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


Bob Jensen's Main Fraud Document --- 

Other Documents

Many of the scandals are documented at 

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

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

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

Updates on the leading books on the business and accounting scandals --- 

I love Infectious Greed by Frank Partnoy --- 

Bob Jensen's American History of Fraud ---

Future of Auditing --- 


This is also what happens when Republican's win elections:  Academic Bias at Berkeley
Statisticians release an analysis debunking a previous Berkeley study that said President Bush received more votes than he should have in Florida counties that used touch-screen voting machines.
Kim Zetter. "Florida E-Vote Study Debunked," Wired News, December 8, 2004 ---,2645,65896,00.html?tw=wn_tophead_2 

Two months ago, shortly before Japan ordered Citigroup to close its private banking unit there for, among other things, failing to guard against money laundering, Charles O. Prince, the chief executive, commissioned an independent examination of his bank's lapses. When he received the assessment in mid-October, he got an eyeful.
"It's Cleanup Time at Citi," by Timothy L. O'Brien and Landon Thomas, Jr., The New York Times, November 7, 2004 ---  
Scroll down for details.

A judge refused to accept a guilty plea from a former AOL software engineer accused of selling 92 million e-mail addresses to spammers, saying he was not convinced the act was a crime under new federal antispam legislation.
"Judge Rejects Guilty Plea In America Online Spam Case," The Wall Street Journal, December 21, 2004 ---,,SB110365400892306111,00.html?mod=technology_main_whats_news 

You just can't teach an old dog insurance firm new tricks.
Marsh is collecting $275 million in commissions that regulators have called improper, under an informal pact with Spitzer's office
Monica Langley, "Marsh Collects Disputed Fees Of $275 Million," The Wall Street Journal, November 2, 2004 ---,,SB109934550843461475,00.html?mod=home_whats_news_us 

Corruption is like garbage, it must be removed every day.
Ignacio Pichardo Pagaza

As part of an ongoing effort to improve ethical standards for tax professionals and to curb abusive tax avoidance transactions, the Treasury Department and the Internal Revenue Service have issued final regulations amending Treasury Department Circular 230.  “The playing field for tax advisors has changed with these standards for tax opinions, the new penalties that Congress recently enacted and other steps the IRS has taken to detect and deter abusive transactions,” said Namorato. "Most professionals share our concern about the egregious behavior of some of their colleagues and we appreciate the efforts of responsible practitioners to promote ethical practice. We are taking steps to ensure that all practitioners live up to their professional obligations.”
AccounitngWeb, December 22, 2004 --- 
New Tax Guide Available from the IRS ---,,id=131175,00.html 
Bob Jensen's tax helpers are at 
Bob Jensen's threads on proposed reforms are at 

"Defining roles in prevention of financial reporting fraud," by Ken Tysiac, Journal of Accountancy, November 17, 2014 ---

There is no way to guarantee that an organization will not experience financial reporting fraud.

But research shows that fraud-resistant organizations share three traits:

That’s according to
The Fraud-Resistant Organization, a report released Monday by the Anti-Fraud Collaboration, whose members include the Center for Audit Quality (CAQ), Financial Executives International, The Institute of Internal Auditors, and the National Association of Corporate Directors.

Continued in article

Jensen Comment
One of the problems is that the first trait may make the organization complacent about the other two traits. Exhibit A is Brigham Young University that certainly gets an A+ on the "encouraging an ethical culture" trait. But this made BYU complacent about skepticism and engaging employees in internal controls. Who would have guessed that a financial officer at BYU would pilfer hundreds of thousands of dollars (2002)?

PROVO — Prosecutors say that a former BYU finance officer and his wife used a defunct corporation as a shell to steal hundreds of thousands of dollars in collection fees from the university over several years.

In a preliminary hearing Friday in 4th District Court, deputy Utah County Attorney David Wayment charged that John Davis and his wife, Carol, used an expired corporate name as a front to skim thousands in inflated student fees that were supposed to go to collection agencies.

By the end of the four-hour hearing, Judge James Taylor found probable cause to bind John Davis over on seven counts of theft and one count of racketeering, all second-degree felonies. Taylor, however, found the state lacked enough evidence to prove that Carol Davis knew that potential criminal activity was going on, despite having her name on several bank accounts related to the crime.

Taylor ordered that four counts of theft and one count of racketeering be dropped against Carol Davis.

During the hearing, finance officials with Brigham Young University testified finding strange financial activity involving John Davis, who worked as BYU's supervisor of collections.

