Accounting Scandal Updates on November 30, 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 

Exodus of Enron employees carrying all their worldly possessions.
Bob Jensen's Enron humor threads --- http://www.trinity.edu/rjensen/fraud.htm#Humor 

Outstanding animations of imploding buildings! 
ImplosionWorld --- http://www.implosionworld.com/  
Sort of reminds me of the public image of corporate CEOs, CFOs, CAOs, and their auditors.

But in contemporary United States, something happened to the national memory. In the last ten years, top executives of a stunning number of very large corporations committed fraud and theft, doctored their books, created false entities designed to let insiders rake in billions when many of them knew their corporations were in crisis. For numerous firms the crisis was fatal and hundreds of thousands of their workers lost their jobs and were cheated of their old-age pensions. It was not only the Enrons and WorldComs but some of the most prestigious monuments of American capitalism — some of the country's oldest and largest banks and accounting firms.
Ben Bagdikian --- http://www.zmag.org/sustainers/content/2002-10/28bagdikian.cfm  

Mr. Berardino (former Andersen CEO) recommends a change in audit opinions from a clean opinion vs. a qualified opinion to opinions issued on a graded scale. He also encourages a change from rules-based accounting to a principles-based model. And he added, "We must increase our ability to detect fraud."
AccountingWeb --- http://www.accountingweb.com/cgi-bin/item.cgi?id=96386 

Those days have certainly changed. I have not seen a poll on this subject, but I would bet that a very high percentage of Americans today know about the Securities and Exchange Commission. I was stunned recently when an airport security man in Atlanta saw "SEC" on my laptop and asked me if I worked at the Securities and Exchange Commission or with the South Eastern Conference. A year or so ago, I'm certain he would have assumed I worked for the football conference. In truth, I'll bet that he was hoping that I could have revealed some inside information about the Georgia Bulldogs' next game instead of inside information about recent rule promulgations under the Sarbanes-Oxley Act. But, alas, his knowledge about my employer did reaffirm my belief that these are unique times and that the SEC has gone mainstream. Whether or not this is a good thing is a debate for another time.
SEC Commissioner Paul Atkins (forwarded by Dennis Beresford from the University of Georgia)

Here's another story for the list. A professor of mine told us about how he was on an audit in the Houston area, though he was from the Dallas office. He observed an inventory count in one warehouse and headed back to his hotel. Part way there, he realized -- horrors! -- that he'd left his briefcase with the workpapers at the warehouse. He had the taxi take him back to the warehouse, where he found 18-wheelers at every dock, loading the inventory to take to the other warehouse for the next day's count! Sometimes being careless with your briefcase can bring unexpected benefits, eh?
Linda Kidwell Niagara University

"The Man With Nine Lives, by Elizabeth MacDonald, Forbes, November 25, 2002 --- http://www.forbes.com/forbes/2002/1125/060a.html 
Under fire from accounting scandals and charges of self-dealing, Barry Melancon is hanging on as head of the American Institute of Certified Public Accountants

For Barry Melancon, the 44-year-old chief executive of the accounting industry's self-regulatory body, it's been a terrible year. A wave of accounting scandals has damaged the AICPA's image. On his watch, the AICPA has been accused of giving short shrift to the auditing rules it sets, which are supposed to protect investors. And under Melancon, the AICPA has set up a Web site that ignited a barrage of conflicts-of-interest charges against him.

Some 160 member accountants have signed a petition asking him to resign. BDO Seidman, the fifth-largest accounting firm, has sued the AICPA over the site, alleging Melancon is trying to enrich himself and that the AICPAis wrongfully competing with accounting firms. An AICPA member has filed an ethics violation accusing him of self-dealing. (None of the AICPA's chiefs, including Melancon, has ever had a finding against them.) Now, Congress has yanked the AICPA's auditing oversight duties away from it and given them to a new federal board. Some wonder how Melancon can hold on to his job.

"I think the AICPA under Melancon's leadership has been the least effective, most backward, most obstructionist group that I encountered in my eight years running the SEC," says Arthur Levitt, former Securities & Exchange Commission chairman. Lynn Turner, former SEC chief accountant, agrees. "If Melancon were a CEOof a company, he'd be fired by now," says Turner, who recently received a big round of applause in a speech before 700 accountants when he called for Melancon to step down.

Part of Melancon's problem is that he's a lightning rod at the worst time for accountants. "Unfortunately, the actions of a few bad ones reflect negatively on all of us," he says. But during his term, the things the AICPA let slide when the markets were at giddy heights are believed to have hurt investors. For instance, Melancon fought the SECover auditor independence rules that Levitt and Turner say would have stopped conflicts involving auditors selling consulting services to their audit clients. The AICPA also didn't tighten rules for simple things, like forcing auditors to provide detailed documentation for an audit or to query lower-level management for problems or even to look at journal entries, says Douglas Carmichael, director of the Center for Financial Integrity at Baruch College in New York. Instead the rules get lazy auditors off the hook by simply letting them obtain a letter from a company that says it isn't faking its numbers, says Carmichael, who notes auditors like weak rules, since they can use them as a defense when sued.

So why doesn't the AICPA boot Melancon? Because he's a business builder intent on making a buck--and that's what its board wants him to do. "Barry brought to the AICPA what the profession wanted: a business approach," says board member Michael Mountjoy. Melancon adds the AICPA has "not reduced one iota the resources" that it puts into standards.

