian after he left H-P in May. The
company was based on the then-hot concept of Bayesian search, named after
18th-century mathematician Thomas Bayes, and ultimately developed an
all-encompassing software package it called IDOL — Intelligent Data
Operating Layer.
H-P today said it stands behind IDOL and well it
should. Otherwise it would have to write off the entire $11 billion it paid
for Autonomy last year. But my source doesn’t think much of the product,
which is supposed to find all of a company’s data, wherever it resides, and
whether or not it can be identified by specific words. (Typical example:
Finding documents that contain the phrase “flightless bird” when you’re
looking for “penguin.”)
“It’s the primary smoke and mirrors that Autonomy
has used to make people think they’ve got something very impressive,” he
told me. “It’s a fancy search engine.”
I attempted to reach Lynch this morning,
unsuccessfully. His spokeswoman told Reuters he is still reviewing H-P’s
allegations. H-P said it has referred the information it uncovered in a
forensic accounting to fraud officials in the U.S. and the U.K.
Here’s what my source observed personally. Autonomy
grew through acquisitions, buying everything from storage companies like
Iron Mountain to enterprise software firms like Interwoven. They’d then go
to customers and offer them a deal they couldn’t refuse. Say a customer had
$5 million and four years left on a data-storage contract, or “disk,” in the
trade. Autonomy would offer them, say, the same amount of storage for $4
million but structure it as a $3 million purchase of IDOL software, paid for
up front, and $1 million worth of disk. The software sales dropped to the
bottom line and burnished Autonomy’s reputation for being a fast-growing,
cutting-edge software company a la Oracle, while the revenue actually came
from the low-margin, commodity storage business.
“They would basically give them software for free
but shift the costs around to make it look like they got $3 million in
software sales,” said my source, who directly observed such deals.
Lynch’s management team also was practiced at the
art of wringing attractive-looking growth out of a string of ho-hum
acquisitions. The typical strategy was to bolt IDOL and other software onto
a company’s existing products and try and convince customers to pay more for
the “new” products. If that failed, they’d milk the existing customer base
by halting development and outsourcing support, my source says, using the
cash from the runoff business to fund more acquisitions.
“Mike Lynch was famous for saying Autonomy never
put an end of life on any product,” said my source. “But the customers were
screaming.”
Now, my source has never been a Mike Lynch fan. In
sales meetings, he says, Lynch “loved to do vague and theoretical
academic-type presentations to show what a visionary he was.”
And Autonomy may have some powerful features my
source didn’t appreciate. The Defense Department reportedly is a customer.
But from his perch within the company, it looked like a lot of vaporware
wrapped up in fancy Cambridge talk and the kind of accounting tricks
managers have engaged in since the dawn of publicly traded stock.
With its announcement today, H-P seems to agree.
The company accused former managers of “a willful effort” “to inflate the
underlying financial metrics of the company in order to mislead investors
and potential buyers. These misrepresentations and lack of disclosure
severely impacted HP management’s ability to fairly value Autonomy at the
time of the deal.”
Calling customers wouldn’t necessarily have
uncovered the problem, my source says.
“I think these companies are embarrassed to admit
they spent $10 million on software that doesn’t actually work,” he said.
Question
When bidding for Autonomy was HP as naive as many of the buyers on eBay?
The dubious title of worst corporate deal ever had
seemed to be held in perpetuity by AOL’s acquisition of Time Warner in 2000,
a deal that came to define the folly of the Internet bubble. It destroyed
shareholder value, ended careers and nearly capsized the surviving AOL Time
Warner.
¶ The deal was considered so bad, and such an
object lesson for a generation of deal makers and corporate executives, that
it seemed likely never to be repeated, rivaled or surpassed.
¶ Until now.
¶ Hewlett-Packard’s acquisition last year of the
British software maker Autonomy for $11.1 billion “may be worse than Time
Warner,” Toni Sacconaghi, the respected technology analyst at Sanford C.
Bernstein, told me, a view that was echoed this week by several H.P.
analysts, rivals and disgruntled investors.
¶ Last week, H.P. stunned investors still reeling
from more than a year of management upheavals, corporate blunders and
disappointing earnings when it said it was writing down $8.8 billion of its
acquisition of Autonomy, in effect admitting that it had overpaid by an
astonishing 79 percent.
¶ And it attributed more than $5 billion of the
write-off to what it called a “willful effort on behalf of certain former
Autonomy employees to inflate the underlying financial metrics of the
company in order to mislead investors and potential buyers,” adding, “These
misrepresentations and lack of disclosure severely impacted H.P.
management’s ability to fairly value Autonomy at the time of the deal.”
¶ In an unusually aggressive public relations
counterattack, Autonomy’s founder, Michael Lynch, a Cambridge-educated
Ph.D., has denied the charges and accused Hewlett-Packard of mismanaging the
acquisition. H.P. asked Mr. Lynch to step aside last May after Autonomy’s
results fell far short of expectations.
¶ But others say the issue of fraud, while it may
offer a face-saving excuse for at least some of H.P.’s huge write-down,
shouldn’t obscure the fact that the deal was wildly overpriced from the
outset, that at least some people at Hewlett-Packard recognized that, and
that H.P.’s chairman, Ray Lane, and the board that approved the deal should
be held accountable.
¶ A Hewlett-Packard spokesman said in a statement:
“H.P.’s board of directors, like H.P. management and deal team, had no
reason to believe that Autonomy’s audited financial statements were
inaccurate and that its financial performance was materially overstated. It
goes without saying that they are disappointed that much of the information
they relied upon appears to have been manipulated or inaccurate.”
¶ It’s true that H.P. directors and management
can’t be blamed for a fraud that eluded teams of bankers and accountants, if
that’s what it turns out to be. But the huge write-down and the
disappointing results at Autonomy, combined with other missteps, have
contributed to the widespread perception that H.P., once one of the
country’s most admired companies, has lost its way.
¶ Hewlett-Packard announced the acquisition of
Autonomy, which focuses on so-called intelligent search and data analysis,
on Aug. 18, 2011, along with its decision to abandon its tablet computer and
consider getting out of the personal computer business. H.P. didn’t stress
the price — $11.1 billion, or an eye-popping multiple of 12.6 times
Autonomy’s 2010 revenue — but focused on Autonomy’s potential to transform
H.P. from a low-margin producer of printers, PCs and other hardware into a
high-margin, cutting-edge software company. “Together with Autonomy we plan
to reinvent how both structured and unstructured data is processed,
analyzed, optimized, automated and protected,” Léo Apotheker, H.P.’s chief
executive at the time, proclaimed.
¶ The deal was considered so bad, and such an
object lesson for a generation of deal makers and corporate executives, that
it seemed likely never to be repeated, rivaled or surpassed.
¶ Until now.
¶ Hewlett-Packard’s acquisition last year of the
British software maker Autonomy for $11.1 billion “may be worse than Time
Warner,” Toni Sacconaghi, the respected technology analyst at Sanford C.
Bernstein, told me, a view that was echoed this week by several H.P.
analysts, rivals and disgruntled investors.
¶ Last week, H.P. stunned investors still reeling
from more than a year of management upheavals, corporate blunders and
disappointing earnings when it said it was writing down $8.8 billion of its
acquisition of Autonomy, in effect admitting that it had overpaid by an
astonishing 79 percent.
¶ And it attributed more than $5 billion of the
write-off to what it called a “willful effort on behalf of certain former
Autonomy employees to inflate the underlying financial metrics of the
company in order to mislead investors and potential buyers,” adding, “These
misrepresentations and lack of disclosure severely impacted H.P.
management’s ability to fairly value Autonomy at the time of the deal.”
¶ In an unusually aggressive public relations
counterattack, Autonomy’s founder, Michael Lynch, a Cambridge-educated
Ph.D., has denied the charges and accused Hewlett-Packard of mismanaging the
acquisition. H.P. asked Mr. Lynch to step aside last May after Autonomy’s
results fell far short of expectations.
¶ But others say the issue of fraud, while it may
offer a face-saving excuse for at least some of H.P.’s huge write-down,
shouldn’t obscure the fact that the deal was wildly overpriced from the
outset, that at least some people at Hewlett-Packard recognized that, and
that H.P.’s chairman, Ray Lane, and the board that approved the deal should
be held accountable.
¶ A Hewlett-Packard spokesman said in a statement:
“H.P.’s board of directors, like H.P. management and deal team, had no
reason to believe that Autonomy’s audited financial statements were
inaccurate and that its financial performance was materially overstated. It
goes without saying that they are disappointed that much of the information
they relied upon appears to have been manipulated or inaccurate.”
¶ It’s true that H.P. directors and management
can’t be blamed for a fraud that eluded teams of bankers and accountants, if
that’s what it turns out to be. But the huge write-down and the
disappointing results at Autonomy, combined with other missteps, have
contributed to the widespread perception that H.P., once one of the
country’s most admired companies, has lost its way.
¶ Hewlett-Packard announced the acquisition of
Autonomy, which focuses on so-called intelligent search and data analysis,
on Aug. 18, 2011, along with its decision to abandon its tablet computer and
consider getting out of the personal computer business. H.P. didn’t stress
the price — $11.1 billion, or an eye-popping multiple of 12.6 times
Autonomy’s 2010 revenue — but focused on Autonomy’s potential to transform
H.P. from a low-margin producer of printers, PCs and other hardware into a
high-margin, cutting-edge software company. “Together with Autonomy we plan
to reinvent how both structured and unstructured data is processed,
analyzed, optimized, automated and protected,” Léo Apotheker, H.P.’s chief
executive at the time, proclaimed.
¶Autonomy had already been shopped by investment
bankers by the time H.P. took the bait. But others who examined the data
couldn’t come anywhere near the price that Autonomy was seeking. An
executive at a rival software maker, Oracle, a company with many successful
software acquisitions under its belt, told me: “We looked at Autonomy. After
doing the math, we couldn’t make it work. We couldn’t figure out where the
numbers came from. And taking the numbers at face value, even at $6 billion
it was overvalued.” He didn’t want to be named because he was criticizing a
competitor.
A former Autonomy executive laughed this week when
I asked if even Autonomy executives thought H.P. had overpaid. “Let’s put it
this way,” this person said. “H.P. paid a very full price. It was certainly
our duty to our shareholders to say yes.” (Former Autonomy executives
declined to be named because of the continuing investigation.)
Wall Street’s reaction to Hewlett-Packard’s
announcement was swift and harsh. Mr. Sacconaghi wrote, “We see the decision
to purchase Autonomy as value-destroying.” Richard Kugele, an analyst at
Needham & Company, wrote “H.P. may have eroded what remained of Wall
Street’s confidence in the company and its strategy” with “the seemingly
overly expensive acquisition of Autonomy (cue the irony) for over $10B.”
¶ Mr. Apotheker addressed the issue two days later,
at a Deutsche Bank technology conference. “We have a pretty rigorous process
inside H.P. that we follow for all our acquisitions, which is a D.C.F.-based
model,” he said, in a reference to discounted cash flow, a standard
valuation methodology. “And we try to take a very conservative view.”
¶ He added, “Just to make sure everybody
understands, Autonomy will be, on Day 1, accretive to H.P.,” meaning it
would add to earnings. “Just take it from us. We did that analysis at great
length, in great detail, and we feel that we paid a very fair price for
Autonomy. And it will give a great return to our shareholders.”
Mike Lynch says Hewlett-Packard has a problem with
math. The founder and former CEO of the British software firm Autonomy says
that at least some of the $5 billion written off by Hewlett-Packard earlier
this week can be attributed to differences in international accounting
standards.
In an interview with Reuters, Lynch, who was
dismissed from running Autonomy by HP CEO Meg Whitman in May, says he’s gone
through the books of his former firm and has found that differences between
the accounting standards observed in the U.S. and in the United Kingdom can
account for at least some of the differences in how things are interpreted.
Lynch made similar comments in an interview with
AllThingsD Tuesday, though he hasn’t sought to put any numbers behind the
contention.
Like most U.S.-based companies, HP followed GAAP,
the Generally Accepted Accounting Principles put out by the U.S.-based
non-profit Financial Accounting Standards Board (FASB). As a U.K. company,
Autonomy had adhered instead to the International Financial Reporting
Standards (IFRS) maintained by the International Accounting Standards
Committee.
Lynch has maintained that differences in how
revenue is recognized under the two systems leave a lot of room for
interpretation in some of the matters in which he and his senior managers
stand accused. One relates to licensing revenue. When a company bundles the
cost of a software license, service and support into a single ongoing
contract, GAAP accounting rules are more strict than IFRS rules in how the
payments are accounted.
Answering one of the big accusations by HP, Lynch
acknowledged that, at least some of the time, Autonomy did sell desktop
machines with Autonomy software installed at a slight loss. In those cases,
the customer would agree to help Autonomy market its product and, in those
cases, the losses were recorded as marketing expenses. HP says that these
improperly recorded hardware sales inflated Autonomy’s revenue by as much as
10 percent to 15 percent prior to its acquisition by HP.
Another difference:Cases where Autonomy would sell
its software through 400 middleman companies known as Value Added Resellers
(VAR), who turn around and sell the software as part of larger package
deals. In Autonomy’s case, some of those VARs included both IBM and India’s
Wipro. Under IFRS rules, a sale to a VAR can be booked as revenue before the
resale takes place. Under GAAP, it’s not revenue to Autonomy until the
resale takes place.
Lynch has also said that once HP took over at
Autonomy, its own practices and bureaucracy slowed things down. Salespeople
were paid commissions to sell products that compete with Autonomy, he said,
but not for selling Autonomy products. On top of that, he accused HP of
jacking up prices on the Autonomy software by 30 percent, driving loyal
customers away.
He also said in numerous interviews that HP had
“ambushed” him with all this, and that he had no idea what was coming.
That’s not quite true, according to sources in HP’s camp, who say that the
company had a conversation with him in mid-June, after a former member of
Lynch’s senior management team is said to have come forward as a
whistleblower. “He has been aware since then that we had questions about all
of this,” one source told me. HP execs considered his answers to their
questions to be “not satisfactory at all.”
At that point, I’m told, communications between HP
and Lynch and other former Autonomy executives ended. After CEO Meg Whitman
hinted, in remarks at an analysts meeting in San Francisco in October, that
more restatements might be coming, certain former Autonomy executives
started calling around to friends and former colleagues still working for
HP, trying to find out what was coming. They had reason to expect a sizable
impairment charge. What has apparently caught Lynch, et al, by surprise, is
the referral to the authorities in the U.S. and the U.K. for possible
criminal investigation. In the U.S., the FBI is said to be taking the lead.
One observation: Lynch tells Reuters he hasn’t yet
lawyered up, which, if he hadn’t said it, would be pretty obvious anyway.
Any lawyer worth their fee would have advised Lynch to stop talking publicly
about all of this.
But that’s not how the Big Four audit industry game
is played now that
consulting is again King. What Deloitte would lose
in audit fees – reportedly £5.422m for Autonomy’s audits during the last
four years – the firm could now openly replace with guilt-free consulting.
According to filings, Deloitte earned an additional
£4.44m from Autonomy in the last four years for services such as tax
compliance, due diligence for acquisitions and other services “pursuant to
legislation”. As the preeminent Big Four tax services provider, HP’s auditor
Ernst & Young, HP’s auditor, would likely start doing everything tax related
for Autonomy. However, Deloitte was now free to team with Autonomy and all
of its technology products as an alliance partner for systems integration
engagements. That could be worth billions in consulting revenue that
Deloitte’s UK firm, at least, had given up to be the auditor of a fast
growing, highly acquisitive technology
“Fast 50” firm.
There are differences in the legislation enacted to
restore confidence in audits by the United States after Arthur Andersen’s
Enron piggishness – Sarbanes-Oxley – and the regulations that govern UK
listed companies and their auditors. For example, the UK does not bar an
auditor from also providing internal audit services to a company it audits.
Regulations in the US and UK do prohibit business
alliance relationships between an auditor and its audit client. The
Financial
Reporting Council (FRC) is the UK’s lead audit
regulator. APB Ethical Standard 2, Financial, Business, Employment and
Personal Relationships, states:
Audit firms, persons in a position to influence
the conduct and outcome of the audit and immediate family members of
such persons shall not enter into business relationships with an audited
entity, its management or its affiliates except where they involve the
purchase of goods and services from the audit firm or the audited entity
in the ordinary course of business and on an arm’s length basis and
whichare not material to either party or are clearly
inconsequential to either party.
Business relationships, says the FRC, may create
self-interest, advocacy or intimidation threats to the auditor’s objectivity
and perceived loss of independence.
Examples of prohibited business relationships
include “arrangements to combine one or more services or products of the
audit firm with one or more services or products of the audited entity and
to market the package with reference to both parties or distribution or
marketing arrangements under which the audit firm acts as a distributor or
marketer of any of the audited entity’s products or services, or the audited
entity acts as the distributor or marketer of any of the products or
services of the audit firm.”
In 2010 Autonomy was named a
Deloitte UK Technology Fast 50 company, one of the
UK’s fastest growing technology companies. Deloitte UK was officially
prohibited from jointly marketing its consulting services with Autonomy or
reselling Autonomy’s products such as IDOL or popular products acquired
while it was the auditor of Autonomy. Popular Autonomy software includes
Interwoven, Verity, and Meridio for government and defense contractors.
That must have been tough.
But that didn’t stop the consulting practices of
other Deloitte member firms all over the world from taking advantage of the
popularity of Autonomy products to boost their revenues. In March of 2011,
less than six months before HP announced its acquisition of Autonomy,
Deloitte Luxembourg announced it had selected
Autonomy’s Intelligent Data Operating Layer (IDOL) as a vendor “to better
manage information and knowledge within the firm to increase productivity.”
In addition, Autonomy would further collaborate with Deloitte to “fast-track
its technology to Deloitte Luxembourg’s extensive customer base…”
Deloitte UK, and its fellow Deloitte firms all over
the world, are allowed to be customers of an audit client of one of them
such as Autonomy “in the ordinary course of business”.
They are customers of Autonomy. Autonomy lists
Deloitte entities and Ernst & Young, HP’s auditor, as customers on numerous
websites and in marketing materials and case studies. In 2011, digital
agency Roundarch, founded in June 2000 by Deloitte and WPP, also selected
Autonomy’s cloud-based comprehensive data backup and recovery solutions for
its own operation. This privately owned company was operated by its senior
management until February 2012 when Aegis Group plc acquired the digital
agency. The Aegis Group plc auditor is Ernst & Young.
But were Deloitte non-UK member firms allowed to
sign marketing and reselling contracts as Autonomy alliance partners while
Deloitte UK audited this multinational company with customers all over the
world? For example, given Autonomy’s extensive US operations and customer
base including the US government, it’s likely Deloitte’s US audit firm
supported the UK firm with the Autonomy audit. Email requests for comment
from HP and Deloitte were not returned. When it comes to irresistible
consulting revenue growth, an audit firm’s “network of seamless service
providers” bound by independence and objectivity regarding the audit of a
multinational listed company stops at each border.
In the largest market for Deloitte’s consulting
services, the United States, Deloitte Consulting’s US arm and Autonomy
worked together prior to HP’s acquisition and after on one of the most high
profile
e-discovery and document management cases ever –
the litigation over the BP Gulf oil spill. Autonomy, or rather a version of
an Autonomy acquisition called Introspect, was used for the enormous BP
Deepwater Horizon review, which employed more than 800 review attorneys at
one point.
The BP Deepwater Horizon review started in the
summer of 2010, after the explosion in April of that year. Deloitte was the
case management consultant working between the client (BP), the review team
and the hosting vendor (Autonomy). It is not clear if this was a joint
project between Deloitte and Autonomy, with Deloitte acting as a systems
integrator for the software, or if the parties contracted separately.
According to a source close to the BP engagement,
the Autonomy software was a total disaster. The larger the review got, the
worse the software performed. “Searches would hang up for long periods of
time, document images would get out of synch with their corresponding coding
records, the entire system would crash or have to be taken offline to be
reset. You name it – when it came to software problems, Autonomy had them
all at one time or another.”
One of the various charges HP is raising about the the Autonomy fraud is channel
stuffing. This charge makes some companies in the software industry very nervous
since something akin to channel stuffing is not all that unusual in the software
industry. Autonomy will probably not have trouble finding friendly expert
witnesses. Personally, I think accounting in the software industry is not a good
model of transparency for our students.
The most serious of the allegations HP has made
against unnamed members of
Autonomy's
management team. A spokeswoman for Lynch has denied any suggestions that
the tactic was used.
Channel stuffing
involves offloading excessive amounts of product to resellers ahead of
demand. Typically, the reseller is charged little or no money up front,
and may not be obliged to pay unless they sell the product on. In
accountancy terms, a line is crossed if those deals are booked as
revenue before an end customer has actually bought the product.
Autonomy had hundreds of
resellers, one of which was Tikit, which specialises in legal and
accountancy software and has just been bought by BT. In December 2010,
Tikit reported a surge in the amount of inventory on its books, up from
£100,000 worth per half year to £4m.
Peel Hunt analyst Paul
Morland says Tikit told him that it had done a big deal to acquire
software at a discount.
Tikit declined to
comment and there is no evidence that Autonomy booked the deal as
revenue. A spokeswoman for Lynch insisted Autonomy never recognised
revenue from resellers if there was a right of return, and that such a
right was almost never granted.
US regulators have taken
high-profile scalps in their efforts to stamp out channel stuffing.
Drugs firm Bristol-Myers Squibb coughed up more than $800m in fines and
legal settlements after admitting to pumping stocks of medicines onto
wholesalers' books in order to inflate its own revenues. During the
dotcom boom, the McAfee antivirus software company engaged in practices
with a reseller called Ingram Micro which saw them eventually fined a
combined $65m.
USING
ACQUISITIONS AS A SMOKESCREEN
In Autonomy's last full
year as an independent company, it claimed to be growing at 17%. This
excluded the contribution of any acquisitions. But one financial analyst
has claimed it was using its purchases to mask the fact that there was
no growth at all.
Over six years, Autonomy
bought at least eight sizeable businesses, culminating in May 2011 with
the digital archiving arm of US group Iron Mountain. "Once they had
bought the company they would close parts of the business down," says
Daud Khan, who followed Autonomy while working at JP Morgan Cazenove,
and is now at Berenberg Bank. "Closing down a business costs money but
the restructuring charges were always very low. Through magic dust
Autonomy managed to do it with very little cost and they did that again
and again." He believed Autonomy was claiming the discontinued revenues
from acquired companies as part of its own organic growth.
Lynch's spokeswoman says
Autonomy's accountant, Deloitte, checked every acquisition. She said
there were more than 30 analysts covering Autonomy's stock, and Khan's
view was in the minority.
DESCRIBING
HARDWARE SALES AS SOFTWARE SALES
HP said Autonomy sold
hardware that was wrongly labelled in its accounts as software and sold
hardware at "negative margin", in other words at a loss, and charged it
as a marketing expense. The sale was then chalked up as licence revenue
for growth calculations. HP said these sales accounted for up to 15% of
Autonomy's total revenue, which was estimated at $1bn in 2011.
Lynch said it was "no
secret" Autonomy sold hardware, and it accounted for around 8% of
revenue. The company would sometimes supply desktop computers to clients
as part of a package. In some cases, Lynch said, deals were struck at a
slight loss, in exchange for the client agreeing to market Autonomy
products. These losses were then charged as a marketing expense.
Crucially, he claims those sales accounted for less than 2% of total
revenues.
EXAGGERATING
SEARCH REVENUES FROM OTHER SOFTWARE COMPANIES
Autonomy's client roster
reads like a software hall of fame. Its website lists most of the
biggest names, from Adobe to IBM and Oracle, and in its last financial
results, it claimed more than 400 separate products were using its
"core" technology.
Original equipment
manufacturer (OEM) licences were one of Autonomy's growth engines,
rising at 27% a year.
Autonomy's top product
is a search engine called IDOL (Intelligent Data Operating Layer), but
Autonomy has rebranded less expensive products as IDOL, such as the
document filter produced by a company called Verity it bought in 2005.
A week after HP
announced it was prepared to acquire Lynch's company at a 64% premium to
its share price, Leslie Owens at Forrester Research published a piece
entitled What is Autonomy, Without its Marketing?, in which she declared
the development of IDOL was "stagnant", with no major release in five
years.
Technology analyst Alan
Pelz-Sharpe, who reported Autonomy to the Serious Fraud Office last
year, claimed last August in his blog: "Where Autonomy is present in
3rd-party software, it is more typically the old (and very basic) Verity
engine, not IDOL."
Autonomy would not be
the first company to have overplayed the popularity of its products.
Lynch's spokeswoman said there was no exaggeration of revenues from
other software companies. The view of the analysts is simply that if
sales of its flagship search software were not soaraway, Autonomy might
not have been worth the premium HP paid.
FRONTLOADING
REVENUES
Changing the payment
model for storing large digital archives on behalf of customers is
another way in which HP believes Autonomy boosted revenues. Autonomy was
supposedly converting long-term "hosting" deals into short-term
licensing deals.
Red flags were raised by
analysts after Autonomy's 2007 acquisition of a US email archiving
company called Zantaz, whose clients included nine of the world's top 10
law firms and JP Morgan and Deutsche Bank. Khan claims Autonomy
renegotiated contracts so that instead of spreading payments over a
three- or four-year contract, it would take a big lump sum upfront and
smaller payments in subsequent years.
"There's nothing illegal
with that but it generates growth that isn't real growth," says Khan.
"If you value a business you have to ascertain whether it is growing."
Lynch's spokeswoman said
this was not an accurate characterisation of the changes: Zantaz
customers that had been pay-as-you-go committed to much larger deals
once Autonomy took over, often including on-premises software.
Jensen Comment
I view attempts to whitewash Autonomy with very legalized interpretations of
IFRS much like I view Ernst & Young's legalistic use of FAS 140 to justify the
Repo 105 and 109 deceptions for Lehman Bros. Such a defense may get auditors off
the hook in court, but use of such defenses simply justifies auditors
intentionally being party to deceptive accounting. There's such a thing as
underlying spirit and intent of an audit to avoid deception even when clients
and their auditors can get away with deception due to defects in the standards.
The irony is that some financial analysts were raising red flags about
Autonomy's accounting well in advance of when HP invested in that dubious
company. I guess it boils down to "buyers beware," and HP seems to have simply
been ignorant of accounting tricks.
The battle over Hewlett-Packard’s claim that it was
bamboozled when it bought Autonomy, a British software company, has been
long on angry rhetoric and short on details about the accounting that was
supposedly wrong and led to an $8.8 billion write-down.
¶ But the eternal question asked whenever a fraud
surfaces — “Where were the auditors?” — does have an answer in this case.
¶ They were everywhere.
¶ They were consulting. They were advising,
according to one account, on strategies for “optimizing” revenue. They were
investigating whether books were cooked, and they were signing off on audits
approving the books that are now alleged to have been cooked. They were
offering advice on executive pay. There are four major accounting firms, and
each has some involvement.
¶ Herewith a brief summary of the Autonomy dispute:
¶ Hewlett-Packard, a computer maker that in recent
years has gone from one stumble to another, bought Autonomy last year. The
British company’s accounting had long been the subject of harsh criticism
from some short-sellers, but H.P. evidently did not care. The $11 billion
deal closed in October 2011.
¶ Last week, H.P. said Autonomy had been cooking
its books in a variety of ways. Mike Lynch, who founded Autonomy and was
fired by H.P. this year, says the company’s books were fine. If the company
has lost value, he says, it is because of H.P.’s mismanagement.
¶ Autonomy was audited by the British arm of
Deloitte. H.P., which is audited by Ernst & Young, hired KPMG to perform due
diligence in connection with the acquisition — due diligence that presumably
found no big problems with the books.
¶ That covered three of the four big firms, so it
should be no surprise that the final one, PricewaterhouseCoopers, was
brought in to conduct a forensic investigation after an unnamed
whistle-blower told H.P. that the books were not kosher. H.P. says the PWC
investigation found “serious accounting improprieties, misrepresentation and
disclosure failures.”
¶ That would seem to make the Big Four tally two
for Autonomy and two for H.P., or at least it would when Ernst approves
H.P.’s annual report including the write-down.
¶ But KPMG wants it known that it “was not engaged
by H.P. to perform any audit work on this matter. The firm’s only role was
to provide a limited set of non-audit-related services.” KPMG won’t say what
those services were, but states, “We can say with confidence that we acted
responsibly and with integrity.’
¶ Deloitte did much more for Autonomy than audit
its books, perhaps taking advantage of British rules, which are more relaxed
about potential conflicts of interest than are American regulations enacted
a decade ago in the Sarbanes-Oxley law. In 2010, states the company’s annual
report, 44 percent of the money paid to Deloitte by Autonomy was for
nonaudit services. Some of the money went for “advice in relation to
remuneration,” which presumably means consultations on how much executives
should be paid.
¶ The consulting arms of the Big Four also have
relationships that can be complicated. At an auditing conference this week
at New York University, Francine McKenna of Forbes.com noted that Deloitte
was officially a platinum-level “strategic alliance technology
implementation partner” of H.P. and said she had learned of “at least two
large client engagements where Autonomy and Deloitte Consulting worked
together before the acquisition.” A Deloitte spokeswoman did not comment on
that report.
¶ To an outsider, making sense of this brouhaha is
not easy. In a normal accounting scandal, if there is such a thing, the
company restates its earnings and details how revenue was inflated or costs
hidden. That has not happened here, and it may never happen. There is not
even an accusation of how much Autonomy inflated its profits, but if there
were, it would be a very small fraction of the $8.8 billion write-off that
H.P. took. Autonomy never reported earning $1 billion in a year.
¶ That $8.8 billion represents a write-off of much
of the good will that H.P. booked when it made the deal, based on the
conclusion that Autonomy was not worth nearly as much as it had paid. It
says more than $5 billion of that relates to the accounting irregularities,
with the rest reflecting H.P.’s low stock price and “headwinds against
anticipated synergies and marketplace performance,” whatever that might
mean.
Continued in article
Teaching Case on Autonomy from The Wall Street Journal's Accounting Weekly
Review on November 30, 2012
TOPICS: Goodwill, Intangible Assets, International Accounting,
Mergers and Acquisitions, Revenue Recognition, Advanced Financial
Accounting, Audit Quality, Financial Accounting
SUMMARY: H-P disclosed another $8 Billion Charge to write down its
software segment which includes Autonomy, a company acquired by H-P for
$11.1 billion in October 2011. H-P chief Meg Whitman says there was a
willful effort to inflate Autonomy's revenue and profitability. Autonomy
founder Mike Lynch, who was fired by H-P in May 2012 for underperformance of
the unit after H-P's acquisition, denies these allegations. In a related
article it is made clear that analysts have long questioned Autonomy's
revenue recognition practices and questioned whether H-P overpaid for the
acquisition in 2011. Deloitte Touche as Autonomy's auditor is now facing
another situation in which the quality of its work is now being questioned.
CLASSROOM APPLICATION: The article includes topics in revenue
recognition, IFRS versus U.S. GAAP, business combinations, and intangible
asset write downs.
QUESTIONS:
1. (Introductory) Summarize the announcement made by H-P on which
this article reports. What types of assets do you think were written down in
the total $8.8 billion charge?
3. (Advanced) How do classifications of revenue result in an asset
write down by an acquirer one year after completion of an acquisition?
Specifically describe how determining an asset account balance in a business
acquisition that may involve past or future revenue amounts.
4. (Introductory) Refer to the first related article. What is the
role of the Chief Financial Officer in assessing the propriety of accounting
at a target/acquired firm, both before and after establishing a price to be
paid by an acquirer?
5. (Advanced) Refer to the second related article. How is it
possible that differences between U.S. GAAP and IFRS might result in
different timing of revenue recognition?
6. (Introductory) What does analyst Dan Mahoney think are issues
that led to H-P's allegations against Autonomy? How do both U.S.GAAP and
IFRS handle these issues in timing revenue recognition?
Reviewed By: Judy Beckman, University of Rhode Island
Hewlett-Packard Co. HPQ -0.50% said on Tuesday it had been duped into
overpaying for one of its largest acquisitions, contributing to an $8.8
billion write-down and a huge quarterly loss.
The technology giant said that an internal investigation had revealed
"serious accounting improprieties" and "outright misrepresentations" in
connection with U.K. software maker Autonomy, which H-P acquired for $11.1
billion in October 2011.
"There appears to have been a willful sustained effort" to inflate
Autonomy's revenue and profitability, said Chief Executive Meg Whitman.
"This was designed to be hidden."
Michael Lynch, Autonomy's founder and former CEO, fired back hours later,
denying improper accounting and accusing H-P of trying to hide its
mismanagement. "We completely reject the allegations," said Mr. Lynch, who
left H-P earlier this year. "As soon as there is some flesh put on the bones
we will show they are not true."
H-P said Tuesday it alerted the U.S. Securities and Exchange Commission
and the U.K. Serious Fraud Office and requested that they open
investigations. The SEC and Federal Bureau of Investigation are launching
inquiries, according to people familiar with the probes. Timeline: A History
of Hewlett-Packard
View Interactive Bios: On H-P's Board for the Troubled Purchase
View Interactive
The accounting-fraud claim adds to a string of recent setbacks and
controversies for Palo Alto, Calif.-based H-P, whose board faced criticism
over its handling of the departures of its last two chief executives. Mark
Hurd resigned in 2010 after he acknowledged having a personal relationship
with a company contractor. His successor, Leo Apotheker, who spearheaded the
Autonomy purchase, was forced out in 2011 and replaced by Ms. Whitman.
H-P General Counsel John Schultz said the internal investigation into the
Autonomy deal began in May when he told Ms. Whitman he had just spoken with
a senior executive in the Autonomy software business, who had alleged that
executives at Autonomy had been cooking the books before the acquisition.
The identity of that senior executive couldn't be determined.
A spokesman for Autonomy's accounting firm, Deloitte LLP, said Tuesday:
"Deloitte UK categorically denies that it had any knowledge of any
accounting improprieties or any misrepresentations in Autonomy's financial
statements, or that it was complicit in any accounting improprieties or
misrepresentations." [image]
Mr. Lynch, the former Autonomy CEO, said H-P is "completely and utterly
wrong." He said of Autonomy: "It is a business we spent 10 years building.
It was a world leader. It was destroyed in less than a year by the petty
infighting at H-P."
The accounting-fraud allegations punctuated another grim set of financial
results for H-P, one of the world's largest sellers of personal computers,
printers and other technology products and services. In recent years, it has
been hurt by executive turnover, cost cuts, mounting debt and slowing demand
for some products.
H-P said Tuesday it swung to a $6.9 billion loss for its fiscal fourth
quarter ended Oct. 31, while revenue fell 7% from a year earlier. The charge
for writing down Autonomy totaled $8.8 billion, of which more than $5
billion is related to the accounting issues, with the balance related partly
to the unit's performance. Revenue fell across H-P's PC, printer, services,
and server and networking divisions.
Hewlett-Packard has claimed that the leadership at Autonomy, the software
firm it acquired last year, misrepresented its performance as the deal was
being negotiated. WSJ's Ben Rooney profiles the company and its founder,
Mike Lynch. Photo: Bloomberg Related Coverage
Autonomy Founder: We Were Ambushed Deloitte in an Unwanted Spotlight Ex
CEO Leo Apotheker: Due Diligence of Autonomy Was Meticulous Meg Whitman:
Those Responsible for Autonomy Deal Are Gone CIO Report: CIOs to 'Keep an
Eye' on H-P Amid Autonomy Write-Down Heard on the Street: Another Fine Mess
Heard on the Street: Fresh Blow for London Law Blog: Should Lawyers Shoulder
Any Blame? Corporate Intelligence: The Warning Signs at Autonomy Deal
Journal: The Advisers on the Deal Digits: Players Behind the Buy Tech
Europe: Mike Lynch Profile Deal Journal: Hewlett-Packard Takes Second $8
Billion Deal Charge This Year Deal Journal: Remember Oracle's Accusations
Too Corporate Intelligence: Write Down Avoidable, With Autonomy Software
Transcript of H-P's Earnings Call
Previously
Autonomy CEO Fires Back at Larry Ellison (9/27/11) Deal Profile: H-P Bids
for Autonomy (8/18/11) Autonomy Shares Soar on H-P Offer (8/19/11) Search Is
Over for Autonomy (8/19/11) Tech Europe: H-P and Autonomy: A Clash of
Cultures (5/24/2012) Buyers Beware: The Goodwill Games (8/14/12) Tech
Europe: Autonomy's Lynch Says H-P Deal Marks IT Shift (8/30/11) Europe Mixed
Over Deal (8/19/11)
It was the technology giant's fifth straight quarter of big declines, a
trend Ms. Whitman said is likely to continue.
H-P's stock, which was already trading near a 10-year low, ended 4 p.m.
trading at $11.71, down $1.59, or 12%, on the New York Stock Exchange.
When the deal was announced in August 2011, Autonomy was Britain's
biggest software company and second-largest in Europe, after Germany's SAP
SAP.XE +0.38% AG. Its customers include intelligence agencies, big
corporations, banks and law firms. H-P said then that Autonomy was key to
its transformation into a higher-margin seller of software.
H-P said Tuesday that Autonomy, before it was acquired, had
mischaracterized some sales of low-margin hardware as software and had
recognized some deals with partners as revenue, even when a customer never
bought the product.
At least one year before the H-P acquisition, an Autonomy executive
brought concerns about the company's accounting practices to U.S. regulators
including the SEC, according to people familiar with the matter. Autonomy
didn't trade on U.S. exchanges prior to the H-P deal, so it is unclear
whether U.S. agencies had jurisdiction.
H-P's internal team was aware of talk about accounting irregularities at
the time the deal was struck, people familiar with the matter have said. At
the time, one of these people said, H-P was looking for a way to unwind the
deal before it closed, but couldn't find any material accounting issues.
Mr. Lynch, in an interview at the time, denied any accounting
irregularities. On Tuesday, he blamed any problems at Autonomy on poor
management by H-P and executive turnover.
Ms. Whitman said Tuesday the company relied on Autonomy's regular auditor
Deloitte and had hired KPMG for an additional review before the deal closed.
Neither firm found any irregularities then, she said. KPMG declined comment.
Mr. Schultz, H-P's general counsel, said H-P was shown "significant
documentation from former Autonomy executives refuting the allegations" of
any accounting issues. In hindsight, "it's fair to say those refutations
were questionable," he said.
After H-P completed the deal, Autonomy's sales suffered. On several
occasions, H-P said the unit didn't meet expectations.
In May 2012, Mr. Lynch left H-P. Shortly after, the unidentified Autonomy
senior executive approached Mr. Schultz. Mr. Schultz said that during a
phone call to discuss other matters, the Autonomy executive asked to speak
with him in person.
The pair met in a conference room at H-P's Palo Alto headquarters, where
the executive provided an outline of the alleged accounting fraud, Mr.
Schultz said. The executive later provided some emails and financial
information that Mr. Schultz said substantiated the claim.
Working with auditing firm PricewaterhouseCoopers LLP, an H-P team
re-created Autonomy's books. People familiar with the investigation said
that the team found that for at least two years, Autonomy booked sales of
low-margin hardware products as software and would label the cost of that
hardware as marketing or other expenses, which made products appear faster
growing and more profitable than they really were.
Mr Echevarria, chief executive since June 2011,
defended Deloitte in an interview with Reuters - his first since the firm
was dragged into the spotlight over its independent reviews of Standard
Chartered.
The New York State Department of Financial
Services, in a case involving US anti-money laundering laws, last week said
Deloitte consultants omitted critical details in a report to regulators
about Standard Chartered.
The regulator cited an email from a Deloitte
partner saying he drafted a "watered-down version" of the report after being
asked by Standard Chartered to omit information.
"It's an unfortunate choice of words that was
pulled out of context," Mr Echevarria said.
A source close to the matter, who asked to remain
anonymous because of its sensitive nature, told Reuters that the Department
of Financial Services had no plans to bring charges against Deloitte. A
spokesman for the department refused to confirm or deny that statement.
Mr Echevarria said he was standing in line with his
16-year-old son at Universal Studios in Orlando, Florida a week ago when he
first heard of the Standard Chartered matter by email. A Bronx native in his
35th year at Deloitte, Mr Echevarria said one of his first thoughts was,
"There's got to be more to this."
The New York banking regulator head, Benjamin
Lawsky, alleged Standard Chartered hid from regulators some 60,000 "secret
transactions" tied to Iran. Standard Chartered has said the regulator's
account did not present "a full and accurate picture of the facts."
Mr Lawsky said that at one point, Standard
Chartered asked Deloitte to delete from its draft report any reference to
payments that could reveal the bank's practices involving Iranian entities.
Mr Lawsky quoted an email from a Deloitte partner
who said "we agreed" to the request.
Mr Echevarria declined to discuss specific
allegations, but in a statement last week, Deloitte said "contrary to the
allegation," it "absolutely did not delete any reference to certain types of
payments" from a final report. Deloitte said the report did not include a
recommendation that had been included in a prior draft.
"Presumably the facts will bear out that we
certainly held up all the standards required and behaved in an ethical and
responsible way," Mr Echevarria said.
Asked if Deloitte has taken action against anyone
at the firm, Mr Echevarria said he could not comment on anything involving
personnel or privacy issues.
In another damaging charge, the banking regulator
said Deloitte gave Standard Chartered two reports with highly confidential
client information - an allegation that, if true, would violate one of the
cardinal rules in the consulting business.
"We have pretty robust processes in place for
behaviour that violates law, rules or firm policies," Mr Echevarria said.
"Appropriate actions are taken when individuals are found to have done
that."
Mr Echevarria, who rose through the auditing ranks
to become chief executive, has battled a series of reputational hits since
taking over the US firm.
Late last year, the firm came under scrutiny from a
member of Congress after audit industry regulators unsealed parts of a
report criticizing quality controls at Deloitte's corporate auditing
business. Deloitte said at the time that it had made investments to improve
its audit practice.
Continued in article
As Andersen discovered, one felony conviction in the U.S. can end a firm's
auditing practice in the entire U.S. I cannot imagine any large auditing firm
gambling with its nationwide authority to conduct audits. However, doubt
that this risk applies to certain rogue author or consultant convictions such as
when a single partner is convicted on insider trading that was much of a
surprise to the firm as it was the SEC and the public. There's a huge gray zone,
especially for a firm like Deloitte that did not sell or spin off most of its
consulting practice before SOX went into effect. The auditing firms that are
roaring back into consulting are putting their auditing divisions somewhat at
risk.
In case you missed it, note how cheaply some Big Four auditing firms wiggled
out of some major bank failure litigation. What could have been billions were
settled for pennies on the dollar.
Latest available figures for the Big Four indicate
total annual global revenues of some $ 102 billion.
Applied to those figures, the model indicates that
the break-up threshold for any one of the Big Four firm’s litigation
“worst-cases” would be in the range from a maximum of $ 6 billion down to $
2.2 billion, if viewed at the global level.
That is a considerable increase from the earlier
numbers, owing to the great leap in total big-firm revenues in the
intervening years.
But cautions remain. Most importantly, cohesion of
the international networks under the strain of death-threat litigation, or
the extended availability of collegial cross-border financial support,
cannot be assumed. Arthur Andersen’s rapid disintegration in 2002 with the
flight of its non-US member firms is illustrative.
So it is necessary to look at the bust-up range
based on figures alone from the Americas, the most hazardous region. If left
to their local resources, as was Andersen’s US firm, the disintegration
range shrinks, from a maximum of less than $ 3 billion down to a truly
frightening $ 675 million.
Amounts at that level compare ominously with the
litigation settlements recently extracted from the larger debacles of the
last decade – examples led by Bank of America’s post-Countrywide
mortgage-securities settlement of $8.5 billion (here)
and including such investor settlements as Enron ($7.2
billion), WorldCom ($6.2 billion) and Tyco ($3.2 billion) (here).
But those amounts were only available because
inflicted on the investor-funded balance sheets of the corporations
contributing to the settlements – resources not available to the private
accounting partnerships. And they are even more darkly comparable with the
exposures looming in the pending claims inventory.
True, in recent months the large accounting
firms have enjoyed remarkable success in disposing of large litigations for
modest sums – examples include KPMG resolving Countrywide for $ 24 million
(here)
and New Century for $ 45 million (here),
and Deloitte settling Washington Mutual for $ 18.5
million (here).
However, hope for the indefinite continuation of
such forbearance on the part of the plaintiffs is not a strategy, but only a
wish.
As the catastrophic impact of “black swan” events
makes clear, it only takes one. And at that tipping point, all the marginal
fiddling by Barnier, Doty and their ilk becomes academic.
Deloitte has settled a
shareholder case against the firm stemming from their role as auditor of
Bear Stearns, one of the early financial services
firms to fail, be force sold or nationalized during the financial crisis of
2008-2009. Deloitte was dangerously close to having to answer for its
actions – or rather inactions – at a trial. For the Big 4 audit firms in the
United States, trials over auditor liability are unheard of.
Rare birds in modern times.
Deloitte’s audits “were so deficient that the
audit amounted to no audit at all,” the [Bear Stearns investors]
plaintiffs argued in court papers.
That was Reuters
describing the rationale behind the decision of US
District Judge Robert Sweet back on January 23, 2011 to allow a case against
executives of Bear Stearns and its outside auditor, Deloitte, to go forward.
I wrote in
Forbes:
In Ernst
& Ernst v. Hochfelder, the Supreme Court held
that actions under Section 10(b) of the Exchange Act and Rule 10b-5
require an allegation of “`scienter’—intent to deceive, manipulate, or
defraud.” The “scienter” requirement, necessary to sustain allegations
against the auditors in a securities claim under Section 10(b), is
notoriously difficult to meet in an auditor liability case.
If there’s anything of substance in a claim
against auditors the case usually settles before the facts are made
public. New Century Trustee v. KPMG is an early crisis mortgage
originator case, cited several times in the Bear Stearns
decision. However, those facts will never be heard in open court. In
spite of – or perhaps because of – very particular examples of reckless
behavior by the auditor documented by the bankruptcy examiner, the
case was settled...since Ernst, most courts
have concluded that recklessness can satisfy the requirement of
“scienter” in a securities fraud action against an accountant.
That standard requires more than a misapplication
of accounting principles. Plaintiffs must prove that the accounting
practices were so deficient that the audit amounted to no audit at all,
or “an egregious refusal to see the obvious, or to investigate the
doubtful,” or that the accounting judgments which were made were such
that no reasonable accountant would have made the same decisions if
confronted with the same facts.
The plaintiffs’ attorneys In
Re: Bear Stearns Companies, Inc. Securities Litigation
successfully pled recklessness equivalent to
“scienter” and more. They knocked the requirements for recklessness to prove
“scienter” out of the park. The Complaint identified as a red flag the fact
that Deloitte knew or should have known, absent recklessness, the risk
factors inherent in the industry, such as declining housing prices,
relaxation of credit standards, excessive concentration of lending, and
increasing default rates.
The Securities Complaint has alleged that JPMorgan discovered in the
course of one weekend the overvaluation of assets and underestimation of
risk exposure in Bear Stearns’ financial statements. JC Flowers & Co., a
leverage-buyout company, had also reviewed Bear Stearns’ books the same
weekend and made an unsuccessful proposal to buy 90% of the Company at a
similar price between $2 and $2.60 per share. These allegations support
an inference of Deloitte’s scienter.
They’re specific enough about who, what, why, and when to nail
“particularity”. The misstatements with respect to valuation and risk were
adequately alleged with sufficient specificity and established as
material. They showed how Deloitte, like the Bear Stearns executives, caused
losses.
But
there will be no trial. Investors led by the State of Michigan Retirement
Systems settled with Bear Stearns executives for $275 million – which will
be covered by insurance – and auditor Deloitte will pay, in cash, an
additional $19.9 million.
To
put Deloitte’s settlement in perspective, I looked at the firm’s audit fees
for Bear Stearns from 2003-2006. (Fee information for 2007 is not available
since the firm was bought, under duress, by JP Morgan in 2008 and the proxy
focuses on that transaction, not the typical disclosures.) Deloitte earned
$110 million dollars, more than 5X this settlement amount, in just the last
four years at Bear.
Jensen Question
Should we hope with Francine that this time Steven Tomas finally succeeds in
destroying the fraudulent auditing firm of Deloitte and Touche?
Maybe another Enron is the only way of making the remaining Big Three firms
get more serious about audit independence and professionalism.
Would you allow your treasury department to make a
manual adjustment to a cash account on the fly without sufficient backup
documentation? Would you even allow it to happen without multiple levels of
authorization or the review of a senior finance executive, especially if the
report was being filed with regulators?
MF Global, the commodity futures dealer that
crashed spectacularly last year and “lost” $1.6 billion of customer money,
apparently did.
A new report by one of the company’s bankruptcy trustees
sheds light on the mystery of an accounting “error”
that bedeviled executives for three days prior to the firm’s bankruptcy – an
error that may have kept some MF Global executives from realizing that
customer funds were being raided to stave off illiquidity.
I wrote about the hunt for the reporting glitch in April,
citing a Chicago Mercantile Exchange timeline of MF Global’s final week.
What was labeled a reporting glitch then, however, was actually an
erroneous, $540 million manual adjustment by treasury staffers – one they
should have never been allowed to make.
Now you might be saying that except for the size of
the adjustment, “So what?” Well, this was no ordinary account. It was the
“customer-segregated” account that securities regulators tracked on a daily
basis, and it was the account that held customer funds along with a buffer –
an amount of money over and above customer funds that had to be maintained
at all times. And the size of the adjustment? It made the difference between
a deficit and a surplus, and the firm’s being in compliance or not.
This collective delusion lasted from a Friday
morning through a Sunday night with apparently no one in treasury or the
company’s financial regulatory group able to prove that no adjustment should
have been made. At one point treasury even thought that maybe the adjustment
“was incorrectly booked backwards,” according to the trustee, because the
customer account deficit was so large. (They hypothesized that $540 million
had been debited to the account instead of credited.) And during all that
time the senior finance leadership (even the company’s general counsel)
seemed to take treasury staffers at their word – that there was no deficit
in customer accounts and that there was some kind of hitch with bank
reconciliations.
To be sure, we may never know the whole truth. The
bankruptcy trustee admits that “witnesses’ descriptions regarding this
matter are confusing and contradictory.” I have no doubt. The fascinating
descriptions of MF Global’s final days
read like a screenplay for a Keystone Kops movie.
“Everyone was running around uncertain what they were supposed to do or how
to do it,” as one congressman described the federal government’s response to
Hurricane Katrina.
Continued in article
Question
Where did the missing MF Global $1+ billion end up?
The Securities and Exchange Commission is rattling
a dull sabre again towards Shanghai-based Deloitte Touche Tohmatsu CPA Ltd.
for its refusal to provide the agency with audit work papers related to
Longtop, a China-based company under investigation for potential accounting
fraud against U.S. investors. The regulator filed
an “enforcement
action” instituting an “administrative proceeding”
yesterday.
Ooooh scary!
This has been
going on now for two years and seems to have
escalated into the kind of fight men have when trying to prove who’s bigger
and tougher. It looks to me like it’s personal rather than productive. The
SEC has access to as much as they need to review the work of the Deloitte
China firm’s audit of Longtop - or any other Chinese fraud for a US listed
company - assuming
the US Deloitte firm had as much as they needed to sign off on the
companies’ filings with the SEC over the years.
The SEC admits in their
latest complaint against Deloitte Shanghai that
they asked Deloitte US for the information the firm has right here in the US
on Longtop and other US listed foreign based audits. The firm’s first answer
was to deny any involvement in the audit.
4. On April 9, 2010, staff served Deloitte LLP,
the U.S. member firm of the Global Firm with a subpoena requesting audit
work papers relating to the Global Firm’s audit of Client A’s financial
statements for the period January 1, 2008 through April 9, 2010.
5. Between April 13, 2010 and May 18, 2010,
staff had several communications with U.S. based counsels for both
Deloitte LLP and the Global Firm.
6. Counsel for Deloitte LLP initially
informed the staff that Deloitte LLP did not perform any audit work for
Client A, that all audit work was conducted by Respondent, and that
Deloitte LLP did not have possession, custody, or control of the
documents called for by the subpoena.
7. Counsel for Deloitte LLP subsequently
informed the staff that Deloitte LLP performed some review work of
Client A’s periodic reports and produced certain documents relating to
this review to the staff.
Deloitte did eventually produce some
documents related to the audit that are, and always have been, available in
the US. If the Deloitte US reviews were sufficient, that should be enough
for the SEC to see the quality of work performed by the Deloitte Shanghai
unit.
So why is SEC continuing to fight this inane fight
when, in reality, they should have all the information they need to
investigate the Longtop or any other fraud? I suspect that the SEC attorneys
are super annoyed with Deloitte’s lawyers and have decided to use their
unlimited budget and intimidating administrative powers to annoy them back.
Unfortunately, this just puts more money in the pocket of the
super expensive Sidley & Austin outside counsel
representing Deloitte Shanghai.
(Coincidentally, it was also a Sidley & Austin
lawyer for KPMG that recently
so annoyed a judge in a class action overtime case against the firm
the judge ordered the firm to preserve the hardrives
of all laptops for past, present and future class members. Note to Sidley &
Austin: Scorched earth tactics not working.)
US-based GAAP and SEC reporting experts in the
global audit firms review the workpapers behind the filings for every non-US
based audit client that is listed on a US stock exchange, all over the
world, before any filing with the SEC. That’s one of the quality control
procedures all the firms who audit foreign-based, US listed multinationals
have in place, not only because it is expected by regulators but because
it’s good business.
The SEC/GAAP reporting team or Reg S-X review team
– it may be drawn from and called something different in each firm – is the
last stop before a foreign-based US issuer can file its quarterly and annual
reports, as well as any filings for additional stock or debt offerings, with
the SEC. Sometimes the team consists of experts from the firm’s financial
advisory consulting group or capital markets group – the professionals who
help companies prepare for IPOs, especially foreign companies who want a
stock exchange listing in the US. The team may also call on additional
expertise from the firm’s national office – a kind of one-stop shop for
getting questions answered on arcane technical matters or standards for
specific industries. Professionals may play double duty as consultants to
some companies and remote members of an audit team for others. That way they
can pick up billable hours reviewing filings when there are no deals to be
done.
When a US-based listed company is a multinational,
the US audit firm will use its member firm network extensively to do the
audit work necessary all over the world to support the overall audit
opinion. In this case, a US audit firm is expected to closely supervise and
control the work of foreign affiliates who contribute to its audit.
From Part 2 of the PCAOB’s inspection report – the
private quality control review of US firms.
Review of Processes Related to the Firm’s Use
of Audit Work that the Firm’s Foreign Affiliates Perform on the Foreign
Operations of the Firm’s U.S. Issuer Audit Clients
The inspection team performed procedures in
this area with respect to the processes the Firm uses to ensure that the
audit work that its foreign affiliates perform on the foreign operations
of U.S. issuers is effective and in accordance with applicable standards
performed by the Firm’s foreign affiliates on the foreign operations of
U.S. issuer clients.
Some non-US audit member firms have more SEC
reporting and GAAP experts on-site than others. I suspect the largest firms
in Canada and the UK have their own SEC and GAAP reporting quality assurance
review team for this purpose, but many countries do not.
PwC, for example, has the Global Capital Markets
Group, a team of professionals dedicated to providing technical, strategic
and project management advisory services to non-US companies actively
interested in raising capital and/or listing their securities in the US
securities markets. GCMG has partners and hundreds of professionals in more
than 20 countries around the world.
GCMG assists companies in meeting ongoing SEC
reporting requirements (e.g., review the company’s annual filing on Form
20-F and assist the company in responding to any SEC review comments). They
are qualified to review management’s evaluation of the accounting treatment
under U.S. GAAP and/or IFRS of new, complex or unusual transactions, such as
a new type of financial instrument or a business combination. (Henri
Steenkamp, a native of South Africa and a PwC alumni, is one of these
accounting technical experts who helped companies prepare for IPOs for
PwC before he helped Man Financial spin off MF Global and went on to become
CFO of that PwC audit client.)
Continued in article
Teaching Case from The Wall Street Journal Accounting Weekly Review on
May 18, 2012
TOPICS: Audit Firms, Audit Quality, Auditing, Big Four,
International Auditing, SEC, Securities and Exchange Commission
SUMMARY: By bringing an enforcement action, the SEC is increasing
pressure on the Chinese unit of Deloitte Touche Tohmatsu to submit audit
work papers relating to its client Longtop Financial Technologies, Ltd. This
company is one of a number of Chinese firms that were traded on U.S. stock
exchanges and have become the subjects of SEC investigations into accounting
fraud. Deloitte's Chinese unit resigned from the audit engagement but states
that it is unable to comply with the SEC's subpoena for work papers under
Chinese secrecy laws. The related article specifically quotes a Deloitte
representative stating that the "Chinese authorities explicitly told its
Shanghai unit in June 2011 that they 'did not consent to the production of
the Longtop work papers directly to the SEC.'" If Deloitte does not comply
with the SEC's recent action to enforce the subpoena, the firm could be
barred from auditing publicly traded firms in the U.S.
CLASSROOM APPLICATION: The article is useful to integrate global
business perspectives on the conduct of the auditing profession.
QUESTIONS:
1. (Introductory) What enforcement action has the SEC taken against
the Chinese unit of the global Big Four accounting firm Deloitte Touche
Tohmatsu?
2. (Advanced) What circumstances precipitated this action by the
SEC? Refer to the main and related article.
3. (Introductory) What is the firm's explanation for not complying
with the SEC subpoena and enforcement action?
4. (Introductory) What could happen to Deloitte's Chinese unit and
its staff if the firm does comply with the SEC request?
5. (Advanced) Refer to the related article. How does the auditing
firm hope that this matter will be resolved?
Reviewed By: Judy Beckman, University of Rhode Island
The Securities and Exchange Commission has
ratcheted up the pressure in its monthslong dispute with Deloitte Touche
Tohmatsu's Chinese arm, saying the firm's refusal to turn over documents
violates U.S. law.
Deloitte Touche Tohmatsu CPA Ltd., the
Shanghai-based Chinese affiliate of the Big Four accounting firm, is
violating the Sarbanes-Oxley Act by refusing to turn over audit work papers
requested for a Deloitte client the agency is investigating, the commission
said in an administrative proceeding filed Wednesday.
The case marks the first time the commission has
brought an enforcement action against a foreign audit firm for failing to
comply with a request under Sarbanes-Oxley, which requires foreign firms
that audit U.S.-traded companies provide documents to the SEC on request. If
the proceeding is decided against the Chinese firm, it could be barred from
auditing U.S.-traded companies.
The SEC's move boosts the stakes in its clash with
the Deloitte China affiliate that began last September, when Deloitte
refused to comply with an SEC subpoena seeking documents relating to its
client Longtop Financial Technologies Ltd., a financial-software company
whose shares traded in the U.S. until last December.
Deloitte cited concerns that Chinese authorities
could penalize the firm or its partners under China's state-secrecy laws.
The SEC filed suit in September to enforce the subpoena, and that case
remains pending in U.S. District Court in Washington. Longtop couldn't be
reached for comment.
Deloitte's international organization said in a
statement that its Chinese affiliate "is caught in the middle of conflicting
laws of two different governments" and that Chinese law prohibits accounting
firms in China from providing documents directly to foreign regulators
without government approval, which hasn't been forthcoming. The firm said it
"is hopeful that this diplomatic disagreement will be resolved soon."
The SEC's latest action raises the potential
penalties for Deloitte's Chinese arm and broadens the dispute, by bringing
in a separate request for Deloitte documents relating to a second,
unidentified client that is under SEC investigation.
"The SEC is really upping the stakes here. This is
a pretty strong action," said Paul Gillis, a professor of practice at Peking
University's Guanghua School of Management in Beijing. The commission, he
said, "is really playing tough on [Deloitte], and on the other side the
Chinese aren't giving them a lot of room to wiggle."
An SEC administrative-law judge will hear the
proceeding against the Chinese firm. If the judge decides in the SEC's
favor, the sanctions against the Deloitte affiliate could range from censure
to denial of "the privilege of appearance and practice before the
commission," according to the filing. The affiliate audits more than 40
Chinese companies that are traded on U.S. markets, according to data from
the Public Company Accounting Oversight Board, the U.S. government's
audit-industry regulator.
Is progress about to be made on cooperation between
the United States and China on the inspection of auditing firms?
¶A year ago,
when senior American and Chinese officials met, the
joint statement pledged efforts to cooperate on
inspections of auditing firms. Given the spate of Chinese accounting
scandals, it is clear that something needs to be done, but the Public
Company Accounting Oversight Board in the United States has been unable to
reach an agreement for joint inspections.
¶Instead of
progress, there has been confrontation. The Securities and Exchange
Commission wants to see work papers used by a Deloitte affiliate in China
for its
audit of Longtop Financial Technologies.
¶Deloitte
exposed the Longtop fraud, but had missed it in previous audits. The firm
has gone to court to fight the S.E.C. request, saying that under Chinese law
it
cannot comply with the subpoena.
¶Treasury
Secretary Timothy F. Geithner and Secretary of State Hillary Rodham Clinton
are in Beijing on Thursday for
another round of talks. A new statement is
expected on Friday.
¶A year ago,
at a financial reporting conference at Baruch College in New York, James R.
Doty, the chairman of the accounting board,
gave a major speech on the integrity of auditing.
This year Mr. Doty is nowhere to be seen, although the board has another
member giving a speech.
On Wednesday, Diamond said its audit committee found
that a "continuity" payment made to growers in August 2010 of approximately $20
million and a momentum payment made to growers in September 2011 of
approximately $60 million weren't accounted for in the correct periods. The
audit committee also identified what it called material weaknesses in the
company's internal controls. Diamond said it will restate its results for both
years.
From The Wall Street Journal Accounting Weekly Review on February 10,
2012
SUMMARY: The Diamond Foods Inc. Board of Trustees launched an
investigation into accounting for payments made to walnut growers in August
2010 and September 2011 after a WSJ investigative report questioned the
transactions. That WSJ article was covered in this review and is listed as a
related article. "Diamond originally maintained that the [2010] payments
were an advance on the 2011 walnut crop. But three growers contacted by The
Wall Street Journal said they were told by the company's representatives to
go ahead and cash the checks even though they didn't intend to deliver
walnuts [in 2011]." The investigation has found a material weakness in
internal controls and that payments to walnut growers were not properly
accounted for. "The company will restate its results for both years."
CLASSROOM APPLICATION: Note to instructors: you likely will want to
remove the above summary before distributing to students and use it as a
solution to question #1. The article is useful in accounting systems or
auditing classes to discuss internal control weaknesses; in financial
reporting classes to discuss restatements, debt covenants, and/or business
acquisitions; and in any class to discuss corporate management ethics.
QUESTIONS:
1. (Introductory) Summarize the events at Diamond Foods reported in
this article and the first related article.
2. (Introductory) What has happened to the CEO and CFO as a result
of their alleged actions? What do you think was their motive for these
alleged actions?
3. (Advanced) What financial statement results will be restated by
Diamond Foods? Describe the specific changes you expect to see in the
balance sheet, the income statement, and the statement of stockholders'
equity.
4. (Advanced) What are debt covenants? How might problems with debt
covenants because of these recent events affect Diamond Foods Inc.'s
operations?
5. (Advanced) Refer to the second related article. Identify all
financial statement ratios listed in that article, explaining their meaning
and how they might be affected by the items you listed in answer to question
2 above.
6. (Introductory) What is a material weakness in internal control?
What must be done when such a weakness is found at any company? What further
must be done when the company is public?
7. (Advanced) Why is Procter & Gamble now concerned about selling
its Pringles operations line to Diamond Foods?
Reviewed By: Judy Beckman, University of Rhode Island
Diamond Foods Inc. fired its chief executive and
chief financial officer, and said it would restate financial results for two
years, after an internal probe found it had wrongly accounted for payments
to walnut growers.
The findings mark a stunning comedown for the
once-obscure walnut growers' cooperative, which under Chief Executive
Michael J. Mendes tried to become a force in the snacks business through a
series of acquisitions since 2005. Those efforts peaked last April, when
Diamond agreed to pay $2.35 billion to buy the Pringles canned-chips
business from Procter & Gamble Co.
P&G is now highly unlikely to complete the sale, a
person familiar with the matter said Wednesday. Diamond's shares, already
down by about 60% since late September, fell more than 40% on Wednesday
after the company's board audit committee released the findings of its
investigation.
Results of the internal probe—which was launched
after The Wall Street Journal raised accounting questions in September—will
now be turned over to the U.S. Securities and Exchange Commission and the
San Francisco U.S. attorney's office, which have been investigating Diamond
and how it handled the payments, a person familiar with the matter said.
Federal investigators have progressed slowly in recent weeks, because they
were waiting for the audit committee to produce its report, two people
familiar with the matter said.
The board notified Mr. Mendes and his chief
financial officer, Steven M. Neil, late Tuesday that they had been removed
from their jobs and placed on administrative leave. Mr. Mendes cleaned out
his office early Wednesday morning, a person familiar with the matter said.
Mr. Neil's attorney, Mike Shepard, said: "I think
it's very disappointing news what we saw from the company in light of the
fact that experts in the area say the company's accounting was strongly
supported."
Mr. Mendes couldn't immediately be reached for
comment.
The executives will remain on leave while the
company negotiates their severance, their exit from their board seats and
possibly clawbacks of previously awarded pay, a person familiar with the
matter said Wednesday.
Diamond board member Rick Wolford will serve as
acting CEO. Michael Murphy, managing director at Alix Partners LLP, will
serve as acting CFO. The board also appointed Robert J. Zollars as chairman.
The company said it will begin searching for permanent replacements.
The accounting controversy sprung out of
California's walnut groves, which once sold
the bulk of their output to Diamond. But the interests of growers and the
company began to separate after the company began to answer to public
shareholders. Growers have complained that Diamond, which sets walnut prices
in secret and pays for crops in a series of payments months after they are
delivered, began paying less than other buyers in recent years, according to
growers and investors who have conducted their own surveys.
At issue in the audit committee's investigation
were payments made in August 2010 and September 2011, according to the
company. The September payments, which the company called "momentum
payments," confused growers who couldn't tell whether they were for the
current or prior fiscal year.
Diamond originally maintained that the payments
were an advance on the 2011 walnut crop. But three growers contacted by The
Wall Street Journal said they were told by the company's representatives to
go ahead and cash the checks even though they didn't intend to deliver
walnuts last year. At the time, Diamond said its agreements with growers are
confidential.
That question mattered a lot for Diamond's
financial reports. Shareholders suing the company allege the payments may
have been used to shift costs from the last fiscal year into the current
one, burnishing Diamond's earnings and improperly boosting its stock price.
The company declined to comment on shareholders'
claims that the payments had been used to inflate its earnings. Those suits
have been consolidated.
On Wednesday, Diamond said its audit committee
found that a "continuity" payment made to growers in August 2010 of
approximately $20 million and a momentum payment made to growers in
September 2011 of approximately $60 million weren't accounted for in the
correct periods.
The audit committee also identified what it called
material weaknesses in the company's internal controls. Diamond said it will
restate its results for both years.
Around the time of the September payments, Diamond
reported that its earnings for the year ended July 31 had nearly doubled, to
$50 million, sending its shares soaring above $90. The shares began a steep
decline soon afterward, after The Wall Street Journal raised questions about
the company's accounting for the payments.
The probe has caused Diamond Foods to delay its
planned acquisition of the Pringles snack brand from P&G.
P&G in April agreed to sell the potato-crisp maker
to Diamond Foods, a deal that would allow it to triple the size of its snack
business.
That deal is now in question, as Diamond is
covering most of the purchase price by issuing stock to P&G's shareholders.
The deal was initially valued at $2.35 billion. Since the deal was
announced, Diamond's stock has lost nearly two-thirds of its value.
P&G had said completing the deal depends on a
favorable resolution of the accounting probe.
"We're obviously disappointed by the information
released by Diamond Foods," says Paul Fox, a P&G spokesman. "We need to
evaluate our next steps…either retain the business or we sell it. It's
already attracted considerable interest from outside parties."
Diamond Foods had annual sales just shy of $1
billion in the latest fiscal year. Pringles has annual sales of nearly $1.4
billion.
Diamond said in November it had opened an
investigation into the payments. The audit committee, advised by law firm
Gibson, Dunn & Crutcher LLP and accounting firm KPMG LLP, looked at hundreds
of thousands of documents, a person familiar with the matter said.
The committee reached its conclusion that the
company's accounting was flawed on Tuesday, Diamond said in a securities
filing. Once it had, the board moved quickly to make changes. It decided
that day to remove Messrs. Mendes and Neil because of "a loss of confidence
by the board more than anything else,'' a person familiar with the matter
said.
The restatements could put Diamond in violation of
its lending agreements. That means it may have to negotiate with creditors,
which in theory could impose increases in Diamond's debt costs.
The company had just over $500 million in debt as
of its last official filing.
The new executives were appointed Tuesday with the
exception of Mr. Murphy, the new CFO, who took his job Wednesday, according
to the filing. Diamond informed P&G about the probe's results less than an
hour before issuing a news release, people familiar with the matter said.
The audit committee didn't uncover any evidence of
intent to deceive shareholders, according to a person familiar with the
matter. "There was a breakdown of controls,'' the person said.
Continued in article
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
of
Diamond Foods, Inc.
San Francisco, California
We have audited the accompanying
consolidated balance sheets of Diamond Foods, Inc. and subsidiaries (the
“Company”) as of July 31, 2010 and 2009, and the related consolidated statements
of operations, stockholders’ equity, and cash flows for each of the three years
in the period ended July 31, 2010. We also have audited the Company’s internal
control over financial reporting as of July 31, 2010, based on criteria
established in
Internal
Control — Integrated Framework
issued by the
Committee of Sponsoring Organizations of the Treadway Commission. As described
in “Management’s Report on Internal Control over Financial Reporting”,
management excluded from its assessment the internal control over financial
reporting at Kettle Foods, which was acquired on March 31, 2010 and whose
financial statements constitute less than 10% of consolidated assets, and less
than 15% of consolidated net sales of the consolidated financial statement
amounts as of and for the year ended July 31, 2010. Accordingly, our audit did
not include the internal control over financial reporting at Kettle Foods. The
Company’s management is responsible for these financial statements, for
maintaining effective internal control over financial reporting, and for its
assessment of the effectiveness of internal control over financial reporting,
included in the accompanying “Management’s Report on Internal Control over
Financial Reporting.” Our responsibility is to express an opinion on these
financial statements and an opinion on the Company’s internal control over
financial reporting based on our audits.
We conducted our audits in accordance with
the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement and whether effective internal control over financial reporting was
maintained in all material respects. Our audits of the financial statements
included examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. Our audit of internal control over financial
reporting included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, and testing and
evaluating the design and operating effectiveness of internal control based on
the assessed risk. Our audits also included performing such other procedures as
we considered necessary in the circumstances. We believe that our audits provide
a reasonable basis for our opinions.
A company’s internal control over
financial reporting is a process designed by, or under the supervision of, the
company’s principal executive and principal financial officers, or persons
performing similar functions, and effected by the company’s board of directors,
management, and other personnel to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting
principles. A company’s internal control over financial reporting includes those
policies and procedures that (1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (2) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company’s assets that could have a
material effect on the financial statements.
Because of the inherent limitations of
internal control over financial reporting, including the possibility of
collusion or improper management override of controls, material misstatements
due to error or fraud may not be prevented or detected on a timely basis. Also,
projections of any evaluation of the effectiveness of the internal control over
financial reporting to future periods are subject to the risk that the controls
may become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial
statements referred to above present fairly, in all material respects, the
financial position of Diamond Foods, Inc. and subsidiaries as of July 31, 2010
and 2009, and the results of their operations and their cash flows for each of
the three years in the period ended July 31, 2010, in conformity with accounting
principles generally accepted in the United States of America. Also, in our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as of July 31, 2010, based on the criteria
established in Internal Control — Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission.
Deloitte & Touche LLP
San Francisco, California
October 5, 2010
A December 21, 2011 WSJ Article on Those Startling Deloitte Audits That Are
Beginning to Remind Us of Those Sorry Andersen Audits
"Accounting Board Finds Faults in Deloitte Audits," by Michael Rapaport,
The Wall Street Journal, December 21, 2011 ---
http://online.wsj.com/article/SB10001424052970204879004577110922981822832.html
Inspectors for the government's audit-oversight
board found deficiencies in 26 audits conducted by Deloitte & Touche LLP in
its annual inspection of the Big Four accounting firm.
The report from the Public Company Accounting
Oversight Board, released Tuesday, said some of the deficiencies it found in
its 2010 inspection of Deloitte's audits were significant enough that it
appeared the firm didn't obtain enough evidence to support its audit
opinions.
The 26 deficient audits found were out of 58
Deloitte audits and partial audits reviewed by PCAOB inspectors. The
inspectors found that, in various audits, Deloitte didn't do enough testing
on issues like inventory, revenue recognition, goodwill impairment and fair
value, among other areas. In one case, follow-up between Deloitte and the
audit client led to a change in the client's accounting, according to the
report.
The board didn't identify the companies involved,
in accordance with its typical practice.
The report is the first PCAOB assessment of
Deloitte's performance issued since the board rebuked Deloitte in October by
unsealing previously confidential criticisms of the firm's quality control.
Deloitte said in a statement that it is "committed
to the highest standards of audit quality" and has taken steps to address
both the PCAOB's findings on the firm's individual audits and the board's
broader observations on Deloitte's quality control and audit quality. The
firm said it has been making a series of investments "focused on
strengthening and improving our practice."
Last month, the board released its annual reports
on PricewaterhouseCoopers LLP, in which it found 28 deficient audits out of
75 reviewed, and KPMG LLP, in which it found 12 deficient audits out of 54
reviewed. The yearly report on the fourth Big Four firm, Ernst & Young LLP,
hasn't yet been issued.
The PCAOB conducts annual inspections of the
biggest accounting firms in which it scrutinizes a sample of each firm's
audits to evaluate their performance and compliance with auditing standards.
The first part of the report is released publicly, but a second part, in
which the board evaluates the firm's quality controls, remains confidential
as long as the firm resolves any criticisms to the board's satisfaction
within a year.
