Accounting Scandal Updates on July 10, 2002
Bob Jensen at Trinity University

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Wall Street Journal on June 28, 2002

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

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

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

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

QUESTIONS: 

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

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

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

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

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

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

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

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

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

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

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

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

QUESTIONS: 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Revenue in Question

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

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

The disclosure from Merck comes amid heightened scrutiny over many companies' accounting policies after several high-profile scandals. Last week, the SEC ordered that chief executive officers and chief financial officers of more than 900 of the nation's largest companies must swear under oath in writing that the numbers in their companies' recent financial reports are correct.

Merck declined to say whether the SEC required it to disclose the amounts of the co-payments in its latest filing, its fourth amended prospectus for the planned Medco initial public offering. But Kenneth C. Frazier, Merck's general counsel, said the latest filing has been thoroughly reviewed by the agency and "reflects the discussions we had with the SEC" over the co-payments. "We are proceeding with the offering and hope to price this week. However, we can't comment further because we are in the quiet period," he said. An SEC spokesman said the commission's approval of the latest filing is still pending.

Continued at  http://online.wsj.com/article/0,,SB1026084613164978760,00.html?mod=home_whats_news_us 

Bob Jensen's threads on revenue reporting are at http://www.trinity.edu/rjensen/ecommerce/eitf01.htm 

Forwarded by Amelia Baldwin

Ethics, Enron, and American Higher Education: An NAS/Zogby Poll of College Seniors http://www.nas.org/reports/zogethics_poll/zogby_ethics_report.htm 

JULY 2002 -- A large majority of this year's college graduates report that their professors tell them there are no clear and uniform standards of right and wrong. A similarly large majority report that they've been taught that corporate policies furthering "progressive" social and political goals are more important than those ensuring that stockholders and creditors receive accurate accounts of a firm's finances. Yet nearly all these students believe that their college studies have prepared them to behave ethically in their professional lives. In light of the issues about contemporary business ethics generated by the Enron scandal, such opinions raise serious doubt about how well our colleges are doing their job to shape the ethical sensibilities of their students. To be sure, the foundations of ethical education are laid in the home and school. At best, universities can only confirm the lessons taught there. But they can also undermine these lessons by providing sophisticated excuses for succumbing to the temptations of greed and power. The relativization and politicization of ethical standards, plus cynicism about business in general, opens the way for such excuse making.

These responses were elicited in a national survey conducted by Zogby International from April 9th to April 16th. The survey was administered to 401 college seniors, chosen by random. It was commissioned by the National Association of Scholars, an organization of professors, graduate students, and university administrators and trustees who are committed to excellence in higher education. The survey's sampling error is +/-5%. (Margins of error are higher in subgroups.)

The specific findings were these:

1. When respondents were asked "Do you strongly agree, somewhat agree, somewhat disagree, or strongly disagree, that your college studies are preparing you to behave ethically in your future professional life? 97% agreed and only 4% disagreed. (Rounding is to the nearest hundred.)

More precisely:

63% strongly agreed 34% somewhat agreed 2% somewhat disagreed 2% strongly disagreed

2. When respondents were given the alternatives listed below and asked: "I will give you several examples of business practices that are generally regarded as good. Based on what you've been taught at college, tell me which one of these business practices would probably rank as the most important?"

38% chose "recruiting a diverse workforce in which women and minorities are advanced and promoted."

23% chose "providing clear and accurate business statements to stockholders and creditors."

18% chose "minimizing environmental pollution by adopting the latest anti-pollution technology and complying with government regulations."

18% chose "avoiding layoffs by not exporting jobs or moving plants from one area to another."

(4% were not sure.)

49% of the women and 58% of the education majors, gave "recruiting and promoting women and minorities" as their most highly rated policy. So too did 49% of students majoring in the humanities and social sciences.

By a plurality of 43%, business and accounting majors accorded "providing clear and accurate business statements" their highest rating, thereby attaching more importance to it than did any other major. But even with this group, a majority of 56% preferred one of the other three alternatives.