To turn a profit, Melancon launched the site, called CPA2Biz, in February 2001. As chairman of the Web site, he got CPA2Biz the exclusive rights to sell the nonprofit AICPA's products, such as auditing manuals. The products brought in $64 million out of the institute's $165 million in 2001 operating revenue. The AICPA raised $70 million from investors such as Microsoft, Thomson and Aon, which bought half the site; the institute invested just $900 for its 50% stake. While the site has never made a profit, Melancon says the companies are at risk for losses. "In other environments people would be lauded for that," he says.

An initial public offering (at a possible $10 a share) was planned for the site. That meant Melancon's personal $100,000 investment in the site could have been worth $12 million. Though no IPOhas occurred, accountants fumed over his stake, which he says won board approval. To quell his critics, Melancon announced in March that he donated it to an accounting foundation.

Even so, Melancon has morphed the once-venerable AICPA into a paid endorser of its financial backers' products, some of which were denounced as inferior by accountants, like Microsoft's small business accounting software, which was eventually killed. And the AICPA gave a contract worth millions to a Thomson unit for exclusively administering an electronic version of the CPA exam. Though that raised the ire of the Texas State Board of Public Accountancy, it now says Melancon has since convinced it that the unit was the best outfit for the job.

While the board says it is behind its man, Melancon hedges whether he will renew his five-year contract when his second term expires in 2005. "We went through a hard year," he says.

From Watson Wyatt Worldwide --- http://www.watsonwyatt.com/research/resrender.asp?id=W-584&page=1# 
Corporate Governance in Crisis: Executive Pay/Stock Option Overhang 2003

Corporate America is in crisis. Scandals, bankruptcies, questionable accounting and the like are eroding public trust. Poorly timed or possibly even fraudulent stock sales by key company executives are igniting legislative action. The overall economy is struggling, the stock market is in a heightened state of volatility, and investor confidence has plummeted so low that CEOs are now legally required to sign a pledge of honesty.

As a result, all the goodwill created by corporate America with the gains of the 1990s has vanished. Executive pay is once again under heavy public scrutiny, and calls to link pay with accurate measures of performance are louder than ever before.

Executive pay, especially CEO pay, has become a lightning rod for this collapse in investor confidence for a number of reasons. CEO pay levels in a few instances have reached into the hundreds of millions of dollars for a single year, raising the question of whether any employee is worth that type of money — especially in cases of a company’s mediocre or even poor performance. There also have been recent examples of overstated profits or outright fraud. Such situations are compounded by the ability of executives to time the exercise of their options and the sale of their stock, and by the fact that stock options are accounted for differently from other forms of compensation.

We believe that the executive pay situation offers a key window into the corporate governance crisis facing America and, accordingly, provides a possible solution. The companies with the pay governance processes that are most transparent and most aligned will be the ones to inspire the most investor confidence.

Watson Wyatt research clearly and consistently documents that a company’s executive pay levels are directly and positively correlated with its financial performance. Companies that give their executives a greater stock incentive opportunity outperform companies with lower opportunity. We also have found that companies with high levels of stock ownership at the executive and other employee levels substantially outperform their low stock ownership counterparts. In fact, our research has shown that stock ownership is more effective than stock options in this regard.

The research in our 2003 Executive Pay/Stock Option Overhang study bears this out. In particular, our findings show:

To better understand some of the concerns of investors, we have investigated the impact of executive pay and stock option overhang on financial performance. The world of executive pay could change in unpredictable ways over the next few years. We believe that our statistical research on pay, ownership and options could be helpful in setting the future direction.

This report details those findings. The first section focuses on executive pay; the second on stock option overhang. It is interesting to note that, if the rules for accounting of stock options change significantly (as we now think likely), it is possible that stock option overhang will become a less important measure. For now, however, these historically reliable gauges continue to offer valuable insights.

Continued at  http://www.watsonwyatt.com/research/resrender.asp?id=W-584&page=1#  

FEI Video on Corporate Governance --- http://www.fei.org/video/

What Does the Future Hold for CPA Firm Consulting? --- http://www.smartpros.com/x35960.xml 

From SmartPros --- http://www.smartpros.com/x35970.xml 
Why do good accountants do such bad audits?

Nov. 14, 2002 (Cox News Service) — Few events have shocked investors as much as the accounting frauds disclosed by major U.S. corporations this year. Even accountants can be crooked, many people concluded. Unfortunately, it's not that simple, Harvard Business Review (November) says in a special report, "Why good accountants do bad audits."

For one thing, HBR says the highly touted Sarbanes-Oxley Act passed by Congress this year to reform the accounting profession is not likely to succeed because it attacks the wrong problem.

That conclusion is based on research by Max Bazerman of the Harvard Business School and George Loewenstein and Don Moore of Carnegie Mellon University. They conclude that the problem with fraudulent auditing is not corruption but the "unconscious bias" of accountants who are too close to their clients.

"Because of the often subjective nature of accounting and the close relationships between accounting firms and their corporate clients, even the most honest and meticulous of auditors can unintentionally massage the numbers in ways that mask a company's true status, thereby misleading investors, regulators and even management," the authors say.

The solution they recommend is for accounting firms to be auditors or business consultants, but not both, and for companies to routinely rotate outside auditors. As for accountants, they need to be more aware of "the profound impact of self-serving biases on their judgement," HBR says.

