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


Updates and issues in the accounting, finance, and business scandals --- 

Many of the scandals are documented at 

Resources to prevent and discover fraud from the Association of Fraud Examiners --- 

Self-study training for a career in fraud examination --- 

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

Source for United Kingdom reporting on financial scandals and other news --- 

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 ---

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

Bob Jensen's threads on resources for accounting educators are at 


Scandals Are a Hot Topic in College Courses --- 

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 --- 
For more about KPMG see 

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 --- 

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 

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

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

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

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

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

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

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

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

Ethics:  Is there a bright line?
This is a gray zone for huge and customary ways of doing business in the U.S.
So what's a little business deal among friends?  It's trouble, if the friends are college or college-foundation trustees who benefit personally from the decisions they make on behalf of the institutions they serve. 

Julianne Basinger, "Boars Crack Down on Members' Insider Benefits," The Chronicle of Higher Education, February 6. 2004, Page A1.

Ware Enterprises and Investments Inc., which targeted blacks and Christians as well as nearly 20 NFL players, is nothing more than a Ponzi scheme, the Securities and Exchange Commission said Tuesday as it acted to shut down the Orlando-based investment firm. 
AccountingWEB, January 29, 2004 --- 

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

Democratic Presidential Candidate John Kerry refers to the Mutual Fund Industry as "Organized Crime."
"John Kerry’s 19 Year Record On Investor Issues," American Shareholders' Association ---  

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

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

Dutch police raid 23 apartments and arrest 52 people in one of the largest busts of suspected Nigerian e-mail hucksters. The detainees' identities are not released, but police believe most were, in fact, Nigerian ---,1272,62124,00.html?tw=newsletter_topstories_html 
Bob Jensen's threads on the enormous Nigerian and other e-mail frauds are at 

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

Federal prosecutors are planning to seek a criminal indictment against a former chief executive of Enron.

International Corruption Surveys and Indices --- 

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

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

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


2. If word of bad dealings (read that the Watkins memo) crosses your desk, hire an unethical law firm (read that Vinson and Elkins --- ) and an accounting firm (read that Andersen ---  ) to absolve you of responsibility by allowing you to claim to have passed the buck along to experts.

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

4. Have your company buy your wife expensive jewelry and clothing and then set her up in a resale shop (read that Jus' Stuff) to lauder the money. See 

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

14. Enron stock certificates, framed and matted 

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

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

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

10. Humble pie, à la mode 

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

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

07. Actual set of blindfolds worn by Andersen auditors 

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

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

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

03. The cabana boy 

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

01. Shredded paper -- lots of it


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

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

Bob Jensen's threads on the Enron/Andersen scandal are at 

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 --- 

Bob Jensen's threads on scandals at Ernst & Young are at 

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

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

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

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

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

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

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

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

Old and New

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

'Maximum Risk'

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bob Jensen's threads on current scandals in the large auditing firms can be found at 

Bob Jensen's summary of proposed auditing reforms is at


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

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

Dear Bob, 

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

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

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

Sorry about the social implications. 

Kind regards, 

Mac Wright

March 27, 2004 reply from Bob Jensen

Hi Mac,

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

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

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


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

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

Update March 2004
From The American Assembly --- 
The Future of the Accounting Profession --- 

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

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

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

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

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

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

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

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

Bob Jensen's Conclusions

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

Denny Beresford

March 6, 2004 reply from Bob Jensen

Hi Denny,

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

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

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

. . . 

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

There are times in life when the project at hand calls for the "bigger hammer" ---

Bob Jensen’s threads on white collar crime are at

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

1. Transaction semantics.

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

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

2. Drilldown.

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

3. Externalities.

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

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

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

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

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

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

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

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

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

Todd Boyle ex-CPA 
Kirkland WA - 425-827-3107  , 

Bob Jensen’s threads on white collar crime are at


Still Rotten to the Core

From the, March 3, 2004 --- 

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

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

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

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

Bob Jensen's threads on other rotten-to-the-core security analysts, investment bankers, mutual funds, and brokers are at 

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

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

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

Recordings of the meeting were broadcast afterwards for those who could not listen in on the original Webcast --- 

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

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

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

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

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


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

The errors largely center around failure to follow FAS 133 rules for accounting for derivative financial statements and hedging activities, with particular problems centered around inappropriate use of hedge accounting for macro hedges.  You can read more about the saga at 

The original and revised sets of financial statements can be downloaded and compared from links at 

"Greenspan Says Congress Should Limit Fannie, Freddie," by Dawn Kopecki and Josepth Rebello, The Wall Street Journal, February 24, 2004 ---,,SB107763512493737729,00.html?mod=home_whats_news_us 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Continued in the article

Bob Jensen's threads on accounting problems in the Freddie and Fannie family are at 

Message from FERF on February 24, 2004

Fraud Checklists

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

FERF researchers found the following references:

An Appendix to Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit (SAS 99), provides examples of fraud risk factors. The appendix is available at the AICPA website at:

The Association of Certified Fraud Examiners provides a fraud prevention checkup that can be used to assist in determining an "entity's vulnerability to fraud."

In January 2003, the Institute of Internal Auditors conducted a survey on red flags used to detect fraud. Though the survey is closed, the text can be used as a checklist.

Somewhat related to the issue of fraud, Mutual Interest published an article about SAS 99 and fraud:

FERF also wrote an article on fraud detection that will be published in the March/April 2004 issue of FE Magazine that will soon be available at

Bob Jensen's main fraud links are at

SOX = Sarbox = Sarbanes-Oxley Act of 2002

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

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

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

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

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

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

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

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

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

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

Continued in the article.

Bob Jensen's threads on proposed reforms in general are at 

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

This article was in RiskCenter today as a reprint from CIO magazine.

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

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

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

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

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

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

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

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

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

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

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

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

How Sarbanes-Oxley Was Defanged

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

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

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

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

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

 (more in article)

dee davidson
Leventhal School of Accounting
Marshall School of Business
University of Southern California

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


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

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

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

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

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

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

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

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

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

Most Companies Get an "F" in Fraud Prevention 

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

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

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

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

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

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

Bob Jensen's threads on whistle blowing are at 

Hackers Hall of Fame --- 

See complete coverage of corporate-scandal trials, including an interactive graphic tracking who's in prison, who's on trial and who's under investigation ---,,2_1040,00.html 

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

Members of the Academy Unite:  Create Change Right Now

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

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

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

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

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

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


One of the key main new approaches is called Create Change Right Now --- 

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

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

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

Please download the revised Create Change brochure at 

Faculty should read the following from 

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

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

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

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

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


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

Forwarded by Amy Dunbar on February 9, 2004

From 2/09/2004 Chronicle of Higher Education.

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

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

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

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

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

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

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

Continued in the article.

FTC: Nearly one in eight U.S. adults fell victim to identity theft in the last five year.
Report says thieves cost $53 billion last year --- 

Bob Jensen's threads on identity theft are at 

New Fraud Links

From "Smart Stops on the Web," Journal of Accountancy, January 2004, Page 31 --- 


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

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

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

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

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

Bob Jensen's threads and links are at 

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

"Tough Senate Bill Would End Three Mutual Fund Practices," AccountingWeb, February 11, 2004 --- 

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

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

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

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

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

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

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

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

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

The trial of three former Adelphia executives may showcase lavish lifestyles and spending sprees, but the complex accounting issues will likely overshadow personal intrigue.  The auditing firm in the hot seat is Deloitte and Touche.  For logs of other Deloitte and Touche scandals, to to 

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

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

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

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

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

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

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

Continued in the article

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

They Just Don't Get It

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

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

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

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

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

Corporate Board Minutes Are Altered; Judgments In Arbitration Go Unpaid

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

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

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

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

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

Altered Minutes

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

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

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

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

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

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

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

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

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

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

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

Unpaid Judgments

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


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 The MSRB, a congressionally created self-regulatory body, provides the price, size and time of each trade -- but typically with a delay of up to 24 hours. The board plans to report same-day trade data for many bonds beginning next year.

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

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

"OVERCOMPENSATING In Fraud Cases Guilt Can Be Skin Deep," by Alex Berenson, The New York Times, February 29, 2004 --- 

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

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

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

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

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

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

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

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

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

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

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

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

Continued in the article

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

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

All too often, it's you.

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

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

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

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

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

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

Continued in the article

Bob Jensen's Threads
Outrageous Executive and Director Compensation Schemes That Reward Failure and Fraud --- 

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

TITLE: Companies Complain About Cost Of Corporate Governance Rules
REPORTER: Deborah Solomon and Cassell Bryan-Low
DATE: Feb 10, 2004
TOPICS: Accounting, Accounting Law, Assurance Services, Audit Quality, Auditing, Auditing Services, Internal Controls, Regulation, Sarbanes-Oxley Act

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

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

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

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

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

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

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

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

"Halliburton: Few Critics on the Street," by Andrew Park, Business Week, February 20, 2004 --- 

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

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

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

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

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

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

Continued in the article

We may have to wave goodbye to streaming media.

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

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

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

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

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

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

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

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


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

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

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

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

 Continued in the article.

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


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

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

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

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

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

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

Check out:

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

David R. Fordham
PBGH Faculty Fellow
James Madison University

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

February 9, 2004 message from Denise Nitterhouse [

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

Denise Nitterhouse 

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

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

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

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

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

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

Head Start wage gap debate rages

By John Tedesco San Antonio Express-News 


Boo to Merrill Lynch

Merrill Lynch was a major player in the infamous Orange County fraud when selling derivative financial instruments.  You can read more about this at 

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

"Merrill Manager Offers Testimony About Tyco Deal," by Colleen Debaise, The Wall Street Journal, February 3, 2004 ---,,SB107574602208418145,00.html?mod=mkts_main_news_hs_h 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Continued in the article.

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

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

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

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

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

Continued in the article

If you want to read more about ethics failures at Merrill Lynch, just search for the word Merrill at 

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

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

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

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

"Feds Want To See Enron Videotape President Bush Also Takes Part In Skit,", December 16, 2002 --- 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Former employees were shocked to see the tape.

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


At Long Last Fastow and His Wife are Headed for Prison, Albeit a Club Fed Prison
Bob Jensen's threads on the history of the Enron accounting scandals can be found at 
The weekly updates on these and other accounting scandals are linked at 
Scandal Updates ---  


"Enron's Fastow Is Set to Plead Guilty," by John Emshwiller, The Wall Street Journal, January 14, 2004 ---,,SB107404282423783100,00.html?mod=home_whats_news_us 

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

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

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

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

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

Continued in the article.

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

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

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

* * *

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

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

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

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

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

Frank Huerta
San Carlos, Calif.

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

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

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

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

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

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

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

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

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

Martin Mobley
LL.M. Candidate
Georgetown University Law Center

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

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

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

Although the "point" doesn't appear to have been made, why don't I take a crack at the "counter-point," anyway? Expensing options doesn't make a whole lot of sense. Where is the expense? An option merely gives its holder the right to purchase the company's stock at specific price during a certain period of time. How does that at all change the fundamental financial position of the company? It doesn't. The company has not expended a thing. It has only given someone the ability to buy some of its stock that it has set aside for that purpose.

If a holder does eventually exercise, has the fundamental financial position of the company changed then? Yes -- for the better! When holders exercise options, it is a capital-raising event for the company -- the company now has MORE money, not less. There will just be more pieces of the corporate pie. Calling the initial grant of the option an "expense," makes about as much sense as calling the proceeds the company receives from its exercise "income."

The real issue here is disclosure. You stumbled across that reality in the part of your piece where you equate the FASB proposal to the "surgeon general's warning on a pack of cigarettes in bigger type." Compelling stock option disclosure through a strained accounting entry, however, is not the way to go. The FASB proposal tries to force a square peg into a round hole. The focus should be on the potential dilution effect of the stock options' exercise on existing shareholders -- the fact that there will be more pieces of the pie with a potentially less than offsetting increase in the size of that pie. This is the salient discussion, and it cannot be communicated through an accounting entry. 