3. When respondents were asked, Which of the following statements about ethics was most often transmitted by those of your professors who discussed ethical or moral issues?

73% chose "what is right and wrong depends on differences in individual values and cultural diversity."

25% chose "there are clear and uniform standards of right and wrong by which everyone should be judged."

( 2% were not sure.)

Generally speaking all subgroups were in agreement in their responses to this question. The highest support for "clear and uniform standards" (33%) came from students majoring in science and math. (Students with majors grouped in a "miscellaneous category" also gave 33% of their support to this option.)

Among those student groups that gave the highest degree of support for "the relativistic option" were majors in education or a pre-professional area (85%) and those majoring in the humanities and social sciences (79%).

The second set of interesting findings produced by this survey was the generally low opinion of the prevailing state of business ethics these students received from their professors. Perhaps somewhat paradoxically students seem to be told, on the one hand, that there are no clear ethical standards, and, on the other, that the business world is notably unscrupulous.

4. When respondents were asked: "Based on what you've been taught about these professions in college, in which of the following professions is an 'anything goes' attitude most likely to lead to success?"

28% chose business 20% chose journalism 16% chose law 5% chose teaching 5% chose science/medicine 5% chose the civil service 3% chose religion 2% chose the military 8% chose none (8% were not sure)

Seniors majoring in the humanities and social sciences (37%), and those with fathers having post-graduate educations (39%), were most likely to point a finger at business. Interestingly, students majoring in journalism tended to put journalism first.

America's graduating seniors also seem to think that Enron represents the rule and not the exception with respect to business ethics.

5. When respondents were asked "do you strongly agree, somewhat agree, somewhat disagree, or strongly disagree, with the following question: the only real difference between executives at Enron and those at most other big companies, is that those at Enron got caught?" 56% agreed and 41% disagreed.

More precisely:

22% strongly agreed 34% somewhat agreed 21% somewhat disagreed 20% strongly disagreed (4% were not sure)

The highest level of support for this statement (64%) came from pre-professional and education majors. However, it is worth emphasizing that business and accounting majors (57%) were no less likely to think the behavior of Enron executives exceptional than were any other majors.

Surely, there are significant reasons for being concerned with these results.

First, it seems reasonable to believe that when students leave college convinced that ethical standards are simply a matter of individual choice they are less likely to be reliably ethical in their subsequent careers. Unfortunately, three-quarters of our respondents report that this was the relativistic view of ethics they received from their professors.

Second, as desirable as diversity producing, environmentally consciousness, and locally-rooted policies may be for businesses to follow, the effectiveness of marketplace depends most fundamentally on honest dealing among those participating in its transactions. The majority of undergraduates, to say nothing of business majors, don't seem to have learned this in college.

Third, it will be more difficult to recruit ethical people to business careers if colleges give them a low opinion of the level of ethics they can expect to find upon entering those careers. Yet this is just what they apparently receive.

Finally, the relativization and politicization of ethical standards that our universities and colleges have embraced, and the cynicism about business and businesspeople they propagate, raise serious questions about the judgment of many on their faculties, including, apparently, those working in their business programs. If the marketplace provides one of the foundations of America's liberty and prosperity, it's discomforting to realize how little college faculties seem to appreciate its virtues or understand its needs.