If accountants are under fire, corporate chief executives are being atom-bombed as a result of corporate fraud disclosures, says Fortune (Nov. 18) in a specual issue devoted to "the CEO under fire."

Today's disgraced chieftains are the products of 100 years of evolution, resulting in the CEO as tyrant, statesman and destroyer. One problem is Wall Street's deification of CEO stars, which often "sets investors up for a fall." The good news, says Fortune, is that "the latest crop of CEOs is disciplined, deferential, even a bit dull -- what a relief!"

Survey: Damaged Perception of Accounting Profession Not Likely to Change --- http://www.smartpros.com/x36059.xml 
By: SmartPros Editorial Staff

HOUSTON, Nov. 21, 2002 — Accounting professionals believe the past year's scandals have significantly damaged the profession's reputation, and that new legislation won't fix the problem, according to a recent survey.

More than 170 accounting professionals weighed in on the recent changes in accounting standards at the Chamberlain Hrdlicka 25th Annual Tax & Business Planning Seminar earlier this month.

Even the aggressive Sarbanes-Oxley Act will not help to salvage the diminished public perception of the profession, respondents said. In narrow results, just over half of respondents believe that the Act and other SEC changes will help to achieve the goal of encouraging public companies to produce more accurate financial statements. And when asked if malpractice or other concerns would cause accounting firms to adopt the Sarbanes-Oxley standards, even if the firm would not otherwise be covered, 63 percent of those surveyed said no.

"From this survey, it is clear that there are mixed opinions about the state of the accounting industry," said George Hrdlicka, co-founder and shareholder of Chamberlain Hrdlicka.

In the last fiscal year, over 150 criminal cases relating to retirement fund fraud were opened, resulting in the indictment of over 135 individuals. To help protect the 46 million Americans who are building their own retirement nest egg, the Pension and Welfare Benefits Administration offers the following warning signs that pension contributions are being misused. http://www.accountingweb.com/item/96774 

Warning Signs That Pension Contributions Are Being Misused

  1. Your 401(k) or individual account statement is consistently late or comes at irregular intervals
  2. Your account balance does not appear to be accurate
  3. Your employer failed to transmit your contribution to the plan on a timely basis
  4. A significant drop in account balance that cannot be explained by normal market ups and downs
  5. 401(k) or individual account statement shows your contribution from your paycheck was not made
  6. Investments listed on your statement are not what you authorized
  7. Former employees are having trouble getting their benefits paid on time or in the correct amounts
  8. Unusual transactions, such as a loan to the employer, a corporate officer, or one of the plan trustees
  9. Frequent and unexplained changes in investment managers or consultants
  10. Your employer has recently experienced severe financial difficulty

Volcker Calls for Non-Exec Board Structure in Large Corporations
Former Federal Reserve Board Chairman Paul Volcker, once the top contender to head the Public Company Accounting Oversight Board before withdrawing his name from consideration, called on large public corporations to establish a board structure that allows non-executive board members to exert authority over the chief executive officer --- http://www.smartpros.com/x35862.xml 

Three Accounting Firms Sued for Raiding Andersen's Assets --- http://www.accountingweb.com/cgi-bin/item.cgi?id=96380 

AccountingWEB US - Nov-13-2002 - Three accounting firms are being sued for looting Andersen's assets and leaving it unable to pay retirement benefits. A class action suit seeks damages of $500 million to $1 billion to cover lost retirement payments for roughly 1,000 former partners of Arthur Andersen. The defendants named in the suit include Deloitte & Touche, Ernst & Young, and KPMG as well as BearingPoint, formerly KPMG Consulting. They are accused of interfering with contractual relations, acquiring Andersen's assets at below fair value and conspiring to suppress that value.

Among other things, the suit cites two "war rooms" operated in Chicago by 100 Deloitte employees. One room targeted Andersen's people for possible jobs, while the other targeted Andersen's clients

Continued at http://www.accountingweb.com/cgi-bin/item.cgi?id=96380 

A portion of a November 22, 2002 message from Risk Waters Group [RiskWaters@lb.bcentral.com] 

... the US energy trading markets suffered a series of setbacks this week with allegations that Houston-based El Paso swapped power contracts with Morgan Stanley to avoid a restatement of earnings. El Paso is said to have swapped power contracts for the five-year period 2006-2011 for the period 2011-2016 in an attempt to convince its auditor, PricewaterhouseCoopers (PwC), that there was still a viable market for power 10 years into the future. In doing so, it convinced PwC that profits it had booked from a previous long-term deal – extending 15 years – were likely to be realised.

Additionally, UBS said it will close its Houston-based energy trading desk, laying off an undetermined number of staff, and Fitch warned that US power and gas companies face another grim year in 2003 as liquidity risk, market weakness and litigation and regulatory concerns seem set to continue. On the exchange front, US single-stock futures trading company OneChicago expanded its product suite with 22 more stock listings. It will also introduce futures on ‘Diamonds’ – shares in an exchange-traded fund that is designed to track the performance of the Dow Jones Industrial Average. The new single-stock futures contracts are in addition to the 21 listings posted at the launch of the market on November 8. A spokeswoman for the company – a joint venture between the Chicago Board of Trade, the Chicago Mercantile Exchange and the Chicago Board Options Exchange – said an average of 3,500 contracts per day were traded on OneChicago’s platform in the first six days of business.