Mark Madsen, assistant treasurer over student financial services at BYU, testified of finding several checks requested by John Davis made payable to a company called RCM (Regional Credit Management). Madsen assumed that the company was a collection agency contracted with BYU to collect on outstanding debts from students who had failed to pay their tuition, library fees or parking tickets.

Continued in article

Bob Jensen's Fraud Updates are at

Using 1.700 Stolen IDs
"Virginia woman admits $7.2 million child-credit tax scam," by Kenrick Ward, Fox News, November 25, 2014 ---

More than a year after Watchdog reported the IRS sent thousands refunds to the tiny town of Parksley, Va., a woman has pleaded guilty to conspiracy and mail fraud.

Linda Avila admitted to obtaining more than $7.2 million in refunds by exploiting the federal government’s child tax credit program.

Avila filed more than 1,700 tax returns with stolen identifications used by illegal immigrants, mainly from Mexico.

The Virginian-Pilot reported that Avila, 50, operated a landscaping and cleaning business in Parksley.

Investigators found copies of refund checks in amounts from $4,000 to more than $7,000. The tax returns frequently cited foreign dependents, which increased the refund amounts.

Click for more from ---

Bob Jensen's Fraud Updates are at


CEO Raines, CFO Howard Feel Push From Regulators; KPMG Is Out as Auditor 
Fannie Mae's CEO, Franklin Raines, and Timothy Howard, the chief financial officer, stepped down amid growing pressure from regulators over accounting violations. The mortgage company's board also
dismissed KPMG as outside auditor.
James R. Hagerty, John R. Wilke and Johathan Weil, "At Fannie Mae, Two Chiefs Leave Under Pressure," The Wall Street Journal, December 22, 2004, Page A1 ---,,SB110366339466106334,00.html?mod=home_whats_news_us 

Fannie Mae, which has borrowings of more than $950 billion and is involved in financing more than a quarter of U.S. residential mortgage debt, described the exit of the 55-year-old Mr. Raines as a retirement and that of Mr. Howard, 56, as a resignation. But people familiar with the board's deliberations said directors had decided that both men had to leave to satisfy the company's regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo.

KPMG knew that FAS 91 and FAS 133 were being violated, but KPMG did not insist on correcting the books.  How much of Fannie’s current trouble can be blamed on KPMG?
Fannie's auditor, KPMG, disagreed with the way the company decided how much
(derivatives instruments debt and earnings fluctuations) to book in 1998. The matter was recorded as "an audit difference" -- a disagreement between a company and its auditor that doesn't require a change in the books.

John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up On Fannie's Pugnacious Chief," The Wall Street Journal, December 17, 2004 ---,,SB110323877001802691,00.html?mod=todays_us_page_one 
Bob Jensen's Fannie Mae threads are at 
Bob Jensen’s threads on KPMG’s troubles are at 

FAS 133 says Fannie can't get hedge accounting for non-homongenious portfolios.  Will the SEC let they (and auditor KPMG) get way with it anyway?
Fannie Mae estimated it will have to post a $9 billion loss if the SEC finds it has been accounting improperly for derivatives. Ofheo, the mortgage firm's regulator, said Fannie incorrectly applied accounting rules in a way that let it spread out losses over many years rather than taking an immediate hit.
James R. Hagerty, "Fannie Warns of $9 Billion Loss If Derivatives Ruling Is Adverse," The Wall Street Journal, November 16, 2004, Page A3 ---,,SB110055804528874668,00.html?mod=home_whats_news_us 
Bob Jensen's threads on the Freddie and Fannie derivatives scandals are at 

The mounting pressure on Mr. Raines comes after a career that lifted him from childhood poverty to Harvard Law School, a Rhodes scholarship, and the pinnacle of power in government and finance. For years, the company he leads got its way in Washington, wielding an army of lobbyists and calling on its many friends in Congress and the homebuilding industry. Fighting Fannie was considered futile. "You didn't question the king," says Andrew Cuomo, housing secretary under President Clinton. Fannie, which has about $957 billion of debt, is involved in financing more than a quarter of U.S. residential mortgage debt outstanding
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up On Fannie's Pugnacious Chief," The Wall Street Journal, December 17, 2004 ---,,SB110323877001802691,00.html?mod=todays_us_page_one 
Bob Jensen's Fannie threads are at 

The SEC is probing "numerous" firms including Tyco, Wyeth and El Paso, that participated in the Iraq oil-for-food program.
Mark Maremont and Michael Schroeder, "SEC Seeks Data From Tyco, Wyeth Over Iraq Program," The Wall Street Journal, December 15, 2004, Page A3 ---,,SB110302684842899549,00.html?mod=home_whats_news_us 