Others at,,SB107964329516259426,00.html?mod=technology%5Ffeatured%5Fstories%5Fhs 


My own arguments for and those of George Scheutze (former Chief Accountant of the SEC) against booking of stock option compensation can be found at 

"Ex-Enron Accounting Chief Charged," John R. Emshwiller, The Wall Street Journal, January 23, 2004 ---,,SB107477724328008831,00.html?mod=mkts_main_news_hs_h 

Continuing to work their way up the Enron Corp. executive ladder, federal prosecutors charged the company's former chief accounting officer, Richard Causey, with fraud and conspiracy in the alleged manipulation of the fallen energy giant's finances.

The indictment of the 44-year-old Mr. Causey had been expected since prosecutors last week announced that they had reached a plea bargain and cooperation agreement with Enron's former chief financial officer, Andrew Fastow. The cooperation of Mr. Fastow, who agreed to a ten-year prison term as part of the deal, was expected to speed the filing of charges against Mr. Causey, said people familiar with the matter.

The indictment, filed in a Houston federal court, charged Mr. Causey with being a "principal architect and operator" of a scheme involving other Enron senior officials to manipulate Enron's financial results and "deceive the investing public about the true performance" of the company. Among other things, the scheme allegedly misused off-balance sheet entities and company reserve accounts to illegally hide losses or boost earnings. In a related action, the Securities and Exchange Commission also filed suit against Mr. Causey in Houston federal court.

Thursday, Mr. Causey appeared in court and pleaded not guilty. In an interview Wednesday evening, Mark Hulkower, one of Mr. Causey's attorneys, said that his client "has done absolutely nothing wrong." Mr. Hulkower added that "Mr. Causey looks forward to having his day in court and having the truth of this matter come out."

Like Mr. Fastow, Mr. Causey dealt directly with Enron's two former chief executives, Kenneth Lay and Jeffrey Skilling. Federal prosecutors continue to investigate Messrs. Skilling and Lay, who have said they did nothing wrong.

Thursday's indictment, which referred to Mr. Lay and Mr. Skilling by their titles, said that Mr. Causey reported to the two former CEOs. It also said that the two top executives, along with Mr. Causey and Mr. Fastow, were among "the principal managers of Enron's finances." While the indictment went on to detail how Mr. Causey worked with "other Enron executives and senior managers" in the alleged fraudulent activities, it didn't specifically identify either former CEO as being part of that group.

The cooperation of Mr. Fastow could be particularly helpful in the investigation of Mr. Skilling, said people familiar with the matter. Prosecutors believe that they might be able to bring criminal charges against Mr. Skilling in the next several weeks, said one such person.

Prosecutors also believe that Mr. Causey could be helpful in the investigation of Messrs. Skilling and Lay. They have, in the past, offered him plea bargain and cooperation deals, say people familiar with the matter. Mr. Causey has turned the offers down, saying that he did nothing wrong. However, the indictment could increase the pressure on Mr. Causey to possibly reconsider his position.

Continued in the article

Bob Jensen's threads on the Enron/Andersen scandal are at 

"Who Will Fastow Implicate? Enron's ex-CFO is a loose cannon who could shoot in several directions, at a string of Enron execs, bankers, and lawyers," Business Week, January 15, 2004 --- 

It's a safe bet that a lot of people in Houston probably had trouble falling asleep last night. Now that former Enron (ENRNQ ) Corp. Chief Financial Officer Andrew S. Fastow has joined forces with the Justice Dept., he could potentially implicate dozens of execs, bankers, and lawyers for contributing to the company's downfall (see BW Online, 1/8/04, "From the Fastows to the Bigger Fish?"). Unlike WorldCom (WCOEQ ), Tyco (TYC ) HealthSouth, (HLSH ), and many other recent corporate scandals, where the circle of accused wrongdoers is small, the Enron case involved "large groups of officers and employees, representing such diverse functions as finance, accounting, tax, and legal," according to a report filed last year by bankruptcy examiner R. Neal Batson.

Continued in the article

Also see "What Does Fastow Know," Fortune, January 2004 ---,15114,574775,00.html 

Bob Jensen's threads on the Enron scandal are at 

Former Senator Gramm's Dead Peasants

As many of us vividly recall, (then) Senator Phil Gramm and his wife Wendy (on Enron’s Board of Directors) were instrumental in building up the Enron scams --- 

Now former Senator Gramm has shifted to "dead peasants."

Doing the Texas Two Step --- 

As any regular reader of Molly Ivins knows, the great state of Texas is a top-notch incubator of crazy public policy schemes. According to an article in yesterday's Los Angeles Times by staff writer Scott Gould, the latest of these is a clever variation of the "dead peasant" scam that is being foisted on the Texas Teacher Retirement System by none other than former Texas senator Phil Gramm, who now works for the UBS Investment Bank of New York. Alert readers of The Irascible Professor might recall that Phil Gramm's wife Wendy Gramm, while Chair of the Commodity Futures Trading Commission, played a key role in pushing through key regulatory exemptions that allowed Enron to game the electricity trading market without government oversight. (At the same time Phil Gramm was collecting six-figure campaign contributions from Enron.)

For those of you who might not be familiar with Russian history, the "dead peasant" scam refers to the practice of buying the ownership rights to dead serfs then selling those rights before the buyer becomes aware of the fact that the serfs are dead. Under the variation of the scheme being promoted by Phil Gramm and Texas governor Rick Perry, the state of Texas would float a bond issue using Gramm's employer -- UBS Investment Bank -- as the underwriter. The proceeds from these bonds then would be used to buy annuities through UBS PaineWebber Inc. The annuities would be used to pay the premiums on life insurance policies that would be taken out on members of the Texas Teachers Retirement System. These life insurance policies would not provide any benefits to the members or their families. Instead, upon the death of an insured member, the proceeds from the life insurance policy would be used to retire the bonds, and if anything is left over it would go to the Texas Teachers Retirement System health fund. The fund currently faces a major long-term shortfall owing to a $30 million loss they suffered when Enron went into bankruptcy and the poor investment climate from 1999 to 2002, as well as to changes in the system put into place to help cover the deficit in the Texas state budget.

. . .

It doesn't take much imagination to realize that if the Perry-Gramm scheme is adopted, the Texas taxpayers will end up footing the bill not only to shore up the retirement system health plan, but also to pay millions of dollars in commissions and fees to UBS.

Continued in the article

"The TRTA Board of Directors is opposed to the insurance arbitrage plan proposed by former U.S. Senator Phil Gramm and currently being discussed by state officials. This opposition remains until further details are known and the Board is assured that funding from any such plan is a growing source of revenue for TRS-Care to keep premiums and other costs from being increased especially at times when retirees are not receiving annuity increases.”

Press Release form the Texas Retired Teachers Association, December 18, 2003 --- 

Over the last couple of weeks, there have been articles in certain Texas newspapers about a proposal often referred to as “dead peasants.” Both the Dallas Morning News and the Houston Chronicle reported about this in stories published on December 5, 2003. (Links to these articles can be found on the TRTA links page). Other newspapers around the state have also begun to publish these stories. The Board of Directors of the Texas Retired Teachers Association (TRTA) wants you to know about this proposal and the position of the Association.

Attached is a summary from two meetings attended by TRTA representatives. You should read all of this information to get a basic understanding of the proposal. While commonly referred to in the stories as “dead peasants,” the correct term is “insurance arbitrage.” Arbitrage is defined as “the purchase of securities on one market for immediate resale on another in order to profit from a price discrepancy.”

The proceeds from the proposed arbitrage arrangement were intended to provide funding to TRS-Care. However, no one from either the governor’s office, the Texas Department of Insurance or the Teacher Retirement System of Texas could tell TRTA how much money, or over what period of time, it would flow to TRS-Care.

The TRTA Board of Directors discussed this issue at its December 17 meeting via conference call and adopted the following position:

“The TRTA Board of Directors is opposed to the insurance arbitrage plan proposed by former U.S. Senator Phil Gramm and currently being discussed by state officials. This opposition remains until further details are known and the Board is assured that funding from any such plan is a growing source of revenue for TRS-Care to keep premiums and other costs from being increased especially at times when retirees are not receiving annuity increases.”

The TRTA Board wanted you to know its stand on this sensitive proposal. Please feel free to contact me if you have any questions.

Patricia Conradt 
Executive Director TRTA

I added this to my "Channel Stuffing" examples at 

From The Wall Street Journal Accounting Educators' Review on March 5, 2004

TITLE: U.S. Probes Coca-Cola's Deal With Takasago on Shipments 
REPORTER: Chad Terhune 
DATE: Mar 01, 2004 
PAGE: B5 LINK:,,SB107808159960642146,00.html  
TOPICS: Accounting, Earnings Management, Channel Stuffing, Earnings Quality, Revenue Recognition, Securities and Exchange Commission

SUMMARY: The U.S. Attorney's Office and the U.S. Securities and Exchange Commission are investigating Coca-Cola Co. Coca-Cola Co. may have overstated revenues by engaging in channel stuffing.

1.) What is revenue? When should revenues be recognized? Distinguish between realized and recognized.

2.) What is channel stuffing? How does channel stuffing impact current and future financial statements?

3.) Do sales that result from channel stuffing meet the criteria to be recognized as revenue? Is channel stuffing a violation of Generally Accepted Accounting Principles? Support your answers with authoritative guidance.

4.) How does channel stuffing impact the purchasers' financial statements? What are the economic implications of channel stuffing on the purchaser?

5.) How can an auditor distinguish between sales made for legitimate business reasons (e.g. potential future delivery problems) and sales resulting from channel stuffing?

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

Coke Has Become Very Filling (i.e., you can get stuffed and stiffed with Coca Cola)

"Coke Employees Are Questioned in Fraud Inquiry," by Sherri Day, The New York Times, January 31, 2004 --- 

Federal investigators are questioning current and former employees of the Coca-Cola Company about accusations that the company inflated its sales figures by selling surplus beverage concentrate in several big international markets including Japan, people close to the investigations said.

The United States attorney's office in Atlanta, the Securities and Exchange Commission and the F.B.I. have been investigating Coke since May, when a former Coke employee filed a lawsuit contending that the company committed accounting fraud and increased revenue by shipping excessive concentrate - a practice known as "channel stuffing" - to bottlers in Japan and elsewhere.

According to two former employees who have been interviewed as part of the investigation, the federal investigators are particularly interested in the role of the company's chairman and chief executive, Douglas N. Daft. He ran the company's Middle East and Far East businesses in 1999, when the two employees say the channel stuffing took place.

"They were really interested in Daft," said one former Coke employee of his recent interview with federal investigators. The former employee said investigators asked questions about the culture of Coke, how the company changed under Mr. Daft's leadership and about his demeanor when he was in charge of the company's Asian operations.

"They're serious about this one," the former employee said. "They're gathering as much info as they can, and they're going to turn it over to the U.S. attorney."

Officials at Coke, which is based in Atlanta, dismissed questions regarding Mr. Daft and said the company stood by its assertion that the claims raised in the lawsuit "lack merit."

"The government has not yet informed us about the specific issues it is interested in investigating, but when it does so, we will continue to offer our full cooperation on its areas of interest," the company said in a statement.

Federal investigators have been closely scrutinizing Coke since last summer after Matthew Whitley, a former finance director, filed a lawsuit against the company contending that he was fired after alerting senior management to illegal business practices in Coke's food service division. Mr. Whitley settled his lawsuit against Coke in October for $540,000. But some embarrassing revelations came out of the process, including Coke's admission that it had rigged a marketing test for Frozen Coke in Burger King restaurants. Federal prosecutors are said to be looking at the breadth of the accusations raised against Coke in recent lawsuits.