United Way Accounting is Questioned

Double booking of revenues, counting revenues targeted to other organizations, and booking volunteer's time as contribution revenues are all accounting practices that are now being questioned at the United Way, according to a report by the New York Times. http://www.accountingweb.com/item/96768 

AccountingWEB US - Nov-20-2002 -  Double booking of revenues, counting revenues targeted to other organizations, and booking volunteer’s time as contribution revenues are all accounting practices that are now being questioned at the United Way, according to a report by the New York Times.

Brian A. Gallagher, president of the United Way of America, indicated that while some of the practices in question conform to GAAP, the post-Enron scrutiny of accounting practices require that the organization now respond to the issues in question.

Many of the practices result in inflated revenues for the local member organizations. The concern is that donors are entitled to know what percent of their contributions are going to the charity and what percent are going to administrative costs, and the inflated revenues tend to show a smaller percentage going to administrative overhead.

Among the issues being questioned:

Member organizations of the United Way are independent organizations, not subject to uniform reporting guidelines, practices, or even accounting software. Member organizations assert that this independence allows them to better react to their local community’s needs without worrying about “big brother” oversight. The tug-of-war between the independence of the organizations and the centralized control of the national United Way organization will continue to be debated.

Bob Jensen’s threads on controversial revenue accounting can be found at http://www.trinity.edu/rjensen/ecommerce/eitf01.htm

Seven professional associations have jointly issued recommendations to help companies combat fraud. The guidelines tell how to prevent, deter and detect frauds ranging from falsified financials to employee theft. http://www.accountingweb.com/item/96765 

Recommended anti-fraud measures include creating a culture of honesty and high ethics, being proactive in implementing and monitoring effective internal controls, and developing an effective oversight function.

A document containing the recommendations, "Management Anti-Fraud Programs and Controls," is available at AICPA's Web site. This document will be included for information purposes as an exhibit in the printed version of Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit. The electronic version of SAS 99 is also being conformed to include the exhibit.

The organizations sponsoring the document are the American Institute of Certified Public Accountants, Association of Certified Fraud Examiners, Financial Executives International, Information Systems Audit and Control Association, Institute of Internal Auditors, Institute of Management Accountants, and the Society for Human Resource Management.

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

The Financial Accounting Standards Board has issued another invitation to comment on stock-based compensation. This one asks for your views on accounting for the fair value of employee stock options. http://www.accountingweb.com/item/96757 

The FASB's news release and links are at http://www.fasb.org/news/nr111802.shtml 

"New Charges Made in Suit on Homestore," by David D. Kirkpatrick, The New York Times, November 16

A complaint filed yesterday in a suit by a large shareholder against the online real estate company Homestore.com makes new accusations of financial fraud at AOL Time Warner, including detailed descriptions of conversations between senior executives who, it says, were planning to inflate revenue improperly at both companies.

 

Federal prosecutors and securities regulators are already investigating possible financial improprieties at both Homestore and AOL Time Warner. The complaint sheds new light on the progress of the investigations because it draws on some of the information that federal prosecutors have gathered.

 

The complaint, filed by the California State Teachers' Retirement System in District Court in Los Angeles, cites information from anonymous executives said to be involved in Homestore's questionable deals.

But people involved in the federal inquiries said that much of the information came from lawyers for three former Homestore executives who pleaded guilty and provided the same information to investigators.

 

The complaint, which adds AOL Time Warner and several other companies as defendants in a previously filed suit against Homestore, portrays two former AOL Time Warner executives — David M. Colburn, head of the AOL division's business affairs department, and Eric Keller, a deputy in the department — as conspiring with their counterparts at Homestore to devise and conceal transactions that overstated the revenue of both companies.

 

AOL Time Warner has dismissed both executives, although it has not provided details about the reasons. Everett C. Johnson Jr., a lawyer for Mr. Keller, and Roger Spaeder, a lawyer for Mr. Colburn, could not be reached. A spokesman for AOL Time Warner declined to comment.

 

In recent weeks, AOL Time Warner has conducted an internal investigation into the accounting at the AOL division, which last month reduced its previously reported revenue for the eight quarters that ended last spring by about $190 million, a tiny portion of its sales. Homestore has acknowledged much more extensive accounting problems in 2000 and 2001.

 

The complaint contends that executives of Homestore and AOL Time Warner invented schemes to inflate revenue of both companies without detection by creating three-way transactions that used bogus advertising buyers as intermediaries. According to the complaint, those transactions took place in the spring of 2001 when AOL Time Warner was in talks about acquiring Homestore.

 

After AOL Time Warner suspended Mr. Keller for his role in similar questionable deals, the complaint contends, other senior executives of AOL Time Warner continued to permit some of the three-way deals to continue for another quarter, even after initially raising concerns.

 

Securities regulators are investigating the dealings of Cendant, the real estate and travel company, with Homestore.com. --- 
http://www.nytimes.com/2002/11/25/business/25CEND.html?ex=1039223264&ei=1&en=b55a66c398cc57fd 

From the AccountingWeb on November 14, 2002 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=96530 
Hit List Picked For Fast-Track FASB/IASB Convergence

Under the tentative game plan for next six months, FASB will examine the topics one at a time and either make the decision to switch to the standard chosen by the International Accounting Standards Board (IASB) or throw the topic back into the hopper for later consideration.

The pivotal question on the decision tree will be: "Is IASB's method better than, or at least as good as, the U.S. standard?" If the answer is "Yes," FASB plans to propose a change to IASB's method. If the answer is "No" or "Needs more study,"” the topic will go back into the hopper until its number comes up again at a later time.