Only if that doesn't happen does the PCAOB release
that section of the report, as it did with Deloitte in October, the first
time it had done so with one of the Big Four. In that case, the board made
public a section of a 2008 inspection report in which it said Deloitte
auditors were too willing to accept the word of clients' management and that
"important issues may exist" regarding the firm's procedures to ensure
thorough and skeptical audits.
The PCAOB, the audit industry regulator,
shamed global audit firm Deloitte recently when
they exposed the private portion of the inspection report of the firm’s 2006
audits. It was the first time that had happened to one the Big Four audit
firms, the largest firms that audit the vast majority of publicly listed
firms in and out of the U.S..
re: The Auditors has seen a confidential,
internal Deloitte training document, prepared this past summer, that reveals
the firm expects the worst when the inspection reports for their 2009, 2010,
and 2011 audits are published by the PCAOB. The 2009 report should be out by
the end of this year. The training document also shows how difficult it is
for Deloitte leadership to steer the largest global firm away from the
“audit failure”
iceberg.
It seems audit competence and capacity to audit
complex topics are in short supply at all the firms, based on PCAOB
inspection
results for audits conducted during the financial crisis period and
the reports for 2010 audits at PwC and KPMG released recently. Deloitte has
been particularly hard pressed to maintain audit quality since the firm lost
several engagements that would have helped to grow specialized knowledge and
retain experts. Big clients like Merrill Lynch, Bear Stearns, and Washington
Mutual helped pay the bills for subject matter experts and quality control
but those revenues were lost to financial crisis failures and forced
combinations with better capitalized, non-audit client banks.
I think the PCAOB decided to publicly criticize
Deloitte for two reasons.
The firm has been
piling on the negatives via a $1,000,000
fine/disciplinary sanction as a firm for a previous issue, two high
level insider trading scandals (Flanagan and McClellan), the failures
and frauds of Deloitte China clients CCME, Longtop and now Focus Media,
and the specific failures of major clients during the crisis (Bear
Stearns, Merrill Lynch, WaMu, Taylor Bean & Whitaker, American Home, and
Royal Bank of Scotland, to name a few).
Deloitte was resistant to the inspections,
resistant to the criticisms, and unwilling to make changes based on the
PCAOB’s requests. If you can’t fix something that’s one thing. If you
won’t and thumb your nose at the regulator, you are getting close to
Arthur Andersen-like behavior.
We know how that story ended.
If they did nothing, the PCAOB risked having a new
major failure of a Deloitte client expose their lack of push on the firm to
even respond, let alone improve.
I wrote in
American Banker about the special risks to
financial services firms when the regulated, like Deloitte, resists the
regulator:
The PCAOB’s decision to make the Deloitte 2006
quality control criticisms public, and the fact that the Securities and
Exchange Commission allowed it to do so, tell me Deloitte is still
fighting the regulators. The deadlines for Deloitte to fix or
sufficiently respond to criticisms in the 2007 and 2008 inspection
reports have passed. We could soon see previously nonpublic information
from those reports, too.
The risk for banks in a situation like this is
that an auditor that brazenly irritates its regulator may draw unwanted
attention to its clients from their regulators. For example, PCAOB
spokeswoman Colleen Brennan reminds me that the SEC knows the names of
every company whose audit deficiencies are mentioned in a PCAOB auditor
inspection report.
These risks apply to all of Deloitte’s clients and
to all public companies if the rest of the firms – KPMG, PwC, and Ernst &
Young – are also playing chicken with the regulator.
A little more than a month after releasing the
Deloitte private report, the PCAOB released the inspection reports for
audits performed by PwC and KPMG in 2009. The Financial Times’Kara
Scannell
summarizes the findings:
The Public Company Accounting Oversight Board’s
findings from an annual inspection revealed that years after the
financial crisis both auditing firms were not adequately challenging
companies’ valuations of certain assets when the market for them dried
up…
The board reviewed 71 audits completed by PwC
in 2010 and 52 audits done by KPMG in 2010.
The government’s auditing regulator found
deficiencies in 28 audits conducted by PricewaterhouseCoopers LLP and 12
audits by KPMG LLP in its annual inspections of the Big Four accounting
firms.
The Public Company Accounting Oversight Board
said many of the deficiencies it found in its 2010 inspection reports of
the two firms, released Monday, were significant enough that it appeared
the firms didn’t obtain sufficient evidence to support their audit
opinions.
The regulator hasn’t yet issued its yearly
reports on its inspections of the other Big Four firms, Ernst & Young
LLP and Deloitte LLP.
KPMG’s response to the PCAOB was not quite as
belligerent as Deloitte’s persistent irritation at having their
“professional judgment second-guessed”. But, it was not exactly conciliatory.
Normally these letters say something like what
KPMG wrote:
“We conducted a thorough evaluation of the
matters identified in the draft report and addressed the
engagement-specific findings in a manner consistent with PCAOB auditing
standards and KPMG policies and procedures.”
You may note that said nothing about whether
the firm accepted the board’s conclusions or not. That is better than
what Deloitte did a few years ago, when it essentially said the board
did not know what it was talking about.
PwC, on the other hand, met the regulator more than
half way according to Norris:
PwC’s letter addressed that issue, saying that
while there were cases where it differed with the board’s conclusions,
“they generally related to the significance of the finding in relation
to the audit taken as a whole, and not to the substance of the finding.”
“Accordingly,” wrote the PWC officials, “the
overall PCAOB inspection results, as well as the results of our internal
inspections, were important considerations in formulating our quality
improvement plan,” which it then describes.
PwC’s spokesperson sent me this additional
statement:
“PwC is built on our reputation for delivering
quality. We also recognize that the role we play in the capital markets
requires consistent, high-quality audit performance. We therefore are
focused on the increase in the number of deficiencies in our audit
performance reported in the 2010 PCAOB inspection over prior years. We
are working to strengthen and sharpen the firm’s audit quality,
including making investments designed to improve our performance over
both the short- and long-term.”
And what about the Deloitte improvement plan for
prior years? Has Deloitte accepted the PCAOB’s criticisms and moved on or
are they still fighting the regulator? Is Deloitte working hard to get ahead
of their 2009, 2010, and 2011 results and avoid the embarrassment or worse –
sanctions – if the PCAOB has to publish another private report?
The confidential internal training report, intended
to brief Subject Matter Resources (SMR), is called, “FY 2012 Engagement
Quality Activities”.
The Audit Quality Activity Plan for FY2012 has
been socialized with:
– The OAQ Steering Committee
– The Audit Quality Council
– The RMPs
– The NPPDs
– The RILs
– Leaders in the PPN
– Extended Leadership Team
– CFO / CEO
Yeah, that’s a lot of acronyms. And I’m not sure
anymore – maybe I’ve been out of the firms too long or maybe I was never in
them enough – what “socializing” a quality plan
means. Suffice to say, the document, one hundred and eight-one very dense
PowerPoint pages, has tons of information for the SMRs to absorb and pass on
to engagement teams like now.
But, by this summer, it was too late to make a
difference in the inspection reports for the 2009 and 2010 audits.
2009
Response submitted on May 4
2010
Total of 98 comments (56 engagements
inspected)
Expect about 25 engagements to appear in
Part I
Draft report has not yet been issued
2011
33 engagements selected to date
Focus areas
– Continue to include: fair value and impairment determinations;
internal controls – Also focusing more on revenue recognition
16 completed
– 5 with no written comments
Total of 24 comments on 11 completed
inspections
If Deloitte sent their response to the PCAOB for
the 2009 audits on May 4th,
why are we still waiting for the final report?
Given the PCAOB’s decision to release Part 2 of the inspection report for
Deloitte’s 2006 audits last month, I believe Deloitte was still treating
PCAOB comments as an affront to partners’ professional judgments.
What are the root causes for so many negative PCAOB
comments, according to Deloitte?
Continued in article
Jensen Comment
Deloitte may be frustrated with the PCAOB at the moment, but my guess is
Deloitte's partners are raising their glasses at being able settle the
Washington Mutual (WaMu) case for a settlement share of a mere $18.5 million.
WaMu was the biggest bank to ever fail. And the bank failed after receiving a
glowing going concern audit reports from Deloitte. It could've been far worse
when the banking lawsuit dust settled for Deloitte, at least to date.
Francine contends that Deloitte is the biggest loser among all the Big Four
firms since the 2008 financial crisis. However, in the banking lawsuits all the
Big Four auditors seem to be getting off for pennies on the dollar relative to
the losses to banking shareholders, creditors, and taxpayers. KPMG seems to be a
bigger loser than Deloitte in terms of subprime fraud settlements, but even for
KPMG the settlements are merely hand slaps relative to damages done by slipshod
auditing and enormous underestimations of loan loss reserves.
None of the Big Four auditing firms are doing well in the PCAOB audit
inspection reports. The highest auditing fees in the world do not seem to be
buying as much auditing value added as those auditing firms would like us to
believe.
Remember Annabel McClellan? She’s the wife of
former Deloitte
partner Arnold McClellan who sorta got wrapped up into
an insider trading mess with her sister and brother-in-law
last fall. Annabel is also a former Deloitte
employee who gave up the glamorous life of a Salzberg solider to be a
stay-at-home mom. Oh! and she was working on
swingers app called My Nookie that was on the
verge of taking the scene by storm. The whole insider trading thing put
those ambitions on hold due to the fact that Annabel may be
looking at some jail time and she
settled civil charges with the SEC yesterday for $1 million.
The good news for Arnie is that if judge gives the
settlement the thumbs-up, he’ll be off the hook who, prosecutors say, had no
clue that the Mrs. was engaging in extracurricular activities:
Deloitte & Touche LLP repeatedly failed to support
assumptions in audits examined in a 2007 inspection, the Public Company
Accounting Oversight Board said in the first public report of unresolved
deficiencies involving one of the so-called Big Four accounting firms.
The firm’s quality controls and independence
systems give “cause for concern,” the PCAOB said in its report, which was
released today. The Washington-based nonprofit, created in 2002 to oversee
audits of public companies after the collapses of Enron Corp. and WorldCom
Inc., gives audit firms at least a year to fix deficiencies and only
releases the reports in cases where auditors fail to make sufficient
improvements.
“These deficiencies may result, in part, from a
Firm culture that allows, or tolerates, audit approaches that do not
consistently emphasize the need for an appropriate level of critical
analysis,” the PCAOB said in the Deloitte report, which didn’t name the
clients involved in the cited audits.
The PCAOB in 2007 looked at Deloitte’s practices
through inspections at the company’s New York headquarters and 18 other
offices. The report made public today lays out instances in which the firm
insufficiently weighed clients’ valuation of assets and income-tax
assumptions. The watchdog also faulted Deloitte’s independence procedures,
saying it “has no formal system in place to monitor the services its foreign
affiliates actually perform.”
“In our drive for continuous improvement, we have
been making a series of investments focused on strengthening and improving
our practice,” Deloitte Chief Executive Officer Joe Echevarria said in a
statement. Echevarria, who has been with the firm since 1978, was elected to
the top job in April.
The disclosure isn’t a disciplinary action, said
Colleen Brennan, a PCAOB spokeswoman. Dozens of smaller registered public
accounting firms have had similar criticisms made public and have retained
their registration, she said.
The Human Rights Campaign has named Deloitte one of
the best places to work for the sixth year in a row. In their 2012 Corporate
Equality Index, the HRC noted that it gave Deloitte a 100 percent rating.
Deloitte chief talent officer, Jennifer Steinmann,
said that Deloitte is constantly working to provide a workplace that
employees will be proud of. Steinmann said that they offer a culture that
helps the LGBT community and encourages all of its employees to feel
accepted.
Steinmann said that Deloitte offers a number of
solutions to the variety of challenges they face as they strive to create an
environment that increases employee morale and gives all employees the
opportunity to thrive. Deloitte has used a number of Business Resource
Groups to educate employees and offer them the resources they need to
address the challenges they face in the workplace.
HRC is making its standards increasingly strict.
Due to the changes in their eligibility standards, about 50 percent of
companies have fallen off of the list. New standards include providing a
culture for members of the LGBT community and promoting company citizenship.
Steinmann and other representatives at Deloitte
state that they are proud of the fact that Deloitte has consistently earned
this recognition since 2006.
Nortel Networks Corp. executives knew as early as
the fall of 2002 that they were facing losses in the first half of 2003, but
manipulated accounting reserves to ensure a profit in the period so they
could trigger their “return to profitability” bonus payments, a Toronto
court heard Tuesday.
In his opening statement in the fraud trial of
three former Nortel executives, Crown attorney Robert Hubbard said the
executives even turned an unexpected profit into a loss in the final quarter
of 2002 because it came too early to trigger their bonuses.
“Contrary to Nortel’s own policy for closing its
books, senior executives solicited further [accounting] accruals from across
the company to turn a profit into a loss,” Mr. Hubbard told Mr. Justice
Frank Marrocco of the Ontario Superior Court.
Defence lawyers in the fraud trial of three former
Nortel Networks executives say the company's independent auditors gave their
stamp of approval to financial matters at Nortel.
The lawyers say that contradicts Crown allegations
the men were conspiring to defraud the company by cooking its books and
manipulating profit reports.
David Porter, counsel for Nortel's ex-CEO Frank
Dunn, says accounting firm Deloitte and Touche closely and continuously
reviewed and approved the finances of the fallen telecom equipment maker.
He says that external approval negates the Crown's
allegations the accused oversaw a widespread scheme to falsify Nortel's
records.
He says the kind of white collar crime ring
described by the Crown would be unprecedented and would have to involve
hundreds of accredited accountants at both Nortel and Deloitte.
Porter delivered opening arguments on behalf of all
three accused as the court hears from the defence after a 2 1/2 day opening
statement by the Crown.
Continued in article
Question
Does this reaffirm the PCAOB implication that Deloitte is the worst of the Big
Four auditing firms?
Personally, I doubt it since all four auditing firms seem to be making a lot
of mistakes lately.
Deloitte & Touche LLP repeatedly failed to support
assumptions in audits examined in a 2007 inspection, the Public Company
Accounting Oversight Board said in the first public report of unresolved
deficiencies involving one of the so-called Big Four accounting firms.
The firm’s quality controls and independence
systems give “cause for concern,” the PCAOB said in its report, which was
released today. The Washington-based nonprofit, created in 2002 to oversee
audits of public companies after the collapses of Enron Corp. and WorldCom
Inc., gives audit firms at least a year to fix deficiencies and only
releases the reports in cases where auditors fail to make sufficient
improvements.
“These deficiencies may result, in part, from a
Firm culture that allows, or tolerates, audit approaches that do not
consistently emphasize the need for an appropriate level of critical
analysis,” the PCAOB said in the Deloitte report, which didn’t name the
clients involved in the cited audits.
The PCAOB in 2007 looked at Deloitte’s practices
through inspections at the company’s New York headquarters and 18 other
offices. The report made public today lays out instances in which the firm
insufficiently weighed clients’ valuation of assets and income-tax
assumptions. The watchdog also faulted Deloitte’s independence procedures,
saying it “has no formal system in place to monitor the services its foreign
affiliates actually perform.”
“In our drive for continuous improvement, we have
been making a series of investments focused on strengthening and improving
our practice,” Deloitte Chief Executive Officer Joe Echevarria said in a
statement. Echevarria, who has been with the firm since 1978, was elected to
the top job in April.
The disclosure isn’t a disciplinary action, said
Colleen Brennan, a PCAOB spokeswoman. Dozens of smaller registered public
accounting firms have had similar criticisms made public and have retained
their registration, she said.
When I’m not wondering, “Where is my coffee?”, I’m
usually curled up in a ball in the corner of my little living room filled
with Latin American art moaning, “Where were the auditors?”
Me insufficiently caffeinated. Not a pretty
picture.
Ugly also are the blank stares from contorted faces
glaring back at me when I talk about auditors and their
“good crisis.”
The largest global audit firms are everywhere – in
every public company and working for the government agencies that regulate
them. They’re about as welcome as a hard rain and, yet, officially
necessary.
Can anyone deny that there are four firms – KPMG,
Deloitte, PricewaterhouseCoopers (PwC), and
Ernst & Young (auditor to Lehman) –
who knew all along what was going on and never told a
soul, including the SEC?
The story
Bloomberg’s Tom Schoenberg tells today of
Fannie Mae’s complicity in the Taylor, Bean &
Whitaker (TBW) $3 billion mortgage fraud scares the bejeezus out of me.
That’s because, like the little boy in “The Sixth Sense” who sees dead
people, I see complicit or, at the very least incompetent, auditors
everywhere. What’s even more frightening is that there are only four firms
of sufficient size to audit the largest public companies and they’re getting
bigger and even more powerful.
Giant accounting and consulting firm Deloitte
Touche Tohmatsu has been accused of failing to detect fraud during audits of
a mortgage firm which failed during the US housing crash.
A trust overseeing now-defunct Taylor, Bean &
Whitaker (TBW), and one of the company's subsidiaries, have filed complaints
in a Florida court.
They are claiming a combined $7.6bn (£4.9bn) in
losses.
TBW shut down after federal agents raided its
headquarters in August 2009.
Deloitte spokesman Jonathan Gandal said the firm
rejected the court claims, and that they were "utterly without merit". 'Red
flags'
The fraud at Ocala-based TBW began in 2002 and
continued until its collapse two years ago.
Seven TBW executives were convicted of federal
criminal charges, with former chairman Lee B Farkas sentenced to 30 years in
jail.
The lawsuits claim Deloitte's certifications of the
TBW books were essential in giving it the appearance of a legitimate
mortgage business.
However the lawsuits say TBW was selling false or
highly overvalued mortgages, mis-stating its liabilities and hiding
overdrawn bank accounts.
"They [Deloitte Touche Tohmatsu] certainly did not
do their job," said attorney Steven Thomas, who represents those suing
Deloitte.
"This is one of those cases where the red flags are
staring you in the face, and you've got to do a lot, and they did not."
Navistar
International Corp. (NAV), a maker of medium- and heavy-duty trucks, accused
its former auditor Deloitte & Touche LLP of professional malpractice in a
lawsuit seeking $500 million in damages.
Navistar claimed
shoddy work by Deloitte & Touche accountants from 2002 to 2005 forced the
company to revise its financial statements, according to a 134-page
complaint filed today in Illinois state court in Chicago.
“Deloitte lied to
Navistar and, on information and belief, to Deloitte’s other audit clients,
as to the competency of its audit and accounting services,” the Warrenville,
Illinois-based truck maker alleged in its complaint.
Deloitte & Touche,
based in New York, functioned as an auditor, accountant and adviser to
Navistar for almost a century, a relationship that ended in April 2006,
according to the complaint.
Navistar said in
April 2006 that its restatements for 2002 through the third quarter of 2005
were related to warranties and product-development programs at suppliers. It
also said it was replacing Deloitte with KPMG LLP. The restatements were
made in 2007.
In its
complaint today, the truck maker accused its former auditor of fraud,
fraudulent concealment, breach of contract and malpractice relating to the
advice and auditing services Deloitte gave Navistar.
Continued in article
Jensen Comment
What makes me think that Francine will be dancing on those stiletto heels
tonight. She loves to play gotcha with Deloitte.
Mainstream media,
and the Financial Crisis Inquiry Commission, are focused mainly on Ernst &
Young as the auditor whipping boy of the financial crisis. That’s really by
default not by design and is thinly justified. No one has given fly-over
journalists anything on a silver platter that would draw in the rest. Not
that there aren’t a number of reasons to look hard at all of them. They are
feigning outrage in the UK. But here in the US, we treat the audit firms as
untouchable.
That doesn’t stop
me from highlighting all the reasons why the rest of the Big 4 should be
scrutinized as much or, perhaps, even more than Ernst & Young for their role
in the crisis. And, of course, you know I believe there’s more than their
behavior during the crisis to warrant significant scrutiny of the industry’s
model and its methods. The popular perception is Ernst & Young is the most
vulnerable of the largest firms because of its troubles with Lehman, but
that’s more a public relations problem than a fact-based conclusion.
Granted, Ernst &
Young hasn’t been very good at crisis communications. In fact, they’ve
really sucked at it since last March. Their delay in responding to the
original Lehman Bankruptcy Examiner’s report and the suit filed by the New
York Attorney General is a case study in how not to respond. Because that’s
what they did. Not respond. They either didn’t respond at all to journalists
or issued the standard auditor response to any lawsuit. That’s the one with
two sentences, or one long one, that includes the phrases “according to
GAAP”, “followed all standards”, “stand by our work”, and “we just stand
there”.
Give me a few
minutes and I can make a case for PricewaterhouseCoopers as the one
teetering on the edge of the abyss instead. Or KPMG.
But today, let’s
talk about Deloitte.
A few weeks ago I
detailed the case of Arnold McClellan, the Deloitte Tax partner who is
accused of using his knowledge of Deloitte client private equity firm
Hellman & Friedman’s acquisitions to pass insider trading tips to his UK
relatives. Deloitte, the firm, is cooperating with FSA, SEC, and DOJ
investigations of these allegations, as they did in the SEC’s investigations
of their other partner inside trader – former Deloitte Vice Chairman Tom
Flanagan. Mr. Flanagan’s case was settled with the SEC last summer and
McClellan’s will eventually be settled, too. In both cases, Deloitte’s
cooperation will save them from fines and sanctions or even a consent decree
requiring them to clean up their compliance act.
How does that
translate into trouble for Deloitte? After all, they’re skating away as a
firm from major insider trading scandals, looking like the good firm.
Well…Two serious insider trading cases, both involving partners and high
profile target companies, playing out during the same time frame equals
holes in Deloitte’s internal compliance processes you can drive a Mack truck
through. Whether the SEC or Deloitte admit it publicly, the heat is on and
it’s only a matter of time before another case bobs to the surface. Or more
than one.
How many times can
Deloitte claim the firm is being “duped” by its own partners? Eventually
there will be an egregious case where the firm has to pay a fine or worse.
I’m sure there’s already a lot more headaches in the annual independence
process for partners and their families. If not, both the SEC and the firm
are playing with fire.
Last week I wrote
in Forbes about the victory for class action plaintiffs suing Bear Stearns
executives and Deloitte for Bear Stearns’ part in the financial crisis. It’s
a major accomplishment to get a crisis suit past the motions to dismiss, in
general but especially significant, in particular, when thesuit also names
the auditor as a defendant. Deloitte will now be subject to discovery and a
trial – if they don’t settle first – to refute allegations they performed
“no audit at all” at Bear Stearns.
That was the
gist of allegations in the UK’s House of Lords regarding Deloitte’s audit of
Royal Bank of Scotland. That failed bank was nationalized by the British
government and never received a “going concern” qualification in enough time
to warn anyone.
Continued in article
Jensen Comment
In spite of the mention of Ernst & Young above, it is my general feeling that
Francine has it in for Deloitte more than the other three of the Big Four
oligopoly. Of course she hammers at all of the Big Four now and then. But
Deloitte seems to ruffle her feathers more than the rest.
Deloitte is the only one of the Big
Four that did not sell or spin off its huge consulting division. However, I
don't think, since the days of Andersen, that consulting is the main threat to
auditor independence. The main threat, in my viewpoint, is that in certain
practice offices in all the Big Four audit firms there are some audit clients
too big to not get clean audit opinions.
Bob Jensen's threads on Deloitte and
the rest are at
http://www.trinity.edu/rjensen/Fraud001.htm
One of Deloitte's worst audits had to be Washington Mutual just prior to when
this enormous bank with what was probably the worst lending practices of all the
failed banks got a clean opinion with badly underestimated loan losses from
Deloitte. Instead WaMu should've gotten a going concern signal from the auditors
before it went belly up!
A Pacific Heights
housewife will be heading to prison after pleading guilty Tuesday to insider
trading and obstruction of justice charges.
In her plea
agreement, Annabel McClellan says she gleaned confidential information about
publicly traded companies by overhearing her husband, Arnold McClellan, then
a partner at Deloitte Tax LLC, discussing details of deals he was working
on. She then passed the information on to her sister, Miranda Sanders, and
brother-in-law, James Sanders, who was involved in a trading business in
London, according to the document.
The Office of
Inspector General of the USAID did release the much-anticipated audit report
of Deloitte’s role in the Kabul bank debacle. It’s a 23 page detailed report
and a quick synopsis follows:
The OIG contends
that BearingPoint and Deloitte advisers embedded at Afghanistan Central Bank
(DAB) did see several fraud indications at Kabul Bank for over 2 years
before the run on Kabul Bank in early September 2010; but did not
aggressively follow up on indications of serious problems at Kabul Bank.
Further, the OIG
contends that Deloitte advisers did not report fraud indicators at Kabul
Bank to USAID. In addition, the mission did not have a policy requiring
contractors and grantees to report fraud indicators.
Finally, the OIG
contends that USAID/Afghanistan’s management of its task order with Deloitte
was weak; and if senior program managers and technical experts had been on
staff at the mission, USAID could have managed Deloitte better and ask
deeper questions than just accepting them at face value.
In a reply back to
Timothy Cox, OIG/Afghanistan Director, David McCloud, Acting Assistant to
the Administrator, Office of Afghanistan and Pakistan Affairs, makes several
counter arguments:
That there was no
indications of fraud, waste or abuse by USAID or Deloitte.
Deloitte could not
have stopped the massive fraud that occurred at Kabul Bank.
USAID and
Deloitte’s scope of work and mandate under Component 2 of the Economic
Growth and Governance Initiative task order was to provide trainers and
technical experts to build the capacity
of the Bank
Supervision unit within the Central Bank of the Government of Afghanistan,
Afghanistan Bank, and not for Deloitte itself to supervise private banks.
USAID agrees that
Deloitte should have aggressively reported evidence of fraud at Kabul Bank
to the Mission.
And then, McCloud
brings up an interesting twist by introducing another Big Four firm, PwC,
which performed an audit of Kabul Bank, but did not bring up any
discrepancies or evidence of fraud, which perhaps delayed any potential
investigations and prevented a true understanding of the situation.
“The audit
performed by an affiliate of PricewaterhouseCoopers (PwC) was not directly
mentioned in the body of the OIG report but it was a significant source of
information to the Central Bank¡¦s examination staff. The resulting clean
bill of financial health of Kabul Bank issued by PwC may have acted to delay
understanding of the gravity of Kabul Bank’s true financial condition both
among the examination staff and the international community.
Deloitte’s
audits “were so deficient that the audit amounted to no audit at all,”
the [Bear Stearns investors] plaintiffs argued in court papers.
That’s
Reuters describing the rationale behind the
decision of US District Judge Robert Sweet on January 23, 2011 to allow a
case against fallen investment bank Bear Stearns and its outside auditor,
Deloitte, to go forward.
The decision
for a group of plaintiffs, including the State of Michigan Retirement
system, and their attorneys is indeed sweet. Subprime suits have been
hampered by the argument they are trying to punish the case of “classic
fraud by hindsight”. Bankers did a great job during and after the crisis of
describing the events that occurred as “black swan” events,
forces of nature that could not have been
identified in advance.
This decision
is even more significant because it provides a successful template for
including claims against the auditors for financial crisis failures when
warranted. In
Ernst & Ernst v. Hochfelder, the Supreme
Court held that actions under Section 10(b) of the Exchange Act and Rule
10b-5 require an allegation of “`scienter’—intent to deceive, manipulate, or
defraud.” The “scienter” requirement, necessary to sustain allegations
against the auditors in a securities claim under Section 10(b), is
notoriously difficult to meet.
If there’s
anything of substance in a claim against auditors the case usually settles
before the facts are made public. New Century Trustee v. KPMG is an
early crisis mortgage originator case, cited several times in this
decision. However, those facts will never be heard in open court. In spite
of – or perhaps because of – very particular examples of reckless behavior
by the auditor documented by the bankruptcy examiner,
the case was settled.
The Ernst &
Ernst v. Hochfelder decision left open the question of “whether, in
some circumstances, reckless behavior is sufficient for civil liability
under § 10(b) and Rule 10b-5.” However, since Ernst, most courts
have concluded that recklessness can satisfy the requirement of “scienter”
in a securities fraud action against an accountant.
“Recklessness” in a
securities fraud action against an accountant is defined as, “highly
unreasonable [conduct], involving not merely simple, or even inexcusable
negligence, but an extreme departure from the standards of ordinary care,
and which presents a danger of misleading buyers or sellers that is either
known to the defendant or is so obvious that the actor must have been aware
of it.”
Cringe] Oops.
To be fair, auditors can’t be expected to be hand-writing experts…can they?
Mr. Calvert seems to think so and told the Seattle Times that he plans on
suing Moss Adams and Deloitte for their roles. Oh, right! How do they fit
in?
TOPICS: Ethics, Insider Trading, Public Accounting, Securities and Exchange
Commission
SUMMARY: "The Securities and Exchange Commission on Tuesday charged a former
partner at Deloitte Tax LLP and his wife with passing nonpublic information
about pending corporate deals to relatives in London, in an alleged
multimillion-dollar insider-trading scheme uncovered jointly by U.K. and
U.S. authorities... The McClellans allegedly learned about the deals through
Mr. McClellan's work leading one of Deloitte's regional mergers and
acquisitions teams and passed along nonpublic information about the
transactions in phone calls and during visit (sic) with the [relatives]...
The U.K. Financial Services Authority last week announced criminal
charges... The SEC decided...to avoid duplicating efforts already being made
by the U.K. authorities, the official said.... 'The McClellans might have
thought that they could conceal their illegal scheme by having close
relatives make illegal trades offshore. They were wrong,' the SEC's
enforcement chief Robert Khuzami said in a statement. "
CLASSROOM APPLICATION: The article can be used to discuss the temptations
towards unethical behavior facing practicing accountants at all levels.
QUESTIONS:
1. (Advanced) What is insider information?
2. (Advanced) Why is trading insider information illegal? Why is trading on
insider information illegal?
3. (Advanced) Of what illegal actions are a former Deloitte Tax partner and
his wife accused? What entities investigated these alleged illegal
activities?
4. (Advanced) How do partners at public accounting firms have access to
insider information? Do lower levels of employees of these firms have this
access to insider information?
5. (Introductory) Refer to the related article. How is it possible that
regulating and prosecuting insider trading by observing market trades misses
some illegal transfers of insider information?
6. (Advanced) If Mr. McClellan is guilty of these alleged crimes, what
professional code has he also violated? What are the implications of such
violations for Mr. McClellan and his wife to produce a personal income in
the future?
Reviewed By: Judy Beckman, University of Rhode Island
The Securities and
Exchange Commission on Tuesday charged a former partner at Deloitte Tax LLP
and his wife with passing nonpublic information about pending corporate
deals to relatives in London, in an alleged multimillion-dollar
insider-trading scheme uncovered jointly by U.K. and U.S. authorities.
The SEC, in a civil
complaint filed in federal district court in Northern California, alleged
that San Francisco residents Arnold McClellan and his wife Annabel alerted
her sister and brother-in-law Miranda and James Sanders about at least seven
pending transactions from 2006 to 2008.
The McClellans
allegedly learned about the deals through Mr. McClellan's work leading one
of Deloitte's regional mergers and acquisitions teams and passed along
nonpublic information about the transactions in phone calls and during visit
with the Sanders, the SEC said.
James Sanders, who
co-founded a derivatives-trading firm in London, allegedly took financial
positions in the acquisition targets based on the tips and shared the
insider information with his colleagues at the now-defunct firm Blue Index
Ltd.
The SEC said the
Sanderses netted $3 million from transactions based on the tips, half of
which they shared with the McClellans. Mr. Sanders's colleagues and clients
made $20 million in profits from the tips, according to the SEC.
Annabel McClellan
worked previously in the London, San Jose and San Francisco offices of
Deloitte.
The U.K. Financial
Services Authority last week announced criminal charges against the
Sanderses and three of James Sanders's colleagues. The Sanderses and the
three other defendants in the case were first arrested by authorities in May
2009.
An SEC official
said the two regulators worked very closely on the case, which involved
overseas travel by enforcement staff. The SEC decided not to charge the
Sanders to avoid duplicating efforts already being made by the U.K.
authorities, the official said.
"The McClellans
might have thought that they could conceal their illegal scheme by having
close relatives make illegal trades offshore. They were wrong," the SEC's
enforcement chief Robert Khuzami said in a statement.
Lawyers for Arnold
McClellan said he denies the SEC's charges and will vigorously contest them.
"He did not trade on insider information, and there will be no evidence that
he passed along any confidential information to anyone," Elliot R. Peters
and Christopher Kearney of the law firm Keker & Van Nest LLP said in a
statement.
A lawyer for
Annabel McClellan also said her client will fight the charges. "Ms.
McClellan did not possess or receive insider information, nor did she pass
it," Nanci Clarence from the law firm Clarence & Dyer in San Francisco said.
Lawyers for the
Sanderses couldn't immediately be reached for comment.
A Deloitte
spokesman said the firm is shocked by the allegations and is cooperating
with the SEC's investigation.
Mr. Sanders
allegedly used derivatives instruments called "spread bet" contracts to take
positions in the stocks of U.S. companies based on the information he
received from the McClellans. Spread bets allow traders to make large bets
on the price movements of an underlying security with relatively small
investments.
Mr. Sanders
allegedly traded in the contracts quickly after he or his wife received
fresh information about the prospects of a transaction occurring.
Some of the alleged
insider trading involved the planned acquisition of Kronos Inc., a
Massachusetts data collection and payroll software company bought by one of
McClellan's clients, San Francisco private-equity firm Hellman & Friedman
LLC, in 2007.
The SEC, in its
complaint, alleged that Mr. McClellan tipped his wife off to Hellman &
Friedman's planned acquisition of Kronos early in 2007.
On Jan. 31, 2007,
there was a phone call from Annabel McClellan's cellphone to the Sanders
home, the SEC said. Later that day, Mr. Sanders made his first purchase of
spread bet contracts tied to Kronos stock.
Mr. Sanders
increased his position in the contracts on March 12, a day after a nearly
20-minute phone call from Mr. McClellan's cell phone to Annabel's mother's
home in France, where the Sanders were staying. The phone call occurred less
than one hour after Mr. McClellan participated in a two-hour call with his
client discussing Kronos.
A spokesman for
Hellman & Friedman declined to comment.
Also on March 12,
Blue Index sent around to its traders a document pitching Kronos stock to
the firm's clients. In a recorded phone call on March 16 with his father,
Mr. Sanders identified Annabel McClellan as the source of information about
the timing and pricing of the Kronos acquisition and told him he had agreed
to split his trading profits with her.
"We are shocked and
saddened by these allegations against our former tax partner and members of
his family," Deloitte spokesman Jonathan Gandal said in a statement. "If the
allegations prove to be true, they would represent serious violations of our
strict and regularly communicated confidentiality policies." Deloitte is
cooperating with the SEC's investigation, Mr. Gandal said.
“In today’s
environment, emerging managers need recognized industry heavyweights for
professional services. Deloitte has launched the hedge fund emerging manager
platform to provide emerging managers with a solution that offers access to
our global network, and customized, creative and responsive service,” said
Cary Stier, vice chairman and Deloitte’s U.S. asset management services
leader. “If you launch with Deloitte, you stay with Deloitte. A client
cannot outgrow our services. Deloitte delivers results that matter.”
Jensen Comment
Could Deloitte also add: "We especially know more than most folks about
firms we've audited!"
Actually Deloitte claims that their auditors are not allowed to communicate with
their consultants about audit clients, but this does not necessarily prevent
public perception that Big Four investor consultants do not have inside
information about corporations they audit. Advancing Quality through
Transparency Deloitte LLP Inaugural Report ---
http://www.cs.trinity.edu/~rjensen/temp/DeloitteTransparency Report.pdf
What the SEC
is doing at Delphi is quite expedient. Merriam-Webster
defines expedient as:
1:
suitable for achieving a particular end in a given
circumstance
2:
characterized by concern with what is
opportune;
especially : governed by self-interest
Expedient
usually implies what is immediately advantageous without regard for
ethics or consistent principles
Deloitte
partner
Nick Defazio testified on November 17th
in the Securities and Exchange Commission’s civil securities-fraud case
against former Delphi CEO J.T. Battenberg III. Mr. Difazio testified, on
behalf of the SEC, that in 2000, Delphi management withheld documents from
Deloitte, their auditor, that might have raised red flags about how the
company booked a large payment to
General Motors, also audited by Deloitte.
The SEC says
a $237 million payment by Delphi to GM was to compensate GM for faulty
parts. Delphi improperly booked most of it as pension and employee-benefit
expenses and avoided an earnings hit, according to
Automotive
News.
Difazio said that
in 2000 he thought the accounting treatment was correct.
“Based on these
documents I’ve shown you this morning, … do you believe the accounting
for the settlement was correct?” SEC attorney Jan Folena asked.
“I have serious
questions about whether it was correct,” Difazio answered. “It appears
it was not.”
GM booked the
entire $237 million as a warranty payment, which went straight to its bottom
line as profit that quarter says the SEC.
Mr. Difazio
was
sanctioned by the SEC for not doing enough to identify the real purpose
of this transaction and others at Delphi.
On February 26,
2008 the Commission instituted two settled administrative proceedings
finding that Nicholas Difazio and Duane Higgins, Deloitte & Touche LLP
(D&T) engagement partners on the 2000 and 2001 audits of the financial
statements of Delphi Corporation, engaged in improper professional
conduct on those audits.
In its first
Order, the Commission found that Difazio, the lead engagement partner,
engaged in improper professional conduct in auditing: (1) Delphi’s
improper accrual of an estimated warranty expense by its former parent
as a direct charge to equity in the second quarter of 2000, rather than
as an expense of the period in accordance with GAAP; (2) Delphi’s
improper classification of most of a $237 million payment settling the
former parent’s warranty claims to pension and other post-employment
benefit “true-up,” causing the amount to be accounted for as prepaid
pension cost in the third quarter of 2000 in contravention of GAAP; and
(3) Delphi’s failure to account for the fourth quarter 2000 sale of
certain batteries and generator cores, coincident with a side agreement
to repurchase that inventory, as a financing transaction, as required by
GAAP…
In each Order,
the Commission found that Difazio and Higgins, among other things,
failed to obtain sufficient competent evidential matter to
afford a reasonable basis for the opinion rendered by D&T, to exercise
due professional care in the planning and performance of the Delphi
audit, and in performing the audit to identify material departures from
GAAP in the financial statements.
The
Commission’s Orders denied Difazio the privilege of appearing or
practicing before the Commission, pursuant to Rule 102(e)(1)(ii) of the
Commission’s Rules of Practice, with a right to reapply after three
years…
Mr. Difazio,
although not admitting or denying the charges, consented to the sanction.
He is not eligible for reinstatement to practice before the SEC until at
least 2011.
Yes. That makes a
lot of sense. You want a guy who can’t get the GAAP right to advise your
company on the impact of converting from GAAP to IFRS and lead new auditors
down the path.
How can the SEC
allow this? Perhaps Mr. Difazio agreed to testify on behalf of the SEC
against Delphi executives to avoid a monetary penalty.
But which is it?
The auditors didn’t do enough? Or the company hid documents from them?
It seems that the
SEC can claim auditors should have known, could have known, and would have
known Delphi, with GM’s help, was pulling a fast one if Difazio and his
colleagues had, “obtained sufficient competent evidential matter to
afford a reasonable basis for the opinion rendered by D&T, exercised due
professional care in the planning and performance of the Delphi audit, and
performed the audit to identify material departures from GAAP in the
financial statements.”
The Obama administration says the bailout of General
Motors (NYSE:GM) is a success. Their former car czar, Steve Rattner, may
have moved the ball out of the opposing team’s end zone by avoiding a full
scale, free-for-all bankruptcy like
Lehman’s, but that doesn’t mean we should be
celebrating any touchdowns just yet.
Mr. Rattner has a new
book out about his experience at GM. It’s Rattner’s view – or his
publicist’s – that
Overhaul: An Insider’s Account of the Obama Administration’s Emergency
Rescue of the Auto Industry, “captures
a unique moment in American business that will have lasting influence on all
industries, as the archetypal American industry (which helped create our
nation’s wealth and status) is used to write the playbook for corporate
bailouts.”
God, I hope not.
The U.S. government
plans to sell the GM garbage barge back to investors after taxpayers poured
$50 billion in to save it. GM will report final third-quarter figures on
November 10th, a week ahead of its November 18th IPO. The company “projects”
a third-quarter profit of between $1.9 billion and $2.1 billion, according
to
preliminary results the automaker released
yesterday. It’s supposedly the third consecutive quarterly profit for
post-bankruptcy GM but none of those numbers were audited and the
financial statements included in the prospectus
for the share offering are also unaudited.
I’m skeptical about any
numbers GM issues, whether blessed by their auditor Deloitte or not.
Tom Selling, blogging
at
The Accounting Onion, extends an argument made by
Jonathan Weil in early September: “GM’s
shareholders’ equity at December 31, 2009 would have been a negative $6.2
billion if it were not able to book a whole bunch of goodwill. To say
that few companies would be able to pull off a successful IPO with a
negative number for shareholders’ equity on its balance sheet would be an
understatement. To say the same after applying fresh-start accounting would
be a statement of fact.”
In March of 2007, GM
reported, “ineffective internal controls over financial reporting might
make it difficult for the company to execute on its business plan.” At
that time,GM was also under investigation by the SEC on several
matters, including financial reporting related to pension accounting,
transactions with suppliers including their former subsidiary Delphi
(another bankrupt company) and transactions in precious metals.
The only news here is that a
lot of suckers will invest in a company that hasn’t produced financial
reports anyone should trust in a long time. Amongst many other weaknesses,
they never have enough competent accounting professionals to book the
complex transactions it takes to create their balance sheet.
When companies go bankrupt, their underfunded pensions
are taken over by the Pension Benefit Guaranty Corp. (PBGC), a
government-run, industry-funded insurance agency, which then pays retirees a
fraction of what they were owed. But that didn’t happen in the GM
bankruptcy. The UAW resisted, according to the
Washington Post. GM’s defined-benefit plans for US
employees were underfunded by $16.7 billion as of June 30. GM’s prospectus
says federal law will require it to start pumping in “significant” amounts
by 2014 if not sooner.
When
I wrote about my preference for a real GM
bankruptcy, I thought it would also be great for GM’s employees to see how
the other half lives with regard to health insurance. Putting GM’s former
employees on the rolls of a single-payer, government-funded program (my hope
at the time) would provide additional economies of scale and volume buying
power for the government as well as get rid of this monkey on our back. No
longer would taxpayers, or car buyers, subsidize health benefit entitlements
that are way beyond what anyone else gets these days. Reset expectations
for this constituency and we can all move on.
Unfortunately, neither the
outsize pension liabilities nor the unrealistic healthcare benefits for
these employees and retirees were cut down to size by the US government’s
approach.
In August of 2008,
General Motors and their auditor Deloitte settled
a class-action securities lawsuit against them alleging the automaker filed
misleading financial reports between 2002 and 2006. GM paid $277 million and
Deloitte kicked in $26 million.
GM was forced to reduce the
amount paid to auditor Deloitte after the Sarbanes-Oxley Act prohibited
companies from using the same firm as a consultant and an auditor. About $49
million was spent on Deloitte for consulting services in 2001 and only $21
million was for audit work. By 2008, GM’s bill for audit work was up to
$31.5 million.
Deloitte has been GM’s
auditor since 1918. That’s ninety-two years of making sure GM survives to
pay another invoice. Don’t bet on independence, objectivity, or lawsuits
ruining this beautiful relationship anytime soon.
Deloitte
is particularly sensitive to issues of audit independence since it was the only
Big Four firm that retained its full consulting division when the other Big Four
firms sold or spun off their consulting divisions. Of course that issue is a bit
moot since the other Big Three firms have since built up new consulting
divisions, particularly financial consulting divisions.
Following the big
lawsuits against the audit firms is fairly easy. Updates on subprime and
financial crisis suits typically hit my Google Alerts. There area few more
like the Banco Espiritu Santo v. BDO Seidman case and the case against PwC
re: Satyam that have their very own customized alerts. And
Kevin LaCroix
can be counted on to pick up the odd securities class action suit naming an
auditor for sport and he also tracks all of the Madoff related filings.
Every once and a while I depend on the kindness of handsome strangers to
catch the latest update like when
Francis Pileggi
told us the what happened in Delaware Chancery Court with Deloitte’s suit
against accused inside trader and their own ex-Vice chairman Tom Flanagan.
The big lawsuits – the
ones that accuse the firms of accounting malpractice or various federal
securities law violations – have been chronicled on this site and by fellow
writers such as
James Peterson
ad infinitum. The accounting industry’s response to
these threats is to ask for liability caps. As if we don’t have enough
moral hazard in the financial system with “too big to fail,” the
auditors want to institutionalize their insulation from accountability to
their clients, the shareholders, with a policy of “too few to pay for
their mistakes.”
If only the lawsuits
claiming lack of audit prowess were the only ones they had to worry about.
Unfortunately for them, and for their “partners” who go along for the ride
leaving the management of “matters” up to senior leadership acting as
caretakers for the 5-10 years they are at the top of the heap, there are so
many more suits that just show what lousy managers they are.
Here are some of the more
interesting lawsuits and legal matters facing each of the Big 4.
[DOJ Tax
Division lawyer Judith] Hagley on Friday argued that the work
product privilege does not apply to the documents Dow turned over to
Deloitte because the documents were prepared during what Hagley said
was the ordinary course of business – and not prepared for
litigation purposes.
A former
Deloitte tax professional has agreed to pay approximately $144,000
to settle insider trading charges with the Securities and Exchange
Commission.
The SEC filed
settled insider trading charges against four individuals, including
John A. Foley, who served as an employee benefits specialist at
Deloitte between July 2005 and May 2007. The others who settled the
SEC charges were Aaron M. Grassian, Timothy L. Vernier, and Bradley
S. Hale. They were accused of participating in insider trading in
the securities of four public companies — Crocs, Inc., YRC
Worldwide, Inc., Spectralink Corporation and SigmaTel, Inc. — over a
22-month period, yielding illegal profits totaling $210,580.62.
Despite the high
standard that Deloitte holds you to — higher than the SEC, PCAOB,
and the AICPA, we might add — this happened, “Based on our own
reviews and that of the PCAOB, we believe compliance with our
independence policies is not what it should be, and the PCAOB has,
in fact, questioned our commitment to adhere to our own policies.
This is clearly not acceptable.”
Our
contributor Francine McKenna reminded us that Deloitte didn’t think
too much of the PCAOB’s report from last year, “They [are] the same
firm that famously responded to the PCAOB’s latest inspection report,
‘How
dare you second guess us?‘”
Although Deloitte
won a
preliminary victory against Flanagan, they
obviously still have a lot of work to do to improve their independence
compliance function and are still subject to PCAOB and
SEC enforcement actions and potential
sanctions.
In the meantime,
they did
settle Parmalat,
but now they’re named in
several suits related to the Merrill Lynch
acquisition by Bank of America and the Bear Stearns failure. Deloitte
is the only Big 4 firm to have escaped any Madoff feeder fund exposure
even though they are supposedly the
number one choice of hedge funds.
Ernst & Young
Ernst & Young has its
own inside trader case to go along with
the ones we saw a few months ago and the rest of
the SEC sanctions they’re collecting.
A former Ernst & Young LLP partner was sentenced
to a year and a day in prison on Monday after he
was convicted last year of fraud charges in an insider-trading scheme
where he allegedly tipped a Pennsylvania broker about pending corporate
takeovers.
At a hearing, U.S.
District Judge Miriam Goldman Cedarbaum in Manhattan sentenced James
Gansman, a lawyer who resigned from Ernst & Young in October 2007. He
was convicted of six counts of securities fraud, but acquitted of
conspiracy and three securities fraud counts in May 2009.
The Securities
and Exchange Commission has instituted public administrative
proceedings against two former Ernst & Young auditors who failed to
uncover the misappropriation of client funds by an investment
advisor they were auditing.
The proceedings
were instituted against two CPAs: Gerard A.M. Oprins, 50, who had
been a partner in Ernst & Young’s financial services practices group
since 1995; and Wendy McNeely, 33, a former audit manager in E&Y’s
financial services group who now works for another firm.
The EY list includes
the usual employment discrimination lawsuits that all of the firms face, in
particular given the significant cuts they have all made to their ranks
during the last two years. Ernst & Young also has
several filings related to writedowns at Regions
Financial Corporation. Regions is
the largest audit client of Ernst & Young LLP’s Birmingham office.
Back in 2003, that office’s largest client had been
HealthSouth Corp., which turned out to be a massive fraud. Tough luck…
The Regions board and
management team, as well as Ernst and Young, are accused of
“continued reporting a grossly inflated value of the
goodwill attributable to the AmSouth acquisition,” which later caused a
large $6 billion write-down equal to more than 60 percent of the total
acquisition, according to
the lawsuit.
Bankruptcy cases are some of
the biggest moneymakers for the firms now globally but can become
contentious.
A MP has written to
the insolvency regulator calling for an investigation into the actions
of Nortel’s administrator Ernst & Young (E&Y).
“Ernst & Young’s
handling of this insolvency case has been woeful and it would appear
that they may have failed to pay appropriate regard to redundancy and
employment legislation,” he said.
Next I’ll summarize which
cases KPMG and PricewaterhouseCoopers are spending their legal dollars on.
Francine
Deloitte
executive partners should be careful what they wish for. The Flanagan insider trading litigation has forced
them to reveal their woefully inadequate policies and procedures regarding
independence compliance. While trying to placate their clients who were dragged
through the mud on this and exact revenge against their own leadership-level
partner, a pillar of the Chicago social and philanthropic community, they’ve
admitted to allowing Flanagan to breach their standards more than 300 times and
to get away with it.
Francine McKenna, "Deloitte Wins Major Round Re: Alleged Inside Trader
Flanagan," re: The Auditors, January 5, 2010 ---
http://retheauditors.com/2010/01/05/deloitte-wins-major-round-re-alleged-inside-trader-flanagan/
Francis Pileggi
at at the Delaware Litigation blogreports that Deloitte has won a partial summary
judgment against Thomas Flanagan, the Chicago-based, ex-Vice Chairman of the
firm accused of multiple counts of insider trading. My original post, describing
how I broke the story first on Twitter based on a confidential tip, ishere.
I spoke to Francis Pileggi who said, “All that’s left is for the court to
decide how much this former partner will be paying his firm. It may take a
while to ascertain this but from the looks of it, it may be a very big number.”
But Deloitte should be careful what they wish for. This litigation has forced
them to reveal their woefully inadequate policies and procedures regarding
independence compliance. While trying to placate their clients who were dragged
through the mud on this and exact revenge against their own leadership-level
partner, apillar of the Chicago social and philanthropic
community, they’ve admitted to allowing
Flanagan to breach their standards more than 300 times and to get away with it.
If it weren’t for the otherwise widely maligned SEC’s targeted action on the
case, Deloitte would have remained oblivious.
Deloitte has sustained more than a bloody nose and a few cuts in this fight,
even though they seem to be winning. It’s not over until the opponent is on the
mat, down for the count. Better yet, knocked out cold, unable to inflict any
more damage to the firm. Given the long tail of matters before the SEC, PCAOB,
DOJ, and of private litigation, it may be a while before all the referees’ final
decisions.
“U.S. accounting firm Deloitte & Touche LLP has won a lawsuit against a former
top executive it accused of improperly trading in stocks and options of the
firm’s clients, including Motorola Inc and Best Buy Co Inc….A
Delaware court sided with Deloitte in the case in an opinion dated December 29,
saying the former executive, Thomas Flanagan, had “obviously” been in
violation of his employers’ independence policies in making certain trades….the
30-year partner who had risen to vice chairman of the firm had secretly
hidden trades in shares of Deloitte’s audit clients and lied about it to the
firm.
“Because an auditor sells, at base, its independence and integrity, the firm
relies heavily on the purported honesty and independence of its professionals,”
Vice Chancellor John Noble, of the Delaware Court of Chancery, wrote in his
opinion…Flanagan had made more than 300 trades in shares of Deloitte’s audit
clients, including several clients for which he was Deloitte’s advisory partner….Dozens
of times, Flanagan entered his holdings in Deloitte’s system, then quickly
“corrected” entries to indicate he had disposed of restricted securities, but in
fact continued to hold them… Deloitte was unaware of the trades until the
U.S. Securities and Exchange Commission contacted the company [re] the audit
for Walgreen Co in 2007…He was also accused of trading in securities of Deloitte
clients Best Buy, Allstate Corp, Motorola, and other firms, often while working
directly on the companies audits.
Flanagan resigned from Deloitte in 2008 about two months before the lawsuit was
filed, … SEC has not announced any charges against Flanagan…exercised his
Fifth Amendment right against self incrimination…”
“I think [Deloitte was] aware
of this guy’s rule-breaking. In my experience, when someone like this 30-year
“elder statesman” is flouting the rules so egregiously, they usually can’t help
blustering about it. He may have complained to others, at all levels, about the
“SOB, dumbass, rule-jockey, non-client service, idiot, loser, dweebs” who were
bugging him to respond to their inquiries about his annual certifications…
I am also surprised that Deloitte doesn’t appear to have a process in place that
most other firms I’m aware of, including PwC, have. PwC, for example, has a
whole team of auditors in their Jersey City office whose only job is to request
tax returns, brokerage, bank and other investment statements from folks that
either come up for review based on a “random sample” or are high risk like Mr.
Flanagan. They have this process because
their colleagues at Coopers and Lybrand screwed up on this stuff so badly
before PriceWaterhouse bought them and they were forced to put it in place….
Or maybe Mr. Flanagan did get audited. Maybe they asked for this info and he
blew them off. Or maybe they were given documents that didn’t match up or were
incomplete. Or maybe he kept putting them off. Or maybe he had been called on
flouting of the rules many times but no one in the partnership was willing to
call him into the Principal’s office and whack his knuckles with a big ruler
once and for all.”
How long will it be until the SEC finishes its investigation of the case, with
regard to Flanagan and/or Deloitte?Six
years like Bally’s?
Will the firm or Flanagan ever get sanctioned by the PCAOB? I’m assuming
Flanagan is “retired”, but will the SEC forbid him to act as a CPA?
If the PCAOB issues a disciplinary sanction against Deloitte as a firm, it will
be only the second time it has done so against a Big 4 firm,both times against Deloitte. How
many strikes does a firm get? If it’s as many as EY seems to be getting, then
we are stuck with seeing outrageous violations of independence indefinitely due
to the profession’s and the regulator’s “too few to fail” policy.
The SEC must look carefully at the Deloitte
internal compliance function. It failed,
and failed miserably. There are so many things wrong with this picture from an
internal risk and quality management perspective, regardless of the individual
partner’s lapses. What good is a profession, and a partnership of
professionals, if they do not police their own according to their standards and
practices? Suing Flanagan puts money back in the Deloitte partners’ pockets –
and perhaps assuages their clients who received calls from the SEC because of
Flanagan – but does nothing for the clients’ cost of their investigations or for
those shareholders’ confidence in their vendor, Deloitte their auditor.
·
Deloitte was not aware of Flanagan’s violations until alerted by the SEC
investigation.
·
Deloitte seemingly does not have a requirement for high risk employees and
partners to submit physical account statements that can be audited against
system reporting. It seems to be depending totally on self-reporting and the
honor system, even for the highest risk partners and restricted entities.
·
Deloitte seems to have a glitch in its independence tracking system and early
warning exception reporting system for compliance if their system allows the
appearance of reporting even though entries are immediately backed out. I guess
Flanagan’s secretary knew how to do that too?
·
Deloitte must encourage a culture of blame and delegation of responsibility for
even the most important partner responsibilities, ones that are critical to its
reputation and integrity. Talk about an embarrassing and completely jerk-face
cop out of leadership responsibility…
“Flanagan suggests that there is no evidence that he, himself, used the Tracking
& Trading System, and that any failure to correctly input his trades was
likely an error by his secretary.”
The SEC and PCAOB must complete a thorough review of Deloitte’s Independence
Compliance process and systems and implement sanctions, recommend immediate
remediation, and install a monitor to correct failings. Some areas to look at:
This is very interesting in particular coming from Deloitte. I would suspect
that their litigations costs right now are higher than the other three, if only
because they have a much bigger consulting side which has been sued quite often.
They also have had more significant litigation from the subprime crisis appear
first.
Is there research that shows “…consulting side which has been sued quite
often.”? In my many years on the consulting side of 2 Big 8 firms in Los
Angeles, I don’t recall any consulting related suits at either firm. We were
threatened with suits. I recall one time that an irate client wanted to be
immediately connected to neither Mr. Cooper or Mr. Lybrand.
I think it is far easier to recover (and not get suited) from a consulting
project that is off track then it is from an audit failure. Basically, if the
consulting client was mad (whether they threatened to sue or not), the partner
would sit down with the client and say what can we do to make you happy (make
you whole) and all was forgiven—and a some or a lot of non-billable time was put
in getting the project back on track.
I do know the consulting side does get sued (such as the DMV debacle in
California a few years ago), but it was the “quit often” in your sentence that
caught my eye.
Glen L. Gray, PhD, CPA Dept. of Accounting & Information Systems College of
Business & Economics California State University, Northridge 18111 Nordhoff ST
Northridge, CA 91330-8372 818.677.3948 http://www.csun.edu/~vcact00f
I write quite a bit about this issue and so does a friend of mine, Michael
Krigsman, who writes about IT project failures for ZDNet and quotes me often.http://blogs.zdnet.com/projectfailures/
Take a look at these recent cases. As far as research studies, well, that's how
I'd like to shore up my writing and why I enjoy being a part of this listserv.
My writing is based on my personal experience on the consulting side of PwC and
KPMG Consulting, then BearingPoint, both here and abroad, especially in Latin
America. Whenever I can supplement it with studies, white papers, data and
academic research, I am thrilled.
I welcome your feedback and additions to the stories. Here's a few. There are
lots more on my site.
Actually I think it is much more common to get sued in consulting than audit,
but it's the audit suits, if they go to trial that are more dangerous for the
firms. Settlements are almost de riguer on the audit side for the Big 4. PSLRA
made it more difficult to sue auditors and Stoneridge made it virtually
impossible to make it stick. SO, when does move along the path, and either get
settled for hundreds of millions like Tyco or go to trial, you know it's a
really big deal. Settlements, by their nature, are not well publicized but when
they're big we hear about them and there have been some really big ones since
Sarbanes-Oxley.
What do HP, Boeing
and Navistar have in common? All three companies, over the years, have
fought SEC investigations, internal investigations, and shareholder
lawsuits.
HP and Boeing
saw their CEOs,
Mark Hurd this week and
Harry Stonecipher in 2005, resign in disgrace
because of “lapses in personal judgment” of the female dalliance kind.
Because,
after all, “boardroom Puritanism covers sex, but not greed. Where, oh
where are the corporate ethics policies prohibiting chummy boards from
approving eye-popping pay packages for C.E.O.’s whether or not they are
doing a good job? Where are the solemn mission statements promising a
workplace free of executive pillaging? Whom would you prefer: a C.E.O. who
writes the occasional indelicate e-mail message? Or someone like [Bob]
Nardelli, who treats shareholders with callous indifference? And which of
the two executives really has worse judgment?”
New York Times June, 25, 2006
Britain’s big four
auditing firms have been left exposed to a surge in negligence claims after
the Government refused to limit further the damages they could face.
Deloitte, Ernst &
Young, KPMG and PricewaterhouseCoopers (PwC) lobbied hard for a cap on
payouts. Senior figures involved in the discussions said that Lord Mandelson,
the Business Secretary, appeared receptive to their concerns but stopped
short of changing the law.
The decision is a
huge blow to the firms — some face lawsuits relating to Bernard Madoff’s $65
billion fraud — which believe there may not be another chance for a change
in the law for at least two years. They fear that they will be targeted by
investors and liquidators seeking to recover losses from Madoff-style frauds
and big company failures.
At present,
auditors can be held liable for the full amount of losses in the event of a
collapse, even if they are found to be only partly to blame.
In April,
representatives of the companies met Lord Mandelson to plead for new
measures to cap their liability. They warned that British business could be
plunged into chaos if one of them were bankrupted by a blockbuster lawsuit.
However, an
official of the Department for Business, Innovation and Skills said: “The
2006 Companies Act already allows auditor liability limitation where
companies and their auditors want to take this course.”
Under present
company law, directors can agree to restrict their auditors’ liability if
shareholders approve; however, to date, no blue-chip company has done so.
Directors have seen little advantage in limiting their auditors’ liability,
and objections by the US Securities and Exchange Commission (SEC) have also
been a significant obstacle.
The SEC opposes
caps on the ground that their introduction could lead to secret deals
whereby directors agree to restrict liability in return for auditors
compromising on their oversight of a company’s accounts. The SEC could
attempt to block caps put in place by British companies that have operations
in the United States.
The big four
auditors had hoped to persuade Lord Mandelson to amend the legislation to
address the SEC’s concerns and to encourage companies to limit their
auditors’ liability.
Peter Wyman, a
senior PwC partner, who was involved in the discussions, said that the
Government’s lack of action was disappointing. He said: “The Government,
having legislated to allow proportionate liability for auditors, is
apparently content to have its policy frustrated by a foreign regulator.”
Auditors are often
hit with negligence claims in the aftermath of a company failure because
they are perceived as having deep pockets and remain standing while other
parties may have disappeared or been declared insolvent.
In 2005 Ernst &
Young was sued for £700 million by Equitable Life, its former audit client,
after the insurance company almost collapsed. The claim was dropped but
could have bankrupted the firm’s UK arm if it had succeeded.
This year KPMG was
sued for $1 billion by creditors of New Century, a failed sub-prime lender,
and PwC has faced questions over its audit of Satyam, the Indian outsourcing
company that was hit by a long- running accounting fraud.
Three of the big
four are also facing numerous lawsuits relating to their auditing of the
feeder funds that channelled investors into Madoff’s Ponzi scheme.
Investors and
accounting regulators worry that the big four’s dominance of the audit
market is so great that British business would be thrown into disarray if
one of the four were put out of business by a huge court action. All but two
FTSE 100 companies are audited by the four.
Mr Wyman said: “The
failure of a large audit firm would be very damaging to the capital markets
at a time when they are already fragile.”
Arthur Andersen,
formerly one of the world’s five biggest accounting firms, collapsed in 2002
as a result of its role in the Enron scandal.
Suits you
KPMG A
defendant in a class-action lawsuit in the Southern District of New York
against Tremont, a Bernard Madoff feeder fund
Ernst & Young
Sued by investors in a Luxembourg court with UBS for oversight of a European
Madoff feeder fund
PwC Included
in several lawsuits in Canada claiming damages of up to $2 billion against
Fairfield Sentry, a big Madoff feeder fund
KPMG Sued in
the US for at least $1 billion by creditors of New Century Financial, a
failed sub-prime mortgage lender, which claimed that KPMG’s auditing was
“recklessly and grossly negligent”
Deloitte
Sued by the liquidators of two Bear Stearns-related hedge funds that
collapsed at the start of the credit crunch
A former
hedge-fund manager has pleaded guilty to criminal charges in an
investment scam in which he bilked as much as
$900-million from investors, including four university endowments.
In his plea, Paul
R. Greenwood said on Wednesday that he and his partner, Steven Walsh, had
spent money from the investment accounts on themselves and their family
members. According to investigators, the two spent at least $160-million on
mansions, horses, rare books, and an $80,000 collectible teddy bear. Mr.
Walsh has pleaded not guilty, and Mr. Greenwood will testify against him at
trial.
The two
promised low risks and high returns to investors in what was essentially a
Ponzi scheme. Their 16 institutional investors included the University of
Pittsburgh ($65-million invested), Carnegie Mellon University ($49-million),
Bowling Green State University ($15-million), and
Ohio Northern University ($10-million).
The universities
realized something was wrong last year, when they discovered that much of
their assets had been signed out as promissory notes attributed to Mr. Walsh
and Mr. Greenwood. Carnegie Mellon's treasurer traveled to the firm's
offices in New Jersey and Connecticut in an unsuccessful quest to find out
what had happened to the university's investment.
After the two money
managers were arrested, an investment adviser who works with university
endowments said that background checks should have spotted problems with the
fund, and that he had advised colleges to pull out of it.
A court-appointed
receiver is pursuing the pair's assets in an attempt to recoup some of the
losses for investors. Mr. Greenwood's assets will be auctioned off,
including, presumably, his collection of rare stuffed animals. He faces a
prison sentence of as long as 85 years and hundreds of millions of dollars
in fines at his December sentencing, according to news reports.
Jensen Comment
Some of you might recall my earlier tidbits on how this case also involved
Deloitte.
Question
Why would four universities (Carnegie-Mellon, Pittsburgh, Bowling Green, and
Ohio Northern) invest hundreds of millions dollars in a fraudulent investment
fund and what makes this fraud different from the Madoff and Stanford fund
scandals?
One of the reasons is that the fraudulent Westridge Capital Management Fund
was audited by the reputable Big Four firm of Deloitte.
It seems to be
Auditing 101 to verify that securities investments actually exist and have not
be siphoned off illegally. Purportedly, Paul R. Greenwood and Stephen Walsh
siphoned off hundreds of millions to fund their lavish personal lifestyles
Koch recently told state lawmakers that Iowa
officials believed they had "covered the bases" but that "obviously, something
went wrong." He and Cochrane, in an interview, said that there was no apparent
problem with Westridge that would raise concerns. Numerous government regulatory
agencies had audited the company and the venerable
Deloitte and Touche
firm was Westridge's auditor. The company's investment
returns did not raise suspicion because they generally followed market trends:
The firm gained and lost money when the rest of the market did.
Stephen C. Fehr, "Iowa, N.D. victims of investment fraud," McClatchy-Tribune
News Service, March 16, 2009 ---
http://www.individual.com/story.php?story=97917687
As with
the investors who lost $65 billion in the Madoff Fund, word of mouth from
respected people and institutions seem to weigh more than factual analysis for
countless investors? Rabbi Ragan says a good man runs this fund? If
Carnegie-Mellon's investing in it it most be safe? Yeah Right!
Various other investors and investment funds allegedly lost millions in the
Greenwood-Walsh Fund Fraud ---
http://www.nytimes.com/2009/02/26/business/26scam.html?scp=1&sq=paul
greenwood&st=cse
The Pennsylvania Employees’ Retirement System was saved in the nick of
time from investing nearly a billion dollars in the fund upon discovering that
the National Futures Association began an investigation of the Greenwood-Walsh
Fund. For other duped investors it was too late.
But in
some cases the auditing firm is reputable and has deep pockets.
"A
4th University Is Missing Money in Alleged $554-Million Swindle,"
by Paul Fain, Chronicle of Higher Education, March 19, 2009 ---
Click Here
Ohio Northern
University is the fourth higher-education institution to announce that it is
seeking to recoup money in an alleged $554-million investment fraud,
university officials
said today.
Ohio Northern’s endowment had $10-million invested
with two Wall Street veterans who face criminal charges for allegedly using
investors’ money as a “personal piggy bank,” spending at least $160-million
on mansions, horses, rare books, and collectible toys.
Also tied up in the
apparent swindle
is $65-million from the University of Pittsburgh, $49-million from Carnegie
Mellon University, and
$15-million from Bowling Green State University.
Securities lawyers say little value from the original investments will be
recovered. Officials from all of the universities say the potential losses
will have no immediate impact on their operations.
Most college endowments rely
on outside investment consultants to help direct their money. Hartland &
Company, a financial firm in Cleveland, steered the now-missing investments
by Ohio Northern and Bowling Green to the firm running the
allegedly-fraudulent scheme. Pitt and Carnegie Mellon relied on the advice
of Wilshire Associates, a major California-based consulting firm.
Paul R. Greenwood and
Stephen Walsh, the two Wall Street traders who owned the suspect firm, face
charges of securities fraud, wire fraud, and conspiracy. Federal regulators
have also sued the men, and are pursuing their assets.
"Pitt, CMU money managers arrested in fraud FBI says they misappropriated
$500 million for lavish lifestyles," by Jonathon Silver, Pittsburgh
Post-Gazette, February 26, 2009 ---
http://www.post-gazette.com/pg/09057/951834-85.stm
Two East Coast investment managers sued for fraud
by the University of Pittsburgh and Carnegie Mellon University
misappropriated more than $500 million of investors' money to hide losses
and fund a lavish lifestyle that included purchases of $80,000 collectible
teddy bears, horses and rare books, federal authorities said yesterday.
As Pitt and Carnegie Mellon were busy trying to
learn whether they will be able to recover any of their combined $114
million in investments through Westridge Capital Management, the FBI
yesterday arrested the corporations' managers.
Paul Greenwood, 61, of North Salem, N.Y., and
Stephen Walsh, 64, of Sands Point, N.Y., were charged in Manhattan -- by the
same office prosecuting the Bernard L. Madoff fraud case -- with securities
fraud, wire fraud and conspiracy.
Both men also were sued in civil court by the U.S.
Securities and Exchange Commission and the Commodity Futures Trading
Commission, which alleged that the partners misappropriated more than $553
million and "fraudulently solicited" $1.3 billion from investors since 1996.
The Accused
Paul Greenwood and Stephen Walsh are accused of
misappropriating millions from investors. Here is a look at some of their
biggest personal purchases:
• HOME: Mr. Greenwood, a horse breeder, owned a
horse farm in North Salem, N.Y., an affluent community that counts David
Letterman as a resident.
• BEARS: Mr. Greenwood owns as many as 1,350
Steiff toys, including teddy bears costing as much as $80,000.
• DIVORCE: Mr. Walsh bought his ex-wife a $3
million condominium as part of their divorce settlement.
"This is huge," said David Rosenfeld, associate
regional director of the SEC's New York Regional Office. "This is a truly
egregious fraud of immense proportions."
Lawyers for the defendants either could not be
reached or had no comment.
Mr. Greenwood and Mr. Walsh, longtime associates
and former co-owners of the New York Islanders hockey team, ran Westridge
Capital Management and a number of affiliated funds and entities.
As late as this month, the partners appeared to be
doing well. Mr. Greenwood told Pitt's assistant treasurer Jan. 21 that they
had $2.8 billion under management -- though that number is now in question.
And on Feb. 2, Pitt sent $5 million to be invested.
But in the course of less than three weeks,
Westridge's mammoth portfolio imploded in what federal authorities called an
investment scam meant to cover up trading losses and fund extravagant
purchases by the partners.
An audit launched Feb. 5 by the National Futures
Association proved key to uncovering the alleged deceit and apparently
became the linchpin of the case federal prosecutors are building.
That audit came about in an indirect way. The
association, a self-policing membership body, had taken action against a New
York financier. That led to a man named Jack Reynolds, a manager of the
Westridge Capital Management Fund in which CMU invested $49 million; and Mr.
Reynolds led to Westridge.
"We just said we better take a look at Jack
Reynolds and see what's happening, and that led us to Westridge and WCM, so
it was a domino effect," said Larry Dyekman, an association spokesman.
"We're just not sure we have the full picture yet."
Mr. Reynolds has not been charged by federal
authorities, but he is named as a defendant in the lawsuit that was filed
last week by Pitt and CMU.
"Greenwood and Walsh refused to answer any of our
questions about where the money was or how much there was," Mr. Dyekman
continued.
"This is still an ongoing investigation, and we
can't really say at this point with any finality how much has been lost."
The federal criminal complaint traces the alleged
illegal activity to at least 1996.
FBI Special Agent James C. Barnacle Jr. said Mr.
Greenwood and Mr. Walsh used "manipulative and deceptive devices," lied and
withheld information as part of a scheme to defraud investors and enrich
themselves.
The complaint refers to a public state-sponsored
university called "Investor 1" whose details match those given by Pitt in
its lawsuit.
The SEC's Mr. Rosenfeld said the fraud hinged not
so much on the partners' investment strategy but on the fact that they are
believed to have simply spent other people's money on themselves.
"They took it. They promised the investors it would
be invested. And instead of doing that they misappropriated it for their own
use," Mr. Rosenfeld said.
Not only do federal authorities believe Mr.
Greenwood and Mr. Walsh used new investors' funds to cover up prior losses
in a classic Ponzi scheme, they used more than $160 million for personal
expenses including:
• Rare books bought at auction;
• Steiff teddy bears purchased for up to $80,000 at
auction houses including Sotheby's;
• A horse farm;
• Cars;
• A residence for Mr. Walsh's ex-wife, Janet Walsh,
53, of Florida, for at least $3 million;
• Money for Ms. Walsh and Mr. Greenwood's wife,
Robin Greenwood, 57, both of whom are defendants in the SEC suit. More than
$2 million was allegedly wired to their personal accounts by an unnamed
employee of the partners.
"Defendants treated investor money -- some of which
came from a public pension fund -- as their own piggy bank to lavish
themselves with expensive gifts," said Stephen J. Obie, the Commodity
Futures Trading Commission's acting director of enforcement.
It is not clear how Pitt and CMU got involved with
Mr. Greenwood and Mr. Walsh. But there is at least one connection involving
academia. The commission suit said Mr. Walsh represented to potential
investors that he was a member of the University at Buffalo Foundation board
and served on its investment committee.
Mr. Walsh is a 1966 graduate of the State
University of New York at Buffalo where he majored in political science.
He was a trustee of the University at Buffalo
Foundation, but the foundation did not have any investments in Westridge or
related firms.
Universities, charitable organizations, retirement
and pension funds are among the investors who have done business with Mr.
Greenwood and Mr. Walsh.
Among those investors are the Sacramento County
Employees' Retirement System, the Iowa Public Employees' Retirement System
and the North Dakota Retirement and Investment Office, which handles $4
billion in investments for teachers and public employees.
The North Dakota fund received about $20 million
back from Westridge Capital Management, but has an undetermined amount still
out in the market, said Steve Cochrane, executive director.
Mr. Cochrane said Westridge Capital was cooperative
in returning what money it could by closing out their position and sending
them the money.
"I dealt with them exclusively all these years,"
Mr. Cochrane said.
"They always seemed to be upfront and honest. I
think they're as stunned and as victimized as we are, is my guess."
He said Westridge Capital had done an excellent job
over the years.
The November financial statement indicated that the
one-year return from Westridge Capital was a negative 11.87 percent, but the
five-year annualized rate of return was a positive 8.36 percent.