A separate lawsuit filed in October 2000 accused the company of channel stuffing in several international markets, including Japan, where Coke records about 20 percent of its profits. An amended version of the lawsuit was filed this summer; Coke has filed a motion to dismiss it.

This month, Coke said it was being formally investigated by the Securities and Exchange Commission, but it has declined to provide details about the focus of the investigation. The specifics of the case were first reported in The Wall Street Journal, which said yesterday that three former Coke finance officers had told federal officials that they witnessed channel stuffing in the Japanese business.

According to the lawsuit, Coca-Cola pressured bottlers to accept beverage concentrate that they did not need. This would result in an increase in Coke's volume, which is the measure used by Coke to calculate its revenue. The lawsuit also contends that Mr. Daft angrily rebuffed a subordinate's attempt to tell him about illegal business practices in Japan. Sonya Soutus, a Coke spokeswoman, called that assertion "ridiculous and fabricated."

In 1999, Coke was experiencing some of its most significant business challenges, including an employee discrimination lawsuit and a product contamination scare in Belgium that resulted in the company's recalling large shipments of its products. That year, Coke shipped more than $600 million of excess concentrate to bottlers, the lawsuit said. It also contends that bottlers were given cash incentives to buy the product and, in instances where they could not sell it, were allowed to return it to concentrate manufacturing plants or receive credit for it.

The lawsuit says that Coke used channel stuffing to falsify its revenue, net income and earnings forecasts and to hide the true state of its business. While Coke's sales rose 2.9 percent in 1999, its operating profit fell 19.8 percent. It declined again in 2000.

Continued in the article

Bob Jensen's threads on channel stuffing are at 

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.  


Hi Sanford,

Thank you for the links.

My scandal threads on KPMG and other firms are at

Some links on Coca Cola are as follows.  The second link carries forward into the current Lancer accounting mess:

"Coke Employees Are Questioned in Fraud Inquiry," by Sherri Day, The New York Times, January 31, 2004 --- 
Bob Jensen's threads on channel stuffing are at 

"Whistleblower Says He Just Wanted Coke to Listen," SmartPros, September 17, 2003 --- 
The reply from the Audit Committee at Coca Cola can be found at

 Bob Jensen

-----Original Message-----
From: Nowlin, Sanford []
Wednesday, February 04, 2004 12:25 PM
To: Jensen, Robert
Subject: Lancer accounting stories

Lancer's news release:

Dow Jones story:

How does changing an audit opinion retrospectively differ from changing a student's grade retrospectively?

Suppose that after ten years have passed, it is discovered that a student completely plagiarized the major paper of a graduate course.  The college can change the student's grade to an F retrospectively and record the grade change in the transcript repository.  The college can even withdraw a degree granted to the former student.  However, the college cannot signal to anybody other than the student that it has done so.  It cannot issue a press release.  Nor can it release a revised transcript without permission from the former student unless there is a court order to do so.

Now consider the following quotation from Dow Jones Business News on February 3, 2004 --- 

SAN ANTONIO (Dow Jones)--Lancer Corp. (AMEX:LAN - News) said KPMG LLP resigned as its independent auditor, days after the company's audit committee ended its investigation into Lancer's relationship with Coca-Cola Co. (NYSE:KO - News) , finding insufficient evidence to show intentional wrongdoing or accounting missteps.

KPMG also said it plans to withdraw its audit opinions for 2000, 2001 and 2002.

Apparently KPMG can signal in news releases that it is changing a clean audit opinion retrospectively.  However, KPMG does not control the audit opinion repository.  There are two main repositories.  One is within the company itself (e.g., Lancer).  The second repository is at the SEC.  I doubt that either repository will revise the "transcripts."

Hence in the case of a student's grade or diploma, the college cannot signal the public, but it can change the repository record.  In the case of a clean audit opinion, the audit firm can signal the public, but it cannot change the repository.

The audit firm cannot control the client's stockpiles of old annual reports.  What I am not clear about, however, is what the SEC will do with the prior financial reports of Lancer.

You can read more about the history of this scandal in these old media releases:

"Whistleblower Says He Just Wanted Coke to Listen," SmartPros, September 17, 2003 --- 
The reply from the Audit Committee at Coca Cola can be found at  

Any thoughts about what the SEC will do with the old "transcripts?"

Hi Roselyn,

Your answers make perfect sense!



February 5, 2004 reply from Morris, Roselyn [

-----Original Message----- 
From: Morris, Roselyn []  
Sent: Thursday, February 05, 2004 5:26 PM 
To: Jensen, Robert Subject: 
RE: Student Grades vs. Audit Opinions


The AECM listserv did not recognize the new email address. So I am responding directly to you on what happens when KPMG withdraws the audit opinions for 2000, 2001, and 2002. This is covered as "Subsequent Discovery of Facts" in audit books and normally tested on CPA exams.

I was on an audit where this situation happened. The audit firm required the client to release all un-used financial statements to be given back to the auditor to be destroyed. In one case with a small closely held company, the audit firm took out large ads in the local papers to inform users of the change in the audit opinion when the client would not release the un-used annual reports to the auditors.

In the case of the SEC, doesn't it become like restated financial statements? In this electronic age, it quickly becomes hard to find the original. For instances try to find the Xerox or World Com financial statements still reporting the original numbers before all the restatements. Hard to do.

Thanks for letting give some input.


Roselyn E. Morris, PhD, CPA 
Associate Dean College of Business Administration 
Texas State University-San Marcos 
601 University Drive San Marcos, Texas 78666-4616 

"'Illegal acts' at Lancer alleged," by Sanford Nowlin, San Antonio Express-News, February 5, 2004 --- 
Note that I think the reporter meant to say external auditor when he wrote internal auditor below.

With the resignation of its outside auditor, troubles appear to be swelling for San Antonio-based Lancer Corp., a manufacturer of drink-dispensing equipment now under investigation by the U.S. Securities and Exchange Commission. Lancer late Tuesday issued a news release saying its independent auditor, KPMG LLC, has resigned. KPMG told Lancer's audit committee that it's withdrawing its audit opinions on the company's financial statements for the years 2000 through 2002.

In addition, KPMG noted that there were "likely illegal acts" at the company.

Lancer President Christopher Hughes said he was "surprised and disappointed" by the auditor's resignation, adding that the company had conducted its own thorough eight-month internal audit of its accounting practices.

"These things will run their course," he said. "My focus right now is on our customers."

A KPMG spokesman would say only that his company stands by its conclusions.

The auditor's departure is the latest chapter in an unfolding drama involving allegations of accounting violations at the once-quiet Lancer.

Friday, Lancer announced the resignation of co-founder and CEO George Schroeder. The same day, the company said its internal audit found no evidence that executives misused company funds or that it improperly dealt with Coca-Cola Co., its largest customer.

The SEC and federal prosecutors are investigating Coke and Lancer about allegations raised by former Coke auditor Matthew Whitley, who has said the companies used improper accounting and bogus transactions to pump up sales of Lancer's new computer-controlled beverage dispenser.

Coke since has fired the head of its fountain unit and acknowledged that some of Whitley's allegations about its other accounting improprieties are true.

Lancer's audit committee in June opened an investigation into company accounting practices, with the assistance of outside attorneys.

The company intensified its internal probe later in the summer after a USA Today article alleged Schroeder and his brother, chairman Alfred Schroeder, misused company assets.

The Schroeders — who together own more than a quarter of Lancer's shares — used company employees to work on their cattle ranch and borrowed Lancer funds at interest rates below those allowed by the Internal Revenue Service, the paper reported.

KPMG told Lancer officials Tuesday that it had informed the audit committee of "likely illegal acts" that will have a material effect on the company's financials, according to the company's news release. Lancer hasn't taken "timely and appropriate" action to respond to those acts, KPMG said.

However, Lancer's audit committee reported Friday that it hadn't found evidence of "intentional misconduct" during its probe.

"The investigation was exhaustive," said Hughes, who will become Lancer's CEO on Feb. 28. "We were surprised KPMG reached a different conclusion."

Lancer has started a search for new outside auditors.

Trading of Lancer shares on the American Stock Exchange has been halted since Tuesday morning. Its stock last closed at $7.50 a share.

Observers said Lancer's latest announcement likely will send its shares down once they resume trading and cause a significant delay in the company's filing of financial records with the SEC.

The company already is late filing its second- and third-quarter reports because of its audit. Its year-end financials are due March 31.

The American Stock Exchange, on which Lancer trades, can delist companies if it determines they're continuously late with filings.

"KPMG's resignation sends up enormous red flags," said Robert Jensen, a Trinity University accounting professor who tracks fraud cases. "This is serious, serious business for the company. Whoever comes in as their next auditor is going to have to be even more cautious as a result of this."

The financial industry has been wracked with high-profile scandals lately, from the disintegration of Houston's Enron Corp. to federal charges that TV host Martha Stewart traded stock on inside information.

KPMG has taken its share of fire.

Most recently, a federal examiner charged that the firm recommended bankrupt WorldCom Inc. set up a flawed tax shelter that may have cost it hundreds of millions of dollars.

Year 2004 Top 10 Scams, Schemes & Scandals

Organized in 1919, the North American Securities Administrators Association (NASAA) is the oldest international organization devoted to investor protection. We are a voluntary association whose membership consists of 66 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, Puerto Rico, Canada, and Mexico. In the United States, NASAA is the voice of the 50 state securities agencies responsible for efficient capital formation and grass-roots investor protection.

State Securities Regulators Release Top 10 Scams, Schemes & Scandals:
Mutual Fund Practices, Senior Investment Fraud, Variable Annuities Join 2004 List

WASHINGTON (January 14, 2004) – State securities regulators today forecast that investors will be challenged with increasingly complex and confusing investment frauds and identified the Top 10 schemes investors are likely to see in 2004. New to the North American Securities Administrators Association’s (NASAA) annual survey of state securities enforcement officials are mutual fund practices, senior investment fraud, and variable annuities.

“Investors face a complex maze of scams, schemes and scandals,” said Ralph A. Lambiase, NASAA’s president and director of the Connecticut Division of Securities. “Our fight against fraud never stops because each year con artists discover new ways to fleece the public. Sadly, many of the age-old scams still work to cheat victims of their hard-earned savings as well. It pays to remember that if an investment opportunity sounds too good to be true, it usually is.”

Investors lose billions of dollars annually to investment fraud, Lambiase said. He cautioned that investors must remain vigilant in the fight against investment fraud. “All securities regulators, whether local, state, or federal, share the common goal of protecting investors,” he said. “I urge legislators to help us continue to do our jobs by ensuring that regulators have sufficient resources to protect our citizens.”

The following ranking of NASAA’s Top 10 scams, schemes and scandals for 2004 is based on the order of prevalence and seriousness as identified by state securities regulators: 1) Ponzi Schemes, 2) Senior Investment Fraud, 3) Promissory Notes, 4) Unscrupulous Broker/Dealer Representatives, 5) Affinity Fraud, 6) Insurance Agent Securities Fraud, 7) Prime Bank/High-Yield Investment Schemes, 8) Internet Fraud, 9) Mutual Fund Business Practices, 10) Variable Annuities.

Lambiase also announced that NASAA has created an interactive Fraud Center on its website. The center features details of NASAA’s Top 10 scams, schemes and scandals; tips on how to detect con artists and avoid becoming a victim; an Investor “Bill of Rights;” instructions on how to file an investment-related complaint; and contact information for each state securities regulator. “Education and awareness are an investor’s best defense against fraud,” Lambiase said.