The 17 topics are as follows:

  1. Classification of liabilities upon a refinancing
  2. Classification of liabilities payable on demand due to breach of borrowing agreement
  3. Voluntary changes in accounting principles
  4. Distinction between changes in accounting principles and changes in accounting estimates
  5. Inventories – idle capacity and spoilage costs
  6. Nonmonetary asset exchanges
  7. Financial instruments: disclosure, presentation, recognition and measurement
  8. Interim reporting
  9. Research and development
  10. Discontinued operations
  11. Costs associated with exit or disposal activities
  12. Government grants
  13. Depreciation on assets held for disposal or idle assets
  14. Income taxes
  15. Long-term construction contracts
  16. Financial reporting in hyperinflationary economies
  17. Joint ventures and the proportionate consolidation method

This is one of those projects where the trees are easier to see than the forest. The specific issues up for reconsideration within each of the above topics are apparently already quite well defined. In contrast, the objectives of the project still seem to have some rough edges.

Coantinued at http://www.accountingweb.com/cgi-bin/item.cgi?id=96530  

SmartPros List of Selected Accounting Textbooks --- http://www.smartpros.com/x34694.xml 
This includes accounting for specialists versus non-specialists.

In a surprising and controversial move, accounting standard-setters and regulators in the U.S. and Europe have jointly announced an agreement to stamp out any differences between FASB and IASB standards that may remain by January 1, 2005. http://www.accountingweb.com/item/95087

Global Accounting Rules Will Cut Two Ways --- http://www.smartpros.com/x36045.xml 

Not-for-profit providers that do not hold themselves to the same standard as their for-profit peers risk being perceived as having betrayed the trust of their communities. http://www.accountingweb.com/item/93014 

Although not-for-profit corporations, including hospitals and healthcare systems, are not literally subject to Sarbanes-Oxley, they soon may feel its effects-especially of the governance provisions:

From SmartPros --- http://www.smartpros.com/x35962.xml 

Nov. 13, 2002 (Partner's Report) — Some colleges are reporting increased interest in accounting courses.

Selected examples:

* Emory University's Goizueta Business School (Atlanta) reports that the number of students who signed up for the fall CPA-track senior courses rose by 35%.

* Baylor University (Waco, Texas) has registered about 30% more women students than previously for the introductory accounting course.

* Western Michigan University's Haworth College of Business (Kalamazoo) saw a 13% leap in the number of accounting majors.

What's the explanation for the change? It could be a growing appreciation for what accountants do, in the wake of the recent accounting scandals, said Robert Keith, director of the University of South Florida's School of Accountancy (Tampa).

Another reason: a perception that it is relatively easy to find an accounting job at a good salary in times of economic weakness. Business schools note that the CPA exam is the only professional designation available to undergraduate business students and as a result is believed to provide job seekers a greater edge in a difficult economy.

"The CPA distinguishes a subset of students as having expert-level knowledge in accounting," said Andrea Hershatter, director of the bachelors of business administration program at Emory. "Job prospects for students who complete the CPA track are essentially 100% in both strong and weak economies. There is never a shortage of jobs for qualified auditors."

Source: Reuters.com

From The Wall Street Journal Accounting Educators' Review on November 15, 2002

TITLE: H&R Block's Mortgage-Lending Business Could Be Taxing 
REPORTER: Joseph T. Hallinan 
DATE: Nov 12, 2002 
PAGE: C1 
LINK:  http://online.wsj.com/article/0,,SB103706997739674188.djm,00.html 
TOPICS: Accounting, Bad Debts, Cash Flow, Debt, Loan Loss Allowance, Securitization, Valuations

SUMMARY: H&R Block's pretax income from mortgage operations grew by 146% during the fiscal year ending April 30, 2002. However, the accounting treatment for the securitization of these mortgages is being questioned.

QUESTIONS: 
1.) Describe the accounting treatment used by H&R Block for the sale of mortgages. Why is this accounting treatment controversial?

2.) What alternative accounting methods are available to record H&R Block's sale of mortgages? Discuss the advantages and disadvantages of each accounting treatment. Which accounting method is most conservative?

3.) Why do companies, such as H&R Block, sell mortgages? Why does H&R Block retain the risks of non-payment? How could the sale be structured to transfer the risks of non-payment to the purchaser of the mortgages? How would this change the selling price of the mortgages? Support your answer.

4.) How do economic conditions change the expected losses that will result from non-payment? How does the credit worthiness of borrowers change the expected losses that will result from non-payment? Support your answers.

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

"H&R Block Faces Issues With Mortgage Business," by Joseph T. Hallinan, The Wall Street Journal,  November 12, 2002, Page C1 ---- http://online.wsj.com/article/0,,SB103706997739674188.djm,00.html 

Famous for its tax-preparation service, H&R Block Inc. last year prepared 16.9 million individual income-tax returns, or about 14% of all individual returns filed with the Internal Revenue Service.

But the fastest-growing money maker for the Kansas City, Mo., company these days is its mortgage business, which last year originated nearly $11.5 billion in loans. The business, which caters to poor credit risks, has been growing much faster than its U.S. tax business. In the fiscal year ended April 30, Block's pretax income from mortgage operations grew 146% over the year before. The tax business, while still the largest in the U.S., grew just 23%.

If those rates remain unchanged, the mortgage business will this year for the first time provide most of Block's pretax income. In the most-recent fiscal year, mortgage operations accounted for 47.3% of Block's pretax income.