The mounting pressure on Mr. Raines comes after a career that lifted him from childhood poverty to Harvard Law School, a Rhodes scholarship, and the pinnacle of power in government and finance. For years, the company he leads got its way in Washington, wielding an army of lobbyists and calling on its many friends in Congress and the homebuilding industry. Fighting Fannie was considered futile. "You didn't question the king," says Andrew Cuomo, housing secretary under President Clinton. Fannie, which has about $957 billion of debt, is involved in financing more than a quarter of U.S. residential mortgage debt outstanding
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up On Fannie's Pugnacious Chief," The Wall Street Journal, December 17, 2004 ---,,SB110323877001802691,00.html?mod=todays_us_page_one 
Bob Jensen's Fannie threads are at 

Fannie's Unethical Tone at the Top:  There's More Wrong Than Just Accounting Fraud
Fannie Mae, eager to unload a batch of fraudulent loans it purchased from a North Carolina lender, knowingly allowed the lender to resell the loans to a government mortgage agency, according to federal law-enforcement officials. A federal judge in Charlotte, N.C., has ordered Fannie Mae to forfeit $6.5 million for not informing the agency about the fraud.

Dawn Kopecki, "Fannie Is Ordered to Forfeit $6.5 Million," The Wall Street Journal, November 30, 2004 ---,,SB110178387928686489,00.html?mod=home%5Fwhats%5Fnews%5Fus 

Unlike recent financial scandals, issues raised by Fannie Mae's regulators pertain to unwieldy accounting rules that are open to widely divergent interpretations.
Timothy L. O'Brien and Jennifer S. Lee (See below)

Creditor claims against Adelphia Communications Corp. total a staggering $3 trillion, or close to 40 percent of the national debt, Dow Jones Newswires reported. But many of the claims pending against the nation's fifth-largest cable company could turn out to be duplicates, and may be more like $18.6 billion.
AccounitngWeb (See below)

Ernst & Young's Chairman and CEO Jim Turley notes in a Wall Street Journal article that Section 404 of the US Sarbanes Oxley Act is a critical step in enhancing investor confidence. He adds that the law entails a major risk in its first year "that the opinions on internal controls provided by management and independent auditors may be misinterpreted by the market." But the bottom line is, "investors will derive significant benefits from the implementation of Section 404. And the markets, in turn, will benefit from the enhanced investor confidence."
E&Y Faculty Connection --- 
Bob Jensen's threads on proposed reforms are at 

Fraud detection can only improve with diligent auditors combined with whistleblowers who are unafraid of retaliation because their rights are protected. According to a survey of members of the Association of Certified Fraud Examiners, less than 20 percent of fraud that is caught is turned up by internal controls versus 40 percent for inside tipsters, the Seattle Times reported.
"Fighting Fraud Calls for Assertive Auditors, Whistleblowers," AccountingWeb, October 4, 2004 --- 
Bob Jensen's updates on fraud detection are at 

Washington's insurance commissioner is seeking millions of dollars from accounting firm Ernst & Young for its alleged neglect in overseeing finances at Metropolitan Mortgage & Securities.  
Washington State Sues E&Y Over Met Mortgage Woes," AccounitngWeb, October 19m 2004 --- 
Bob Jensen's threads on E&Y scandals are at 

AT&T agreed to a $100 million settlement of a suit by shareholders who claimed they were misled about the company's finances.
Shawn Young, "AT&T Settles Suit by Shareholders," The Wall Street Journal, October 27, 2004 ---,,SB109881211718455994,00.html?mod=home_whats_news_us 

Still, the most damaging legacy of Fannie Mae's years of unchecked growth may not be evident until the next significant economic slump. Only then, argued Josh Rosner, an analyst at Medley Global Advisors in New York, will the effects of Fannie Mae's relaxed mortgage underwriting standards be felt. A result could be a more pronounced downturn in the real estate market and more stress on the consumer.
Gretchen Morgenson, A Coming Nightmare of Homeownership?" The New York Times, October 3, 2004 --- 

More bad news for the auditing firm of Deloitte & Touche
The spectre of a fresh scandal to follow the Parmalat affair hung over the Italian financial world as magistrates continued a probe into accounting irregularities at Italy's top construction company Impregilo.  The company said in a statement the investigation by public prosecutors in Monza, near Milan, concerned up to 300 million euros (394.5 million dollars) in credit the company gave to its subsidiary Imprepar, which went into liquidation early last year., November 24, 2004 --- 
Bob Jensen's threads on Deloitte's scandals, including the recent $2 billion lawsuit over its Forest Re audit, are at 