NASAA’s 2004 Top 10 List of Scams, Schemes and Scandals
(based on a survey of state securities enforcement officers and regulators)

1. PONZI SCHEMES. Named for swindler Charles Ponzi, who in the early 1900s took investors for $10 million by promising 40 percent returns, these schemes are a perennial favorite among con artists. The premise is simple: promise high returns to investors and use money from new investors to pay previous investors. Inevitably, the schemes collapse and the only people who consistently make money are the promoters who set the Ponzi in motion. Con artists typically attribute government intervention as the reason why new investors didn’t get their promised returns. In Mississippi last year, a Tennessee attorney and a Mississippi securities dealer pled guilty to 58 counts of investment fraud for their role in a Ponzi scheme that bilked 41 investors from four states out of $10.2 million. Authorities said the victims were told they were investing in a money-trading program that, in fact, did not exist.

2. SENIOR INVESTMENT FRAUD. Volatile stock markets, low interest rates, rising health care costs, and increasing life expectancy, combined to create a perfect storm for investment fraud against senior investors. State securities regulators said older investors are being targeted with increasingly complex investment scams involving unregistered securities, promissory notes, charitable gift annuities, viatical settlements, and Ponzi schemes all promising inflated returns. Pennsylvania securities regulators last year shut down a “Ponzi” scheme that targeted seniors, but not before 13 Philadelphia-area investors had lost nearly $2 million from their pensions and IRAs. In Arizona, the Arizona Corporation Commission ordered a Scottsdale company and four individuals to return more than $15 million to mostly senior investors and pay penalties of $45,000 to the state in a case involving “CD alternatives” earning up to 8.5 percent. “These schemes offer products and pitches that may sound tempting to many seniors who’ve seen their retirement accounts and income dwindle in recent years,” Lambiase said. To learn more, visit NASAA’s Senior Investor Resource Center.

3. PROMISSORY NOTES. A long-time member of the Top 10 list, these short-term debt instruments often are sold by independent insurance agents and issued by little known or non-existent companies promising high returns – upwards of 15 percent monthly – with little or no risk. When interest rates are low, investors often are lured by the higher, fixed returns that promissory notes offer. These notes, however, can become vehicles for fraud when the issuer of the note has no intention or capability of ever delivering the returns promised by the sales person. In November 2003, for example, Grammy-nominated polka star Jan Lewan pled guilty to charges that he defrauded investors in 21 states through the sale of promissory notes. State authorities said Lewan, who defected from Poland in 1979 and launched a successful career that included performances before President Reagan and Pope John Paul II, illegally persuaded investors to invest in a series of failing business ventures. Lewan offered promissory notes that were supposed to pay an interest rate of 12 to 20 percent. Authorities said investors lost between $2 million and $2.5 million. Lewan sold the promissory notes during a period of time when he was under a five-year ban by the Pennsylvania Securities Commission barring him from selling securities in the state. New Jersey authorities also acted against Lewan in 2003, fining him $950,000 and prohibiting him from selling securities in the state. Connecticut securities regulators are also investigating Lewan.

4. UNSCRUPULOUS BROKERS. Despite the stock market’s rebound in 2003, state securities regulators say they are still receiving a high level of complaints from investors of brokers cutting corners or resorting to outright fraud to fatten their wallets. “I give credit to the increasing numbers of investors who are giving their brokerage statements a closer look and asking the right questions about unexplained fees, unauthorized trades or other irregularities,” Lambiase said. In October 2003, US Bancorp Piper Jaffray agreed to pay $2.6 million to settle a complaint by the state of Montana alleging unethical business practices and fraudulent securities dealing by the investment firm and one of its brokers. State regulators accused Thomas J. O`Neill, who was a broker in the firm’s Butte office, of making more than 6,000 unauthorized trades for mostly elderly customers between 1997 and early 2001. They said some trades were made for a customer who was in a coma and again after he died. Authorities said O`Neill generated commissions for himself and the firm through the illegal trades that transformed mostly conservative retirement investments into risky portfolios.

5. AFFINITY FRAUD. Con artists know that its only human nature to trust people who are like yourself. That’s why scammers often use their victim’s religious or ethnic identity to gain their trust and then steal their life savings. No group seems to be immune from fraud. In November 2003, authorities arrested five people accused of defrauding evangelical Christians of $160 million in three years and using the money to live extravagantly. Federal and state investigators charged that a California family promoted an affinity fraud scheme through evangelical leaders and groups, targeting people who shared religious beliefs and common ethnicities. A joint effort involving the FBI, the SEC, the IRS and the Texas State Securities Board, brought criminal and civil charges to halt the scheme, which promised returns of 25 percent within three months.

6. INSURANCE AGENTS AND OTHER UNLICENSED SECURITIES SELLERS. While most independent insurance agents are honest professionals, too many are lured by high commissions into selling fraudulent or high-risk investments, such as promissory notes, ATM and payphone investment contracts and viatical settlements. “Scam artists continue to entice independent insurance agents into selling investments they may know little about,” Lambiase said. The person running the scam instructs the independent sales force – usually insurance agents but sometimes investment advisers and accountants – to promise high returns with little or no risk. For example: Arizona securities regulators in 2003 obtained a $4.3 million final judgment against a Scottsdale company and two insurance agents who fraudulently sold charitable gift annuities to mostly senior investors who were told their money would be invested in secure accounts. Instead it was placed in high-risk, speculative investments while the insurance agents helped themselves to $1.3 million in commissions. California authorities in 2003 ordered several insurance agents to stop selling viatical investments – interests in the death benefits of terminally ill patients that are always high risk and sometimes fraudulent. The agents promised returns as high as 150 percent in three years, and guaranteed the investment through a “fidelity” bond, but failed to tell investors that the bond was issued by a company incorporated in Vanuatu, South Pacific that is not licensed by to issue bonds in California.

7. PRIME BANK SCHEMES. A perennial favorite of con artists who promise investors triple-digit returns through access to the investment portfolios of the world’s elite banks. The negative publicity attached to these schemes has caused promoters in recent cases to avoid explicitly referring to Prime Banks. Now it is common to avoid the term altogether and underplay the role of banks by referring to these schemes as “risk free guaranteed high yield instruments” or something equally deceptive. In 2003, five Oklahoma men were convicted on fraud charges stemming from a prime bank scheme in which 5,000 investors lost $14.6 million.

8. INTERNET FRAUD. With the Internet becoming a common part of daily life for increasing numbers of people, it should be no surprise that con artists have made cyberspace a prime hunting ground for victims. Internet fraud has become a booming business. The most recent figures show cyberfraudsters took in $122 million in 2002, according to the Federal Trade Commission. “The Internet has turned from an information superhighway to a road of ruin for victims of cyber fraud,” Lambiase said. The Internet has made it simple for a con artist to reach millions of potential victims at minimal cost. Many of the online scams regulators see today are merely new versions of schemes that have been fleecing offline investors for years.” In November 2003 various federal, state, local, and foreign law-enforcement agencies targeted cyberfraudsters and netted 125 arrests and more than 70 indictments. Operation Cyber Sweep identified more than 125,000 victims with losses estimated to exceed $100 million. Lambiase also warned investors to ignore e-mail offers from individuals representing themselves as Nigerian or West African government or business officials in need of help to deposit large sums of money in overseas bank accounts. “Don’t be dot.conned. If you get an e-mail pitching a deal that can’t be beat, hit delete,” Lambiase cautioned.

9. MUTUAL FUND BUSINESS PRACTICES. Although mutual funds play a tremendous role in the wealth and savings of our nation, ongoing scandals throughout the industry clearly demonstrate that some in the mutual fund industry are putting their own interests ahead of America’s 95 million mutual fund shareholders. State securities regulators, the SEC, NASD, and mutual-fund firms themselves have launched a series of inquiries into mutual fund trading practices. To date, more than a dozen mutual funds are under investigation and several mutual funds and mutual fund employees have either pleaded guilty, been charged or settled with state regulators. State and federal investigations have uncovered sales contests where investors have been steered to funds paying higher commissions to brokers; abusive trading practices, such as “market timing,” that may cost tradition buy-and-hold investors more than $5 billion each year; and illegal trading practices, such as “late trading,” that may cost investors $400 million each year. “These investigations demonstrate a fundamental unfairness and a betrayal of trust that hurts Main Street investors while creating special opportunities for certain privileged mutual fund shareholders and insiders,” Lambiase said. “We will continue to actively pursue inquiries into mutual fund improprieties and are committed to aggressively addressing mutual fund complaints raised by investors in our jurisdictions.”

10. VARIABLE ANNUITIES. Sales of variable annuities have increased dramatically over the past decade. As sales have risen, so too have complaints from investors. Regulators are concerned that investors aren’t being told about high surrender charges and the steep sales commissions agents often earn when they move investors into variable annuities. Some investors also are misled with claims of guaranteed returns when variable annuity returns actually are vulnerable to the volatility of the stock market. The benefits of variable annuities – tax-deferral, death benefits among others – come with strings attached and additional costs. High commissions often are the driving force for sales of variable annuities. Mississippi securities regulators moved last year against a licensed securities broker in the state who rang up commissions of approximately $1 million within a 15-month period largely through sales of variable annuities. Often pitched to seniors through investment seminars, regulators say these products are unsuitable for many retirees. “Variable annuities make sense only for consumers willing to invest for 10 years or longer, but they are not suitable for many retirees who cannot afford to lock up their money for a long time,” Lambiase said. Variable annuities are considered to be securities under federal law and the laws of 17 jurisdictions. Most states consider variable annuities to be insurance products. NASAA is encouraging changes in state laws that would allow state insurance regulators to continue to oversee the insurance companies that sell variable annuities while authorizing state securities regulators to investigate complaints about variable annuities and to take action against the companies and individuals who sell them. “Those who buy variable annuities should not be denied the protections enjoyed by every other class of investor,” Lambiase said.

Bob Jensen's threads on consumer frauds are at 

"Market Regulators Scrutinize Odd Muni-Bond Trading Patterns," by Randall Smith and Aaron Lucchetti, The Wall Street Journal, January 27, 2004 ---,,SB107513054068911619,00.html?mod=home%5Fwhats%5Fnews%5Fus 

Unusual trading patterns in the municipal-bond market that may be resulting in differences of more than 10% between prices at which customers buy and sell the same bonds on the same day are being studied by securities regulators, according to people familiar with the probes.

The probes are being conducted by the staffs of the Securities and Exchange Commission and the National Association of Securities Dealers, based on pricing anomalies drawn to their attention in part by an industry critic who runs a bond-pricing Web site and the Municipal Securities Rulemaking Board, the people said.

The regulators are looking at whether different securities dealers have traded certain municipal bonds among themselves at successively higher or lower prices, adversely affecting the prices customers receive when they buy or sell the bonds.

Continued in the article

"Representative Stearn Calls for GAAP Overhaul," AccountingWeb, February 3, 2004 --- 


In the course of holding hearings into the accounting issues at Freddie Mac, Rep. Cliff Stearns (R-FL) said there are fundamental flaws in generally accepted accounting principles (GAAP) that need to be addressed to prevent future abuses.

"Specifically, GAAP should not allow companies to change the characterization of an asset and thereby change its accounting," said Stearns. "I applaud the Federal Accounting Standards Board (FASB) for its efforts to change and reform the system over the last two years. Nevertheless, I intend to offer legislation in the next few weeks concerning FASB that will reform accounting standards."

As part of the hearings, Stearns asked Armando Falcon, director of the Office of Federal Housing Enterprise Oversight (OFHEO), which oversees Freddie Mac and the larger Frannie Mae, to look into whether compensation of the two agency’s 20 top officials contributed to accounting problems.

"Through our past hearings we learned that Freddie Mac disregarded accounting rules, internal controls, and disclosure standards to maintain a reputation for steady earnings," stated Stearns, chairman of the Commerce, Trade & Consumer Protection Subcommittee. "I appreciate hearing from Freddie Mac about the new controls it is instituting to guard against improper accounting. Given that Freddie Mac hid billions of dollars in income in a way that complied with GAAP (Generally Accepted Accounting Principles), this Subcommittee has a responsibility to look at improving these accounting standards."