According to
Bloomberg, Carnegie-Mellon University received audited financial statements
and relied heavily on the certification from Deloitte ---
http://www.bloomberg.com/apps/news?pid=20601087&sid=abOuQYqKtndc&refer=home
Actually, CMU’s consulting firm (Wilshire) claims it relied on that Deloitte
certification:
******Begin Quotation
“It said all clients received audited financial results from Deloitte &
Touche, and custodial statements from trustee banks showing Westridge’s
trading. Carnegie Mellon hires consultants to provide expertise and perform
substantial due diligence, said Ken Walters a spokesman for the school. “In
this case, this investment was “highly recommended” to the university by
Wilshire, he said. He declined to comment further on the consultant.”
******End Quotation
The Federal Deposit
Insurance Corporation sued the former chief executive of Washington Mutual
and two of his top lieutenants, accusing them of reckless lending before the
2008 collapse of what was the nation’s largest savings bank.
F.D.I.C. Sues
Ex-Chief of Big Bank That Failed By ERIC DASH Published: March 17, 2011
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The Federal Deposit
Insurance Corporation sued the former chief executive of Washington Mutual
and two of his top lieutenants, accusing them of reckless lending before the
2008 collapse of what was the nation’s largest savings bank.
The civil lawsuit,
seeking to recover $900 million, is the first against a major bank chief
executive by the regulator and follows escalating public pressure to hold
bankers accountable for actions leading up to the financial crisis.
Kerry K. Killinger,
Washington Mutual’s longtime chief executive, led the bank on a “lending
spree” knowing that the housing market was in a bubble and failed to put in
place the proper risk management systems and internal controls, according to
a complaint filed on Thursday in federal court in Seattle.
David C. Schneider,
WaMu’s president of home lending, and Stephen J. Rotella, its chief
operation officer, were also accused of negligence for their roles in
developing and leading the bank’s aggressive growth strategy.
“They focused on
short-term gains to increase their own compensation, with reckless disregard
for WaMu’s long-term safety and soundness,” the agency said in the 63-page
complaint. “The F.D.I.C. brings this complaint to hold these highly paid
senior executives, who were chiefly responsible for WaMu’s higher-risk home
lending program, accountable for the resulting losses.”
In addition, the
complaint says that Mr. Killinger and his wife, Linda, set up two trusts in
August 2008 to keep his homes in California and Washington out of the reach
of the bank’s creditors. Months earlier, in the spring of 2008, Mr. Rotella
and his wife, Esther, made similar arrangements. The F.D.I.C. is seeking to
freeze the assets of both couples and named the wives as defendants in the
lawsuit.
In unusually
vigorous denials, Mr. Killinger and Mr. Rotella came out swinging against
the F.D.I.C. Mr. Killinger said the agency’s claims were “baseless and
unworthy of the government” and its legal conclusions were “political
theater.” Mr. Rotella said the action “runs counter to the facts about my
relatively short time at the company,” calling it “unfair and an abuse of
power.” He said the trust was for normal estate planning purposes and was
set up before the bank’s downfall. Mr. Schneider, who is represented by the
same lawyer as Mr. Rotella, did not release a public statement.
Although the
F.D.I.C. is mainly known for its role in shuttering failed lenders, the
agency has a legal obligation to bring lawsuits against former directors and
officers when it finds evidence of wrongdoing.
So far, the F.D.I.C.
has brought claims against 158 individuals at about 20 small banks that
failed during the recent crisis. The agency is seeking a total of more than
$2.6 billion in damages. But the $900 million case against the former WaMu
officials is its biggest and most prominent action to date.
Federal regulators
have come under fire for failing to hold executives responsible for their
involvement in the worst financial crisis since the Great Depression. Last
fall, the Securities and Exchange Commission reached a settlement with
Angelo R. Mozilo, the former chief executive of Countrywide Financial, to
pay a $22.5 million penalty over misleading investors about the financial
condition of the giant mortgage lender.
The New York
attorney general’s office has brought a civil suit against Kenneth D. Lewis
over improper disclosures related to the 2008 rescue of Merrill Lynch by
Bank of America, of which he was chief executive.
The largest bank failure in history!
How could Deloitte give a thumbs up audit report on these scams known by the
bank's executives?
"Eyes Open, WaMu Still Failed," by Floyd Norris, The New York Times,
March 24, 2011 ---
http://www.nytimes.com/2011/03/25/business/25norris.html?_r=1
At that same bank,
executives checking for fraudulent mortgage applications found that at one
bank office 42 percent of loans reviewed showed signs of fraud, “virtually
all of it attributable to some sort of employee malfeasance or failure to
execute company policy.” A report recommended “firm action” against the
employees involved.
In addition to such
internal foresight and vigilance, that bank had regulators who spotted
problems with procedures and policies. “The regulators on the ground
understood the issues and raised them repeatedly,” recalled a retired bank
official this week.
This is not,
however, a column about a bank that got things right. It is about Washington
Mutual, which in 2008 became the largest bank failure in American history.
What went wrong?
The chief executive, Kerry K. Killinger, talked about a bubble but was also
convinced that Wall Street would reward the bank for taking on more risk. He
kept on doing so, amassing what proved to be an almost unbelievably bad book
of mortgage loans. Nothing was done about the office where fraud seemed
rampant.
The regulators “on
the ground” saw problems, as James G. Vanasek, the bank’s former chief risk
officer, told me, but the ones in Washington saw their job as protecting a
“client” and took no effective action. The bank promised change, but did not
deliver. It installed programs to spot fraud, and then failed to use them.
The board told management to fix problems but never followed up.
WaMu, as the bank
was known, is back in the news because the Federal Deposit Insurance
Corporation sued Mr. Killinger and two other former top officials of the
bank last week, seeking to “hold these three highly paid senior executives,
who were chiefly responsible for WaMu’s higher-risk home-lending program,
accountable for the resulting losses.”
Mr. Killinger
responded by going on the attack. His lawyers called the suit “baseless and
unworthy of the government.” Mr. Killinger, they said, deserved praise for
his excellent management.
I’ll let the courts
sort out whether Mr. Killinger will become the rare banker to be penalized
for making disastrously bad loans. But I am fascinated by how his bank came
to make those loans despite his foresight.
Answers are
available, or at least suggested, in the mass of documents collected and
released by the Senate Permanent Subcommittee on Investigations, which held
hearings on WaMu last year. Mr. Killinger wanted both the loan book and
profits to rise rapidly, and saw risky loans as a means to those ends.
Moreover, this was
a market in which a bank that did not reduce lending standards would lose a
lot of business. A decision to publicly decry the spread of high-risk
lending and walk away from it — something Mr. Vanasek proposed before he
retired at the end of 2005 — might have saved the bank in the long run. In
the short run, it would have devastated profits.
Ronald J. Cathcart,
who became the chief risk officer in 2006, told a Senate hearing he pushed
for more controls but ran into resistance. The bank’s directors, he said,
were interested in hearing about problems that regulators identified over
and over again. “But,” he added, “there was little consequence to these
problems not being fixed.”
There were
consequences for him. He was fired in 2008 after he took his concerns about
weak controls and rising losses to both the board and to regulators from the
Office of Thrift Supervision.
By early 2007, the
subprime mortgage market was collapsing, and the bank was trying to rush out
securitizations before that market vanished. The Federal Deposit Insurance
Corporation, a secondary regulator, was pushing to impose tighter
regulation, but the primary regulator, the Office of Thrift Supervision, was
successfully resisting allowing the F.D.I.C. to even look at the bank’s loan
files.
Continued in article
More Headaches for Deloitte After Auditing
the Biggest Bank to Ever Fail
"Investigation finds fraud in WaMu lending: Senate report: Failed bank’s
own action couldn’t stop deceptive practices," by Marcy Gordon, MSNBC, April 12,
2010 ---
http://www.msnbc.msn.com/id/36440421/ns/business-mortgage_mess/?ocid=twitter
The mortgage lending
operations of Washington Mutual Inc., the biggest U.S. bank ever to fail,
were threaded through with fraud, Senate investigators have found.
And the bank's own probes
failed to stem the deceptive practices, the investigators said in a report
on the 2008 failure of WaMu.
The panel said the bank's
pay system rewarded loan officers for the volume and speed of the subprime
mortgage loans they closed. Extra bonuses even went to loan officers who
overcharged borrowers on their loans or levied stiff penalties for
prepayment, according to the report being released Tuesday by the
investigative panel of the Senate Homeland Security and Governmental Affairs
Committee.
Sen. Carl Levin, D-Mich.,
the chairman, said Monday the panel won't decide until after hearings this
week whether to make a formal referral to the Justice Department for
possible criminal prosecution. Justice, the FBI and the Securities and
Exchange Commission opened investigations into Washington Mutual soon after
its collapse in September 2008.
The report said the top WaMu
producers, loan officers and sales executives who made high-risk loans or
packaged them into securities for sale to Wall Street, were eligible for the
bank's President's Club, with trips to swank resorts, such as to Maui in
2005.
Fueled by the housing boom,
Seattle-based Washington Mutual's sales to investors of packaged subprime
mortgage securities leapt from $2.5 billion in 2000 to $29 billion in 2006.
The 119-year-old thrift, with $307 billion in assets, collapsed in September
2008. It was sold for $1.9 billion to JPMorgan Chase & Co. in a deal
brokered by the Federal Deposit Insurance Corp.
Jennifer Zuccarelli, a
spokeswoman for JPMorgan Chase, declined to comment on the subcommittee
report.
WaMu was one of the biggest
makers of so-called "option ARM" mortgages. These mortgages allowed
borrowers to make payments so low that loan debt actually increased every
month.
The Senate subcommittee
investigated the Washington Mutual failure for a year and a half. It focused
on the thrift as a case study for the financial crisis that brought the
recession and the loss of jobs or homes for millions of Americans.
The panel is holding
hearings Tuesday and Friday to take testimony from former senior executives
of Washington Mutual, including ex-CEO Kerry Killinger, and former and
current federal regulators.
Washington Mutual "was one
of the worst," Levin told reporters Monday. "This was a Main Street bank
that got taken in by these Wall Street profits that were offered to it."
The investors who bought the
mortgage securities from Washington Mutual weren't informed of the
fraudulent practices, the Senate investigators found. WaMu "dumped the
polluted water" of toxic mortgage securities into the stream of the U.S.
financial system, Levin said.
In some cases, sales
associates in WaMu offices in California fabricated loan documents, cutting
and pasting false names on borrowers' bank statements. The company's own
probe in 2005, three years before the bank collapsed, found that two top
producing offices — in Downey and Montebello, Calif. — had levels of fraud
exceeding 58 percent and 83 percent of the loans. Employees violated the
bank's policies on verifying borrowers' qualifications and reviewing loans.
Washington Mutual was
repeatedly criticized over the years by its internal auditors and federal
regulators for sloppy lending that resulted in high default rates by
borrowers, according to the report. Violations were so serious that in 2007,
Washington Mutual closed its big affiliate Long Beach Mortgage Co. as a
separate entity and took over its subprime lending operations.
Senior executives of the
bank were aware of the prevalence of fraud, the Senate investigators found.
In late 2006, Washington
Mutual's primary regulator, the U.S. Office of Thrift Supervision, allowed
the bank an additional year to comply with new, stricter guidelines for
issuing subprime loans.
According to an internal
bank e-mail cited in the report, Washington Mutual would have lost about a
third of the volume of its subprime loans if it applied the stricter
requirements.
Deloitte is Included in the Shareholder
Lawsuit Against Washington Mutual (WaMu)
Oct. 16, 2008 (The Seattle
Times) — U.S. Attorney Jeffrey Sullivan's office [Wednesday] announced that
it is conducting an investigation of Washington Mutual and the events
leading up to its takeover by the FDIC and sale to JP Morgan Chase.
Said Sullivan in a
statement: "Due to the intense public interest in the failure of Washington
Mutual, I want to assure our community that federal law enforcement is
examining activities at the bank to determine if any federal laws were
violated."
Sullivan's task force
includes investigators from the FBI, Federal Deposit Insurance Corp.'s
Office of Inspector General, Securities and Exchange Commission and the
Internal Revenue Service Criminal Investigations division.
Sullivan's office asks that
anyone with information for the task force call 1-866-915-8299; or e-mail
fbise@leo.gov.
"For more than 100 years
Washington Mutual was a highly regarded financial institution headquartered
in Seattle," Sullivan said. "Given the significant losses to investors,
employees, and our community, it is fully appropriate that we scrutinize the
activities of the bank, its leaders, and others to determine if any federal
laws were violated."
WaMu was seized by the FDIC
on Sept. 25, and its banking operations were sold to JPMorgan Chase,
prompting a Chapter 11 bankruptcy filing by Washington Mutual Inc., the
bank's holding company. The takeover was preceded by an effort to sell the
entire company, but no firm bids emerged.
The Associated Press
reported Sept. 23 that the FBI is investigating four other major U.S.
financial institutions whose collapse helped trigger the $700 billion
bailout plan by the Bush administration.
The AP report cited two
unnamed law-enforcement officials who said that the FBI is looking at
potential fraud by mortgage-finance giants Fannie Mae and Freddie Mac, and
insurer American International Group (AIG). Additionally, a senior
law-enforcement official said Lehman Brothers Holdings is under
investigation. The inquiries will focus on the financial institutions and
the individuals who ran them, the senior law-enforcement official said.
FBI Director Robert Mueller
said in September that about two dozen large financial firms were under
investigation. He did not name any of the companies but said the FBI also
was looking at whether any of them have misrepresented their assets.
The federal government is
investigating whether the
leadership of shuttered bank
Washington Mutual broke
federal laws in the run-up
to its collapse,
the largest in U.S. history.
. . .
Eighty-nine
former WaMu employees are confidential witnesses in
a
shareholder class action lawsuit against
the bank, and some former insiders
spoke exclusively to ABC News,
describing their claims that
the bank ignored key advice from its own risk
management team so they could maximize profits
during the housing boom.
In
court documents, the insiders said the company's
risk managers, the "gatekeepers" who were supposed
to protect the bank from taking undue risks, were
ignored, marginalized and, in some cases, fired. At
the same time, some of the bank's lenders and
underwriters, who sold mortgages directly to home
owners, said they felt pressure to sell as many
loans as possible and push risky, but lucrative,
loans onto all borrowers, according to insiders who
spoke to ABC News.
Continued in article
Allegedly "Deloitte Failed to Audit WaMu in
Accordance with GAAS" (see Page 351) ---
Click Here
Deloitte issued unqualified opinions and is a defendant in this lawsuit (see
Page 335)
In particular note Paragraphs 893-901 with respect to the alleged negligence of
Deloitte.
From The Wall Street Journal on Accounting Weekly Review on December
14, 2007
TOPICS: Accounting,
Audit Firms, Auditing, Big Four, PCAOB, Public Accounting,
Public Accounting Firms
SUMMARY: The
PCAOB, the nation's audit watchdog, recently fined Deloitte
& Touche $1 million and censured the firm over its work
checking the books of a San Diego-based pharmaceutical. This
is the first PCAOB enforcement case against a Big Four
accounting firm.
CLASSROOM
APPLICATION: This article can serve as a basis of
discussion of audit firm responsibility and the enforcement
process. It also discusses the PCAOB and a little of its
history and enforcement, as well as provides information for
discussion of Deloitte's response.
QUESTIONS:
1.) What firm recently agreed to a fine imposed by the PCAOB?
What was the reason for the fine? Is this firm a large,
medium, or small firm?
2.) What is the PCAOB? What is its purpose? When was it
created? What caused the creation of the PCAOB?
3.) What is Deloitte's response to the fine? How does the
firm defend itself against the allegations? What do you
think of the firm's comments and actions?
4.) What does it mean that Deloitte settled this case
"without admitting or denying claims?" Why would that be a
good tactic to take? How could it hurt the firm/
5.) Is the PCAOB's main focus enforcement? Why or why not?
What other responsibilities does the organization have?
6.) Relatively speaking, is this a substantial or minor fine
for the firm? Will fines like this change the behavior of
the firms? Why or why not?
SMALL
GROUP ASSIGNMENT:
Examine the PCAOB's website? What information is offered
there? What information are you interested in as an
accounting student? What might interest you as an investor?
What would interest a businessperson? Does the website offer
extensive information or is it general information? What
information is offered regarding enforcement? Is the website
a good resource for accountants? Why or why not? Is it a
valuable resource for businesspeople? Please explain your
answers. Offer specific examples of value offered on the
website? What would you like to see detailed or offered on
the website that is not included? What did you learn from
this website that you have not seen elsewhere?
Reviewed By: Linda Christiansen, Indiana University
Southeast
In its first-ever enforcement case
against a Big Four accounting firm, the nation's audit watchdog fined
Deloitte & Touche LLP $1 million and censured the firm over its work
checking the books of a San Diego-based pharmaceutical company.
Deloitte settled the matter without
admitting or denying claims brought by the Public Company Accounting
Oversight Board that one of the firm's former audit partners failed to
perform appropriate and adequate procedures in a 2004 audit of
Ligand Pharmaceuticals Inc.
Deloitte signed off on Ligand's books, finding they
fairly presented the firm's results and complied with U.S. generally
accepted accounting principles, or U.S. GAAP.
Ligand later restated financial results for 2003
and other periods because its recognition of revenue on product shipments
didn't comply with U.S. GAAP.
Ligand's restatement slashed its reported revenue
by about $59 million and boosted its net loss in 2003 by more than 2½ times,
the oversight board said.
First-Ever Case
The PCAOB's action against Deloitte marked the
first time since it was created in 2003 by the Sarbanes-Oxley
corporate-reform legislation that it has taken action against one of the Big
Four accounting firms -- Deloitte, PricewaterhouseCoopers LLP, KPMG LLP and
Ernst & Young LLP.
The PCAOB previously took enforcement actions
against 14 individuals and 10 firms, according to a spokeswoman, although
they all involved smaller firms.
Oversight-board Chairman Mark Olson told reporters
yesterday after a speech to the American Institute of Certified Public
Accountants that the board isn't looking to bring a lot of enforcement
actions but said "it is reasonable to expect that there will be others"
against Big Four firms.
Mr. Olson said in an earlier statement that the
board's disciplinary measures are needed to ensure public confidence isn't
undermined by firms or individual auditors who fail to meet "high standards
of quality and competence."
Competence was lacking in the 2003 Ligand audit,
according to the regulatory body. The oversight board said former auditor
James Fazio didn't give enough scrutiny to Ligand's reported revenue from
sales of products that customers had a right to return, even though Ligand
had a history of substantially underestimating such returns.
Deloitte's Response
In a statement yesterday, Deloitte said it is
committed to ongoing efforts to improve audit quality and "fully supports"
the role of the accounting-oversight board in those efforts.
"Deloitte, on its own initiative, established and
implemented changes to its quality control policies and procedures that
directly address the PCAOB's concerns," the company said.
It added that it is confident that Deloitte's audit
policies and procedures "are among the very best in the profession and that
they meet or exceed all applicable standards."
New York-based Deloitte began auditing Ligand in
2000 and resigned in August 2004.
Mr. Fazio, who resigned from Deloitte in October
2005, agreed to be barred from public-company accounting for a minimum of
two years, the PCAOB said. Mr. Fazio's lawyer couldn't be reached to
comment.
The oversight board also faulted Mr. Fazio for not
adequately supervising others working on the audit and faulted Deloitte for
leaving him in place even though some managers had determined he should be
removed and ultimately asked him to resign from the firm.
Mr. Fazio remained on the job despite the fact that
questions about his performance had been raised in the fall of 2003, the
oversight board said.
In addition, the oversight board said Deloitte had
assigned a greater-than-normal risk to Ligand's 2003 audit but failed to
ensure that the partners assigned to the work had sufficient experience to
handle it.
"Deloitte Agrees to Pay $38 Million to
Ex-Delphi Investors," SmartPros, December 31, 2007
A U.S. Securities and
Exchange Commission investigation found that Delphi manipulated its earnings
from 2000 to 2004, using several illegal schemes to boost its earnings,
including the concealment of a $237 million transaction in 2000 with GM
involving warranty costs.
Deloitte & Touche, now part
of the privately held Deloitte Touche Tohmatsu, served as Delphi's outside
accountant.
The agreement requires
approval by Detroit U.S. District Judge Gerald Rosen and completes a $325
million settlement of investor claims over the accounting issue, lawyers for
the investors said. Delphi agreed to pay about $205 million, with Delphi's
insurers and banks paying the rest.
"It's about holding the
gatekeepers accountable," said attorney Stuart Grant of Grant & Eisenhofer,
one of four law firms representing public employee pension funds and other
Delphi investors in the class action suit. "We're forcing the accountants
... to say, 'I am my brother's keeper.'"
In its first inspection report of a Big Four firm in
the year 2010, the PCAOB just released its 2009 inspection report of Deloitte &
Touche LLP, finding quite a high percentage of errors in the sample of audits
selected to be reviewed.
The Public Company Accounting Oversight Board on May
4, 2010 conducted an inspection of the registered public accounting firm
Deloitte & Touche LLP ("Deloitte" or "the Firm") in 2009, and issued a report in
accordance with the requirements of the Sarbanes-Oxley Act of 2002.
Here are some interesting facts and numbers from this
report summary:
Members of the Board's inspection staff conducted
primary procedures for the inspection from October 2008 through October 2009.
Field work was done at Deloitte’s National Office and
at 30 of its approximately 69 U.S. practice offices, indicating about 40% of
offices were covered.
The scope of this review was determined according to
the Board's criteria, and the Firm was not allowed an opportunity to limit or
influence the scope.
The inspection reviewed aspects of 73 audits
performed by Deloitte and found 15 issues (Issues A to O), which works out to a
20% error rate, by simply dividing 15 by 73, which we would think is quite high.
Imagine that one of every five audits randomly selected and signed off by one of
the largest accounting firms on the planet has purported errors.
We summarize below all the 15 issues, which PCAOB
calls, “audit deficiencies, including failures by the Firm to identify or
appropriately address errors in the issuer's application of GAAP, including, in
some cases, errors that appeared likely to be material to the issuer's financial
statements. In addition, the deficiencies included failures by the Firm to
perform, or to perform sufficiently, certain necessary audit procedures.” – so
quite stringent in its scope.
Issuer A The issuer's total U.S. net federal deferred
tax assets, which exceeded its stockholders' equity at year end, included
substantial U.S. income tax net operating loss carry forwards for which no
valuation allowance had been recorded. The Firm, however, failed to give
sufficient weight to relevant evidence that was more objectively verifiable,
such as the fact that the issuer had experienced losses in seven of the last
eight years (including cumulative losses in the last three years), had
experienced two successive year-over-year declines in U.S. sales volumes, and
considered the disruptions in the financial markets to be a risk factor to its
business.
Issuer B The issuer evaluated its recorded goodwill
for impairment during the third quarter of the year and concluded that the fair
value of its total assets exceeded their book value by a small margin. The Firm
failed to sufficiently evaluate the effect of these events on its assessment of
the potential impairment of goodwill at year end.
Issuer C The Firm failed in the following respects to
obtain sufficient competent evidential matter to support its audit opinion, in
failing to perform adequate audit procedures to test the valuation of the
issuer's inventory and investments in joint ventures (the primary assets of
which were inventory). Etc.
Issuer D The Firm failed to adequately test the
valuation of the issuer's inventory and the issuer's investments in
unconsolidated entities, whose primary assets were inventory ("investments").
Issuer E The Firm failed to adequately test an
intangible asset for impairment.
Issuer F The Firm failed to perform adequate audit
procedures pertaining to a sale of a subsidiary to a newly formed entity in
which the issuer held an ownership interest.
Issuer G The Firm failed in the following respects to
obtain sufficient competent evidential matter to support its audit opinion, in
one reporting unit, the Firm failed to evaluate whether management's use of
historical results as the sole basis for its revenue projections, without
considering the issuer's future prospects or the economic conditions, was
reasonable.
Issuer H The issuer engaged a specialist to calculate
the estimated amount of a significant contingent liability. The amount
calculated by the specialist exceeded the amount recorded by the issuer by an
amount that was approximately 13 times the Firm's planning materiality. The Firm
failed to perform sufficient procedures to test the contingent liability.
Issuer I The Firm failed to perform adequate audit
procedures to test the issuer's conclusion that certain available-for-sale
securities with unrealized losses did not require a charge for
other-than-temporary-impairment.
Issuer J The Firm failed to evaluate the
reasonableness of certain significant assumptions that the issuer had used in
developing its cash flow estimates to assess the recoverability of certain
long-lived assets etc.
Issuer L The issuer acquired a company during the
year, and this acquired company operated as a subsidiary of the issuer after the
acquisition and was the source of a significant portion of the issuer's reported
revenue. The Firm failed to test the operating effectiveness of the controls
over the acquired company's revenue and, as a result, the Firm's testing of
revenue was inadequate.
Issuer M The Firm failed to perform adequate audit
procedures to test the fair value of an embedded derivative liability at year
end.
Issuer N The Firm failed to sufficiently test revenue
and cost of goods sold.
Issuer O The Firm failed to identify a departure from
GAAP that it should have identified and addressed before issuing its audit
report.
In its response to the PCAOB, Deloitte said, “We have
evaluated the matters identified by the Board’s inspection team for each of the
Issuer audits described in Part I of the Draft Report and have taken actions as
appropriate in accordance with D&T’s policies and PCAOB standards….none of our
reports on the Issuers’ financial statements was affected.”
A few things stand out in this report:
First, the PCAOB is actually providing the sample
size of the inspected audits, for the first time, enabling us to calculate an
error rate
The error rate in this situation is quite high,
almost one of every five audits has errors. Obviously, Deloitte performs
thousands of audit each year and extrapolating from a small sample is quite
dangerous, nonetheless, even at half of 20%, the natural conclusion is that one
in ten audits has an error, and would have gone unnoticed had not the PCAOB done
a good post-audit on the audit.
Finally, there is a good deal of variance in the type
of errors found, ranging from lack of inventory checking to impairment testing.
Interesting to see that not all of these issues related to accounting for
financial securities.
We’ll of course be waiting for the report on Ernst &
Young to see if the PCAOB is highlighting any accounting deficiencies relating
to its audit of Lehman Brothers’ infamous Repo 105, if that were indeed in the
scope of the 2009 audit.
A Parmalat Ruling May
Broaden Auditing Firm Liability
From The Wall Street Journal Accounting Weekly Review
on February 6, 2009
SUMMARY: U.S.
District Judge Lewis Kaplan of New York ruled on Tuesday,
January 27, 2009, that "...Deloitte Touche Tohmatsu potentially
could be held liable for an allegedly defective Parmalat audit
by its Italian member firm, Deloitte & Touche SpA."
CLASSROOM
APPLICATION: Understanding the structure of audit firms and
the nature of business risk associated with worldwide operations
can be achieved with this article.
QUESTIONS:
1. (Introductory) What was the nature of the Parmalat
scandal in 2003? Cite your source for this information.
2. (Advanced) The judge in this case concluded that
Deloitte Touche Tohmatsu "...exercised substantial control over
the manner in which its member firms conducted their
professional activities." How is such control achieved? What are
the limits to the firm being able to achieve this control?
3. (Advanced) How might Deloitte Touche Tohmatsu,
located in the U.S. and other places, be held responsible for an
alleged audit failure in relation to the Parmalat engagement run
by the Italian arm of the audit firm? What does this
responsibility imply, in terms of choices of affiliated entities
when growing an audit firm's business?
4. (Advanced) Refer to the related article. How might
an alleged audit failure over Satyam Computer Services, Ltd.,
affect PriceWaterhouseCoopers' worldwide operations?
Reviewed By: Judy Beckman, University of Rhode Island
A U.S. judge issued a ruling
in the Parmalat securities litigation that could worry large accounting
firms with offices in many countries.
Parmalat SpA, an Italian
conglomerate, collapsed in 2003 following the discovery of a massive fraud
in which the company allegedly overstated its assets by $16 billion.
At issue in Tuesday's
ruling, by U.S. District Judge Lewis Kaplan of New York, was whether
Deloitte Touche Tohmatsu potentially could be held liable for an allegedly
defective Parmalat audit by its Italian member firm, Deloitte & Touche SpA.
Judge Kaplan held that it was possible, in denying Deloitte Touche
Tohmatsu's motion for summary judgment. A request for summary judgment asks
that part or all of the case be dismissed before trial.
"This is huge," says Stuart
Grant, counsel for people who bought Parmalat shares. "Judge Kaplan has
finally made the law reflect reality. These accounting firms sell themselves
as world-wide, seamless organizations. Now they are going to be held
responsible in the same fashion."
Deloitte Touche Tohmatsu
"provided no services of any kind to any Parmalat entity," the firm said in
a statement. "We are confident of victory at any trial of this matter."
Whether Deloitte
Touche Tohmatsu can be held liable for Deloitte & Touche SpA turns on
whether it had a "principal-agent" relationship with the Italian affiliate.
Judge Kaplan concluded that "DTT exercised substantial control over the
manner in which its member firms conducted their professional activities."
A CPA Auditor in Deloitte Commits Felony
Fraud Over Years of Managing Audits
Question
How should his fraud be disclosed on a victim's financial statements?
WILMINGTON, DEL. (CN) -
Deloitte & Touche says a 30-year partner traded on inside information he
got from audits, and lied about it for years. It sued Thomas P. Flanagan
in Chancery Court. Flanagan "for 30 years was a partner" in Deloitte &
Touche or a predecessor "until his abrupt resignation less than two
months ago," Deloitte claims. It says he betrayed his trust and violated
company policy by trading in securities of audit clients, including some
of his own accounts, since 2005. "Compounding his wrongdoing, Flanagan
repeatedly lied to Deloitte about his clandestine trading activities in
annual written certifications, going to far as to conceal the existence
of a number of his brokerage accounts to avoid detection of his improper
conduct," Deloitte says. It says that both Deloitte and its clients have
had to pay legal costs to investigate Deloitte's ability to continue as
independent auditor, due to Flanagan's shenanigans. It seeks monetary
damages. The complaint does not state, or estimate, how much Flanagan
made from his alleged inside trades. Deloitte says that it still does
not know the extent of them. Deloitte & Touche is represented by Paul
Lockwood with Skadden Arps.
Here's a little more information. This is
from the most recent 10-Q for USG. I understand that similar approaches were
used in the other cases where this occurred.
Note that the person in question was the
"advisory partner" rather than engagement partner or concurring partner.
Most of the large firms use senior partners in a similar "relationship
management" way. So the person wouldn't necessarily have been involved in
detailed auditing or review, but he might have been involved if there were
significant judgmental issues that the engagement team needed to resolve. In
this case it looks like D&T decided that wasn't the case.
Denny
ITEM 5. OTHER
INFORMATION
Since 2002, Deloitte & Touche LLP has served as the independent registered
public accountants with respect to our financial statements. In September
2008, Deloitte advised us that they believed a member of Deloitte’s client
service team that serves us had entered into two option trades involving our
securities in July 2007. This individual had served as the advisory partner
on Deloitte’s client service team for us from 2004 until September 2008. The
advisory partner is no longer an active partner at Deloitte. Under the
Deloitte client service model as we understand it, the role of an advisory
partner is primarily to serve in a client-relationship maintenance and
assessment role. Securities and Exchange Commission rules require that we
file annual financial statements that are audited by registered independent
public accountants. SEC rules also provide that when a partner serving in a
capacity such as that of this advisory partner has an investment in
securities of an audit client, the audit firm should not be considered
independent with respect to that client. Based on our review of the former
advisory partner’s role and activities, we do not believe that he had any
substantive role or influenced any substantive portion of any audit or
review of our financial statements. The former advisory partner attended
many, but not all, of our audit committee meetings. At these meetings, he
reviewed with the committee reports of the annual inspection of Deloitte
conducted by the Public Company Accounting Oversight Board as well as
Deloitte’s annual client service assessments. He did not review any
substantive audit matters with the committee at any of these meetings or at
any other time. The former advisory partner also met once or twice a year
with our audit committee chair and once per year with the other members of
our audit committee as well as our chief executive officer and chief
financial officer. The stated purpose of these meetings was to foster and
strengthen Deloitte’s ongoing relationship with us. The former advisory
partner attended our annual meetings of shareholders as one of the Deloitte
representatives attending those meetings. Neither the former advisory
partner nor any other Deloitte representatives spoke at any of these
meetings and no questions were asked of Deloitte. At the direction of our
audit committee, we conducted an extensive investigation into the facts and
circumstances of the extent of any involvement of the former advisory
partner with our audit. We retained outside counsel and a consulting firm
specializing in accounting issues to assist in this investigation. Outside
counsel led the process and conducted personal interviews with the current
and former lead client service partners, the concurring review partner, the
current and former senior managers on our account and the tax matters
partner, as well as the members of our audit committee and key members of
our internal finance and accounting departments, including our chief
financial
Deloitte Settles With a a Japanese Audit Client for More
Than $200 Million Deloitte & Touche LLP has paid about $100 million to a
Japanese insurer to settle litigation related to the collapse of a giant
aviation reinsurance pool, bringing the total paid by Deloitte in the case to
well more than $200 million in what has become one of the costliest-ever legal
settlements for an auditing firm.
Mark Maremont and Miho Inada, "Deloitte Pays Insurers More Than $200 Million,"
The Wall Street Journal, January 6, 2006; Page C3 ---
http://online.wsj.com/article/SB113651878950639466.html?mod=todays_us_money_and_investing
From The Wall Street Journal Accounting Weekly Review
on June 29, 2007
SUMMARY: This very short article reports on the results of PCAOB's inspection
report on Deloitte and Touche's public company audits, noting that the PCAOB
found fault with eight of Deloitte and Touche's audits. "Deloitte contested
inspectors' conclusions in two audits and said it undertook additional work on
the remaining six."
QUESTIONS:
1.) Why is the Public Company Accounting Oversight Board undertaking an
inspection of Deloitte and Touche's audit work. You may refer to any source,
such as your textbook or the world wide web, to obtain the answer to this
question.
2.) What is the significance of finding fault with 6 or 8 of Deloitte and
Touche's audits?
3.) How is the Deloitte and Touche response both clearly a public relations
statement and at the same time a reflection of what should be done following
outside criticism of one's work?
Reviewed By: Judy Beckman, University of Rhode Island
Deloitte & Touche LLP performed additional audit
work for six public-company clients after accounting-industry inspectors
raised concerns about its work, but it said the extra effort didn't change
the inspectors' conclusions on the firm's finances.
The audit firm's comments came in a 2007 inspection
report by the Public Company Accounting Oversight Board, which found fault
with eight of Deloitte's public-company audits. Deloitte contested
inspectors' conclusions in two audits, and said it undertook additional work
on the remaining six audits where inspectors faulted its efforts. Only a
portion of the findings are publicly released each year.
"Deloitte & Touche is dedicated to conducting the
highest quality audits," a spokeswoman said. "The PCAOB inspections are
important, and the process is constructive and informative. The observations
and comments from the inspectors will continue to be a key contributor in
our efforts to improve our audit execution, methodologies and policies."
Delphi Settles Lawsuits Over Accounting Fraud Charges Delphi Corp. settled fraud lawsuits by investors,
including about 40,000 current and former employees and several pension funds,
who contended former managers fraudulently inflated financial results to make
Delphi more attractive. Participants in employee-retirement plans will get $24.5
million in allowed interest in Delphi's Chapter 11 bankruptcy case and $22.5
million in cash from insurance carriers. Buyers of Delphi's debt and equity will
get $204 million in combined allowed interest and about $90 million in cash from
other defendants and insurers.
"Delphi Settles Lawsuits Over Fraud Charges," The Wall Street Journal,
September 4, 2007; Page A9 ---
http://online.wsj.com/article/SB118887586498116651.html?mod=todays_us_page_one
Jensen Comment
I think what's important about this is that Deloitte is the only one of the Big
Four that did not sell its consulting division (although those firms that did
sell have started up new advisory services divisions). It would seem that
Deloitte was still auditing an information system that it once designed.
However, some other firms are probably doing the same thing even though they
sold the consulting divisions that once designed the information systems being
audited.
A group of large investors has asked the judge
presiding over Delphi Corp.'s bankruptcy proceedings to disqualify Big Four
accounting firm Deloitte & Touche LLP from continuing to audit the
auto-parts maker's financial statements.
Delphi filed for Chapter 11 bankruptcy-court
protection in October, just months after disclosing a litany of accounting
violations involving hundreds of millions of dollars. The disclosures
prompted a series of government investigations that are continuing. Shortly
after filing for bankruptcy protection, Delphi asked the court for
permission to continue using Deloitte, its longtime outside auditor.
In their request Friday, the Teachers' Retirement
System of Oklahoma, the Public Employees' Retirement System of Mississippi
and two other large institutional investors asked U.S. Bankruptcy Judge
Robert D. Drain to reject that application, arguing that Deloitte faces
unmanageable conflicts of interests.
"The more Deloitte were to discover about Delphi's
past accounting problems, the more it would implicate itself for having
failed to detect them at the time," the funds wrote in their court filing.
"In fact, Deloitte has strong incentive to conceal pre-petition accounting
and auditing problems, and to minimize its own liability."
Those same investors are the lead plaintiffs in a
lawsuit that seeks class-action status accusing Delphi, Deloitte and several
other defendants of misleading investors. They also have filed papers before
Judge Drain objecting to potentially lucrative pay packages that Delphi has
proposed for certain key employees, including senior Delphi executives,
while the company reorganizes.
In a statement, Deloitte spokeswoman Deborah
Harrington said the accounting firm "does not believe it would be
appropriate to publicly comment on a retention application that is currently
pending before the federal bankruptcy court. However, any allegations that
Deloitte & Touche LLP acted improperly with respect to its prior audit
engagements for Delphi are untrue."
A Delphi spokesman declined to comment.
In addition to auditing Delphi's financial
statements, Deloitte also designed and implemented Delphi's
financial-information systems following the company's 1999 spinoff from
General Motors Corp. In 2000, Delphi paid Deloitte $6.6 million for its
annual audit and $50.8 million for nonaudit services, including $41.3
million for the information-systems project; it paid Deloitte an additional
$12 million related to the project in 2001.
Since then, Delphi's audit fees have risen, while
nonaudit fees have declined. For 2004, Delphi paid Deloitte $14 million in
audit fees and $1.7 million for other services.
Continued in article
Ex-Software Officer Settles With S.E.C A former executive of McAfee, the antiviral software
maker, agreed to pay about $757,000 to settle charges that he played a role in
the company’s $622 million accounting fraud, the Securities and Exchange
Commission said Tuesday. The S.E.C. charged in a civil lawsuit filed Monday in
federal court in San Francisco that the company’s former treasurer, Eric
Borrmann, aided in fraud from mid-1999 until he left McAfee in July 2000.
"Ex-Software Officer Settles With S.E.C.," The New York Times, November
1, 2006 ---
http://www.nytimes.com/2006/11/01/technology/01mcafee.html?ref=business
The external auditor for McAfee is Deloitte and Touche.
Deloitte's Concept of Pricing Options is Legally and Ethically
Questionable
So when new hires began complaining that the
company's volatile share price meant that colleagues who had arrived just
days earlier were receiving stock options worth thousands of dollars more,
Micrel executives moved to satisfy the troops. They raised with their
auditor, Deloitte & Touche, the idea of adopting a new options pricing
strategy similar to one that other tech companies, including Microsoft, used
at the time.
Instead of granting options at the market price on
a new employee's hire date, Micrel proposed setting the price at the lowest
point in the 30 days from when the grant was approved.
It seemed like an ideal solution. The 30-day window
could help Micrel attract and reward new hires on a more equal footing,
while helping to retain existing employees. And if it were extended up the
corporate ladder, the prospect of built-in gains and tax breaks, worth
millions of dollars, could enrich senior executives.
But the 30-day pricing method, which Micrel adopted
in mid-1996, was an aggressive move legally and financially. In hindsight,
it was also a major misstep.
Nearly five years later, Deloitte reversed its
opinion and urged Micrel to restate its financial reports. The Internal
Revenue Service came banging on its door. And today, Micrel and Deloitte are
passing blame back and forth in court.
Micrel is hardly the only firm ensnared in such a
mess. What began as a creative solution among a handful of technology firms
to address recruitment issues soon became common practice in Silicon Valley.
It appears the practice also became a way to enrich chief executives and
other top managers.
The result is a nationwide scandal with major
accounting, corporate governance, tax and disclosure ramifications. Dozens,
perhaps hundreds, of companies are caught up in a giant civil and criminal
law enforcement sweep by the Justice Department, the I.R.S. and the
Securities and Exchange Commission.
It is no coincidence that stock option abuses are
once again taking center stage in an unfolding scandal. The easy money that
options can rain down on recipients motivated many of the numbers games that
companies played with their quarterly earnings during the stock market boom,
leading to numerous accounting fraud prosecutions at Enron, WorldCom and
others.
In the latest scandal, companies seem to have
handed out stock options that were already "in the money" on the date of
grant, undermining the idea of using options as a pay-for-performance tool.
The practice appears to have been widespread from the early 1990's to 2002,
and possibly beyond.
Handing out in-the-money options is not illegal as
long as the grants are disclosed to shareholders. At the time, in-the-money
options had to be counted as an expense on the company's books. (New rules
now require companies to routinely deduct options as an expense.) Failure to
disclose or to deduct in-the-money options from income could lead to
securities fraud charges. And because such options do not qualify for tax
breaks once they are exercised, such grants raise tax fraud issues, too.
The Micrel case and others raise troubling
questions about how companies that were pushing the envelope of accounting
and tax practice were able to get the blessings of auditors and lawyers. And
the widening scandal reveals the extent to which boards of directors,
especially the compensation committees that approve option grants, may have
failed to do their jobs.
"It appears, from the S.E.C. and a number of
reports that are coming up daily, that there was a systemic problem at a lot
of companies," said Bradley E. Beckworth, a plaintiffs' attorney who has
filed one of the first class-action lawsuits against Brocade Communications
and KPMG, its auditor, for options backdating. "If these accounts turn out
to be true, you have to ask the question, Who was the gatekeeper here?"
Micrel, by most accounts, is one of the last
technology companies where one might expect to find problems. While the chip
manufacturer was one of the high-flying growth businesses of the 1990's, it
was different in several respects from most of the era's fledgling public
companies.
Its founder and longtime chief executive, Raymond
D. Zinn, a 68-year-old engineer, is a Mormon who calls honesty his guiding
rule. And unlike many of its technology rivals, Micrel's own profits, not
venture financing, fueled its growth until it went public in 1994.
But like many high-tech firms in the mid-1990's,
Micrel went on a hiring binge. The Bay Area was booming with opportunities
for ambitious people. Companies were growing at astronomical rates and
desperately needed talent to fill new jobs. And instead of higher salaries,
companies preferred to grant stock options to lure new employees.
Micrel, a company that had a few hundred employees
but was adding two or three new people a week, began facing a fairness
problem in its options awards in mid-1996.
Yet Another Executive Looting of a Corporation The Securities and Exchange Commission has announced
the filing of securities fraud charges against three former top officers of an
operator of national restaurant chains in connection with their receipt of
approximately one million dollars in undisclosed compensation, participation in
undisclosed related party transactions, and financial statement fraud from 2000
to 2004. The SEC charges were filed against Buca, Inc.'s former CEO, Joseph
Micatrotto, the company's former CFO, Greg Gadel, and its former Controller,
Daniel J. Skrypek. Buca is a Minneapolis, Minn., company that operates the Buca
di Beppo and Vinny T's of Boston national restaurant chains. "Buca's top
officers created a tone at the top and a corporate culture that allowed them to
loot the company and engage in a financial fraud," stated Linda Thomsen, the
SEC's Director of Enforcement. "Such conduct is a fundamental violation of the
trust placed in corporate officers by public shareholders and cannot be
countenanced."
"SEC FILES FRAUD CHARGES AGAINST FORMER RESTAURANT EXECUTIVES FOR UNDISCLOSED
COMPENSATION AND ACCOUNTING FRAUD; FORMER CEO AGREES TO PAY $500,000 CIVIL
PENALTY," AccountingEducation.com, June 22, 2006 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=143074
Jensen Comment
In 2005 the external auditor of Buca was Deloitte and Touche.
SEC instigates probe of General Motors' Accounting General Motors Corp. said on Wednesday it had been
subpoenaed by the U.S. Securities and Exchange Commission as part of a probe
into its accounting practices and other matters. It was the latest blow to the
world's largest automaker, which is bleeding money from its core North American
automotive operations and confronting its biggest financial crisis since a
narrow brush with bankruptcy 13 years ago. GM said the subpoenas related to its
financial reporting for pension and other post-employment benefits, and to
transactions between the company and auto parts supplier Delphi Corp. (Other
OTC:DPHIQ - news). They also relate to the SEC's interest in GM's recovery of
various costs from suppliers and supplier price credits, and any obligations to
fund pension and post-employment benefits costs related to Delphi's Chapter 11
bankruptcy proceedings, the company said in a statement.
"GM subpoenaed in accounting probe," The New York Times, October 26, 2005
From The Wall Street Journal Accounting Weekly Review
on November 18, 2005
TITLE: GM Will Restate Results for 2001 in Latest Stumble
REPORTER: Joseph B. White and Lee Hawkins, Jr.
DATE: Nov 10, 2005
PAGE: A1
LINK:
http://online.wsj.com/article/SB113158081329892910.html
TOPICS: Accounting, Accounting Changes and Error Corrections, Advanced Financial
Accounting, Financial Accounting, Impairment
SUMMARY: GM inappropriately recorded credits from suppliers in 2001, boosting
earnings in that year by about 100%, rather than recording them in later
periods. "The practice of suppliers making payments to customers, effectively
rebating projected cost savings up front, is a touchy one in the auto industry."
2.) What was the total impact on GM's 2001 net income of the "supplier
credits" issue described in this article? What will be the ultimate impact on
the company's shareholder's equity through today? Explain your answer.
3.) What factors, particularly related to actions following September 11,
2001, negatively affected GM's 2001 and later earnings?
4.) How does GM's management argue that their 2001 and later results would
have been even worse had they not undertaken programs to maintain sales
following the September 11, 2001, tragic events? In your answer, make reference
to the concepts of fixed and variable costs, defining each of these terms.
5.) Using the related article as well as the main article for this review,
describe GM's strategy with investments in foreign entities. What is the issue
regarding impairment reviews for those investments? In your answer, define
"impairment review" and cite the authoritative accounting literature requiring
those reviews.
6.) What controls do you think might have been put in place given the
statement, quoted in the main article, that "GM said it is 'confident' that it
now 'has substantially completed the process of fully remediating its related
controls and procedures.' In answering this question, rely on specific
requirements for timing of impairment reviews from authoritative accounting
literature.
Reviewed By: Judy Beckman, University of Rhode Island
--- RELATED ARTICLES ---
TITLE: At General Motors, Troubles Mount for Man Behind the Wheel
REPORTER: Joseph B. White and Lee Hawkins, Jr.
PAGE: A1 ISSUE: Nov 11, 2005
LINK:
http://online.wsj.com/article/SB113167989835994535.html
"GM Will Restate Results for 2001 In Latest Stumble: Auto
Maker Says It Booked 'Erroneous' Supplier Credits; Stock Price Hits 13-Year
Low," by Joseph B. White and Lee Hawkins, Jr., The Wall Street Journal,
November 10, 2005; Page A1 ---
http://online.wsj.com/article/SB113158081329892910.html
DETROIT -- General Motors Corp., whose accounting
is under scrutiny by the Securities and Exchange Commission, said it must
restate financial results for 2001 and possibly subsequent years, the latest
blow to the beleaguered auto giant and its chairman and chief executive,
Rick Wagoner.
Late yesterday, after the close of New York Stock
Exchange trading, GM said it overstated income for 2001 by as much as $300
million to $400 million -- equivalent to about 50% of the profit it reported
at the time -- by "erroneously" booking credits from suppliers. The company
said its accounting for credits from suppliers is "one of the matters" being
investigated by the SEC.
GM's admission ended a day in which its shares fell
to their lowest level since November 1992 -- during the company's last
financial and management crisis -- in 4 p.m. Big Board trading, closing down
$1.23, or nearly 5%, at $24.63. Also yesterday, Fitch Ratings cut its
already junk-level rating on GM's debt by another two notches.
GM spokeswoman Toni Simonetti said GM's audit
committee had met earlier this week to discuss the accounting issue.
"The issue here was that we basically booked the
income in the wrong period," Ms. Simonetti said. "We're going to restate it
rather than taking it all in 2001. That income still exists. It's not like
that income shouldn't have been booked, it just shouldn't have been booked
in all of 2001."
Still, the disclosure that GM materially overstated
2001 income from continuing operations -- and may have to make what it said
would likely be "immaterial" adjustments to earnings reported for subsequent
years -- likely will add pressure on Mr. Wagoner. He has been battling to
turn around losses that have totaled more than $3 billion for the company so
far this year.
Mr. Wagoner, who was CEO in 2001, has spent his
five years at the company's helm trying to expand its global footprint while
propping up North American sales to generate revenue to cover burgeoning
U.S. health-care and pension costs. But this year, intensified competition
coupled with rising gas prices, which have dented demand for GM's most
profitable models, have undermined Mr. Wagoner's strategy for keeping GM in
the black.
The company's falling stock price -- shares are
down 39% this year -- and the downgrading of its debt to junk status by all
the major credit-rating agencies symbolize the declining confidence in Mr.
Wagoner, who became GM's chief financial officer in 1992 in a boardroom coup
that swept out top management.
Neither GM nor Mr. Wagoner or any GM officer has
been accused by the SEC of any wrongdoing.
Deloitte & Touche LLP has paid a huge sum to settle
litigation with a group of Japanese insurers over the collapse of an obscure
North Carolina reinsurance agent, underscoring the legal risks faced by
auditing firms from their work for even the smallest of clients.
The precise amount of the settlement is
confidential, but it appears to be in the range of $250 million, based on a
disclosure by one of the Japanese firms. Aioi Insurance Co., which had the
biggest potential claim, said Friday it would post an extraordinary gain
from the settlement of 10.6 billion yen, or $95 million. Because the gain
was an after-tax figure, the actual cash payment to Aioi was likely even
larger.
The settlement -- which arose from a dispute over
"finite" reinsurance, a controversial financial product that regulators have
been probing more broadly -- appears to be one of the largest ever paid by
an accounting firm over its audit work. The biggest such settlement was a
$335 million payment in 2000 by Ernst & Young LLP in a shareholder suit
related to the Cendant Corp. scandal.
The Japanese firms and a related Bermuda entity had
sued Deloitte in state court in Geensboro, N.C., in connection with its
audit work for Fortress Re, a reinsurance agent that sold policies on behalf
of a pool of Japanese companies. The plaintiffs claimed that Deloitte
improperly let Fortress hide liabilities that should have been on the books.
Reinsurance is purchased by insurance companies to spread risks in case they
are hit by large claims.
Fortress, which specialized in reinsurance for
aviation risk, collapsed after the 2001 terrorist attacks, leaving the
Japanese firms with losses they estimated at $3.5 billion. The case had been
scheduled to go to trial earlier this month.
Deborah Harrington, a Deloitte spokeswoman,
declined to comment on the size of the settlement, saying only that "the
litigation was settled amicably."
Continued in article
Deloitte still a bigger one and some smaller ones pending (See below).
Deloitte & Touche under investigation Deloitte & Touche LLP is under investigation by the
nation's accounting regulator over a 2003 audit of Navistar International
Corp.'s financial statements, according to a published report. Earlier this
year, Warrenville, Ill.-based Navistar restated its financial results for the
fiscal years 2002 and 2003, and the first three quarters of fiscal 2004 because
of an error in how it accounted for customer truck loans that were packaged into
securities for sale to investors. The regulator, the Public Company Accounting
Oversight Board, is looking into whether Deloitte's work at Navistar may have
failed to comply with at least five auditing standards, according to Bloomberg
News. Those standards cover checking for fraud, performing work in a
professional manner and preparing reports on financial statements. The two-page
order does not explain what Deloitte may have done wrong, Bloomberg said.
Ameet Sachdev, "Deloitte & Touche under investigation," Herald Today,"
July 9, 2005 ---
http://www.bradenton.com/mld/bradenton/business/12092705.htm
Question
What CPA auditing firm has the dubious honor of having been the auditor for the
company that is now designated as the largest bankruptcy case in the history of
the world?
Answer
Deloitte Touche Tomatsu
Deloitte faces a potential $2 billion legal claim over audits of Forest Re,
an aviation reinsurer that failed after 2001's terror attacks.
In a case that shows how the insurance
industry's woes could spread to its auditors, Deloitte & Touche LLP faces
a potential $2 billion legal claim related to the type of earnings-management
insurance products that are the subject of government investigations at other
companies.
The dispute involves Deloitte's audits
of Fortress Re Inc., a closely held North Carolina insurance company.
Fortress, which specialized in reinsurance for aviation risk, collapsed after
the Sept. 11, 2001, terrorist attacks. Two Japanese insurers that had relied
on Fortress to minimize their risk with additional insurance charge that its
use of unconventional coverage and its fraudulent accounting resulted in an
estimated $3.5 billion in total losses for them and for a third insurer that
was forced into bankruptcy. Deloitte denies any liability in the dispute.
The case, which is entering
court-ordered mediation this week, could be one of the most troublesome legal
claims Deloitte faces. The accountant also is being sued in connection with
its audits of Italy's scandal-plagued Parmalat SpA and cable-TV firm Adelphia
Communications Corp.
In the broad crackdown on corporate
fraud of recent years, the trail often has led to legal problems for auditors.
Arthur Andersen LLP essentially dissolved after being convicted of criminal
behavior in connection with its audits of Enron Corp.
The current probes into the insurance
industry are at a relatively early stage, but they already have touched on the
accounting profession. The Securities and Exchange Commission, the Justice
Department and New York Attorney General Eliot Spitzer recently have launched
investigations into the industry's use of products similar to those involved
in the Deloitte case.
Last year, now-defunct Andersen was
faulted by an Australian government investigator for an "insufficiently
rigorous" audit in connection with the 2001 collapse of HIH Insurance,
Australia's largest bankruptcy. Andersen wasn't directly blamed in the case,
in which Australian authorities found that "audacious" and suspect
insurance transactions played a role in the bankruptcy.
Continued in article
Auto-parts maker Delphi
Corp. disclosed multiple accounting irregularities dating back to 1999,
including a period when it reported healthy results despite cutbacks in the auto
industry, and said a committee of outside directors is investigating the way it
accounted for a $237 million payment in 2000 to former parent General
Motors Corp., among other transactions. Delphi said it has ousted two
executives, including its vice chairman and chief financial officer, Alan S.
Dawes, and demoted a third in connection with the board's investigation. Mr.
Dawes couldn't be reached to comment.
Karen Lundegaard, "Delphi Discloses Accounting Problems," The Wall
Street Journal, March 7, 2005 --- http://online.wsj.com/article/0,,SB110994509329670632,00.html?mod=todays_us_page_one
The independent auditor for Delphi is Deloitte and Touche.
More bad news for the auditing firm of Deloitte & Touche
The spectre of a fresh scandal to follow the Parmalat affair hung over the
Italian financial world as magistrates continued a probe into accounting
irregularities at Italy's top construction company Impregilo. The company
said in a statement the investigation by public prosecutors in Monza, near
Milan, concerned up to 300 million euros (394.5 million dollars) in credit the
company gave to its subsidiary Imprepar, which went into liquidation early last
year. Designers.com, November 24, 2004 --- http://economy.news.designerz.com/suspect-impregilo-accounts-raise-fears-of-new-italian-scandal.html
Large CPA firms are in a settlement mood Deloitte & Touche LLP is expected to announce today it
will pay a $50 million fine to settle Securities and Exchange Commission civil
charges that it failed to prevent massive fraud at cable company Adelphia
Communications Corp. In another case, the now-largely defunct accounting firm
Arthur Andersen LLP agreed to a $65 million settlement in a class-action suit by
investors in WorldCom Inc. over losses from stocks and bonds of the
once-highflying telecommunications company now known as MCI Inc. These follow a
$22.4 million settlement the SEC reached last week with KPMG LLP related to its
audits of Xerox Corp. from 1997 through 2000, and a $48 million settlement by
PricewaterhouseCoopers LLP last month to end class-action litigation over its
audit of Safety-Kleen Corp., an industrial-waste-services company that filed for
bankruptcy-court protection in 2000.
Diya Gullapalli, "Deloitte to Be Latest to Settle In Accounting Scandals,"
The Wall Street Journal, April 26, 2005; Page A3 ---
http://online.wsj.com/article/0,,SB111444033641815994,00.html?mod=todays_us_page_one
Instead of facing immediate prison time, experts
say Rigases might win a new trial.
Nearly two and a half years after being convicted
of bank fraud and other corporate crimes, former Buffalo Sabres owner John
J. Rigas and his son Timothy remain comfortably at home in Coudersport, Pa.,
awaiting the results of their appeal.
Meanwhile, many other executives who found
themselves on the government's rap sheet in recent years - Andrew Fastow of
Enron, Bernard Ebbers of WorldCom, Dennis Kozlowski of Tyco are all behind
bars.
What's more, lawyers close to the Rigas case and
independent experts are now entertaining a possibility that, to
trial-watchers, seemed laughable at the time of the Rigases' conviction in
July 2004: that they could win their appeal and thus face a retrial.
While it's rare for a federal appeals court to
reverse a criminal conviction, it's also rare for a court to take nearly six
months to decide such a matter. Yet that's how long ago a three-judge
appellate panel in New York City heard the Rigas appeal, and some lawyers
think the long wait for a decision is indication that the court is taking
the appeal very seriously.
"Usually, you expect a decision in a case like this
in about a month and a half," said Mark Mahoney, the Buffalo attorney who
won freedom for one of the Adelphia Communications Corp. defendants, Michael
Mulcahey. "The delay means they are taking more time because the issues here
are somewhat knotty."
Of course, the elaborate frauds concocted at Enron,
WorldCom and Tyco are inherently knotty, but courts were able to unravel
them sufficiently to make sure that the convicts in each case went to prison
comparatively quickly.
Ebbers was convicted in March 2005, lost an appeal
and was sent to a federal prison in Louisiana in September.
Fastow was sentenced in September and joined Ebbers
in Oakdale Federal Detention Facility this month.
And Kozlowski was sent to Mid-State Correctional
Facility in Marcy within weeks after his 2005 conviction and even before he
appealed.
There's one thing that separates all those cases
from the one that ensnared the Rigases, who ran Adelphia, a huge cable
company based in Coudersport. Their appeal raises a serious legal question
that even the judge in their trial agreed ought to be heard.
At a little-noticed court hearing in July 2005, a
month after he sentenced John Rigas to 15 years and Timothy Rigas to 20
years in prison, Judge Leonard B. Sand allowed them to go free on bail
pending their appeal.
He said he did so because the defense raised a
novel argument: the government persuaded the jury to convict the Rigases of
fraud and conspiracy based on their violations of generally accepted
accounting principles but never called an expert witness to explain what
those principles are.
At the hearing, Sand said he didn't necessarily buy
that argument, but added it "is something that I can't call frivolous."
Mahoney said "a lot of people felt it was generous"
when Sand let the Rigases out on bail, because it's rare that people
convicted in the federal courts win that sort of freedom.
Denise O'Donnell, a former U.S. attorney in the
Western District of New York, agreed.
"There is a presumption against bail in the federal
system, so the Rigases had a very high hurdle to overcome just to get
released pending the appeal," she said.
The fact that they were released shows that they
"raised a substantive question of law" that could lead to the reversal of
their conviction, O'Donnell added.
Attorneys for the Rigases spelled out that question
at a hearing before a three-judge federal appeals panel on June 13.
Without an expert witness explaining accounting
rules, "the jury was never put in a position to decide whether the Rigases'
conduct was proper or improper," argued John Nields, the lawyer for Timothy
Rigas.
Richard Owens, the prosecutor in the case,
countered by saying the government didn't want to prolong an already lengthy
trial by starting "a battle of the experts."
Three federal judges are still pondering that
argument, and independent legal experts agreed with the Rigas attorneys that
the appeal needs to be taken seriously.
"I was surprised" that such an expert witness
wasn't called, said Eugene O'Connor, a former federal prosecutor who now
teaches law and accounting at Canisius College. "The question I have is: How
is the jury to assess with some certainty that these men violated the
accounting standards?"
Then again, the prosecution laid out a case that,
in the court of public opinion at least, might be seen as difficult to
refute.
Arguing that the Rigases treated Adelphia as their
"private piggy bank," Owens showed that John Rigas billed the company for
his Columbia House record club and used the corporate jet to send Christmas
trees to his daughter in New York City.
Timothy Rigas, meanwhile, dipped into corporate
funds to purchase 100 pairs of luxury slippers and a flight meant to impress
an actress friend.
In total, prosecutors said the Rigases "looted"
Adelphia of $100 million while hiding $2.3 billion in debt and misleading
banks and investors about Adelphia's earnings.
The jury convicted John and Timothy Rigas of 18 of
the 23 charges against them. A mistrial was declared in the case of another
Rigas son, Michael, who later pleaded guilty and was sentenced to home
confinement.
That's not entirely different than what John and
Timothy Rigas are currently facing. Paul Shechtman, John Rigas' appeals
lawyer, said both John and Timothy Rigas are still in Coudersport.
"Under the circumstances, John is doing as well as
can be expected," Shechtman said. "He's enjoying his grandchildren."
Of course, those circumstances could change at any
time. Lawyers close to the case said they don't know what to think about the
fact that the appeals court is taking so much time to render a decision.
"It's usually a good sign," Shechtman said. "I know
they've issued opinions in cases that were heard after ours in several
instances."
However, the Second Circuit U.S. Court of Appeals
is especially busy and may simply want to take its time poring over the
record of the four-month trial, several lawyers said.
One thing is for sure: if the appeals court rules
for the Rigases and orders a retrial, it will be issuing an opinion that
will have ramifications far beyond the borough of 2,600 that the Rigases
call home.
"It would be a huge decision with wide
ramifications in financial fraud cases," O'Donnell said. "I can't think of
any other similar case where this could happen."
It was the
largest fine ever imposed on an auditing firm Deloitte & Touche LLP incurred the wrath of
federal regulators Tuesday over public statements that appeared to shift the
blame away from the auditing firm for failed audits of Adelphia Communications
Corp. and Just for Feet Inc. Deborah Harrington, a Deloitte spokeswoman, said
regulators requested that the firm revise the first press release it put out.
The second release omitted some disputed statements. Deloitte, the U.S.
accounting branch of Big Four accounting firm Deloitte Touche Tohmatsu, Tuesday
agreed to pay $50 million to settle charges by the Securities and Exchange
Commission that it failed to detect fraud at Adelphia. It was the largest fine
ever imposed on an auditing firm.
"SEC Rebukes Deloitte on Adelphia Audit Spin," SmartPros, April 28, 2005
---
http://accounting.smartpros.com/x48015.xml
From The Wall Street Journal Accounting Weekly Review on April 29,
2005
TITLE: Deloitte to Be Latest to Settle in Accounting Scandals
REPORTER: Diya Gullapalli
DATE: Apr 26, 2005
PAGE: A3
LINK:
http://online.wsj.com/article/0,,SB111444033641815994,00.html
TOPICS: Auditing, Fraudulent Financial Reporting, Securities and Exchange
Commission
SUMMARY: Deloitte & Touche LLP agreed to pay a $50 million fine to settle SEC
civil charges related to fraud at Adelphia Communications Corp. One related
article discusses Adelphia's fine. A second related article discusses a negative
reaction by the SEC to Deloitte's statement about Adelphia executives
"deliberately misleading" their auditors in its public disclosure about payment
of the fine.
QUESTIONS:
1.) The author describes the fine of $50 million paid by Deloitte & Touche as
resulting from failure to "prevent massive fraud" as cable company Adelphia
Communications Corp. What is the purpose of a financial statement audit? Can an
audit "prevent" fraudulent financial reporting? In your answer, define the
phrase "fraudulent financial reporting."
2.) Refer to the first related article. Of what failure did the SEC accuse
Deloitte & Touche?
3.) Given your answers to #'s 1 and 2 above, how can auditors serve as
gatekeepers in a line of defense against fraud?
4.) Refer to the second related article. What steps did the SEC require
Deloitte to undertake in relation to its fine regarding Adelphia audits?
5.) Why was the SEC concerned about Deloitte & Touche's characterization of
the reason for the failure of the Adelphia audit to detect fraudulent financial
reporting? In your answer, comment on the intent of the agreement associated
with the payment of the $50 million fine.
Reviewed By: Judy Beckman, University of Rhode Island
Deloitte to Pay an
Added $167.5M in Adelphia Case
Officials at the trust formed after Adelphia went bankrupt claim the settlement
with Deloitte & Touche is among the largest between a public accounting firm and
a client. Sarah Johnson, CFO.com August 06, 2007
---
http://www.cfo.com/article.cfm/9612110/c_2984378?f=FinanceProfessor.com
A Deloitte spokesman confirmed to CFO.com that the
accounting firm has settled the case but believes it would have prevailed
had the case continued. "As part of the settlement, Deloitte & Touche denies
any wrongdoing," the firm said in a prepared statement, adding that Deloitte
"believes ... that it was in the best interests of the firm and its clients
to settle this action rather than to continue to face the burden, expense,
and uncertainty of further litigation."
Deloitte served as Adelphi's audit firm from the
mid-1980s to May 14, 2002, when Deloitte suspended its work on the audit for
the year ended December 31, 2001, saying Adelphia's books and records had
been falsified.
The Rigases were convicted in 2004 on several
counts, including securities fraud, bank fraud, and conspiracy to commit
bank fraud at what had been the fifth-largest cable company before its
collapse. Prosecutors claimed that the two executives hid nearly $2.3
billion in Adelphia debt from stockholders to mask the company's unhealthy
financial status.
Starting Monday, Timothy Rigas will serve 20 years
in prison, and his father will serve 15. In an interview with USA Today
published over the weekend, 82-year-old John Rigas said fraud did not occur
at Adelphia. He went on to say the government's case against him was based
on the business environment at the time, amid other corporate scandals like
Enron, WorldCom, and Tyco. "It was a case of being in the wrong place at the
wrong time," Rigas said. "If this had happened a year before, there wouldn't
have been any headlines."
More than two years ago, Deloitte settled charges
with the Securities and Exchange Commission, which claimed the accounting
firm had "failed to detect a massive fraud perpetrated by Adelphia and
certain members of the Rigas family" in its fiscal 2000 audit. Deloitte paid
$50 million to settle the case.
Adelphia Communications Corp. agreed to a $715 million settlement Adelphia Communications Corp. agreed to a $715 million
settlement with the U.S. Justice Department and Securities and Exchange
Commission to resolve claims stemming from the corporate looting and
accounting-fraud scandal that toppled the country's fifth-largest
cable-television operator.
Peter Grant and Deborah Solomon," "Adelphia to Pay $715 Million In 3-Way
Settlement," The Wall Street Journal, April 26, 2005, Page A3 ---
http://online.wsj.com/article/0,,SB111445555592816193,00.html?mod=todays_us_page_one
Regas Father and Son in
Club Fed at Last In June, U.S. District Judge Leonard Sand rescinded the
order allowing them to remain free, giving the father and son until Aug. 13 to
report to prison. John Rigas, 82, was sentenced to 15 years and Timothy Rigas,
51, to 20 years for their role in the collapse of one of the nation's largest
cable television companies (Adelphia). The pair had asked that they be allowed
to serve their time together at a facility close to their homes in Coudersport,
Pa. Instead, the federal Bureau of Prisons sent them to the Butner Federal
Correctional Complex, located about 45 minutes northwest of Raleigh.
Martha Waggoner, "Adelphia's Rigases Report to Prison," Forbes, August
13, 2007 ---
http://www.forbes.com/feeds/ap/2007/08/13/ap4014493.html
David Reilly and Alessandra Galloni, "Facing Lawsuits, Parmalat Auditor
Stresses Its Disunity: Deloitte Presented Global Face, But Says Arms Acted
Alone; E-Mail Trail Between Units: A Liability Threat for Industry,"
The Wall Street Journal, April 28, 2005; Page A1 ---
http://online.wsj.com/article/0,,SB111464808089519005,00.html?mod=todays_us_page_oneThe Big Four accounting firms -- Deloitte,
PricewaterhouseCoopers, KPMG and Ernst & Young -- have long claimed in court
cases that their units are independent and can't be held liable for each other's
sins. U.S. courts to date have backed that argument. The firms say the
distinction is important -- allowing them to boost the efficiency of the global
economy by spreading uniform standards of accounting around the world, without
worrying that one unit's missteps will sink the entire enterprise. But Deloitte
e-mails seized by Italian prosecutors and reviewed by The Wall Street Journal,
along with documents filed in the court cases, show how the realities of
auditing global companies increasingly conflict with the legal contention that
an accounting firm's units are separate. The auditing profession -- which plays
a central role in business by checking up on companies' books -- has become
ever-more global as the firms' clients have expanded around the world. But
that's creating new problems as auditors face allegations that they bear
liability for the wave of business scandals in recent years.
Bob Jensen's threads on Deloitte's legal woes are at
http://www.trinity.edu/rjensen/fraud001.htm#Deloitte
Nortel Networks, the troubled maker of
telecommunications equipment, offered about $2.4 billion in cash and stock
Wednesday to settle two class-action lawsuits over an accounting debacle two
years ago.
The announcement was the latest in a series of
steps taken by Mike S. Zafirovski, the company's chief executive, to
strengthen Nortel. The company is recovering from the collapse of the
technology bubble in 2000 and from accounting irregularities, among them
reporting sales that had not yet been made, that led to the firing of seven
of its top executives in 2004. The company later restated four years of
results.
If the settlement is accepted, Nortel would pay the
plaintiffs $575 million cash and issue shares equal to about 14.5 percent of
its outstanding equity. Nortel will take charges totaling about $2.47
billion to cover the cost of the settlement in the fourth quarter, which it
has not yet reported. The $575 million payment will come out of Nortel's
cash reserves, which now total $3 billion.
Nortel, based in Brampton, Ontario, is not
acknowledging any wrongdoing under the settlement proposal, nor would the
deal have any impact on criminal and securities investigations of the
company in the United States and Canada.
"Our intent is to achieve a fair resolution of
these lawsuits and avoid a prolonged, uncertain and costly litigation
process," Harry J. Pearce, Nortel's chairman, wrote in a statement. "A final
settlement would remove a significant impediment to Nortel's future success
and allow Mike Zafirovski and the Nortel team to move forward."
Continued in article
Nortel (NT :Nasdaq) this week joined a fast-growing
string of public companies to say prior financial reports inflated real business
trends - - - Nortel restate earnings for 2003 and earlier periods; Nortel
already restated earnings for the past three years in October 2003
"Rash of Restatements Rattles," by K.C. Swanson, TheStreet.com, March 17,
2004
http://www.thestreet.com/tech/kcswanson/10149112.html
Jensen Comment
Nortel's external auditor is Deloitte, an auditing firm that seems to have a lot
of patience with repeated restatements by Nortel.
The Securities and Exchange Commission sued four
former finance officers at Nortel Networks yesterday, saying they helped the
former chief executive, Frank A. Dunn, manipulate reserves to enhance
earnings.
The four men — Douglas A. Hamilton, Craig A.
Johnson, James B. Kinney and Kenneth R. W. Taylor, all former vice
presidents for finance at Nortel units — were named as defendants in an
amended complaint filed in Federal District Court in Manhattan, the
commission said.
The S.E.C. initially filed suit in March against
Mr. Dunn; the former chief financial officer, Douglas C. Beatty; and the
former controller, Michael J. Gollogly, saying they improperly manipulated
reserves to create the false impression that Mr. Dunn was improving results.
The agency said yesterday that the manipulation was carried out “with the
active participation” of the four new defendants.
Nortel, based in Toronto, restated financial
results in 2005, saying it had inflated sales by $3.4 billion, going back to
1999. The company is the biggest maker of telecommunications equipment in
North America.
The lawyer representing Mr. Taylor, who was once
vice president for finance at Nortel’s enterprise business unit, said he did
not know the S.E.C. was going to amend its complaint. “I wasn’t given
advance notice, and it comes as a surprise to me,” said the lawyer, Harold
McGuire.
Lawyers for the other three men either declined
to comment or did not immediately return telephone calls.
Nortel fired all four men on Aug. 9, 2004, after
the company learned about allegations of an accounting fraud, according to
the S.E.C.
The S.E.C. opened a formal investigation into
Nortel’s accounting in 2004. That led to the firings of Mr. Dunn, Mr. Beatty
and Mr. Gollogly in July 2004. At that time, Nortel said it had put four
individuals holding senior finance positions on a paid leave. It did not
identify the executives.
In May, Nortel settled with the Ontario
Securities Commission, which conducted a parallel investigation, by agreeing
to pay 1 million Canadian dollars ($940,000) to cover the cost of the
inquiry. Nortel did not admit or deny wrongdoing.
The company has agreed to pay $2.4 billion to
settle shareholder lawsuits over the accounting irregularities.
Question
What is "cookie jar" accounting?
Answer
Earnings management, often revenue reporting manipulation, that entails the use
of reserves to smooth earnings volatility.
Canada-Based Nortel Accounting Cookie Jar Accounting Update:
Details Mistakes, Says Executives Will Return Millions in Bonus Payments.
Five directors, including Chairman Lynton Wilson and former ambassador James
Blanchard, who is also a former Michigan governor, will step down.
Nortel Networks Corp. unveiled details of additional
accounting errors involving billions of dollars and said that a dozen
executives will return millions of dollars of bonuses as the telecom-equipment
maker attempts to put a major financial scandal behind it.
The Brampton, Ontario, company also said five
directors, including Chairman Lynton Wilson and former ambassador James
Blanchard, who is also a former Michigan governor, will step down. Nortel's
board has faced criticism for allowing the company's accounting fiasco to go
on and approving the bonus plans, but none of the five directors was accused
of wrongdoing in a company investigation, details of which were announced
yesterday.
Nortel said 12 of the company's most senior
executives will take the unusual step of returning $8.6 million in bonuses
they were paid based on the erroneous accounting. Already, Nortel's accounting
problems led to the ouster of 10 top executives last year.
It is very rare for senior executives to voluntarily
refund bonuses following an earnings restatement, several pay specialists
said. "This is something very, very new," said Robert Fields, an
attorney and executive-compensation consultant in South Salem, N.Y. An
increased emphasis on corporate governanceby boards "is really putting
executives' feet to the fire," said Mr. Fields, adding that the voluntary
return of executive bonuses "should see a lot more play in the
future."