Insuring against blunders by executives and officers is a lot costlier than it used to be for U.S. companies. Tech and telecom firms, insurers say, are facing some of the steepest rate hikes --- http://www.wired.com/news/business/0,1367,53566,00.html 

"Accounting for Impaired Assets in Bank Credit Analysis, by Roger B Taillon, New York (1) 212-438-7400, Standard & Poor's, July 3, 2002 --- http://www.standardandpoors.com/

Accounting for impaired assets not only differs markedly from country to country, it also offers substantial scope for management judgment. The accounting method prescribed and the judgment exercised in following that method has a profound impact on bank balance sheets and income statements. Although not new, accounting for impaired assets probably remains the biggest accounting-related issue in the credit analysis of a bank. Whether triggered by systemic crises or by poor lending practices specific to a single bank, poor asset quality is the most common fundamental cause of bank failure, although a liquidity crisis when depositors or lenders begin to suspect the poor asset quality typically is the proximate cause. Thus, the credit analyst must understand accounting for impaired assets and attempt to adjust for differences in order to make more meaningful comparisons between banks, particularly banks in different countries. For rating purposes, Standard & Poor's will make these adjustments and generally opt for the more conservative accounting techniques, given the dangers of underestimating the extent of (or underreserving for) impaired assets.

The following major issues must be considered in accounting for impaired assets: What is the definition of an impaired asset? To what extent is interest accrued on impaired assets? What is the policy for providing or reserving against losses on impaired assets? What is the policy for finally writing off impaired assets?

Even the terminology of impaired assets differs from system to system. In some countries, both a contra-asset account used to reduce the accounting value of the loan portfolio and the income statement item used to create it are called "loan loss reserves" (or something similar). In other countries, both items are called "provisions." To distinguish between the two in its publications, Standard & Poor's calls the balance sheet item a "reserve" and the income statement item a "provision." Thus, in Standard & Poor's terminology, a provision creates a reserve. When the loan is ultimately judged to be uncollectable, it is either "written off" directly against the income statement or "charged off" by reducing a previously created reserve (although this may also be called a "write-off"). "Write-backs" refer to the reversal of a reserve no longer considered necessary, and "recoveries" refer to the recuperation of all or part of a previously written-off loan. Types of Impaired Assets Impaired assets can include loans, loan-related assets such as foreclosed properties, securities, off-balance-sheet assets such as guarantees receivable, or in-the-money derivatives. Additionally, there can be off-balance-sheet commitments that require provisioning, such as guarantees provided or LOCs payable, where the primary obligor is expected to default, and commitments to lend to problem borrowers. Securitized assets on which the bank still bears the risk are also off balance sheet.

In a number of cases, banks suffering from large amounts of problem loans have "sold" them to special purpose companies, sometimes called "bad banks," designed to remove the problem loan portfolios from the bank's balance sheets and liquidate them. On a few occasions, these companies have been set up by individual banks; more frequently, they have been set up by governments following a systemic crisis. In most cases, these special purpose companies have been funded by the banks, which also bear all or most of the risk of eventual losses. Standard & Poor's puts the assets sold to these companies back on a bank's balance sheet for the purpose of analyzing the amount of a bank's impaired assets and the adequacy of its reserves.

The loan portfolio is typically a bank's largest asset category; it is also the category most likely to suffer impairment. For this reason, knowing the definition of nonperforming loans (NPLs) is the key first step in analyzing asset quality. In the U.S., the definition of nonaccrual loans is standardized as loans that are maintained on a cash basis because of deterioration in the borrower's financial condition, where payment in full of principal or interest is not expected and where principal and interest have been in default for 90 days, unless the asset is both well-secured and in the process of collection. Restructured loans (loans restructured for credit reasons at a below-market interest rate) and "other real estate owned" (OREO, or properties obtained through or in lieu of foreclosure) must also be disclosed and are considered nonperforming.

In other countries, the definition can vary considerably. Nonperforming consumer loans and residential mortgage loans are typically identified by aging, but the past-due period necessary for the loan to be considered nonperforming can vary from as short as 30 days to as long as 180 days. Some countries and banks define delinquency on a contractual basis, and others define it on a recency of payments basis. If delinquency is defined on a recency basis, sometimes only full payments are counted, and sometimes partial payments are sufficient to show the loan as performing. In some countries, there can be different standards for mortgage and other consumer installment loans, with the mortgage loans being put in nonperforming categories only after longer periods.