Looking for ways to cut their audit costs in light of rising regulatory demands, some companies are dropping their Big Four accounting firms and deciding the status of Corporate America's version of a Good Housekeeping seal of approval isn't worth the price. All of the Big Four accounting firms -- Deloitte, KPMG, PricewaterhouseCoopers (PWC) and Ernst & Young -- lost more clients than they gained during the first eight months of the year, says Audit Analytics. In two-thirds of the 396 departures, it was the Big Four firm that got the boot.
USA Today,
September 28, 2004, as reproduced by SmartPros --- 

Wiggle Room:  Still Playing Games With Employee Stock Options to Prop Up Earnings
At first glance, the change in assumption is puzzling, because there has been no big rush by Cisco employees to exercise options. But the change could help boost Cisco's bottom line if proposals to treat stock options as an expense are finalized: By assuming a shorter life span for the options, Cisco reduced by more than $300 million the estimated value of the 162 million stock options it granted to employees in August. After taxes, that's about $190 million that Cisco may not have to expense over the next five years.  The incident highlights the flexibility of the assumptions that companies use to value stock options. Accounting experts say companies can alter assumptions -- sometimes in contradictory ways -- to influence the estimated value of the options. The Financial Accounting Standards Board offers guidance on setting those assumptions, but it leaves companies plenty of wiggle room.
Scott Thurm, "Cisco May Profit On New Option Assumptions," The Wall Street Journal, December 7, 2004 ---,,SB110237572102492564,00.html?mod=technology%5Fmain%5Fwhats%5Fnews 
Bob Jensen's threads on the options game are at 

CEO Raines, CFO Howard Feel Push From Regulators; KPMG Is Out as Auditor 
Fannie Mae's CEO, Franklin Raines, and Timothy Howard, the chief financial officer, stepped down amid growing pressure from regulators over accounting violations. The mortgage company's board also
dismissed KPMG as outside auditor.
James R. Hagerty, John R. Wilke and Johathan Weil, "At Fannie Mae, Two Chiefs Leave Under Pressure," The Wall Street Journal, December 22, 2004, Page A1 ---,,SB110366339466106334,00.html?mod=home_whats_news_us 

It just gets deeper and deeper for KPMG, the auditing firm that approved some the Fannie Mae's earnings smoothing with questionable allowance of hedge accounting for speculations under FAS 133 rules.  Fannie's outside auditor, KPMG, certified its results knowing OFHEO's concerns.

OFHEO alleges that Fannie didn't qualify for this break (hedge accounting) because it didn't test whether the derivatives were eligible for such treatment.  Now, OFHEO says Fannie may not use this method (hedge accounting) at all.  Fannie could suffer a $12 billion hit from losses in derivatives, offset by $5 billion in gains, if OFHEO prevails.  But the impact could be greatly diminished if the SEC rules that Fannie can continue to account for derivatives this way if it follows the rules more closely.
Paula Dwyer, "Fannie Mae:  What's the Damage?" Business Week, October 11, 2004, Page 36 ---

Bob Jensen's threads on the Fannie Mae and Freddie Mac scandals are at 
Note that the 2004 scandal is the second time FAS 133 has tripped up Fannie Mae's auditors.

KPMG and the auditors agreed to settle the action without admitting or denying the SEC's findings. As part of the settlement, KPMG was censured and agreed to pay $10 million to harmed Gemstar shareholders. This represents the largest payment ever made by an accounting firm in an SEC action. The auditors, all of whom are certified public accountants, agreed to suspensions from practicing before the SEC.
SEC as quoted at 

Bob Jensen's threads on KPMG scandals are at 

Cynthia Cooper, the former vice president of internal audit at WorldCom who exposed the largest corporate fraud in U.S. history, will lead the list of three new inductees into the 2004 American Institute of Certified Public Accountants' (AICPA) Business & Industry Hall of Fame, an annual event sponsored by staffing services company Ajilon Finance.
SmartPros, October 21, 2004 --- 
Bob Jensen's threads on Worldcom's scandals are at 

Will it ever be possible to prevent Wall Street from becoming rotten to the core without freezing it?

This is a Very Depressing Commentary About Continued Rot

Investors appear to be losing the war with Wall Street
"The Street's Dark Side:  The markets can still be treacherous for investors," by Charles Gasparino, Newsweek Magazine, December 20, 2004 --- 

The hammer came down quickly on Wall Street after the stock-market bubble burst. Regulators and lawmakers, under pressure to avenge the losses of millions of average Americans duped by unscrupulous brokers and corporate book-cookers, imposed swift reforms. Eliot Spitzer, the crusading New York state attorney general, demanded big brokerage firms overhaul their fraudulent stock research (they had been hyping companies that paid them huge investment banking fees). Congress passed the Sarbanes-Oxley Act to tighten up accounting and other standards for corporate behavior. With the reforms in place, Wall Street was again "an environment where honest business and honest risk-taking will be encouraged and rewarded," William Donaldson, chairman of the Securities and Exchange Commission, declared in a speech last year.