Nortel executives said the board also
will seek repayment of bonuses paid to executives who have already been
ousted. People familiar with the company say that there may be additional
disciplinary actions taken against current employees.
Nortel's actions came as the company
filed with regulators its financial statements for 2003 and restated, for the
second time, its results from earlier years.
Nortel shares soared in the late 1990s
and collapsed along with the technology bubble. But Nortel then made good on a
promise by former Chief Executive Frank Dunn to return to profitability in
early 2003.
Mr. Dunn and six other top executives
were fired in April. He and his lawyer didn't return calls seeking comment.
But that early 2003 profit and the
gains in subsequent quarters turned out to be illusory. Investigators hired by
Nortel's directors determined the company improperly employed a financial
maneuver, known as "cookie-jar accounting," that turned a loss into
a profit. The profits triggered millions in bonuses for senior executives, but
eventually unraveled. The board later brought in outside investigators, who
uncovered details of the improper accounting.
Investors appeared relieved Nortel is
getting a handle on its accounting scandal. Shares of Nortel rose 14 cents, or
4.2%, to $3.48 at 4 p.m. in New York Stock Exchange composite trading
yesterday. Yesterday's filing detailed a different set of accounting issues
beyond the cookie-jar accounting originally uncovered by investigators. The
company said the newly reported errors resulted in higher revenues and profits
for Nortel in 1999, 2000 and 2001.
In addition, Nortel said its 2003
financial statements show net income of $434 million, or 10 cents a share, on
revenue of $10.2 billion. Before announcing its revisions, Nortel originally
had reported net income of $732 million, or 17 cents, on revenue of $9.8
billion.
The latest findings were made by Nortel
personnel. The company has hired Washington law firm Wilmer Cutler Pickering
Hale & Dorr LLP, which also conducted an earlier investigation for the
company's board, to investigate the revenue-recognition issues. The inquiry
into the revenue-recognition issue is continuing to look into questions of
potential misconduct among Nortel executives.
At Nortel, while some of the
revenue-recognition problem appears to be due to ignorance, there are some
situations, people with knowledge of the company say, where the intentions are
questionable.
In one situation, people with knowledge
of the company say, Nortel sold $200 million worth of equipment to Qwest
Communications International Inc., the regional Bell company based in
Denver, and booked the revenue right before the end of 2000, boosting that
year's results. But Nortel booked the revenue too soon, the company later
determined, because Qwest hadn't taken title to the equipment. In yesterday's
restatement, Nortel shifted the revenue to 2001. A Qwest spokesman declined to
comment.
At Nortel, investigators ultimately
found about $3 billion in revenue had been booked improperly in 1998, 1999 and
2000. More than $2 billion was moved into later years, about $750 million was
pushed forward beyond 2003 and about $250 million was wiped away completely.
The company has mentioned the
revenue-recognition issues for several months, but this is the first time it
has released details of them.
The board members stepping down are:
Mr. Wilson, the chairman; Yves Fortier; Sherwood Smith; Guylaine Saucier; and
Mr. Blanchard, a former U.S. ambassador to Canada.
Nortel Networks Corp. said that
revenue reporting issues and remaining accounting matters will again delay the
restatement of its financial results.
Initially, the company said that it would restate
results for 2003 and report results for part of 2004 by the end of September.
It then said that it would file those statements at the end of October, and
then postponed again until mid-November. Now, Nortel said that is targeting
completion within one to two months.
Nortel plans to release preliminary unaudited results
for 2003 and the first and second quarters of 2004 "as soon as
practicable." It plans to release limited preliminary results for the
third quarter of 2004 by mid-December.
"In the course of the company's reviews over the
last two weeks, we have found a level of revenue restatement which warrants
that we undertake a deliberate, focused but bounded double-checking of several
revenue areas," Nortel president and chief executive Bill Owens said
Thursday. "We have taken this decision to postpone our filings as a
prudent measure to take the steps needed to ensure that we have captured all
necessary corrections and adjustments in our restated results."
Owens, a former director, was named president and CEO
in April, after the firm fired three of its top executives, including its
former chief executive, and said that it would restate results as far back as
2001.
Nortel, which is under investigation by U.S. and
Canadian securities regulators in connection with its past restatements, is
the subject of criminal probes in the United States and in Canada. In August,
the company fired seven more of its finance executives and said that it would
trim roughly 10 percent of its workforce by the end of the year in an effort
to cut costs.
Nortel increased previous revenue adjustments, which
it said would cut revenue by $600 million in 1999 and $2.5 billion in 2000. Of
the amount in 2000, about $250 million will be permanently reversed, while the
remainder will be deferred and recognized in later years. It also revised
revenue adjustments that increased annual revenues by 8 percent in 2001, 4
percent in 2002 and 5 percent in 2003 (adjusted from a previously announced 7
percent, 1 percent and 3 percent, respectively). Nortel said that it will cut
net earnings for 2003 by 35 percent, down from the 50 percent previously
announced.
The company is discussing other accounting matters
with the Securities and Exchange Commission, including its historical and
continuing accounting treatment of revenues recognized on sales of certain
optical products containing embedded software.
Nortel also said that its shares could be delisted
from the New York Stock Exchange and Toronto Stock Exchange if it fails to
file its 2003 annual reports with the SEC and the Ontario Securities
Commission by Dec. 15.
The infamous McKesson & Robbins (now known as McKesson)
Mckesson & Robbins scandal of 1938 is probably the best known auditing fraud
in the 20th Century.. A crisis in public accounting was provided by the
celebrated McKesson & Robbins case. McKesson & Robbins, Inc., whose
financial statements had been audited by Price Waterhouse & Co., had
inflated inventory and receivables by $19 million dollars through falsification
of supporting documents. The auditors merely accepted inventory and
receivables balances reported by management without bothering to even verify
their existence in McKesson & Robbins. This fraud changed CPA auditing
standards to require on-site test checking to verify the existence of warehouses
and inventory.
Now McKesson is in the news again on the fraud beat.
McKesson, the nation's largest drug distributor, agreed to pay $960 million to
settle a lawsuit based on accounting fraud at HBOC, a health care software
company.
In indictments
involving the case, prosecutors said HBOC sold software or services to more than
a dozen hospitals with conditional "side letters" that allowed the
hospitals to back out of the deals. The side letters were then hidden from
auditors and the transactions were reported as sales.
"McKesson Agrees to Pay $960 Million in Fraud Suit," by Milt
Freudenheim, The New York Times, January 13, 2005 --- http://www.nytimes.com/2005/01/13/business/13settle.html
McKesson,
the nation's largest drug distributor, said yesterday that it had agreed to pay
$960 million to settle a class-action lawsuit based on accounting fraud at HBOC,
a health care software company that it bought in 1999.
The settlement, which will be divided among New York
State pension funds and thousands of other plaintiffs, was one of the largest
in history on a list led by $3.2 billion in a class-action suit against the
Cendant Corporation and more than $2.6 billion in the WorldCom case, including
payments by WorldCom directors.
The settlement ends a suit filed after McKesson
shareholders lost $8.6 billion in one day, April 28, 1999, nearly half the
value of their holdings. The stock plunged after McKesson said that HBOC had
improperly booked sales and that it would restate earnings and revenues.
McKesson said it would take an af-ter-tax charge of
$810 million, or $2.70 a share, in its Dec. 31 quarter and would set aside
$240 million for remaining related lawsuits.
John H. Hammergren, who took over as chief executive
in 1999 after McKesson's top officers were ousted, said yesterday in a
telephone interview that the company had held back on spending in anticipation
of the settlement. It reported $1 billion in cash on hand on Sept. 30.
"It's a relief to put this ordeal behind
us," Mr. Hammergren said.
Eric W. Coldwell, a health care securities analyst
with Robert W. Baird & Company in Chicago, said that "very little of
the settlement is covered by insurance," but he said McKesson had reduced
its debt and rearranged its finances and would not have to go to Wall Street
seeking money to cover the settlement.
Continued in article
The external auditor
is Deloitte and Touche.
More Troubles for Deloitte & Touche
Adelphia had billions in losses since 2001 and
underreported losses before that, according to an audited financial
statement. Examples of improper accounting included Adelphia's treatment
of certain operating expenses as capital expenses, Ms. Wittman said. The company
also didn't accurately record management fees and interest that flowed between
the Adelphia and the Rigas-owned properties, she added.
Peter Grant (See below)
Adelphia Communications Corp. posted billions of
dollars in losses during the past three years and underreported losses before
that, according to the cable company's first audited financial statement
released since 2002.
Adelphia, which was forced into bankruptcy-court
protection in 2002 because of an accounting and corporate-looting scandal,
posted losses of $7.25 billion in 2002 and $6.17 billion in 2001, mostly due
to asset write-offs, the new financial statement says. The company also
reported a 2003 net loss of $839.9 million, or $3.31 a share, on revenue of
$3.6 billion.
In addition, the company, based in Greenwood Village,
Colo., said it failed to report $1.7 billion in losses in the years before
2001. All the figures were contained in the company's annual report for the
year ended Dec. 31, 2003, filed yesterday with the Securities and Exchange
Commission.
The financial statement is seen as an important step
in the company's move toward selling itself or emerging from bankruptcy
proceedings. To produce an audited financial statement for 2003, the company
had to go back and clean up its books for several previous years.
Adelphia, the country's fifth-largest cable operator
by subscribers, is selling itself in an auction that has attracted several
potential buyers, including the country's top cable operators and
private-equity firms. Adelphia founder John Rigas and his son, Timothy Rigas,
the company's former chief financial officer, were convicted on numerous
counts of criminal fraud and conspiracy in the summer and are awaiting
sentencing.
The filing totals more than 800 pages. The company
hadn't filed annual reports for 2001 and 2002 because its records were found
to be in terrible shape after the scandal erupted in the spring of 2002.
"We had to crawl through such a mess to try to
restore this company to order," Vanessa Wittman, Adelphia's chief
financial officer as part of its new management, said yesterday. She said that
reconstructing Adelphia's books took a team of accountants tens of thousands
of hours.
Ms. Wittman said the accounting team spent a long
time determining an opening balance for 2001. To do that, the team had to wade
through a number of fraudulent accounting methods and dealings between
Adelphia and companies owned independently by the Rigas family. "The
cumulative losses for the prior periods were $1.7 billion worse than
reported," Ms. Wittman said.
Examples of improper accounting included Adelphia's
treatment of certain operating expenses as capital expenses, Ms. Wittman said.
The company also didn't accurately record management fees and interest that
flowed between the Adelphia and the Rigas-owned properties, she added.
Adelphia Communications Corp. revealed
its real results and its publicly reported inflated numbers in the books given
to many employees, including founder John Rigas and two of his sons, a former
executive testified.
But these financial statements,
detailing actual numbers and phony ones dating back to 1997, weren't disclosed
to the company's auditors, Deloitte & Touche, said former Vice President
of Finance James Brown in his second day on the stand. Former Chief Financial
Officer Timothy Rigas supported the system to keep employees aware of the
company's real performance, Mr. Brown testified.
For example, one internal document
showed that while Adelphia's operating cash flow was $177 million for the
quarter ended in September 1997, its publicly reported operating cash flow was
$228 million, Mr. Brown said.
Mr. Brown has pleaded guilty in the
case and is testifying in hopes of receiving a reduced sentence.
John Rigas, his sons Timothy Rigas and
former Executive Vice President Michael Rigas, and former Assistant Treasurer
Michael Mulcahey are on trial here on charges of conspiracy and fraud. Michael
Rigas was back in court yesterday, one day after court was canceled due to a
medical issue that sent him to the hospital over the weekend. People close to
the case said the problem was minor.
Mr. Brown said he devised various
schemes to inflate Adelphia's publicly reported financial measures. Company
executives were afraid that if Adelphia's true performance was revealed, the
company would be found in default of credit agreements, he said. "I used
the term 'accounting magic,' " Mr. Brown said.
In March 2001, phony documents dated
1999 and 2000 were created "to fool the auditors into believing that they
were real economic transactions," he testified.
Mr. Brown discussed the details of how
to inflate Adelphia's financial measures with Timothy Rigas more than the
other defendants, but John Rigas and Michael Rigas also knew that the
company's public filings didn't represent its real performance, he testified.
John Rigas occasionally showed discomfort with the inflation, but did nothing
to stop it, Mr. Brown said.
Mr. Brown testified he used to
regularly tell John Rigas Adelphia's real results and how they compared with
those of other cable companies. "On one occasion John told me, 'We need
to get away from this accounting magic,' " he recalled. Mr. Brown
added that he understood that to mean that Adelphia needed to boost its
operations so that at some point in the future, the inflation could stop.
In another discussion about inflated
numbers in early 2001, John Rigas "told me he felt sorry for Tim Rigas
and me because the operating results were putting so much pressure on us ...
but he said, 'You have to do what you have to do,' " Mr. Brown
testified. "He also said we can't afford to have a default." Mr.
Brown said he took that to mean that reporting inflated numbers was preferable
to defaulting.
Creditor claims against Adelphia
Communications Corp. total a staggering $3 trillion, or close to 40 percent of
the national debt, Dow Jones Newswires reported. But many of the claims pending
against the nation's fifth-largest cable company could turn out to be
duplicates, and may be more like $18.6 billion
It is what some are calling the most complicated
bankruptcy case in history.
Creditor claims against Adelphia Communications Corp.
total a staggering $3 trillion, or close to 40 percent of the national debt,
Dow Jones Newswires reported. But many of the claims pending against the
nation's fifth-largest cable company could turn out to be duplicates, and may
be more like $18.6 billion when all is said and done.
Regardless, the company's structure is extremely
complex and more than 60 accountants are wading through mountains of documents
trying to reconcile claims against the Colorado company's 243 separate
entities.
Company spokesman Paul Jacobson told Dow Jones that
Adelphia's case is "arguably the most complex bankruptcy in U.S.
business. It is a strange animal."
"A person is only entitled to be paid once, but
trying to sort that out turns into an accounting nightmare," Paul Rubner,
a Denver bankruptcy lawyer, told Dow Jones. He said creditors must correctly
identify the entity that owes them.
"The good news is that you have to be specific
about where you file it," Rubner said. "The bad news is that if the
client is unsure, the lawyer is apt to file it in every possible case."
With more than 5 million subscribers, the cable
company filed for bankruptcy in 2002 and expects to restate its financial
statements from 1999 through 2001.
The company's founder John Rigas, and his son Timothy
were convicted this year of conspiracy, bank fraud and securities fraud for
looting the company and lying about its finances before the bankruptcy, Dow
Jones reported.
North Carolina is investigating whether accounting firm
Deloitte & Touche gave companies advice designed to help them avoid paying
unemployment taxes. The North Carolina Employment Security Commission
issued subpoenas on Thursday (March 25, 2004) requesting Deloitte to
produce records, correspondence, sales brochures and other items
pertaining to the firm's unemployment insurance tax planning practices.
http://www.accountingweb.com/item/98916
SEC Settles Securities Fraud Case with i2
Technologies, Inc. Involving Misstatement of Approximately $1 Billion
in Revenues
i2 Will Pay a $10 Million Civil Penalty
The Securities and Exchange Commission today
announced a settled enforcement action against i2 Technologies, Inc.
("i2") in connection with alleged accounting improprieties
and misleading revenue recognition by the Dallas-based developer and
marketer of enterprise supply chain software and management solutions.
i2 agreed to pay a $10 million civil penalty and nominal $1
disgorgement in a civil suit the Commission filed in the United States
District Court for the Northern District of Texas (Dallas Division).
As part of the settlement, but without admitting or denying the
Commission's substantive findings or allegations, i2 consented to the
entry of a cease-and-desist order finding that i2 committed securities
fraud in accounting for certain software license agreements and in
accounting for and improperly disclosing four "barter"
transactions. As provided under the Sarbanes-Oxley Act of 2002, the
penalty amount will become part of a disgorgement fund for the benefit
of injured i2 investors.
In summary, the Commission's cease-and-desist
order finds and civil complaint alleges that, for the four years ended
December 31, 2001 and the first three quarters of 2002, i2 misstated
approximately $1 billion of software license revenues. As a result,
i2's periodic filings with the Commission and earnings releases during
this period materially misrepresented i2's revenues and earnings.
Specifically, the order finds and complaint
alleges that i2 favored up-front recognition of software license
revenues, purportedly in accordance with generally accepted accounting
principals ("GAAP"). i2's compensation structure fostered
this preference, because compensation of sales and pre-sales personnel
was largely based on the amount of revenue recognized and cash
collected in the current period. However, as i2 knew or recklessly
ignored, immediate recognition of revenue was inappropriate for some
of i2's software licenses because they required lengthy and intense
implementation and customization efforts to meet customer needs. In
some cases, i2 shipped certain products and product lines that lacked
functionality essential to commercial use by a broad range of users.
In other cases, the company licensed certain software that required
additional functionality to be usable by particular customers. On
still other occasions, i2 exaggerated certain product capabilities, or
entered into side agreements with certain customers that were not
properly reflected in the accounting for those transactions. In each
case, significant modification and customization efforts were
necessary to provide the required functionality.
i2 also improperly recorded revenue from four
barter transactions during the restatement period. These transactions
involved third-party purchases of software licenses from i2, with i2
recognizing the revenue immediately, in exchange for i2's agreement to
purchase from the other parties in the future a comparable amount of
products or services. In some of these transactions, i2 paid a premium
over the prevailing rates for those products or services, in an effort
to equalize both sides of the deal. When i2 recorded revenue from
these transactions, it could not determine the fair value of the items
exchanged within reasonable limits. Accordingly, i2's up-front
recognition of license revenue from these transactions was improper
under GAAP. Moreover, i2's financial statements and Commission filings
failed to disclose the true nature of these transactions, which
improperly inflated i2's reported revenues by approximately $44
million.
The Commission also found and alleges that,
during the summer of 2001, i2 received two documents flagging issues
impacting software license revenue recognition. First, in June 2001,
i2 generated a summary of revenue recognition risks, outlining such
potential problems as identifying products to meet customer needs
after licenses were signed; bundling wrong or incorrectly positioned
products in deals; substantial underestimation of implementation
services necessary to meet customer needs; the provision of
development and customization services without separate formal
agreements; and barter transactions.
Second, also in June 2001, i2 received the
initial report of a Massachusetts Institute of Technology professor
the company had hired to examine its business practices. The
professor's report identified serious deficiencies within the
organization, from shortcomings in its product and technology strategy
to weaknesses in its sales practices, product release management, and
quality assurance. Critically, this report indicated that i2's
products had largely become "custom" software requiring
considerable customization and modification, which would preclude
up-front recognition of revenue from these licenses. Neither i2's
auditors nor Audit Committee learned of the MIT professor's report
until September 2002.
Deloitte Touche Tomatsu's Bermuda affiliate
agreed to pay $32 million to settle litigation over its audits for the
Manhattan Investment Fund, nearly four years after a collapse that cost
the hedge fund's investors roughly $400 million.
The settlement, which last month received
preliminary approval from the federal district judge in New York
presiding over the litigation, marks the latest chapter in a
high-profile case that has helped spark calls for greater regulatory
oversight of the hedge-fund industry. A hearing on whether the judge
will grant final approval to the accord is expected sometime next year.
The Pennsylvania Insurance Department is
pointing fingers at Big Four firm Deloitte, alleging that the accounting
firm contributed to the largest insurance company failure in the United
States. According to a court filing, within days of Deloitte signing off
on an audit of Reliance Insurance Co. indicating sufficient cash
reserves in February 2000, the firm told an investment partnership of a
"seriously deficient" $350 million shortfall in the insurance company.
Deloitte told the investment company about the
shortfall "in exchange for millions of dollars" in accounting fees,
according to the state. Deloitte "exploited the competing interests of
[the investment company] and Reliance and benefited financially by
receiving payments from clients on opposite sides" of the proposed deal,
according to the state.
After the disclosure about the true condition
of Reliance Insurance Co., the company could not be reorganized and
subsequently collapsed.
The Pennsylvania Insurance Department says
Deloitte knew of the true condition of the company prior to signing off
on the audit, and wants Deloitte to pay for part of the $2 billion cost
of Reliance's collapse.
Deloitte refuted the charges and accused the
state of "serious distortion of the facts."
The trial of three former Adelphia executives may showcase lavish
lifestyles and spending sprees, but the complex accounting issues will
likely overshadow personal intrigue. The auditing firm in the hot
seat is Deloitte and Touche.
"Adelphia Trial Is Scheduled To Start Monday," by Christine Nuzum,
The
Wall Street Journal, February 20, 2004 ---
The trial of former Adelphia Communications
Corp. executives John Rigas and his two sons is about to begin. While it
may showcase lavish lifestyles and spending sprees, the complex
accounting issues will likely overshadow personal intrigue.
The government has accused the Rigases, along
with former Adelphia executive Michael Mulcahey, of looting hundreds of
millions of dollars from the cable company, defrauding investors and
misleading regulators. All four have pleaded not guilty.
Jury selection for the trial of the Adelphia
executives is scheduled to begin Monday. Adelphia was formerly based in
Coudersport, Pa., but now is based in the Denver suburb of Greenwood
Village under new management; the firm may even change its name.
At the trial, which is expected to last three
months, the government may depict Manhattan apartments, a golf course
and private jets as perks that Adelphia bankrolled. However, those
details will likely take second stage to how debt is documented on
company balance sheets and on accounting practices unique to the cable
industry.
Central to the case: a loan to the Rigas family
that was guaranteed by Adelphia, and allegations that the company
inflated its subscriber base and the portion of its cable network that
had been upgraded.
In arguing a pretrial motion Thursday morning,
Assistant U.S. Attorney Christopher Clark said he intends to present
jurors with copious documents. Attorneys also said to expect electronic
displays.
Continued in the article
Mr.
Brown said the dispute with the auditor about disclosing the borrowings
occurred in March 2001 as the company and Deloitte were preparing
Adelphia's 2000 annual report. Deloitte issued a clean audit opinion in
that report. He said he was able to convince the Deloitte auditor not to
disclose the total amount the Rigases had borrowed, but to disclose only
the amount the Rigases could borrow under the arrangement. "I
didn't want the public to know how much the Rigases had borrowed because
I thought there would be significant negative ramifications," Mr.
Brown said. He testified that Timothy Rigas told him "we should
give up on other points if we have to, but that's the last point we want
to give up on with the auditors." Christine Nuzum (see below)
Deloitte & Touche, the
former auditor for Adelphia Communications Corp., wanted the cable
company to disclose the total amount of debt held by the Rigas family
and guaranteed by Adelphia in 2001, but backed off under pressure from
company executives.
A year later, when the company
revealed that the family that controlled Adelphia had borrowed close
to $2.3 billion, it triggered the accounting scandal that led the
Rigases to resign and the company to file for bankruptcy protection.
Testifying in federal court
yesterday, Adelphia's former vice president of finance, James R.
Brown, said even when the company did make the disclosure about the
Rigas borrowings in early 2002, it understated the debt by more than
$250 million. Mr. Brown said the company determined Adelphia had
guaranteed $2.55 billion in Rigas family debt as of the end of 2001,
and that roughly $1.3 billion had been used to buy securities. He said
he and Timothy Rigas discussed "ways to represent the $2.5
billion as a lower number and the $1.3 billion as a lower
number," Mr. Brown said.
Mr. Brown said the dispute with
the auditor about disclosing the borrowings occurred in March 2001 as
the company and Deloitte were preparing Adelphia's 2000 annual report.
Deloitte issued a clean audit opinion in that report. He said he was
able to convince the Deloitte auditor not to disclose the total amount
the Rigases had borrowed, but to disclose only the amount the Rigases
could borrow under the arrangement.
"I didn't want the public
to know how much the Rigases had borrowed because I thought there
would be significant negative ramifications," Mr. Brown said. He
testified that Timothy Rigas told him "we should give up on other
points if we have to, but that's the last point we want to give up on
with the auditors."
Deborah Harrington, a spokesman
for Deloitte, said, "We don't intend to comment on the
trial."
Adelphia founder John Rigas,
his sons Timothy and Michael, and former assistant treasurer Michael
Mulcahey are on trial in New York on charges of conspiracy and fraud.
They are accused of using Adelphia as a "personal piggy
bank" for the Rigas family and misleading investors, creditors
and the public about Adelphia's finances and operations. Mr. Brown,
the government's star witness, has pleaded guilty in the case and is
testifying in the hope of receiving a lighter sentence.
Continued in article
"Adelphia Founder And
One Son Are Found Guilty," by Peter Grant and Christine Nuzum, The
Wall Street Journal, July 9, 2004, Page A1 ---
Jury Remains Deadlocked On Second Son, Acquits
Former Assistant Treasurer
Notching another victory
against the corporate excesses of the 1990s, prosecutors won criminal
convictions against the father-and-son team of John and Timothy Rigas,
former top executives at cable company Adelphia Communications Corp.
However, they failed to persuade a jury that the looting involved
Adelphia's former assistant treasurer.
The jury left unresolved the
case against another member of the Rigas family -- Michael Rigas,
former head of Adelphia operations -- remaining deadlocked on most of
the counts against him.
But after deliberating for eight days, the
jury found Michael Mulcahey, Adelphia's former assistant treasurer,
not guilty on all 23 counts of conspiracy and fraud that he and the
other defendants were facing.
The jury remained deadlocked on charges
against the other son, Michael Rigas, and is scheduled to reconvene
today to try to break the impasse.
The trouble at Adelphia, the nation's
fifth-largest cable company, now operating in bankruptcy protection,
began in March 2002 when a footnote in an otherwise routine quarterly
earnings statement revealed that the Rigas family had borrowed more
than $2 billion under an arrangement with Adelphia that made the
family and the company responsible for each other's debts.
In the four-month trial, prosecutors called
former employees, a golf pro and actress Peta Wilson to testify about
the family's lavish spending habits. Ms. Wilson, the star of the show
"La Femme Nikita," and the golf pro testified that they flew
on Adelphia's corporate jets for no apparent business purpose.
Prosecutors contended that the family treated the company like
"their own ATM machine."
The jury appears to have separated Michael
Rigas from his brother and father because Michael had little to do
with the company's finances. His lawyer also repeatedly told jurors
that his client drove an old Toyota, in contrast with Timothy and
John, who had a collection of 22 cars paid for by Adelphia, according
to one witness. Jurors also were shown stacks of checks written by
Michael Rigas to reimburse Adelphia for personal expenses ranging from
a flight to Paris to $3.45 in postage.
The verdicts were read out in a hushed and
packed U.S. district courtroom in downtown Manhattan. Many family
members of the defendants were in the courtroom, as well as supporters
from Coudersport, Pa., the village in north-central Pennsylvania where
Adelphia used to be based. Several people cried as the verdicts were
read. So did Michael Mulcahey, when, after court adjourned, he was
hugged by his wife, Cathy Mulcahey, who had been in court virtually
every day.
Adelphia
Communications Corp.
revealed its real results
and its publicly reported
inflated numbers in the
books given to many
employees, including
founder John Rigas and two
of his sons, a former
executive testified.
But
these financial
statements, detailing
actual numbers and phony
ones dating back to 1997,
weren't disclosed to the
company's auditors,
Deloitte & Touche,
said former Vice President
of Finance James Brown in
his second day on the
stand. Former Chief
Financial Officer Timothy
Rigas supported the system
to keep employees aware of
the company's real
performance, Mr. Brown
testified.
For
example, one internal
document showed that while
Adelphia's operating cash
flow was $177 million for
the quarter ended in
September 1997, its
publicly reported
operating cash flow was
$228 million, Mr. Brown
said.
Mr.
Brown has pleaded guilty
in the case and is
testifying in hopes of
receiving a reduced
sentence.
John
Rigas, his sons Timothy
Rigas and former Executive
Vice President Michael
Rigas, and former
Assistant Treasurer
Michael Mulcahey are on
trial here on charges of
conspiracy and fraud.
Michael Rigas was back in
court yesterday, one day
after court was canceled
due to a medical issue
that sent him to the
hospital over the weekend.
People close to the case
said the problem was
minor.
Mr.
Brown said he devised
various schemes to inflate
Adelphia's publicly
reported financial
measures. Company
executives were afraid
that if Adelphia's true
performance was revealed,
the company would be found
in default of credit
agreements, he said.
"I used the term
'accounting magic,' "
Mr. Brown said.
In
March 2001, phony
documents dated 1999 and
2000 were created "to
fool the auditors into
believing that they were
real economic
transactions," he
testified.
Mr.
Brown discussed the
details of how to inflate
Adelphia's financial
measures with Timothy
Rigas more than the other
defendants, but John Rigas
and Michael Rigas also
knew that the company's
public filings didn't
represent its real
performance, he testified.
John Rigas occasionally
showed discomfort with the
inflation, but did nothing
to stop it, Mr. Brown
said.
Mr.
Brown testified he used to
regularly tell John Rigas
Adelphia's real results
and how they compared with
those of other cable
companies. "On one
occasion John told me, 'We
need to get away from this
accounting magic,' "
he recalled. Mr. Brown
added that he understood
that to mean that Adelphia
needed to boost its
operations so that at some
point in the future, the
inflation could stop.
In
another discussion about
inflated numbers in early
2001, John Rigas
"told me he felt
sorry for Tim Rigas and me
because the operating
results were putting so
much pressure on us ...
but he said, 'You have to
do what you have to do,' "
Mr. Brown testified.
"He also said we
can't afford to have a
default." Mr. Brown
said he took that to mean
that reporting inflated
numbers was preferable to
defaulting.
The Securities and Exchange Commission (SEC) has filed charges against
Adelphia Communications Corp. and arrested the founder and members of his
family.
http://www.accountingweb.com/item/87019
Update in November 2002
Adelphia Communications filed a lawsuit against Deloitte &Touche claiming
the firm knew about "self-dealing and looting" by corporate officers, but
failed to disclose it to the audit committee or suggest changes in
corporate control practices.
http://www.accountingweb.com/item/95846
After my move to the White
Mountains on June 10, the only cable TV service available is from
Adelphia. Now I will be able to get those "adult channels."
But at my age, what's the use?
Well after a
few months of relative quiet, Adelphia sure has been in the news a great
deal of late. If you do not remember, Adelphia was the US’s sixth
largest cable provider and was headquarter in nearby Coudersport PA.
Then due to what most see as fraud and self-serving behavior of the
Rigases, the firm was forced into bankruptcy and delisted. The Rigases
were the first of the big names to be arrested by Federal authorities
when the elder John Rigas was taken away in handcuffs.
So just a quick
update of what has happened recently.
They have hired
a new executive team to what many (including former CEO John Rigas)
claim is an exorbitant contract, they are moving their headquarters from
Coudersport PA to Denver Colorado, they ended their long term ban on
“adult” channels, and they began charging significantly higher rates
(over a 100% increase in many cases) to their commercial users.
And as amazing
as it sounds, it seems like all of the accounting problems are not yet
over! The company just admitted they would have to restate their 2002
earnings after certain expenses were classified as capital expenditures.
Last week
Adelphia announced a new controversial pay package for the new
executives. The pay plan, which calls for $26 million to the new CEO
Michel William Schleyer and $16 million for the new COO Ronald Cooper,
has been called excessive by many shareholders, including the Rigases
themselves. The new execs both come from ATT’s Broadband unit. Since the
firm is in bankruptcy the pay plan must be approved by the bankruptcy
judge. The new CEO is saying that if the pay plan is cut, he may not
leave the firm. (personally I doubt it, but maybe). The plan as
structured has a $7.6 “severance package” (platinum parachute, which
pays him $7.6 million if Schleyer is removed from either his CEO or
Chairman of the board positions for any reason! Schleyer is threatening
to not take the job if the pay is reduced, but I think I would call his
bluff.
http://www.buffalonews.com/editorial/20030227/1019818.asp
Viewing telecom’s scandals through a forensic lens
Anyone who cares to watch the evening news recalls the recent Justice
Department publicity stunts involving Scott Sullivan, former chief
financial officer for WorldCom, and several members of the Rigas family
who founded Adelphia Cable.
http://www.americasnetwork.com/an/an.cgi?id=scandals-28593.html
IN THE AFTERMATH of Enron, the tarnished
auditing profession has mounted what might be called the "complexity
defense." This involves frowning seriously, intoning a few befuddling
sentences, then sighing that audits involve close-call judgments that
reasonable experts could debate. According to this defense, it isn't
fair to beat up on auditors as they wrestle with the finer points of
derivatives or lease receivables -- if they make calls that are
questionable, that's because the material is so difficult. Heck, it's
not as though auditors stand by dumbly while something obviously bad
happens, such as money being siphoned off for the boss's condo or golf
course.
Really? Let's look at Adelphia Communications
Corp., the nation's sixth-largest cable firm, which is due to be
suspended from the Nasdaq stock exchange today. On May 24, three days
after the audit lobby derailed a Senate attempt to reform the
profession, Adelphia filed documents with the Securities and Exchange
Commission that reveal some of the most outrageous chicanery in
corporate history. The Rigas family, which controlled the company while
owning just a fifth of it, treated Adelphia like a piggy bank: It used
it, among other things, to pay for a private jet, personal share
purchases, a movie produced by a Rigas daughter, and (yes!) a golf
course and a Manhattan apartment. In all, the family helped itself to
secret loans from Adelphia amounting to $3.1 billion. Even Andrew
Fastow, the lead siphon man at Enron, made off with a relatively modest
$45 million.
Where was Deloitte & Touche, Adelphia's
auditor, whose role was to look out for the interests of the nonfamily
shareholders who own four-fifths of the firm? Deloitte was apparently
inert when Adelphia paid $26.5 million for timber rights on land that
the family then bought for about $500,000 -- a nifty way of transferring
other shareholders' money into the Rigas's coffers. Deloitte was no
livelier when Adelphia made secret loans of about $130 million to
support the Rigas-owned Buffalo Sabres hockey team. Deloitte didn't seem
bothered when Adelphia used smoke and mirrors to hide debt off its
balance sheet. In sum, the auditor stood by while shareholders' cash
left through the front door and most of the side doors. There is nothing
complex about this malfeasance.
When Adelphia's board belatedly demanded an
explanation from its auditor, it got a revealing answer. Deloitte said,
yes, it would explain -- but only on condition that its statements not
be used against it. How could Deloitte have forgotten that reporting to
the board (and therefore to the shareholders) is not some special favor
for which reciprocal concessions may be demanded, but rather the sole
reason that auditors exist? The answer is familiar. Deloitte forgot
because of conflicts of interest: While auditing Adelphia, Deloitte
simultaneously served as the firm's internal accountant and as auditor
to other companies controlled by the Rigas family. Its real allegiance
was not to the shareholders but to the family that robbed them.
It's too early to judge the repercussions of
Adelphia, but the omens are not good. When audit failure helped to bring
down Enron, similar failures soon emerged at other energy companies --
two of which fired their CEOs last week. Equally, when audit failure
helped to bring down Global Crossing, similar failure emerged at other
telecom players. Now the worry is that Adelphia may signal wider trouble
in the cable industry. The fear of undiscovered booby traps is spooking
the stock market: Since the start of December, when Enron filed for
bankruptcy, almost all macro-economic news has been better than
expected, but the S&P 500 index is down 2 percent.
Without Enron-Global Crossing-Adelphia, the
stock market almost certainly would be higher. If the shares in the New
York Stock Exchange were a tenth higher, for example, investors would be
wealthier by about $1.5 trillion. Does anyone in government care about
this? We may find out when Congress reconvenes this week. Sen. Paul
Sarbanes, who sponsored the reform effort that got derailed last month,
will be trying to rally his supporters. Perhaps the thought of that $1.5
trillion -- or even Adelphia's fugitive $3 billion -- will get their
attention.
The above article must be juxtaposed against this earlier Washington
Post article:
But the review of Andersen reflected the
limitations of the peer-review process, in which each of the so-called
Big Five accounting firms is periodically reviewed by one of the others.
Deloitte's review did not include Andersen's audits of bankrupt energy
trader Enron Corp. -- or any other case in which an audit failure was
alleged, Deloitte partners said yesterday in a conference call with
reporters.
. .
Concluding Remarks
In its latest review, Deloitte said Andersen
auditors did not always comply with requirements for communicating with
their overseers on corporate boards. According to Deloitte's report, in
a few instances, Andersen failed to issue a required letter in which
auditors attest that they are independent from the audit client and
disclose factors that might affect their independence.
In a recent
letter to the American Institute of Certified Public Accountants,
Andersen said it has addressed the concerns that Deloitte cited.
Southern Alaska Carpenters Pension Fund this
week filed a complaint this week calling into question accounting firms'
Grant Thornton and Deloitte Touche Tohmatsu's involvement in the
Parmalat scandal, dubbed "one of the most shocking corporate scandals
ever to afflict the public financial markets."
Filed in U.S. District Court in the Southern
District of New York, the complaint charges former Parmalat Chairman
Calisto Tanzi and former Chief Financial Officer Fausto Tonna, together
with Citigroup Inc. and legal, accounting and financial advisors, with
violations of the Securities Exchange Act of 1934.
The suit alleges the concoction of "a massive
scheme whereby they overstated Parmalat's reported profits and assets
for more than a decade" which allowed "defendants to divert
approximately $1 billion to themselves and/or to companies controlled by
them via professional fees and clandestine asset transfers and enabled
Parmalat to raise more than $5 billion from unsuspecting investors from
the sale of newly issued securities."
Parmalat is Italy's largest food company. The
company admitted last week that it had discovered a $5 billion shortfall
on its books. The U.S. Securities and Exchange Commission is
investigating if U.S. financial institutions have any responsibility for
the scandal.
Oct. 17, 2002 (The
Philadelphia Inquirer) — The Pennsylvania Insurance Department is
blaming one of the nation's biggest accounting firms for inflating
Reliance Insurance Co.'s financial statements by $1 billion and
contributing to its financial collapse last year.
In a civil suit
filed in Commonwealth Court yesterday, state insurance commissioner M.
Diane Koken accused Deloitte Touche LLC and Deloitte principal actuary
Jan A. Lommele of "professional negligence and malpractice,
misrepresentation, breach of contract, and aiding and abetting
breaches of fiduciary duties" by Reliance chairman Saul P. Steinberg
and other former officials.
The New
York-based accounting giant denied wrongdoing on behalf of its
Philadelphia office, which audited Reliance.
"Deloitte and
Touche performed its services for Reliance in accordance with all
applicable professional standards and will defend itself accordingly,"
said spokesman Paul Marinaccio. He added that the firm had not yet
seen the suit and could not comment on specific claims.
Lommele,
former head of a financial reporting committee for the American
Academy of Actuaries, a national group that sets and enforces
professional standards for its members, was unavailable for comment at
his Connecticut office.
Pennsylvania
liquidated Reliance last fall after estimating a shortfall of over $1
billion between the company's assets and its likely future claims.
Founded in 1817, Philadelphia-based Reliance employed over 7,000
workers in the late 1990s.
To bail out
Reliance policyholders, along with customers of a string of smaller
failed insurers, Pennsylvania home and business insurers are paying
the legal maximum 2 percent surcharge on policies; smaller surcharges
have been levied by other states in connection with Reliance.
Typically those costs are passed on to policyholders in the form of
higher premiums.
Whether
"motivated by the desire to increase fee income from an important
client" or "hopelessly conflicted" by its dual role checking the books
of both Reliance and its owner, Deloitte and Lommele understated the
company's expected insurance claims by more than $500 million and
exaggerated assets by nearly as much, resulting in a "billion dollar
overstatement" of the company's financial surplus in 1999, according
to the suit, prepared by Philadelphia lawyer Jerome Richter.
Deloitte
collected $6.5 million in auditing fees from both Reliance and its
owner, New York investor Saul P. Steinberg's Reliance Group Holdings,
in 1998-99, and Deloitte is still collecting additional payments from
Reliance Group, which is now in bankruptcy proceedings.
Deloitte
should have blown the whistle on Reliance by issuing a warning about
the company's ability to stay in business by "the end of 1999, and
probably earlier", the suit maintains. The firm's failure to issue
such a warning "helped Reliance to preserve its favorable rating" from
A.M. Best & Co. and other insurance rating firms, giving customers a
false sense of security, the suit said.
According to
the suit, Lommele employed a discredited method called "summing" to
calculate Reliance's cash reserves while "manipulating" loss ratios,
sometimes by crudely cutting them in half, to reduce apparent reserve
requirements.
The suit also
accuses Deloitte staff of ignoring loss trends in calculating future
losses for certain unnamed "large lines of business", and of failing
to properly account for tax and reinsurance obligations. And the suit
says Deloitte "obscured" Reliance's increasing dependence on
Steinberg's "bull market" stock investments as a source of capital in
1999 and 2000.
Had Deloitte
and Lommele done their job, "hundreds of millions of dollars in losses
to Reliance", its creditors and the U.S. insurance policyholders who
are currently bailing the company by paying surcharges on their
policies might have been "avoided", according to the suit.
Instead,
according to the suit, the auditors allowed Steinberg and his fellow
directors to "drain" over $500 million in cash from Reliance Insurance
by "recklessly, intentionally or negligently concealing" the company's
poor financial condition from the Insurance Department, policyholders
and creditors.
Steinberg and
his fellow Reliance officers, directors and executives, including
former Pennsylvania Insurance Commissioner and Reliance lawyer Linda
S. Kaiser, are the subject of a separate Insurance Department lawsuit
alleging they caused or failed to prevent the company's collapse. The
ex-Reliance officials have sought to have the suit thrown out,
alleging it lacks specific allegations.
Koken's
department says it has raised over $130 million by suing the lawyers,
accountants, executives, directors and other people connected to a
string of failed Pennsylvania insurers over the past five years, a
period in which the state has led the nation in property-and-casualty
insurance company failures.
Contact
Joseph N. DiStefano at 215-854-595 or jdistefano@phillynews.com
Version
edited by News Service:
To see more
of The Philadelphia Inquirer, or to subscribe to the newspaper,
go to
http://www.philly.com
Update February 21, 2003
A lawsuit initiated in 1994 ended this week with Big Four auditor Deloitte
& Touche agreeing to pay $23 million to the State of Kentucky's Department
of Insurance on behalf of Kentucky Central Life Insurance Company.
http://www.accountingweb.com/item/97178
More bad news for KPMG from the SEC regarding KPMG audit quality and
professionalism
The Securities
and Exchange Commission accused two KPMG auditors who had overseen
the audit of Royal Ahold NV's U.S. Foodservice unit of failing to
act upon numerous "red flags" amid the unit's estimated $30 billion
accounting fraud.
The SEC on Thursday announced
administrative proceedings against Kevin Hall, a KPMG partner, and
Rosemary Meyer, a senior manager. The agency said that even though
Hall and Meyer identified or had evidence of accounting problems
with U.S. Foodservice's fiscal 1999 financial statements, the two
ignored irregularities and failed to clarify inconsistencies or
bring problems to the attention of the company's audit committee.
"This case is an example of our continuing
efforts to hold auditors and other gatekeepers responsible for
failing to fulfill their professional obligations," said Scott
Friestad, associate director of the SEC's enforcement division.
Bill Baker, an attorney for Hall, declined
to comment. An attorney for Meyer could not immediately be reached.
Tom Fitzgerald, a KPMG spokesman, said,
"our partners look forward to presenting the facts in support of the
work that was performed under the circumstances at U.S. Foodservice
in 1999."
Ahold, the Dutch supermarket operator, in
2004 settled SEC charges that its filings for at least fiscal 2000
through 2002 were false and misleading because its U.S. Foodservice
unit had inflated "promotional allowances." These are payments that
food makers make to wholesalers such as U.S. Foodservice that choose
which goods to keep in stock.
Hall and Meyer knew that the company's
dependence on promotional allowances was rapidly growing, and that
without the rebates, the company would have operated at a loss, the
SEC said. They also knew that U.S. Foodservice had no automated
system for tracking the payments, according to the SEC.
Even so, and even after flagging some
discrepancies between the promotional allowances claimed by U.S.
Foodservice and information provided by vendors, Hall and Meyer
accepted explanations from management that the rebates were properly
accounted for, the SEC said.
Hall and Meyer were also accused in
connection with their review of a supply contract for U.S.
Foodservice's 2000 second quarter. The SEC said that the two KPMG
auditors allowed the distributor to avoid expensing payments they
would be obligated to make if minimum purchase requirements weren't
met.
From
The Wall Street Journal Accounting Weekly Review
on December 2, 2005
TITLE:
Ahold to Settle Shareholder Suit For $1.1
Billion
REPORTER: Nicolas Parasie, Fred Pals, Chad Bray
DATE: Nov 29, 2005
PAGE: A5
LINK:
http://online.wsj.com/article/SB113316836281807923.html
TOPICS: Accounting, Contingent Liabilities,
Financial Accounting, Auditing
SUMMARY: "Ahold NV said it settled a U.S.
class-action lawsuit related to its accounting
scandal two years ago, agreeing to pay 945
million euro, or about $1.1 billion, to
shareholders world-wide." The company
"...operates Stop & Shop and Giant supermarkets
in the US."
QUESTIONS:
1.) For what losses did Ahold NV shareholders
file their class-action lawsuit? In your answer,
define the term "class-action." How was this
lawsuit resolved?
2.)
Based on information given in the main article
and a related one, what were the means by which
the company overstated its profits? What steps
were undertaken to avoid the outside auditor's
detection of the accounting irregularities? Is
it possible for an auditor to undertake
procedures to overcome such collusion?
3.)
What factors besides the accounting
irregularities committed by the company could
have impacted Ahold NV's share price during the
years 2003 and 2004? How likely do you think it
is that the company might have been able to
defend against the shareholder lawsuit on the
argument that other factors caused the company's
stock price decline? Explain your reasoning for
your answer to this question.
4.)
Access Ahold's SEC filing on Form 20-F for under
company name Royal Ahold (Ticker Symbol AHO).
How were these outstanding lawsuits disclosed in
the company's financial statements for the year
ended January 2, 2005 filed with the SEC on June
24, 2005? To answer, describe the specific
location of the disclosure and summarize the
statements made therein.
5.) In
what time period was most of the expense
associated with this lawsuit settlement
recorded? Based on the information provided in
the article, provide a summary journal entry to
account for the lawsuit settlement.
6.)
What accounting literature in USGAAP requires
the disclosure described in answer to question 4
and the accounting treatment described in answer
to question 5? Specifically cite the standard
and its paragraphs promulgating this accounting
and reporting.
Reviewed By: Judy Beckman, University of Rhode
Island
From The Wall Street Journal Accounting Educators' Review on
February 28, 2003
TITLE: Supermarket Firm Ahold Faces U.S. Inquiries
REPORTER: ANITA RAGHAVAN, ALMAR LATOUR and MICHAEL SCHROEDER
DATE: Feb 26, 2003
PAGE: A2
LINK:
http://online.wsj.com/article/0,,SB1046206345249379943,00.html
TOPICS: Accounting, Accounting Fraud, Accounting Irregularities, Audit
Quality, Executive compensation, Fraudulent Financial Reporting,
Securities and Exchange Commission
SUMMARY: Ahold, the third largest food retailer in the world, announced
that profits for 2001 and 2002 were overstated by at least $500 million
dollars. The Securities and Exchange Commission is investigating and has
requested working papers from Ahold's auditor, Deloitte & Touche.
QUESTIONS:
1.) Refer to the first related article. Describe the accounting issue that
led to the overstatement in profits on Ahold's financial statements.
According to U.S. Generally Accepted Accounting Principles, when should
revenue be recognized? Should rebates and bonuses received from food
makers follow this general principle? Support your answer.
2.) Since Ahold is a Dutch company, why are they being investigated by
the Securities and Exchange Commission in the United States? Refer to the
second related article. Discuss the issues that relate to non-U.S.
accounting firms that audit companies listed in the U.S. Is Ahold required
to report financial statements prepared in accordance with U.S. GAAP?
Support your answer.
3.) Discuss the impact of bonuses paid for meeting growth targets on
incentives to manipulate accounting profits.
4.) The main article states, "the probes center on whether fraud was
involved in the improper accounting . . . " What is fraud? If the improper
accounting is not the result of fraud, what other explanation for it
exists?
5.) The SEC has asked Deloitte & Touche for workpapers related to its
audit of Ahold. Under what conditions can an auditor share details of
workpapers?
"Ahold Inquiry in U.S.
Bearing Fruit," by Anita Raghavan and Deborah Solomon, The Wall Street
Journal, July 27, 2004, Page A3 ---
Ex-Executive Pleads Guilty As Indictments Are
Sought For Other Former Officials
U.S. prosecutors, intensifying a
broad international investigation of the food industry, are set to unveil
the first criminal charges stemming from massive accounting problems at
supermarket giant Ahold
NV.
A former purchasing executive at
Netherlands-based Ahold's U.S. Foodservice unit pleaded guilty Friday in
federal court in New York to insider trading and securities fraud, among
other criminal charges, people familiar with the situation say. The plea
agreement by Timothy J. Lee, 40 years old, has been sealed and is expected
soon to be publicly disclosed, the people say.
The pact comes as the Manhattan
U.S. attorney's office seeks to indict other U.S. Foodservice executives,
including former marketing manager Mark Kaiser, former Chief Financial
Officer Michael Resnick and former Vice President William Carter, as early
as this week for conspiracy to commit securities fraud, which the
government claims cost investors $6 billion, these people say. The figure
represents the decline in Ahold's market value after the accounting
irregularities came to light.
The plea agreement by Mr. Lee
stemmed from allegations that he tipped off representatives of food
vendors to the impending $3.5 billion sale of U.S. Foodservice to Ahold in
2000, the people say. Ahold of the Netherlands is one of the world's
largest food retailers, along with Wal-Mart Stores Inc. and Carrefour SA
of France.
The Securities and Exchange
Commission also plans to bring civil charges of securities fraud against
Messrs. Lee, Kaiser, Resnick and Carter for allegedly inflating revenue
and profits by improperly booking rebates, these people say. Mr. Lee also
will be charged by the SEC with civil insider trading, the people say. The
investigation is continuing and the SEC is expected to bring additional
charges against individuals at Ahold as well as some of the salespeople at
vendor companies that helped U.S. Foodservice inflate its revenue, the
people say.
Jane F. Barrett, Mr. Lee's lawyer
at Blank Rome LLP in Washington, D.C., declined to comment. Richard
Morvillo, a lawyer for Mr. Kaiser, said: "I'm not aware of what
charges may be brought against my client by either the U.S. attorney's
office or the SEC, but as we said previously, we expect to defend Mr.
Kaiser vigorously and ultimately believe he will prevail." Scott B.
Schreiber, an attorney for Mr. Resnick, didn't immediately return a call
seeking comment. Mr. Carter couldn't be reached for comment.
The developments, in the largest
investigation by U.S. prosecutors into an overseas company, underscore
that the American prosecutors and securities regulators are aggressively
seeking to expand their investigation into the food industry, potentially
laying the groundwork to bring charges against major food vendors by
putting pressure on their low-level employees.
The legal maneuvers underscore the
increasing scrutiny that U.S. regulators are placing on foreign companies
that trade securities such as American depositary receipts in the U.S. The
U.S. attorney's office and the U.S. Securities and Exchange Commission
also have been investigating whether Royal
Dutch/Shell Group improperly overbooked reserves.
At issue in the Ahold matter is the
hundreds of millions of dollars in rebates, "allowances" and
other promotions that food makers pay to supermarket operators for coveted
shelf space, and to distributors that can choose which brands to stock in
their warehouses. These payments, while at times advantageous for certain
big players in the market, can hurt smaller competitors and may drive up
prices paid by consumers.
In recent years, these rebates and
allowances appear to have been used by food distributors to help make
their revenue and profits appear rosier than they actually were,
regulators say.
As part of their investigation into
U.S. Foodservice, prosecutors have been examining whether suppliers to the
Columbia, Md., unit of Ahold signed off on inaccurate documents that could
have been used to help inflate earnings at U.S. Foodservice. Last spring, Sara
Lee Corp. and ConAgra
Foods Inc. acknowledged that some salespeople endorsed inaccurate
documents that showed the two suppliers owed more to U.S. Foodservice in
rebates than they actually did.
While investigators began their
probe by focusing on the accounting irregularities, the inquiry evolved
into an insider-trading investigation as prosecutors started sifting
through stock-trading records, say people familiar with the situation. As
the probe deepened, prosecutors began scrutinizing whether Mr. Lee tipped
off salesmen at vendors to curry favor, these people say.
The potential indictments come as
the SEC has informed a number of food companies, including Kraft
Foods Inc., Dean
Foods Co. and PepsiCo
Inc.'s Frito-Lay, that it is considering legal action against them in
connection with accounting problems at grocery distributor Fleming Cos.
These companies have received so-called Wells notices, in which the SEC
discloses that its enforcement division has recommended filing a legal
action.
Continued in the article
From The Wall Street Journal Accounting Weekly Review on December 2,
2005
TITLE: Ahold to Settle Shareholder Suit For $1.1 Billion
REPORTER: Nicolas Parasie, Fred Pals, Chad Bray
DATE: Nov 29, 2005
PAGE: A5
LINK:
http://online.wsj.com/article/SB113316836281807923.html
TOPICS: Accounting, Contingent Liabilities, Financial Accounting,
Auditing
SUMMARY: "Ahold NV said it settled a U.S. class-action lawsuit
related to its accounting scandal two years ago, agreeing to pay 945
million euro, or about $1.1 billion, to shareholders world-wide." The
company "...operates Stop & Shop and Giant supermarkets in the US."
QUESTIONS:
1.) For what losses did Ahold NV shareholders file their class-action
lawsuit? In your answer, define the term "class-action." How was this
lawsuit resolved?
2.) Based on information given in the main article and a related one,
what were the means by which the company overstated its profits? What
steps were undertaken to avoid the outside auditor's detection of the
accounting irregularities? Is it possible for an auditor to undertake
procedures to overcome such collusion?
3.) What factors besides the accounting irregularities committed by
the company could have impacted Ahold NV's share price during the years
2003 and 2004? How likely do you think it is that the company might have
been able to defend against the shareholder lawsuit on the argument that
other factors caused the company's stock price decline? Explain your
reasoning for your answer to this question.
4.) Access Ahold's SEC filing on Form 20-F for under company name
Royal Ahold (Ticker Symbol AHO). How were these outstanding lawsuits
disclosed in the company's financial statements for the year ended
January 2, 2005 filed with the SEC on June 24, 2005? To answer, describe
the specific location of the disclosure and summarize the statements
made therein.
5.) In what time period was most of the expense associated with this
lawsuit settlement recorded? Based on the information provided in the
article, provide a summary journal entry to account for the lawsuit
settlement.
6.) What accounting literature in USGAAP requires the disclosure
described in answer to question 4 and the accounting treatment described
in answer to question 5? Specifically cite the standard and its
paragraphs promulgating this accounting and reporting.
Reviewed By: Judy Beckman, University of Rhode Island
Ahold NV said it settled a U.S.
class-action lawsuit related to its accounting scandal two years
ago, agreeing to pay €945 million, or about $1.1 billion, to
shareholders world-wide.
Separately, a Pennsylvania supermarket
vendor pleaded guilty in federal court in Manhattan to a conspiracy
charge in connection with the alleged accounting fraud at Ahold's
U.S. unit.
Amsterdam-based Ahold, which operates Stop
& Shop and Giant supermarkets in the U.S. and the Albert Heijn
supermarkets in the Netherlands, came close to bankruptcy
proceedings after disclosing a €1 billion profit overstatement at
its U.S. Foodservice unit in 2003. Revelations of accounting
irregularities over a five-year period followed, and Ahold was sued
by shareholders for the resulting drop in share price.
The settlement will result in an after-tax
charge of €585 million for the third quarter. Shareholders will
receive about $1 to $1.30 for each Ahold share before tax, it said.
The company also has reached an agreement with the Dutch
shareholders' association VEB, to which it will pay €2.5 million.
Ahold reports third-quarter results today.
"We will avoid lengthy, costly and
time-consuming litigation," said Ahold board member and chief legal
counselor Peter Wakkie.
Ahold said this settlement is the last one
"with significant financial exposure" to the litigation resulting
from the 2003 overstatement. There is one continuing investigation
being carried out by the U.S. Justice Department that is mainly
focusing on executives at U.S. Foodservice, Mr. Wakkie said.
Federal prosecutors have also charged 16
U.S. Foodservice vendors with aiding former executives at the
Columbia, Md., company in the alleged scheme to artificially inflate
U.S. Foodservice's results. So far, 15 of those suppliers or
brokers, including one yesterday, have pleaded guilty to criminal
charges in the matter.
At a hearing yesterday before U.S. District
Court Judge Jed S. Rakoff, Robert Henuset, a sales manager at
Crowley Foods LLC in Yardley, Pa., pleaded guilty to one count of
conspiracy. Mr. Henuset, who was a supplier to U.S. Foodservice,
admitted to signing an audit-confirmation letter in January 2003
that overstated the amount of money owed to U.S. Foodservice by
Crowley.
Mr. Henuset, 55 years old, faces as much as
five years in prison in connection with the conspiracy charge.
Sentencing is set for March 20.
Fraud Continues to
Haunt Online Retail Online fraud losses for 2001 were 19 times as high,
dollar for dollar, as fraud losses resulting from offline sales, GartnerG2
found.
http://www.newmedia.com/default.asp?articleID=3427
The Office of the Comptroller of the Currency has issued an alert to
banks asking them to warn their customers about a new fraud scheme that
uses fictitious IRS forms and bank correspondence in an attempt at
identity theft.
http://www.accountingweb.com/item/78966
The Office of the Comptroller of the Currency
(OCC) has issued an alert to banks, asking them to warn their customers
about a new fraud scheme that uses fictitious IRS forms and bank
correspondence.
Under the scheme, bank customers receive a
letter outlining the procedures that need to be followed to protect the
recipient from unnecessary withholding taxes on their bank accounts and
other financial dealings. The letter instructs the recipient to fill in
the enclosed IRS Form W-9095 and return it within seven days. According
to the letter, anyone who doesn't file the form is subject to 31%
withholding on interest paid to them. A fax number is provided for the
recipient's convenience.
The growing number of financial
scandals and frauds in recent years have made forensic accounting one of
the fastest growing areas of accounting and one of the most secure career
paths for accountants.
http://www.accountingweb.com/item/78110
"PwC Reveals Dramatic Rise in
Securities Litigation Cases More than half of cases filed against IPO
underwriters and recently public companies," ---
http://accounting.smartpros.com/x30924.xml
From the AccountingWeb newsletter
on January 11, 2002
Xerox Corporation served notice on Monday that it plans to dispute the
Securities and Exchange Commission's ruling of improper treatment of
accounting for leases. The SEC has been investigating Xerox for the past
18 months and has concluded that the method Xerox uses for accounting for
sales leases has resulted in financial reporting that is not in accordance
with generally accepted accounting principles.
http://www.accountingweb.com/item/68557
WASHINGTON,
April 8, 2002 — Barry Melancon, chief of the American Institute of CPAs,
announced he will donate to a charitable organization his stake in
CPA2Biz, the AICPA's for-profit Web portal, according to The New York
Times.
The donation is
an attempt to silence critics that have called his investment a conflict
of interest because he was using his position as head of a nonprofit
organization to profit from its commercial ventures. Additionally,
critics questioned his ability to exercise independent judgment with
such substantial potential for financial gain.
The New York
Times reported Melancon's original $100,000 investment is now worth more
than $5 million.
The $2.25 billion e-rate fund has helped connect thousands of U.S.
schools and libraries to the Net. The fund is also subject to widespread
fraud, abuse and "honest" accounting mistakes ---
http://www.wired.com/news/school/0,1383,57172,00.html
April 2, 2002
(TheStreet.com) — Xerox agreed Monday to pay a $10 million civil penalty
and restate earnings since 1997 to settle a looming Securities and
Exchange Commission suit over accounting practices.
Xerox said it
started settlement talks after the agency's enforcement arm made a
preliminary decision to recommend an enforcement action regarding the
company's 1997-2000 financial statements. Xerox said it would seek an
extension of up to 90 days to file its restatement and its 2001 10-K
report.
The deal, which
is subject to the full commission's approval, would put to rest an
investigation the agency began in 2000 amid allegations that Xerox's
Mexican operations had overstated revenue by using improper lease
accounting. The SEC told Xerox its revenue-allocation methodology for
certain contracts did not comply with the Statement of Financial
Accounting Standards No. 13. Xerox said Monday that under the proposed
settlement, the company "would neither admit nor deny the allegations of
the complaint, which would include claims of civil violations of the
antifraud, reporting and other provisions of the securities laws."
Xerox said the
restatement could involve the "reallocation" of up to $2 billion in
equipment sales revenue and "adjustments that could be in excess of $300
million" regarding certain reserves. But "the resulting timing and
allocation adjustments cannot be estimated until the restatement process
has been completed," Xerox said.
A group of hedge funds and a state
retirement system have filed suit against Wachovia Corp.'s
investment-banking unit, claiming Wachovia knew a now-bankrupt
beverage company was committing fraud when the bank underwrote $285
million in debt for the company in 2006.
The amended complaint, filed in federal
court in New York, contends Wachovia knew LeNature's Inc. was
reporting sales figures that couldn't be accurate and had been
unable to make interest payments on its existing loans. The bank
fronted the payments for the troubled company in order to keep
current and potential lenders from finding out, the suit alleges.
Wachovia arranged the $285 million credit
facility, underwrote it and syndicated it, selling the debt to banks
and other investors. Those investors included the suing funds, led
by Harbinger Capital Partners, which collectively hold more than
$165 million in debt the company is unable to repay. Wachovia pushed
forward with the deal to reduce its potential exposure to LeNature's
debt and to earn a $7 million fee for its work on the credit
facility, the funds claim. As a result of the syndication,
Wachovia's exposure was reduced to about $7 million of the overall
loan, slightly less than the fee it earned in the process. But the
bank never mentioned any of LeNature's problems to the
"unsuspecting" funds Wachovia solicited to purchase the debt, they
claim.
A Wachovia spokeswoman says the company is
also a victim of the fraud and believes the suit is without merit.
She said the bank is waiting for a ruling on a motion to dismiss the
case.
A group of hedge funds including BlackRock
Inc. and Harbinger Capital Partners has sued Wachovia Capital
Markets, an accounting firm and two former executives of
LeNature's Inc. of Latrobe,
accusing them of conspiring to hide the
company's massive debts from investors.
BlackRock is 37 percent owned by PNC
Financial Services Group of Pittsburgh. Harbinger Capital is the
lead plaintiff against Wachovia, BDO Seidman, former CEO Gregory
Podlucky and former vice president Robert Lynn, both of Ligonier, in
the lawsuit filed Monday in U.S. District Court in the southern
district of New York.
The suit accuses Wachovia of withholding
information about LeNature's "improper practices and struggling
finances" before Wachovia loaned the company $285 million last year,
just two months before the company was forced into bankruptcy. That
debt then was sold to investors to reduce Wachovia's liability,
according to the filing.
"Absent Wachovia's active and knowing
participation, LeNature's fraudulent scheme could not have been
perpetrated," contends the suit filed by attorney Michael Carlinsky
of Quinn Emanuel Urquhart Oliver & Hedges of New York
The national accounting firm
BDO Seidman LLP
on Friday was charged and agreed to the fine to avoid prosecution. The
firm prepared tax returns for Gibson and his former companies, SBU Inc.,
Flag Finance and Family Company of America, through which he operated
the failed National supermarket chain.
The accounting firm knew in October 1995 that
Gibson, formerly of Belleville, failed to purchase the promised U.S.
Treasury notes to fund 22 of SBU's clients' trust funds, according to a
statement of facts filed in court Friday. SBU was a company that was to
make safe investments that would provide income for people who won
lawsuits or insurance settlements after being injured.
In 1996, the accountants knew Gibson sold
treasury notes or failed to purchase them for SBU clients to purchase
and operate his 23 National grocery stores. He bought the stores from
Schnucks Markets Inc.
During a 1998 tax audit, the accounting firm
submitted tax returns to the Internal Revenue Service but failed to tell
the IRS about Gibson misusing the trust funds to prop up his grocery
chain.
The accountants agreed to cooperate in the
government's case and pay a total of $16 million to SBU's former clients
for restitution. The fine is the amount Gibson looted from the trust
accounts of his clients between October 1994 and September 1996.
In exchange for the fine and accounting firm's
cooperation, federal prosecutors agreed to defer prosecution, with the
intention of dismissing charges after 18 months if the agreement is
kept.
BDO Seidman snags guilty verdict National CPA firm BDO Seidman LLP has been found
grossly negligent by a Florida jury for failing to find fraud in an audit that
resulted in costing a Portuguese Bank $170 million. The verdict opens up the
opportunity for the bank to pursue punitive damages that could exceed $500
million.
"BDO Seidman snags guilty verdict," AccountingWeb, June 26, 2007 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=103667
AccountingWEB US - Mar-4-2003 -
The trend of suing accounting firms continues, this time in Switzerland.
Aided by the results of a year-long study performed by
PricewaterhouseCoopers, the Swiss state of Geneva
has demanded 3 billion Swiss francs (US$2.2 billion) from Big Four
firm Ernst & Young for damages from audits stemming from 1994 to the
present.
According to the PwC report, E&Y used a method
of risk evaluation that was "outside legal norms" when issuing
statements concerning the merger of audit client Banque Cantonale de
Geneve with another bank.
Continued in the article.
From the Free Wall Street
Journal Educators' Reviews for December 13, 2001
TITLE: Former Auditor of Superior
Bank Cites Grand-Jury Probe Into Collapse of Thrift
REPORTER: Mark Maremont
DATE: Dec 12, 2001
PAGE: C16
LINK:
http://interactive.wsj.com/archive/retrieve.cgi?id=SB1008126509354552200.djm
TOPICS: Accounting, Accounting Fraud, Accounting Irregularities, Auditing,
Auditing Services, Bad Debts, Banking, Loan Loss Allowance
SUMMARY: Ernst & Young LLP,
former auditor of Superior Bank, is cooperating with a grand-jury
investigation. Superior Bank, which failed in July, is one of the largest
banking institutions to fail in recent years. A representative from the
Office of Thrift Supervision told Congress that Ernst and Young permitted
improper accounting. Ernst and Young contends that there were no
accounting mistakes.
QUESTIONS:
1.) What actions has Ernst and Young taken in cooperation with the
grand-jury investigation? Is Ernst and Young required to take these
actions? Are they violating client confidentiality by surrendering working
papers to a third party? Under what circumstances is it acceptable to
share client work papers with a third party?
2.) What factors does Ernst and
Young contend contributed to the failure of Superior Bank? If Ernst and
Young had perfect foresight about these events, what changes in the
financial reporting would have been required? Is it reasonable to expect
auditors to anticipate changes in the economy? Why or why not?
3.) What factors does the Office
of Thrift Supervision claim contributed to the failure of Superior Bank?
Discuss two financial reporting issues that should have been considered by
Ernst and Young. Do you think that Ernst and Young allowed misleading
financial reporting by Superior Bank? Why or why not?
Reviewed By: Judy Beckman,
University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
"Equitable Life sues E&Y," by
James Moore, Times Online, April 15, 2002
EQUITABLE LIFE
yesterday heaped further misery on the auditing profession as it sought
to recover as much as £2.6 billion from Ernst & Young, its former
auditor.
In a High Court
claim filed yesterday afternoon, the troubled life insurer said Ernst &
Young should not have signed off its accounts as a “true and fair” view.
The action alleges that E&Y should not have cleared the insurer’s books,
given the potentially huge liabilities Equitable faced to holders of
guaranteed pensions.
Equitable
closed to new business in 2000 after the High Court ruled it must meet
the guarantees in full at a cost of more than £1.5 billion.
Experts say
that actions against auditors usually realise between 10 and 30 per cent
of the original claim if successful. BDO Stoy Hayward, former auditor to
Asil Nadir’s Polly Peck International (PPI), paid an estimated £30
million to settle a negligence claim brought by PPI’s administrators.
They had been seeking £250 million from Stoy, which always denied
negligence.
Charles
Thomson, chief executive of Equitable, accepted that the insurer was
unlikely to receive the full amount.
Ernst & Young
said: “We are confident there is no basis for this claim. We note the
society’s intention ‘to resist opportunistic claims and those based on
hindsight’ and we believe that this claim falls into that category.”
Equitable also
said it was cutting policyholders’ bonuses because of the poor
performance of the stock market over the past year, despite having the
lowest proportion of equities of any of the big UK life insurance funds.
Critics
attacked the move, which comes just three months after policyholders
backed a compromise deal designed to stabilise Equitable’s finances.
Holders of guaranteed pensions gave up the guarantees for a 17.5 per
cent bonus to their policies. People without guarantees were given 2.5
per cent but can no longer sue the society for mis-selling.
February 2003 Update
Ernst & Young breathed a sigh of relief this week as a judge threw
out two out of three of the claims made against it in a negligence case
brought against the Big Four firm by Equitable Life. Had it been
successful, the suit could have cost the accounting firm $4.5 billion in
damages.
http://www.accountingweb.com/item/97126
TITLE: HealthSouth Corp.
Executives Had Hint of Billing Problems
REPORTER: Ann Carrns
DATE: Sep 05, 2002
PAGE: A2
LINK:
http://online.wsj.com/article/0,,SB1031186453640899435.djm,00.html
TOPICS: Accounting Changes and Error Corrections, Advanced Financial
Accounting, Disclosure Requirements, Earning Announcements, Financial
Accounting
SUMMARY: HealthSouth Corp. is
being required by Medicare to reduce billings for certain physical therapy
services they provide. The change will have a substantial impact on the
company's profitability.
QUESTIONS:
1.) Describe HealthSouth Corp.'s operations as you understand them from
the article.
2.) Describe the nature of the
problem facing HealthSouth Corp.'s executives. What accounting adjustment
will result from resolving this matter? Specifically state the journal
entry that will have to be made. What accounting standard governs this
adjustment? How will this item be displayed and what disclosures about it
must be made in the financial statements?
3.) Why does the author title
this issue a "billing problem" rather than a revenue recognition issue?
4.) The author questions whether
HealthSouth executives should have alerted investors to this problem
earlier than they did. Under what venue would they make this disclosure?
What standards or regulations govern the requirement to disclose this
information to investors?
5.) Management argues that they
would not have had to disclose this item to shareholders if it were not
material. What defines materiality? Could the issue be material even in
the amount affecting current year results is small relative to the
company's overall operations? Explain.
6.) Do you think the discussion
of Mr. Scrushy's executive stock options is relevant to the issue at hand?
Why do you think the author included this information?
Reviewed By: Judy Beckman,
University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
KPMG Gets
Probation For Bungling Orange County Audit
AccountingWEB US - July
29, 2002 - International accounting firm KPMG has been
slapped with a $1.8 million fine and a year of probation after being
found guilty of gross negligence and unprofessional conduct for its
handling of the 1992 and 1993 audit and financial statements of
Orange County, California. The California Board of Accountancy also
ordered three years of probation and 100 hours community service for
KPMG partner Margaret Jean McBride and two years of probation each
for former KPMG accountants Joseph Horton Parker and Bradley J.
Timon. All were found guilty of gross negligence and unprofessional
conduct.
The county declared bankruptcy in late 1994
after it lost $1.7 billion in its investment pool. County treasurer
Robert L. Citron oversaw the investment pool. Mr. Citron was
convicted of faking interest earnings and falsifying accounts. The
Board claims that KPMG, attempting to save money on what turned out
to be an underbid audit, cut corners by allowing junior staff
members to conduct certain areas of the audit and by not helping the
county solve its problem of a lack of internal controls with regard
to the investment pool. KPMG auditors did not speak with the county
treasurer regarding the investment pool, nor did they determine the
true market value of the highly leveraged and speculative
investments. KPMG paid a settlement of $75 million to Orange County
in 1998.
KPMG refutes the claims and
says the accountancy board wasted millions of dollars with the
goal of making KPMG a scapegoat. "The claims by the board
incorrectly challenge how KPMG reached its conclusions rather than
claim our conclusions were wrong," said KPMG spokesman George
Ledwith.
We don't hear from you very often
on the AECM, but when we do it is POW!
It's beginning to sound like we
need to take a closer look at the long-standing warnings from Abe Briloff
on the melt down of professionalism in public accounting.
I am president
of the Board of Directors of a higher education authority, which
provides secondary financing for student loans. By nature of that
position, I am chairman of the audit committee. From that experience, I
know that I do battle with the auditors annually. The auditors did not
see any reason to meet with the audit committee until they were
threatened with dismissal. I know that I have asked hard questions and
do not allow the auditors to take the easy way out. I am continuing
being told by the auditors that I am the only one asking these questions
and that I am wasting valuable time, especially for a small client. The
quality of the audit from the Big Five firm is of questionable quality.
I continually find mistakes, and for the last two of three years the
audit report draft was completely wrong. As I press hard, the auditors
annually let me know that the audit is a small audit ($100,000 annually
for the authority, and $35,000 for a subsidiary) and that there are more
valuable and worthwhile jobs to be done. Why is the authority using Big
Five auditors then? Because is required by the bond covenants. The Big
Five have worked hard to get all the publicly traded and SEC audit work,
but want to make more money through the big audits or consulting only.
In working with
the audit committee, I have found that real-world auditors don't know
what the standards or the profession require, only what that particular
Big Five firm requires. The real-world auditors do not want to know
those things because most of those auditors are putting in their time at
the Big Five in order to get a bigger paying job.
As an academic,
what can we do?
Roselyn E.
Morris, PhD, CPA
Associate Dean College of Business Administration
Southwest Texas State University San Marcos, Texas 78666-4616 Phone
(512)245.2311 Fax (512)245.8375 e-mail:
rm13@business.swt.edu
Time and time again, corporate executives who looted the
company put up a legal defense that the looting was approved by the crooked or
incompentent Board of Directors and Audit Committees that they themselves
appointed. When will the courts finally catch on to this scheme?
The Securities and Exchange
Commission's roundtable on proxy advisory firms last week was long
overdue. In July 2010, the agency asked for public comment about
these organizations in light of growing concerns that "proxy
advisory firms may be subject to conflicts of interest or may fail
to conduct adequate research and base recommendations on erroneous
or incomplete facts." Since then, silence.