Stearns pointed to an anomaly that allows Freddie Mac and some other financial companies to engage in earnings arbitrage: "So Called 'mixed-attribute accounting' allows companies to decide whether financial assets are carried at current market price or at historic cost." Freddie Mac shifted assets between categories to manipulate earnings, without any change in the underlying economics of its performance. Said Stearns, "Taxpayers do not have the option of changing the characterization of assets to change the tax treatment; I think GAAP should not allow this either."

Martin Bauman, chief financial officer, Freddie Mac, testified, "While the restatement represented an important milestone, now that it has been completed, Freddie Mac is focused on bringing our financials up-to-date." In reacting to Stearns' concerns over the adequacy of current standards, Bauman stated, "Freddie Mac recognizes the importance of transparent accounting and reporting standards and we are committed to providing investors with the information they need to understand how we view and manage our business. We fully support the Subcommittee's efforts to move toward a principles-based accounting framework."

February 7, 2004 reply from Patricia A. Doherty [pdoherty@BU.EDU

" ...applaud the Federal Accounting Standards Board (FASB) ..."

Might be nice if Mr. Stearns actually knew the name of the agency he is trying to change.


Bob Jensen's threads on Freddie Mac are at 


Commodity-futures regulators are probing if traders had advance knowledge that an animal tested positive for mad-cow disease.

"U.S. Investigates Cattle Trades," by John R. Wilke, The Wall Street Journal, January 27, 2004 ---,,SB107515641699512022,00.html?mod=home_whats_news_us 

Federal regulators are investigating whether some commodity traders last month had advance knowledge that the first U.S. case of mad-cow disease was confirmed in Washington state.

Investigators with the Commodity Futures Trading Commission are interviewing possible witnesses, reviewing documents and phone records, and examining trading patterns on the Chicago Mercantile Exchange, the commission's enforcement chief said Monday. At issue are investors who took short positions in live-cattle futures, betting on a price decline, in the days just before the Dec. 23 announcement by U.S. Department of Agriculture Secretary Ann Veneman.

Prices of cattle contracts fell sharply on futures exchanges in the days following the announcement, as investors reacted to fears that more cases would be uncovered or that sales of beef would slow. The USDA determined within days that the diseased cow had entered the U.S. from Canada and been born before a ban on potentially contaminated feed went into effect, but concerns about export bans and additional mad-cow problems have kept cattle prices depressed. Live-cattle futures prices are down 18% at the Chicago Merc since the mad-cow finding. Monday, the most-active April futures contract was down 1.025 cents to $74.05 cents a pound.

The investigation was triggered by concerns that the market-sensitive news leaked, either by the government or elsewhere, before the USDA's announcement after trading ended Dec. 23.

The CFTC can issue subpoenas of witnesses or documents. Its definition of insider trading is more narrow than that of the Securities and Exchange Commission, and the range of civil charges it could bring against investors with any advance knowledge of the USDA announcement would depend on where, when and from whom they got the information. It isn't clear, for example, whether an employee of a slaughterhouse could be charged. But any employee of the USDA or the Iowa testing lab could potentially face charges if found to have traded on early knowledge.

Rumors that an animal had tested positive for mad-cow disease were widespread in the cattle and beef-processing industry in the hours before the late-afternoon statement on Dec. 23, and circulated as early as the night before, an official at the National Cattlemen's Beef Association said. But futures trading and volume weren't unusual on Dec. 22 and Dec. 23. That suggests the investigation may be focusing on individuals' trades, not broad market-moving bets.

Gregory Mocek, the commission's enforcement chief, confirmed that the agency opened an investigation on Dec. 23, "as a result of various issues that came to our attention." When cattle-futures trading opened Dec. 24, prices plunged the daily maximum limit, and did so in subsequent days as well.

Mr. Mocek said the investigation "is focusing on the individuals and companies that could have received the information prior to the public announcement." The inquiry, he said, "will involve taking of testimony of individuals, reviewing market data and analyzing trading patterns for the relevant time period prior to and shortly after the USDA's announcement." Mr. Mocek declined to say how long the inquiry might take but said he planned to devote the necessary resources to the investigation.

Investigators declined to say where they suspect a leak may have originated. A sample from the cow, which was slaughtered in eastern Washington state, was sent to the USDA's test lab in Ames, Iowa, Dec. 11. The test results were forwarded to the USDA in Washington, D.C., after an initial or "presumptive" positive result was found Dec. 22.

"The department has a long history of handling market-sensitive information, and we take it very seriously," said Alisa Harrison, chief spokeswoman for the USDA. "Given how fast this happened, I find it hard to believe" that the news leaked out, she said. Ms. Veneman was at the White House on the morning of Dec. 23, attending a Christmas event, and wasn't aware of the positive test, other department officials said.

Continued in the article

From Smart Stops on the Web, Journal of Accountancy, January 2004, Page 27 --- 

Accountability Resources Here
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 archives --- 

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)

Bob Jensen's related humor links are at 


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
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.



Get Information Online
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
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
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.

January 14, 2004 message from David Albrecht [albrecht@PROFALBRECHT.COM

Remember the army's deck of cards for IRAQ? Well, this is for corporate America's Least wanted. 

David Albrecht

"Tyco Jury Hears About Huge Fee," by Mark Maremont, The Wall Street Journal, January 14, 2004 ---,,SB107402266984359500,00.html?mod=home%5Fwhats%5Fnews%5Fus 

The Tyco trial took a turn Tuesday, when testimony from a prominent Wall Street investor suggested that former Tyco International Ltd. CEO L. Dennis Kozlowski misled him into buying $50 million in stock two years ago by claiming that the company's board had approved payment of a huge fee to one of its directors.

Leon Cooperman, who runs hedge fund Omega Advisers Inc., provided some of the strongest testimony to date against Mr. Kozlowski, who along with former Tyco Chief Financial Officer Mark H. Swartz is on trial in state court in New York on charges that they misused Tyco funds on behalf of themselves and others. Among the charges is that they improperly paid -- without board approval -- a $20 million fee to then-director Frank Walsh for help on an acquisition.

Several board members have previously testified that the board didn't approve the payment to Mr. Walsh, and demanded he repay it when they found out. The defense has suggested that the board implicitly approved the payment, albeit months after it was made, by signing a proxy statement that described it.

Continued in the article


A Nobel Laureate on Accounting When a Nobel laureate in economics writes on accounting, I want to read what he has to offer. Fortunately, deep insights into economics often translate into wisdom about accounting; unfortunately, the lack of institutional knowledge about the subject may cause one to make a few mistakes.
Read Professor Ketz's commentary at 

A Kickback By Any Other Name is a ____________!


"Why a Brokerage Giant Pushes Some Mediocre Mutual Funds," by Laura Johannes and John Hechinger, The Wall Street Journal, January 9, 2004, Page A1.

Like many who bought poorly performing Putnam mutual funds in recent years, Nancy Wessels lost big. One of her investments, Putnam Vista fund, dropped 40% from when she bought it in April 2000, near the stock-market peak, until she sold it in May 2002. That performance was worse than 80% of similar stock funds.

What the 80-year-old widow's broker, Edward D. Jones & Co., never told her was that it had a strong incentive to sell Putnam funds instead of rivals that performed better. Jones receives hefty payments -- one estimate tops $100 million a year -- from Putnam and six other fund companies in exchange for favoring those companies' funds at Jones's 8,131 U.S. sales offices, the largest brokerage network in the nation.

When training its brokers in fund sales, Jones gives them information almost exclusively about the seven "preferred" fund companies, according to former Jones brokers. Bonuses for brokers depend in part on selling the preferred funds, and Jones generally discourages contact between brokers and sales representatives from rival funds. But while revenue sharing and related incentives are familiar to industry insiders, Jones typically doesn't tell customers about any of these arrangements.

The situation "gives you the feeling of being violated," says Mrs. Wessels's son, DuWayne, a Waterloo, Iowa, real-estate broker. He says he found out about the fund-company payments to Jones from his mother's new broker when the son moved her $300,000 account to another firm in 2002.

Jones, whose storefront offices are common across much of the country, is one of the nation's largest distributors of mutual funds, with 5.3 million individual customers who hold more that $115 billion in fund shares. The firm has earned respect for its advocacy of conservative, buy-and-hold investing, and it hasn't been tarnished by the scandals sweeping the mutual fund and brokerage industries.

But Jones, based in St. Louis, is also among the nation's leading practitioners of a little-understood fund-sales practice now under scrutiny by federal securities regulators. In the industry it's known by the bland name of "revenue sharing": Fund companies give brokers a cut of their management fees to induce them to sell their products. Critics call it "pay to play."

Continued in the article

January 14, 2003 Update
A rule proposed by the SEC on January 14, 2004 would change that. Brokers would be required to tell investors about any payments, compensation or other incentives they receive from fund companies, including whether they were paid more to sell a certain fund. Conflicts would have to be disclosed before the sale is completed, with a more detailed account of costs and conflicts in a subsequent confirmation statement. If adopted, investors would get a document showing the amount they paid for a fund, the amount their broker was paid and how the fund compares with industry averages based on fees, sales loads and brokerage commissions.

Bob Jensen's threads on the mutual fund scandals can be found at 

"SEC Readies Cases on Deals Between Mutual Funds, Brokers," by Tom Lauricella and Deborah Solomon, The Wall Street Journal, January 14, 2004 ---,,SB107401775870784300,00.html?mod=home_whats_news_us 

The Securities and Exchange Commission is close to filing its first charges against mutual-fund companies related to arrangements that direct trading commissions to brokerage houses that favor those fund companies' products, according to a person familiar with the investigation.

Such actions, which according to that person could come within the next month or so, would be yet another black eye for the mutual-fund industry, which has been battered by months of allegations of improper trading of fund shares.

The SEC has been investigating the business arrangements between fund companies and brokerage houses since last spring. It held a news conference Tuesday to announce that it has found widespread evidence that brokerage houses steered investors to certain mutual funds because of payments they received from fund companies or their investment advisers as part of sales agreements.

Officials said the agency has opened investigations into eight brokerage houses and a dozen mutual funds that engaged in a longstanding practice known as "revenue sharing." Agency officials said they expect that number to increase as its probe expands. They declined to name either the funds or the brokerage houses.

The SEC said payments varied between 0.05% and 0.4% of sales and as much as 0.25% of assets that remained invested in the fund. So for every $100,000 in new sales, a broker-dealer would receive between $50 and $400, plus another $250 annually for every $100,000 that remained invested.

"In many cases we're concerned that the disclosure [to shareholders] doesn't adequately reflect the nature of the relationship," said Stephen Cutler, the SEC's Director of Enforcement. To help address the problem, the SEC Wednesday plans to propose new rules on sales-related disclosure.

The potential SEC charges likely would revolve around fund companies' use of commissions paid for stock and bond trading to pay brokerage houses as part of sales agreements to favor their funds. The SEC, as part of charges filed against Morgan Stanley last year, said certain fund companies -- which it didn't name -- paid higher-than-normal commissions to cover some or all the costs of sales agreements with Morgan. The cost of a fund's stock and bond trading is subtracted directly from the accounts of fund shareholders. Fund companies are obligated to act in the best interest of a fund's shareholders when deciding which firm to direct their trading commissions.

Morgan settled those charges without admitting or denying wrongdoing.