Despite the changes, however, Wall Street remains a treacherous place for the small investor. The big financial firms are still rife with conflicts that put their own interests, and those of big banking clients, ahead of everyone else's. (Just last week, for example, Citigroup was fined $275,000 for steering customers to invest in certain Citigroup funds that were "unsuitable'' for them.) Also, watchdog agencies like the SEC, even with bulked-up resources, continue to be ill-equipped to root out corporate crime. And when investors think they've been cheated, the system for ruling on their complaints remains stacked against them. "There are all sorts of practices and conflicts of interest on Wall Street that still have to be addressed, " says John Coffee, a Columbia University law professor.

. . . 

Conflicts (Continued): During the 1990s, brokerage firms, regulators and lawmakers agreed to tear down the legal barriers that forced commercial bankers and investment bankers to operate independently. Wall Street quickly sought out merger partners, creating behemoths like Citigroup and JPMorgan Chase. They touted the convenience of one-stop shopping for consumers. But they also created incentives for staffers in different divisions to steer business to each other that would help the overall company. Spitzer's probe, for example, showed that many research analysts, supposedly peddling objective ratings, were working hand in glove with banking colleagues to win lucrative underwriting business from big corporate clients. The carrot for analysts: their compensation was tied in large part to the banking business they helped win. That's why analysts like Jack Grubman of Salomon Smith Barney told investors that he thought WorldCom was a "buy,'' even as it fell from more than $60 a share down to penny-stock territory.

Spitzer's settlement with Wall Street in 2002 was supposed to establish a higher wall separating banking and research; analysts could no longer work with bankers to pitch to corporate clients, and their pay had to be separated from such deals. But what's really changed? Analysts, under the guise of "due diligence,'' can still meet with executives around the time they're considering which investment bankers to hire. And many Wall Street firms acknowledge that investment-banking fees continue to flow into a pool of money used to pay analysts.

Are analysts' judgments more objective? Consider Google, which went public in August. Morgan Stanley's top Internet analyst, Mary Meeker, has been among Google's biggest boosters. Meeker was not supposed to play a direct role in helping Morgan land a slot to underwrite the IPO. But Morgan confirms that she did talk with Google founders Larry Page and Sergey Brin in meetings and lunches before the IPO. People familiar with the deal say those meetings helped play a big role in helping Morgan land the Google underwriting work. Meeker, along with the other four analysts whose firms underwrote the IPO, have been devoted cheerleaders of the stock, even as it has climbed from its $85 IPO price to above $171, a 101 percent increase in a matter of months. Clearly, it was a great call for those who bought at the outset. But many professional investors are now betting that at these levels, the stock is too pricey and due for a fall (recently the so-called short position on the stock jumped 34 percent in a month). Some Wall Street firms agree, particularly those who weren't part of the IPO underwriting. Morgan officials say that Meeker's call reflects her belief in the stock's potential.

Weak Watchdogs: If Wall Street firms could use a few more walls, the regulators charged with overseeing the firms could use fewer. The task of policing sprawling companies like Citigroup and JPMorgan Chase, which employ hundreds of thousands of people, is difficult enough. But the responsibilities for regulating them are also divided among different agencies—the Federal Reserve oversees banking, while the SEC regulates the securities side. NEWSWEEK has learned a nasty turf battle has erupted between the two agencies. The SEC wanted to examine possible leaks of confidential information from a firm's bank-debt departments to its trading desk. People at the SEC say it could open up a whole new area of insider-trading abuse. Counterparts at the Fed, however, "went nuts," according to a high-level SEC official, and tried to block the exam. SEC chairman William Donaldson conceded in a recent interview with NEWSWEEK that the Fed's mission has at times put it at odds with SEC. Neither agency would comment on the incident. "We're a cop,'' he said, noting that the Fed's main task is to protect the banking system. "We have two different roles," he added.