Meanwhile, legislation including
"say on pay" has increased the power of proxy advisory firms,
especially the two biggest, Institutional Shareholder Services (ISS)
and Glass Lewis and Co. Like the bond rating agencies of the last
decade, these firms have been granted significant influence by the
SEC in the shaping of corporate governance policies for all U.S.
public companies. There is evidence that such influence may not be
for the better, as far as shareholder value is concerned.
Proxy advisory firms have become
prominent as the result of government regulations. In 2003, SEC
rules and related actions allowed institutional investors to rely on
advice from third-party advisory firms to fulfill their fiduciary
obligations when they voted their shares.
In prior years, Department of
Labor regulations had effectively established a mandate for all
institutional investors to vote their shares on all proxy issues.
But many institutional investment advisers lack the resources to
consider thoughtfully the hundreds or thousands (or more) of proxy
issues that come before them for a vote. As a result they rely
largely—or in many cases nearly exclusively—on the advice of proxy
advisory firms.
Research has consistently shown a
strong correlation between recommendations of proxy advisory firms
and proxy voting. The policies these firms prescribe also influence
decisions by the directors of public companies. But our research,
published in the Journal of Accounting and Economics, found that
when public companies implement certain "best practices" promulgated
by proxy advisers—in this case with regard to stock option exchange
programs—their gains in shareholder value are on average 50% to 100%
less than other firms.
The problem is that few proper
rules of corporate governance can be properly evaluated without deep
knowledge of a company and its management. Rule-based approaches,
such as those developed by proxy advisory firms, tend to be based on
"best practices"—better termed "one-size-fits-all best guesses"—that
have little or no relation to the specific strategic, competitive or
management situations facing individual companies. We are unaware of
any evidence from proxy advisory firms that their policy choices
benefit shareholders. Yet rule-based approaches are what the SEC has
effectively prescribed for institutional investors.
Another concern, even more basic,
is the current regulatory structure—which effectively requires all
institutional investors to vote their shares, prove that their votes
are not conflicted, and allows them to prove this by relying on
proxy advisory firms. Does this system help or hurt shareholders?
SEC Commissioners Daniel Gallagher and Michael S. Piwowar attempted
to raise this fundamental issue at the roundtable. Unfortunately,
there was little interest among the proxy advisers and institutional
investors, who dominated the meeting, to pursue the matter.
Equally unfortunate, there was no
direct representation of corporate directors on the panel, leaving
out the very people the law requires to be responsive to
shareholders. A thorough assessment of the impact of proxy advisers
(and proxy voting regulation) on all shareholders cannot be obtained
without understanding how corporate board members evaluate feedback
from proxy voting and turn it into action.
We suggest that regulators rethink
rules about when and how institutional investors are required to
execute shareholder votes. Yes, investors should vote their shares
if doing so is expected to increase shareholder value. But it is
surely worth considering what would happen if institutional
investors weren't required to vote in every election. Individual
investors have no such obligation.
The SEC should reconsider the
entirety of the shareholder voting process, including the mandate
that institutional investors participate in all corporate votes.
Institutional investors should be free to make judgments about when
it is in the interests of their shareholders to expend resources to
research and vote proxies. They also must demand that proxy advisers
ground their analyses and recommendations in sound, transparent
research that ensures enhancement of shareholder value.
Question
How much shareholder power exists in most corporations?
If
capitalism’s border is with socialism, we know why the world
properly sees the United States as strongly capitalist. State
ownership is low, and is viewed as aberrational when it occurs (such
as the government takeovers of General Motors and Chrysler in recent
years, from which officials are rushing to exit). The government
intervenes in the economy less than in most advanced nations, and
major social programs like universal health care are not as deeply
embedded in the US as elsewhere.
But these
are not the only dimensions to consider in judging how capitalist
the US really is. Consider the extent to which capital – that is,
shareholders – rules in large businesses: if a conflict arises
between capital’s goals and those of managers, who wins?
Looked at
in this way, America’s capitalism becomes more ambiguous. American
law gives more authority to managers and corporate directors than to
shareholders. If shareholders want to tell directors what to do –
say, borrow more money and expand the business, or close off the
money-losing factory – well, they just can’t. The law is clear: the
corporation’s board of directors, not its shareholders, runs the
business.
Someone
naïve in the ways of US corporations might say that these rules are
paper-thin, because shareholders can just elect new directors if the
incumbents are recalcitrant. As long as they can elect the
directors, one might think, shareholders rule the firm. That would
be plausible if American corporate ownership were concentrated and
powerful, with major shareholders owning, say, 25% of a company’s
stock – a structure common in most other advanced countries, where
families, foundations, or financial institutions more often have
that kind of authority inside large firms.
But that is
neither how US firms are owned, nor how US corporate elections work.
Ownership in large American firms is diffuse, with block-holding
shareholders scarce, even today. Hedge funds with big blocks of
stock are news, not the norm.
Corporate
elections for the directors who run American firms are expensive.
Incumbent directors typically nominate themselves, and the company
pays their election expenses (for soliciting votes from distant and
dispersed shareholders, producing voting materials, submitting legal
filings, and, when an election is contested, paying for high-priced
US litigation). If a shareholder dislikes, say, how GM’s directors
are running the company (and, in the 1980’s and 1990’s, they were
running it into the ground), she is free to nominate new directors,
but she must pay their hefty elections costs, and should expect that
no one, particularly not GM, will ever reimburse her. If she owns
100 shares, or 1,000, or even 100,000, challenging the incumbents is
just not worthwhile.
Hence,
contested elections are few, incumbents win the few that occur, and
they remain in control. Firms and their managers are subject to
competitive markets and other constraints, but not to shareholder
authority.
In lieu of
an election that could remove recalcitrant directors, an outside
company might try to buy the firm and all of its stock. But the
rules of the US corporate game – heavily influenced by directors and
their lobbying organizations – usually allow directors to spurn
outside offers, and even to block shareholders from selling to the
outsider. Directors lacked that power in the early 1980’s, when a
wave of such hostile takeovers took place; but by the end of the
decade, directors had the rules changed in their favor, to allow
them to reject offers for nearly any reason. It is now enough to
reject the outsider’s price offer (even if no one else would pay
more).
American
corporate-law reformers have long had their eyes on corporate
elections. About a decade ago, after the Enron and WorldCom
scandals, America’s stock-market regulator, the Securities and
Exchange Commission (SEC), considered requiring that companies allow
qualified shareholders to put their director nominees on the
company-paid election ballot. The actual proposal was anodyne, as it
would allow only a few directors – not enough to change a board’s
majority – to be nominated, and voted on, at the company’s expense.
Nevertheless, the directors’ lobbying organizations – such as the
Business Roundtable and the Chamber of Commerce (and their lawyers)
– attacked the SEC’s initiative. Lobbying was fierce, and is said to
have reached into the White House. Business interests sought to
replace SEC commissioners who wanted the rule, and their lawyers
threatened to sue the SEC if it moved forward. It worked: America’s
corporate insiders repeatedly pushed the proposal off of the SEC
agenda in the ensuing decade.
Then, in
the summer of 2010, after a relevant election and a financial crisis
that weakened incumbents’ credibility, the SEC promulgated election
rules that would give qualified shareholders free access to
company-paid election ballots. As soon as it did, the US managerial
establishment sued the SEC, and government officials felt compelled
to suspend the new rules before they ever took effect. The
litigation is now in America’s courts.
The lesson
is that the US is less capitalist than it is “managerialist.”
Managers, not owners, get the final say in corporate decisions.
Perhaps
this is good. Even some capital-oriented thinking says that
shareholders are better off if managers make all major decisions.
And often the interests of shareholders and managers are aligned.
Jensen Comment
This reminds me of the scandal I followed in the San Antonio Express
News when a young mother loved the income she made from being in the
U.S. Army reserve. She was another type of fair weather "friend." When
her unit was being shipped off to the Middle East in time of war, she
promptly resigned from the U.S. Army reserves and argued that, as a
single parent, she should not have to go to war because she was the
mother of young children.
Democracy is Not Entirely Dead Among Shareholders of Corporations
From the CFO.com Morning Ledger Newsletter on January 30, 2013
Activist investors are ramping up their fight
to reform the energy sector. Shareholders are getting fed up with
slumping share prices at companies they see as doling out excessive
pay and perks, writes
the WSJ’s Daniel Gilbert.
Hess is
the latest flashpoint. Shareholder Elliott Management plans to
nominate five directors for the company’s board, including one CFO —
Ultra Petroleum’s
Marshall Smith,
Reuters notes.
Elliott wants Hess to separate its holdings in North Dakota’s Bakken
Shale from its international properties and sell the business that
refines oil and sells gasoline. Investors cheered Elliott’s move,
sending Hess shares up 9% after the announcement.
Meanwhile,
Chesapeake Energy’s
Aubrey McClendon, who stepped down as chairman after a boardroom
coup in June, is giving up his job as CEO. McClendon cited
“philosophical differences” with a board that was installed by
shareholders to put a stop to his risk-taking and free-spending
ways,
the WSJ notes.
Investors are also challenging management at
drillers Nabors
Industries and
Transocean.
But Gilbert says the biggest battle is playing out at
SandRidge,
where TPG-Axon Capital is trying to take over the board. SandRidge’s
shares have lost about 90% of their value since 2008 and TPG isn’t
happy with SandRidge’s heavy spending – or the fact that CEO Tom
Ward was paid $25.2 million in 2011, more than four times his peers
at similar companies, according to ISS.
How much voting power lies in shareholder hands?
Teaching Case from The Wall Street Journal Accounting Weekly Review
on April 27, 2012
TOPICS: Executive Compensation, SEC, Securities and
Exchange Commission
SUMMARY: At Citigroup's annual meeting on April 17,
2012, shareholders voted not to support the company's executive
compensation plan. The article is written by Francesco Guerrera, the
WSJ's Money & Investing editor; this piece is an opinion item and
students are asked to identify that fact. The related video
specifically identifies the Citigroup executive pay proposal on
which shareholders voted as bad "corporate governance" both for
proposing that top management be given bonuses based on a low
threshold of performance and for poorly explaining the reason behind
that pay. Questions ask the students to access SEC filings of both
the proxy statement filed prior to the annual meeting and the report
of the results of the meeting.
CLASSROOM APPLICATION: The article is useful in any
class covering executive compensation and SEC disclosure in
undergraduate or graduate financial accounting or auditing classes.
3. (Introductory) Based on the discussion in the article,
what was the most significant outcome of the Citigroup annual
meeting?
4. (Advanced) How does the result of this shareholder vote
impact what Citigroup may pay its top executives? In your answer,
define the term "corporate governance."
5. (Introductory) Who is the author of this article? Do you
feel that the author's opinion on this matter is expressed in the
article? Support your answer.
Reviewed By: Judy Beckman, University of Rhode Island
Citigroup
Inc.'s C +0.59% shareholders have spoken but is anybody listening?
The
rejection of Citi's compensation plan at last week's annual investor
meeting is more than a stinging rebuke for its board and management.
Citigroup
Inc.'s C +0.59% shareholders have spoken but is anybody listening?
The
rejection of Citi's compensation plan at last week's annual investor
meeting is more than a stinging rebuke for its board and management.
Citigroup
Inc.'s C +0.59% shareholders have spoken but is anybody listening?
The
rejection of Citi's compensation plan at last week's annual investor
meeting is more than a stinging rebuke for its board and management.
Sure, Mr.
Pandit can share with Uncle Sam the credit for pulling Citi back
from the brink.
But Citi's
shares are down more than 88% since he took over. The stock has
underperformed not just healthier banks like J.P. Morgan Chase JPM
+1.46% & Co. and Wells Fargo WFC +1.45% & Co. but also fellow
problem child Bank of America Corp. BAC +0.12% And dividend
increases and share buybacks for Citi have been halted by
regulators, leaving shareholders with little to celebrate.
This is no
time for lucrative victory laps.
If the pay
bump is to compensate Mr. Pandit for two lean years, let's remember
that the decision to take $1 in salary was his. And that he received
at least $165 million in 2007 when Citigroup bought his hedge
fund—only to wind it down 11 months later amid mediocre returns.
The second
argument is that, with the profit-sharing arrangement, Citigroup's
directors sought to provide Mr. Pandit with "a financial incentive
to remain as CEO."
That's what
Citi's blog says. What it really means is that, after years during
which some regulators, directors and shareholders privately
questioned Mr. Pandit's leadership of the company, the board of
directors wanted to back him unequivocally.
That's
understandable but if directors are so confident in his ability,
they should set much more demanding performance targets.
Not once
has the board explained how it arrived at the $12 billion figure or
how it has calculated the profit shares of each executive.
Mr. Parsons
and fellow directors are at fault on this: They should have dealt
with shareholders' concerns long before last week's embarrassing
vote. Michael O'Neill, the banking veteran who replaced Mr. Parsons,
will have to pick up the pieces.
Mr.
O'Neill, who will also head the board's compensation committee,
should review the performance targets, discuss them with
shareholders and then change them.
My
suggestion: Set relative metrics that compare Citigroup's profits to
its peers; have more than one target, so different levels of
performance are compensated differently; and make sure that the
CEO's bonus is tied to more-demanding hurdles than his underlings.
Years of Creative Accounting by
CitiGroup My all-time heroes Frank Partnoy and Lynn Turner contend
that Wall Street bank accounting is an exercise in writing fiction:
Watch the video! (a bit slow loading) Lynn Turner is Partnoy's co-author
of the white paper "Make Markets Be Markets" "Bring Transparency to
Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute,
March 2010 ---
http://makemarketsbemarkets.org/modals/report_off.php
TOPICS: Audit Committee, Board of Directors,
Sarbanes-Oxley Act
SUMMARY: Due to the push for greater independence
of boards of directors from company managements, "just 19 [chief
financial officers] CFOs of fortune 500 companies sit on their own
boards, down from 37 in 2005....Eleven of those CFOs joined their
boards more than a decade ago, before the Sarbanes-Oxley Act of 2002
prompted U.S. stock exchanges to require that the majority of
public-company directors be independent...." Further, 'governance
advocates back the idea of fewer CFOs serving on their respective
company's board...[because it] calls into question the relationship
with the audit committee..."
CLASSROOM APPLICATION: The article helps students
to see the detailed impact of Sarbanes-Oxley on the structure of
boards of directors, particularly with respect to participation by
the top finance/accounting executive, the CFO.
QUESTIONS:
1. (Advanced) What are the responsibilities of a company's
chief financial officer (CFO)? Include in your list at least one
item required by Sarbanes-Oxley Act of 2002.
2. (Advanced) What are the responsibilities of a company's
board of directors? Of the audit committee of a board of directors?
3. (Advanced) What might be the benefit of having a CFO on
a company's board of directors? Consider the benefits if that CEO is
from the company itself and consider the benefits if that CEO is
from another company.
4. (Introductory) Based on the discussion in the article,
what factors weigh against having CFOs on the board of directors?
5. (Advanced) Given the difficulties of a CFO obtaining
board experience within his or her own company, what are the
implications for these executives to obtain positions on other
boards? How can a CFO overcome these obstacles?
Reviewed By: Judy Beckman, University of Rhode Island
Chief
financial officers serving as directors at their own companies are a
dying breed, thanks to a push for greater board independence.
Just
19 CFOs of Fortune 500 companies sit on their own boards as of
earlier this year, down from 37 in 2005, according to new research
by executive-recruiting firm SpencerStuart. And 11 of those CFOs
joined their boards more than a decade ago, before the
Sarbanes-Oxley Act of 2002 prompted U.S. stock exchanges to require
that the majority of public-company directors be independent, with
certain exceptions. The last appointment among the group came in
late 2009, when Milton Johnson was named a director of hospital
operator
HCA Holdings Inc.
HCA-2.37%
Corporate-governance experts don't expect the
CFO ranks to grow. Boards are more keen to appoint so-called
independent directors—those who don't have a connection to current
management.
Independent
boards are also seen as less likely to harbor an entrenched
management team that, for example, wants to avoid even attractive
mergers that would see them lose their jobs.
"Boards are
becoming much more independent each year," says Julie Daum, co-head
of SpencerStuart's North American board and CEO search practice.
Sarbanes-Oxley actually created a demand to recruit outside CFOs to
corporate boards to improve board audit and finance committees, but
that demand has subsided after an initial surge.
Governance
advocates, of course, back the idea of fewer CFOs serving on their
respective company's board.
Naming the
sitting CFO to the board of directors is "a waste of a board seat,"
says Paul Hodgson, chief research analyst for governance firm GMI
Ratings.
Including a
CFO on a corporate board calls into question the relationship with
the audit committee that oversees company financials and the CFO's
performance, Mr. Hodgson says. A better approach is to simply have
the CFO available for questions on an as-needed basis, Mr. Hodgson
adds.
The CEOs of
virtually all Fortune 500 companies are on the boards of their
respective companies, according to SpencerStuart's Ms. Daum.
Recent CFO
moves provide further evidence that finance chiefs are less likely
to serve on their own boards, at least until they retire.
Last
month,
Goldman Sachs Group Inc.
GS-1.22%
said CFO David Viniar would retire at the end
of the January and then become a director on the board.
Goldman on
Monday appointed Adebayo Ogunlesi to the board as the first of what
it expects to be two additional independent director appointments to
offset adding Mr. Viniar, who would be considered nonindependent.
Goldman declined to comment.
At
AOL Inc.,
AOL-0.25%
which isn't part of the Fortune 500, Karen Dykstra had to step down
as a board director in September to assume the role of CFO after
Artie Minson was promoted to chief operating officer.
AOL
Chief Executive Tim Armstrong says the company's board has had a
policy of allowing only its CEO to serve as a director ever since
its late-2009 spinoff from
Time Warner Inc.,
TWX-2.11%
so the matter of keeping Ms. Dykstra on the
board was never up for discussion.
But Mr.
Armstrong says he feels AOL's board will benefit both from the
continued counsel of Ms. Dykstra, and the new independent directors.
"The CFO is
an integral part of the board process," and sits in on the majority
of director meetings, Mr. Armstrong says.
Richard Galanti has held the top finance post of warehouse retailer
Costco Wholesale Corp.
COST-1.61%
since 1984, and joined its board in 1995. Mr.
Galanti says he brings perspective to the board, having been with
the company as it grew from four warehouse clubs to more than 600 in
the U.S. and overseas.
But he says
he understands the push for "good governance and good independence,"
and thought it would be unlikely that his successor would sit on the
board.
A majority
of Costco's directors are independent, he adds, and the company
believes its governance is both "pro-shareholders" and "pro-Costco."
Among
the 19 finance chiefs who sit on their company's board is
News CorpNWSA-2.01%
. CFO David DeVoe. He has been CFO and on the
News Corp. board since 1990. A spokesman for News Corp., which owns
Dow Jones and The Wall Street Journal, declined to comment.
Representatives for the other 18 companies either declined to
comment or didn't respond to inquiries.
Adam
Kovach, a member of SpencerStuart's financial officer practice, says
CFO candidates continue to ask about the possibilities of a board
seat at companies interested in hiring them, even though such a
discussion is "not even an option."
And
while there is still a market for CFOs on corporate boards, Mr.
Kovach says most companies want a director that has served on a
public-company board before, experience that they now have little
chance of obtaining at their employer.
Are
companies in denial when it comes to executives' annual bonuses for
2011? Judge for yourself.
Among 265
companies that participated in a newly released Towers Watson
survey, 42% said their shareholders' total returns were lower this
year than in 2010. No surprise there, given the stock markets' flat
performance in 2011.
Yet among
those that reported declining shareholder value, a majority (54%)
said they expected their bonus plan to be at least 100% funded,
based on the plan's funding formula. That wasn't much behind the 58%
of all companies that expected full or greater funding (see chart).
"It boggles
the mind. How do you articulate that to your investors?" asks Eric
Larre, consulting director and senior executive pay consultant at
Towers Watson. Noting that stocks performed excellently in 2010
while corporate earnings stagnated — the opposite of what has
happened this year — he adds, "How are you going to say to them, 'We
made more money than we did last year, but you didn't'?"
In
particular, companies would have to convincingly explain that annual
bonus plans are intended to motivate executives to achieve targets
for short-term, internal financial metrics such as EBITDA, operating
margin, or earnings per share, and that long-term incentive programs
— which generally rest on stock-option or restricted-stock awards,
giving executives, like investors, an ownership stake in the company
— are more germane to investors.
But such
arguments may hold little sway with the average investor, who
"doesn't bifurcate compensation that discretely," says Larre.
Rather, investors simply look at the pay packages as displayed in
the proxy statement to see how much top executives were paid
overall, and at how the stock performed.
Larre
attributes much of the current, seeming generosity to executives to
complacence within corporate boards. This year, the first in which
public companies were required to give shareholders an advisory
("say on pay") vote on executive-compensation plans, 89% received a
thumbs-up. But that came on the heels of 2010, when the S&P 500
gained some 13% and investors were relatively content with their
returns. "They may not be as content now," Larre observes. "I think
the number of 'no' say-on-pay votes will be larger during the 2012
proxy season."
TOPICS: Corporate Governance, SEC, Securities and
Exchange Commission
SUMMARY: The article describes the SEC's recent
change to rules "...under which investors can nominate candidates to
serve on boards of directors." This rule change allows individual
investors to propose amendments to corporations' bylaws and for
certain groups of small investors to propose members to boards of
directors. The proposals must be included in proxy statements sent
in preparation for annual meetings. These potential improvements to
corporate governance should provide better access for shareholders
to exercise their rights to "throw the bums out" when they think
that "corporate managers and directors are overpaid and
underperforming...." For instructors: introductory information about
the SEC is available on the web at
http://www.sec.gov/about/whatwedo.shtml; requirements for a
proxy statement is available on the web at
http://www.sec.gov/answers/proxy.htm
CLASSROOM APPLICATION: This is the second of two
articles this week on the corporate form of organization that should
be useful in introductory level undergraduate or MBA financial
accounting and reporting courses.
QUESTIONS:
1. (Advanced) Describe the corporate form of business
organization in comparison to two other forms, partnership and sole
proprietorship.
2. (Advanced) Are all U.S. corporations publicly traded?
Explain your answer.
3. (Advanced) In general, what is the role of the
Securities and Exchange Commission (SEC)?
4. (Advanced) What is a proxy statement? State your source
for this answer.
5. (Introductory) What significant change has recently been
introduced by the SEC in rules related to nominating boards of
directors? In your answer, define how these changes are meant to
improve corporate governance, including a definition of that term.
Reviewed By: Judy Beckman, University of Rhode Island
Goliath
hasn't been hit hard yet, but David is getting new slingshots.
The
unending struggle between the managers who control America's
corporations and the investors who own them is about to become more
interesting. It might even become a fairer fight.
Last fall,
the Securities and Exchange Commission clarified the rules under
which investors can nominate candidates to serve on boards of
directors.
In the
waning weeks of 2011, just in time to meet the 120-day advance
notice typically required to get onto the proxy ballot ahead of
springtime annual meetings, investors in 16 major
companies—including Goldman Sachs, Hewlett-Packard and Wells
Fargo—filed petitions to amend corporate bylaws to open up the
nominating process under the revised SEC rule.
Meanwhile,
networks are springing up online to rally investors large and small.
These websites could enable investors—anyone from a dogcatcher in
Dubuque with 100 shares to giant pension funds holding tens of
millions of shares—to mingle online and pool their dispersed power
as never before.
"Mechanisms
like these," says James McRitchie, who runs CorpGov.net, a
shareholder-activism site, "will eventually lead to the revolution
in corporate governance that people have been talking about for many
years."
Make that
"dreaming about." In theory, whenever corporate managers and
directors are overpaid and underperforming, investors should
exercise their rights and throw the bums out.
In
practice, most investors have long responded to bad management
either by sitting on their hands or by voting with their feet.
Breaking decades of inertia won't be easy.
If change
does come, it might be led by people like Kenneth Steiner and Argus
Cunningham.
Mr.
Steiner, 45 years old, is a private investor from New York's Long
Island who filed petitions at five companies late last year under
the new SEC rule. Over the past decade or so, Mr. Steiner estimates,
he has formally made several hundred proposals to improve how
companies are run—including simplifying the election of directors,
giving more say over how top executives are paid and eliminating
"poison pills" that can entrench management.
"It's up to
the small shareholders to get these things on the agenda," Mr.
Steiner says. "Institutional investors have been horribly negligent
in what I consider their fiduciary duty to the people who invest
with them and to the country in general. They don't want to ruffle
feathers, and they're cowards."
After all,
professional investors want to manage—or to keep managing—the
pension and 401(k) plans at the very companies whose stocks they
invest in. These folks aren't going to throw bombs at board members.
Using a
form he downloaded from proxyexchange.org, Mr. Steiner late last
year requested that the boards at Bank of America, Textron, Ferro,
Sprint Nextel and MEMC Electronic Materials amend their companies'
bylaws to permit any group of 100 or more shareholders who have held
at least $2,000 in stock for at least one year—or any holder of 1%
or more for at least two years—to nominate directors.
In recent
years, many of Mr. Steiner's proposals have been approved by a
majority of investors at companies' annual meetings. "It's sort of a
David and Goliath situation," he says, "but sometimes David wins."
Mr.
Cunningham, 36, is a former Navy pilot whose portfolio crash-landed
in 2008. "Losing a lot of money will cause you to re-evaluate your
role," he says. "You feel disempowered and disconnected even though
you are the owner of your companies, and I started thinking about
what I didn't like about the system."
Frustrated
by how hard it is to find other investors willing to shake up
moribund companies, Mr. Cunningham founded Sharegate. Likely to
launch later this year, the website will join others that seek to
rally shareholders, including United States Proxy Exchange,
ProxyDemocracy.org and Moxy Vote.
If you
think the directors at XYZ Corp. should be fired, you will be able
to circulate a throw-the-bums-out proposal on Sharegate with the
click of a mouse. Every other XYZ shareholder on the site will see
it immediately; you will promptly be able to tell whether they agree
with you.
Contrast
that with the status quo, in which you can't know what actions other
investors are prepared to take until your annual proxy statement
arrives—assuming that any grievances haven't already been quashed by
the company.
Continued in the article
Question
How much shareholder power exists in most corporations?
Buffett’s
reluctance to sell loser portfolio operating companies or fire under
performing managers means he has to make repetitive $5 billion Bank
of America and Goldman Sachs preferred stock plays to compensate for
tragic flaws like misplaced loyalty and day-to-day conflict
avoidance.
And then
there’s the numbers.
Berkshire
Hathaway is a publicly traded company, listed on the New York Stock
Exchange and regulated by the Securities and Exchange Commission.
The integrity of Berkshire Hathaway’s external financial reporting
should be ensured by the strictures of the Sarbanes-Oxley Act of
2002. Berkshire Hathaway and Warren Buffett, however, pay no more
than lip service to the requirements and reject many other
recommended corporate governance practices.
What’s left
– of the financial reporting process, the internal audit
organization, and the external audit relationship – is not enough,
in my opinion, to prevent someone from spinning straw into gold.
Questionable corporate political campaign finance practices and
foreign corrupt practices in the mid -1970s prompted the U.S.
Securities and Exchange Commission and the U.S. Congress to enact
campaign finance law reforms and the 1977 Foreign Corrupt Practices
Act (FCPA) which criminalized transnational bribery and required
companies to implement internal control programs. The Treadway
Commission, a private-sector initiative, was formed in 1985 to
inspect, analyze, and make recommendations on fraudulent corporate
financial reporting. The original chairman of the Treadway
Commission was James C. Treadway, Jr., Executive Vice President and
General Counsel, Paine Webber and a former Commissioner of the U.S.
Securities and Exchange Commission.
The
accounting industry regulator,
the PCAOB, tells us that existing auditing
standards are neutral regarding the internal control framework that
auditors use for obtaining an understanding of internal controls
over financial reporting (ICFR), testing and evaluating controls,
and, in integrated audits, reporting on ICFR. For integrated audits,
PCAOB standards state that auditors should use the same internal
control framework that management uses.
Since the
Committee Of Sponsoring Organizations of the Treadway Commission’s (COSO)
Internal Control-Integrated Framework (IC-IF) was published in 1992,
many companies and auditors have used IC-IF as their framework in
considering internal control over financial reporting. Also, since
companies and auditors began reporting on the effectiveness of ICFR
pursuant to §404 of Sarbanes-Oxley Act of 2002, many of those
companies and auditors have used IC-IF as the framework for
evaluating and reporting on ICFR.
Before
leading the Treadway Commission, before the savings and loan
scandals of the 1980’s, before Enron and the rest of the scandals of
the 90’s such as WorldCom, Tyco, Adelphia, HealthSouth, and many
others, James Treadway, SEC Commissioner, made a speech about
financial fraud. His remarks specifically mentioned corporate
structure, in particular a decentralized organizational structure,
as a common characteristic of companies involved in financial fraud.
I refer
to a decentralized corporate structure, with autonomous
divisional management. Such a structure is intended to encourage
responsibility, productivity, and therefore profits—all entirely
laudable objectives. But the unfortunate corollary has been a
lack of accountability.
The situation has been exacerbated when central headquarters has
unilaterally set profit goals for a division or, without
expressly stating goals, applied steady pressure for increased
profits. Either way, the pressure has created an atmosphere in
which falsification of books and records at middle and lower
levels became possible, even predictable. This atmosphere has
caused middle and lower level management and entire divisions to
adopt the attitude that the outright falsification of book and
records on a regular, on going, pervasive basis is an entirely
appropriate way to achieve unrealistic profit objectives, as
long as the falsifications get by the independent auditors, who
are viewed as fair game to be deceived.
Treadway
goes on to describe a company that’s almost an exact replica of
Berkshire Hathaway. What’s most troubling is that nearly thirty
years later there’s no excuse – lack of technology, real time
communications, or specific regulatory requirements - for these
conditions to still exist in a company of the size and systemic
importance of Berkshire Hathaway. The weaknesses remain by design,
not by default, which begs the question of whether they could serve
an illegal or unethical purpose at any time.
For decades
Fannie and Freddie behaved like other large, publicly held financial
corporations. They were profit-seeking companies, listed on the New
York Stock Exchange (NYSE). They displayed an unfettered drive for
greater sales, profits, executive bonuses and stock options for the
top brass. Their shareholders received dividends and rising stock
values.
These
so-called government sponsored enterprises (GSEs) dominated the
secondary mortgage market. The implied government backstop slightly
lowered their borrowing costs in return for a poorly enforced
obligation to facilitate a mortgage market for lower-income home
buyers. Otherwise, the GSE moniker meant little, since everybody
knew that, like Citigroup, Goldman Sachs and other Wall Street
giants, Washington viewed them as "too big to fail."
With the
onset of the subprime mortgage collapse, Fannie and Freddie went
down with the rest of the financial industry. The federal government
moved into high bailout gear during the latter half of 2008 with
three distinct rescue models for Wall Street and Detroit.
One model
provided capital and credit lines to Bank of America, Citigroup,
Morgan Stanley, J.P. Morgan Chase and AIG, leaving their
shareholders beaten down but intact to start recovering value.
The second
model dispatched General Motors into a well-orchestrated, stunningly
quick bankruptcy process. While the bankruptcy court treated the
common shareholders like flotsam and jetsam, GM emerged well
subsidized and tax-privileged with a clean balance sheet under
temporary ownership by the U.S. and Canadian governments and the
United Auto Workers.
The third
model placed Fannie and Freddie under an indeterminate
conservatorship scheme that kept but abused its common shareholders,
who had already lost up to 99% of their investment. Neither
vanquished nor given an opportunity to recover, the institutional
and individual shareholders are trapped in limbo.
Here is how
the scheme congealed. In return for providing an open credit line,
the government received warrants to buy up to 79.9% of the GSEs'
common stock for $0.00001 per share. The government's share stayed
under 80% to avoid forcing the liabilities of these two behemoths
onto the government's books. Treasury achieved this by having the
common shareholders nominally own the other 20%.
Here's the
rub: The zombie common shareholders have no rights or remedies
against Fannie and Freddie, both operationally active companies, or
their regulator—the Federal Housing Finance Agency. FHFA ordered the
Fannie and Freddie boards and executives to suspend communications
with shareholders and abolish the annual stockholders meeting.
In 2008,
then-Treasury Secretary Henry Paulson and Federal Reserve Chairman
Ben Bernanke told Fannie and Freddie investors that the companies
"are adequately capitalized." Moreover, another regulator, the
Office of Federal Housing Enterprise Oversight (Ofheo), assured
investors—including many mutual funds, pension trusts and small
banks—of the soundness of their investment.
Fannie
Mae's then-Senior Vice President Chuck Greener, backed by his
then-CEO Daniel Mudd, said, "We are maintaining a strong capital
base, building reserves for credit losses and generating solid
reserves as our business continues to serve the market." That was on
July 11, 2008.
These
former officials (both have since left Fannie Mae) should have known
better. On Sept. 8, 2008, when Treasury announced the
conservatorship, the GSEs' common stock dropped to pennies and the
shareholders realized they were misled.
Such
statements by private executives controlling a publicly traded
corporation should have prompted a Securities and Exchange
Commission investigation. Such was the betrayal of trust of
investors who were told for years that putting their money in these
GSEs was second only to investing in Treasury bonds.
Still, some
faithful shareholders, including me, held on, believing that they
might have a chance to recover something—as did their counterparts
in Citigroup, AIG and the rest of the rescued.
Then came
the cruelest and most unnecessary diktat of all. On June 16, 2010,
the FHFA directed Fannie and Freddie to delist their common and
preferred stock from the NYSE. The exchange did not demand this
move. True, Fannie had dropped slightly below the $1 per share
threshold stipulated by NYSE rules, but the Big Board is quite
flexible with time either to get back over $1 or to allow companies
to offer a reverse stock split. Freddie was comfortably over the $1
level. Why delist with one irresponsible stroke of the government's
pen and destroy billions of dollars of remaining shareholder value?
This move took the shares down to the range of 30 cents, chasing
away many institutional holders.
The Resignation of David Sokol: Mountain or Molehill for
Berkshire Hathaway? (PDF)
In 2011, David Sokol, CEO of
Berkshire Hathaway’s energy subsidiary, purchased $10 million of
Lubrizol stock days before recommending that Berkshire Hathaway acquire
the firm. Did Sokol’s actions reflect a broad governance failure for the
firm?
TOPICS: Auditing, Regulation, Sarbanes-Oxley Act, SEC,
Securities and Exchange Commission
SUMMARY: "A
combination of mergers, fewer U.S. IPOs, lower listing costs abroad
and a shift in how investors and stockbrokers do their jobs has
driven down the number of U.S. stock listings by a startling 43%
since the peak in 1997-all during a period when the number of
listings outside the U.S. has more than doubled." The article begins
by describing the LinkedIN Corp. executives participation in ringing
the opening bell on May 26; the ringing of the closing bell was done
by the head of Sybase in honor of a golf tournament, but that
company is no longer listed on the NYSE because it has been taken
over.
CLASSROOM
APPLICATION: Questions ask students to understand the overall
scenario described in the article as well as the impact of
regulation on companies undertaking listings on U.S. stock
exchanges. The article could be used in any course covering
regulation, such as auditing, and the role of stock exchanges, such
as a financial reporting class.
QUESTIONS:
1. (Introductory) Overall, what has been the trend in new
listings (initial public offerings, or IPOs) on U.S. stock exchanges
as described in this article?
2. (Introductory) Access the interactive graphic related to
the article. What are the locations of the stock exchanges competing
for major listings that are depicted in the graphic? Describe the
trend in activity on each of these exchanges and in total for the
time period covered.
3. (Introductory) What recent merger agreement has been
made by the company that owns the New York Stock Exchange (NYSE)?
What is the strategy behind that merger? (Hint: the related video
will be most helpful with this question.)
4. (Advanced) What is the impact of regulation, such as
complying with Sarbanes-Oxley, on companies' willingness to launch
IPOs on U.S. exchanges as opposed to elsewhere?
5. (Advanced) What other costs besides regulatory
compliance were cited by HaloSource, the Seattle-based
water-purification company, in deciding to list its shares in London
as opposed to listing in the U.S.?
Reviewed By: Judy Beckman, University of Rhode Island
Executives from LinkedIn Corp., reveling in
their enormously successful initial public offering last Thursday,
rang the New York Stock Exchange's opening bell. Big money, big
smiles, the kind of moment that made the NYSE the Big Board.
The day's closing ceremonies told a
different tale: The head of Sybase, in honor of a golf tournament it
sponsored, rang the bell to end the day's trading. The firm, having
been taken over by a European company, is no longer listed on the
Big Board.
The steady decline in the number of stocks
listed in the U.S. finally reached the point this year where both of
the nation's big stock exchanges took dramatic action—NYSE Euronext
agreeing to a foreign takeover, and then Nasdaq OMX Group trying
unsuccessfully to bust that up and take over the NYSE itself.
A combination of mergers, fewer U.S. IPOs,
lower listing costs abroad and a shift in how investors and
stockbrokers do their jobs has driven down the number of U.S. stock
listings by a startling 43% since the peak in 1997—all during a
period when the number of listings outside the U.S. has more than
doubled.
The result is some 3,800 fewer companies
trade on the U.S. exchanges today than in 1997, according to
consulting firm Capital Markets Advisory Partners. Abroad, there are
nearly eight times as many listings as in the U.S., with Hong Kong,
China and India among the leading venues.
"We're losing the ecosystem that has helped
buoy the U.S. economy over decades," said Kate Mitchell, co-founder
of Scale Venture Partners, a Silicon Valley venture-capital firm.
The U.S. exchanges aren't competitive for
some large global IPOs, according to Nasdaq Chief Executive Robert
Greifeld. "You see companies such as Prada who in the past would
list here in the States," he said in April, blaming in part a
"fractured message coming out of the U.S." as the two exchanges
compete fiercely against each other. Italy's Prada SpA plans to list
in Hong Kong. More From Deal Journal
NYSE's Niederauer on the Decline Nasdaq's
Greifeld on Global Competition for Stock Listings
U.S. exchanges will certainly continue to
attract some big IPOs. U.S. exchanges remain a draw for companies in
industries such as social media, where U.S. investors are willing to
pay a high price because they see a burgeoning profit opportunity.
Looming in future years are public offerings from companies like
Facebook Inc., Groupon Inc. and Twitter Inc. that are expected to be
as splashy as LinkedIn's debut or more so.
Large consumer-product companies with many
of their employees in the U.S. also tend to be more loyal to a U.S.
stock listing. And several smaller IPOs are on tap soon, such as
Spirit Airlines and Freescale Semiconductor Holdings.
But NYSE Euronext CEO Duncan Niederauer has
acknowledged that the heyday of U.S. exchanges in listing newly
public companies is long gone. It is one reason he has fought for
the deal to be acquired by Deutsche Börse AG, he said in an
interview last month.
NYSE executives say that being more global
will make them more attractive for emerging-market companies looking
to list their stocks somewhere in addition to their home markets,
and also will position the NYSE to be a better partner for exchanges
in emerging economies that want a joint venture or merger.
"The capital markets are global just like
every other industry," Mr. Niederauer said. "No matter what happens
in the U.S., there are 5,000 more public companies in China" coming
to the market in the next 10 to 15 years. Mr. Niederauer is expected
to be the head of the combined NYSE-Deutsche Börse if the deal is
approved by shareholders and regulators. U.S. antitrust officials
blocked Nasdaq's bid for the NYSE this month.
One of the leading reasons for U.S.
exchanges' difficulty in gaining more listings is a prolonged slump
in U.S. initial public offerings. The annual supply of U.S. IPOs
since 2000 has averaged just 156, down 71% from the pace in the
1990s, according to Capital Markets Advisory.
Some U.S. start-ups that in the past might
have turned to a U.S. exchange when they needed capital now list
abroad, where fees are lower and they don't face costs such as
complying with the Sarbanes-Oxley corporate-governance law.
Other closely held companies get capital by
borrowing, rather than going public, amid today's historically low
interest rates.
And many more private companies now simply
sell themselves to a larger company. In technology, especially,
cash-rich behemoths like Google Inc. and Intel Corp. are on the
prowl, making offers that start-ups and entrepreneurs find hard to
resist.
Skype Technologies SA filed for an IPO last
August and was headed for a listing on the Nasdaq Stock Market, but
this month the Internet phone company instead decided to sell itself
to Microsoft Corp. for $8.5 billion.
A Bay Area technology company called BigFix
Inc. worked on an IPO for nearly three years and had even selected a
Nasdaq ticker symbol. But amid a choppy stock market last summer,
plus an earlier hiccup in the company's growth rate, it dropped the
plan and accepted a buyout offer from International Business
Machines Corp.
Warren Buffet announced the sudden resignation of his heir apparent,
David Sokol, on March 30, 2011. Berkshire Hathaway shareholders,
fundamental style value investors,
law professors,
and
the business media have been talking about it ever since. However,
Buffett doesn’t want us to question him
further and is not willing to say anything more…
I
have held back nothing in this statement. Therefore, if
questioned about this matter in the future, I will simply refer
the questioner back to this release.
The Berkshire Hathaway Annual Meeting is typically a marathon of
openness and transparency. Buffet has been known to stay on stage at
the revival-style event, this year scheduled for April 30, for up to
eight hours. But Berkshire Hathaway has an Achilles heel. Buffett’s
storied forthcoming manner is not going to carry over to this case:
Alice Schroeder,
author of “The Snowball: Warren Buffett and the Business of
Life”: ORIGINALLY I didn’t think Buffett was going to entertain
questions on this subject at the meeting. I think he’ll talk
about it for maybe five or ten minutes in a statement at the
beginning of the meeting, much of which time will be a recap of
what happened. He could then cite litigation as a reason for why
he can’t have an open-ended discussion and take questions.
I’ve written several articles about this case because it fascinates
me to see an iconic figure stumble. Call it
schadenfreude.
Or just call it my natural cynicism. Either way, I’m gratified that
my first hunch – it’s not a case of insider trading but one of an
agent/fiduciary taking advantage of his trusted position to benefit
himself first – has been ratified.
When asked by
CNBC
what he’d learned from the controversy over the transaction,
Sokol responded:
“Knowing today what I know, what I would do differently is I
just would never have mentioned it to Warren, and just made my
own investment and left it alone…”
On
April 11,
Professor Stephen Bainbridge reconsidered his and others’ idea that
this was an “insider trading” case. His reconsideration is based on,
reportedly, an email from his co-author Bill Klein.
Professor Bainbridge doesn’t mention that I sent him an email on
April 8 in response to his March 30 post discussing the insider
trading theory and drawing his attention to my April 4th
post at Forbes. I asked him to consider the possibility that Sokol
had “usurped a corporate opportunity” and breached his fiduciary
duty to Berkshire Hathaway. Bainbridge never responded to me.
Bainbridge does not expand on the agency, fiduciary duty, and
usurpation theories until April 20, after the shareholder derivative
lawsuit is filed against Sokol and the Berkshire board for breach of
fiduciary duty. The suit also asks for disgorgement of Sokol’s gain
on his investment of Lubrizol stock.
In
the meantime, I wrote quite a few more more posts at Forbes and on
this site, including one about the lawsuit.
My
posts and links to my opinions were as follows:
So, what, you might ask, is wrong with Sokol taking a little bit
of the action ahead of his typically successful dealmaking for
Berkshire Hathaway? After all, as he told CNBC,
Charlie Munger did it.
…[C]orporate actors do not engage in criminal activity to
benefit the firms for which they work but to benefit themselves.
In some, but not all cases, these activities will benefit the
firms for which the corporate actors work. But the basic
motivation for the behavior is self-interest.
Professor Macey told me he doesn’t think this is an insider
trading issue at all unless Sokol failed to disclose his
interests and his trading to Berkshire, according to their
policies.
I
agree.
April 5:
I posted here at re: The Auditors about my April 4th
post at Forbes with some additional information including a link to
Sokol’s interview on CNBC:
I have developed and
taught a "Corporate Governance, Ethics and Business Sustainability"
course. All MBA students are required to take this course at the
University of Memphis. I am attaching the course syllabus and will
gladly share my PPT slides and other teaching materials.
Best,
Zabi
Zabihollah "Zabi" Rezaee, PhD, CPA, CMA, CIA,
CGFM, CFE, CSOXP, CGRCP, CGOVP
Thompson-Hill Chair of Excellence/
Professor of Accountancy Fogelman College of Business and Economics
300 Fogelman College Administration Bldg.
The University of Memphis
Memphis, TN 38152-3120
901.678.4652 (phone)
901.678.0717 (fax)
zrezaee@memphis.edu (e-mail)
https://umdrive.memphis.edu/zrezaee/www/
Comment Letter from 80 Professors Regarding Corporate Governance I submitted to the SEC yesterday a comment
letter on behalf of a bi-partisan group of eighty professors of law,
business, economics, or finance in favor of facilitating shareholder
director nominations. The submitting professors are affiliated with
forty-seven universities around the United States, and they differ in
their view on many corporate governance matters. However, they all
support the SEC’s “proxy access” proposals to remove impediments to
shareholders’ ability to nominate directors and to place proposals
regarding nomination and election procedures on the corporate ballot.
The submitting professors urge the SEC to adopt a final rule based on
the SEC’s current proposals, and to do so without adopting modifications
that could dilute the value of the rule to public investors. Lucian Bebchuk, Harvard Law School, on Tuesday August 18, 2009
---
Click Here
Abstract:
Abstract: This paper explores the effects of deregulation and
globalization on the dominant mode of corporate governance in
Swedish public firms. The effects are multidimensional - the
direction of change in corporate governance cannot be determined by
simply examining whether a convergence towards the Anglo-Saxon model
is occurring. Dispersed ownership with management control has not
proven to be a viable model of corporate governance for Swedish
listed companies. Instead, the control models with the most rapid
growth in the most recent decades are found outside the stock
market, notably private equity and foreign ownership. After a major
revival of the Swedish stock market its importance for the Swedish
economy is again in decline. Instead of adjustments in pertinent
institutions and practices to ensure effectiveness of the corporate
governance of Swedish public firms under these new conditions, a
great deal of endogenous adjustment of the ownership structure has
taken place.
How can
investors reel in pay and get more out of corporate bosses? Here's
one view: Kick the chief executive out of the boardroom.
When it
comes to the way corporate boards oversee chief executives--or, all
too often, fail to--few people have as many war stories to tell from
as many vantage points as Gary Wilson. He was Walt Disney Co. ( DIS
- news - people )'s chief financial officer and, as a director, the
subject of scorn when its board was twice ranked the worst in the
country. As a Yahoo ( YHOO - news - people ) director Wilson was
targeted by investor Carl Icahn, who sought to oust the board during
a 2008 failed shotgun marriage with Microsoft ( MSFT - news - people
). As a private equity guy he led the 1989 Northwest Airlines ( NWA
- news - people ) buyout along with Alfred Checchi.
So Wilson
can say, with more than a little credibility, that the boards
supposedly overseeing management are instead packed with lackeys
with appalling frequency. It's a familiar complaint but one that he
believes is responsible for out-of-control pay, the short-term greed
that helped spawn the recent financial meltdown and a staggering
waste of resources. Wilson's solution: Abolish the joint role of
chief executive and chairman and install independent bosses to
oversee boards.
"From what
I've seen, managers are interested in what goes into their pockets
and willing to use lots of leverage to add short-term profits, boost
the stock price and sell their options," says Wilson, 70. "Long-term
shareholders risk getting screwed."
The
Alliance, Ohio native has joined up with Ira Millstein, a Wall
Street attorney, and Harry Pearse, former General Motors general
counsel and Marriott Corp. director, to push for independent
chairmen. Their platform is the Millstein Center for Corporate
Governance at Yale.
Does
splitting the title benefit shareholders? Evidence is inconclusive,
but here's an indicator suggesting they're on to something: 76% of
the 25 bosses who rank lowest on our annual survey comparing
compensation to shareholder return hold dual titles. Only 44% of the
best 25 hold both titles. The dual players include Richard D.
Fairbank of Capital One, Ray Irani of Occidental Petroleum ( OXY -
news - people ), David C. Novak of Yum Brands and Howard Solomon of
Forest Labs. ( FRX - news - people ) Wilson and Pearse insist that
they saw boards transformed overnight from supplicants to
independents when the roles were separated at companies where they
were directors.
Boards
occasionally go through spasms of feistiness. In 1992 General
Motors' board ousted Robert Stemple as chairman, which led to
similar moves at American Express ( AXP - news - people ),
Westinghouse and other companies. But today only 21% of boards are
chaired by bona fide independents, says RiskMetrics Group, a New
York financial advisory firm that owns ISS Proxy Advisory Services.
In 43% of big companies the roles are ostensibly split, but the
chairman, says RiskMetrics, is an ex-chief executive or otherwise
defined as a company "insider."
In some
cases nothing less than corporate survival is at stake, Wilson
argues. He points to Lehman Brothers ( LEHMQ - news - people ),
where Richard Fuld was chief executive and chairman for 15 years and
where management took the sorts of big risks that ultimately sank
the firm.
Wilson
isn't against stock options but believes in tying them to long-term
returns with strike prices that rise at the rate of inflation plus
some risk premium, as he has done at some companies he has invested
in. That way management isn't rewarded just for showing up.
Independent
boards might also rein in pay. In Europe Wilson sat on KLM's
advisory board and says it's no coincidence that (a) chief
executives typically run a management board, which reports up to the
separate advisory board, and (b) pay is well below U.S. levels. At
many U.S. companies, he says, the combined boss often recruits board
members and then "directors feel obligated to the CEO/chairman, make
the friendliest member chairman of the compensation committee and
then hire a friendly consultant to do an analysis that favors high
management pay."
Continued in Article
Comment Letter from 80
Business and Law Professors Regarding Corporate Governance I submitted to the SEC yesterday a comment
letter on behalf of a bi-partisan group of eighty professors of law,
business, economics, or finance in favor of facilitating shareholder
director nominations. The submitting professors are affiliated with
forty-seven universities around the United States, and they differ in
their view on many corporate governance matters. However, they all
support the SEC’s “proxy access” proposals to remove impediments to
shareholders’ ability to nominate directors and to place proposals
regarding nomination and election procedures on the corporate ballot.
The submitting professors urge the SEC to adopt a final rule based on
the SEC’s current proposals, and to do so without adopting modifications
that could dilute the value of the rule to public investors. Lucian Bebchuk, Harvard Law School, on Tuesday August 18, 2009
---
Click Here
A book written by two Stanford Graduate School of Business alums
describing how leaderless organizations find their ideas has
resonated with groups ranging from the Tea Party to environmental
organizations. Their 2006 book, The Starfish and the Spider,
champions the strength and flexibility of autonomous organizations.
Jensen Comment
I'm not a great fan of political extremists on either side of most
issues (for example I support pay-as-you-go socialized medicine and a
new VAT tax despised by corporate executives), but this is an
interesting book on the nature of autonomous organizations in general.
Question
How is extreme bank leveraging now harming the greater society?
Question
If an executive has hedged the equity position, why does the board
continue to grant new equity and not cash?
Accounting
Pledge (and Hedge) Allegiance to the Company (PDF)
Many executives accumulate substantial dollar ownership in the firm
they manage as part of their compensation package. They may want to
limit their exposure by hedging a portion of the position through
financial instruments or pledging shares as collateral for a loan.
Can boards explain why they do or do not allow executive hedging?
asks Professor David Larcker. If an executive has hedged the equity
position, why does the board continue to grant new equity and not
cash?
It has been amazing to listen to the discourse over executive
compensation during the past year or so. On one side we have the
pure capitalists who tell us that government ruins everything,
neatly forgetting that unbridled capitalism exploits those with
little power and ignoring the fact that many CEOs do not provide
enough value to shareholders to justify their compensation. On the
other extreme we have those who trust government to cure all ills,
overlooking the idiocy of many bureaucrats and the possibility of a
dangerous slide toward totalitarianism. We shall not find a solution
at either end of this spectrum.
The Bush administration leaned toward the pure capitalists by
appointing Harvey Pitt and Christopher Cox to head the SEC. Both of
them slept during scandalous times, Enron and WorldCom occurring on
Pitt’s watch and the collapse of the banking industry on Cox’s. They
failed shareholders by allowing CEOs to run roughshod over the
investors.
The Obama administration wants to intervene by setting maximum
compensation levels for corporate managers and to regulate bonuses.
It may come as a shock to this administration and its supporters,
but neither Obama nor anybody on his team is omniscient. They just
do not have a sufficient knowledge of business and economics to
determine these parameters. In fact, some of the decisions already
made are so faulty that one wonders just how much economics anybody
in this administration understands (increasing the deficit by more
than the deficits produced by all previous presidents combined and
attempting to pass an energy tax during a recession are two
examples).
It is no wonder the public is starting to stir over the compensation
issue—some CEOs are indeed overpaid. While numerous current examples
exist, my favorite illustration remains Sprint in 2003. Somehow
Sprint CEO William Esrey and President Ronald LeMay finagled the
firm to give, and the board of directors to approve, so many stock
options that they made approximately $1.9 billion. Clearly, the two
of them did not add that much value to the firm! But the question is
what to do about these problems.
After lying dormant on this issue for years, the SEC on July 1 voted
5-0 to require business entities that received bailout money to
permit shareholders to vote on executive pay {http://www.sec.gov/news/press/2009/2009-147.htm}.
They also voted to require all SEC registrants to disclose more
information about executive compensation. These issues must still be
aired in public for two months before becoming final. This is a step
in the right direction as it attempts to deal with the issue but
without having Big Brother dictate the actual salary and bonus.
The SEC proposal is quite disappointing, however, because the vote
is nonbinding. Given that, I’m not sure what the point is. It is
almost as if they want to fail so that Big Brother will have to
intervene and set prices for all of us.
What the SEC and Congress and the President should be doing is
creating incentives and disincentives so that the economic system
would function more smoothly. They should stay out of the details
because they don’t have the knowledge to make the right decisions
and because we would like to keep some freedoms in our society.
Perhaps they should read Hayek’s The Road to Serfdom.
The central problem continues to be the enervation of shareholders
by the management class. We need to rectify this imbalance and
empower the shareholders to regain control over their own companies.
After all, they are the owners!
The other thing to do is to put some fire under the directors at
corporate enterprises. The board of directors supposedly represents
the shareholders, but often belies that point by assisting mangers
in their grab for power and wealth. The Congress could help by
enacting legislation that would allow investors to sue directors
when the directors abrogate their duties to the shareholders.
(Recall that the Supreme Court greatly restricted the liability of
directors in Central Bank of Denver v. First Interstate Bank of
Denver.)
Of course, the impotence of most boards of directors is frequently
the consequence of allowing managers to choose their buddies to be
on the board. “Independent directors” is a joke; I don’t if very
many of them are really independent. So another thing that should be
done is to give shareholders the right to vote for the directors.
And not with a manager-stacked deck of choices as if we lived in
some communist country. Give the shareholders the opportunity to add
candidates to the ballot. Again, they are the owners!
The executive compensation issue remains a hot-button item. But it
cannot be ignored by the pure capitalists nor remedied by the
governments’ controlling the price of labor. A more moderate
approach is appropriate. I think the key institution in this matter
is the board of directors. If empowered and if held accountable for
their decisions, I think the board of directors could properly
address the issue of executive compensation.
Little of the ire
against outsize C.E.O. paychecks has been aimed at the people who
signed off on them: corporate directors.
Instead, the anger
has been concentrated on the executives themselves, particularly
those running companies at the heart of the financial crisis. And
boards — thrust into the limelight only rarely, as when the
directors of the New York Stock Exchange were in a legal battle over
the pay collected by Richard A. Grasso — have managed to stay in the
background.
The exchange’s board
“really took a lot of heat for that controversy,” says Sarah
Anderson, an analyst on executive pay at the Institute for Policy
Studies in Washington. “But so far, with this crisis, I don’t feel
like boards have been getting as much attention as they should be.”
Last spring, the
House Committee on Oversight and Government Reform examined pay
practices at Countrywide Financial, Merrill Lynch and Citigroup, but
those issues eventually took a back seat to broader concerns about
the viability of the country’s financial system. As investors
frustrated by the continuing crisis start seeking ways to avoid the
next one, advocates of change in corporate governance expect boards
to come under renewed scrutiny that could yield big changes.
Emboldened
shareholder activists are pressing more companies to hold annual
nonbinding votes on executive pay packages. They’re also pursuing,
and appear increasingly likely to win, rules to make it easier for
investors to nominate or replace board members.
And as more people
start connecting the dots between pay incentives that boards laid
out for executives and the risk-taking at the heart of the financial
crisis, some lawmakers have been eager to step in, and many
directors themselves are re-examining their approach to
compensation.
“When you look at
cases where compensation of senior management was out of line, or
where people arguably were overpaid, it’s definitely the fault of
the compensation committee of the board,” says Thomas Cooley, dean
of the Stern School of Business at New York University and a
director of Thornburg Mortgage. “Congress has gotten into the
business of dictating executive pay now, and they shouldn’t be in
that business. What they should be doing is turning the light on the
committees.”
Activist
shareholders have been criticizing executive pay practices for well
over a decade, accusing directors of being too cozy with C.E.O.’s,
too eager to lavish pay on them and too ambiguous about the formulas
they use for setting compensation.
Improved standards
for determining director independence and disclosing the procedures
of board compensation committees were supposed to help solve those
problems. And activist shareholders played a major role in spreading
the notion of pay-for-performance, by which executives would be
compensated based on their ability to meet board-devised financial
targets.
But amid all the
changes, a crucial piece of the equation — the unintended risks that
could arise from these pay-for-performance incentives — went
unnoticed, said James P. Hawley, co-director of the Elfenworks
Center for the Study of Fiduciary Capitalism at St. Mary’s College
of California.
“The problem isn’t
just when people in a particular firm are getting rewarded in ways
that take away from the shareholder. That’s been well recognized,”
Mr. Hawley says. “What’s not been recognized is that the
misalignment of incentives has resulted in firm, sector and systemic
risks. None of the corporate governance activists ever made the
connection.”
It took the
disastrous results of 2008 to expose such links, and to make
compensation a central issue for politicians and corporate America.
TWO factors
contributed to the pay scales that now have C.E.O.’s earning more
than 300 times the pay of the average American worker.
First was the advent
of giant stock option grants, a form of compensation made all the
more attractive by a 1993 change to the tax law that maintained
corporate tax deductions for executive pay over $1 million, but only
if the pay was tied to performance.
Second was the
widespread practice of linking pay to the levels at companies of
similar size or scope. Every time a board tries to keep an executive
happy by offering above-average pay, the net effect is to raise the
average that everyone else will use as a baseline.
In the absence of
fraud or self-dealing, it’s hard for shareholders to make a legal
argument that boards have failed at their job. State law in
Delaware, where most big public entities are incorporated, simply
requires companies to have boards that direct or manage their
affairs, and it affords broad legal protection to board members so
long as they act in good faith and in a manner “believed to be in or
not opposed to the best interests of the corporation.”
That was the basis
for the recent ruling of a Delaware judge who threw out most of the
claims in a shareholder lawsuit seeking to hold Citigroup directors
and officers liable for big losses tied to subprime mortgages. But
the judge did allow the plaintiffs to pursue one of their claims,
which alleged corporate waste stemming from a multimillion-dollar
parting pay package that Citigroup’s board awarded Charles O. Prince
III, the former C.E.O., in 2007.
As we try to
understand why our economy is so troubled, fingers are increasingly
being pointed at the academic institutions that educated those who
got us into this mess. What have business schools failed to teach
our business leaders and policy makers? There are three profound
failures of sound business practices at the root of the economic
crisis, and none of them have been adequately addressed by our
business schools.
Just about everyone
agrees that misaligned incentive programs are at the core of what
brought our financial system to its knees. Countless individuals
became multimillionaires by gambling away shareholders' money.
Incentive systems that rewarded short-term gain took precedence over
those designed for long-term value creation.
We could chalk this
all up to greed, as many pundits have. But first we should ask how
many of the business schools attended by America's CEOs and
directors educate their students about the best way to design
management compensation systems. Amazingly, this subject is not
systematically addressed at most business schools, and not even
discussed at others.
Secondly, as
Washington scrambles to restructure the financial regulatory system,
those who still believe in the private sector are asking why
corporate boards were AWOL as institution after institution
crumbled. Why did it take rumors of nationalization and a drop in
Citicorp stock to below $2 a share to inspire Citigroup to nominate
directors with experience in financial markets?
American icon
General Electric was stripped of its coveted AAA-rating because of
problems emanating from its financial services unit. Yet its board
has only one director with experience in a financial institution. If
it is the board's job to oversee a corporation, it seems logical
that there would be a segment in the core curriculum of every
business school devoted to board structure, composition and
processes. But most programs don't cover the topic.
The third breakdown
came in the investment community. Nearly 20 years ago I wrote a book
titled "Short-Term America" that warned about the growing chasm
between those who provide capital and the companies who use it. The
concept is simple: When money provided to homeowners or businesses
comes from an anonymous source, possibly half way around the world,
there are serious challenges to operating a functioning system of
accountability.
Nationally, finance
departments at business schools offer hundreds of courses in asset
securitization and portfolio diversification. They have taught a
generation of financial leaders that risk can be diversified away.
But in their B-school days, few investment bankers examined the
notion of "agency costs." That concept explains that as the gulf
between the provider and the user of capital widens, the risks
involved with selecting and monitoring the participants in the
portfolio increase. It should come as no surprise that financial
institutions amassed securities that consist of a diversified
portfolio of deadbeats.
About 70% of the
shares of American corporations are held by institutional investors
such as pension and mutual funds. These organizations are brimming
with MBAs. But how many of these MBAs took a class devoted to how
shareholders should exercise their rights and obligations as the
owners of America's corporations? Few, if any. When shareholders are
uneducated about their obligations, how can a corporate
accountability system function properly?
Recently, when I
delivered a guest lecture at another school, a distraught-looking
student pulled me aside after class. She explained that my talk was
very disturbing to her. After investing two years and $100,000, she
was only weeks away from receiving her MBA. But prior to our class,
she had never heard a discussion about board responsibilities or the
rights of shareholders. She said she felt cheated.
By failing to teach
the principles of corporate governance, our business schools have
failed our students. And by not internalizing sound principles of
governance and accountability, B-school graduates have matured into
executives and investment bankers who have failed American workers
and retirees who have witnessed their jobs and savings vanish.
Most B-schools paper
over the topic by requiring first-year students to take a compulsory
ethics class, which is necessary, but not sufficient. Would Bernie
Madoff have acted differently if he had aced his ethics final?
Could we have
avoided most of the economic problems we now face if we had a
generation of business leaders who were trained in designing
compensation systems that promote long-term value? And who were
educated in the proper make-up and responsibilities of boards? And
who were enlightened as to how shareholders can use their proxies to
affect accountability? I think we could have.
America's business
schools need to rethink what we are teaching -- and not teaching --
the next generation of leaders.
Mr. Jacobs, a professor at the
University of North Carolina's Kenan-Flager Business School, was
director of corporate finance policy at the U.S. Treasury from 1989
to 1991.
Jensen Comment
I don't think Bernie Madoff would've behaved differently if he aced five
courses in ethics. Ethics failures are largely situational and relative
based upon motive, opportunity, and a follow-the-herd mentality.
Students should learn more about ethics and corporate governance, but
there's a great danger in relying too much on college courses in the
area of ethics and responsibility. More important are such things as the
tone at the top and strengthening whistleblower laws and rewards ---
http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing
SUMMARY: The
article assesses the situation of two companies associated with
financial difficulties: Crown Media, 67% owned by Hallmark Cards,
and Clear Channel Outdoor, 89% owned by Clear Channel Media. In the
latter case, the entity in financial difficulty is the owner
company. Questions ask students to look at a quarterly filing by
Crown Media, to consider the situation facing noncontrolling
interest shareholders, and to understand the use of earnings
multiplier analysis for pricing a security.
CLASSROOM APPLICATION: The
article is good for introducing the interrelationships between
affiliated entities when covering consolidations. It also covers
alternative calculations of, and analytical use of, a P/E ratio.
QUESTIONS:
1. (Introductory)
Access the Crown Media 10-Q filing for the quarter ended March 31,
2009 at
http://www.sec.gov/Archives/edgar/data/1103837/000110383709000008/mainform5709.htm
Alternatively, click on the live link to Crown Media in the WSJ
article, click on SEC Filings in the left hand column, then choose
the 10-Q filing made on May 7, 2009. Describe the company's
financial position and results of operations.
2. (Advanced)
Crown Media's majority shareholder is Hallmark Cards "which also
happens to be its primary lender to the tune of a billion
dollars...." Where is this debt shown in the balance sheet? How is
it described in the footnotes? When is it coming due?
3. (Advanced)
What has Hallmark Cards proposed to do about the debt owed by Crown
Media? What impact will this transaction have on the minority Crown
Shareholders?
4. (Advanced)
Do you think the noncontrolling interest shareholders in Crown Media
can do anything to stop Hallmark Cards from unilaterally
implementing whatever changes it desires? Support your answer.
5. (Introductory)
Refer to the description of Clear Channel Outdoor. How is the
company's share price assessed? In your answer, define the term
"price-earnings ratio" or P/E ratio and explain the two ways in
which this is measured.
6. (Advanced)
What does the author mean when he writes that "anyone buying Outdoor
stock should remember that" the existence of a majority shareholder
with significant debt holdings also could pose problems for an
investment?
Reviewed By: Judy Beckman, University of Rhode Island
Investing in a company controlled by its
primary lender can be hazardous. Just ask shareholders in Crown
Media.
Owner of the Hallmark TV channel, Crown is
67%-owned by Hallmark Cards, which also happens to be its primary
lender to the tune of a billion dollars. With the debt due next
year, Hallmark on May 28 proposed swapping about half of its debt
for equity, which would massively dilute the public shareholders.
Crown's stock, long supported by hope that the channel would get
scooped up by a big media company, is down 36% since then.
Helping feed outrage among some
shareholders was the fact that the swap proposal comes as the
Hallmark Channel was making inroads with advertisers. Profits were
on the horizon.
Clear Channel Outdoor holds parallels. The
billboard company owes $2.5 billion to Clear Channel Media, its 89%
shareholder, a fraught situation for Outdoor's public holders.
In this case, of course, the parent is in
financial distress. Hence the significance of Outdoor's
contemplation of refinancing options, which could lead to the loan
being repaid. The hope among some investors is that events conspire
to prevent that, forcing the parent into bankruptcy and putting
Outdoor up for auction.
That could bail out shareholders. At $6.36
a share at Friday's close, Outdoor's enterprise value is roughly 9.8
times projected 2009 earnings before interest, taxes, depreciation
and amortization, below Lamar Advertising's 10.9 times multiple.
Using 2010 projections and an equivalent multiple implies a share
price above $10.
But as Crown showed, the interests of a
majority shareholder who doubles as a lender don't necessarily
coincide with minority holders. Anyone buying Outdoor stock should
remember that.
2009 Teaching Cases in Corporate
Responsibility and Compensation
Topic:
Corporate Responsibility
The markets are down and the economy is in a recession. The
causes are complex and varied, but many people are focusing the
blame on a breakdown in corporate responsibility. How much
corporate directors and executives are to blame remains
debatable, but most would agree that the investing public has
lost confidence in the corporate governance and ethics of boards
and executives.
The following articles present some of the reactions and
consequences resulting from the leadership lapses reported
recently. Current and future business professionals need to be
aware of the consequences that will impact all businesses and
industries, regardless of whether those businesses have acted
improperly. Additionally, all in the business world must deal
with negative perceptions the investing public now has of boards
and corporate activity. On a positive note, with the widespread
lack of confidence in the markets, fiscally and
ethically-responsible companies can use that reputation to
develop a distinct advantage in the marketplace. This month's
articles highlight some of the recent ethical and leadership
lapses, as well as the public outcry and emerging rules and
regulations resulting from those decisions. Regardless of your
position or industry, there are important lessons to be learned
and shared so that you and your organizations are not punished,
but instead thrive.
SUMMARY: Policy makers are advancing plans to give
shareholders more power in boardrooms at a time when decisions
about executive pay have ignited a public furor.
DISCUSSION:
What measures are policy makers considering that would
provide shareholders with additional rights in corporate
governance? What authority and interests do each of these
policy-making groups have in the governance arena? Why are
corporations regulated by many different bodies?
What are proxies and why are they a point of contention
between corporations and shareholders? What are the pros and
cons of shareholder access to proxies? Why are shareholder
rights so important? Up to this point, what parties have had
most of the control over a corporation? What are some
reasons that these types of rules were not enacted sooner?
What could be some unintended negative consequences of
these new laws and rules? What are the costs involved? Would
small and medium-sized businesses impacted by these rules?
How does this information impact your attitudes and concerns
regarding your current and future investment decisions? What
are some of the cumulative effects of those concerns when
held by millions of shareholders?
SUMMARY: Government-appointed lawyer James Cole has been on
site and inside AIG board-committee meetings for the past four
years, but his reports to regulators aren't public.
DISCUSSION:
What is a deferred-prosecution agreement? Why would
companies agree to this? What are the costs involved versus
the corresponding benefits? Why would the government agree
to one of these agreements? Why do these agreements seem to
be more common today than they have been in the past?
What AIG activities led to its deferred-prosecution
agreement? What have been the duties of the
government-appointed attorney? How were day-to-day
operations affected by the agreement? Have these activities
corrected the problems that triggered the government actions
at AIG? Were they meant to prevent further problems as well?
Are deferred-prosecution agreements effective tools for
punishing and preventing negative corporate activity? Should
similar plans be implemented for currently troubled
companies? Please give reasons for your answers.
FOCUS ARTICLE>> Corporate Governance, Director Responsibility
SUMMARY: A directors' trade group in a new report urges
boards to do a better job of governing corporate America.
DISCUSSION:
What is the NACD and what is its purpose? What is the
reasoning for its new report and why was the report issued?
What specific suggestions does it contain? What is your
opinion of the ideas presented in the report? Do you think
that these ideas will restore investor confidence? Why or
why not?
What is the purpose of a corporate board of directors?
What are its duties and responsibilities? Why is the board
so important? Why do business professionals serve on boards?
Have any of these ideas been implemented at one of your
past or current employers? What other ideas could be
implemented to increase corporate governance at your current
employer or other companies?
SUMMARY: Furor over big AIG bonuses and other Wall Street
firms is prompting nonprofits to brace for more scrutiny of
their executive pay practices.
DISCUSSION:
What nonprofit industries and organizations are being
impacted by the increase in scrutiny? What are some of the
positive outcomes that could result from this closer
examination of nonprofits? What would be some negative
outcomes from these current pressures?
Corporations are facing increased scrutiny as a result
of the market meltdown. Why are nonprofits also feeling
pressure from additional scrutiny for compensation and other
expenses? How are nonprofits different from profit-seeking
entities? Should they be held to the same standards? Why or
why not?
How might this additional scrutiny impact nonprofits?
How might your career, business, or industry be affected by
increased scrutiny of nonprofits? How will you be affected
personally, either through services you receive or donations
that you make?
SUMMARY: Geithner will call for changes in how the government
oversees risk-taking in financial markets, pushing for tougher
rules on how big companies manage their finances.
DISCUSSION:
What changes is Geithner proposing? What ideals would
this new regulation support? Do you think that the newly
proposed rules would achieve these goals? Are there other
ways to achieve those same goals?
Why is Geithner calling for changes in the regulation of
risk management? What will be the costs to industry for this
new government oversight? Who will pay these costs, both
directly and ultimately?
How will these rules change your current or future
industry and career? How could these rules impact you as an
investor?
The
rules that the statute imposes for selection of the members of the
committee give no guarantee that the right people will be found to serve
onit. Indeed, many eminent professors of accounting cannot serve on
audit committees because they do not have the requisite level of
practical experience. Richard Epstein, "In Defence of theCorporation,"
December 2004 --- http://www.nzbr.org.nz/documents/publications/publications-2004/in_defence.pdf
Jonathan Macey is Deputy Dean and
Sam Harris Professor of Corporate Law, Corporate Finance, and
Securities Law at Yale Law School. He is the author most recently of
Corporate Governance: Promises Made, Promises Broken (Princeton
University Press, 2008) available at
http://www.amazon.com
The Icahn Report has
exposed: (1) abuses in the use of golden parachute agreements; (2)
many of the false premises behind the faulty assumption that
corporate elections are "democratic" event that legitimize corporate
boards; (3) the entrenchment effects of staggered boards of
directors and, most importantly perhaps; (4) the sheer corruption of
law and morality that is represented by the continued legality and
adoption of poison pill defensive devices.
In my next two blog
postings I would like to bring my own, admittedly academic
perspective to two topics that are, I believe, highly relevant to
the agenda of this blog. The first topic is the problem of "board
capture" among boards of directors of public companies. The second
is the general problem with shareholder democracy caused by defects
in the shareholder voting process.
Director Capture
In the academic
world, particularly among political scientists and economists,
"capture" occurs when decision-makers such as corporate directors
favor certain vested interests such as incumbent management, despite
the fact that they purport to be acting in the best interests of
some other group, i.e. the shareholders. The problem of capture and
the theories associated with the idea of capture are most closely
associated with George Stigler, and the free-market Chicago School
of Economic thought. Among the more interesting and important
theories of Stigler and other proponents of capture theory is the
idea that capture is not only possible, in many contexts it is
inevitable.
In my recent
Princeton University Press book "Corporate Governance: Promises
Made: Promises Broken" I apply capture theory, which is usually used
to describe and model the behavior of bureaucrats in the public
sector, to the directors of publicly traded companies who come to
their positions through the board nominating committee.
In my view, such
directors are highly susceptible to capture… even more susceptible
than bureaucrats and politicians. Capture is inevitable because
management controls the machinery of the corporate election process.
Management's narrow interest in having passive and supportive boards
manifests itself in the appointment of docile directors who are
likely to support management's initiatives and unlikely to challenge
management or to demand that managers earn their compensation by
maximizing value for shareholders.
The extension of
capture theory to corporate boards of directors is supported not
only by foundational work in political science and economics but
also by important work in social psychology. Directors participate
in corporate decision-making. In doing so, these directors, as a
psychological matter, come to view themselves in a very real way as
the owners of the strategies and plans that the corporation pursues.
And of course, these plans and strategies inevitably are proposed by
incumbent management. Thus, directors inevitably risk simply
becoming part of the management "team" instead of the vigorous
outside monitors and evaluators that they are supposed to be.