Continued in the article

On December 24, 2003, the FASB published a revision to Interpretation 46 as a Christmas present to clarify and expand on accounting guidance for variable interest entities. The additional guidance is in response to comments received from constituents. The complete revised Interpretation 46 is available on the FASB's website --- 

Bob Jensen's threads on variable interest entities (including a summary of Interpretation 46) and the thousands of SPEs utilized by Enron to defraud the public can be found at 

From The Wall Street Journal Accounting Educators' Reviews on January 14, 2004

TITLE: Year of the (Shrugged Off) Scandal 
REPORTER: Jesse Eisinger 
DATE: Jan 02, 2004 
TOPICS: Accounting, Fraudulent Financial Reporting

SUMMARY: The article provides a summary of the year's scandals, allowing readers unfamiliar with the events to "catch up" on the news. Discussion questions revolve around the association between reliable financial reporting and efficient capital markets.

1.) Define the phrase "efficient capital markets." What fundamental factors affect the values of equity and debt securities traded in efficient markets?

2.) How are those fundamental factors reflected in corporate financial reporting? What other sources of information, besides corporate financial statements, are available to investors to serve as a basis for trading decisions?

3.) Why should investors care whether financial statements accurately reflect economic fundamentals? Should investors care if there are sometimes problems with fraudulent financial statements?

4.) What authority requires that US financial reporting be free from fraudulent statements? How is authority put into practice? In your answer, fully describe all parties that influence the process supporting proper financial reporting practices in the U.S.

5.) What factors are listed as reasons for the stock market's rise despite the reporting and other scandals that developed in 2003? From this article, do you get the impression that financial reporting matters to stock and bond market participants? Give your reaction to that assessment.

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

Meet an Ex Con Named Walter Pavlo Who Did Time in Club Fed

What you find below is a message (actually three messages and a phone call) I received  from a man involved in MCI's accounting fraud who went to prison and is now trying to apologize (sometimes for a rather high fee) to the world. 

You can read details about Walter Pavlo's fraud at

I wrote the following last year at

I watched the AICPA's excellent FBI Webcast ( Nov. 6, 2003 ). One segment that I really enjoyed was a video of Walter Pavlo, a former MCI executive who served prison time for fraud. This was a person with all intentions of being highly professional on a fast track to being in charge of collecting reseller bad debts for MCI. In that position, he just stumbled upon too much temptation for what is tantamount to a kiting scheme.

Message 1 from Walter Pavlo on February 24, 2004


I routinely do a search on my name over the Internet to see if there are comments on my speeches that I conduct around the country. I saw that you had a comment on a video in which I appeared but was unable to find the complete comment on your extensive web-site. Whether positive or negative I could not ascertain but am still interested in your thoughts and would appreciate them.

I did read some of your comments regarding the stashing of cash off-shore by executives who commit crimes and the easy life they have at "club fed". Here I would agree that there are a few who have such an outcome, but this is not the norm. However, I would disagree that there is a "club fed" and on that you are misinformed.

I had off-shore accounts and received a great deal of money. However, the results of story are more tragic. All of the money is gone or turned over to authorities (no complaints here, this is justice), I lost my wife of 15 years and custody of my children, I lost all of my assets (retirement, etc.) and at 41 I am starting life over with little to show of my past accomplishments (which were many). Stories like mine are more common among rank and file middle managers who find themselves on the other side of the law. There are few top executives in prison but that appears to be changing. Time will tell if they fare as well.

Prison, while deserving for a crime of the magnitude that I and others committed, is a difficult experience and one that is difficult from which to recover. In the media and in comments such as the ones your offer, it appears that this part of the story is not revealed and that it is better to appeal to the fears and anger of the general population. I would encourage you to consider other view points for reasons of understanding the full story. I feel that this is important for people to know.

Thank you for your time and would appreciate receiving your feedback.

Walt Pavlo
125 Second Avenue, #24 New York, NY 10003
Phone: (201) 362-1208

Message 2 from Walter Palvlo (after he phoned me)


Attached is an article that appeared in Forbes magazine in the June 10, 2002 issue. I was interviewed for this article while still in prison and some six months prior to WorldCom's revelations of the multi-billion dollar fraud that we know of today.

It was a pleasure to speak with you and I hope to correspond with you more in the future.

Walt Pavlo

125 Second Avenue, #24 New York, NY 10003

Phone: (201) 362-1208

This is part of a resume that he sent to me (I think he wants me to promote him as a speaker)

Walter "Walt" Pavlo holds an engineering degree from West Virginia University and an MBA from the Stetson School of Business at Mercer University. He has worked for Goodyear Tire in its Aerospace division as a Financial Analyst, GEC Ltd. of England as a Contract Manager and as a Senior Manager in MCI Telecommunication's Division where he was responsible for billing and collections in its reseller division.

As a senior manager at MCI, and with a meritorious employment history, Mr. Pavlo was responsible for the billing and collection of nearly $1 billion in monthly revenue for MCI's carrier finance division. Beginning in March of 1996, Mr. Pavlo, one member of his staff and a business associate outside of MCI began to perpetrate a fraud involving a few of MCI's own customers. When the scheme was completed, there had been seven customers of MCI defrauded over a six-month period resulting in $6 million in payments to the Cayman Islands.

In January 2001, in cooperation with the Federal Government, Mr. Pavlo pled guilty to wire fraud and money laundering and entered federal prison shortly thereafter. His story highlights the corrupt dealings involving the manipulation of financial records within a large corporation. His case appeared as a cover story in the June 10, 2002 issue of Forbes Magazine, just weeks before WorldCom divulged that it had over $7 billion in accounting irregularities.

Currently, Mr. Pavlo is the Director of Business Development at the Young Entrepreneurs Alliance (YEA), a non-profit organization in Maynard, Massachusetts. YEA's mission is to provide at-risk and adjudicated teens with the opportunity to attain long-term economic independence by teaching them about business ownership. Mr. Pavlo's primary responsibility is to develop the business programs, raising funds through speaking engagements and charitable donations to YEA.

Mr. Pavlo has been invited to speak on his experiences by the Federal Bureau of Investigation, US Attorney's Office, major university MBA programs, corporations and various professional societies. The purpose of these speeches is to convey to audiences an understanding of the inner-workings and motivations associated with complex white-collar crimes, with an emphasis on ethical decision-making.

Message 3 from Walter (following my inquiry about his pro-bono presentations):

Walter Pavlo sent me the following information regarding my question whether he makes pro-bono presentations. He replied as follows:

Bob, On the note of pro-bono work, most of what I have done to date has been pro-bono. Whenever I am in an area with a paying gig, I try to reach out to universities in the area to offer my services at no charge. I could have done this for Trinity when I was in San Antonio last year for the Institute of Internal Auditors. I'll be sure to look you up if I'm going to be in the area.


Bob Jensen's threads on the Worldcom/MCI frauds are at 

What were the two leading causes of financial report restatements in 2003?


"Upward Trend in Financial Restatements Ends After Five Record Setting Years; Reserve Accounting Leading Cause of Restatements," The Huron Consulting Group, January 13, 2004 --- 

Related Information Resource Library Restatement Study 2003

Huron Consulting Group today released a summary of its 2003 Annual Review of Financial Reporting Matters, a report analyzing the leading causes and trends in financial restatements filed with the U. S. Securities and Exchange Commission (SEC) for the year ending December 31, 2003. The analysis is broken down by company size, industry, and accounting issue and also notes whether the accounting error was initially reported in either a quarterly or an annual financial statement.

Public companies that changed their previously released financial statements due to accounting errors totaled 323 in 2003, a slight decline compared to the 330 restatement filings identified in 2002, and up from 270 in 2001 and 233 in 2000. These restatements have been filed in both amended quarterly (10Q/A) and annual (10K/A) financial statements filed with the SEC. (Graph 1)

“The number of accounting errors identified in 2003, though certainly not a cause for celebration, may indicate that we have put the worst restatement period behind us and can expect to see further improvements in the years ahead,” said Joseph J. Floyd, chief operating officer for Huron’s Financial and Economic Consulting practice.

“As we have observed in prior years, problems applying accounting rules, human and system errors, and fraudulent behavior are the three primary causes for accounting errors,” added Floyd.

In 2003, the number of restated audited annual financial statements rose to a record high of 206, representing 63 percent of total restatements filed during the year. While investors rely on both quarterly and annual financial statements of public companies, there is a different level of procedures and responsibility assumed by the auditors for each. Annual financials have a higher level of effort and association required since an audit opinion is rendered. (Graph 2)

Errors in accounting for reserves and contingencies was the leading cause of restatements in 2003. This category includes accounting errors related to accounts receivable and inventory reserves, restructuring reserves, accruals, and other loss contingencies. Restatements attributable to this category experienced a greater increase in 2003 than any other accounting issue. (Graph 3)

Reserves and contingencies may be among the most judgmental accounts in a company’s financial statements as they are subject to an estimation process. These restatements, however, do not simply reflect changes in estimates, but rather reflect flawed judgments due to the oversight or misuse of facts, fraud, or a misapplication of Generally Accepted Accounting Principals (GAAP).

Revenue recognition was the second leading cause of restatements in 2003. However, the 63 revenue recognition related restatements identified in 2003 represent a 26 percent decrease from 2002 when revenue recognition restatements reached an all time high. (Graph 4)

The number of 2003 restatements by companies with annual revenues under $100 million rose to 158, or 49 percent of all restatements filed during the year. The percentage of restatements filed by companies with annual revenues greater than $1 billion decreased slightly in 2003, from 22 percent in 2002 to 20 percent in 2003. (Graph 5)

“Sarbanes-Oxley and recent catastrophic restatements have resulted in major changes in our financial reporting world,” Floyd said. “Increased internal and external scrutiny plus shareholder demands are working to improve the financial reporting process.”

In addition, this year Huron Consulting Group’s full report will summarize the major events impacting the financial reporting world in 2003 including actions taken by the SEC, Public Company Accounting Oversight Board (PCAOB), Financial Accounting Standards Board (FASB) and major observations regarding the public accounting industry. The full report will be available in early February.

Companies wishing to learn more about how Huron Consulting Group can help them should contact Joseph J. Floyd at 617-226-5510 or . Members of the media should contact Jennifer Frost Hennagir at 312-880-3260 or .

"Rash of Restatements Rattles," by K.C. Swanson,, March 17, 2004 

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.


In-Substance Defeasance Controversy Arises Once Again

You can read the following at

  1. 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.
  2. 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.
  3. 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 
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.

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

TITLE: A Peek at the Frenzied Final Days of Parmalat 
REPORTER: Alessandra Galloni 
ISSUE: Jan 02, 2004 


"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.

Continued in the article

Bob Jensen's threads on current scandals in the large accounting firms can be found at 

"Grant Thornton, Deloitte Named in Parmalat Lawsuit," SmartPros, January 7, 2004 --- 

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.

From The Wall Street Journal Accounting Educators' Review on January 23, 2004

TITLE: Grant Thornton Is Accused by SEC of Assisting Fraud 
REPORTER: Jonathan Weil 
DATE: Jan 21, 2004 
TOPICS: Audit Quality, Auditing, Auditing Services, Fraudulent Financial Reporting, Regulation, Securities and Exchange Commission

SUMMARY: The Securities and Exchange Commission (SEC) has accused Grant Thornton of aiding and abetting securities fraud violations. Questions focus on the role of the SEC in the financial reporting process and the auditors responsibilities for detecting and reporting illegal activities.

1.) Describe the role of the SEC in the financial reporting process. What power does the SEC have to enforce laws related to financial reporting?

2.) Describe the auditors' responsibilities for detecting fraudulent financial reporting. What defenses are available to Grant Thornton for the alleged violations?

3.) Why is the independent auditor's reputation important?

4.) Describe what is meant by "financial statements were jointly audited." What reporting options are available if financial statements are jointly audited? What type of audit report was issued for MCA Financial Corp.?

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 January 30, 2004

TITLE: Scope of Parmalat's Problems Emerges 
REPORTER: Alessandra Galloni 
DATE: Jan 27, 2004 
TOPICS: Accounting, Accounting Fraud, Audit Quality, Auditing, Financial Accounting, Fraudulent Financial Reporting, International Accounting

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.