A more fundamental problem with much of Wall Street oversight is the notion of "self-regulation.'' Because of their limited resources, regulators ask Wall Street firms to police themselves in some areas. Their legal and "compliance" departments, for example, are supposed to provide "frontline'' regulation of their own brokerage departments. It doesn't always work out that way. Just ask Robert Pellegrini, who owns a winery on New York's Long Island. He says lax oversight allowed his financial adviser, Todd Eberhard, to steal about $1.2 million from his brokerage account. Eberhard later pleaded guilty to criminal securities fraud for making improper client trades, and he awaits sentencing that could land him in jail for 25 years. Pellegrini says in an arbitration claim that for several years, UBS PaineWebber processed Eberhard's illegal trades, despite numerous red flags. A simple background check by PaineWebber, his lawyer Jake Zamansky says, would have showed that three other firms refused to clear trades for Eberhard because of customer complaints. Eberhard Investment Advisors was not even registered with the NASD. A spokeswoman for PaineWebber said it "fully complied with its obligations as a clearing firm" and will "vigorously defend the allegations."

Justice Served? When customers like Pellegrini think they've been misled by a Wall Street broker, they have only one option for pressing their claim: to submit to arbitration. (Investors, when they sign up for a brokerage account, effectively sign away their right to use any system to settle a dispute.) But investors complain the deck is stacked against them, because the arbitrators are appointed by the industry, resulting in decisions that often favor the Wall Street firms. Investors won about half their cases last year, for example. Spitzer has said they should be winning more. Speaking before a private meeting of lawyers in Ft. Lauderdale, Fla., two weeks ago, Spitzer, according to a lawyer who was present, said he was frustrated that arbitration panels were blocking the use of evidence of conflicted research that he released as part of his investigation.

Investors appear to be losing the war with Wall Street in recovering money over conflicted research. Attorney Seth Lipner estimates that only 30 percent of all cases alleging that investors lost money because they relied on conflicted research has resulted in an award of money. Lipner blames the terms of the $1.4 billion settlement that Spitzer reached with Wall Street—the firms were allowed to pay the fine and agree to certain structural changes without having to admit guilt for misleading investors. "It has basically allowed arbitration panels to throw cases out," Lipner says. A spokesman for Spitzer says it's up to the courts to determine guilt, and that he simply laid out the evidence so investors could recoup their money. All of which proves that the best defense may be a twist on the old warning: caveat investor.

Regulators are concerned about Wall Street firms tipping off selected investors to information about securities offerings.
"Securities Cops Probe Tipoffs Of Placements," by Ann Davis, The Wall Street Journal, December 16, 2004; Page C1 ---,,SB110315579554001426,00.html?mod=home_whats_news_us 

Regulators are examining whether insiders at Wall Street firms that oversee big securities offerings for corporate clients have tipped off selected investors with valuable information about deals that can cause stock prices to fall.

Two recent cases demonstrate the regulators' concern: Federal prosecutors this week charged a former SG Cowen trader with trading on confidential knowledge that the firm's corporate clients were about to issue millions of dollars of new stock. Last month, the Ontario Securities Commission in Canada accused the Canadian brokerage house Pollitt & Co. and its president in a civil action of tipping off some clients to a pending deal involving bonds that could later be converted to stock. The Ontario authorities also accused one client of acting on the tip.

Regulators also are concerned about inadvertent tip-offs. The Securities and Exchange Commission, the New York Stock Exchange and other regulators are especially worried about information related to corporate stock and bond deals that are executed quickly, sometimes overnight. Such deals require brokerage houses to contact potential buyers to see if they are interested in buying the newly available securities, thereby giving them insider information that could be misused. (See a related article.)

Continued in article

Bob Jensen's threads on proposed reforms are at 

Bob Jensen's "Rotten to the Core" threads are at 

Bob Jensen's fraud conclusions are at 

A Politically Divided SEC:  Why We Can't Trust Government Agencies to Protect US from Big Business

Of all the lawsuits, one filed against Mr. Winnick last October in federal court in Manhattan holds special significance. J. P. Morgan Chase and other leading banks are seeking $1.7 billion in damages from Mr. Winnick and other Global Crossing executives, contending that the group engaged in a "massive scam" to "artificially inflate" the company's performance to secure desperately needed loans. Mr. Winnick, whose lawyers dispute the accusations, declined to be interviewed for this article.  Among other things, the suit refocuses attention on exactly what Mr. Winnick knew about his company's finances during times when it was borrowing heavily and he was selling hundreds of millions of dollars in stock. It also outlines a troubling series of meetings he held with Mr. Lay and other Enron executives just months before their company crumpled.
Timothy O'Brian, "A New Legal Chapter for a 90's Flameout," The New York Times, August 15, 2004 --- 

"SEC Won't Charge, Fine Global Crossing Chairman:  Agency's Donaldson Goes Against Staff, Noting Winnick's Nonexecutive Role," by Deborah Solomon, The Wall Street Journal, December 13, 2004; Page A1 ---,,SB110290635013498159,00.html?mod=todays_us_page_one

The Securities and Exchange Commission won't file civil securities charges against former Global Crossing Ltd. Chairman Gary Winnick over disclosure violations or impose a $1 million fine, according to people familiar with the matter.