As Block's mortgage business has soared, so has its stock price, topping $53 a share earlier this year from less than $15 two years ago, though it has dropped in recent months as investors have fretted about the cost of lawsuits in federal court in Chicago and state court in Texas on behalf of tax clients who received refund-anticipation loans. But now, some investors and analysts are raising questions about the foundation beneath Block's mortgage earnings. "The game is up if interest rates rise and shut off the refinancing boom," says Avalon Research Group Inc., of Boca Raton, Fla., which has a "sell" rating on Block's shares.

On Monday, the shares were up $1.53, or 4.8%, to $33.63 in 4 p.m. New York Stock Exchange composite trading -- a partial snapback from a $3.25, or 11%, drop on Friday in reaction to the litigation in Texas over fees H&R Block collected from customers in that state.

The company dismisses concerns about its mortgage results. "We think it's a great time for our business right now," says Robert Dubrish, president and CEO of Block's mortgage unit, Option One Mortgage Corp.

Much of Block's mortgage growth has come because the company uses a fairly common but controversial accounting treatment that allows it to accelerate revenue, and thus income. This treatment, known as gain-on-sale accounting, has come back to haunt other lenders, including Conseco Inc. and AmeriCredit Corp. At Block, gains from sales of mortgage loans accounted for 62% of revenue at the mortgage unit last year.

In essence, under gain-on-sale accounting, lenders post upfront the estimated profit from a securitization transaction, which is the sale to investors of a pool of loans. Specifically, the company selling the loans records profit for the excess of the sales price and the present value of the estimated interest income that is expected to be received on the loans above the amounts funded on the loans and the present value of the interest agreed to be paid to the buyers of the loan-backed securities.

But if the expected income stream is cut short -- say, because more borrowers refinance their loans than expected when the profit was calculated -- the company essentially has to reverse some of the gain, taking a charge.

That is what happened at Conseco. The Carmel, Ind., mobile-home lender was forced to take a $350 million charge in 1998 after many of its loans were paid off early. It stopped using gain-on-sale accounting the following year, saying that the "clear preference" of investors was traditional loan accounting. AmeriCredit in Fort Worth, Texas, which lends money to car buyers with poor credit histories, abandoned the practice in September in the midst of a meltdown of its stock price.

But Block says it faces nowhere near the downside faced by AmeriCredit and Conseco, which it says had different business models. Big Block holders seem to agree. "Block doesn't have anywhere near the scale of exposure [to gain on sale] that the other companies had," says Henry Berghoef, co-manager of the Oakmark Select mutual fund, which owns 7.7 million, or about 4.3%, of Block's shares.

Another potential problem for Block is the way it treats what is left after it sells its loans. The bits and pieces that it keeps are known as residual interests. Block securitizes most of these residual interests, allowing it to accelerate a significant portion of the cash flow it expects to receive rather than taking it over the life of the underlying loans. The fair value of these interests is calculated by Block considering a number of factors, such as expected losses on its loans. If Block guesses wrong, it could be forced to take a charge down the road.

Block says its assumptions underlying the valuation of these interests are appropriately conservative. It estimates lifetime losses on its loan pools at roughly 5%, which it says is one percentage point higher than the 4% turned in by its worst-performing pool of loans. (Comparable industry figures aren't available.) So Block says the odds of a write-up are much greater than those of a write-down and would, in a worst-case scenario that it terms "remote," probably not exceed $500 million. Block's net income for the fiscal year ended April 30 was $434.4 million, or $2.31 a share, on revenue of $3.32 billion.

Block spokeswoman Linda McDougall says gain-on-sale provides an "insignificant" part of the company's revenue. She notes that Option One, Block's mortgage unit, recently increased the value of its residual interest by $57 million. She also says that the company's underwriting standards are typical of lenders who deal with borrowers lacking pristine credit histories.

Bears contend that Block has limited experience in the mortgage business. It bought Option One in 1997, and Option One in Irvine, Calif., has itself been in business only since 1993. So its track record doesn't extend to the last recession of 1990 to 1991.

On top of that, Block lends to some of the least creditworthy people, known in the trade as "subprime" borrowers. There is no commonly accepted definition of what constitutes a subprime borrower. One shorthand measure is available from credit-reports firm Fair, Isaac & Co. It produces so-called FICO scores that range from 300 to 850, with 850 being perfect. Anything less than 660 is usually considered subprime. Securities and Exchange Commission documents filed by Block's mortgage unit show its borrowers typically score around 600. Moreover, according to the filings, hundreds of recent Block customers, representing about 4% of borrowers, have FICO scores of 500 or less, or no score at all. A score below 500 would place an applicant among the bottom 5% of all U.S. consumers scored by Fair Isaac.

Mr. Dubrish says Block stopped lending to people with FICO scores below 500 some two years ago and says he is puzzled as to why those with scores below 500 still appear in the company's loan pools.

Block says its loans typically don't meet the credit standards set by Fannie Mae or Freddie Mac, which are the lending industry's norms. Block's customers may qualify for loans even if they have experienced a bankruptcy in the previous 12 months, according to underwriting guidelines it lists in the SEC documents.

In many cases, according to Block's SEC filings, an applicant's income isn't verified but is instead taken as stated on the loan application. In other cases, an applicant with a poor credit rating may receive an upgraded rating, depending on factors including "pride of ownership." Most Block mortgages are for single-family detached homes, but Block also makes mobile-home loans, according to the filings.