Management’s persistent support of and acquiescence in the proposals
of management consistently renders directors incapable of
objectively evaluating these strategies and plans later on. Of
course this is not the case when the directors represent hedge funds
or other large investors who have a large financial stake in making
sure that the company prospers.
Another factor
leading to board capture is the fact that boards of directors have
conflicting jobs. They are supposed not only to monitor management,
but also to select and evaluate the performance of top management.
After top managers have been selected, the boards of directors
making the selection decisions are highly likely to become committed
to these managers. For this reason, as board tenure lengthens, it
becomes increasingly less likely that boards will remain
independent.
The theory of
"escalating commitments" predicts that decision-makers such as
corporate directors will come to identify strongly with management
once they have endorsed the strategies and decisions made by
management. Earlier board decisions supporting management, once made
and defended, will affect future board decisions such that later
decisions comport with earlier decisions. As the well-respected
Cornell psychologist Thomas Gilovich has shown, "beliefs are like
possessions" and "[w]hen someone challenges our beliefs, (for
example the belief of directors that management is highly competent)
it is as if someone [has] criticized our possessions."
The cognitive bias
that threatens boards of directors and other proximate monitors is a
manifestation of what Daniel Kahneman and Dan Lovallo have described
as the "inside view." Like parents unable to view their children
objectively or in a detached manner, directors tend to reject
statistical reality (such as earnings performance or stock prices)
and view their firms as above average even when they are not. The
first step in dealing with the problem of board capture is to
recognize that the problem exists.
Boards should be
free to choose whether they wish to be trusted advisors of
management or whether they want to be credible monitors of
management. They can’t be both. We should stop pretending that they
can.
One policy proposal
would be for companies to have two boards of directors (as they do
in Germany and the Netherlands), one for monitoring and one for
assisting in the management of the company. Firms that decide to
retain the single board format should be required to choose whether
their board should devote itself to "monitoring" (or supervising)
management or to advising (or managing along with) the company’s CEO
and the rest of the management team. The farce that board can do
both should end.
Boards that purport
to monitor or supervise management should be held to an extremely
high standard of independence. Management should not be involved in
any way in the recruitment or retention of these board members.
Socializing and gift-giving should be prohibited. And, of course,
managers themselves should not be allowed to sit on monitoring
boards. Managers should not be allowed to serve as the chairmen of
monitoring boards.
Independence
standards should be relaxed for the boards of companies that elect
to participate in management. Decisions that involve a conflict
between the interests of shareholders and the interests of
management should be subjected to close scrutiny. Such decisions
include decisions about executive compensation of all kinds,
particularly bonus and severance payments, as well as decisions
about such things as the adoption of staggered terms for the board
or the adoption of a poison pill rights plan.
How to Prevent Corporate and Other
Organizational Cheating
Moore explains how
auditors can go from behavior that is technically correct but ethically
borderline to outright corrupt in just a few years. First, the auditor
sees the client doing something that’s just on the edge of
permissibility and doesn’t say anything. The next year, the client
pushes just a bit further, this time over the line. Now the auditor
doesn’t confront the client about it, since the practice is so similar
to the one that went unremarked the previous year. By the third year,
the client’s practice is clearly wrong, but the auditor realizes that to
challenge it would be to admit mistakes in previous audits. And by the
fourth year, the auditor is actively engaged in a coverup with the
client to prevent the corrupt practice from being discovered.
WHEN A CORPORATE
SCANDAL throws a company into crisis or even destroys it, many
onlookers’ reaction is that the people involved must have been
immoral. Certainly they, the onlookers, would never become involved
in cooking the company books, approving mortgages without proper
documentation, or lying to customers about a product’s capabilities.
Yet it’s
easier than most people realize for ordinary, well-meaning people to
get caught up in activities they should have known were wrong. These
activities do “real harm to real people,” says GSB accounting
Professor Maureen McNichols, who
teaches an elective course called Understanding Cheating. Among
other things, the course helps students see how good leadership and
the right organizational structure can cut down on the opportunities
for corruption.
Creating a structure
that reduces the chances of cheating requires a balancing act:
between too few controls and too many, and between understanding why
people cheat and intolerance for such behavior.
Many people,
including students at business schools, resist discussing how the
influence of a group or a situation can lead good people to do bad
things. It seems to excuse the behavior, and they want individuals
to be held accountable for their actions. But research indicates
that leaders who don’t acknowledge that group pressure exists—so
they can use that understanding to promote an ethical organizational
culture and appropriate controls—may be setting their organizations
up for corruption.
“I would say that
there are some people who are just flat-out corrupt: They would
steal the offering from the church plate,” says Douglas Brown, MBA
’61, who was named treasurer of the state of New Mexico in 2005
after a corruption scandal led to the indictment of the two previous
treasurers. But there’s a much larger group who are deeply
conflicted about what to do and finally “just kind of tunnel under
and put up with it.”
Brown didn’t fire
everyone who had had a hand in his department’s corrupt practices.
For example, an employee who was asked by her boss to send out
invitations to a golf tournament “which was basically lining the
pockets of the state treasurer” was kept on.
Just as posting
speed limit signs and exhortations that “Speed Kills!” will do
little to reduce speeding if the police aren’t issuing tickets, so
businesses need controls and independent auditors to rein in
potential cheating. But “too many controls can breed enormous
inefficiencies,” Brown says, causing business to grind to a halt.
“This is a common managerial problem: You have to trust your people
and empower them” while still monitoring what they’re doing.
The idea that
ordinary, good people can end up involved in corruption is
counterintuitive to some. “We underestimate the power of a situation
to control people’s actions,” says GSB organizational behavior
Professor Deborah Gruenfeld. “Most of us believe we’re much more
auto-nomous than we are.”
Social science
research suggests leaders need to take into account group power,
organizational structure, rationalization, and fear and confusion.
• GROUP POWER. If
the supervisor of the storeroom notices supplies are disappearing
fast, he or she is likely to remind coworkers that too many people
are stealing. That’s exactly the wrong approach to take,
psychologist Robert Cialdini of Arizona State University told
researchers at a recent Business School conference. In an experiment
in Petrified Forest National Park in Arizona, Cialdini placed signs
at entrances asking people not to take home petrified wood. The sign
at one entrance showed three thieves with an X over them, while at
another entrance, the sign depicted just one thief. The latter was
far more effective at reducing theft.
“You want to alert
people to the extent of a problem as a way of mobilizing them
against it,” Cialdini says. But when you emphasize how common
cheating is, “there’s a subtext message, which is that all of your
neighbors and coworkers are doing this. And if there’s a single,
most primitive lever for behavior in our species, it’s the power of
the crowd.”
• ORGANIZATIONAL
STRUCTURE. “My lifetime’s work in business ethics suggests that
business corruption has everything to do with culture and with
incentives,” says Kirk Hanson, MBA ’71, executive director of the
Markkula Center for Applied Ethics at Santa Clara University and an
emeritus GSB faculty member.
For example, Don
Moore, associate professor of organizational behavior and theory at
the Tepper School of Business at Carnegie Mellon University, has
written about how the relationship between accounting firms and
their clients “makes it impossible for auditors to be objective,
given what we know about human psychology.” Auditors want smooth
working relationships with their clients, and they don’t want to be
fired, so they have an incentive not to ask awkward questions.
Executives may also
“look the other way when a salesperson overpromises,” Cialdini says.
They may ignore exaggeration in the company’s marketing materials or
use proprietary information gained from one vendor in negotiation
with another.
Actions speak louder
than words. “You can’t dupe people by saying, ‘This is what we stand
for,’ when promotions are based on something else,” Gruenfeld says.
• RATIONALIZATION.
Because people generally want to view themselves as ethical, they
will reframe a situation to justify their actions, says Elizabeth
Mullen, assistant professor of organizational behavior at the GSB,
whose courses on negotiation and organizational behavior include
ethics topics. “The division of labor required for much corporate
work, with many people contributing a small amount to a project,
makes this easier. For example, an employee can tell himself, ‘I’m
not the person who falsified the safety data for the product; I just
reported the data that I had,’” Mullen says.
People also accept
uncritically information that confirms what they want to believe,
Moore said, while poking holes in statements they wish weren’t true.
• FEAR AND
CONFUSION. GSB political economy Professor Jonathan Bendor, who
teaches a course on negotiation that includes discussions of
cheating, thinks for most people fear is a more common cause of
corrupt behavior than greed. People want to avoid conflict, and
being a whistleblower can ruin a person’s career, even if the person
is vindicated. So many people keep quiet.
“It takes a huge
amount of courage to say ‘stop.’ Some of this stuff is a judgment
call, and you may be wrong, and then you really look stupid. But you
have to take the risk,” says Bowen “Buzz” McCoy, a former member of
the Business School’s Advisory Council who spent 30 years at Morgan
Stanley. He has written and consulted on business ethics and, with
his wife, endowed a GSB chair in leadership values and helped fund
the Stanford Program in Ethics in Society.
Although many cases
of corruption involve behavior that anyone should know is wrong,
it’s not always so clear cut. For example, says Professor Blake
Ashforth of Arizona State’s W.P. Carey School of Business, “Small
gifts are ways of cementing friendships. Big gifts are bribes. How
big is big?”
McCoy points out
that a good salesperson may use hyperbole but doesn’t lie, and that
in some cases the sophistication of the customer plays a role in how
far a salesperson should go in making claims. Adds Gruenfeld: “When
people say someone is entrepreneurial or resourceful, part of what
they mean is that person knows how to work around constraints in the
system.”
GSB Professor
Emeritus James March adds that “without a certain amount of
cheating—violating rules—and corruption—inducing others to violate
rules—no organization can survive. It is often called ‘taking
initiative’ or ‘using your head.’ That is not a justification of
egregious behavior, but a reminder that the boundary between art and
obscenity is often hazy.”
Tepper’s Moore
describes “an endless process of co-evolution” in which businesses
explore new models. Some are deemed by society to be unethical or
undesirable and eventually outlawed. Others become the norm.
Moore explains how
auditors can go from behavior that is technically correct but
ethically borderline to outright corrupt in just a few years. First,
the auditor sees the client doing something that’s just on the edge
of permissibility and doesn’t say anything. The next year, the
client pushes just a bit further, this time over the line. Now the
auditor doesn’t confront the client about it, since the practice is
so similar to the one that went unremarked the previous year. By the
third year, the client’s practice is clearly wrong, but the auditor
realizes that to challenge it would be to admit mistakes in previous
audits. And by the fourth year, the auditor is actively engaged in a
coverup with the client to prevent the corrupt practice from being
discovered.
A study by Stanford
law and business faculty members casts strong doubt upon the value
and validity of the ratings of governance advisory firms that
compile indexes to evaluate the effectiveness of a publicly held
company’s governance practices.
Enron, Worldcom,
Global Crossing, Sunbeam. The list of major corporations that
appeared rock solid—only to founder amid scandal and revelations of
accounting manipulation—has grown, and with it so has shareholder
concern. In response, a niche industry of corporate watchdog firms
has arisen—and prospered.
Governance advisory
firms compile indexes that evaluate the effectiveness of a publicly
held company’s governance practices. And they claim to be able to
predict future performance by performing a detailed analysis
encompassing many variables culled from public sources.
Institutional
Shareholder Services, or ISS, the best known of the advisory
companies, was sold for a reported $45 million in 2001. Five years
later, ISS was sold again; this time for $553 million to the
RiskMetrics Group. The enormous appreciation in value underscores
the importance placed by the investing public on ratings and
advisories issued by ISS and its major competitors, including Audit
Integrity, Governance Metrics International (GMI), and The Corporate
Library (TCL).
But a study by
faculty at the Rock Center for Corporate Governance at Stanford
questions the value of the ratings of all four firms. “Everyone
would agree that corporate governance is a good thing. But can you
measure it without even talking to the companies being rated?” asked
David Larcker, codirector of the Rock Center and the Business
School’s James Irvin Miller Professor of Accounting and one of the
authors. “There’s an industry out there that claims you can. But for
the most part, we found only a tenuous link between the ratings and
future performance of the companies.”
The study was
extensive, examining more than 15,000 ratings of 6,827 separate
firms from late 2005 to early 2007. (Many of the corporations are
rated by more than one of the governance companies.) It looked for
correlations among the ratings and five basic performance metrics:
restatements of financial results, shareholder lawsuits, return on
assets, a measure of stock valuation known as the Q Ratio, and
Alpha—a measure of an investment’s stock price performance on a
risk-adjusted basis.
In the case of ISS,
the results were particularly shocking. There was no significant
correlation between its Corporate Governance Quotient (or CGQ)
ratings and any of the five metrics. Audit Integrity fared better,
showing “a significant, but generally substantively weak”
correlation between its ratings and four of the five metrics (the Q
ratio was the exception.) The other two governance firms fell in
between, with GMI and TCL each showing correlation with two metrics.
But in all three cases, the correlations were very small “and did
not appear to be useful,” said Larcker.
There have been many
academic attempts to develop a rating that would reflect the overall
quality of a firm’s governance, as well as numerous studies
examining the relation between various corporate governance choices
and corporate performance. But the Stanford study appears to be the
first objective analysis of the predictive value of the work of the
corporate governance firms.
The Rock Center for
Corporate Governance is a joint effort of the schools of business
and law. The research was conducted jointly by Robert Daines, the
Pritzker Professor of Law and Business, who holds a courtesy
appointment at the Business School; Ian Gow, a doctoral student at
the Business School; and Larcker. It is the first in a series of
multidisciplinary studies to be conducted by the Rock Center and the
Corporate Governance Research Program.
The current study
also examined the proxy recommendations to shareholders issued by
ISS, the most influential of the four firms. The recommendations
delivered by ISS are intended to guide shareholders as they vote on
corporate policy, equity compensation plans, and the makeup of their
company’s board of directors. The researchers initially assumed that
the ISS proxy recommendations to shareholders also reflect their
ratings of the corporations.
But the study found
there was essentially no relation between its governance ratings and
its recommendations. “This is a rather odd result given that [ISS’s
ratings index] is claimed to be a measure of governance quality, but
ISS does not seem to use their own measure when developing voting
recommendations for shareholders,” the study says. Even so, the
shareholder recommendations are influential; able to swing 20 to 30
percent of the vote on a contested matter, says Larcker.
There’s another
inconsistency in the work of the four rating firms. They each look
at the same pool of publicly available data from the Securities and
Exchange Commission and other sources, but use different criteria
and methodology to compile their ratings.
ISS says it
formulates its ratings index by conducting “4,000-plus statistical
tests to examine the links between governance variables and 16
measures of risk and performance.” GMI collects data on several
hundred governance mechanisms ranging from compensation to takeover
defenses and board membership. Audit Integrity’s AGR rating is based
on 200 accounting and governance metrics and 3,500 variables while
The Corporate Library does not rely on a quantitative analysis,
instead reviewing a number of specific areas, such as takeover
defenses and board-level accounting issues.
Despite the
differences in methodology, one would expect that the bottom line of
all four ratings—a call on whether a given corporation is following
good governance practices—should be similar. That’s not the case.
The study found that there’s surprisingly little correlation among
the indexes the rating firms compile. “These results suggest that
either the ratings are measuring very different corporate governance
constructs and/or there is a high degree of measurement error (i.e.,
the scores are not reliable) in the rating processes across firms,”
the researchers wrote.
The study is likely
to be controversial. Ratings and proxy recommendations pertaining to
major companies and controversial issues such as mergers are watched
closely by the financial press and generally are seen as quite
credible. Indeed, board members of rated firms spend significant
amounts of time discussing the ratings and attempt to bring
governance practices in line with the standards of the watchdogs,
says Larcker.
But given the
results of the Stanford study, the time and money spent by public
companies on improving governance ratings does not appear to result
in significant value for shareholders.
Deloitte & Touche USA LLP has launched a
corporate governance Web site.
Accessible at
www.corpgov.deloitte.com ,
the Center for
Corporate Governance Web site is a publicly available resource that
offers regularly updated governance information for boards of
directors, C-suite executives, investors, attorneys and others
interested in governance.
The site has four main content sections:
audit committees, board governance, compensation committee, and
Deloitte periodicals.
"The Web site provides a 'one-stop shop'
for boards and committee members to find governance thought-ware
which includes perspectives from various experts on the latest
governance topics and best practices as well as tools and resources
to assist them in fulfilling their responsibilities as board
members," said Steve Wagner, managing partner for the Center for
Corporate Governance.
Question
Where were (are) the lawyers in the recent corporate governance and investment
scandals?
I was recently asked where a reader could
find the corporate governance index, so I figured others might
like to know that it is available through Andrew Metrick's
website.
"For details on the construction of
the Governance Index, see Gompers, Paul A., Joy L. Ishii,
and Andrew Metrick, 'Corporate Governance and Equity
Prices', The Quarterly Journal of Economics 118(1), February
2003, 107-155."
In
the years after Enron, many chief executives had been operating in a
defensive crouch. Last year, however, they switched to offense, yelping
about the new securities rules — way too strict and so time-consuming
— and whining that Eliot Spitzer and his meddlesome investigations
could wreck the nation’s economy. The United States Chamber of
Commerce even sued the Securities and Exchange Commission, hoping to
overturn its new rule requiring mutual fund chairmen to be
independent. So as 2005 dawns, it is again time to grant the
Augustus Melmotte Memorial Prizes, named for the charlatan who parades
through “The Way We Live Now,” the novel by Anthony Trollope. Mr.
Melmotte, who would fit just fine into today’s business world, is a
confidence man who takes London by storm in the late 1800’s.
Gretchen Morgensen, "The Envelopes, Please," The New York
Times, January 1, 2005 --- http://www.nytimes.com/2005/01/01/business/yourmoney/02award.backup.html?oref=login
Bob Jensen's threads on corporate governance are at http://www.trinity.edu/rjensen/fraud001.htm#Governance
Bob Jensen's threads on "Rotten to the Core" are at http://www.trinity.edu/rjensen/
"Corporate governance gets more transparent worldwide,"
USA Today, February 18, 2008 ---
Click Here
With trillions of dollars in
capital sailing the globe in search of investments, the
shareholders' crusade for more open, well-run companies is gaining
strength across many major and emerging markets. In what some call a
worldwide corporate-governance movement, shareholders are pushing
for stronger corporate-governance laws, teaming with investors from
different countries and negotiating behind the scenes with
businesses.
In earlier years, it was hard for
shareholders to dig up details from thousands of global companies on
their finances, their directors, executives' pay packages and other
information critical to making investment moves.
"We've seen some dramatic
changes," says Stanley Dubiel, head of governance research at
RiskMetrics Group, the largest U.S.-based proxy research firm, with
offices in 50 countries. "There's a strong desire on the part of
many companies to attract capital from international investors."
Those investors carry a lot of
weight. Pension funds and other large institutional investors
oversaw $142 trillion in assets in 2006, reports the Organization
for Economic Co-operation and Development.
More of those funds — led by
Calpers (California Public Employees' Retirement System) and
TIAA-CREF in the USA and the Hermes pension fund in the United
Kingdom — are wielding their financial clout in the name of
shareholders.
Dozens of countries are developing
systems of watchdog corporate-governance and shareholder activism,
with some modeling themselves after U.S. and United Kingdom
governance practices or the Sarbanes-Oxley Act, the U.S. anti-fraud
law passed after the Enron accounting scandal six years ago led to
the demise of the company.
South Africa, Italy and Japan, for
instance, have recently beefed up their corporate-governance codes
to strengthen shareholders' oversight of corporate boards, pay
practices, accounting and auditing policies and other watchdog
issues.
While corporate-governance experts
say there's still a long way to go, activist investors appear to be
making progress globally on key issues, from clearer financial
disclosure to winning a greater voice for shareholders in
determining executives' pay packages.
Shareholders make gains
In the United Kingdom,
shareholders gained clout in policymaking with passage of the
landmark Companies Act of 2006, which went into force last year.
Among other provisions: Severance pay for a director needs approval
by shareholders if it's more than twice the director's annual
salary.
In Australia, where investors
gained the right to cast advisory votes on executive pay practices
in 2005, shareholders of the country's top 200 companies tallied a
record 22% dissenting votes against company pay proposals and other
resolutions last year, RiskMetrics Group reports.
Last June, in a big leap forward
for the European Union, the European Commission signed new rules
that require even the most secretive of publicly traded companies to
communicate more openly with shareholders. Companies must allow
electronic voting, notify investors of annual meetings and answer
shareholders' questions.
"For many countries, corporate
governance is at the top of their business agenda," says Anne
Simpson, executive director of the International Corporate
Governance Network (ICGN), a London-based group of large investors
in 30 countries with $20 trillion in assets. "The conduct of
companies is everyone's concern."
Institutional investors are
gradually making progress and learning to adapt their tactics to
different business cultures.
Take Calpers, the largest U.S.
public pension fund, which has sparked a shareholders' movement in
Japan, the world's No. 2 economy after the USA.
In the 1990s, Calpers began
investing in Japanese companies on the Tokyo Stock Exchange and
lobbying aggressively for corporate-governance reform to break the
stranglehold of the keiretsu, the secretive clubby network of
Japanese corporate giants that dominate industries and stack boards
with insiders.
But the Japanese business
establishment rebuffed the foreign investors, and Calpers'
hard-charging style met with limited success, according to
management professor Sanford Jacoby at UCLA's Anderson School of
Business.
Now, rather than embarrass poorly
performing companies with media publicity, Calpers meets quietly
with other pension-fund managers and large investors — including the
Pension Fund Association, Japan's largest pension fund, with more
than $100 billion in assets — to gain allies.
Among other changes, they're
seeking more directors of Japanese boards who are independent of
management, greater financial disclosure and the elimination of
anti-takeover defenses that protect poorly run corporations. Calpers
has $1 billion invested in Japanese companies such as Matsushita and
Kenwood, and that number is likely to rise, says Dennis Brown,
senior portfolio manager at Calpers.
About 21% of Calpers' $255 billion
in assets under management are foreign stock holdings in 52
countries. The pension fund also is researching South Korea and
South Africa for potential investments.
"We're still in the very early
stages of global advancement in corporate governance," Brown says.
"A tremendous amount of work needs to be done."
Why is global corporate governance
taking off now?
Corporate scandals in the USA and
other countries have led to corporate reform laws such as the USA's
Sarbanes-Oxley, aiming to strengthen corporate-governance rules.
Shareholders have suffered many
billions of dollars in losses from major business scandals in recent
years involving engineering firm Siemens in Germany, the Parmalat
food-and-dairy company in Italy, energy giant Royal Dutch Shell in
the Netherlands, China Aviation Oil in Singapore and other foreign
firms.
"There's no question that the
Enrons and WorldComs of the world have heightened the need for
better governance, and that momentum has carried all over the
globe," says Reena Aggarwal, a Georgetown University finance
professor. "Everybody is trying to get their governance practices
straight."
Global markets linked
Shareholders and companies also
realize that the global financial markets are more closely linked
than ever before, especially after the Asian financial crisis in the
late 1990s led to debt crises in many countries and hastened the
collapse of U.S. hedge fund Long-Term Capital Management.
Nor is shareholder activism likely
to wane. Tens of millions of retiring workers in major economies
will continue to feed the growth of activist pension and investment
funds. Thousands of formerly state-run companies in Asia, Russia,
Latin America and other regions will need much oversight as they
join the financial markets and seek investors.
Advocates of tougher corporate
governance face formidable hurdles, of course.
Continued in article
Corrupt Corporate Governance For years, the health insurer didn't tell investors
about personal and financial links between its former CEO and the "independent"
director in charge of compensation
Jane Sasseen, "The Ties UnitedHealth Failed to Disclose: For years, the
health insurer didn’t tell investors about personal and financial links between
its former CEO and the "independent" director in charge of compensation,"
Business Week, October 18, 2006 ---
Click Here
"Gluttons At The Gate: Private equity are using slick
new tricks to gorge on corporate assets. A story of excess," by Emily
Thornton, Business Week Cover Story, October 30, 2006 ---
Click Here
Buyout firms have always been aggressive.
But an ethos of instant gratification has started to spread through
the business in ways that are only now coming into view. Firms are
extracting record dividends within months of buying companies, often
financed by loading them up with huge amounts of debt. Some are
quietly going back to the till over and over to collect an array of
dubious fees. Some are trying to flip their holdings back onto the
public markets faster than they've ever dared before. A few are
using financial engineering and bankruptcy proceedings to wrest
control of companies. At the extremes, the quick-money mindset is
manifesting itself in possibly illegal activity: Some private equity
executives are being investigated for outright fraud.
Taken together, these trends serve as a
warning that the private-equity business has entered a historic
period of excess. "It feels a lot like 1999 in venture capital,"
says Steven N. Kaplan, finance professor at the University of
Chicago. Indeed, it shares elements of both the late-1990s VC craze,
in which too much money flooded into investment managers' hands, as
well as the 1980s buyout binge, in which swaggering dealmakers
hunted bigger and bigger prey. But the fast money--and the
increasingly creative ways of getting it--set this era apart. "The
deal environment is as frothy as I've ever seen it," says Michael
Madden, managing partner of private equity firm BlackEagle Partners
Inc. "There are still opportunities to make good returns, but you
have to have a special angle to achieve them."
Like any feeding frenzy, this one began
with just a few nibbles. The stock market crash of 2000-02 sent
corporate valuations plummeting. Interest rates touched 40-year
lows. With stocks in disarray and little yield to be gleaned from
bonds, big investors such as pension funds and university endowments
began putting more money in private equity. The buyout firms,
benefiting from the most generous borrowing terms in memory, cranked
up their dealmaking machines. They also helped resuscitate the IPO
market, bringing public companies that were actually making money--a
welcome change from the sketchy offerings of the dot-com days. As
the market recovered, those stocks bolted out of the gate. And
because buyout firms retain controlling stakes even after an IPO,
their results zoomed, too, as the stocks rose. Annual returns of 20%
or more have been commonplace.
The success has lured more money into
private equity than ever before--a record $159 billion so far this
year, compared with $41 billion in all of 2003, estimates researcher
Private Equity Intelligence. The first $5 billion fund popped up in
1996; now, Kohlberg Kravis Roberts, Blackstone Group, and Texas
Pacific Group are each raising $15 billion funds.
And that's the main problem: There's so
much money sloshing around that everyone wants a quick cut. "For the
management of the company, [a buyout is] usually a windfall," says
Wall Street veteran Felix G. Rohatyn, now a senior adviser at Lehman
Brothers Inc. (LEH ) "For the private equity firms with cheap money
and a very well structured fee schedule, it's a wonderful business.
The risk is ultimately in the margins they leave themselves to deal
with bad times."
Continued in article
Insiders are still screwing the investing public "Trading in Harrah's Contracts Surges Before LBO Disclosure: Options,
Derivatives Make Exceptionally Large Moves; 'Someone...Was Positioning'," by
Dennis K. Berman and Serena Ng, The Wall Street Journal, October 4, 2006;
Page C3 ---
http://online.wsj.com/article_print/SB115992145253481882.html
Bitterness Outside the Boardroom: Carly Fiorina's snarky memoir But what if a former boss decided instead to write
a really snarky book, sharing all the nastiness--the back-stabbing,
grudge-holding and rival-bashing--that must be part of life at the top? What
would it be like? We no longer have to imagine. Carly Fiorina has written
exactly such a memoir.
"Bitterness Outside the Boardroom: Carly Fiorina's snarky memoir," by
George Anders, The Wall Street Journal, October 12, 2006 ---
http://www.opinionjournal.com/la/?id=110009076
In the spring of 2003, the chairman of the
New York Stock Exchange, Richard A. Grasso, had his eyes on a very
rich prize. Although Mr. Grasso's annual compensation at the time
was about $12 million, on a par with the salaries of Wall Street
titans whose companies the exchange helped regulate, he had
accumulated $140 million in pension savings that he wanted to cash
in — while still staying on the job.
Now Henry M. Paulson Jr., the chairman of
Goldman Sachs and a member of the exchange's compensation committee,
was grilling Mr. Grasso about the propriety of drawing down such an
enormous amount and suggested that he seek legal advice. So Mr.
Grasso said he would call Martin Lipton, a veteran Manhattan lawyer
and the Big Board's chief counsel on governance matters. Would it be
legal, Mr. Grasso subsequently asked Mr. Lipton, to just withdraw
the $140 million if the exchange's board approved it? Mr. Grasso
told Mr. Lipton that he worried that a less accommodating board
might not support such a move, according to an account of the
conversation that Mr. Lipton recently provided to New York State
prosecutors. (Mr. Grasso has denied voicing that concern.) Mr.
Lipton said he told Mr. Grasso not to worry; as long as directors
used their best judgment, Mr. Grasso's request was appropriate.
Mr. Grasso continued to fret. What about
possible public distaste for the move? Yes, there would be some
resistance from corporate governance activists, Mr. Lipton recalled
telling him, but given his unique standing in the business community
he was "fully deserving of the compensation."
Then Mr. Lipton, a founding partner of
Wachtell Lipton Rosen & Katz and a longtime adviser to chief
executives on the hot seat, dangled another, hardball option in
front of Mr. Grasso. If a new board resisted a payout, Mr. Lipton
advised, Mr. Grasso could just sue the board to get his $140
million. The conversation represented a pivotal moment at the
exchange, occurring when corporate governance and executive
compensation were already areas of public concern. Mr. Grasso
eventually secured his pension funds. But the particulars
surrounding the payout later spurred Mr. Paulson to organize a
highly publicized palace revolt against Mr. Grasso, leading to the
Big Board's most glaring crisis since Richard Whitney, a previous
president, went to jail on embezzlement charges in 1938.
An examination of thousands of pages of
depositions from participants in the Big Board drama, as well as
other recent court filings, highlights the financial spoils
available to those in Wall Street's top tier. It also shines a light
on deeply flawed governance practices and clashing egos at one of
America's most august financial institutions, all of which came into
sharp relief as Mr. Grasso jockeyed to secure his $140 million.
ELIOT SPITZER, the New York State attorney
general, sued Mr. Grasso in 2004, contending that his Big Board
compensation was "unreasonable" and a violation of New York's
not-for-profit laws. With a trial looming this fall, prosecutors
have closely questioned both Mr. Lipton and Mr. Grasso about their
phone call. Prosecutors are likely to highlight Mr. Grasso's own
doubts about the propriety of cashing in his pension; on two
separate occasions Mr. Grasso withdrew his pension proposal from
board consideration before finally going ahead with it.
The depositions paint a portrait of Mr.
Grasso as a man who paid meticulous attention to every financial
perk, from items like flowers and 99-cent bags of pretzels that he
billed to the exchange, to his stubborn determination to corral his
$140 million nest egg. While the board ultimately approved his deal,
court documents also show a roster of all-star directors, including
chief executives of all the major Wall Street firms, often at odds
with one another or acting dysfunctionally.
A recent filing by Mr. Spitzer contended
that Mr. Grasso's chief advocate, Kenneth G. Langone, a longtime
friend and chairman of the Big Board's compensation committee, was
less than forthcoming in keeping the exchange's 26-member board in
the loop about how Mr. Grasso's rising pay was also inflating his
retirement savings.
The Committee for
Economic Development (CED), a business-led public policy group, on
Tuesday released a policy statement examining the state of corporate
governance in the U.S. and offering practical recommendations for
restoring public trust in business.
“The high-profile corporate scandals of the
past few years, coupled with numerous problems regarding financial
statements, have shaken shareholders’ trust in many businesses
leaders and their companies,” Roderick M. Hills, co-chair of CED and
chair of the CED Subcommittee on Corporate Governance, said in a
prepared statement. “It is imperative that we take concrete steps to
restore the practices and processes that are the foundation of good
business ethics. Specifically, I believe that the auditing process
must reflect responsibility by company leaders, not just a rigid
adherence to accounting rules. The auditing process needs to be
guided by an over-arching set of principles that guarantee that the
CEO, Board of Directors, and other top company officials know that
they are fully committed to providing a truly fair and clear
presentation of the firm.” Hill is currently a partner at Hills,
Stern and Morley.
CED’s recommendations include:
Making Audit Committees Autonomous
and Vigorous
In order to accurately present a company’s position, the board
of directors must have access to all pertinent data. This will
only occur if a board’s auditing committee is competent,
independent and establishes effective control over both internal
and independent external auditors. The relationship between the
audit committee and the internal and external auditors is
crucial. The audit committee should exercise the same tone of
control over the internal auditor as it does over the external
auditor, extending to decisions of hiring, firing and
compensation.
Ensuring that Users Understand that
financial Information is Based on Judgments
Financial statement would be more useful if they were governed
by fewer rules and displayed more judgment that lies behind
estimated numbers. Stock analysts, the investing public, and
regulators, must recognize the inherently judgmental character
of accounting statements and financial information. Ranges of
values, rather than precise numbers, should be explained and
understood as such. In addition, financial statements should be
supplemented with non-financial indicators of value.
Giving Sarbanes-Oxley a Chance to
Work
CED sees room to tailor the requirements imposed by Section 404
of Sarbanes-Oxley within the existing statute, and endorses the
Public Company Accounting Oversight Board (PCAOB) and Securities
and Exchange Commission (SEC) implementation guidance, based on
their evaluation of the first-year experience. The guidance,
issued simultaneously by the two agencies in May 2005, should
lower the costs and increase the value of Section 404
compliance. Moreover, CED does not recommend a broad exemption
from Sarbanes-Oxley requirements for small capitalization
companies, but nevertheless, supports the objective of
mitigating the costs to smaller companies.
Taming Excessive Executive
Compensation
In CED’s view, the disparity of income between top corporate
executives and average employees is a cause for serious concern.
The differentials that exist today too often reflect neither
market conditions nor individual performance. The procedure for
determining executive compensation has been broken at far too
many of our larger corporations, and CED believes that the
solution to excessive compensation must be regarded as a matter
of process and disclosure, including compensation committees
must adopt measurable, specific, and genuinely challenging goals
for the performance of their businesses, and judge management by
them; the compensation process must be run by compensation
committees composed of independent directors; the compensation
committee should have direct authority over all terms of any
management contract, including all forms of compensation;
management should have a substantial equity interest in their
company; and management should make a full, timely, and
transparent disclosure to shareholders of its compensation.
Using Independent Nominating
Committees to Select and Appraise Directors
A paradox of corporate stewardship is that, despite the principle that
directors represent shareholders in the selection and retention
of management, historically, most directors have been selected
by management. In the CED’s view, the best approach to building
high-quality boards is to assign to truly independent nominating
committees the responsibility for recommending new board
candidates and for evaluating the performance of existing board
members. The nominating committee should also have the
responsibility of recommending committee assignments. ,/li> “We
acknowledge at the outset that no laws or policies will ever be
sufficient to end all corporate misbehavior – or, for that
matter, misbehavior in any segment of public life,” Hills
continues. “We are confident, however, that truly independent
and inquisitive boards of directors will provide the best
safeguard against corporate wrongdoing.”
Stanford University is setting up a
research center to focus on the emerging academic discipline of
corporate governance, funded with $10 million from legendary Silicon
Valley venture capitalist Arthur Rock and his wife.
The new institution at Stanford Law School
will be led by law professors Robert Daines and Joseph Grundfest and
will study issues such as executive pay, shareholder rights and the
state of the auditing industry, the university said. Organizers hope
the center will also be more hands-on, interacting with regulators
and judges and creating teaching materials for business-school
students.
"We don't want to be just an academic
center," Mr. Grundfest said in an interview. "We also want to help
improve the quality of corporate governance in the real world." He
added that Stanford's law school has been active in the area since
1993, when it launched a program called Directors College to help
educate corporate-board members.
Mr. Grundfest served as a commissioner with
the Securities and Exchange Commission from 1985 to 1990. He will
direct the center with Mr. Daines, a corporate-law scholar who once
worked at investment bank Goldman Sachs Group Inc
I have been busy and did a good deal on
this and you may be interested in this information, please see
below. Pleae post this for us.
1. The Open Compliance and Ethics Group (OCEG
- www.oceg.org) has released a new 88 page internal audit guide for
use in auditing compliance & ethics programs.
2. The press release with all the details
is available at:
Mr. Seward's paper, as co-author on
"Protecting Client-CPA-Attorney Information in the Electronic Age"
will be included in the Research Forum Session of the International
Meeting of the American Accounting Association 2006 Annual Meeting
on August 6-9 in Washington, D.C.
A
Typical Day in Corporate Governance
Turning to
business, the board rapidly approved a series of transactions, according to the
minutes and a report later commissioned by Hollinger. The board awarded a
private company, controlled by Lord Black, $38 million in "management
fees" as part of a move by Lord Black's team to essentially outsource the
company's management to itself. It agreed to sell two profitable community
newspapers to another private company controlled by Lord Black and Hollinger
executives for $1 apiece. The board also gave Lord Black and his colleagues a
cut of profits from a Hollinger Internet unit.Finally,
the directors gave themselves a raise. The meeting lasted about an hour and a
half, according to the minutes and two directors who were present. Robert Frank and Elena Cheney (See below)
Ever since he sued the University of Southern
California for fraud four years ago, accusing it of misusing his $1.6
million gift for biological research on aging and then lying about it,
Paul F. Glenn has put his beneficiaries on a short leash.
He still gives, but he tries not to call it
that. Instead, he likes to say that he strikes deals with universities
for the betterment of humanity, then polices them with all the ardor
of a businessman who has been burned, badly.
"We were assuming the honesty and
integrity of everyone involved," said Mr. Glenn, who settled his
case against U.S.C. this year. "We now know that there's got to
be a quid pro quo here. This is not a donation. It's a contract, and
both parties have to live up to it."
In the genial world of university
fund-raising, clashes between donors and beneficiaries are rare, and
such public animosity is rarer still. But in recent years a few noisy
disputes at major universities like Yale and Princeton - where $600
million is at stake -have had a powerful effect on the fund-raising
game, prodding donors to become more vigilant and universities to
become unusually careful about accepting gifts at a time when
institutions are particularly hungry for them.
"Universities have rightly paid close
attention to these cases," said John Lippincott, president of the
Council for Advancement and Support of Education, which represents
college fund-raisers. "Even though they may be few and far
between, they are not situations that any university would want to
face."
To avoid them, colleges and donors are
drawing up painstaking agreements to prevent future disputes over how
the money should be spent. Instead of turning over the entire gift at
once, donors like Mr. Glenn sometimes parcel it out over time, with
regular checkups along the way. Universities are often equally
exacting, in hope of keeping down unrealistic expectations of how much
power a benefactor might have.
In its most recent $2.6 billion fund-raising
campaign, for example, Duke tried to make it clear that no matter how
generous donors were, they would not be able to orchestrate how the
university was run - a central point of contention in donor clashes at
Yale in the mid-1990's and at Case Western Reserve two years ago.
"We all watch, and we learn from these
things," said John Burness, a spokesman for Duke.
The universities recognize that they are
dealing with a new breed of philanthropists who are demanding a more
active role in shaping the outcomes of their gifts, a result both of
their entrepreneurial wealth and an emerging belief that institutions
need to be scrutinized more closely.
In the dispute with the University of
Southern California, for instance, Mr. Glenn accused the university of
surreptitiously withholding his money from a researcher he wanted to
support while spending it on another one whom he considered
ineligible.
"Too often, it was that the universities
wanted alums or donors to put up and shut up," said Anne Neal,
president of the American Council of Trustees and Alumni, which was
formed in 1995 after Yale agreed to return a $20 million gift from Lee
M. Bass, a billionaire alumnus. "There's a feeling that that was
inappropriate, that in fact there was absolutely nothing wrong for a
donor to insist that their intent was followed."
At the same time, universities are under
growing pressure to raise money for as general a purpose as they can
manage. Donations to educational institutions dropped last year for
the second year in a row, though universities say the economy, not any
bad blood, is to blame.
Beyond that, university endowments have
shrunk in recent years, while expenses have grown. Having money set
aside that colleges can use in any way they please not only eases that
pressure, but it also improves their creditworthiness at a time when
university debts are soaring.
"We're reaching more of a crossroads
than we've been at in the past," said Richard A. Raffetto, a
managing director at the Bank of New York. "Universities want to
be more and more vague about how they use money, but donors want their
agreements to be less and less vague." Some battles have a way of
outlasting the original combatants. In the four decades since Charles
and Marie D. Robertson gave Princeton $35 million to prepare graduate
students for government service, the gift has romped through a series
of investments and blossomed into a $600 million fund that dwarfs the
entire endowments of most other universities.
The Robertsons have since died, but their
children want the money back. All of the $600 million - and then some.
It took Thomas B. Sager 17 years and five
employers to attain his dream of becoming a chief financial officer;
it took him five years and two chief finance posts to realize that he
did not like the job. "I got tired of spending years defending
strategies I knew were flawed, of
working with values that weren't my own,
of being responsible to chief executives and boards that were under
huge pressure to perform," he said.
Two years ago, Mr. Sager, 45, quit as the
chief financial officer of Zoots, a national chain of dry cleaners,
and bought Tri-Valley Sports, a small sporting goods business in
Medway, Mass., eight miles from his home.
Kenneth S. Goldman loved being a chief
financial officer, a role he played at six companies over 20 years.
But his next-to-last employer, Student
Advantage, fell apart during the dot-com implosion. He had a
"difference of philosophies" with the chief executive of
Lodestar, his last employer. And he watched with dismay as a growing
number of chief financial officers "fell on their swords" in
the post- Enron
glare of regulatory scrutiny.
In July 2002, Mr. Goldman became an
investment banker at Mirus Capital Advisors. He has several clients,
so he does not feel the pressure to be loyal to one boss at all costs.
He can eat dinner with his children more often. And he is not in a
harsh public spotlight.
"Every C.F.O. has been pushed at times
to take something that is clearly black and white and color it a shade
of gray," Mr. Goldman, 46, said. "But when the chief
executive is shot at, he uses the chief financial officer as a human
shield. Being a C.F.O. has become one of the riskiest jobs in
America."
The push for better ethics and transparent
accounting in corporate America, including the drive to pass the
Sarbanes-Oxley law in 2002, has had an unexpected side effect: more
finance chiefs are calling it quits.
"Coping with the pressures of
Sarbanes-Oxley even as they try to guide companies through a recession
has put an enormous strain on C.F.O.'s and their staffs," said
Julia Homer, editor in chief of CFO magazine.
It has also taken the fun out of the job.
"Sarbanes-Oxley has turned C.F.O.'s into scorekeepers rather than
players, and they just can't be strategic anymore," said Eleanor
Bloxham, co-president of the Corporate Governance Alliance, a
consulting firm in Westerville, Ohio.
E. Peter McLean, a vice chairman at Spencer
Stuart, the executive search firm, said that this year through
mid-November, 62 chief financial officers at Fortune 500 companies had
left their jobs; by year-end, he expects that total to reach nearly
70, a number that would mirror last year's. Over the last three years,
more than 225 C.F.O.'s of the Fortune 500 companies have left.
Continued in the article
November 28, 2004 reply from David Fordham, James Madison University [fordhadr@JMU.EDU]
Bob, as much as it might ruin my (dubious)
reputation on this list, I have to agree wholeheartedly with you. This
sad situation is exactly why I'm the thorn in this list's paw today!
My only comment is: this isn't news.
It was 1989, when I was CFO at one of North
America's top ten packaging companies (now bought out and defunct),
when I resigned upon being asked to "make a mistake" in the
accounting records to overstate earnings so that the company would be
eligible for a Canadian government bond guarantee.
The board of directors of the private company
suggested I make a mistake in the depreciation tables which would
result in overstated earnings on the UNauditied financials. These
would be submitted to the government the week after the fiscal
year-end, the bond guarantee would come through a couple of weeks
later, after which I was to "discover" the error, and fix
the books before the auditors arrived to perform their detailed
testing about 60 days after closing.
"This isn't really lying, because you'll
fix the books before the auditors see it, and everyone is warned that
these are unaudited financials and subject to correction," was
the justification I was given in the 9:00 am meeting.
I had cleaned out my desk before lunchtime.
(For those with an unsatiable curiosity, no,
my successor and his successor and his successor all refused, too, as
did the CFO's of the Scottish, Australian, and South Africa
affiliates, whereas the Canadian, English, and Scandinavian affiliates
all agreed... probably more because of the individuals involved than
the national cultures. The bond issue never went through, so the
pursuit of the guarantee was dropped.)
Although I gave up a six-figure salary,
company car, and five-figure expense account (and a six-figure bonus
(in 1989 dollars!) had I agreed!), the end justifies the means: I went
back to the company a year later just to say "hi" to some of
my employees, and found out that of the nine men (the board) who had
sat around the table a year earlier, two were in Canadian prison --
for fraud and embezzlement related to OTHER companies (not mine!) that
they were directors of. Four more had left the company, and two were
under investigation, again for activities unrelated to my company.
The former CFO of the Canadian holding
company, the last I heard, was working as a clerk in a video rental
store in Toronto!
These were closely held companies, not
publicly-traded ones. They were getting in trouble for falsification
of the books to obtain governmental funding, or more accurately,
governmental guarantees of funding. The company never defaulted, to
the best of my knowledge, but just the whole attitude that it is
"okay" to do this soured me on working for such people.
I fully intended to find another CFO job, but
the first three interviews I had convinced me that these sort of
attitudes were commonplace (remember, this was back in 1989!) and my
naivete about it was embarrasssing.
Contemporaneous with this situation, I had a
very touching event with my five-year-old son, which convinced me I
needed a job with more predictability. So I figured I'd go into
academe where (silly me!) I figured that the quality of individual
ethics would be a little higher.
Guess we all make mistakes, don't we!
David Fordham
Lord Black Convicted of Fraud A federal jury convicted fallen media tycoon Conrad Black and three
of his former executives at Hollinger International Inc. Friday of
illegally pocketing money that should have gone to stockholders. Black,
62, was convicted of three counts of mail fraud and one count of
obstruction of justice. He faces a maximum of 35 years in prison for the
offenses, plus a maximum penalty of $1 million. He was acquitted of nine
other counts, including racketeering and misuse of corporate perks, such
as taking the company plane on a vacation to Bora Bora and billing
shareholders $40,000 for his wife's birthday party.
"Conrad Black Convicted of Fraud," NPR, July 14, 2007 ---
Click Here
"Lord Black's
Board: A-List Cast Played Acquiescent Role," by Robert Frank
and Elena Cherney, The Wall Street Journal, September 27, 2004,
Page A1
On a winter afternoon four
years ago, Hollinger
International Inc.'s directors met with the company's chief
executive, Conrad Black, for an especially busy board meeting.
Gathered around a mahogany
table in a boardroom high above Manhattan's Park Avenue, eight
directors of the newspaper publisher, owner of the Chicago Sun-Times
and Jerusalem Post, nibbled on grilled tuna and chicken served on
royal-blue Bernardaud china, according to two attendees.
Marie-Josee Kravis, wife of
financier Henry Kravis, chatted about world affairs with Lord Black
and A. Alfred Taubman, then chairman of Sotheby's.
Turning to
business, the board rapidly approved a series of transactions, according to the
minutes and a report later commissioned by Hollinger. The board awarded a
private company, controlled by Lord Black, $38 million in "management
fees" as part of a move by Lord Black's team to essentially outsource the
company's management to itself. It agreed to sell two profitable community
newspapers to another private company controlled by Lord Black and Hollinger
executives for $1 apiece. The board also gave Lord Black and his colleagues a
cut of profits from a Hollinger Internet unit.
Finally, the directors gave
themselves a raise. The meeting lasted about an hour and a half,
according to the minutes and two directors who were present.
The boards of scandal-plagued
companies from Enron to Tyco have been heavily criticized for lax
corporate governance and poor oversight. The board of Hollinger -- a
star-studded club with whom Lord Black had longstanding social,
political and business ties -- is emerging as a particularly passive
watchdog. Hollinger directors openly approved more than half of the
transactions that allowed Lord Black and his colleagues to improperly
siphon more than $400 million from the publisher, according to a
company investigation overseen by former Securities and Exchange
Commission Chairman Richard Breeden.
High Society
Mr. Breeden's 500-page report,
which was released earlier this month, gives a detailed picture of a
board that functioned like a high-society political salon, while
neglecting its oversight responsibilities. Lord Black worked hard to
win his directors' loyalty, giving to their charities and holding
dinners in their honor. As the scandal unfolded, director Henry
Kissinger even tried to negotiate with the company on Lord Black's
behalf.
According to the Breeden
report, plus interviews with directors and company officials, the
board rarely asked basic questions to get the facts it needed, despite
warning signs. In addition to the management fees and other payments,
the report says the board retroactively approved Lord Black's use of
$8 million in company money to buy Franklin D. Roosevelt memorabilia,
which he used to write a biography of the president. A company jet, a
platoon of servants, four homes and a constant round of parties -- all
partly funded by Hollinger -- were left largely unscrutinized by the
board, according to the Breeden report.
Hollinger's then-corporate
counsel, Mark Kipnis, told investigators there was no need to
"slip" anything past the audit committee because they
"routinely approved" everything, according to the Breeden
report.
Several Hollinger directors say
in interviews they were misled by Lord Black about some transactions.
Robert Strauss, 85 years old, a former ambassador to the Soviet Union
who left the board in 2002, says in an interview that he asked limited
questions at board meetings because, "I relied on Mr. Black, I
confess."
Some directors say it wasn't
their job to police Hollinger's business. "The board doesn't run
the company and I think directors are entitled to presume that they're
not being lied to or that information is not being withheld,"
says James Thompson, the former governor of Illinois, who was a member
of the board and head of its audit committee.
The Breeden report acknowledges
that the board "wasn't fully and accurately" informed about
a range of issues. In fact, the board ousted Lord Black as CEO last
November after learning he'd received a portion of $32 million in
payments it hadn't authorized. Mr. Breeden's report concludes that the
board should be judged on its "entire record," including its
attempt to clean up the mess.
In a statement made through a
spokesman, Lord Black says none of Hollinger's senior management or
directors acted improperly. He says Hollinger's management isn't aware
of any "instance where directors were denied information or
deliberately misinformed."
"The audit committee is
being disingenuous if it is attacking payments that it knowingly
approved," Lord Black continued. "The former management of
Hollinger International believes that the members of the audit
committee acted conscientiously, and that the absence of any dissent
from them reflected their accurate judgment of management's
performance."
A resolution of the scandal
could prove costly for Hollinger's board. The company's ninth-largest
institutional shareholder, Connecticut-based Cardinal Capital
Management LLC, is suing the directors, alleging they breached their
fiduciary duty. The company's independent directors are also in
mediation talks with Hollinger's new management to settle potential
claims the company might have against them.
The earliest outside board
members were Richard Perle, an assistant secretary of defense under
President Reagan, and Mr. Thompson, the former governor of Illinois.
Lord Black later added his wife, Barbara Amiel Black, and recruited
Ms. Kravis, an economist and the wife of financier Henry Kravis. The
Kravises and Blacks socialize in New York and Palm Beach, Fla., where
they both have homes, according to people familiar with the matter.
Lord Black also recruited former Secretary of State Mr. Kissinger and
Sotheby's Mr. Taubman.
Lord Black was able to pick all
the directors slots. Even after the company went public in 1996, he
retained control. As of August, he controlled 18% of Hollinger
International's equity through a series of holding companies -- that
figure has ranged between 30% and 60% since 1996 -- and 68% of the its
voting interest. Told by a Hollinger executive he should inform Mr.
Thompson of certain transactions, Lord Black retorted: "I am the
controlling shareholder and I'll decide what the governor needs to
know and when," the Breeden report says.
Casual Affairs
Board meetings were brief,
casual affairs, according to minutes and directors. They were usually
held at Hollinger's New York offices, which are hidden behind a poorly
marked wooden door. From a pop-up computer screen in front of his
chair, Lord Black controlled the room's lights, sound and window
blinds, which he would alter during board meetings, according to one
attendee. On the boardroom walls are letters written by FDR and a
framed picture of mobster Al Capone that hung over Lord Black's left
shoulder.
The lunch resembled a think
tank as members discussed Monica Lewinsky, the future of China and the
wisdom of the European Union, directors recall. Lord Black would
flatter his guests. During one exchange, he invited Mr. Kissinger to
weigh in by introducing him as one of the world's greatest
negotiators, according to two people present.
Lord Black collected management
fees for running Hollinger under an arrangement dating back to the
company's founding. The fees were paid to Ravelston Corp. and
Hollinger Inc., two holding companies through which Lord Black
controlled Hollinger International.
Once a year, Mr. Thompson, head
of the company's audit committee, would sit down over lunch or coffee
with David Radler, Hollinger's chief operating officer and a Ravelston
shareholder, and set the fee, according to the Breeden report. Mr.
Radler announced what Ravelston wanted and after a "cursory
discussion," Mr. Thompson would agree, the report says. After
1997, the fees increased by more than 20% a year, hitting $38 million
in 2000, even as Hollinger shrank in size after asset sales.
"In the time needed to
consume a tuna sandwich, Radler would win as much as $40 million in
Hollinger revenues for Ravelston," the report states.
Some directors say they relied
on the audit committee's recommendations. Members of the audit
committee give contradictory accounts of how they approved the fees.
Mr. Thompson says in an interview that the negotiations were "the
product of the whole audit committee, not just me and Radler."
Richard Burt, a former ambassador to Germany, and Ms. Kravis told
investigators they "deferred entirely" to Mr. Thompson.
Ms. Kravis also told
investigators she thought the compensation committee negotiated the
fees, the Breeden report says. By contrast, Mr. Thompson told
investigators it was Ms. Kravis's idea that he negotiate directly with
Mr. Radler. Ms. Kravis didn't respond to numerous requests seeking
comment. Mr. Radler declined to comment.
The board blessed another set
of payments, relating to the sale of Hollinger assets, the Breeden
report says. After Hollinger sold the bulk of its Canadian newspapers
in 2000, Lord Black and his colleagues asked the board for a special
$19.4 million "break fee" because Ravelston would see a fall
in management fees because Hollinger was becoming a smaller company.
The executives also asked the
board for $32.4 million in payments relating to noncompete agreements.
Such agreements, in which companies agree not to compete against the
assets they sell, are common in the industry. But the fees that come
with these deals are typically paid to companies, not individual
executives, as Lord Black and his colleagues requested.
Mr. Kipnis, the former
corporate counsel, told the board that the fees were requested by the
acquirer. Months after the board approved the fees, Mr. Kipnis,
reversed himself, telling the board in a memo that the buyer hadn't
specifically asked that individual executives get paid. He said the
discrepancy was "inadvertent," the Breeden report says.
Nonetheless, Mr. Kipnis, who
wasn't a beneficiary of these fees, recommended in the memo that the
executives still receive the entire $52 million in fees. The board and
audit committee approved the payments for a second time with only a
"perfunctory examination" of the changes, according to the
Breeden report.
Continued in the article
From The Wall Street
Journal's Accounting Weekly Review on September 17, 2004
TITLE: Letters to the Editor: Protecting Shareholders Is No
"Shenanigan"
REPORTERS: Reeves, William T., Jr. and Nicholas Maiale
DATE: Sep 10, 2004
PAGE: A13
LINK: http://online.wsj.com/article/0,,SB109478214704214479,00.html
TOPICS: Accounting, Board of Directors, Corporate Governance, Dividends,
Shareholder Class-Action Lawsuit
SUMMARY: Representatives of two institutional investors respond to a
WSJ opinion piece on litigation against companies in which they invest.
For a summary of the 1995 Securities Litigation Reform Act and related
research, one good resource is a Stanford Law School web page
http://securities.stanford.edu/research/studies/19970227firstyr_firstyr.html
QUESTIONS:
1.) In general, why would institutional investors such as the Teachers'
Retirement System of Louisiana (TRSL) undertake litigation against the
companies in which they invest?
2.) What recent events make it particularly likely that, at this
point in time, institutional investors will undertake litigation against
the companies in which they invest?
3.) How can this litigation contribute to improved corporate
governance? How might it detract from good governance? In your answer,
define the term "corporate governance."
4.) Refer to the related article. In regards to two funds
representing Pennsylvania public school teachers and state employees
suing Time Warner and Royal Dutch/Shell, the author writes that
"shareholders are essentially suing themselves" and,
therefore, "the main winners will be the lawyers." Why does
the author argue that shareholders suing a company are "suing
themselves"? Explain this statement in terms of the balance sheet
equation. Also, explain in detail your understanding of potential wealth
impacts of the lawsuit on all company shareholders.
5.) The Teachers' Retirement System of Louisiana (TRSL) brought one
legal action to stop a particular dividend payment. Why did this
institutional investor want to stop this dividend payment? How are
dividends typically funded? Are there any legal requirements for funding
dividend payments? Cite examples and describe the source of these laws.
6.) Summarize the political tones of these letters to the editor and
contrast with the political tone of the related article (the WSJ Opinion
piece). How do these political perspectives influence the opinions
expressed in the articles? In your discussion, also reference the
political parties discussed in detail in the article.
Reviewed By: Judy Beckman, University of Rhode Island
"Horizon tale is Black example for Hollinger," by
Stephanie Kirchgaessner, The New York Times, May 10, 2004
2004
To illustrate the degree to which executives
were overpaid, the suit contends that for the $33.5m Hollinger paid in
management fees in 2003 it could have hired "the top fve
officers" at the Washington Post, Dow Jones and Knight Ridder
"and had more that $5m left over".
Lord Black's private company said on Friday
it looked forward to litigating the matter and would respond through
"appropriate legal channels".
His company also hinted at its
defence: many of the disputed transactions were approved by
Hollinger's independent board of directors.
May 7, 2004 message from Todd Boyle
"The relationship stockholders have to
the modern corporation looks very little like ownership. Stockholders
have no tangible relationship to the thing owned, take no
responsibility for its misuse, and play no part in its upkeep. As CFO
magazine notes, only a quarter of market value for S&P 500
companies comes from tangible assets. So talk about
"ownership" is more and more nonsensical, as our legal
system has recognized. "Sophisticated lawyers these days don't
use the "ownership" term," Margaret Blair of the
Brookings Institution in Washington told me several years ago.
"The corporation is a nexus of contracts. It's not a thing that
can be owned."
What helped knock the ownership idea out of
currency was the 1932 book by Adolf Berle and Gardiner Means, The
Modern Corporation and Private Property, which first noted the
separation of ownership and control in corporations. This separation
dissolved the unity of private property, so no one "owned"
the corporation any more, Berle and Means wrote. This "released
management from the overriding requirement that it serve
stockholders."
Chartered Jets, a Wedding At Versailles and Fast Cars To Help Forget
Bad Times. As financial companies start to pay out big
bonuses for 2003, lavish spending by Wall Streeters is showing signs of a
comeback. Chartered jets and hot wheels head a list of indulgences sparked
by the recent bull market. Gregory Zuckerman and Cassell Bryan-Low, "With the Market Up,
Wall Street High Life Bounces Back, Too," The Wall Street Journal,
February 4, 2004 ---
http://online.wsj.com/article/0,,SB107584886617919763,00.html?mod=home%5Fpage%5Fone%5Fus
Paychecks are now more politically correct, but CEO wallets won't
shrink overnight. See which executives nabbed the juiciest pay bonanzas
last year.
"Here Comes Politically Correct Pay," The Wall Street Journal,
April 12, 2004 ---
http://online.wsj.com/page/0,,2_1081,00.html?mod=home_in_depth_reports
Welcome to the new world of politically
correct pay, where directors increasingly scrutinize their leader's
compensation through the eyes of irate shareholders, workers and
regulators. That already means some big changes are in the works. But
nobody should weep for the CEO just yet: Even the most sweeping moves
won't shrink chief executives' bulging wallets overnight.
SUMMARY: The Solomon article, as well as the related articles,
outlines the efforts to "reign-in" the abuses that have been
exposed in the governance of some of the biggest corporations in the
country in the past several years. The related articles by Burns,
Hymowitz, Maremont and Bandler delineate what "should be." The
current article depicts, in some cases, what "is."
QUESTIONS:
1.) What function is served by the compensation committee of a company?
Explain in terms of the competing incentives for compensating the chief
executives of a firm.
2.) What is a nominating committee? Why is it important that
directors be independent?
3.) It has been argued that the underlying philosophy of
international accounting standards versus American accounting standards
are that the international standard-setting focus is on the
"end-product" while the American focus is on the
"process." Critics of the American system maintain the
focusing on the process provides a roadmap to those disinclined to
adhere to the "intent" of the standards. Argue that this is
happening in the corporate governance area. Explain in terms of the
first paragraph of the Solomon article which begins with, "Dozens
of companies are avoiding new rules."
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
In a further sign that the U.S.
is taking a hard line on criminal antitrust cases, four senior Infineon
Technologies AG executives agreed to serve prison terms and pay
hefty fines for their role in a scheme to fix prices in the
computer-memory-chip market, the Department of Justice said.
Under their plea agreement, the
four agreed to pay $250,000 (€187,675) each and serve prison times
between four and six months. The four, all vice presidents, include
three Germans, Heinrich Florian, Peter Schaefer and Günter Hefner,
and one American, T. Rudd Corwin.
The plea agreement is the
latest twist in a Justice Department investigation into what officials
say was a global conspiracy to fix prices in the $16 billion market
for random-access memory chips, which are used in a wide range of
products, including personal computers, digital cameras and game
consoles. Officials said the probe would continue.
"This case reinforces our
commitment to investigate and hold accountable all conspirators,
whether domestic or foreign, that harm American consumers through
their collusive conduct," said R. Hewitt Pate, assistant attorney
general in charge of the department's antitrust division. "True
deterrence occurs when individuals serve jail terms, and not just when
corporations pay substantial criminal fines."
Is there room for yet another "C"
in the C-suites of Corporate America? According to a new study by
Ernst & Young, one of the world's largest accounting firms, the
answer is yes -- especially for companies actively engaged in
transactions such as mergers & acquisitions.
According to the Ernst & Young study,
"Striving for Transaction Excellence: The Emerging Role of the
Corporate Development Officer," the corporate development
officer, or "CDO," is emerging as the newest class of
C-suite executive as a direct result of increased investor scrutiny
and a renewed commitment to corporate governance throughout the
transaction lifecycle.
The study is the most comprehensive
examination of the CDO role ever completed. E&Y's Transaction
Advisory Services practice conducted over 175 in-depth interviews with
executives bearing responsibility for corporate development.
Participants were drawn from a diverse range of companies, including
89 Fortune 1000 companies -- 26 of which represented the Fortune 100.
"There is a shift in how companies are
approaching corporate development, and the emergence of the CDO role
is at the center of that change," said Kerrie MacPherson,
Americas Markets
Dozens of Firms Use Exemption
That Allows Them to Avoid
Rules Mandating Board Structure
Dozens of companies are
avoiding new rules intended to make their boards more independent from
management, taking advantage of a little-noticed exemption for
corporations that are controlled by small groups of shareholders.
The list includes Cox
Communications Inc., EchoStar
Communications Corp. and Weight
Watchers International Inc., which have said in Securities and
Exchange Commission filings that a majority of their directors won't
be independent. Primedia
Inc., Cablevision
Systems Corp. and others have said they won't have independent
compensation committees to determine executives' pay or independent
nominating committees to select director candidates.
These companies are able to
escape the new rules required by the New York Stock Exchange and the
Nasdaq Stock Market by designating themselves as
"controlled" companies in which more than 50% of the voting
power rests with an individual, a family or another group of
shareholders who vote as a block or another company. This allows them
to avoid requirements that were adopted by stock exchanges and
regulators after the corporate meltdowns of the late 1990s.
The rules mandate a majority of
directors be independent and only independent directors sit on
nominating, compensation and audit committees. Independent directors
are those who don't work at a company, haven't been employed there
within three years and don't have close relatives who work there. All
firms must have independent audit committees, even those with a
controlling shareholder.
The exemptions are riling some
large institutional investors and corporate-governance experts who say
they are weakening safeguards established to protect investors and the
broader market. They also raise troubling issues at companies where a
controlling shareholder may have substantial voting interest but a
small economic stake, the critics say.
Don Kirshbaum, the investment
officer for policy at the Connecticut State Treasurer's office, said
the state became concerned when Dillard's
Inc. disclosed that it planned to avoid the rule requiring a majority
of directors be independent and that an independent nominating
committee select director candidates. The family that controls the
Little Rock, Ark., retailer retains 99.4% of voting power through
Class B shares. The company's bylaws allow the family to elect eight
of its 12 directors, although the Dillard family holds less than 10%
of shares outstanding. "This just seemed baffling to us,"
said Mr. Kirshbaum. "How can a company that is owned mostly by
institutional and other investors outside the family not be allowed to
elect a majority of the board?" A Dillard's representative said
shareholders knew when they bought the stock that the family had the
right to elect a majority of the board.
Connecticut's State Treasurer
and the Council of Institutional Investors unsuccessfully lobbied the
Big Board and the SEC against the exemption. But the SEC signed off on
it when it approved the new corporate-governance standards last year.
Under the exemption,
"controlled" companies can opt out of the rules on the
makeup of boards and their compensation and nominating committees by
disclosing that they are controlled companies and outlining the
exemptions they plan to take. Approval from regulators or shareholders
isn't required. The exemption was written into the rules at the behest
of companies with controlling shareholders, according to regulatory
officials. When a first draft of the listing standards didn't contain
the exemption, some companies lobbied the Big Board and Nasdaq, saying
it didn't make sense to require companies with a controlling
shareholder to have a majority of independent directors because the
large shareholder effectively controlled the board.
"The exception ... was
made because the ownership structure of these companies merited
different treatment," the New York Stock Exchange said.
"Majority voting control generally entitles the holder to
determine the makeup of the board of directors, and the exchange
didn't consider it appropriate to impose a listing standard that would
in effect deprive the majority holder of that right." A
spokeswoman for Nasdaq said the exemption "acknowledges the
unique ownership rights of a majority controlled company."
Cox Communications, which
qualifies for the exemption because it is controlled by the Cox
family's Cox Enterprises Inc., said it "doesn't need to have a
majority of independent directors for shareholders to be protected
because the controlling company's interests are aligned with the
shareholders."
Securities lawyers said the
exemption was designed in large part for companies controlled by
publicly traded parents, such as Kraft
Foods Inc., controlled by Altria
Group Inc. Because Altria shares trade on the Big Board and are
widely held, it must comply with the standards, giving Kraft
shareholders protection at the parent company level. But many of the
companies that have opted out aren't controlled by a publicly traded
parent.
Primedia, a New York publisher,
disclosed in an SEC filing earlier this month that it wouldn't have a
majority of independent directors or an independent compensation
committee and that board nominations would be made by all directors
instead of an independent committee. More than 50% of Primedia's
voting power is held by investment partnerships controlled by Kohlberg
Kravis Roberts & Co.
Investors have been hit with a wide array of
scandals over the past two years, tarnishing the reputations of some of
the nation's largest corporations and financial institutions. The facts
have varied, but the scandals share a common thread: bad behavior that
had been tolerated for years, often with regulators and industry
insiders looking the other way.
Savvy investors long knew that some research
analysts were overly bullish in recommending shares of their firm's
banking clients. But regulators ignored complaints until Eliot Spitzer,
the New York attorney general, launched a probe leading to a $1.4
billion settlement with 10 top securities firms last year. Ditto for
Wall Street firms that doled out hot initial public offerings of stock
to corporate executives to get their companies' financing business --
and in the process, shut out the little guy.
It also was no big secret that corporate boards
rubber-stamped management decisions, stomping shareholders in the
process. Abuses were left unchecked until a rash of accounting scandals
led to sweeping reforms in 2002 that redefined the duties of directors.
There are many more such "open secrets":
practices that raise eyebrows but persist on Wall Street and in
corporate boardrooms. Here are three open secrets -- regarding
corporate-board minutes, payment of arbitration awards and pricing of
municipal bonds -- that exemplify the hazards to investors.
Altered Minutes
One reason it has been so difficult to
determine what top management and directors knew about -- and did to
cause -- the business disasters of the late 1990s is the distortion of
corporate-board minutes. All too often, these critical records are
altered or left incomplete. When fraud comes to light, investigators
struggle to assign blame, making it harder for investors to recoup
losses and less likely that misbehavior will be deterred in the future.
"The attitude is that it's OK to lie by
omission in board minutes," says Charles Niemeier, a member of the
Public Company Accounting Oversight Board. "It's the way it gets done,
and the problem is that we have become accepting of this." The oversight
board was set up under the Sarbanes-Oxley Act, legislation Congress
passed in 2002 to improve corporate accountability. While the act
addressed financial statements and public filings, lawmakers didn't look
closely at problems concerning internal corporate documents.
Name a corporate blowup, and there is usually
an example of board minutes being altered or left incomplete. At Enron
Corp., investigators traced the board's knowledge of one dubious
off-balance-sheet vehicle only through handwritten notes taken by the
corporate secretary during a board meeting in May 2000. The information
from the scribbled notes suggested that at least some Enron directors
knew the arrangement was an accounting maneuver, rather than something
aimed at substantive economic activity. But the formal board minutes
from that meeting contained no reference to the directors' knowledge on
this point.
There aren't hard rules on how thorough board
minutes should be. As a result, some corporate lawyers routinely use
bare-bones minutes as a shield to protect companies from liability.
"There is a huge gulf between the two schools
of thought on board minutes," says Rodgin Cohen, a partner at the New
York law firm of Sullivan & Cromwell. "One is that they should be a full
recording. The other is that they should be limited. Most lawyers would
suggest that they should be quite limited," he says. "It's like
anything: The more words you put down, the greater exposure you have."
Mr. Cohen says that he advocates more extensive minutes.
Amy Goodman, a lawyer at Gibson, Dunn &
Crutcher who specializes in corporate-governance issues, says that after
the recent wave of scandals, many corporate attorneys and their clients
are re-evaluating whether they need to include more detail in minutes
"to be able to show that directors have acted with due care and in good
faith."
In the WorldCom Inc. fiasco, a court-appointed
bankruptcy examiner has found that the company created "fictionalized"
board minutes in connection with its announcement in November 2000 of
plans to create a so-called tracking stock that would correspond to the
performance of its consumer business. The long-distance telephone
company, now known as MCI, said at the time that the board had approved
this move.
In fact, the board hadn't given its approval,
the bankruptcy examiner, Richard Thornburgh, a former U.S. attorney
general, concluded. The board had held only a "minimal" discussion of
the idea during a brief "informational" meeting on Oct. 31, 2000, Mr.
Thornburgh's report said. WorldCom management decided to transform
records from the October meeting into minutes of a formal board meeting,
complete with references to a discussion about the tracking stock that
hadn't really taken place, the report found.
One WorldCom lawyer said during the examiner's
investigation that transforming the Oct. 31 meeting into a "real meeting
was 'wrong' and made the transaction 'look nefarious' when that was not
the case," the report said. The examiner faulted former senior WorldCom
executives for the decision, although board members and WorldCom lawyers
also bear responsibility, the report said.
The practice highlighted the lack of oversight
by WorldCom's board, which contributed to the company's downfall and
made it into a "poster child" for poor corporate governance, Mr.
Thornburgh has said.
Bradford Burns, an MCI spokesman, says the
company has instituted reforms "to ensure what happened in the past will
never happen again."
Unpaid Judgments
On those occasions when investors catch their
brokers cheating and win an arbitration award -- no small feat -- the
customer still sometimes ends up losing.
IN PLAIN SIGHT
Here are three 'open secrets' known to
regulators and financial-industry insiders but still harmful to
investors
• Corporate-board minutes are often
manipulated, with important facts changed or left out. That makes it
difficult, once fraud is discovered, to determine what directors and top
managers knew and what they did.
• Arbitration awards to investors who have been
cheated often go unpaid, as, for example, when suspect brokerage firms
simply shut down. Wall Street has opposed certain changes that would
ease the problem, such as requiring brokerage firms to have increased
capital and more liability insurance.
• Municipal bonds are difficult for individual
investors to price because of a lack of information, often resulting in
their paying too much. There have been improvements lately, but bond
dealers are opposing certain additional reforms that would give
investors real-time bond data.
Fabien Basabe says that in the late 1990s, his
brokerage firm recklessly traded away nearly $500,000 of his money. The
65-year-old Miami restaurateur filed an arbitration claim with the
National Association of Securities Dealers, as many investors do when
they clash with their brokers. In 2002, after a two-year fight, a state
court in Florida confirmed an NASD arbitration-panel award ordering J.W.
Barclay & Co. to pay Mr. Basabe more than $550,000, plus $150,000 in
punitive damages.
The problem was that the small New Jersey
securities firm had closed its doors in early 2001, after it lost the
initial round of arbitration. Mr. Basabe has yet to see any money. "I
went through all of it for nothing," he says.
In the first quarter of 2003, the NASD imposed
$99 million in damage awards against brokerage firms and brokers
nationwide. What the NASD doesn't trumpet is that investors haven't been
able to collect $30 million -- or almost one-third -- of that amount
during that period, the most recent for which numbers are available. For
2001, the most recent full year for which figures are available, 55% of
the $100 million in arbitration awards went uncollected.
The NASD can suspend the license of a broker or
securities firm that refuses to pay up. But many firms and brokers just
walk away rather than pay. Because of his disaster with Barclay & Co.
(no relation to the big British bank Barclays PLC), Mr. Basabe says he
lost his Italian restaurant, I Paparazzi, in the Breakwater Hotel in
South Beach.
In 1987, the Supreme Court ruled that
securities firms may require customers to waive their right to sue in
court as a condition of opening a brokerage account. Since then,
arbitration generally has become the sole forum for customers to seek
redress from Wall Street firms. And Wall Street has resisted some steps
that could protect investors when firms fail to pay.
In 2000, the General Accounting Office, the
investigative arm of Congress, issued a report calling for improvements
in arbitration-award payouts. The NASD has responded by installing a
system that tracks unpaid awards and requiring firms to certify they
have paid, among other steps.
But securities firms have successfully lobbied
against two other potentially effective reforms. One would increase
capital requirements, so that firms would have cash on hand to pay
awards. The other would require firms to carry more liability insurance
to cover awards. The Securities and Exchange Commission, which oversees
the NASD and has jurisdiction on these issues, has reinforced this
resistance in its own comments to the GAO.
In reports released in 2000 and last year, the
GAO recounted arguments made by the SEC that increasing capital
requirements could force many brokerage firms out of business and
potentially penalize responsible firms. The SEC also has argued that
stiffer insurance requirements could raise investor costs.