The action came despite objections from the SEC's two Democratic members and represents a rare reversal by the commission of its enforcement staff. It also caps a lengthy investigation of Global Crossing, the former Wall Street darling that helped set off a gold rush to capitalize on the Internet boom of the late-1990s.

. . .

The SEC had been expected to fine Mr. Winnick $1 million for failing to properly disclose a series of transactions undertaken by the telecom company, and he had tentatively agreed to pay that sum as part of a settlement agreement. But at a closed-door commission meeting last week, SEC Chairman William Donaldson and his two fellow Republican commissioners, Cynthia Glassman and Paul Atkins, opposed a staff recommendation to charge Mr. Winnick. Mr. Donaldson expressed concern that Mr. Winnick was a nonexecutive chairman and hadn't signed off on the inadequate disclosure, these people said.

This is what happens when Republicans win elections (and I'm a Republican)
The SEC is facing resistance from two Republican commissioners over the stiff fines it has been imposing on companies.
Deborah Solomon, "As Corporate Fines Grow, SEC Debates How Much Good They Do," The Wall Street Journal, November 12, 2004 ---,,SB110021198122471832,00.html?mod=home_whats_news_us 
Bob Jensen's threads on why white collar crime pays (even when you get caught) are at 

It's about time.
The SEC staff is set to propose an overhaul of rules governing how billions of shares trade each day in the U.S. The proposed plan would expand a trading rule to mandate that investors are entitled to the best price for most stock orders on both the NYSE and Nasdaq.
Kate Kelly and Deborah Solomon, "SEC Preps 'Best-Price' Overhaulm" The Wall Street Journal, November 22, 2004 ---,,SB110108697957180493,00.html?mod=home_whats_news_us 

Forget it!  The DC part of Washington DC means Donate Cash
"SEC Loves NYSE," The Wall Street Journal,  December 6, 2004; Page A14

Never underestimate the ability of a bureaucracy to wiggle backward. After many months of heavy breathing, the Securities and Exchange Commission is about to take stock trading back several decades. If you're thinking: Hmmm, this will help the New York Stock Exchange, you're right.

Back in February, the SEC proposed an overhaul of the national market system, called Reg NMS. The idea was to modernize an increasingly laborious and inefficient structure put in place in the 1970s. The main driver for reform, especially from institutional investors who often trade on behalf of smaller investors, was the trade-through rule.

This little bit of regulatory favoritism dictates that traders must do business with the exchange showing the "best" price for a security. It has also long given the New York Stock Exchange, with its auction system of stock specialists on the trading floor, a monopoly on a large amount of trading. Of course, having a monopoly, the NYSE had little incentive to upgrade its trading technology. And it didn't for years. Meanwhile, all sorts of swift, efficient electronic markets were created.

Institutional investors now find that they can trade faster, with anonymity and confidence, on these electronic markets. But the trade-through rule hinders them. The NYSE argues that this rule protects small investors who otherwise might not get the "best" price. In fact, the "best" price on the NYSE is often just a "maybe" price because it can disappear during the 15-30 seconds it takes to execute an order. On electronic venues, however, the price is firm and execution is achieved as soon as the computer key is hit.

The SEC's February proposal stopped short of abolishing the trade-through rule, but it did relax it. The proposal would have allowed traders to ignore the best price within a certain range and granted an explicit opt-out -- investors could give permission to ignore the best price on an order-by-order basis. Essentially, the proposal recognized the virtues of fast, automated markets by giving them trading priority over slow, manual markets.

The NYSE -- the queen of slow markets -- went wild. It aggressively lobbied against the SEC proposal and, in an effort to qualify as a fast market, introduced the first real reform in decades. In a plan unveiled in August, the NYSE has proposed to make itself into a "hybrid" market by expanding its tiny automated system, called Direct Plus.

The new Direct Plus lifts restrictions on size and timing of orders, allows orders that are not immediately executed to be canceled, and permits investors to gobble up or dump a lot of shares in one sweep at multiple prices. Specialists will, however, retain their role. The plan allows for the automatic market to switch into an auction mode if additional "liquidity" becomes necessary -- which sounds as if the NYSE is up to its old tricks. At least the threat of losing its monopoly has, finally, spurred the Big Board into some long-needed changes toward automated trading.

But then came word that the SEC has backpedaled. In a draft scheduled to be voted on this month, the new Reg NMS has dropped the opt-out provision and extended the trade-through rule to Nasdaq. Rumors were that all markets will also be required to display their full depth-of-book -- the entire list of bids and offers -- not just their best price. Simply put, the trade-through rule would not only be retained but would reign supreme. The uproar over this news has been so loud that the SEC has now agreed to put the new rule out for comment before any final vote.