In terms of corporate loans, in most countries management judgment is the most important factor in deciding whether a loan is classified as nonperforming or not. For certain types of loans, such as overdraft loans, which are very common in some countries such as the U.K., management judgment is actually the only possible standard for determining if the loan is performing or not, since there are no specific maturities as long as the borrower is within its credit limit. Deciding just how liberal or conservative management is in making that judgment is one of the most difficult parts of the analysis and is generally possible only after extensive discussions.

The Basel Committee on Banking Supervision proposed a "reference definition" of a default to be used by banks that plan to use the "internal ratings-based approach" to the proposed new capital standards. Under the proposed definition, "a default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place:

The obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full; A credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees; The obligor is past due more than 90 days on any credit obligation; or The obligor has filed for bankruptcy or similar protection from creditors." If widely adopted, this definition would lead to greater standardization between countries, but it still relies heavily on management judgment.

There are also differences as to whether a particular loan is considered nonperforming only when it goes into arrears, or if all loans to that legal entity are treated as nonperforming. The most conservative method is to consider all loans to the defaulting entity and loans to closely related entities as nonperforming. In some countries, only that portion of a loan that is actually past due is considered nonperforming. In a few countries, the latter condition is the rule for mortgage loans, but the entire balance of other loans is considered nonperforming.

In addition, restructured loans may or may not be separately disclosed depending on the country. In many countries, the figures for restructured loans will not be disclosed, and loans may be reclassified from nonperforming to performing as soon as they are restructured. In other countries, they will be reclassified to performing only after they have met the new terms for a specified period.

Foreclosed properties are only grouped with NPLs in a few countries, as they are in the U.S. In most countries, they will not be considered in management discussions of nonperforming asset (NPA) trends. However, they frequently are available as a separate category on the balance sheet or else are disclosed in the footnotes.

Although the analysis of impaired assets is focused on the loan portfolio (and the real estate portfolio, to the extent that it represents foreclosed assets), impaired assets can also be present in the securities portfolio, including:

Debt securities either purchased as investments or as loan-equivalents, which have defaulted; and Debt and equity securities received in exchange for loans as part of reorganizations or debt restructurings, or as foreclosed collateral. Equity securities purchased as investments that declined sharply in value might also be considered impaired, but would be looked at separately rather than combined with NPAs.

For analytical purposes, Standard & Poor's believes a broad definition of NPAs is appropriate. According to that definition, NPAs should include:

The full amount of all loans 90 days or more past due, and any other loans to the same legal entity; The full amount of all loans to an entity whose creditworthiness is believed to be impaired to the point where collection is doubtful, which would typically include any closely related entities of borrowers that were nonperforming; All loans restructured at nonmarket rates of interest, even if they are performing according to the new terms; All foreclosed properties, and properties received in lieu of foreclosure; Impaired securities as described above; and Impaired off-balance-sheet assets, including loans sold to problem asset disposition companies where there is recourse back to the bank, and nonperforming securitized assets where the bank retains the risk. To the extent possible, Standard & Poor's will adjust total NPAs to conform to this broad definition. If this is not possible, Standard & Poor's will make qualitative distinctions to recognize the difference in definitions.

Policies on Accrual of Interest Policies related to the accrual of interest on NPAs also differ substantially from country to country. The cleanest method is that which is used currently in most countries, where interest is not accrued on NPLs. Even there, there are differences as to whether interest previously accrued but not received is reversed or capitalized. In addition, the treatment of cash interest received is a matter of management judgment: typically, it would flow into interest income if the bank believed it would likely recoup its principal, but if this were in doubt, it would be used instead to reduce the principal balance on the bank's books. In other countries, interest continues to accrue but is fully provisioned. On a bottom-line basis, this provides the same results as the first policy: net NPAs and net income are the same as they would be under the nonaccrual method. However, a number of line items will differ: gross NPAs, reserves on the balance sheet, gross and net interest income, and loan loss provisions charged to the income statement will all be higher than they would be at banks that use the nonaccrual method. Comparisons between banks in different countries using the two methods will have to be adjusted to take this into account.