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

Bob Jensen's threads on scandals at Deloitte and Grant Thornton can be found at 



"Grant Thornton Is Accused by SEC Of Assisting Fraud," by Jonathan Weil, The Wall Street Journal, January 21, 2004 ---,,SB107463471951306723,00.html?mod=home_whats_news_us 

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.

Continued in article

Bob Jensen's threads on scandals at Grant Thornton and other large accounting firms can be found at 



It Just Gets Deeper and Deeper for KPMG



In my main accountancy fraud log, I picture KPMG with two faces (it's happy PR face and it's sad face of scandal and illegal acts) --- 


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


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.



There is a Website covering some of the Frontline broadcast entitled "Tax Me If You Can" at 


The video can now be viewed online for free from


In particular, KPMG's illegal acts are focused on at 



My summary of the highlights is as follows:


  1. 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 --- 

  2. 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" --- 

  3. 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.

  4. 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 
    This is really, really bad for the image of professionalism that KPMG tries to portray on their happy face side of the firm.

  5. The reason that KPMG and the other large accounting firms did and can continue to sell unethical 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.

  6. 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.

    "Wachovia, Accountants KPMG Get Caught in Tax-Shelter Fallout," SmartPros, January 13, 2004 --- 

    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, XXXXX, 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.

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.

As Art Wyatt admitted:

You can read more about the ongoing scandals at all the largest CPA firms at 

"KPMG Tax-Shelter Probe Grows As U.S. Classifies 30 as 'Subjects'," by Cassell Bryan-Low, The Wall Street Journal, March 5, 2004 ---,,SB107844214963247026,00.html?mod=home%5Fwhats%5Fnews%5Fus 

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 
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.

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


"Audit Firms Face Heavy Fallout From Tax Business," by Cassel Bryan-Low, The Wall Street Journal, February 25, 2004 ---,,SB107766373003838199,00.html?mod=home%5Fpage%5Fone%5Fus 

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 

The video can now be viewed online for free from

 In particular, KPMG's illegal acts are focused on at 

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.

Bob Jensen's log of the Department of Justice investigation of KPMG's sales of illegal tax shelters can be found at 

February 20, 2004 reply from Robert Bowers [M.Robert.Bowers@WHARTON.UPENN.EDU

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.

February 20, 2004 reply from CPAS-L@LISTSERV.LOYOLA.EDU 

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.

February 20, 2004 reply from MILT COHEN [uncmlt@JUNO.COM

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.

Robin Alexander
15 Indigo Creek Trail
Durham, NC

February 20, 2004 reply from Cathy [cjsherwood@EARTHLINK.NET

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' 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...


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 --- 

My guess is that Mike Hammersley could write a book about KPMG much like Frank Parnoy wrote about Morgan Stanley and First Boston in his FIASCO books referenced at 

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 

"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 

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.

"MCI Examiner Criticizes KPMG On Tax Strategy," by Dennis K. Berman, Jonathan Weil, and Shawn Young, The Wall Street Journal, January 27, 2004 ---,,SB107513063813611621,00.html?mod=technology%5Fmain%5Fwhats%5Fnews 

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.

February 21, 2004 reply from Todd Boyle [tboyle@ROSEHILL.NET

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.

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?


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 --- 


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.

The PBS Frontline show being criticized by the "hucksters" can be studied at


"KPMG Shakes Up Management Amid Probe of Some Tax Shelters," by Casell Bryan-Low, The Wall Street Journal, January 13, 2004 ---,,SB107393693113460000,00.html?mod=home_whats_news_us 

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.

Continued in the article

"KPMG Names Two New Partners Amid Overhaul," by Cassell Bryan-Low, The Wall Street Journal, January 29, 2004 ---,,SB107534598573414950,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh 

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.

Continued in the article

Bob Jensen's threads on KPMG's recent scandals are at 

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.

"MCI Examiner Criticizes KPMG On Tax Strategy," by Dennis K. Berman, Jonathan Weil, and Shawn Young, The Wall Street Journal, January 27, 2004 ---,,SB107513063813611621,00.html?mod=technology%5Fmain%5Fwhats%5Fnews 

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

Bob Jensen's threads on KPMG's recent scandals are at 

Bob Jensen's threads on the Worldcom/MCI scandal are at 

"U.S. Indicts WorldCom Chief Ebbers," by Susan Pullam, almar Latour, and ken Brown, The Wall Street Journal, March 3, 2004 ---,,SB107823730799144066,00.html?mod=home_whats_news_us

In Switch, CFO Sullivan Pleads Guilty,
Agrees to Testify Against Former Boss

After trying for two years to build a case against Bernard J. Ebbers, the federal government finally charged the man at the top of WorldCom Inc., amid growing momentum in the prosecution of the big 1990s corporate scandals.

Mr. Ebbers was indicted Tuesday for allegedly helping to orchestrate the largest accounting fraud in U.S. history. The former chairman and chief executive, who had made WorldCom into one of the biggest stock-market stars of the past decade, was charged with securities fraud, conspiracy to commit securities fraud and making false filings to regulators.

After a grueling investigation, prosecutors finally got their break from an unlikely source: Scott Sullivan, WorldCom's former chief financial officer. He had vowed to fight charges against him and was set to go to trial in late March. But instead, after a recent change of heart, he pleaded guilty Tuesday to three charges just before Mr. Ebbers's indictment was made public. Mr. Sullivan also signed an agreement to cooperate in the case against his former boss.

The indictment, which centers around the two executives' private discussions as they allegedly conspired to mislead investors, shows that Mr. Sullivan's cooperation already has yielded big results for prosecutors. "Ebbers and Sullivan agreed to take steps to conceal WorldCom's true financial condition and operating performance from the investing public," the indictment stated.

WorldCom, now known as MCI, is one of the world's largest telecommunications companies, with 20 million consumer and corporate customers and 54,000 employees. The company's investors lost more than $180 billion as the accounting fraud reached $11 billion and drove the company into bankruptcy. Ultimately almost 20,000 employees lost their jobs.

Attorney General John Ashcroft traveled to New York Tuesday to announce the indictment, as years of prosecutors' efforts in WorldCom and other big corporate fraud cases finally start to bear fruit. Little progress had been made in the WorldCom case since five employees pleaded guilty to fraud charges in the summer of 2002. As outrage over the wave of corporate scandals built, prosecutors struggled with several key puzzle pieces as they sought to assign blame for the corporate wrongdoing.

They were initially unable to make cases against Mr. Ebbers and Enron Corp. Chief Executive Jeffrey Skilling. And Mr. Sullivan and former Enron Chief Financial Officer Andrew Fastow gave every indication that they were going to vigorously fight the charges against them. Enron, the Houston-based energy company, filed for bankruptcy-court protection in 2001.

But in recent weeks a lot has changed. In January Mr. Fastow pleaded guilty and agreed to cooperate with prosecutors. Soon afterward the government indicted his former boss, Mr. Skilling. Meanwhile, highly publicized fraud trials of the top executives of Tyco International Ltd. and Adelphia Communications Corp. are under way in New York and prosecutors have continued to make plea agreements in the cases stemming from the fraud at HealthSouth Corp. Two former HealthSouth executives agreed to plead guilty Tuesday (see article). Former HealthSouth Chairman Richard Scrushy was indicted last year.

Mr. Ashcroft in his announcement Tuesday said that two years of work had paid off with more than 600 indictments and more than 200 convictions of executives. "America's economic strength depends on ... the accountability of corporate officials," he said.

Mr. Sullivan, a close confidant of Mr. Ebbers, pleaded guilty to three counts of securities fraud. He secretly began cooperating with prosecutors in recent weeks, according to people close to the situation.

Continued in the 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 

"New Issues Are Raised Over Independence of Auditor for MCI," by Jonathan Weil, The Wall Street Journal, January 28, 2004 ---,,SB107524105381313221,00.html?mod=home_whats_news_us 

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.

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.

Bob Jensen's threads on the Worldcom/MCI scandal are at 


January 28, 2004 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU


Jonathan Weil stated:

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?

Amy Dunbar
University of Connecticut


January 28, 2004 reply from Dennis Beresford [dberesfo@TERRY.UGA.EDU


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.

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
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.

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

Bob Jensen's threads on KPMG's recent scandals are at 

Bob Jensen's threads on the Worldcom/MCI scandal are at 

Note from Bob Jensen
Especially note Amy Dunbar’s excellent analysis 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

From The Wall Street Journal Accounting Educators' Review on January 16, 2004

TITLE: SEC May Charge Computer Associates 
REPORTER: Charles Forelle 
DATE: Jan 13, 2004 
TOPICS: Accounting, Audit Committee, Auditing, Revenue Recognition, Securities and Exchange Commission, Software Industry

SUMMARY: Computer Associates International Inc received a Wells notice from the Securities and Exchange Commission (SEC). The notice is in relation to improper revenue recognition during the 2000 fiscal year. Questions focus on revenue recognition and auditing of the revenue cycle.

1.) Explain the revenue recognition principle. Why is revenue recognition in the software industry complicated? When should revenue be recognized in the software industry?

2.) Why is Computer Associates being investigated by the SEC? If the allegations are true, what fines are penalties may be imposed by the SEC? What is the difference between a civil and a criminal investigation? Why is Computer Associates the subject of a civil investigation?

3.) What is the purpose of an audit committee? Discuss the role played by the chairman of the audit committee at Computer Associates in the current investigation?

4.) Describe the change in accounting for revenue that was adopted by Computer Associates. How does this accounting policy "remove the incentive for financial malfeasance?"

5.) If the allegations against Computer Associates are true, what management assertion was violated? Design an audit procedure that should have discovered the improper accounting.

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


"SEC May Charge Computer Associates," by Charles Forelle, The Wall Street Journal, January 13, 2004 ---,,SB107391611740713400,00.html?mod=mkts_main_news_hs_h 

The Securities and Exchange Commission is considering civil charges against Computer Associates International Inc. for improperly booking revenue, the software maker said.

CA said it received a so-called Wells notice from the commission, a procedural letter that informs it of the potential action and gives it a chance to respond before charges are filed.

The Wells notice echoes preliminary findings released in October by CA's audit committee chairman, who is leading an internal inquiry into accounting practices. The letter indicates that federal investigators are focusing, at least initially, on contracts booked improperly in the 2000 fiscal year, which ended March 31, 2000.

The SEC told CA that the contracts in question were printed with phony dates -- or had their dates altered -- in order to push revenue into quarters earlier than the ones in which the deal had actually been signed in order to meet securities analysts' predictions, according to a person familiar with the matter. But the notice doesn't rule out irregularities in other years.

As a result of the audit committee findings, CA forced out Chief Financial Officer Ira Zar and two top finance executives in October. A CA spokesman said Monday that "to our knowledge," no current or former CA employees had received individual Wells notices. An SEC spokesman, citing policy, declined to comment.

"Computer Associates' Ex-Executive Testifies He Lied in Inquiry," by Alex Berenson, The New York Times, January 23, 2004 --- 

Several senior executives of Computer Associates conspired to obstruct a continuing federal investigation into the company's accounting practices, a former senior vice president said yesterday in Federal District Court in Brooklyn.

In a subdued 30-minute hearing before Judge I. Leo Glasser, the executive, Lloyd Silverstein, admitted lying to prosecutors and lawyers from the Securities and Exchange Commission in September 2002 about whether the company had booked revenue from unsigned contracts.