"We are doing a lot to help people own houses who wouldn't have the chance to do it otherwise," Mr. Dubrish says. "We think we're doing something that's good for the economy and good for our borrowers."

A key figure in the mortgage business is the ratio of loan size to value of the property being mortgaged. Loans with LTV rates above 80% are thought to present a greater risk of loss. The LTV on many of Block's mortgages is just under 80%, according to the SEC filings. The value of these properties can be important if Block is forced to foreclose on the loans and resell the properties. Nationwide, roughly 4.17% of subprime mortgage loans are in foreclosure, according to LoanPerformance, a research firm in San Francisco. As of June 30, only 3.52% of Block's loans, on a dollar basis, were in foreclosure, even though its foreclosure ratio more than tripled between Dec. 31, 1999, and June 30.

PricewaterhouseCoopers announced the firm's adoption of what is believed to be the accounting profession's first global code of conduct. This step follows the firm's release of its first-ever "showcase" annual report. http://www.accountingweb.com/item/96764 

Also see http://www.prnewswire.com/cgi-bin/stories.pl?ACCT=104&STORY=/www/story/11-19-2002/0001844104&EDATE= 

From SmartPros --- http://www.smartpros.com/x35996.xml 

SEC: Ernst & Young Violated Rules

Nov. 15, 2002 (Associated Press) — Federal regulators, after an initial failure, alleged for a second time Wednesday that Ernst & Young violated rules designed to keep accountants independent from the companies they audit when it engaged in business with a software company client.

The Securities and Exchange Commission took the action again against the big accounting firm now that there are enough SEC commissioners without a conflict of interest in the case. An administrative law judge at the SEC dismissed it several months ago because only one commissioner had voted to authorize the action.

New York-based Ernst & Young disputed the SEC's allegations, as it did when they were first raised in May. "Our position has remained the same throughout: Our conduct was entirely appropriate and permissible under the profession's rules," firm spokesman Les Zuke said in a statement.

"It did not affect our client, its shareholders or the investing public, nor has the SEC claimed any error in our audits or our client's financial statements as a result of them. The commission's proceedings are focused on consulting, which, because we sold our consulting business in May 2000, is now a moot point," the statement said.

The issue of auditor independence was among those at the heart of the Enron affair, which raised questions about Enron's longtime accountant, Arthur Andersen, having done both auditing and consulting work for the energy-trading company.

Andersen was convicted in June of obstruction of justice for destroying Enron audit documents.

In its administrative proceeding, the SEC said that Ernst & Young was auditing the books of business software maker PeopleSoft Inc. at the same time it was developing and marketing a software product in tandem with the company. Ernst & Young engaged in the dual activities from 1993 through 2000, according to the SEC.

The SEC said the product, named EY/GEMS, incorporated some components of PeopleSoft's proprietary source code into software previously developed and marketed by Ernst & Young's tax department. The SEC alleged that Ernst & Young tried to gain a competitive advantage by putting the source code into its product and agreed to pay PeopleSoft royalties of 15 percent to 30 percent from each sale of the product.

When the case arose in May, there were only three commissioners on the five-member SEC: Chairman Harvey Pitt, Cynthia Glassman and Isaac Hunt. Pitt and Glassman removed themselves from voting on whether to take the action against Ernst & Young because Pitt had represented the firm as a private securities lawyer and Glassman had been an Ernst & Young executive.

That left only Hunt to authorize the SEC attorneys to proceed, prompting the administrative law judge's dismissal.

A new hearing will be scheduled before a law judge to determine whether any sanctions should be imposed on Ernst & Young, the SEC said.

It was the second time the SEC had brought an auditor independence action against Ernst & Young. The firm settled a 1995 action by agreeing to comply with independence guidelines.

Robert Herdman, who resigned as the SEC's chief accountant last Friday in the controversy over the selection of former FBI director William Webster to head a special accounting oversight board, also had been an executive of Ernst & Young before coming to the SEC.

In a similar case, the SEC in January censured another Big Five accounting firm, KPMG, for allegedly violating the auditor independence rules. The agency said KPMG invested $25 million in a mutual fund at the same time it was auditing the fund's books.

KPMG, which was not fined, agreed to the SEC's censure without admitting or denying the allegations and agreed to take measures to prevent future violations.

The SEC adopted the independence rules in November 2000 after a bitter fight between the accounting industry and Arthur Levitt, then the SEC chairman. He and others worried that accountants in some cases had become too cozy with the companies they audited, threatening the integrity of financial reports and undermining investor confidence.

The rules identified several services as inconsistent with auditor independence, including bookkeeping, financial systems design and implementation, human resources and legal services.

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

"Facing the Bear: The 2002 Compensation Survey:  With stock options under scrutiny, companies are once again seeking the elusive link between pay and performance," byTim Reason, CFO Magazine, November 07, 2002 --- http://www.cfo.com/Article?article=8037 

"I'm willing to lay it all on the line in terms of performance." Four years ago, that was what WorldCom's Scott Sullivan — at the time the highest-paid CFO in our compensation survey — told us when he chose a cash bonus over a base-pay increase. Two years later, our biennial survey showed that CFOs were enjoying the fruits of new, CEO-style compensation packages laden with stock options, but also that the booming stock market was rewarding leaders and laggards alike.