Securities-industry executives have told the GAO that carrying more
insurance to cover arbitration awards "could raise costs on
broker-dealers industrywide and ultimately on investors."
An SEC spokesman says the agency "continues to
explore ideas about how to improve investor recovery of losses from
firms that go out of business."
Investors' inability to collect arbitration
awards has broader ripple effects: "A lot of lawyers won't even touch
these cases because they know they have no hope of collecting money,"
says Mark Raymond, Mr. Basabe's attorney.
The NASD arbitration panel found that the
Barclays broker who handled Mr. Basabe's account, Anton Brill, engaged
in "intentional misconduct" when he made unauthorized trades. Mr. Brill
now works at another securities firm in Florida. He has yet to pay the
$6,000 in punitive damages levied against him, or any of the remainder
of the arbitration award, for which he is jointly liable.
In an interview, Mr. Brill said the case took
place "a long time ago," adding that the matter is "still under
negotiation." He declined to elaborate. After receiving questions about
the case from The Wall Street Journal, an NASD spokeswoman said that the
association had begun proceedings to suspend Mr. Brill's license.
Murky Municipals
In October 2002, John Macko bought $15,000 of
municipal bonds issued by a trust organized by the government of Puerto
Rico. The 57-year-old lawyer in Geneseo, N.Y., discovered after the fact
that he had paid $25 to $44 more per $1,000 bond than brokers paid for
the same type of bond during the same trading day. This information
wasn't available to him at the time he made his purchases. The muni-bond
market, Mr. Macko says, "is very opaque."
State and local governments issue municipal
bonds to raise money for public projects. The bonds typically are exempt
from federal taxes, and most are seen as relatively safe investments.
Munis trade on an open market, but there isn't a place small investors
such as Mr. Macko can go to figure out whether they are getting a fair
price. (In contrast, stock prices are reported minute-to-minute by
exchanges, and mutual-fund prices are set once a day. Treasury bonds and
many corporate bonds are priced throughout the day with a short delay.)
Bond dealers, with their superior knowledge of
the market, can make a legitimate profit on the difference between what
they buy bonds for and their sales prices. But dealers have gone a step
further: opposing full online dissemination of real-time muni-bond
prices that would help small investors. The dealers say that because
many munis trade infrequently, it's difficult to determine precise
prices. Immediate disclosure of some prices, they add, might increase
volatility in the market and cause some dealers to stop trading certain
bonds.
Without fresh data on bond trading, individuals
can fall prey to brokers who tack on excessive "markups." An example:
Last May, the NASD alleged that Lee F. Murphy, a former broker at Morgan
Keegan & Co., charged too much in 35 bond sales, including deals in 2001
for bonds sold by St. James Parish, La., to raise money for solid-waste
disposal. Mr. Murphy obtained markups from investors ranging from 4.07%
to 7.18%. There aren't specific limits on markups, but the industry rule
of thumb is that margins should be well below 5%, unless there are
exceptional circumstances, such as the strong possibility that a
municipality will default.
In the case involving the Morgan Keegan broker,
the bonds "were readily available in the marketplace, and Murphy offered
no special services justifying an increased markup," the NASD alleged.
Mr. Murphy, who settled the administrative charges without admitting or
denying wrongdoing, was suspended for 15 days and fined $6,000.
Thomas Snyder, a managing director at Morgan
Keegan, says the trades were part of a unique situation in which Mr.
Murphy didn't have full information about a volatile, unrated bond.
Morgan Keegan officials add that the firm hadn't been sanctioned and
that it canceled the trades in question and reimbursed investors. Mr.
Murphy wasn't available at the New Orleans office of his current
employer, Sterne, Agee & Leach Inc.
Investors in theory can shop around, as they
would for a car. But as a practical matter, most individuals buy
municipal bonds through their regular broker and don't do much
comparing. Securities laws hold brokers to a higher standard of
protecting customers' interests than is applied to merchants such as car
dealers.
Individual investors -- who directly own an
estimated $670 billion of the $1.9 trillion in outstanding munis -- are
better off than they were just a year ago. That's when the Municipal
Securities Rulemaking Board expanded the amount of muni-bond data
available on a Web site called Investinginbonds.com. The MSRB, a
congressionally created self-regulatory body, provides the price, size
and time of each trade -- but typically with a delay of up to 24 hours.
The board plans to report same-day trade data for many bonds beginning
next year.
But Wall Street is resisting. Brokers are
lobbying the MSRB to delay the release of real-time data for some larger
trades and lower-quality bonds so that the impact of the disclosures can
be examined. These brokers point to the argument about increasing
volatility, which, they say, could heighten the risk of trading losses
for both dealers and investors.
Regulatory actions such as the NASD's move
against Mr. Murphy have been relatively infrequent, but that may be
changing. The SEC and the NASD have launched separate probes of bond
pricing, focusing on whether brokers have choreographed transactions
among themselves that drive muni prices up or down, to the detriment of
customers.
One voice is missing from the mix of
regulators, attorneys, shareholder activists and business leaders who
are trying to fix corporate boards — psychologists.
Jeffrey Sonnenfeld, associate dean at the Yale
School of Management, suggests in Forbes.com that psychologists could
add information about the "litany of pathologies" on corporate boards,
which he lists as "groupthink, bystander apathy, diffusion of
responsibility, inconsistent incentives, obedience to authority, atrophy
and the like."
Sonnenfeld says that now is the time to move
the governance debate away from new procedures and checklists and toward
"intelligent thinking about people and their character." With this in
mind, he offers advice on selecting directors:
Seek knowledge, not names. Corporations have
hidden behind the impressive, marquee names of their board members,
rather than seeking directors who are knowledgeable in their field.
Pay more attention to character than
independence. While the push for supermajorities of independent
directors gains steam, Sonnenfeld says "independent-mindedness is not
the same thing as independence." Directors who know the business can
prevent the chief executive from being the board’s sole source of
inside knowledge.
Purge those with commercial or social
agendas. Major conflicts are often political and personal, not
financial.
Find people with a passion for the business.
Overlook people who seek board posts for the vanity and power, but are
indifferent about the company they want to oversee, Sonnenfeld says.
Avoid joiners. The Corporate Library
estimates that a single board post requires 15 to 20 days a year of
preparation and meetings. People who collect board memberships like
trophies are spread too thin.
Beware false recipes by governance
consultants. It’s now fashionable, Sonnenfeld says, to avoid directors
who worked with troubled firms or those who are past retirement age.
Some businesses are wisely seeking energetic older leaders to sit on
their boards.
How Not to Fix Corporate Boards
The
planned deal raised questions about whether the two investors slated to
join the board -- David Matlin of MatlinPatterson and Glenn Hutchins of
Silver Lake -- had received favorable treatment from MCI.
"MCI Rescinds Deal With Investors After Criticism," by Mitchell Pacelle
and Shawn Young, The Wall Street Journal, April 19, 2004 ---
http://online.wsj.com/article/0,,SB108232471768285933,00.html?mod=technology_main_whats_news
MCI, the long-distance phone
company scheduled to emerge from bankruptcy this week, has canceled a
confidential arrangement it struck with two of its largest investors
after other investors called the deal unfair. A judge criticized the
company's handling of the arrangement with the two investors, who until
last week were expected to join the company's board.
The deal, which had been struck
in January, called for the two investment firms, MatlinPatterson Asset
Management and Silver Lake Partners, to swap all of their old MCI bonds
for new MCI bonds, instead of the mix of new stock and bonds that many
other creditors will receive. MCI said the arrangement was intended to
preserve a tax benefit for the company potentially valued at as much as
$500 million.
But when other creditors learned
of the confidential arrangement, some of them objected, arguing that it
would have given the two large investors a richer deal than was
available to other investors holding the same defaulted bonds. In recent
months, as questions mounted about MCI's future, MCI's stock, which has
been trading on a when-issued basis, has fallen in value, while the
bonds have held up. Moreover, the bonds will be easier to sell in
quantity than the new stock, investors said.
The planned deal raised
questions about whether the two investors slated to join the board --
David Matlin of MatlinPatterson and Glenn Hutchins of Silver Lake -- had
received favorable treatment from MCI.
Because of the objections, MCI agreed about one week ago to cancel the
agreements with these two investors, who will now be treated the same as
other bondholders, according to New York lawyer Marcia Goldstein, who
represents MCI and helped negotiate the agreements.
The new wave of corporate fraud trials was
supposed to be about systemic problems with the way American companies
are run. The trials were supposed to be about the collapse of accounting
standards and the way huge stock option grants can corrupt executives.
Instead prosecutors have spent a lot of
courtroom time talking about perks and obstruction of justice - about
floral arrangements and hotel bills run up by the indicted executives,
as well as whether they lied to prosecutors or federal investigators.
In the trial of L. Dennis Kozlowski, the former
chairman of Tyco International who is accused of looting his company,
prosecutors have repeatedly presented evidence of perks received by the
defendant, even when the benefits seem only tangentially related to the
charges at hand.
The trial of John J. Rigas, the founder of
Adelphia Communications, and his sons Timothy and Michael, which began
last week, appears set to follow a similar tack. Prosecutors are
preparing to present evidence about safari vacations and a $13 million
golf course allegedly paid for out of corporate funds.
Meanwhile, federal prosecutors investigating
Computer Associates, the Long Island software giant, have focused on
alleged lies that executives told to prosecutors, not the accounting
chicanery that Computer Associates allegedly used to inflate its
profits.
Prosecutors have good tactical reasons for
making these trials more about executive greed or obstruction of justice
than about accounting or securities fraud, securities lawyers say.
White-collar crime cases are often difficult to prove, as prosecutors
learned again Friday when the judge in the Martha Stewart case dismissed
a securities fraud charge against Ms. Stewart that was at the core of
the indictment against her.
So prosecutors look for every possible way to
simplify the cases for jurors - and to make defendants look bad.
Evidence of defendants' lavish lifestyles is
often used to provide a motive for fraud. Jurors sometimes wonder why an
executive making tens of millions of dollars would cheat to make even
more. Evidence of habitual gluttony helps provide the answer.
"You're trying to make the case that this
individual is greedy, should not be viewed as credible, is only out for
himself,'' said Joel Seligman, dean of the Washington University School
of Law. "It does have a kind of relevance.''
But prosecutors have other reasons for
introducing evidence of extravagant spending. Because the details of the
fraud charges can be so difficult to understand, jurors' decisions may
ultimately turn on their personal impressions of the indicted
executives.
"It's a lot more interesting to show the tape
of Jimmy Buffett playing in the background and people walking around
nude and drunk than to show the dry accounting evidence,'' said James
Cox, a professor of corporate and securities law at Duke University, in
reference to a videotape played by prosecutors in the Tyco trial about a
birthday party for Mr. Kozlowski's wife, Karen. Tyco paid $1 million,
about half the cost, for the party.
"The trial is partly about what the rules are,
but a lot about what the defendant is,'' Mr. Cox said.
The poison pill, one of the most
popular corporate-takeover defenses of the past two decades, is getting
tougher to swallow.
Faced with opposition from
activist shareholders and new pressures to clean up governance after
corporate scandals, companies are dismantling what has been one of the
best known of the antitakeover mechanisms. In the past month,
Circuit City Stores Inc.,
Goodyear Tire & Rubber Co.,
FirstEnergy Corp.,
PG&E Corp., and
Raytheon Co., among others, all took steps toward eliminating their
pills.
So far this year, a dozen
companies have taken steps to dismantle their pills, compared with 29
for all of 2003 and just 18 in 2002, according to TrueCourse Inc., which
tracks corporate-takeover defenses. Although such actions typically are
heaviest just ahead of the annual-meeting season in which shareholders
air gripes, people who follow corporate-governance issues say the trend
is likely to continue through the year.
Meanwhile, fewer companies are
putting the measure in place: The rate of new poison-pill adoptions fell
to a 10-year low in 2003, according to TrueCourse. About 99 companies
adopted new plans in 2003, down 42% from the prior year.
While there may still be a net
gain in pills this year, the figures show the sharp decline in the rate
of increase. "In the current environment, there is an increasing desire
by boards to be viewed as following good governance and not be
entrenched," says Alan Miller, co-chairman of proxy-solicitation firm
Innisfree M&A Inc. "This is the flavor of the day, and it's going to
accelerate."
Continued in the article
Question
What lawsuit is shaking up corporate governance at the moment?
Hint: It's a Mickey Mouse lawsuit.
Answer
It's Been Mickey Mouse Corporate Governance: Until Now
"Boards Beware! A lawsuit by Disney shareholders is shaking up much
more than the Mouse House. Thanks to a Delaware court ruling,
less-than-conscientious board members everywhere are running scared."
FORTUNE, October 27, 2003, by Marc Gunther ---
http://www.fortune.com/fortune/ideas/articles/0,15114,526338,00.html
In fall 1996, Michael Eisner, the chairman and
CEO of Walt Disney Co., decided he had made a big mistake. Just a year
earlier he had hired Hollywood power broker Michael Ovitz as Disney's
president. Ovitz had flopped, badly. The men needed to find a way to
disengage without unduly embarrassing either of them.
In a three-page, handwritten letter dated Oct.
9, 1996, Eisner proposed an amicable separation to Ovitz, a friend who
had literally stood by him after his coronary-bypass surgery two years
earlier. "We must work together to assure a smooth transition and deal
with the public relations brilliantly," Eisner wrote. "I am committed to
make this a win-win situation, to keep our friendship intact, to be
positive, to say and write only glowing things. You still are the only
one who came to my hospital bed—and I do remember."
"This all can work out!"
It has not worked out—not even close. Ovitz,
you may recall, walked away with a severance package that was generous
even by entertainment-industry standards. For 15 months of labor, he got
$38 million in cash, plus stock options valued at $101 million. That
package caused an uproar and triggered a lawsuit by Disney shareholders,
who want their money back. Since then none of them—not Ovitz, not
Eisner, not the company, not shareholders—has fared very well. Ovitz's
next venture failed, Eisner's reputation soured, and Disney shares
currently trade at about $22 each, the same price as when Ovitz left in
'96.
We revisit this unhappy moment in Hollywood
history seven years later not merely for its gossip value but because
the shareholder lawsuit that it provoked has, improbably, taken on
enormous significance for the boards of public companies. In a ruling
issued in May that has become must-reading in corporate boardrooms,
Delaware judge William B. Chandler III said that the suit can go to
trial. His reason: The facts, as alleged, indicate that Disney's
directors failed to make a good-faith effort to do their job when they
approved Ovitz's contract and once again when they allowed him such a
lucrative going-away present. The $140 million package represented
nearly 10% of Disney's net income in 1996.
The Disney directors who are defendants—there
are 18 in all, including Eisner, Ovitz, and such well-known figures as
former Senator George Mitchell, former Capital Cities CEO Thomas S.
Murphy, and actor Sidney Poitier—all have been subpoenaed to testify. So
have Hollywood bigwigs Sean Connery, Martin Scorsese, former Seagram
chairman Edgar Bronfman, Revolution Studios chief Joe Roth, and Ron
Meyer, Ovitz's former partner at Creative Artists Agency. Lawyers for
the shareholders want the directors to return the money that Ovitz was
paid, plus interest, to Disney's coffers. They also want Disney to
radically shake up its board, stripping Eisner of his chairmanship and
getting rid of the directors who, the lawsuit alleges, failed to do
their jobs.
This is a big deal, and not just for Disney.
Judge Chandler's opinion has put directors of public companies on notice
that the courts in Delaware, where more than half of the FORTUNE 500 are
incorporated, are inclined to hold them to a higher standard of
performance than has been expected in the past. Boards have enjoyed
virtually unlimited protection from lawsuits, particularly on the issue
of executive pay—until now.
Says Scott Spector, a partner in the corporate group of the Silicon
Valley law firm of Fenwick & West: "This case has tremendous importance
at a time when executive compensation is under intense media and
shareholder scrutiny."
To be sure, the Disney case will not by itself
change the way boards do business. But it's one more reason directors
need to take their jobs more seriously in the aftermath of Enron,
WorldCom, and Sarbanes-Oxley. Already directors are feeling multiple
pressures: Institutional investors are paying more attention to
governance; insurance companies are asking more questions before they
write policies that protect directors and officers of public companies
from liability; shareholder lawsuits are proliferating; and regulators
want to give shareholders access to proxy statements so that they can
vote out the directors who are no more essential than a sprig of parsley
on a filet of sole.
To understand why the Disney case matters, you
need to know a little about Delaware. The economy of this tiny
state—it's just 30 miles across and 100 miles long—consists largely of
DuPont, banking, beaches, and the business of corporate law. Companies
choose to incorporate there because since 1899 the state government has
made it easy for them to do so. Back then other states required a
special act of the legislature to form a corporation. Delaware asked
only for a few forms and a small filing fee.
Question
What else is shaking up corporate governance?
Hint: Vanguard is one of the largest and most ethical mutual fund
companies on the planet.
Answer
Vanguard also is cracking down on companies
that pay their auditors less for their audit than for other services such
as consulting. "We want companies to spend more for their audit than for
everything else," says Glenn Booraem, who heads Vanguard's
corporate-governance effort.And Vanguard voted against any directors that
served on audit committees that didn't meet the firm's standard on auditor
pay.
Vanguard Group, the nation's
second-biggest mutual-fund firm behind Fidelity Investments, is turning
up the heat on corporate CEOs.
In a letter sent last week to the
chief executive officers at several hundred of
Vanguard Group's top holdings, the fund firm said that while there
has been progress in corporate governance following the scandals of the
past few years, "there is much more change needed."
So, Vanguard is taking a much
harder line this year, going against the managements' wishes in hundreds
of proxy votes.
Vanguard's stance on three key
proxy issues highlights its new standards. In voting for corporate
directors, Vanguard approved just 29% of the full slates of directors
proposed by companies in which it invests. Last year, Vanguard approved
90% of the full slates of directors.
In addition, Vanguard approved
79% of its companies' auditors, down from 100% last year. And the firm
voted in favor of just 36% of employee-option plans, the same number as
last year.
Votes like those by Vanguard are
one reason why a record number of proposals from shareholders were
approved this year. According to Institutional Shareholder Services
Inc., which advises mutual funds and pension funds on proxy voting, 164
shareholder resolutions on everything from staggered boards to takeover
defenses to executive compensation earned majorities this year. The
previous record was 106 for all of last year. "It was a record year for
activism any way you look at it," says Patrick McGurn, senior vice
president of ISS.
Corporate governance -- which is
simply how a board oversees management, makes sure the company is run
well and that shareholders are treated fairly -- has been a hot-button
issue since the collapse of Enron Corp., WorldCom Inc. (now MCI) and
others. Since then, investors have become increasingly skeptical that
board members and managements have their best interests at heart. Many
have registered that displeasure by voting against proposals favored by
management in the companies' annual proxy -- proposals that usually are
approved with little notice.
For example, companies need to
nominate some or all of their directors for re-election each year and
shareholders get to vote on the names. It's rare that these nominees are
voted down. But Vanguard approved only 29% of the full slates of board
members nominated by companies. (Vanguard says it has to vote for all of
the directors on a slate for it to count as approved.) Last year, it
approved 90% of the full slates of boards.
Why the switch? In a similar
letter to CEOs last year, Vanguard CEO and Chairman Jack Brennan warned
that the firm would tighten its standards in response to the scandals.
Vanguard now votes against directors who are on the board's audit,
nominating or compensation committees, if they aren't considered
independent of management. The firm also votes against board members if
the committees they are on did things that Vanguard didn't like.
For example," Mr. Brennan said in
an e-mail,"we now withhold votes for directors who serve on the
compensation committee if the company is proposing excessive annual
option grants or other compensation approaches that we are voting
against." Vanguard also is cracking down
on companies that pay their auditors less for their audit than for other
services such as consulting. "We want companies to spend more for their
audit than for everything else," says Glenn Booraem, who heads
Vanguard's corporate-governance effort.And Vanguard voted against any directors
that served on audit committees that didn't meet the firm's standard on
auditor pay.
Corporate-governance experts say
that while Vanguard has voted against management before, it never has
made such a show of it. That will change next year, when fund companies
must disclose their votes on individual company proxies. Vanguard
opposed that shift, but experts hope it will make funds even more
willing to stand up to management.
"One of the thoughts behind
disclosure of voting was it would probably cause funds to vote more
against management now that the votes were out in the sunlight," says
Peter Clapman, chief counsel at TIAA-CREF, the big pension fund that has
a history of shareholder activism.
Corporate
America is in crisis. Scandals, bankruptcies, questionable accounting
and the like are eroding public trust. Poorly timed or possibly even
fraudulent stock sales by key company executives are igniting
legislative action. The overall economy is struggling, the stock market
is in a heightened state of volatility, and investor confidence has
plummeted so low that CEOs are now legally required to sign a pledge of
honesty.
As a result,
all the goodwill created by corporate America with the gains of the
1990s has vanished. Executive pay is once again under heavy public
scrutiny, and calls to link pay with accurate measures of performance
are louder than ever before.
Executive pay,
especially CEO pay, has become a lightning rod for this collapse in
investor confidence for a number of reasons. CEO pay levels in a few
instances have reached into the hundreds of millions of dollars for a
single year, raising the question of whether any employee is worth that
type of money — especially in cases of a company’s mediocre or even poor
performance. There also have been recent examples of overstated profits
or outright fraud. Such situations are compounded by the ability of
executives to time the exercise of their options and the sale of their
stock, and by the fact that stock options are accounted for differently
from other forms of compensation.
We believe that
the executive pay situation offers a key window into the corporate
governance crisis facing America and, accordingly, provides a possible
solution. The companies with the pay governance processes that are most
transparent and most aligned will be the ones to inspire the most
investor confidence.
Watson Wyatt
research clearly and consistently documents that a company’s executive
pay levels are directly and positively correlated with its financial
performance. Companies that give their executives a greater stock
incentive opportunity outperform companies with lower opportunity. We
also have found that companies with high levels of stock ownership at
the executive and other employee levels substantially outperform their
low stock ownership counterparts. In fact, our research has shown that
stock ownership is more effective than stock options in this regard.
The research in
our 2003 Executive Pay/Stock Option Overhang study bears this out. In
particular, our findings show:
Companies
with senior executives with high stock ownership financially
outperform companies with lower executive ownership. This performance
is measured by Total Returns to Shareholders (TRS), Return on Equity,
Earnings Per Share (EPS) growth and Tobin’s Q, among others.
Companies
with high actual CEO pay have better historical financial performance,
as measured by TRS, than companies with low actual pay.
Both cash
compensation and stock option profits are highly sensitive to
shareholder returns.
Stock
options remain a positive factor in company and economic performance
despite the current economic uncertainty and the fact that fewer
options are now being exercised. However, our research also shows that
companies with excessively large amounts of stock option “overhang”
have lower returns to shareholders than companies with more moderate
usage. In addition, the optimal point in stock option overhang has
gone down dramatically for companies in the high-tech sector.
To better
understand some of the concerns of investors, we have investigated the
impact of executive pay and stock option overhang on financial
performance. The world of executive pay could change in unpredictable
ways over the next few years. We believe that our statistical research
on pay, ownership and options could be helpful in setting the future
direction.
This report
details those findings. The first section focuses on executive pay; the
second on stock option overhang. It is interesting to note that, if the
rules for accounting of stock options change significantly (as we now
think likely), it is possible that stock option overhang will become a
less important measure. For now, however, these historically reliable
gauges continue to offer valuable insights.
One interesting sidebar on this
was an NBC News feature last night on February 6, 2003. It was
pointed out that most of the bad deeds in the Enron scandal were committed
by men (e.g., Skilling, Lay, Fastow, and Duncan). Most of the white
knights in whistle blowing have been women (the show featured three of
those women). The implication was that we should place more trust in the
feminine gender. Sounds good to me!
Bob, I was
turning out what passes for my "home office" earlier today and came
across the Winter 1997 issue of Contemporary Accounting Research
(Vol 14, #4). One of the articles therein (page 653) is entitled:
"An Examination
of Moral Development within Public Accounting by Gender, Staff Level and
Firm" by Bernardi, R and Arnold, D F (Sr)
The authors'
dataset covers 494 managers and seniors from five "Big Six" firms.
According to
the abstract;
"The results
indicate a difference in the average level of moral development among
firms.....Second, female managers are at a significantly higher average
level of moral development than male managers. In fact, average scores
for male managers fell between those expected for senior high school and
college students. The data suggest that a greater percentage of
high-moral-development males and a low-moral development females are
leaving public accounting than their respective opposites. These
results indicate that the profession has retained, through advancement,
males who are potentially less sensitive to the ethical implications of
various issues."
- all of which
leads me to wonder whether your comments (about Enron) re our needing
more female executives wasn't right on target - and also, which
accounting firms ranked where in "average level of moral development".
A new study released today by Catalyst
demonstrates that companies with a higher representation of women in
senior management positions financially outperform companies with
proportionally fewer women at the top. These findings support the
business case for diversity, which asserts companies that recruit,
retain, and advance women will have a competitive advantage in the
global marketplace.
In the study The Bottom Line: Connecting
Corporate Performance and Gender Diversity, sponsored by BMO Financial
Group, Catalyst used two measures to examine financial performance:
Return on Equity (ROE) and Total Return to Shareholders (TRS). After
examining the 353 companies that remained on the F500 list for four out
of five years between 1996 and 2000, Catalyst found:
The group of companies with the highest
representation of women on their senior management teams had a
35-percent higher ROE and a 34- percent higher TRS than companies with
the lowest women's representation.
Consumer Discretionary, Consumer Staples,
and Financial Services companies with the highest representation of
women in senior management experienced a considerably higher ROE and
TRS than companies with the lowest representation of women.
"Business leaders increasingly request hard
data to support the link between gender diversity and corporate
performance. This study gives business leaders unquestionable evidence
that a link does exist," said Catalyst President Ilene H. Lang. "We
controlled for industry and company differences and the conclusion was
still the same. Top-performing companies have a higher representation of
women on their leadership teams."
"The Catalyst study confirms my own long-held
conviction that it makes the best of business sense to have a diverse
workforce and an equitable, supportive workplace," said Tony Comper,
Chairman and CEO of BMO Financial Group, sole sponsor of the research.
A Note on Methodology
Catalyst divided the 353 companies into four
roughly equal quartiles based on the representation of women in senior
management. The top quartile is the 88 companies with the highest gender
diversity on leadership teams. The bottom quartile is the 89 companies
with the lowest gender diversity. Catalyst then compared the two groups
based on overall ROE and TRS.
"It is important to realize that our findings
demonstrate a link between women's leadership and financial performance,
but not causation," said Susan Black, Catalyst Vice President of Canada
and Research and Information Services. "There are many variables that
can contribute to outstanding financial performance, but clearly,
companies that understand the competitive advantage of gender diversity
are smart enough to leverage that diversity."
From The Wall Street Journal's Accounting Educators' Reviews on
February 14, 2002
SUMMARY: Microsoft is undergoing a continuing SEC investigation into
whether the company has understated its revenues. Questions relate to
issues in unearned revenue.
QUESTIONS:
1.) What is conservatism in accounting? Is it an accepted practice?
2.) In general, what is unearned revenue? How is it presented in the
financial statements? When is this balance recognized as earned? What
accounting adjustment is made at that time?
3.) Why must Microsoft record some unearned revenues from software
sales? Could that practice be supported through reserves of some cash
accounts?
4.) Given Microsoft's recent experiences in testifying against
allegations of violating federal antitrust laws, why might the company
want to understate its income?
5.) Why does the former Microsoft employee, Mr. Pancerzewski, say that
"he disagrees that there is no harm in a company understating its income"?
Do you think there could be problems in understating income even for
companies that are not facing charges of earning excess profits through
anti-competitive practices?
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
The
Enron Scandal on Creative Accounting and Audit
Independence
Message to Valero on April 17, 2004
Hi Pepper,
I request that you print this message for all participants of the
workshop that I will present at Valero.
Of all the many documents and books that I have read about
derivative financial instruments, the most important have been the
books and documents written by Frank Partnoy. Some of his books are
listed at the bottom of this message.
The single most important document is his Senate Testimony. More
than any other single thing that I've ever read about the Enron
disaster, this testimony explains what happened at Enron and what
danger lurks in the entire world from continued unregulated OTC
markets in derivatives. I think this document should be required
reading for every business and economics student in the world.
Perhaps it should be required reading for every student in the
world. Among other things it says a great deal about human greed and
behavior that pump up the bubble of excesses in government and
private enterprise that destroy the efficiency and effectiveness of
what would otherwise be the best economic system ever designed.
It would be neat if you could print his entire testimony as
advance reading (15 pages) for the audience ---
http://www.senate.gov/~gov_affairs/012402partnoy.htm
Please print my message as well since it lists some of his other
writings.
I appreciate this opportunity to meet with Valero specialists in
derivatives and derivatives accounting.
Thanks,
Bob
Frank Partnoy is best known as a whistle blower at Morgan Stanley
who blew the lid on the financial graft and sexual degeneracy of
derivatives instruments traders and analysts who ripped the public
off for billions of dollars and contributed to mind-boggling
worldwide frauds. He is a Yale University Law School graduate
who shocked the world with various books include the
following:
FIASCO: The Inside Story of a Wall Street Trader
FIASCO: Blood in the Water on Wall Street
FIASCO: Blut an den weißen Westen der Wall Street
Broker.
FIASCO: Guns, Booze and Bloodlust: the Truth About High
Finance
Infectious Greed : How Deceit and Risk Corrupted the
Financial Markets
Codicia Contagiosa
His other publications include the following highlight:
"The Siskel and Ebert of Financial Matters: Two Thumbs Down for
the Credit Reporting Agencies" (Washington University Law
Quarterly)
In the end, derivatives are like antibiotics. It's
dangerous to live with them, but the world is better off because of
them. The same can be said about FAS 133 and its many
implementation guides and amendments. Booking derivatives at
fair value is dangerous, but the economy would be worse off without
it. What we have to do is to strive night and day to improve
upon reporting of value and risk in a world that relies more and
more on derivative financial instruments to manage risks.
Selected works of FRANK PARTNOY
Bob Jensen at
TrinityUniversity
1. Who
is Frank Partnoy?
The
controversial writings of Frank Partnoy have had an enormous impact on my
teaching and my research. Although subsequent writers wrote somewhat
more entertaining exposes, he was the one who first opened my eyes to what
goes on behind the scenes in capital markets and investment banking.
Through his early writings, I discovered that there is an enormous gap
between the efficient financial world that we assume in agency theory
worshipped in academe versus the dark side of modern reality where you
find the cleverest crooks out to steal money from widows and orphans in
sophisticated ways where it is virtually impossible to get caught.
Because I read his 1997 book early on, the ensuing succession of enormous
scandals in finance, accounting, and corporate governance weren’t really
much of a surprise to me.
From his
insider perspective he reveals a world where our most respected firms in
banking, market exchanges, and related financial institutions no longer
care anything about fiduciary responsibility and professionalism in
disgusting contrast to the honorable founders of those same firms
motivated to serve rather than steal.
Young men and
women from top universities of the world abandoned almost all ethical
principles while working in investment banks and other financial
institutions in order to become not only rich but filthy rich at the
expense of countless pension holders and small investors. Partnoy
opened my eyes to how easy it is to get around auditors and corporate
boards by creating structured financial contracts that are
incomprehensible and serve virtually no purpose other than to steal
billions upon billions of dollars.
Most
importantly, Frank Partnoy opened my eyes to the psychology of greed.
Greed is rooted in opportunity and cultural relativism. He graduated
from college with a high sense of right and wrong. But his standards
and values sank to the criminal level of those when he entered the
criminal world of investment banking. The only difference between
him and the crooks he worked with is that he could not quell his
conscience while stealing from widows and orphans.
Frank Partnoy
has a rare combination of scholarship and experience in law, investment
banking, and accounting. He is sometimes criticized for not really
understanding the complexities of some of the deals he described, but he
rather freely admits that he was new to the game of complex deceptions in
international structured financing crime.
2.
What really happened at Enron?
I begin with the following document the best thing I ever read explaining
fraud at Enron.
Testimony of Frank Partnoy Professor of Law, University of San Diego
School of Law Hearings before the United States Senate Committee on
Governmental Affairs, January 24, 2002 ---
http://www.senate.gov/~gov_affairs/012402partnoy.htm
The following
selected quotations from his Senate testimony speak for themselves:
Quote:
In other words, OTC derivatives markets, which for
the most part did not exist twenty (or, in some cases, even ten) years
ago, now comprise about 90 percent of the aggregate derivatives market,
with trillions of dollars at risk every day. By those measures,
OTC derivatives markets are bigger than the markets for U.S.stocks. Enron may have been just an
energy company when it was created in 1985, but by the end it had become
a full-blown OTC derivatives trading firm. Its OTC
derivatives-related assets and liabilities increased more than five-fold
during 2000 alone.
Quote:
And, let me repeat, the OTC derivatives markets
are largely unregulated. Enron’s trading operations were not
regulated, or even recently audited, by U.S. securities regulators, and
the OTC derivatives it traded are not deemed securities. OTC
derivatives trading is beyond the purview of organized, regulated
exchanges. Thus, Enron – like many firms that trade OTC
derivatives – fell into a regulatory black hole.
Quote:
Specifically, Enron used derivatives and
special purpose vehicles to manipulate its financial statements in three
ways. First, it hid speculator losses it suffered on technology
stocks. Second, it hid huge debts incurred to finance unprofitable
new businesses, including retail energy services for new customers.
Third, it inflated the value of other troubled businesses, including its
new ventures in fiber-optic bandwidth. Although Enron was founded
as an energy company, many of these derivatives transactions did not
involve energy at all.
Quote:
Moreover, a thorough inquiry into these
dealings also should include the major financial market “gatekeepers”
involved with Enron: accounting firms, banks, law firms, and credit
rating agencies. Employees of these firms are likely to have
knowledge of these transactions. Moreover, these firms have a
responsibility to come forward with information relevant to these
transactions. They benefit directly and indirectly from the
existence of U.S.securities regulation, which in many instances both forces companies
to use the services of gatekeepers and protects gatekeepers from
liability.
Quote:
Recent cases against accounting firms –
including Arthur Andersen – are eroding that protection, but the other
gatekeepers remain well insulated. Gatekeepers are kept honest –
at least in theory – by the threat of legal liability, which is
virtually non-existent for some gatekeepers. The capital markets
would be more efficient if companies were not required by law to use
particular gatekeepers (which only gives those firms market power), and
if gatekeepers were subject to a credible threat of liability for their
involvement in fraudulent transactions. Congress should consider
expanding the scope of securities fraud liability by making it clear
that these gatekeepers will be liable for assisting companies in
transactions designed to distort the economic reality of financial
statements.
Quote:
In a nutshell, it appears that some Enron employees used dummy accounts
and rigged valuation methodologies to create false profit and loss
entries for the derivatives Enron traded. These false entries were
systematic and occurred over several years, beginning as early as 1997.
They included not only the more esoteric financial instruments Enron
began trading recently – such as fiber-optic bandwidth and weather
derivatives – but also Enron’s very profitable trading operations in
natural gas derivatives.
Quote:
The difficult question is what to do about the
gatekeepers. They occupy a special place in securities regulation,
and receive great benefits as a result. Employees at gatekeeper
firms are among the most highly-paid people in the world. They
have access to superior information and supposedly have greater
expertise than average investors at deciphering that information.
Yet, with respect to Enron, the gatekeepers clearly did not do their
job.
For more on
Frank Partnoy's testimony, click here.
3.
What are some of Frank Partnoy’s best-known books?
Frank Partnoy,
FIASCO: Blood in the Water on Wall Street (W. W. Norton & Company,
1997, ISBN 0393046222, 252 pages).
This is the
first of a somewhat repetitive succession of Partnoy’s “FIASCO” books
that influenced my life. The most important revelation from his
insider’s perspective is that the most trusted firms on Wall Street and
financial centers in other major cities in the U.S., that were once
highly professional and trustworthy, excoriated the guts of integrity
leaving a façade behind which crooks less violent than the Mafia but far
more greedy took control in the roaring 1990s.
After selling
a succession of phony derivatives deals while at Morgan Stanley, Partnoy
blew the whistle in this book about a number of his employer’s shady and
outright fraudulent deals sold in rigged markets using bait and switch
tactics. Customers, many of them pension fund investors for
schools and municipal employees, were duped into complex and enormously
risky deals that were billed as safe as the U.S. Treasury.
His books
have received mixed reviews, but I question some of the integrity of the
reviewers from the investment banking industry who in some instances
tried to whitewash some of the deals described by Partnoy. His
books have received a bit less praise than the book Liars Poker
by Michael Lewis, but critics of Partnoy fail to give credit that
Partnoy’s exposes preceded those of Lewis.
Frank Partnoy,
FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance
(Profile Books, 1998, 305 Pages)
Like his
earlier books, some investment bankers and literary dilettantes who
reviewed this book were critical of Partnoy and claimed that he
misrepresented some legitimate structured financings. However, my
reading of the reviewers is that they were trying to lend credence to
highly questionable offshore deals documented by Partnoy. Be that
as it may, it would have helped if Partnoy had been a bit more explicit
in some of his illustrations.
Frank Partnoy,
FIASCO: The Inside Story of a Wall Street Trader (Penguin, 1999,
ISBN 0140278796, 283 pages).
This is a
blistering indictment of the unregulated OTC market for derivative
financial instruments and the devious million and billion dollar deals
conceived by drunken sexual deviates in investment banking. Among
other things, Partnoy describes Morgan Stanley’s annual drunken
skeet-shooting competition.
This is also
one of the best accounts of the “fiasco” caused by Merrill Lynch in
which Orange Counting lost over a billion dollars and was forced into
bankruptcy.
Frank Partnoy,
Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
(Henry Holt & Company, Incorporated, 2003, ISBN: 0805072675, 320 pages)
Partnoy shows
how corporations gradually increased financial risk and lost control over
overly complex structured financing deals that obscured the losses and
disguised frauds pushed corporate officers and their boards into
successive and ingenious deceptions." Major corporations such as Enron,
Global Crossing, and WorldCom entered into enormous illegal corporate
finance and accounting. Partnoy documents the spread of this
epidemic stage and provides some suggestions for restraining the disease.
4.
What are examples of related books that are somewhat more entertaining
than Partnoy’s early books?
Michael
Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN
0340767006)
Lewis writes
in Partnoy’s earlier whistleblower style with somewhat more intense and
comic portrayals of the major players in describing the double dealing
and break down of integrity on the trading floor of Salomon Brothers.
John Rolfe and
Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle
(Warner Books, Incorporated, 2002, ISBN: 0446676950, 288 Pages)
This is a hilarious
tongue-in-cheek account by Wharton and Harvard MBAs who thought they
were starting out as stock brokers for $200,000 a year until they
realized that they were on the phones in a bucket shop selling sleazy
IPOs to unsuspecting institutional investors who in turn passed them
along to widows and orphans. They write. "It took us
another six months after that to realize that we were, in fact,
selling crappy public offerings to investors."
There are
other books along a similar vein that may be more revealing and
entertaining than the early books of Frank Partnoy, but he was one of
the first, if not the first, in the roaring 1990s to reveal the high
crime taking place behind the concrete and glass of Wall Street.
He was the first to anticipate many of the scandals that soon
followed. And his testimony before the U.S. Senate is the best
concise account of the crime that transpired at Enron. He lays
the blame clearly at the feet of government officials (read that Wendy
Graam) who sold the farm when they deregulated the energy markets and
opened the doors to unregulated OTC derivatives trading in energy.
That is when Enron really began bilking the public.
Is troubled
Enron Corp. the
Long Term Capital Management of the energy markets, or merely yet
another mismanaged company whose executives read too many of their own
press releases? Or is poor Enron just misunderstood? Those are the
questions after another week of Chinese water torture financial releases
from the beleaguered Houston-based energy concern.
A year ago
Enron was the hottest of the hot. While tech stocks were tanking,
Enron's shares gained 89% during 2000. Even die-hard Enron skeptics --
of which there are many -- had to concede that last year was a
barnburner for the company. Earnings were up 25%, and revenues more than
doubled.
Not bad,
considering where the company came from. A decade ago 80% of Enron's
revenues came from the staid (and regulated) gas-pipeline business. No
longer. Enron has been selling those assets steadily, partly fueling
revenues, but also expanding into new areas. By 2000, around 95% of its
revenues and more than 80% of its profits came from trading energy, and
buying and selling stakes in energy producers.
The stock
market applauded the move: At its peak, Enron was trading at around 55
times earnings. That's more like Cisco's once tropospheric valuation
than the meager 2.5 times earnings the market affords Enron competitor
Duke Energy.
But Enron
management wanted more. It was, after all, a "new economy" Web-based
energy trader where aggressive performers were lucratively rewarded.
According to Enron Chairman and CEO Ken Lay, the company deserved to be
valued accordingly. At a conference early this year he told investors
the company's stock should be trading much higher -- say $126, more than
double its price then.
Then the new
economy motor stalled. The company's president left under strange
circumstances. And rumors swirled about Enron's machinations in
California's energy markets. Investors pored over Enron's weakening
financial statements. But Enron analysts must have the energy and
persistence of Talmudic scholars to penetrate the company's cryptic
financials. In effect, Enron's troubles were hiding in plain sight.
It should have
been a warning. Because of the poor financial disclosure there was no
way to assess the damage the economy was doing to the company, or how it
was trying to make its numbers. Most analysts blithely concede that they
really didn't know how Enron made money -- in good markets or bad.
Not that Enron
didn't make money, it did -- albeit with a worrisomely low return on
equity given the capital required -- but sometimes revenues came from
asset sales and complex off-balance sheet transactions, sometimes from
energy-trading revenues. And it was very difficult to understand why or
how -- or how likely it was Enron could do it again next quarter.
Enron's
financial inscrutability hid stranger stuff. Deep inside the company
filings was mention of LJM Cayman, L.P., a private investment
partnership. According to Enron's March 2000 10-K, a "senior officer of
Enron is the managing member" of LJM. Well, that was a puzzler. LJM was
helping Enron "manage price and value risk with regard to certain
merchant and similar assets by entering
into derivatives, including swaps, puts, and collars." It was, in a
phrase, Enron's house hedge fund.
There is
nothing wrong with hedging positions in the volatile energy market -- it
is crucial for a market-maker. But having an Enron executive managing
and benefiting from the hedging is something else altogether, especially
when the Enron executive was the company's CFO, Andrew Fastow. While he
severed his connection with LJM (and related partnerships) in July of
this year -- and left Enron in a whirl of confusion last week -- the
damage had been done.
As stories in
this paper have since made clear, Mr. Fastow's LJM partnership allegedly
made millions from the conflict-ridden, board-approved LJM-Enron
relationship. And recently Enron ended the merry affair, taking a
billion-dollar writedown against equity two weeks ago over some of LJM's
wrong-footed hedging. Analysts, investors, and the Securities & Exchange
Commission were left with many questions, and very few answers.
To be fair, I
suppose, Enron did disclose the LJM arrangement more than a year ago,
saying it had erected a Chinese wall between Fastow/LJM and the company.
And in a bull market, no one paid much attention to what a bad idea that
horribly conflicted relationship was -- or questioned the strength of
the wall. Now it matters, as do other Enron-hedged financings, a number
of which look to have insufficient assets to cover debt repayments due
in 2003.
We didn't
do anything wrong is Mr. Lay's refrain in the company's current round of
entertainingly antagonistic conference calls. That remains to be seen,
but at the very least the company has shown terrible judgment, and
heroic arrogance in its dismissal of shareholders interests and
financial transparency.
Where has
Enron's board of directors been through all of this?
What kind of
oversight has this motley collection of academics, government sorts, and
retired executives exercised for Enron shareholders? Very little, it
seems. It is time Enron's board did a proper investigation, and then
cleaned house -- perhaps neatly finishing with themselves.
Then I
discovered the "tip of the iceberg" article below:
Dealings with a
related party have tarnished Enron's (ENE:NYSE - news - commentary -
research - analysis) reputation and crushed its stock, but it looks like
that case is far from unique.
The battered
energy trader has done business with at least 15 other related entities,
according to documents supplied by lawyers for people suing Enron.
Moreover, Enron's new CFO, who has been portrayed by bulls as opposing
the related-party dealings of his predecessor, serves on 12 of these
entities. And Enron board members are listed as having directorships and
other roles at a Houston-based related entity called ES Power 3.
The extent of
Enron's dealings with these companies, or the value of its holdings in
them, couldn't be immediately determined. But the existence of these
partnerships could feed investors' fears that Enron has billions of
dollars of liabilities that don't show up on its balance sheet. If
that's so, the company's financial strength and growth prospects could
be much less than has generally been assumed on Wall Street, where the
company was long treated with kid gloves.
Enron didn't
immediately respond to questions seeking details about ES Power or about
the role of the chief financial officer, Jeff McMahon, in the various
entities. Enron's board members couldn't immediately be reached for
comment.
Ten Long Days
Enron's
previous CFO, Andrew Fastow, was replaced by McMahon Wednesday after
investors criticized Fastow's role in a partnership called LJM, which
had done complex hedging transactions with Enron. As details of this
deal and
two others emerged, Enron stock cratered.
The turmoil
that resulted in Fastow's departure began two weeks ago, when Enron
reported third-quarter earnings that met estimates. However, the company
failed to disclose in its earnings press release a $1.2 billion charge
to equity related to unwinding the LJM transactions. Since then,
investors and analysts have been calling with increasing vehemence for
the company to divulge full details of its business dealings with other
related entities. Enron stock sank 6% Friday, meaning it has lost 56% of
its value in just two weeks.
Enron's
End Run? New financial chief's involvement in Enron
business partners
Enron-Related Entity
Creation
Date
McMahon
Involved?
ECT
Strategic Value Corp.
4/18/1985
Yes
JILP-LP Inc.
9/27/1995
Yes
ECT
Investments Inc.
3/1/1996
Yes
Kenobe Inc.
11/8/1996
Yes
Enserco LLC
1/7/1997
Yes
Obi-1
Holdings LLC
1/7/1997
Yes
Oilfield
Business Investments - 1 LLC
1/7/1997
Yes
HGK
Enterprises LP Inc.
7/29/1997
Yes
ECT Eocene
Enterprises III Inc.
2/20/1998
Yes
Jedi Capital
II LLC
9/4/1998
Yes
E.C.T. Coal
Company No. 2 LLC
12/31/1998
Yes
ES Power 3
LLC
1/7/1999
Yes
Enserco Inc.
3/25/1999
No
LJM
Management LLC
7/2/1999
No
Blue Heron I
LLC
9/17/1999
No
Whitewing
Management LLC
2/28/2000
No
Jedi Capital
II LLC
4/16/2001
No
Source:
Detox
However, Enron
has yet to break out a full list of related entities. The company has
said nothing publicly about McMahon's participation in related entities,
nor has it mentioned that its board members were directors or senior
officers in ES Power 3. (Nor has it explained the extensive use of
Star Wars-related names by the related-party companies.) It's not
immediately clear what ES Power 3 is or does. So far, subpoenas issued
by lawyers suing Enron have determined the names of senior officers of
ES Power 3 and its formation date, January 1999.
Among ES Power
3's senior executives are Enron CEO Ken Lay, listed as a director, and
McMahon and Fastow, listed as executive vice presidents. A raft of
external directors are named as ES Power 3 directors, including
Comdisco CEO Norman Blake and Ronnie Chan, chairman of the Hong
Kong-based Hang Lung Group. A Comdisco spokeswoman says Blake
isn't commenting on matters concerning Enron and a call to the Hang Lung
group wasn't immediately returned.
Demands,
Demands
Rating agencies
Moody's, Fitch and S&P recently put Enron's credit rating on review for
a possible downgrade after an LJM deal that led to the $1.2 billion hit
to equity. Enron still has a rating three notches above investment
grade. But its bonds trade with a yield generally seen on subinvestment
grade, or junk, bonds, suggesting the market believes downgrades are
likely.
If Enron's
rating drops below investment grade, it must find cash or issue stock to
pay off at least $3.4 billion in off-balance sheet obligations. In
addition, many of its swap agreements contain provisions that demand
immediate cash settlement if its rating goes below investment grade.
Friday, the
company drew down $3 billion from credit lines to pay off commercial
paper obligations. Raising cash in the CP market could be tough when
investors are jittery about Enron's condition.
This week, a
number of energy market players reduced exposure to Enron. However, in a
Friday press release, CEO Lay said that Enron was the "market-maker of
choice in wholesale gas and power markets." He added: "It is evident
that our customers view Enron as the major liquidity source of the
global energy markets."
McMahon
reportedly objected to Fastow's role in LJM, allegedly believing it
posed Fastow with a conflict of interests. But he will need to convince
investors that the 12 entities he's connected to don't do the same.
Enron has said that its board fully approved of the LJM deals that
Fastow was involved in. Now, board members will have to comment on their
own roles in a related entity.
Related Links
Selected quotations from "Why
Enron Went Bust: Start with arrogance. Add greed, deceit, and
financial chicanery. What do you get? A company that wasn't
what it was cracked up to be." by
Benthany McLean, Fortune
Magazine, December 24, 2001, pp. 58-68.
Why Enron Went
Bust: Start with arrogance. Add greed, deceit, and financial
chicanery. What do you get? A company that wasn't what it
was cracked up to be."
In fact , it's
next to impossible to find someone outside Enron who agrees with Fasto's
contention (that Enron was an energy provider rather than an energy
trading company). "They were not an energy company that used
trading as part of their strategy, but a company that traded for
trading's sake," says Austin Ramzy, research director of Principal
Capital Income Investors. "Enron is dominated by pure trading,"
says one competitor. Indeed, Enron had a reputation for taking
more risk than other companies, especially in longer-term contracts, in
which there is far less liquidity. "Enron swung for the fences,"
says another trader. And it's not secret that among non-investment
banks, Enron was an active and extremely aggressive player in complex
financial instruments such as credi8t derivatives. Because Enron
didn't have as strong a balance sheet as the investment banks that
dominate that world, it had to offer better prices to get business.
"Funky" is a word that is used to describe its trades.
In early 2001, Jim
Chanos, who runs Kynikos Associates, a highly regarded firm that
specializes in short-selling, said publicly what now seems obvious:
No one could explain how Enron actually made money ... it simply didn't
make very much money. Enron's operating margin had plunged from
around 5% in early 2000 to under 2% by early 2001, and its return on
invested capital hovered at 7%---a figure that does not include Enron's
off-balance-sheet debt, which, as we now know, was substantial. "I
wouldn't put my money in a hedge fund earning a 7% return," scoffed
Chanos, who also pointed out that Skilling (the former Enron CEO
who mysteriously resigned in August prior to the December 2 meltdown of
Enron) was aggressively selling shares---hardly
the behavior of someone who believed his $80 stock was really worth
$126.
Enron's executives will
probably claim that they had Enron's auditor, Arthur Andersen, approving
their every move. With Enron in bankruptcy, Arthur Andersen is now
the deepest available pocket, and the shareholder suits are already
piling up.
The Famous Enron Video on Hypothetical Future Value
(HFV) Accounting
The video shot at Rich Kinder's retirement party at Enron features CEO Jeff
Skilling proposing Hypothetical Future Value (HPV)
accounting with in retrospect is too true to be funny during the subsequent melt
down of Enron.
The people in this video are playing themselves and you can actually see
CEO Jeff Skilling, Chief Accounting Officer Richard Causey, and others proposing
cooking the books. You can download my rendering of a Windows Media Player
version of the video from
http://www.cs.trinity.edu/~rjensen/video/windowsmedia/enron3.wmv
You may have to turn the audio up full blast in Windows
Media Player to hear the music and dialog.
Skits and jokes by a few former Enron Corp.
executives at a party six years ago were funny then, but now border on bad
taste in light of the events of the past year.
VIDEO Feds Want To See Controversial Enron Videotape
Watch Clips From Enron Retirement Tape INTERACTIVES The End Of Enron What's
The Future Of Enron?
A videotape of a January 1997 going-away party for
former Enron President Rich Kinder features nearly half an hour of absurd
skits, songs and testimonials by company executives and prominent Houstonians,
the Houston Chronicle reported in its Monday editions.
The collection is all meant in good fun, but some of
the comments are ironic in the current climate of corporate scandal.
In one skit, former Administrative Executive Peggy
Menchaca played the part of Kinder as he received a budget report from
then-President Jeff Skilling, who played himself, and Financial Planning
Executive Tod Lindholm.
When the pretend Kinder expressed doubt that Skilling
could pull off 600 percent revenue growth for the coming year, Skilling
revealed how it could be done.
"We're going to move from mark-to-market accounting
to something I call HFV, or hypothetical future value accounting," Skilling
joked as he read from a script. "If we do that, we can add a kazillion dollars
to the bottom line."
Richard Causey, the former chief accounting officer
who was embroiled in many of the business deals named in the indictments of
other Enron executives, made an unfortunate joke later on the tape.
"I've been on the job for a week managing earnings,
and it's easier than I thought it would be," Causey said, referring to a
practice that is frowned upon by securities regulators. "I can't even count
fast enough with the earnings rolling in."
Joe Sutton and Rebecca Mark, the two executives
credited with leading Enron on an international buying spree, did a painfully
awkward rap for Kinder, while former Enron Broadband Services President Ken
Rice recounted a basketball game where employees from Enron Capital & Trade
beat Kinder's Enron Corp. team, 98-50.
"I know you never forget a number, Rich," Rice said.
President George W. Bush, who then was governor of
Texas, also took part in the skit, as did his father.
At the party, the younger Bush pleaded with Kinder:
"Don't leave Texas. You're too good a man."
The governor's father also offered a send-off to
Kinder, thanking him for helping his son reach the governor's mansion.
"You have been fantastic to the Bush family," the
elder Bush said. "I don't think anybody did more than you did to support
George."
Federal investigators told News2Houston Tuesday that
they want to take a closer look at the tape.
Investigators with the House committee on government
reform are in the process of obtaining a copy of the tape, according to
News2Houston.
Former federal prosecutor Phil Hilder said that what
was a joke could become evidence for federal investigators.
"There's matters on there that a prosecutor may want
to introduce as evidence should it become relevant," Hilder said.
Former employees were shocked to see the tape.
"It's too close to the truth, very close to the
truth," said Debra Johnson, a former Enron employee. "I think there's some
inside truth to the jokes that they portrayed."
Early 1995
Warning Signs That Bad Guys Were Running Enron and
That Political Whores Were Helping
There were some warning signs, but nobody seemed
care much as long as Enron was releasing audited accounting reports showing
solid increases in net earnings. Roger Collins sent me a 1995 link that
lists Enron among the world's "10 Most Shameless Corporations." I guess
they are reaping what was sown.
A Bit of Accountancy Humor Inspired by Enron and the Scandals That Follow
and Follow and . . .
Possible headlines on the Enron saga following the guilty
plea of Michael J. Kopper:
Kopper Wired to the Top Brass (with reference to his promise to rat
on his bosses)
The Coppers Got Kopper
Kopper Cops a Plea
Kopper’s Finish is Tarnished
Kopper Caper
Kopper Flopper
Kopper in the Kettle
A Kopper Whopper
These are Jensen originals, although I probably shouldn’t admit it.
Andersen audits got
"behind!"
Sure seemed
enough,
When Waste Management audits ignored smelly stuff.
And Andersen's
unveilings bottomed out,
When Victoria Secret audits turned into doubt.
Now the latest
criminal issue,
Is Andersen's clean wipe of American Tissue.
AccountingWEB
US - Mar-12-2003 - In yet another black mark against the now-defunct
accounting firm of Arthur Andersen, LLP, a former senior auditor of the
firm has been arrested in connection with the audit of American Tissue,
the nation's fourth-largest tissue maker. Brendon McDonald, formerly of
Andersen's Melville, NY office, surrendered Monday at the United States
Courthouse in Central Islip, NY. He could face as much as 10 years in
prison for his role in allegedly destroying documents related to the
American Tissue audits.
Mr. McDonald is
accused of deleting e-mail messages, shredding documents, and aiding the
officers of American Tissue in defrauding lenders of as much as $300
million. American Tissue's chief executive officer and other executives
were also arrested and charged with various counts of securities and
bank fraud and conspiracy.
According to
court documents, American Tissue inflated income and diverted money to
subsidiaries in an attempt to make the company eligible to borrow
additional money. "The paper trail of phony sales transactions, bogus
supporting documentation and numerous accounting irregularities ended
quite literally with the destruction of the falsified documents by
American Tissue's auditor," said Kevin P. Donovan, an assistant director
of the Federal Bureau of Investigation, according to a statement that
appeared in The New York Times ("Paper Company Officials Charged," March
11, 2003).
Cartoon 1: Two kids competing on the blackboard. One
writes 2+2=4 and the other kid writes 2+2=40,000. Which kid as the
best prospects for an accounting career?
Cartoon 36: Where the Grasso is greener (Also see Cartoon 37)
With tongue in cheek, New
Yorker and writer Andy Borowitz has penned a new book that
successfully captures what humor can be found in the recent rash of
corporate malfeasance ---
http://www.smartpros.com/x40231.xml
A friend told me the following
story about a former Enron accountant who gave up his CPA position to
become a farmer. The first thing he decided to do was to buy a mule.
He dickers with a local farmer at
the general store, and they agree that the local will sell the accountant
a mule for $100. The Enron accountant gives the man $100 cash, and the man
agrees to deliver the mule the next day.
Next morning, the man shows up at
the Enron accountant's place without the mule. "I'm sorry," he explains,
"but the mule died last night. I guess I owe you the $100 back."
"Hey, no problem," says the
accountant. "Just keep the money, and as for the mule, hey, go ahead and
dump him in my barn anyway. I'll raffle him off."
"Ain't nobody around here going
to buy a dead mule," says the local farmer.
"Leave that to me. I worked for
Enron," replies the accountant.
A week later, the farmer meets
the accountant back at the general store, and asks, "So, how'd you make
out with the dead mule?"
"Great," replies the accountant.
"I sold over 1000 raffle tickets for $2 each, to my former stockholders
and debtholders. Nobody ever bothered to ask if the mule was alive or
not."
"But didn't the winner complain
when he found out?" asked the farmer.
"Yep, he sure did, and being the
honest, ethical man that I am, I refunded his $2 to him promptly."
"So my profit, after deducting my
$100 cost for the dead mule and the $2 sales allowance, is $1898. By the
way, do you have any chickens?"
Exodus of Enron employees carrying all their worldly
possessions.
Accounting firm
Arthur Andersen took another beating Thursday night, but this time it
was at a minor league baseball game instead of in a Texas courtroom.
The Portland
Beavers, the triple-A farm team for the San Diego Padres, held "Andersen
Appreciation Night" during its game with the Edmonton Trappers at PGE
Park.
While Edmonton
won the game, 9-1 -- that's the real score -- the team announced record
attendance of 58,667. But there were only 12,969 fans who actually
attended the game. The fans bought $5 tickets but were given $10
receipts for accounting purposes as a one-time "nonrecurring charge."
The game also
featured a trivia quiz, where the prize was awarded to the fan whose
guess was furthest from the correct answer. The question was: "How many
career pitching wins [did] Gaylord Perry have?" A woman won by guessing
in the single digits -- she was off by about 320.
Fans were
encouraged to bring their own documents that could be destroyed at
"shredding stations" throughout the park.
In addition,
the 90 people with either "Arthur" or "Andersen" in their names who
attended were given free admission. Two people named Arthur Andersen
were among them.
Roger Devine of
Portland, who attended the game, said some fans were momentarily
befuddled by inflated player stats that appeared on the scoreboard
during the first inning. "The people sitting next to me were from out of
town and they were going 'This guy's batting .880? What the hell?'" he
said.
Recognition of Pro-Formalist
Movement Gets WorldCom, Andersen Off Hook; Washington, D.C.
(SatireWire.com) - In a surprise decision that exonerates dozens of major
companies, the U.S. Supreme Court today ruled that corporate earnings
statements should be protected as works of art, as they "create something
from nothing." One plus one is two. That is math. That is science. But as
we have seen, earnings and revenues are abstract and original concepts,
ideas not bound by physical constraints or coarse realities, and must
therefore be considered art," the Court wrote in its 7-2 decision. The
impact of the ruling was widespread. Investigations into hundreds of firms
were canceled, and collectors began snatching up original balance sheets,
audits, and P&L statements from WorldCom, Enron, and Global Crossing.
Meanwhile, auditing firms such as Arthur Andersen (now Art by Andersen)
were reclassified as art critics, whose opinions are no longer liable.
"Before we had to go in and decide, 'Is it right, or is it wrong?'" said
KPMG spokesman Dan Fischer. "Now we must only decide, 'Is it art?'"
In Congress, all further hearings
into irregularities were abandoned in favor of an abstract accounting
lecture given by Scott Sullivan, former Chief Financial Artist of
WorldCom, which had been charged with fraud for improperly accounting for
$3.85 billion. "Art should reflect life, so what I was really trying to
accomplish with this third quarter report was acknowledge that life is an
illusion," said Sullivan, explaining his acclaimed work, "10Q for the
Period Ending 9/30/01." U.S. Rep. Billy Tauzin of Louisiana, however, was
forced to apologize, admitting he could only see a lie. "Yes, well, a man
with a concretized view of the world may only be able to see numbers that
'Don't add up,'" said a haughty Sullivan. "But someone whose perceptions
are not always chained to reality - a stock analyst, say - may see numbers
that, like the human spirit, aspire to be greater than they are." Several
Sullivan pieces are now part of a new show at New York's Museum of Modern
Art entitled, "Shadows; Spreadsheets: The Origins of Pro-Formalism."
Robert Weidlin, an SEC investigator and avid collector, was among the
first to peruse the Enron exhibit, which takes up an entire wing of the
museum. "You look at these works, and you say 'Is this a profit, or a
loss? Is this firm a subsidiary, or a holding company?'" said Walden. "I
have stood in front of this one balance sheet for hours, and each moment I
come away with something different." Like other patrons, Weidlin said he
didn't know whether to be impressed or outraged, a reaction that pleased
Andrew Fastow, the former Enron CFA who is a leading proponent of the
Trompe L'Shareholder style. "An artist should not be afraid to be
shocking," said Fastow. "
As did the Modernists, we should
fearlessly depart from tradition and embrace the use of innovative forms
of expression. Like, say, 'Special Purpose Entities' and 'Pooling of
Interests.'" Sullivan, meanwhile, said he was influenced by the Flemish
Masters, particularly Lernout Hauspie, the Belgian speech recognition
software company that collapsed last year after an audit discovered the
firm had cooked its books in 1998, 1999, and 2000. "Lernout Hauspie simply
invented sales figures, just willed them out of thin air and onto the
paper," he said. "Me? I must live with a spreadsheet a long time before I
begin to work it. You must be patient and wait until the numbers reveal
themselves to you." And what about the reaction to his work? "I realize
people are angry, people are hurt. But I cannot concern myself with that,"
he said. "As with all true artists, I don't expect to be understood during
my lifetime." (The MOMA exhibit runs through Sept. 3. Admission is $8,
excluding a one-time write down of deferred stock compensation and other
costs associated with the carrying value of inventory.)
TIMING IS
EVERYTHING in humor, but the jokes told by a few former Enron executives
on a recently surfaced videotape border on bad taste in light of the
events of the past year.
Home Video Uncovered by the Houston Chronicle, December 19, 2002 Skits for Enron ex-executive funny then, but full
of irony now ---
http://www.chron.com/cs/CDA/story.hts/metropolitan/1703624 (The above link includes a "See it Now" link to download the
video itself which played well for me.)
Question: How does former Enron CEO Jeff Skilling define
HFV?
The tape, made
for the January 1997 going-away party for former Enron President Rich
Kinder, features nearly 30 minutes of absurd skits, songs and
testimonials by company executives and prominent Houstonians. The
collection is all meant in good fun, but some of the comments are ironic
in the current climate of corporate scandal.
In one skit,
former administrative executive Peggy Menchaca plays the part of Kinder
as he receives a budget report from then-President Jeff Skilling, who
plays himself, and financial planning executive Tod Lindholm. When the
pretend Kinder expresses doubt that Skilling can pull off 600 percent
revenue growth for the coming year, Skilling reveals how it will be
done.
"We're going to
move from mark-to-market accounting to something I call
HFV,
or hypothetical future value accounting," Skilling jokes as he reads
from a script. "If we do that, we can add a kazillion dollars to the
bottom line."
Richard Causey,
the former chief accounting officer who was embroiled in many of the
business deals named in the indictments of other Enron executives, makes
an unfortunate joke later on the tape.
"I've been on
the job for a week managing earnings, and it's easier than I thought it
would be," Causey says, referring to a practice that is frowned upon by
securities regulators. "I can't even count fast enough with the earnings
rolling in."
Texas'
political elite also take part in the tribute, with then-Gov. George W.
Bush pleading with Kinder: "Don't leave Texas. You're too good a man."
Former
President George Bush also offers a send-off to Kinder, thanking him for
helping his son reach the Governor's Mansion.
"You have been
fantastic to the Bush family," he says. "I don't think anybody did more
than you did to support George."
Note: Jim Borden
showed me that it is possible to download and save this video using
Camtasia. Thank you Jim. It is not a perfect capture, but it
gets the job done.
UPSKILLING: To develop new
skills, generally technical ones -- often by reskilling (retraining).
To see the full Buzzword Compliant Dictionary. Click here.
http://www.buzzwhack.com According to Ed Scribner, former Enron employees have a
different definition for "upskilling."
The corporate scandals are getting bigger
and bigger. In a speech on Wall Street, President Bush spoke out on
corporate responsibility, and he warned executives not to cook the
books. Afterwards, Martha Stewart said the correct term was to saute the
books.
Conan O'Brien
Martha Stewart denied allegations that she
had been given inside information to sell 4,000 shares of a stock in a
biotech firm about to go under. Stewart then showed her audience how to
make a festive, quick-burning yule log out of freshly-shredded financial
documents. Dennis Miller
In New York the other day, there was a
pro-Martha Stewart rally. Only four people showed up ... and three of
them were made out of crepe paper! Conan O'Brien
When reached for comment on the charges,
Martha didn't say much, (only) that a subpoena should be served with a
nice appetizer.
Conan O'Brien
NBC is making a movie about Martha Stewart
that will cover the recent stock scandal. They are thinking of calling
it 'The Road To Extradition."
Conan O'Brien
Things are not looking good for Martha
Stewart. Her stock was down 23 percent yesterday. Wow, that dropped
quicker than Dick Cheney after a double-cheeseburger.
Jay Leno
Tom Ridge announced a new color-coded alarm
system. ... Green means everything's okay. Red means we're in extreme
danger. And champagne-fuschia means we're being attacked by Martha
Stewart.
Conan O'Brien
EBITDA Earnings Before I Tricked the Dumb Auditor
EBIT Earnings Before Irregularities and Tampering
CEO Chief Embezzlement Officer
CFO Corporate Fraud Officer
NAV Nominal Andersen's Valuation
FRS Fantasy Reporting Standards
P/E Parole Entitlement
EPS Eventual Prison Sentence
Paul Zielbauer in The New York Times reports on the new Enron
lexicon developing:
To "enronize" means "to hide fiscal shortcomings through slick
financial legerdemain and bald-faced lies."
It is "enronic" when a seemingly invincible person goes down in
flames.
"Enronica" refers to cheap souvenirs like Enron stock certificates.
"Enrontia" is the burning desire to shred things.
"Enronomania" is the mania for reform sweeping the nation – the
first good kind of mania the market has seen in a very long time.
Note the 1995 Year Below The accountants at Arthur Andersen knew Enron was
a high-risk client who pushed them to do things they weren’t comfortable
doing. Testifying in court in May, partner James Hecker said he wrote a
parody to that effect in 1995.
The Financial Times of London reported: "To the tune of the Eagles hit
song ‘Hotel California,’ Mr. Hecker wrote lines such as: ‘They livin’ it
up at the Hotel Cram-It-Down-Ya, When the [law]suits arrive, Bring your
alibis.’"
Business Ethics
[BizEthics@lb.bcentral.com] on May 15, 2002
I don't know who wrote the
following, but it was forwarded by a former student who is at the local
office of Arthur Andersen.
A take-off from the movies "A Few Good Men"
(Some phrases are in the original script and some are altered.)
Tom Cruise: "Did you order the shredding?"
Jack Nicholson: "You want answers?"
Tom Cruise: "I think I'm entitled."
Jack Nicholson: "You want answers!!"
Tom Cruise: "I want the truth!"
Jack Nicholson: "You can't handle the truth!"
Jack Nicholson: "Son, we live in a world that
has financial statements. And those financial statements have to be
audited by men with calculators. Who's gonna do it? You? You, Dept. of
Justice? I have a greater responsibility than you can possibly fathom.
You weep for Enron and you curse Andersen. You have that luxury. You
have the luxury of not knowing what I know: that Enron's death, while
tragic, probably saved investors. And my existence, while grotesque and
incomprehensible to you, saves investors. You don't want the truth.
Because deep down, in places you don't talk about at parties, you want
me on that audit. You need me on that audit! We use words like
materiality, risk-based, special purpose entity...we use these words as
the backbone to a life spent auditing something. You use 'em as a
punchline. I have neither the time nor the inclination to explain myself
to a man who rises and sleeps under the blanket of the very assurance I
provide, then questions the manner in which I provide it. I'd prefer you
just said thank you and went on your way. Otherwise, I suggest you pick
up a pencil and start ticking. Either way, I don't give a damn what you
think you're entitled to!!"
Tom Cruise: "Did you order the shredding???"
Jack Nicholson: "You're damn right I did!"
Remember how the consulting divisions called Andersen Consulting split
off of Aurther Andersen and became a company known as Accenture. Now
you can also read about Indenture ---
http://www.indenture.ac/
A November
2001 message from Ken Lay, CEO of Enron
Happy Thanksgiving!
This past
weekend, I was rushing around in Houston, Texas trying to do some
holiday season shopping done. I was stressed out and not thinking very
fondly of the weather right then. It was dark, cold, and wet in the
parking lot as I was loading my car up. I noticed that I was missing a
receipt that I might need later. So mumbling under my breath, I retraced
my steps to the mall entrance. As I was searching the wet pavement for
the lost receipt, I heard a quiet sobbing. The crying was coming from a
poorly dressed boy of about 12 years old. He was short and thin. He had
no coat. He was just wearing a ragged flannel shirt to protect him from
the cold night's chill. Oddly enough, he was holding a hundred dollar
bill in his hand. Thinking that he had gotten lost from his parents, I
asked him what was wrong. He told me his sad story. He said that he came
from a large family. He had three brothers and four sisters. His father
had died when he was nine years old. His Mother was poorly educated and
worked two full time jobs. She made very little to support her large
family. Nevertheless, she had managed to skimp and save two hundred
dollars to buy her children some holiday presents (since she didn't
manage to get them anything during the previous holiday season).
The young boy
had been dropped off, by his mother, on the way to her second job. He
was to use the money to buy presents for all his siblings and save just
enough to take the bus home. He had not even entered the mall, when an
older boy grabbed one of the hundred dollar bills and disappeared into
the night. "Why didn't you scream for help?" I asked. The boy said, "I
did." "And nobody came to help you?" I queried. The boy stared at the
sidewalk and sadly shook his head. "How loud did you scream?" I
inquired.
The soft-spoken
boy looked up and meekly whispered, "Help me!"
I realized!
that absolutely no one could have heard that poor boy cry for help. So I
grabbed his other hundred and ran to my car.
Happy
Thanksgiving everyone!
Signed,
Kenneth Lay
Enron CEO
A potential investor came to seek
investment advice from a financial analyst (F.A.). The F.A. told the
investor, " I have the experience, you have the money."
Several weeks later, after the
investor has lost all the money from following the advice of the F.A., the
investor came to see the F.A. and the F.A. said to the investor:
"You have the experience, I have
the money!"
I liked the one below about Teaching
Accounting in the 1970s. It is so True!
Also forwarded by Dick Haar
Teaching Accounting in 1950:
A logger sells a truckload of
lumber for $100.
His cost of production is 4/5 of
the price.
What is his profit?
Teaching Accounting in 1960:
A logger sells a truckload of
lumber for $100.
His cost of production is 4/5 of
the price, or $80.
What is his profit?
Teaching Accounting in 1970:
A logger exchanges a set "L" of
lumber for a set "M" of money.
The cardinality of set "M" is
100. Each element is worth one dollar.
Make 100 dots representing the
elements of the set "M."
The set "C", the cost of
production contains 20 fewer points than set "M."
Represent the set "C" as a subset
of set "M" and answer the following
question: What is the cardinality
of the set "P" of profits?
Teaching Accounting in 1980:
A logger sells a truckload of
lumber for $100.
His cost of production is $80 and
his profit is $20.
Your assignment: Underline the
number 20.
Teaching Accounting in 1990:
By cutting down beautiful forest
trees, the logger makes $20.
What do you think of this way of
making a living?
Topic for class participation
after answering the question:
How did the forest birds and
squirrels feel as the logger cut down the trees?
There are no wrong answers.
Teaching Match in 2000:
A logger sells a truckload of
lumber for $100.
His cost of production is $120.
How does
Arthur Andersen determine that his profit margin is $60?
In an Enron tort litigation
trial, the defense attorney was cross-examining a pathologist.
Attorney: Before you signed the
death certificate, had you taken the pulse?
Coroner: No.
Attorney: Did you listen to the
heart?
Coroner: No.
Attorney: Did you check for
breathing?
Coroner: No.
Attorney: So, when you signed the
death certificate, you weren't sure the man was dead, were you?
Coroner: Well, let me put it this
way. The man's brain was sitting in a jar on my desk. But I guess he still
managed to audit Enron.
Forwarded by George Lan
1. Enronitis : A company suffering from accounting concerns
2. To do an "enron" : To do an end-run
One of my colleages keeps referring to "getting 'Layed.'"
Forwarded by Glen Gray
A company is interviewing candidates for a new
position.
The first candidate is an engineer. The
interviewer says, "I only have one question, what is 2 plus 2?" The
engineer pulls out his calculator and punches in the numbers and says,
"4.000000."
The next candidate is a lawyer. She says 4, but
wraps her answer in legalize.
The third candidate is a CPA. When asked what
is 2 plus 2, he looks around and looks at the interviewer and says,
"Whatever you want it to be."
Feudalism
You have two cows. Your lord takes some of the milk.