From a credit analyst's viewpoint, the most pernicious policy is the methodology of ceasing to accrue interest or provide for it only in those cases where management believes that collateral on the loan will be insufficient for it to recover the interest. This is consistent with "mark-to-market" accounting (which will be covered more generally in a separate article that will be forthcoming from Standard & Poor's). This methodology suffers from the following disadvantages:

It relies more heavily on valuations of collateral. Even if collateral valuations are theoretically correct, a bank may have great difficulty realizing these values. The costs of workout and recovery can be very high. Unless detailed information is provided on how much interest is accrued on NPLs, comparisons with banks using more conservative accounting methods will be impossible. All of these issues concerning accrual of interest apply to restructured loans and nonperforming debt securities as well as to identified NPLs. This is particularly true in restructurings that involve grace periods or extremely low payments in early years, postponing the day of reckoning where the borrower's true ability to repay will be tested.

Unfortunately, it is generally impossible to actually adjust for differences in accrual policies where provisioning for interest is not done fully. However, in many cases the balance sheet asset of accrued interest receivable is available. If this figure grows significantly more rapidly than that of earning assets (taking into account interest rate fluctuations) or the liability item of accrued interest payable, it can be an indication of aggressive accounting.

Policies on Loan Loss Reserves Loan loss reserving policies also differ substantially from country to country, and can vary to a greater or lesser extent among banks within a country. The most conservative policy is to fully write off or reserve for any identified problem loans, as well as to establish general reserves for potential future loan losses that have not yet been identified as problems. In the U.S. the emphasis has been on writing off problem loans, while in most other countries the emphasis has been on reserving. The policy itself is much less important than the adequacy of the amount. Comparison between NPLs in systems emphasizing charge-offs and NPLs in systems emphasizing reserving needs must be made net of reserves, however.

The following factors must be considered in terms of reserves and provisioning:

Are necessary reserves determined based solely on the number of days past due, on regulatory or internal loan classification, or (for the larger loans) on loan-by-loan estimates of loss? To what extent is collateral taken into account in determining necessary reserves, how is its value calculated, and are related costs fully taken into account? How does the percentage coverage of NPLs by reserves compare to regulatory minimums, historical figures, and that of the bank's peers? Have reserves been constituted for other impaired assets, such as securities, and for off-balance-sheet items such as guarantees of debt of problem clients or commitments to lend to them, and are both the income-statement and balance sheet figures disclosed? In addition to (or instead of, if the bank charges off rapidly) "specific" reserves covering individual problem loans, are there "general" reserves? If so, how are they calculated? Are there also "country risk reserves"? How does the tax treatment of the provisions affect the adequacy of the reserves? Are loan loss provisions shown only as net, or are both gross new provisions and write-backs disclosed? Generally, reserves that are determined based on loan-by-loan analysis for corporate loans are preferable to those that are determined based on some mechanical method, assuming they are conservatively estimated. Unfortunately, it is also more difficult to judge how conservative such reserves are, although detailed discussions with management can help. From a credit rating viewpoint, the ideal is probably a situation in which the reserve on a given loan is the larger of (a) a minimum based on the number of days past due, or (b) the necessary amount estimated through detailed analysis.

For consumer and residential mortgage loans, typically the reserve amount will be determined through a formula either based on the aging of the portfolio or on the bank's experience with the particular type of loan.

Similarly, from a credit rating viewpoint, one needs to be very skeptical of taking collateral into account in determining the adequacy of reserves. There are difficulties in valuing the collateral, with banks often using valuations assuming "normal" markets when they are in the midst of a recession with markets falling sharply. There can be legal and other difficulties in foreclosing, and these difficulties intensify in bad economic times. Even if banks eventually can foreclose, substantial costs may be involved that may not have been fully taken into account in the valuations. Finally, in a bad market, even if the bank can foreclose, it may be difficult to sell the collateral.