How times change. Both Sullivan, now under indictment for securities fraud, and the market have since gone seriously awry. Thanks to the havoc wreaked by both, corporate boards are once again pursuing the elusive goal of tying executive pay more closely to individual company performance. Much of the consequent reshuffling of CFO pay packages will likely involve rethinking the use of stock options, which have become a singular focus of reform efforts.

Much of the consequent reshuffling of CFO pay packages will likely involve rethinking the use of stock options, which have become a singular focus of reform efforts. But CFOs have already felt the pain of the bear market in their short-term pay, according to the 2002 compensation survey, conducted by Mercer Human Resource Consulting. Total CFO cash compensation (salary and paid bonuses) stayed flat this year, averaging $432,400. The lack of growth — a sharp contrast with the 9.6 percent increase the previous year — is testament to frozen salaries and lower or unpaid bonuses, even as other finance functions saw their pay go up. And as the stock market has gone south, "options have also shown significant erosion in value to executives," says Mercer analyst Lee McCullough.

To Have and to Hold It isn't just the market that is eroding the value of options. The features that made them so wildly popular — grants don't affect earnings, and companies get a tax deduction when they're exercised — are under heavy fire. Many companies have already opted to expense them under FAS 123, and the Financial Accounting Standards Board (FASB) now may have the moral clout to win a rematch with Congress, which killed its 1995 effort to require expensing of options. And should expensing become mandatory, options will lose a key advantage over other forms of incentive-based compensation.

None of this suggests that options are going away. Indeed, the survey shows that a slightly higher percentage of CFOs were eligible for stock options this year than last. Options have the benefit of being exempt from Section 162(m) of the Internal Revenue Code, which limits the tax deductibility of cash compensation over $1 million. And serious issues still stand in the way of a universal expensing requirement. In October, FASB issued a draft of rules meant to clarify the process for companies making a transition to expensing from footnote disclosure. But that's an administrative fix that ignores, or at least lags, growing questions among businesses about the accounting problems inherent in expensing options. Without a provision for truing up the estimated "fair-value" expense of options with the actual expense when they are exercised, option expensing in a down economy could ultimately skew the bottom line in much the same way pension gains did during the boom.

Until the accounting and tax-treatment changes, options still carry hefty advantages over stock and cash, argues Jack Dolmat-Connell, vice president of Clark/Bardes Consulting, an executive compensation and benefits consulting firm based in North Barrington, Illinois. And although they are no longer perceived to have unlimited upside, options doled out in a bear market have room to grow. "People say options are dead, cash is king," he says. "That's bunk. Companies aren't in the position these days to give lots of cash."

But turning options into cash may get harder for CFOs. Already it is nominally more expensive. Until the Securities and Exchange Commission clarifies the rules for the Sarbanes-Oxley Act prohibition on corporate loans to executives, most companies have suspended cashless exercise programs, forcing executives to pay the strike price out of pocket or seek financing.

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

November 15, 2002 message from Head, Kate [Khead@ADMIN.USF.EDU] 

I always find these worthy of a read and laugh http://www.cfenet.com/media/follies.asp  
In order to handle the millions of dollars in cash, checks, stocks, and bonds that passed through a stock brokerage firm each week, an employee of the company had to be photographed and fingerprinted. One day, she assisted a nervous walk-in customer, who reluctantly handed the employee a stack of bearer bonds to be placed in various accounts. The poor man nearly jumped out of the chair when the employee's boss passed by and called out, "Your mug shots were good, but they need you to come down for fingerprints again."

(Source: Contributed to Reader's Digest by T. Diane Slatton.)

Kate M. Head, CPA, CIG, CFE 
Audit and Investigation Manager 
USF Office of Inspector General 
PHONE (813) 974-2705 FAX (813) 974-3735 EMAIL Khead@admin.usf.edu 

Fraud Follies from http://www.cfenet.com/media/follies.asp 

Fraud Follies

The business of fraud isn't always serious. Below are some of our favorite funny stories. If you would like to share one with us, please send it to fraudfollies@cfenet.com.

Former New York City Mayor Rudolph Giuliani said he is committed to help turn around WorldCom because WorldCom represents the "biggest challenge" in returning investor confidence in the public markets. http://www.accountingweb.com/item/96772 

Questionable Hardware of the Week (But if it works, all auditors and teachers should carry this Handy Truster device)
Think of the possibilities is you ask if a student is aware of cheating in your class!
Your own personal hand-held lie detector that claims to reveal when someone is telling you a lie over the phone or face-to-face --- http://store.yahoo.com/special-offers/truster.html 

Find out the TRUTH with the World's first Handheld, Portable Lie Detector!  Just ask your question and the Handy Truster will analyze the truthfulness of the response.

 

With the Handy Truster, you can find out if your lover has been faithful, what your co-workers and boss really think, and how honest your friends and family truly are!  


Do you want to know the truth? Just ask! The Handy Truster can be used

Sounds to me like Miss Cleo has formed a new company --- http://www.ftc.gov/opa/2002/02/accessresource.htm 

My new and updated documents the recent accounting and investment scandals are at the following sites:

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 Summary of Suggested Reforms --- http://www.trinity.edu/rjensen/FraudProposedReforms.htm 

Bob Jensen's Bottom Line Commentary --- http://www.trinity.edu/rjensen/FraudConclusion.htm 

The Virginia Tech Overview:  What Can We Learn From Enron? --- http://www.trinity.edu/rjensen/fraudVirginia.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