Fascism
You have two cows. The government takes both, hires you to take care of
them, and sells you the milk.
Communism
You have two cows. Your neighbors help take care of them and you share
the milk.
Totalitarianism
You have two cows. The government takes them both and denies they ever
existed and drafts you into the army. Milk is banned.
Capitalism
You have two cows. You sell one and buy a bull. Your herd multiplies,
and the economy grows. You sell them and retire on the income.
Enron Venture Capitalism
You have two cows. You sell three of them to your publicly listed
company, using letters of credit opened by your brother-in-law at the
bank, then execute a debt/equity swap with an associated general offer
so that you get all four cows back, with a tax exemption for five cows.
The milk rights of the six cows are transferred via an intermediary to a
Cayman Island company secretly owned by the majority shareholder who
sells the rights to all seven cows back to your listed company. The
annual report says the company owns eight cows, with an option on one
more.
Enronism:
You have two cows. You borrow 80% of the forward value of the two cows
from your bank, then buy another cow with 5% down and the rest financed
by the seller on a note callable if your market cap goes below $20B at a
rate 2 times prime. You now sell three cows to your publicly listed
company, using letters of credit opened by your brother-in-law at a 2nd
bank, then execute a debt/equity swap with an associated general offer
so that you get four cows back, with a tax exemption for five cows. The
milk rights of six cows are transferred via an intermediary to a Cayman
Island company secretly owned by the majority shareholder who sells the
rights to seven cows back to your listed company. The annual report says
the company owns eight cows, with an option on one more and this
transaction process is upheld by your independent auditor and no Balance
Sheet is provided with the press release that announces that Enron as a
major owner of cows will begin trading cows via the Internet site COW
(cows on web).
In case you
were wondering how Enron came into so much trouble, here is an
explanation reputedly given by an Ag Eco professor at Texas A&M, to
explain it in terms his students could understand.
CAPITALISM:
You have two
cows.
You sell one
and buy a bull.
Your herd
multiplies and you hire cowhands to help out on the ranch. You sell
cattle.
The economy
grows and eventually you can pass the business on and your cowhands can
retire on the profits.
ENRON
VENTURE CAPITALISM:
You have two
cows. You sell three of them to your publicly listed company, using
letters of credit opened by your brother-in-law at the bank, then
execute a debt/equity swap with an associated general offer so that you
get all four cows back, with a tax exemption for five cows.
The milk rights
of the six cows are transferred via an intermediary to a Cayman Island
company secretly owned by the majority shareholder who sells the rights
to all seven cows back to your listed company.
The annual
report says the company owns eight cows, with an option on one more.
Now do you see
why a company with $62 billion in assets is declaring bankruptcy?
"President Bush didn't help the company's image, joking over the
weekend that Saddam Hussein has now agreed to weapons inspections. "The
bad news is he wants Arthur Andersen to do it," Bush said."
The founder-namesake of the Enron-racked
accounting megafirm (Arthur Andersen)
was born in 1885, the stalwart son of new Norwegian immigrants, and to his
dying day in 1947 at age 61, he maintained a passion for preserving
Norwegian history. He even held an honorary degree from St. Olaf College.
And would you believe he straightened out the finances of a pioneering
energy empire and won his reputation for honesty by keeping it from
bankruptcy? Is that a cosmic joke, or what? Not if you bought Enron stock
at $80 a share, it's not. Ken Ringle Washington Post Staff Writer ---
http://www.trinity.edu/rjensen/history.htm#AndersenHistory
(There are some humorous and some sobering parts of this article by Ken
Ringle that Don Ramsey pointed out to me.)
The business of
fraud isn't always serious. Below are some of our favorite funny
stories. If you would like to share one with us, please send it to
fraudfollies@cfenet.com.
We are neither
hunters nor gatherers. We are accountants..
New Yorker Cartoon
It's up to you now
Miller. The only thing that can save us is an accounting
breakthrough.
New Yorker Cartoon
Money is life's
report card.
New Yorker Cartoon
Millions is craft.
Billions is art.
New Yorker Cartoon
My strength is the
strength of ten, because I'm rich. New Yorker Cartoon
Picture a Pig Ready for Market
Basic economics --- sometimes the parts are worth
more than the whole.
New Yorker Cartoon
You drive yourself
too hard. You really must learn to take time to stop and sniff the
profits.
New Yorker Cartoon
I was on the cutting
edge. I pushed the envelope. I did the heavy lifting. I
was the rain maker. Then suddenly it all crashed when I ran out of
metaphors.
New Yorker Cartoon
Try as we might,
sir, our team of management consultants has been unable to find a single
fault in the manner in which you conduct your business. Everything
you do is a hundred per cent right. Keep it up! That will be
eleven thousand dollars. New Yorker Cartoon
I rolled out this morning...ACEMers had email systems on
AccountingWeb tells of an audit failure long after old Enron
SmartPros shows us how accounting careers have grown dicey
It's gonna get worse you see, we need a change in policy
There's a Wall Street Journal rolled up in a rubber band
One more sad story's one more than I can stand
Just once, how I'd like to see the headline say
Not much to print about, can't find any frauds today
Because...
Nobody cheated on taxes owed
No lawsuits filed, no investors got POed
No new FASB rules, no unaccounted stock options in our pay
We sure could use a little good news today
I'll come home this evening...I'll bet that the news will be the same
Ernst & Young's fired a partner, PwC's been found to blame
How I wanna hear the anchor man talk about a county fair
And how we cleaned up the air...how everybody's playing fair
Whoa, tell me...
Nobody was cheated by their brokers
And the mutual funds all played square
And everybody loves everybody in the good old USA
We sure could use a little good news today
Nobody embezzled a widow on the lower side of town
Nobody OD'd, only the courthouses got burned down
Nobody failed an exam...nobody cussed out FAS 133 Now that
would surely be good news for me
Sorry folks!
Bob Jensen
-----Original Message-----
From: Richard C. Sansing
[mailto:Richard.C.Sansing@DARTMOUTH.EDU]
Sent: Wednesday, October 22, 2003 10:28 AM
Subject: Re: An accounting parody
--- You wrote:
I am looking for an "accounting" song. I would
like to be able to have a popular song and change some of the lyrics to
include basic accounting principles but my creative juices do not flow
in that way. Does anyone know of such a parody?
--- end of quote ---
Possibilities include "Enron-Ron-Ron" (on the
Capital Steps CD, "When Bush comes to shove") and "When IRS Guys are
Smilin'" (Capital Steps, "Unzippin' My Doodah"). Also, the first part of
"I want to be a producer" (The Producers) deals with accounting.
Richard C. Sansing Associate Professor of
Business Administration Tuck School of Business at Dartmouth 100 Tuck
Hall Hanover, NH 03755
In a $2.1 billion action against
accounting firm Grant Thornton, a Baltimore Circuit Court is investigating
a possible violation involving the withholding and willful destruction of
audit records in a manner likened to the contemporary but more- publicized
Enron case. A court action also alleges that a former director of risk
management and senior partner of the firm, "willfully, knowingly, and
intentionally destroyed (client) documents with the full understanding
that litigation was imminent."
http://www.accountingweb.com/item/69042
Big Five firm Ernst & Young has been hit
with a lawsuit by Bull Run Corp., a company that provides, among other
things, marketing and event management services to universities, athletic
conferences, associations, and corporations. The lawsuit alleges that E&Y
failed to discover material errors in its audit of a company that Bull Run
acquired in late 1999.
http://www.accountingweb.com/item/69888
Credit Suisse First Boston -- the
investment bank that managed some of the most hyped stock offerings of the
Internet boom era -- agrees to pay a $100 million fine for improperly
pumping up share prices ---
http://www.wired.com/news/business/0,1367,49930,00.html
Arthur Andersen: The
Enron Scandal's Other Big Donor
By Holly Bailey
During the
record-breaking 1999-2000 fund-raising cycle, very few companies
outpaced Enron's prolific giving to George W. Bush. In fact, only 11
companies gave more money to the Bush-Cheney ticket, and one of them was
Arthur Andersen, the embattled energy giant's now equally troubled
auditor.
Andersen was the fifth
biggest donor to Bush's White House run, contributing nearly $146,000
via its employees and PAC. Furthermore, Andersen fielded one of Bush's
biggest individual fund-raisers that year. D. Stephen Goddard, who until
yesterday was the managing partner of Andersen's Houston office, was one
of the "Pioneers," individuals who raised at least $100,000 for the Bush
campaign during 1999-2000. (Goddard was among the employees "relieved of
their duties" Tuesday by Andersen.)
But that's only the tip
of the iceberg when it comes to Andersen's political ties to Washington.
As Congress prepares to launch hearings into the Enron collapse,
lawmakers will be examining two companies whose political giving has
affected the bottom line of nearly every campaign on Capitol Hill. Since
1989, Andersen has contributed nearly $5 million in soft money, PAC and
individual contributions to federal candidates and parties, more than
two-thirds to Republicans.
While Enron's giving was
concentrated mainly in big soft money gifts to the national political
parties, Andersen's generosity often was targeted directly at members of
Congress. For instance, more than half the current members of the House
of Representatives were recipients of Andersen cash over the last
decade. In the Senate, 94 of the chamber's 100 members reported Andersen
contributions since 1989.
Among the biggest
recipients, members of Congress now in charge of investigating
Andersen's role in the Enron debacle-a list that includes House Energy
and Commerce Committee chairman Billy Tauzin (D-La.), who, with $47,000
in contributions, is the top recipient of Andersen contributions in the
House.
In the fall of 2000,
Tauzin helped broker a deal between the Securities and Exchange
Commission and the Big Five accounting firms, including Andersen, which
essentially dropped the SEC's push to restrict auditors from selling
consulting services to their clients. The provision had been aimed at
ending what the SEC had deemed a major conflict of interest between
accountant's duties as an auditor and the money they earn to consult on
behalf of that same client.
Before the SEC could
act, however, the accounting industry unleashed a massive lobbying
campaign to block the proposed rule. In Andersen's case, it nearly
doubled its campaign contributions-going from $825,000 in overall
spending during the 1997-98 election cycle to more than $1.4 million in
1999-2000. In lobbying expenditures alone, Andersen spent $1.6 million
between July and December 2000-compared to $860,000 for the first six
months of that year.
It's unclear what kind
of impact, if any, the proposed rule might have had on the Enron
collapse. Andersen, according to press reports, collected $25 million in
auditing fees and $27 million in consulting fees from Enron during 2001.
Click here for a
breakdown of Andersen contributions, including contributions to members
of Congress and presidential candidates, as well as information on the
company's lobbying expenditures and other money in politics stats:
This article is much
too long to do justice to in a few quotes. I did, however, extact
the quotes connected with Andersen, the firm that audited and certified
the Enron financial statements prior to Enron's meltdown.
The collapse
came swiftly for Enron Corp. when investors and customers learned they
could not trust its numbers. On Sunday, six weeks after Enron disclosed
that federal regulators were examining its finances, the global
energy-trading powerhouse became the biggest bankruptcy in U.S. history.
Like all
publicly traded companies in the United States, Enron had an outside
auditor scrutinize its annual financial results. In this case, blue-chip
accounting firm Arthur Andersen had vouched for the numbers. But Enron,
citing accounting errors, had to correct its financial statements,
cutting profits for the past three years by 20 percent -- about $586
million. Andersen declined comment and said it is cooperating in the
investigation.
The number of
corporations retracting and correcting earnings reports has doubled in
the past three years, to 233, an Andersen study found. Major accounting
firms have failed to detect or have disregarded glaring bookkeeping
problems at companies as varied as Rite Aid Corp., Xerox Corp., Sunbeam
Corp., Waste Management Inc. and MicroStrategy Inc.
Corporate
America's accounting problems raise the question: Can the public depend
on the auditors?
"Financial
fraud and the accompanying restatement of financial statements have cost
investors over $100 billion in the last half-dozen or so years," said
Lynn E. Turner, who stepped down last summer as the Securities and
Exchange Commission's chief accountant.
The shareholder
losses resulting from accounting fraud or error could rival the cost to
taxpayers of the savings-and-loan bailout of the early 1990s, he said.
Enron investors, including employees who held the company's stock in
their retirement accounts, lost billions.
Accounting
industry leaders deny they are to blame. They say that the number of
failed audits is tiny in relation to the many thousands performed
successfully, and that it's often impossible for auditors to see through
a sophisticated fraud.
Quotations
Relating to the Andersen Accounting Firm
Quote 01
Accounting firms cite a number of reasons for the
rise in corrections. It's tough to apply standards that are nearly 70
years old to the modern economy, they say. And the SEC has made matters
worse by issuing new interpretations of complex standards. "The question
is not how does this reflect on the auditors," Arthur Andersen said in a
written statement. Instead, the firm asked: "How is it that auditors are
able to do so well in today's environment?"
Quote 02
A case study posted on Arthur Andersen's Web site
under "Success Stories" shows how the firm sees itself. As auditor for
TheStreet.com Inc., a financial news service, Arthur Andersen said, it
helped its client prepare for an initial public offering of stock,
develop a global expansion strategy and secure a weekly television show
through another client, News Corp.
One of Arthur
Andersen's "greatest strengths . . . is developing full-service
relationships with emerging companies and then using all of our
capabilities to find inventive ways to help them continue to grow,"
auditor Tom Duffy is quoted as saying.
Quote 03 Last
year, Gene Logic Inc., a Gaithersburg biotechnology firm, fired Arthur
Andersen, saying it was disappointed with the outside auditor's level of
service and cost. Andersen said in a letter included in an SEC filing
that, before Andersen was fired, the accounting firm had told the
company it thought it was trying to book $1.5 million of revenue from
new contracts prematurely. Gene Logic spokesman Robert Burrows said the
revenue disagreement had nothing to do with the auditor's dismissal.
Arthur Andersen
said it quickly resigned or refused to accept more than 60 auditing jobs
last year after its background checks turned up questions about the
integrity of the clients' management.
Quote 04 Some
industry veterans say audits have become loss leaders -- a way for firms
to get their foot in a client's door and win consulting contracts.
Arthur Andersen
disagreed, telling The Post that audits are among the more profitable
services the firm provides, adding that "lower pricing in some years" is
"made up over time."
Indeed,
accounting firms say that if the audit becomes more complicated than
initially expected, their contracts generally allow them to go back to
their clients and adjust the fee.
In a
long-running lawsuit, Calpers, the giant pension fund for California
public employees accused Arthur Andersen of doing such a superficial job
auditing a finance company that the "purported audits were nothing more
than 'pretended audits.' "
Andersen
assigned a young, inexperienced auditor "who has candidly testified he
did not even know what a Contract Receivable was, then or now,"
consultants for Calpers wrote in a September 2000 report prepared in
support of the lawsuit.
Andersen didn't
test any of those accounts while the unpaid balances soared, and it
failed to recognize that a substantial amount was uncollectible, the
report said.
Andersen
declined to comment on the case, which was settled confidentially
Quote 05 Few
cases illustrate the potential conflicts in the accounting business as
vividly as the one involving Arthur Andersen and Waste Management.
Many investors
may not realize they were victims because they held Waste Management
stock indirectly, through mutual funds and retirement plans. Lolita
Walters, an 80-year-old retired New York City government employee who
suffers from diabetes and a heart condition, can count what she lost --
more than $2,800, enough money to pay for almost a year of prescription
drugs.
"I think it's
unconscionable," Walters said of Andersen's role.
According to
the SEC, Andersen lent its credibility to Waste Management's annual
reports even though it had documented that they were deeply flawed.
Waste
Management eventually admitted that, over several years, it had
overstated its pretax profits by $1.4 billion.
In a civil suit
filed in June, the SEC accused Arthur Andersen of fraud for signing off
on Waste Management's false financial statements from 1993 through 1996.
For example, during the 1993 audit, the SEC said, the auditors noted
$128 million of cumulative "misstatements" that would have reduced the
company's earnings, before including special items, by 12 percent. But
Andersen partners decided the misstatements were not significant enough
to require correction, the SEC said.
An Andersen
memorandum showed the accounting firm disagreed with the approach Waste
Management used "to bury charges" and warned Waste Management that the
practice represented "an area of SEC exposure," but Andersen did not
stop it, the SEC said.
An SEC order
noted that, from 1971 until 1997, all of Waste Management's chief
financial officers and chief accounting officers were former Andersen
auditors. The Andersen partner assigned to lead the disputed audits
coordinated marketing of non-audit services, and his compensation was
influenced by the volume of non-audit fees Andersen billed to Waste
Management, the SEC said.
Over a period
of years, Andersen and an affiliated consulting firm billed Waste
Management about $18 million for non-audit work, more than double the
$7.5 million it was paid in audit fees, which were capped, the SEC said.
Andersen said some of the non-audit work was related to auditing.
Andersen, which
continues to serve as Waste Management's auditor, agreed to pay a $7
million fine to the SEC, and joined with Waste Management to settle a
class-action lawsuit on behalf of shareholdersfor a combined $220
million. Andersen did not admit wrongdoing in either settlement.
"There are
important lessons to be learned from this settlement by all involved in
the financial reporting process," Terry E. Hatchett, Andersen's managing
partner for North America, said in a statement after the SEC action.
"Investors can continue to rely on our signature with confidence."
Starting in the
mid-1980s, he oversaw the outside audits of JWP Inc., an obscure New
York company that bought a string of businesses and transformed itself
into a multibillion-dollar conglomerate. The job required LaBarca, a
partner at the big accounting firm Ernst & Young LLP, to scrutinize the
work of JWP's chief financial officer, Ernest W. Grendi, a running buddy
and former colleague.
In 1992, a new
president at JWP discovered rampant accounting manipulations, and the
company's stock sank. When the numbers were corrected, the 1991 earnings
were slashed from more than $60 million to less than $30 million.
After hearing
extensive evidence in a bondholders' lawsuit, a federal judge criticized
"the seeming spinelessness" of LaBarca.
"Time and
again, Ernst & Young found the fraudulent accounting at JWP, but managed
to 'get comfortable' with it," Judge William C. Conner wrote in a 1997
opinion. "The 'watchdog' behaved more like a lap dog."
Today, LaBarca
is senior vice president of financial operations and acting controller
at the media conglomerate AOL Time Warner Inc., where his duties include
overseeing internal audits.
The Securities
and Exchange Commission filed and settled fraud charges against Grendi
but took no action against LaBarca. Neither did the American Institute
of Certified Public Accountants (AICPA), a 340,000-member professional
organization charged with disciplining its own, or the state of New
York, which licensed LaBarca.
LaBarca
declined to discuss the JWP case but maintainedduring thetrial that the
accounting was "perfectly within the guidelines."
An Ernst &
Young spokesman said the firm was confident it upheld a tradition "of
integrity, objectivity and trust." Grendi declined comment.
A Washington
Post analysis of hundreds of disciplinary cases since 1990 found that,
when things go wrong, accountants face little public accountability.
"The deterrent
effect that's necessary is just not there," said Douglas R. Carmichael,
a professor of accountancy at the City University of New York's Baruch
College. That "makes investing like Russian roulette," he added.
In theory, the
system has several complementary layers of review. In practice, it is
undermined by a lack of resources, coordination and will.
The SEC can bar
accountants from auditing publicly traded companies for unprofessional
conduct. The agency, however, has the personnel to investigate only the
most egregious examples of auditing abuse, officials say. It typically
settles its cases without an admission of wrongdoing, often years after
the trouble surfaced.
Between 1990
and the end of last year, the SEC sanctioned about 280 accountants,
evenly divided between outside auditors and corporate financial
officers, The Post's review found.
The AICPA can
expel an accountant from its ranks, whichcan prompt the accountant's
firm to reassign or fire him. The trade grouptook disciplinary action in
fewer than a fifth of the cases in which the SEC imposed sanctions, The
Post found. About one-third of the accountants the SEC sanctioned
weren't AICPA members and thus were beyond its reach.
Even when the
AICPA determined that accountants sanctioned by the SEC had committed
violations, it closed the vast majority of ethics cases without
disciplinary action or public disclosure.
President Bill
Clinton's SEC chairman, Arthur Levitt Jr., a frequent critic of the
industry, said the AICPA "seems unable to discipline its own members for
violations of its own standards of professional conduct."
The membership
group works as a lobbying force for accountants and often battles SEC
regulatory efforts.
State
regulators have the ultimate authority. They can take away an
accountant's license. But some state authorities acknowledge that their
efforts are hit-or-miss.
"We only find
out about violations on the part of regulants [licensees] in two ways:
One, somebody complains, or two, we get lucky," said David E.
Dick,assistant director of Virginia's Department of Professional and
Occupational Regulation, which until recently administered discipline
for the state's accountants.
When the SEC
settles without a court judgment or an admission of culpability, state
authorities must build their case from scratch, said regulators in New
York, where many corporate accountants are licensed.
"You could
probably fault both state boards and the SEC for not having worked
cooperatively enough with one another over the years," said Lynn E.
Turner, who stepped down this summer as the SEC's chief accountant. He
added that the agency has tried harder over the past year and a half to
share investigative records with state regulators.
As of June, the
state of New York had taken disciplinary action against about a third of
the New York accountants The Post culled from 11 years of SEC
professional-misconduct cases.
While
prosecutors occasionally file criminal charges against corporate
officials in financial fraud case, they hardly ever bring criminal cases
against independent auditors, in part because the accounting rules are
so complex. The AICPA's general counsel could recall only a handful of
prosecutions.
"From my
perspective, this was very hard stuff," said a federal prosecutor who
investigated a major accounting fraud. "The prospect of litigating a
case against people who actually do this stuff for a living and at least
in theory are the world's experts . . . is a daunting prospect."
Investor
lawsuits sometimes lead to multimillion-dollar settlements. But they
rarely shed light on the performance of individual auditors because
accounting firms generally get court records sealed and settle before
trial, limiting public scrutiny.
The accounting
firms say they discipline those who violate professional standards,
including removing them from audits or terminating their employment.
Barry Melancon,
president of the AICPA, said "you cannot look at discipline alone" when
assessing accountability in the accounting profession.
The
profession's emphasis is on preventing rather than punishing mistakes,
he added. Thus, it invests heavily in quality-control efforts, such as
periodic "peer reviews" of the paperwork accounting firms generate
during audits.
In disciplinary
cases, the AICPA's goal is to rehabilitate accountants, not to expel
them, officials said. "While it may feel good and it may give somebody
something to write about when somebody is disciplined, the most
important thing is whether or not this profession does a good job doing
audits or not," Melancon said.
"Watchdogs
and Lapdogs," by Burton Malkiel,
Editorial in The Wall Street Journal, January 16, 2002 ---
http://interactive.wsj.com/articles/SB1011145236418110120.htm
Dr. Malkiel, professor of economics at Princeton, is author of "A Random
Walk Down Wall Street," 7th ed. (W.W. Norton, 2000).
The bankruptcy
of Enron -- at one time the seventh-largest company in the U.S. -- has
underscored the need to reassess not only the adequacy of our financial
reporting systems but also the public watchdog mission of the accounting
industry, Wall Street security analysts, and corporate boards of
directors. While the full story of what caused Enron to collapse has yet
to be revealed, what is clear is that its accounting statements failed
to give investors a complete picture of the firm's operations as well as
a fair assessment of the risks involved in Enron's business model and
financing structure.
Enron is not
unique. Incidents of accounting irregularities at large companies such
as Sunbeam and Cendant have proliferated. As Joe Berardino, CEO of
Arthur Andersen, said on these pages, "Our financial reporting model is
broken. It is out of date and unresponsive to today's new business
models, complex financial structures, and associated business risks."
Blind Faith
It is important
to recognize that losses suffered by Enron's shareholders took place in
the context of an enormous bubble in the "new economy" part of the stock
market during 1999 and early 2000. Stocks of Internet-related companies
were doubling, then doubling again. Past standards of valuation like
"buy stocks priced at reasonable multiples of earnings" had given way to
blind faith that any company associated with the Internet was bound to
go up. Enron was seen as the perfect "new economy" stock that could
dominate the market for energy, communications, and electronic trading
and commerce.
I have sympathy
for the Enron workers who came before Congress to tell of how their
retirement savings were wiped out as Enron's stock collapsed and how
they were constrained from selling. I have long argued for broad
diversification in retirement portfolios. But many of those who suffered
were more than happy to concentrate their portfolios in Enron stock when
it appeared that the sky was the ceiling.
Moreover, for
all their problems, our financial reporting systems are still the
world's gold standard, and our financial markets are the fairest and
most transparent. But the dramatic collapse of Enron and the rapid
destruction of $60 billion of market value has shaken public trust in
the safeguards that exist to protect the interests of individual
investors. Restoring that confidence, which our capital markets rely on,
is an urgent priority.
In my view, the
root systemic problem is a series of conflicts of interest that have
spread through our financial system. If there is one reliable principle
of economics, it is that individual behavior is strongly influenced by
incentives. Unfortunately, often the incentives facing accounting firms,
security analysts, and even in some circumstances boards of directors
militate against their functioning as effective guardians of
shareholders' interests.
While I will
concentrate on the conflicts facing the accounting profession, perverse
incentives also compromise the integrity of much of the research product
of Wall Street security analysts. Many of the most successful research
analysts are compensated largely on their ability to attract investment
banking clients. In turn, corporations select underwriters partly on
their ability to present positive analyst coverage of their businesses.
Security analysts can get fired if they write unambiguously negative
reports that might damage an existing investment banking relationship or
discourage a prospective one.
Small wonder
that only about 1% of all stocks covered by street analysts have "sell"
recommendations. Even in October 2001, 16 out of 17 securities analysts
covering Enron had "buy" or "strong buy" ratings on the stock. As long
as the incentives of analysts are misaligned with the needs of
investors, Wall Street cannot perform an effective watchdog function.
In some cases,
boards of directors have their own conflicts. Too often, board members
have personal, business, or consulting relationships with the
corporations on whose boards they sit. For some "professional
directors," large fees and other perks may militate against performing
their proper function as a sometime thorn in management's side. Our
watchdogs often behave like lapdogs.
But it is on
the independent accounting profession that we most rely for assurance
that a corporation's financial statements accurately reflect the firm's
condition. While we cannot expect independent auditors to detect all
fraud, we should expect we can rely on them for integrity of financial
reporting. While public accounting firms do have reputations to maintain
and legal liability to avoid, the incentives of these firms and general
auditing practices can sometimes combine to cloud the transparency of
financial statements.
In my own
experience on several audit committees of public companies, the audit
fee was only part of the total compensation paid to the public
accounting firm hired to examine the financial statements. Even after
the divestiture of their consulting units, revenues from tax and
management advisory services comprise a large share of the revenues of
the "Big Five" accounting firms. In some cases auditing services may be
priced as a "loss leader" to allow the accounting firm to gain access to
more lucrative non-audit business.
In such a
situation, the audit partner may be loath to make too much of a fuss
about some gray area of accounting if the intransigence is likely to
jeopardize a profitable relationship for the accounting firm. Indeed,
audit partners are often compensated by how much non-audit business they
can capture. They may be incentivized, then, to overlook some
particularly aggressive accounting treatment suggested by their clients.
Outside
auditors also frequently perform and review the inside audit function
within the corporation, as was the case with Andersen and Enron. Such a
situation may weaken the safeguards that exist when two independent
organizations examine complicated transactions. It's as if a professor
let students grade their own papers and then had the responsibility to
hear any appeals. Auditors may also be influenced by the prospect of
future employment with their clients.
Unfortunately,
our existing self-regulatory and standard-setting organizations fall
short. The American Institute of Certified Public Accountants has
neither the resources nor the power to be fully effective. The institute
may even have contributed to the problem by encouraging auditors to
"leverage the audit" into advising and consulting services.
The Financial
Accounting Standards Board has often emphasized the correct form by
which individual transactions should be reported rather than the
substantive way in which the true risk of the firm may be obscured. Take
"Special Purpose Entities," for example, the financing vehicles that
permit companies such as Enron to access capital and increase leverage
without adding debt to the balance sheet. Even if all of Enron's SPEs
had met the narrow test for balance sheet exclusion (which, in fact,
they did not), our accounting standard would not have illuminated the
effective leverage Enron had undertaken and the true risks of the
enterprise.
Given the
complexity of modern business and the way it is financed, we need to
develop a new set of accounting standards that can give an accurate
picture of the business as a whole. FASB may have helped us measure the
individual trees but it has not developed a way to give us a clear
picture of the forest. The continued integrity of the financial
reporting system and our capital markets must be insured. We need to
modernize our accounting system so financial statements give a clearer
picture of what assets and liabilities on the balance sheet are at risk.
And we must find ways to lessen the conflicts facing auditors, security
analysts, and even boards of directors that undermine checks and
balances our capital markets rely on.
Change
Auditors
One possibility
is to require that auditing firms be changed periodically the way audit
partners within each firm are rotated. This would incentivize auditors
to be particularly careful in approving accounting transactions for fear
that leniency would be exposed by later auditors.
The
SEC will not tolerate a pattern of growing
restatements, audit failures, corporate failures and massive investor
losses," Pitt said in a news conference. "Somehow we have got to put a
stop to the vicious cycle that has now been in evidence for far too many
years."
Securities &
Exchange Commission Chairman Harvey Pitt called Thursday for reform of
the way accounting firms are monitored and regulated in the United
States in an effort to restore public confidence in the profession in
the wake of scandals involving Enron Corp. and other companies.
"This
commission cannot and will not tolerate a pattern of growing
restatements, audit failures, corporate failures and massive investor
losses," Pitt said in a news conference. "Somehow we have got to put a
stop to the vicious cycle that has now been in evidence for far too many
years."
Pitt proposed
the creation of a new body, composed mostly of representatives from the
public sector, to oversee and discipline accounting firms, and he called
for a reform of the triennial peer review process, which has been
criticized "with some merit," Pitt said.
His suggestions
were prompted mostly by the recent collapse of energy trader Enron and
the revelations of accounting irregularities that led to it. Its
auditor, Arthur Andersen, has come under intense scrutiny for failing to
discover or disclose problems with Enron's books that hid massive debt
and helped the company avoid paying taxes.
Enron's shares
lost almost all their value as the disclosures came to light, the
company filed for bankruptcy and investor confidence in the accuracy of
companies' financial disclosures was shaken.
"I place
restoring the public's confidence in the auditing profession to be
immediate goal number one," Pitt said
Pitt said he
and others in the SEC were still trying to work out the details of the
new oversight group, which would have the power to compel testimony and
the production of documents, and were investigating the circumstances of
Enron's collapse.
Despite Pitt's
proposals, Sen. Jon Corzine, D - New Jersey, told CNNfn's The Money Gang
that the SEC should be policing the accounting firms. (WAV 597KB) (AIFF
597KB).
Pitt did say he
thought the SEC should have oversight of the new body's decisions and
actions.
Of particular
interest to the SEC may be the actions of Andersen, which admitted to
intentionally destroying Enron documents -- excepting the important
"work papers" associated with an audit -- and recently fired the partner
heading up its work on Enron.
Andersen's
actions were only the latest in a series of stumbles by accounting
firms. Andersen was recently fined $7 million by the SEC, the largest
penalty ever, for irregularities connected with its work on Waste
Management Inc. Other venerable firms like PricewaterhouseCoopers and
Ernst & Young have also had their share of trouble.
Note: Harvey Pitt resigned
from the SEC following allegations that he was aiding large accounting
firms in stacking the new Public Company Accounting Oversight Board
(PCAOB) created in the Sarbanes-Oxley Act of 2002.
In a surprise response to last week's SEC
announcement, the Public Oversight Board, the independent body that
oversees the self-regulatory function for auditors of companies registered
with the Securities & Exchange Commission, passed a resolution stating its
intent to close its doors no later than March 31, 2002.
http://www.accountingweb.com/item/69876
Note: Harvey Pitt resigned
from the SEC following allegations that he was aiding large accounting
firms in stacking the new Public Company Accounting Oversight Board
(PCAOB) created in the Sarbanes-Oxley Act of 2002.
Warren
Buffett Three years ago the Berkshire Hathaway CEO proposed three questions any
audit committee should ask auditors:
(1) If
the auditor were solely responsible for preparation of the company's
financial statements, would they have been done differently, in either
material or nonmaterial ways? If differently, the auditor should explain
both management's argument and his own.
(2) If
the auditor were an investor, would he have received the information
essential to understanding the company's financial performance during
the reporting period?
(3) Is
the company following the same internal audit procedure the auditor
would if he were CEO? If not, what are the differences and why? Damn
good questions.
http://www.fortune.com/articles/206334.html
Andersen Was Not Forthcoming to
the Audit and Compliance Committee
The opportunity to cross to-do's off the list
came just one week later, on Feb. 12. That day, the Enron board's audit
and compliance committee held a meeting, and both Mr. Duncan and Mr.
Bauer from Andersen attended. At one point, all Enron executives were
excused from the room, and the two Andersen accountants were asked by
directors if they had any concerns they wished to express, documents
show.
Subsequent testimony by board members suggests
the accountants raised nothing from their to-do list. "There is no
evidence of any discussion by either Andersen representative about the
problems or concerns they apparently had discussed internally just one
week earlier," said the special committee report released last weekend.
Tone at the Top
AUDIT
COMMITTEE MEMBERS AND BOARDS of directors are taking a fresh look at
potential risks within their organizations following the Enron
debacle. What financial reporting red flags and key risk factors should
your organization know? Read more in Tone
at the Top,
The IIA’s corporate governance newsletter for executive management, boards
of directors, and audit committees.
http://www.theiia.org/ecm/newsletters.cfm?doc_id=739
In response to the Enron
situation, The Institute of Internal Auditors (IIA) is conducting
Internet-based “flash surveys” of directors and chief audit executives
(CAEs). The purpose of these surveys is gaining information — and
sharing it in an upcoming Tone at the Top — on how audit committees and
other governance entities monitor complex financial transactions. We
encourage you to participate by typing in
www.gain2.org/enrontat
You might enjoy "The AICPA's Prosecution of Dr. Abraham Briloff: Some
Observations," by Dwight M. Owsen ---
http://accounting.rutgers.edu/raw/aaa/pi/newsletr/spring99/item07.htm
I think Briloff was trying to save the profession from what it is now
going through in the wake of the Enron scandal.
Confession season is upon us, but the problem so far
isn't companies owing up to earnings shortfalls. Instead, they're admitting
past financial results were simply wrong.
Unnerved by a sterner accounting culture, companies
have been increasingly reaching back years to ratchet down reported profits by
tens or even hundreds of millions of dollars. Eyeing the March 15 filing
deadline for calendar 2003 annual reports, Bristol-Myers Squibb (BMY:NYSE)
, P.F. Chang's (PFCB:Nasdaq) , Veritas (VRTS:Nasdaq) and Nortel
(NT :Nasdaq) this week joined a fast-growing string of public companies to say
prior financial reports inflated real business trends.
The number of restated audited annual financial
statements hit a record high of 206 last year, according to Chicago-based
Huron Consulting Group. Observers say 2004 is already shaping up as a banner
year for revisions.
"There are certainly more high-profile
restatements and you're hearing about them more" compared to past years,
said Jeff Brotman, an accounting professor at the University of Pennsylvania.
For Bristol-Myers Squibb, Nortel and Network
Associates (NET:NYSE) , recent restatements came on top of prior
restatements, much to the irritation of investors. In at least two cases, the
embarrassing double restatements prompted internal shifts; Nortel put two of
its financial executives on leave as part of a bookkeeping probe. Network
Associates fired PricewaterhouseCoopers, according to various news reports,
after the auditor cited "material weakness" in its internal controls
in the company's annual report.
Probably the biggest reason for the wave of honesty
is a host of new corporate governance and accounting rules in the wake of the
corporate reform legislation known as Sarbanes-Oxley, which went into effect a
year and a half ago. Also, accounting firms have grown far more cautious,
cowed by the collapse of auditor Arthur Andersen in 2002 after massive fraud
at its client Enron.
The upshot is that both managers and auditors are now
more likely to err on the side of conservative accounting.
"A lot of things in accounting are judgment
calls, gray areas," said Peter Ehrenberg, chair of the corporate finance
practice group at Lowenstein & Sandler, a Roseland, N.J.-based law firm.
"If there are issues in any given company and we were in 2000, a person
acting in good faith might easily say, 'We can pass on that.' But that same
person looking at the same facts today might say, 'There's too much risk.'
"Certainly regulators in general are more
credible because they're much less likely to give the benefit of the doubt in
this environment," he added. "The auditors know that and they're
[therefore] less likely to stick their necks out."
Case in point: Last week Gateway (GTW:NYSE)
said longtime auditor PricewaterhouseCoopers won't work for it anymore. PwC
did the books back in 2000 and 2001 -- an era of aggressive accounting that
still haunts Gateway, though it's now under different management.
From Executive Suite to Cell Block
Tougher law enforcement against corporate offenders is
also fueling more prudent behavior. The long-underfunded Securities and
Exchange Commission, which is now required to review the financial
statements of public companies every three years, has finally been given more
dollars to hire staff. In 2003, the SEC's workforce was 11% higher than in
2001. This year, the agency's budget allocation should allow it to expand its
payroll an additional 9%, to nearly 3,600 employees.
On the corporate side, CEOs and CFOs have had to
certify their financial reports since August 2002, also as a result of
Sarbanes-Oxley. "I think Sarbanes-Oxley makes executives ask the hard
questions they should have always asked," said Jeffrey Herrmann, a
securities litigator and partner in the Saddle Brook, N.J.-based law firm of
Cohn Lifland Pearlman Herrmann & Knopf. "Maybe today an executive
says to his accounting firm: 'I'm not going to regret anything here about how
we handled goodwill or reserves, am I? It isn't coming back to haunt us, is
it?' "
Recent government prosecutions against high-level
executives such as Tyco's Dennis Kozlowski, Worldcom's Bernie
Ebbers, and Enron's Andrew Fastow and Jeffrey Skilling starkly underscore the
penalties managers may face for playing fast-and-loose with accounting.
Meanwhile, auditing firms are starting to rotate
staff, bringing in newcomers to take a fresh look at clients' accounting.
Also, new rules handed down by the Financial Accounting Standards Board have
prompted reassessments of past accounting methods, which can lead to earnings
revisions reaching back five years (the period for which financial data is
included in annual reports).
Another level of checks and balances on accounting
shenanigans arrived last April when the SEC ruled that corporate audit
committees must be composed entirely of members independent from the company
itself. "Audit committees are getting more active and making sure that
when they learn of problems, they're going to be dealt with," said Curtis
Verschoor, an accounting professor at DePaul University.
In this environment of heightened scrutiny, however,
the notion that a restatement was tantamount to a financial kiss of death has
faded, too.
"We have now seen companies that issued
restatements that have lived to do business another day," said Brotman.
"The stock hasn't crashed; nobody's been fired or gone to jail; they
haven't lost access to the capital markets; there haven't been any more
shareholder lawsuits than there would have already been. If a company does a
restatement early, fully and explains exactly what it is and why, it's not a
lethal injection."
Meanwhile, corporate reform rules are being put in
place that could lead to yet more accounting cleanups down the road. One
provision will make companies find a way for whistleblowers to confidentially
report possible wrongdoings, noted Verschoor.
Still, "the pendulum swings both ways,"
said Herrmann. "If the government continues to prosecute people in
high-level positions, maybe that will last for a while. It probably will send
a message and the fear of God will spread. But my guess is that politics being
what it is, somewhere down the line the spotlight will be off and there will
be fewer prosecutions."
A
Round-Up of Recent Earnings Restatements Some firms are no stranger to the restatement
dance
Company
Financial Scoop
Number of restatements in past year
Bristol-Myers Squibb (BMY:NYSE)
Restating fourth-quarter and full-year results for 2003
due to accounting errors. Follows an earlier restatement of earnings
between 1999 and 2002, as of early 2003
Twice
P.F. Chang's China Bistro (PFCB:Nasdaq)
Will delay filing its 10K; plans to restate earnings for
prior years, including for calendar year 2003
Once
Veritas (VRTS:Nasdaq)
Will restate earnings for 2001 through 2003
Once
Nortel (NT:NYSE)
Will restate earnings for 2003 and earlier periods;
Nortel already restated earnings for the past three years in October
2003
Twice
Metris (MXT:NYSE)
Restated its financial results for 1998 through 2002 and
for the first three quarters of 2003 following an SEC inquiry
Once
Quovadx (QVDX:Nasdaq)
Restating results for 2003
Once
WorldCom
Restated pretax profits from 2000 and 2001; this month
former CEO Bernie Ebbers indicted on fraud charges in accounting scandal
that led to 2002 corporate bankruptcy
Once
Service Corp. International (SRV:NYSE)
Restating results for 2000 through 2003
Once
Flowserve (FLS:NYSE)
Restating results for 1999 through 2003
Once
OM Group (OMG:NYSE)
Restating results for 1999 through 2003
Once
IDX Systems (IDXC:Nasdaq)
Restated results for 2003
Once
Network Associates (NET:NYSE)
Restated results for 2003 this month; restated earnings
for periods from 1998 to 2003 after investigations by the SEC and
Justice Department
Twice
Take-Two (TTWO:Nasdaq)
In February, restated results from 1999 to 2003 following
investigation by the SEC
Once
Sipex (SIPX:Nasdaq)
In February, restated results from 2003, marking the
second revision of third-quarter '03 results
Twice
Source: SEC
filings, media reports.
March 1, 2004 message from Mike Groomer
Bob,
Do you have any idea
about who coined the phrase “Cooking the Books? What is the lineage of these
magic words?
Mike
Hi Mike,
The phrase "cooking the
books" appears to have a long history. Several friends on the AECM found
some interesting facts and legends.
However, there may be a little urban
legend in some of this.
I suspect that the phrase may have
origins that will never be determined much like double entry bookkeeping itself
with unknown origins. And I'm not sure were the term "books" first
appeared although I suspect it goes back to when ledgers were bound into
"books."
-----Original
Message-----
From: David Albrecht
Sent: Monday, March 01, 2004 9:56 PM
Subject: Acct 321: Cooking the books
The phrase
"Cooking the Books" has been part of our linguistic heritage for
over two hundred years. Here is a discussion of the origination of the phrase.
Enjoy! Dr. Albrecht
Cooking the books, an old recipe - http://www.accountantsworld.com/DesktopDefault.aspx?tabid=2&faid=290
--> "No one knows for sure when all the ingredients in the phrase
'cooking the books' were first put together. Shakespeare was the first to
refer to "books" as a business ledger (King Lear, Act III, Scene iv,
"Keep...thy pen from lenders books"). The American Heritage
Dictionary of Idioms cites 1636 as the first time the word 'cook' was used to
mean falsify (but it didn't also include the word 'books'). Combining 'cook'
and 'books' may be a 20th century innovation. Even the origin of "cooking
the books" is controversial.
A related term is "cookbooking," as used in
Gleim's 'Careers in Accounting: How to Study for Success.' Per Gleim ". .
.cookbooking is copying from the chapter illustration, step-by-step. Barely
more than rote memorization is required to achieve false success. Do not
cookbook!"
According to http://www.businessballs.com/clichesorigins.htm
, the phrase dates back to the 18th century, to an (unattributed) report that
used the phrase "the books have been cooked." The report dealt with
the conduct of George Hudson and the accounts of the Eastern Counties
Railways.
Original
Message-----
From: Groomer, S. Michael [mailto:groomer@indiana.edu]
Sent: Tuesday, March 02, 2004 9:40 AM
To: Jensen, Robert Subject: RE: Acct 321: Cooking the books
Hi Bob,
Yes… very
interesting… See below… Thanks for your efforts.
Best regards, Mike
cook the books -
falsify business accounts - according to 18th century Brewer, 'cook the books'
originally appeared as the past tense 'the books have been cooked' in a report
(he didn't name the writer unfortunately) referring to the conduct George
Hudson (1700-71), 'the railway king', under whose chairmanship the accounts of
Eastern Counties Railways were falsified. Brewer says then (1870) that the
term specifically describes the tampering of ledger and other trade books in
order to show a balance in favour of the bankrupt. Brewer also says the
allusion is to preparing meat for the table. These days the term has a wider
meaning, extending to any kind of creative accounting. Historical records bear
this out, and date the first recorded use quite accurately: Hudson made a
fortune speculating in railway shares, and then in 1845, which began the
period 1845-47 known as 'railway mania' in Britain, he was exposed as a
fraudster and sent to jail. Other cliche references suggest earlier usage,
even 17th century, but there appears to be no real evidence of this. There is
an argument for Brewer being generally pretty reliable when it comes to first
recorded/published use, because simply he lived far closer to the date of
origin than reference writers of today. If you read Brewer's Dictionary of
Phrase and Fable you'll see it does have an extremely credible and prudent
style. The word 'book' incidentally comes from old German 'buche' for beech
wood, the bark of which was used in Europe before paper became readily
available. The verb 'cook' is from Latin 'coquere'
From Smart Stops on the Web, Journal of Accountancy, January 2004,
Page 27 ---
Accountability Resources Here www.thecorporatelibrary.com CPAs can read about corporate governance in the real world in
articles such as “Alliance Ousts Two Executives” and “Mutual Fund
Directors Avert Eyes as Consumers Get Stung” at this Web site. Other
resources here include related news items from wire services and newspapers,
details on specific shareholder action campaigns and links to other corporate
governance Web stops. And on the lighter side, visitors can view a slide show
of topical cartoons.
Cartoon 1: Two kids competing on the blackboard. One writes
2+2=4 and the other kid writes 2+2=40,000. Which kid as the best
prospects for an accounting career?
Cartoon 36: Where the Grasso is greener (Also see Cartoon 37)
Show-and-Tell www.encycogov.com This e-stop, while filled with information on corporate
governance, also features detailed flowcharts and tables on bankruptcy,
information retrieval and monitoring systems, as well as capital, creditor and
ownership structures. Practitioners will find six definitions of the term
corporate governance and a long list of references to books, papers and
periodicals about the topic.
Investors, Do Your Homework www.irrc.org At this Web site CPAs will find the electronic version of the
Investor Responsibility Research Center’s IRRC Social Issues Reporter, with
articles such as “Mutual Funds Seldom Support Social Proposals.” Advisers
also can read proposals from the Shareholder Action Network and the IRRC’s
review of NYSE and Sarbanes-Oxley Act reforms, as well as use a glossary of
industry terms to help explain to their clients concepts such as acceleration,
binding shareholder proposal and cumulative voting.
SARBANES-OXLEY
SITES
Get Information Online www.sarbanes-oxley.com CPAs looking for links to recent developments on the
Sarbanes-Oxley Act of 2002 can come here to review current SEC rules and
regulations with cross-references to specific sections of the act. Visitors
also can find the articles “Congress Eyes Mutual Fund Reform” and “FBI
and AICPA Join Forces to Help CPAs Ferret Out Fraud.” Tech-minded CPAs will
find the list of links to Sarbanes-Oxley compliance software useful as well.
Direct From the Source www.sec.gov/spotlight/sarbanes-oxley.htm To trace the history of the SEC’s rule-making policies for
the Sarbanes-Oxley Act, CPAs can go right to the source at this Web site and
follow links to press releases pertaining to the commission’s involvement
since the act’s creation. Visitors also can navigate to the frequently asked
questions (FAQ) section about the act from the SEC’s Division of Corporation
Finance.
PCAOB Online www.pcaobus.org The Public Company Accounting Oversight Board e-stop offers
CPAs timely articles such as “Board Approves Registration of 598 Accounting
Firms” and the full text of the Sarbanes-Oxley rules. Users can research
proposed standards on accounting support fees and audit documentation and
enforcement. Accounting firms not yet registered with the PCAOB can do so here
and check out the FAQ section about the registration process.
Where
are some great resources (hard copy and electronic) for teaching ethics?
"An
Inventory of Support Materials for Teaching Ethics in the Post-Enron Era,” by
C. William Thomas, Issues in Accounting Education, February 2004, pp.
27-52 --- http://aaahq.org/ic/browse.htm
ABSTRACT:
This paper presents a "Post-Enron" annotated bibliography of resources
for accounting professors who wish to either design a stand-alone course in
accounting ethics or who wish to integrate a significant component of ethics
into traditional courses across the curriculum. Many of the resources
listed are recent, but some are classics that have withstood the test of time
and still contain valuable information. The resources listed include texts
and reference works, commercial books, academic and professional articles, and
electronic resources such as film and Internet websites. Resources are
listed by subject matter, to the extent possible, to permit topical access.
Some observations about course design, curriculum content, and instructional
methodology are made as well.
Discount retailer Kmart is under
investigation for irregular accounting practices. In January an anonymous letter
initiated an internal probe of the company's accounting practices. Now, the
Detroit News has obtained a copy of the letter that contains allegations
pointing to senior Kmart officials as purposely violating accounting principles
with the knowledge of the company's auditors, PricewaterhouseCoopers. http://www.accountingweb.com/item/82286
Bankrupt retailer Kmart explained the
impact of accounting irregularities and said employees involved in questionable
accounting practices are no longer with the company. http://www.accountingweb.com/item/90935
Kmart's
CFO Steps up to Accounting Questions
AccountingWEB
US - Sep-19-2002 - Bankrupt retailer Kmart
explained the impact of accounting irregularities in a Form 10-Q filed
with the U.S. Securities and Exchange Commission (SEC) this week. Chief
Financial Officer Al Koch said
several employees involved in questionable accounting practices are no
longer with the company.
Speaking to the
concerns about vendor allowances recently raised in anonymous letters
from in-house accountants, Mr. Koch said, "It was not hugely
widespread, but neither was it one or two people."
The Kmart whistleblowers
who wrote the letters said they were being asked to record transactions
in obvious violation of generally accepted accounting principles. They
also said "resident auditors from PricewaterhouseCoopers are
hesitant to pursue these issues or even question obvious changes in
revenue and expense patterns."
In response to
the letters, the company admitted it had erroneously accounted for
certain vendor transactions as up-front consideration, instead of
deferring appropriate amounts and recognizing them over the life of the
contract. It also said it decided to change its accounting method.
Starting with fourth quarter 2001, Kmart's policy is to recognize a cost
recovery from vendors only when a formal agreement has been obtained and
the underlying activity has been performed.
According to
this week's Form 10-Q, early recognition of vendor allowances resulted
in understatement of the company's fiscal year 2000 net loss by
approximately $26 million and overstatement of its fiscal year 2001 net
loss by approximately $78 million, both net of taxes. The 10-Q also said
the company has been looking at historical patterns of markdowns and
markdown reserves and their relation to earnings.
Kmart is under
investigation by the SEC and the Justice Department. The Federal Bureau
of Investigation, which is handling the investigation for the U.S.
Attorney, said its investigation could result in criminal charges. In
the months before Kmart's bankruptcy filing, top executives took home
approximately $29 million in retention loans and severance packages. A
spokesperson for PwC said the firm is cooperating with the
investigations.
24 Days:
How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in
Corporate America, by John R. Emshiller and Rebecca Smith (Haper Collins, 2003, ISBN:
0060520736)
Here's a powerful Enron Scandal book in the words of the lead whistle blower
herself: Power Failure: The Inside Story of the Collapse of Enron by Mimi
Swartz, Sherron
Watkins
ISBN: 0385507879 Format: Hardcover, 400pp Pub. Date: March 2003
“They’re still trying to hide the weenie,”
thought Sherron Watkins as she read a newspaper clipping about Enron two weeks
before Christmas, 2001. . . It quoted [CFO] Jeff McMahon addressing the
company’s creditors and cautioning them against a rash judgment....
Chronicling the inner workings of Andersen at the
height of its success, Toffler reveals "the making of an Android,"
the peculiar process of employee indoctrination into the Andersen culture; how
Androids - both accountants and consultants--lived the mantra "keep the
client happy"; and how internal infighting and "billing your brains
out" rather than quality work became the all-important goals. Final
Accounting should be required reading in every business school, beginning with
the dean and the faculty that set the tone and culture." - Paul Volker,
former Chairman of the Federal Reserve Board.
The AccountingWeb, March 25, 2003.
Barbara Ley Toffler is
the former Andersen was the partner-in-charge of
Andersen's Ethics & Responsible Business Practices Consulting Services.
Title: Final
Accounting: Ambition, Greed and the Fall of Arthur Andersen Authors: Barbara Ley Toffler, Jennifer Reingold ISBN: 0767913825 Format: Hardcover, 288pp Pub. Date: March 2003 Publisher: Broadway Books
Book Description A
withering exposé of the unethical practices that triggered the indictment and
collapse of the legendary accounting firm.
Arthur Andersen's
conviction on obstruction of justice charges related to the Enron debacle
spelled the abrupt end of the 88-year-old accounting firm. Until recently, the
venerable firm had been regarded as the accounting profession's conscience. In
Final Accounting, Barbara Ley Toffler, former Andersen partner-in-charge of
Andersen's Ethics & Responsible Business Practices consulting services,
reveals that the symptoms of Andersen's fatal disease were evident long before
Enron. Drawing on her expertise as a social scientist and her experience as an
Andersen insider, Toffler chronicles how a culture of arrogance and greed
infected her company and led to enormous lapses in judgment among her peers.
Final Accounting exposes the slow deterioration of values that led not only to
Enron but also to the earlier financial scandals of other Andersen clients,
including Sunbeam and Waste Management, and illustrates the practices that
paved the way for the accounting fiascos at WorldCom and other major
companies.
Chronicling the inner
workings of Andersen at the height of its success, Toffler reveals "the
making of an Android," the peculiar process of employee indoctrination
into the Andersen culture; how Androids—both accountants and
consultants--lived the mantra "keep the client happy"; and how
internal infighting and "billing your brains out" rather than
quality work became the all-important goals. Toffler was in a position to know
when something was wrong. In her earlier role as ethics consultant, she worked
with over 60 major companies and was an internationally renowned expert at
spotting and correcting ethical lapses. Toffler traces the roots of Andersen's
ethical missteps, and shows the gradual decay of a once-proud culture.
Uniquely qualified to
discuss the personalities and principles behind one of the greatest shake-ups
in United States history, Toffler delivers a chilling report with important
ramifications for CEOs and individual investors alike.
From the Back Cover
"The sad demise of the once proud and disciplined firm of Arthur Andersen
is an object lesson in how 'infectious greed' and conflicts of interest can
bring down the best. Final Accounting should be required reading in every
business school, beginning with the dean and the faculty that set the tone and
culture.” -Paul Volker, former Chairman of the Federal Reserve Board
“This exciting tale
chronicles how greed and competitive frenzy destroyed Arthur Andersen--a firm
long recognized for independence and integrity. It details a culture that, in
the 1990s, led to unethical and anti-social behavior by executives of many of
America's most respected companies. The lessons of this book are important for
everyone, particularly for a new breed of corporate leaders anxious to restore
public confidence.” -Arthur Levitt, Jr., former chairman of the Securities
and Exchange Commission
“This may be the
most important analysis coming out of the corporate disasters of 2001 and
2002. Barbara Toffler is trained to understand corporate ‘cultures’ and
‘business ethics’ (not an oxymoron). She clearly lays out how a high
performance, manically driven and once most respected auditing firm was
corrupted by the excesses of consulting and an arrogant culture. One can hope
that the leaders of all professional service firms, and indeed all corporate
leaders, will read and reflect on the meaning of this book.” -John H. Biggs,
Former Chairman and Chief Executive Officer of TIAA CREF
“The book exposes
the pervasive hypocrisy that drives many professional service firms to put
profits above professionalism. Greed and hubris molded Arthur Andersen into a
modern-day corporate junkie ... a monster whose self-destructive behavior
resulted in its own demise." -Tom Rodenhauser, founder and president of
Consulting Information Services, LLC
"An intriguing
tale that adds another important dimension to the now pervasive national
corporate governance conversation. -Charles M. Elson, Edgar S. Woolard, Jr.,
Professor of Corporate Governance, University of Delaware
“You could not ask
for a better guide to the fall of Arthur Andersen than an expert on
organizational behavior and business ethics who actually worked there.
Sympathetic but resolutely objective, Toffler was enough of an insider to see
what went on but enough of an outsider to keep her perspective clear. This is
a tragic tale of epic proportions that shows that even institutions founded on
integrity and transparency will lose everything unless they have internal
controls that require everyone in the organization to work together, challenge
unethical practices, and commit only to profitability that is sustainable over
the long term. One way to begin is by reading this book. –Nell Minow,
Editor, The Corporate Library
About the Author
Formerly the Partner-in-Charge of Ethics and Responsible Business Practices
consulting services for Arthur Andersen, BARBARA LEY TOFFLER was on the
faculty of the Harvard Business School and now teaches at Columbia
University's Business School. She is considered one of the nation's leading
experts on management ethics, and has written extensively on the subject and
has consulted to over sixty Fortune 500 companies. She lives in the New York
area. Winner of a Deadline Club award for Best Business Reporting, JENNIFER
REINGOLD has served as management editor at Business Week and senior writer at
Fast Company. She writes for national publications such as The New York Times,
Inc and Worth and co-authored the Business Week Guide to the Best Business
Schools (McGraw-Hill, 1999).
March 8, 2004
message from neil glass [neil.glass@get2net.dk]
Note that you can download the first chapter of his book for free. The
book may be purchased as an eBook or hard copy.
Dr. Jensen,
I just came across your website and was pleased to
find you talk about some of the frauds and other problems I reveal in my
latest book. If you had a moment, you might be amused to look at my website
only-on-the-net.com where I am trying to attract some attention to my book
Rip-Off: The scandalous inside story of the Management Consulting Money
Machine.
Lessons Learned From Paul
Volker:
The Culture of Greed Sucked the Blood Out of Professionalism
In an effort to
save Andersen's reputation and life, the top executive officer, Joe
Berardino, in Andersen was replaced by the former Chairman of the
Federal Reserve Board, Paul Volcker. This great man, Volcker,
really tried to instantly change the culture of greed that overtook
professionalism in Andersen and other public accounting firms,
but it was too little too late --- at least for Andersen.
The bottom line:
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 will be
shaded.
Paul Volcker (See below)
WASHINGTON,
May 17 (Reuters) - Former Federal Reserve Board Chairman Paul
Volcker, who took charge of a rescue team at embattled accounting
firm Andersen (ANDR), said on Friday that creating "a new
Andersen" was no longer possible.
In a letter
to Sen. Paul Sarbanes, Volcker said he supports the Maryland
Democrat's proposals for reforming the U.S. financial system to
prevent future corporate disasters such as the collapse of Enron
Corp. (ENRNQ).
"The
sheer number and magnitude of breakdowns that have increasingly
become the daily fare of the business press pose a clear and present
danger to the effectiveness and efficiency of capital markets,"
Volcker said in the letter released to Reuters.
"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
At
FEI's recent financial reporting conference in New York, Paul
Volcker gave the keynote address and declared that the accounting
and auditing profession were in a "state of crisis."
Earlier that morning, over breakfast, he lamented the daily
bombardment of financial reporting failures in the press.
I
agree with his assessment. The causes and contributing factors are
numerous, but one thing is clear: We as financial executives need to
do better, be stronger and take the lead in restoring the
credibility of financial reporting and preserving the capital
markets.
If
you didn't already know it and believe it deeply, recent cases prove
the value of a financial management team that is ethical, credible
and clear in its communications. A loss of confidence in that team
can be a fatal blow, not just to the individuals, but to the company
or institution that entrusts its assets to their stewardship. I
think the FEI Code of Ethical Conduct says it best, and it is worth
reprinting the opening section here. The full code (signed by all
FEI members) can be found here.
.
. .
So
how did the profession reach the state Volcker describes as a
crisis?
The
market pressure for corporate performance has increased
dramatically over the last 10 years. That pressure has produced
better results for shareholders, but also a higher fatality rate
as management teams pressed too hard at the margin.
The
standard-setters floundered in the issue de jour quagmire,
writing hugely complicated standards that were unintelligible
and irrelevant to the bigger problems.
The SEC
fiddled while the dot-com bubble burst. Deriding and undermining
management teams and the auditors, the past administration made
a joke of financial restatements.
We've
had no vision for the future of financial reporting. Annual
reports, 10Ks and 10Qs are obsolete. Bloomberg and Yahoo!
Finance have replaced the horse-and-buggy vehicles with summary
financial information linked to breaking news.
We've
had no vision for the future of accounting. Today's mixed model
is criticized one day for recognizing unrealized fair value
contractual gains and alternatively for not recognizing the fair
value of financial instruments.
The
auditors dropped their required skeptical attitude and embraced
business partnering philosophies. Adding value and justifying
the audit fees became the mandate. Management teams and audit
committees promoted this, too.
Audit
committees have not kept up with the challenges of the
assignment. True financial reporting experts are needed on these
committees, not the general management expertise required by the
stock exchange rules.
How
Tyco's CEO Enriched Himself by Mark Maremont and Laurie P. Cohen, The Wall Street
Journal The latest story of corporate abuse surrounds the former Tyco CEO.
This story provides a vivid example of the abuses that are leading many to
question current business practices. http://www.msnbc.com/news/790996.asp
A
To-Do List for Tyco's CEO by William C. Symonds, BusinessWeek online The new CEO of Tyco has a tough job ahead of him cleaning up the mess
left behind.
http://www.businessweek.com/magazine/content/02_32/b3795050.htm
Implausible
Deniability: The SEC Turns Up CEO Heat by Diane Hess, TheStreet.com The SEC's edict requires written statements, under oath, from senior
officers of the 1,000 largest public companies attesting to the accuracy
of their financial statements.
http://www.thestreet.com/markets/taleofthetape/10029865.html
You buy shares in a company. The government
charges one of the company's executives with fraud. Who foots the
legal bill?
All too often, it's you.
Consider the case of a former Rite Aid
Corp. executive. Four days before he was set to go to trial last
June, Frank Bergonzi pleaded guilty to participating in a criminal
conspiracy to defraud Rite Aid while he was the company's chief
financial officer. "I was aggressive and I pressured others to
be aggressive," he told a federal judge in Harrisburg, Pa., at
the time.
Little more than a month later, Mr.
Bergonzi sued his former employer in Delaware Chancery Court,
seeking to force the company to pay more than $5 million in unpaid
legal and accounting fees he racked up in connection with his
defense in criminal and civil proceedings. That was in addition to
the $4 million that Rite Aid had already advanced for Mr. Bergonzi's
defense in civil, administrative and criminal proceedings.
In October, the Delaware court sided with
Mr. Bergonzi. It ruled that Rite Aid was required to advance Mr.
Bergonzi's defense fees until a "final disposition" of his
legal case. The court interpreted that moment as sentencing, a time
that could be months -- or even years -- away. Mr. Bergonzi has
agreed to testify against former colleagues at coming trials before
he is sentenced for his crimes.
Rite Aid's insurance, in what is known as a
directors-and-officers liability policy, already has been depleted
by a host of class-action suits filed against the company in the
wake of a federal investigation into possible fraud that began in
late 1999. "The shareholders are footing the bill" because
of the "precedent-setting" Delaware ruling, laments Alan
J. Davis, a Philadelphia attorney who unsuccessfully defended Rite
Aid against Mr. Bergonzi.
Rite Aid eventually settled with Mr.
Bergonzi for an amount it won't disclose. While it is entitled to
recover the fees it has paid from Mr. Bergonzi after he is
sentenced, the 58-year-old defendant has testified he has few
remaining assets. "We have no reason to believe he'll
repay" Rite Aid, Mr. Davis says.
Rite Aid has lots of company. In recent
government cases involving Cendant Corp.; WorldCom Inc., now known
as MCI; Enron Corp.; and Qwest Communications International Inc.,
among others, companies are paying the legal costs of former
executives defending themselves against fraud allegations. The
amount of money being paid out isn't known, as companies typically
don't specify defense costs. But it totals hundreds of millions, or
even billions of dollars. A company's average cost of defending
against shareholder suits last year was $2.2 million, according to
Tillinghast-Towers Perrin. "These costs are likely to climb
much higher, due to a lot of claims for more than a billion dollars
each that haven't been settled," says James Swanke, an
executive at the actuarial consulting firm.
Continued in the article
Corporate Accountability: A Toolkit for Social Activists
The Stakeholder Alliance (ala our friend Ralph Estes and well-meaning
social accountant) --- http://www.stakeholderalliance.org/
WASHINGTON,
Feb. 19, 2002 (Knight-Ridder / Tribune News Service) — Enron
Corp.'s collapse was a symptom of a financial recklessness that
spread during the 1990s economic boom as investors and corporate
executives pursued profits at all costs, former Federal Reserve
Chairman Paul Volcker told a Senate committee Thursday.
Volcker --
chairman of the new oversight panel created by Enron's auditor, the
Andersen accounting firm, to examine its role in the financial
disaster -- told the Senate Banking Committee he hoped the debacle
would accelerate current efforts to achieve international accounting
standards. Such standards could reassure investors around the world
that publicly traded companies met certain standards regardless of
where such companies were based, he said.
"In
the midst of the great prosperity and boom of the 1990s, there has
been a certain erosion of professional, managerial and ethical
standards and safeguards," Volcker said.
"The
pressure on management to meet market expectations, to keep earnings
rising quarter by quarter or year by year, to measure success by one
'bottom line' has led, consciously or not, to compromises at the
expense of the public interest in full, accurate and timely
financial reporting," he added.
But the
74-year-old economist also blamed the new complexity of corporate
finance for contributing the problem. "The fact is,"
Volcker said "the accounting profession has been hard-pressed
to keep up with the growing complexity of business and finance, with
its mind-bending complications of abstruse derivatives, seemingly
endless varieties of securitizations and multiplying,
off-balance-sheet entities. (Continued in the article.)
I've been teaching Intermediate Financial Accounting for several years.
Recently, I've been thinking about having students read a supplemental book .
Given the current upheaval, there are several possibilities for additional
reading. Can anyone make a recommendation? BTW, these books would make great
summer reading.
Dave Albrecht
Benston et. al. (2003). Following the Money: The
Enron Failure and the State of Corporate Disclosure.
Berenson, Alex. (2003). The Number: How the Drive for
Quarterly Earnings Corrupted Wall Street and Corporate America.
Brewster, Mike. (2003). Unaccountable: How the
Accounting Profession Forfeited an Public Trust.
Brice & Ivins. (2002.) Pipe Dreams: Greed, Ego
and the Death of Enron.
DiPiazza & Eccles. (2002). Building Public Trust:
The Future of Corporate Reporting.
Fox, Loren. (2002). Enron, the Rise and Fall.
Jeter, Lynne W. (2003). Disconnected: Deceit and
Betrayal at WorldCom.
Mills, D. Quinn. (2003). Wheel, Deal and Steal:
Deceptive Accounting, Deceitful CEOs, and Ineffective Reforms.
Financial Shenanigans : How to Detect Accounting
Gimmicks & Fraud in Financial Reports by Howard Schilit (McGraw-Hill
Trade; 2nd edition (March 1, 2002))
How Companies Lie: Why Enron Is Just the Tip of the
Iceberg by Richard J. Schroth, A. Larry Elliott
Quality Financial Reporting by Paul B. W. Miller,
Paul R. Bahnson
Take On the Street: What Wall Street and Corporate
America Don't Want You to Know by Arthur Levitt, Paula Dwyer (Contributor)
And for fun: Who Moved My Cheese? An Amazing Way to
Deal with Change in Your Work and in Your Life by Spencer, M.D. Johnson,
Kenneth H. Blanchard
Neal J. Hannon, CMA Chair, I.T. Committee, Institute
of Management Accountants Member, XBRL_US Steering Committee University of
Hartford (860) 768-5810 (401) 769-3802 (Home Office)
Book Recommendation from The AccountingWeb on April 25, 2003
The professional service accounting firm is being
threatened by a variety of factors: new technology, intense competition,
consolidation, an inability to incorporate new services into a business
strategy, and the erosion of public trust, just to name a few. There is relief.
And promise. And hope. In The Firm of the Future: A Guide for Accountants,
Lawyers, and Other Professional Services, confronts the tired, conventional
wisdom that continues to fail its adherents, and present bold, proven strategies
for restoring vitality and dynamism to the professional service firm. http://www.amazon.com/exec/obidos/ASIN/0471264245/accountingweb
COSO is a voluntary private sector organization
dedicated to improving the quality of financial reporting through business
ethics, effective internal controls, and corporate governance. COSO was
originally formed in 1985 to sponsor the National Commission on Fraudulent
Financial Reporting, an independent private sector initiative which studied
the causal factors that can lead to fraudulent financial reporting and
developed recommendations for public companies and their independent auditors,
for the SEC and other regulators, and for educational institutions.
The National Commission was jointly sponsored by the
five major financial professional associations in the United States, the
American Accounting Association, the American Institute of Certified Public
Accountants, the Financial Executives Institute, the Institute of Internal
Auditors, and the National Association of Accountants (now the Institute of
Management Accountants). The Commission was wholly independent of each of the
sponsoring organizations, and contained representatives from industry, public
accounting, investment firms, and the New York Stock Exchange.
The Chairman of the National Commission was James C.
Treadway, Jr., Executive Vice President and General Counsel, Paine Webber
Incorporated and a former Commissioner of the U.S. Securities and Exchange
Commission. (Hence, the popular name "Treadway Commission").
Currently, the COSO Chairman is John Flaherty, Chairman, Retired Vice
President and General Auditor for PepsiCo Inc.
This is
Levitt's no-holds-barred memoir of his turbulent tenure as chief overseer of
the nation's financial markets. As working Americans poured billions into
stocks and mutual funds, corporate America devised increasingly opaque
strategies for hoarding most of the proceeds. Levitt reveals their tactics in
plain language, then spells out how to intelligently invest in mutual funds
and the stock market. With integrity and authority, Levitt gives us a bracing
primer on the collapse of the system for overseeing our capital markets, and
sage, essential advice on a discipline we often ignore to our peril - how not
to lose money. http://www.amazon.com/exec/obidos/ASIN/0375421785/accountingweb
Don Ramsey called my attention to the
following audio interview: For a one-hour audio archive of Diane Rehm's
recent interview with Arthur Levitt, go to this URL:
http://www.wamu.org/ram/2002/r2021015.ram
A free video from Yale University and the AICPA (with an introduction by
Professor Rick Antle and Senior Associate Dean from Yale). This video can
be downloaded to your computer with a single click on a button at http://www.aicpa.org/video/
It might be noted that Barry Melancon is in the midst of controversy with ground
swell of CPAs and academics demanding his resignation vis-a-vis continued
support he receives from top management of large accounting firms and business
corporations.
A New
Accounting Culture
Address by Barry C. Melancon
President and CEO, American Institute of CPAs
September 4, 2002
Yale Club - New York City
Taped immediately upon completion
From The Conference Board Corporate Citizenship in the New Century: Accountability,
Transparency, and Global Stakeholder Engagement Publication Date: July 2002 Report Number: R-1314-02-RR --- http://www.conference-board.org/publications/describe.cfm?id=574
My new and updated
documents the recent accounting and investment scandals are at the
following sites:
Chicago's
Andersen accounting firm must stop auditing publicly traded companies
following the firm's conviction for obstructing justice during the federal
investigation into the downfall of Enron Corp. For decades, Andersen was a
fixture in Chicago's business community and, at one time, the gold standard of
the accounting industry. How did this legendary firm disappear?
The
fall of Andersen
September 1, 2002. This
series was reported by Delroy Alexander, Greg Burns, Robert Manor, Flynn
McRoberts and E.A. Torriero. It was written by McRoberts.
'Merchant
or Samurai?'
September 1, 2002. Dick
Measelle, then-chief executive of Andersen's worldwide audit and tax practice,
explores a corporate cultural divide in an April 1995 newsletter essay to
Andersen partners.
One New Book on
Accounting Professionalism
and Public Trust
Building Public
Trust: The Future of
Corporate Reporting
by Samuel A. DiPiazza, Jr
(CEO of
PricewaterhouseCoopers
(PwC))
and Robert G. Eccies
(President of Advisory
Capital Partners)
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
Books on Fraud --- Enter
the word "fraud"
in the search box at http://www.bn.com/
You might enjoy "The AICPA's Prosecution of Dr. Abraham Briloff: Some
Observations," by Dwight M. Owsen --- http://accounting.rutgers.edu/raw/aaa/pi/newsletr/spring99/item07.htm
I think Briloff was trying to save the profession from what it is now going
through in the wake of the Enron scandal.
Internal
auditing is an independent, objective assurance and consulting activity
designed to add value and improve an organization's operations. It helps
an organization accomplish its objectives by bringing a systematic,
disciplined approach to evaluate and improve the effectiveness of risk
management, control, and governance processes. (Institute of Internal
Auditors)
Fraud
Investigation consists of the multitude of steps necessary to resolve
allegations of fraud - interviewing witnesses, assembling evidence, writing
reports, and dealing with prosecutors and the courts. (Association of
Certified Fraud Examiners)
This site focuses on topics that
deal with Internal
Auditing and Fraud
Investigation with certain hyper-links
to other associated and relevant sources. It is dedicated to sharing
information.
This column from Law Library Resource Xchange (LLRX)
(last mentioned in the September 7, 2001 Scout Report) by Kathy Biehl becomes
more interesting with every revelation of misleading corporate accounting
practices. This is a straightforward listing of state government's efforts to
provide easy access to required disclosure filings of businesses within each
state. Each entry is clearly annotated, describing services offered and any
required fees (most services here are free). The range of information and
services varies considerably from very basic (i.e. "name
availability") to complete access to corporate filings. The noteworthy
exception here is tax filings. Most states do not currently include access to
filings with taxing authorities.
List of
Securities Fraud Class Actions
SORTED BY COMPANY NAME
IMPORTANT NOTE:
If another district or date than the one for which
you searched appears in the "Court" column, the explanation may be that
the district/date for which you searched is related to this case but is
not singled out as our "First Identified District". This list may be
considered inclusive.
AECM
(Educators)
http://listserv.aaahq.org/cgi-bin/wa.exe?HOME
AECM is an email Listserv list which
provides a forum for discussions of all hardware and software
which can be useful in any way for accounting education at the
college/university level. Hardware includes all platforms and
peripherals. Software includes spreadsheets, practice sets,
multimedia authoring and presentation packages, data base
programs, tax packages, World Wide Web applications, etc.
Over the years the AECM has become the worldwide forum for accounting
educators on all issues of accountancy and accounting education,
including debates on accounting standards, managerial accounting,
careers, fraud, forensic accounting, auditing, doctoral programs, and
critical debates on academic (accountics) research, publication,
replication, and validity testing.