Provisions taken against foreclosed assets, impaired securities, off-balance-sheet items, and the like also must be aggregated with the loan loss provisions in order to judge the bank's credit track record. These provisions frequently are included in securities losses or other expenses, and they may or may not be disclosed in the footnotes.

Write-backs of provisions are generally (but not always) disclosed separately for banks that emphasize specific reserves. Sometimes necessary reserves are added up and then compared to those of the previous period, with the difference being the loan loss provision, so there are no gross and write-back figures available. The more robust method calls for looking at each loan individually, recording new and increased reserves separately from decreased reserves. The total of the new reserves and the increases to the reserves is the gross new provision, and the total of the decreases in reserves is the write-back figure. These separate figures are usually disclosed in the footnotes. The loan loss provision shown on the income statement is normally the net figure, although it is sometimes the gross figure, with write-backs included in other income. Ideally, specific and general provisions are disclosed separately. When the information is available, Standard & Poor's will use net new provisions as the expense item, but it will analyze the separate components to help evaluate the conservatism of a bank's reserving policies.

Charge-Off Policies Charge-off policies are subject to most of the same considerations as reserving policies. This is true at banks such as those in the U.S., which are more likely to charge off quickly than they are to create a specific reserve. In most countries, however, the issue of when and how much of a loan is actually charged off is much less important. In these countries, loans are not charged off until: The borrower has completely gone through the bankruptcy process, or the bank is nearly certain it will not recover anything for other reasons; A time period prescribed by regulation has elapsed; The tax authorities allow them to; or Some combination of the above. Even in these cases, however, the analyst must be aware of the charge-off procedures to make more meaningful comparisons of bank loan loss records: if charge-offs are quick, NPAs will tend to be low compared to where charge-offs take longer. Loan loss reserves also tend to be lower at banks where charge-offs are quicker; if not, it is probably a sign of more conservative accounting.

Tax Treatment of Impaired Assets Finally, there is the question of tax treatment. In some countries, banks account for the tax benefits of a loan loss when the provision is made, even though the loss cannot be taken for tax purposes until the charge-off is made. Where there is a big delay between the two and loan loss provisions are increasing more rapidly than charge-offs, banks can build up large deferred tax assets, which can amount to a substantial proportion of reported equity. This was the case for both the Japanese and the Mexican banks in the 1990s. Analysts had to question when or even whether the banks would actually be able to realize these future tax benefits, taking into account both the difficulties in getting charge-offs accepted by tax authorities and whether profits would be sufficient to use the tax benefits, even if the charge-offs were allowed. On the other hand, if provisions or certain types of provisions are not deductible for tax purposes, and the bank does not immediately account for the deferred tax benefit, the bank will be able to realize and account for these benefits in the future. Thus, reserves created without booking the tax benefits can cover more than their face value of loan losses, if the future charge-off is tax deductible and the bank has taxable income at the time the charge-off is made.

The August, 2002 issue of PLAYBOY has a pictorial entitled "The Women of Enron" --- http://www.playboy.com/magazine/current/pictorial_enron.html 

Now we are anxiously awaiting "The Women of Andersen" and "The Women of WorldCom."  

However, I doubt that there will be a pictorial event for "The Women of the Baptist Foundation" or "The Women of Waste Management."

From the Financial Times, 28th June 02

EBITDA Earnings Before I Tricked the Dumb Auditor 
EBIT Earnings Before Irregularities and Tampering 
CEO Chief Embezzlement Officer 
CFO Corporate Fraud Officer 
NAV Nominal Andersen's Valuation 
FRS Fantasy Reporting Standards 
P/E Parole Entitlement 
EPS Eventual Prison Sentence

Ruth Bender 
Cranfield School of Management 
UK

EVA (economic value added) should be EVAA i.e. economic value artificially added

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

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

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

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

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

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

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

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

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

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

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

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