Continued in the article

"Royal Dutch/Shell Ousts Chairman," by Chip Cummins and Bhushan Bahree, The Wall Street Journal, March 4, 2004 ---,,SB107832574420845328,00.html?mod=home_whats_news_us 

Move Comes as Company, SEC Probe Overbooking Of Oil and Gas Reserves 

The twin boards of Royal Dutch/Shell Group forced out the oil company's embattled chairman and a top deputy as the Securities and Exchange Commission and internal investigators probe the company's massive overbooking of oil and natural-gas reserves.

The surprise move ends Sir Philip Watts's short and troubled tenure at the helm of one of the world's largest publicly traded oil companies. The shuffle at the top also raises new questions about the role of Sir Philip and Walter van de Vijver, who had led Shell's global exploration and production business, in the reserve overbookings.

Shell stunned investors and industry observers on Jan. 9 by saying it would slash its tally of oil and gas reserves by 20%. The announcement triggered a sharp drop in the share prices of Shell's two holding companies, Royal Dutch Petroleum Co. of The Hague and London-based Shell Transport & Trading Co.

Share prices rose on news of Sir Philip's departure. In 4 p.m. trading on the New York Stock Exchange, American depositary shares in Royal Dutch rose $1.01, or 2% to $50.65, while those of Shell increased 85 cents, or 2% to $42.93

Continued in the article

Audits getting more intense under spotlight of SAS 99 ---

As Statement of Auditing Standards 99, Consideration of Fraud in a Financial Statement Audit, goes into effect, audit firms are realizing that its stiff new requirements can help a firm do a better job -- or doom a firm to litigation.

In either case, SAS 99 is most likely going to raise the cost of audits for nonpublic companies, including not-for-profits.

The Auditing Standards Board made an ineffectual attempt to deal with fraud in SAS 82, which went into effect in 1997. It didn’t do much more than simply require auditors to make a reasonable effort to find fraud.

The new standard pushes SAS 82 a lot farther, requiring of auditors a more strenuous effort to look for, if not actually find, misrepresentation in financial statements. Auditors are now required to presume malfeasance in management, to brainstorm the methods by which a client might commit fraud, to vary the pattern of the audit with surprise visits and procedures, and to document every anti-fraud effort that has been suggested or made.

Grace B. Ghezzi, a CPA and certified fraud examiner with Grimaldi & Associates CPAs PLLC, of Syracuse, N.Y., has been performing audits for fraud for over 12 years and, lately, has been traveling the nation to lecture on the new demands of SAS 99. She has found more curiosity than resistance.

“Clients are recognizing that we are taking on more responsibilities and that our profession is finally addressing fraud,” Ghezzi said.

After the devastating corporate financial scandals of 2001, the ASB wrote the more demanding SAS 99. It gives auditors specific guidance and procedures for looking for fraud, and, thus, to some extent defines the reasonable effort that auditors must make. It requires that the hunt for fraud continue throughout the audit process.

SAS 99 stresses the importance of revenue recognition, which is the most common type of financial statement fraud. It identifies inventory as the asset that is more materially misappropriated, and it calls for special assessment of management estimates because they are so subject to bias.

Audit firms can be held liable for neglecting to take all the appropriate steps that are specified in the statement. Gary D. Zeune, CPA, a frequent lecturer on the dangers, detection and prevention of fraud, said that SAS 99 can be friend or foe, depending on how well the audit firm has met its requirements.

“SAS 99 holds auditors to a higher standard of care,” Zeune said. “If they don’t meet the reasonable assurance requirement, the standard gives a plaintiff’s lawyers a roadmap of how to sue an accounting firm.”

On the other hand, Zeune said, the standard tells auditors how to do the job right. SAS 99 says: “Stop making it easy for the client to pull the wool over your eyes,” Zeune explained. “If you look at the procedures that SAS 99 says you should do, that’s the message between the lines. Do the procedures on a surprise basis. Don’t do the same damn thing every time. Don’t automatically trust your client because you’ve never had a problem in 27 years. Every year’s audit has to stand on its own.”

Ghezzi said that communication is of crucial importance in the search for fraud, and SAS 99 requires, for the first time, that auditors talk to each other and to management. The audit team must discuss ways in which a client may be susceptible to fraud, and they must document their discussion. They must talk with management to assess internal controls, look for ways that controls can be overridden, and then test those risks. They must also talk to personnel, including people who have nothing to do with accounting, bookkeeping or finance.

She told the story of a visit to a client whose inventory had been disappearing. She asked to speak with a variety of workers, including a maintenance man. The managers said, “You don’t need to talk to that old guy. He don’t know nothin’.” She insisted, however, and asked the man if he knew anything about the thefts. He asked her if she’d like to see his photo album.

It turned out that he had pictures of the in-house thieves in the act of their evil deed. 

Why hadn’t he reported the thefts? Because management didn’t respect him. He told Ghezzi, “They think I don’t know nothin’.”

Ghezzi said that, in general, auditors know about SAS 99   and what is expected of them. Not all, however, have enough training in interviewing and identifying the warning signs of fraud. A big sale at the end of the year, for example, followed by high levels of returns early in the next year can indicate a manager who is desperately juggling figures to meet revenue expectations.

Toby J.F. Bishop, president and chief executive officer of the Association of Certified Fraud Examiners, said that SAS 99 does too little to detect fraud and barely begins to prevent it.

“I haven’t heard anyone say that this is a silver bullet that will finally allow them to detect all fraud,” Bishop said. “It is impossible for auditors to detect 100 percent of fraud at any degree of cost and practicality, so a strategy aimed at fraud detection alone is a losing strategy. Our profession needs to focus at least as much, if not more, on fraud prevention.”

Bishop said that SAS 99 gives only off-hand mention of auditing the internal controls that could prevent a lot of fraud. The standard does not provide procedures or require an opinion on the adequacy of internal controls.

Continued in the article

"Ernst & Young Sued in Medicare Billing Case," AccountingWEB, January 9, 2003 

Ernst & Young is the subject if a civil lawsuit that contends the accounting firm’s advice led nine hospitals to overbill the federal Medicare program by nearly $1 million. The Associated Press reported that the suit, filed Monday by the U.S. attorney in Philadelphia, states that the firm’s incorrect advice in the early to mid-1990s caused the hospitals to submit more than 200,000 false claims for common blood tests.

The hospital laboratories used equipment that automatically performed a more extensive number of blood tests than were necessary, the suit says. Even though some of the tests had not been required by a doctor, Ernst & Young advised the hospitals to bill for the complete battery of tests to maximize their Medicare reimbursement, according to court papers.

''Our work was fully consistent with professional standards and coding guidelines at the time,'' Ernst & Young said in a statement. ''We intend to defend the matter vigorously, and believe that the facts will show that our services were entirely proper.''

Mark H. Tuohey, Ernst & Young's attorney, hospitals were allowed to bill for the tests in that manner until a rule change in 1996. At that time, he said, Ernst & Young told its clients to stop the practice.

Ernst & Young said it was paid a flat consulting fee for its work, and had nothing to gain if hospitals boosted revenues.

Some of the hospitals involved — in Connecticut, Indiana, Virginia and Pennsylvania — have already repaid the money to the Medicare program, said Associate U.S. Attorney James Sheehan.

The firm could be ordered to pay triple damages, plus millions of dollars in fines if found culpable by a judge.

Bob Jensen takes a stroll down memory lane!
Many of you may not recall the following October 25, 2001 settlement by KPMG for a somewhat similar implications in Medicare and Medicaid billing fraud.

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 

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.

Bob Jensen's threads on the large accounting firm scandals can be found at 

Current updates on the accountancy scandals are available in my running draft at 





See the indictment of L. Dennis Kozlowski and Mark Swartz, plus Mr. Kozlowski's retention agreement with Tyco, by arrangement with FindLaw ( ).

See complete coverage of corporate-scandal trials, including an interactive graphic tracking who's in prison, who's on trial and who's under investigation.


Dow Jones, Reuters

Tyco International Ltd. (TYC)

"Tyco's Auditor Undercuts Bonus Defense," by Chad Bray, The Wall Street Journal, January 28, 2004 ---,,SB107533538133514636,00.html?mod=mkts_main_news_hs_h 

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.

"Big Four Accounting Firms Lose Public Company Audit Clients," AccountingWEB, January 28, 2004 --- 

For the first time in at least a decade, in 2003 each of the accounting profession's biggest firms lost more public company audit clients than it acquired, according to an analysis by Auditor-Trak. PricewaterhouseCoopers suffered the biggest decline with a net loss of 91 audit clients. This shrinkage in PWC's client base reduced the firm's client revenue under audit by $46.4 billion and cut its client assets under audit by $543 billion. Auditor-Trak considers revenue for most public company audit clients but assets for certain financial services and other investment-oriented companies.

Among the Big Four firms, KPMG recorded the smallest decline in its audit client base with a net loss of 51 companies (and enjoyed a net gain of $59.7 billion in combined client revenue audited but a net loss of $17.3 billion in assets).

Ernst & Young finished 2003 with 76 fewer audit clients (a decline of $24.5 billion in client revenue audited but an increase of $150.9 billion in assets) and Deloitte & Touche had a net loss of 65 clients (audited client revenue down $45.6 billion, assets up $394.9 billion).

"After the rapid growth of the Big Four's audit client lists in the wake of the 2002 collapse of Andersen, we expected 2003 would be a year of rationalization of their client bases -- and that has clearly taken place," says Richard Ossoff, publisher of Auditor-Trak. "Also, we expected to see increased client selectivity on the part of the firms in light of the new Sarbanes-Oxley environment. However, these circumstances alone do not seem to fully explain the extent of these client losses."

Smaller national firms -- Grant Thornton, BDO Seidman and McGladrey & Pullen -- collectively acquired 21% of the clients lost by their Big Four competitors. Significantly, 34% of the public companies that formerly used a Big Four auditor opted for a regional or local firm as a replacement.

Prominent new audit clients acquired by KPMG last year include Sprint Corp. and AutoNation Inc. Deloitte & Touche added Royal Bank of Canada and its U.S. unit, RBC Centura Banks. Ernst & Young brought U.S. Bancorp and Clorox Co. into its client portfolio, while PricewaterhouseCoopers was hired by Calpine Corp. and Carnival PLC.

On the negative side of the ledger, KPMG lost Neuberger Berman Inc. and Spiegel Inc. Deloitte & Touche lost Denny's Corp. and CITGO Petroleum Corp., Ernst & Young departed from the American Skandia Life Assurance Corp. and Steak n Shake Co. engagements, and PricewaterhouseCoopers lost Kmart and Pharmacia Corp.

Continued in the article

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.

Also note ---

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 [
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

February 23, 2004 message from PwC

7th Annual Global CEO Survey (Managing Risk: An Assessment of CEO Preparedness)

This edition of the Annual Global CEO Survey focuses on the critical issue of risk, with particular emphasis on enterprise risk management (ERM). Nearly 1,400 CEOs in 40 countries shared their views with PwC on how they are managing enterprise risk. ERM provides a framework for CEOs and management teams to deal effectively with uncertainty, and the risks and opportunities associated with uncertainty, in order to enhance value. This year's edition features management strategies and performance forecasts from the CEOs as well as interviews with several chief executives. Nearly 40 percent of the CEOs report that they already have effective and efficient ERM in place, while 46 percent view this as a one to three year project.

Here are a few additional highlights:

It is obvious from the survey that US CEOs are concerned with risk, which is a reasonable and expected reaction to Sarbanes-Oxley. The full survey can provide you additional insights into what businesses are facing.

PwC's 7th Annual Global CEO Survey is available electronically through our website. We'd like to make this available to you, so that you may explore the contents of the Survey in an interactive manner. Additionally, you may download a PDF copy of the Survey from the website. We felt that the Survey could useful for classroom discussions. 

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 --- 

Bob Jensen's threads on scandals at Ernst & Young are at 

"Behind Wave of Corporate Fraud: A Change in How Auditors Work:  'Risk Based' Model Narrowed Focus of Their Procedures, Leav