Extending trade-through to Nasdaq is an unnecessary extension of regulatory reach. The SEC itself has admitted that, even without a trade-through rule, Nasdaq offers competitive quoting in actively traded stocks. Moreover, recent academic studies show that there is less volatility on Nasdaq and other electronic trading markets.

The impetus for reforming the national market system was an acknowledgement that both the technology and motives for trading have changed radically in the past 30 years. The practical point was to break the monopoly strictures so that competition among markets would direct order flow to the venues that best suited investors. There is an argument that the NYSE, with its specialists, provides value for trading medium- and low-cap stocks, and no doubt the Big Board will retain its market share if that's the case. But that hardly suggests that trading in the most liquid stocks should be forced into the NYSE.

And so after all this, the SEC has failed to grapple with the central question: Why shouldn't the markets for trading stocks be free to compete on service and innovation? Instead, it looks like the SEC is going to give investors the same-old, very old, story.

Bob Jensen's threads on proposed reforms are at 

Securities regulators are probing whether fund companies directed trades toward firms that lavished them with "excessive" gifts.  SEC, NASD Investigate Whether Securities Firms Gave Excessive Presents
Deborah Solomon, "Probe Focuses on Gifts to Advisers," The Wall Street Journal, November 25, 2004, Page c19 ---,,SB110123997986182154,00.html?mod=home_whats_news_us 
Bob Jensen's thread on securities trading frauds are at 

So where was Levitt before Spitzer did his job?  While heading up the SEC, Levitt always seemed willing to take on the CPA firms, but he treaded lightly (really did very little) while the financial industry on Wall Street ripped off investors bigtime.  It never ceases to amaze me how Levitt capitalizes on his failures.
Forget Enron, WorldCom or mutual funds. The crisis enveloping the insurance industry is "the scandal of the decade, without a question" and "dwarfs anything we've seen thus far."
Arthur Levitt as quoted by SmartPros, October 25, 2004 --- 
Bob Jensen's threads on insurance frauds are at 

Reining in the CPA Hucksters

All the Big Four and other CPA firms were huckstering abusive tax shelters, with KPMG being the worst of the lot --- 

"Auditing-Rule Maker Seeks New Limits On Tax Services," by Jonathan Weil, The Wall Street Journal, December 15, 2004, Page C3 ---,,SB110306143764900061,00.html?mod=home%5Fwhats%5Fnews%5Fus 

The auditing profession's chief regulator unveiled a broad proposal aimed at preventing accounting firms from auditing the books of public companies to which they have sold tax shelters that the Internal Revenue Service deems abusive tax-avoidance schemes.

The proposal by the two-year-old Public Company Accounting Oversight Board also would prohibit accounting firms from selling any tax services at all to senior officers of publicly held audit clients. Until recently, regulators had seen little need to pass significant restrictions on firms' ability to sell tax services to audit clients, believing they created few conflicts of interest. In the past two years, however, several highly publicized controversies have called that premise into question.

Last year, Sprint Corp.'s board forced the resignations of the long-distance company's top two executives after learning that the IRS was challenging tax shelters they had purchased from the company's independent auditor at the time, Ernst & Young LLP. And Senate hearings last year into KPMG LLP's tax-shelter practices revealed numerous examples in which the firm had mass-marketed allegedly abusive strategies to audit clients.

The tax proposal comes on top of Securities and Exchange Commission restrictions, passed in 2000 and 2003, limiting consulting and other nonaudit services by auditors. "This is a time when the most important task of the profession is to restore the investing public's confidence in the quality, integrity and worth of its work on the public's behalf," said William J. McDonough, chairman of the accounting board, which voted 5-0 to submit the proposal for public comment. "The appearance that some in the profession assist corporate and other privileged clients to evade the rules, whether they are tax rules or accounting rules, threatens the restoration of public confidence."

Some auditors began signaling displeasure with the board's auditor-independence initiative on tax services months ago. In a Sept. 22 letter to Rep. Richard Baker, chairman of the House subcommittee that oversees the accounting board, Deloitte & Touche LLP Chief Executive Officer James Quigley said his firm believes the issue should be "addressed by tax regulation, legislation and the courts, rather than through independence regulation with a sole focus on auditors."

Deloitte, Ernst and PricewaterhouseCoopers LLP officials declined to comment on the proposal's specifics yesterday. In a statement, KPMG said that "the proposed rules appear to be balanced and provide a level of clarity concerning what is or is not a permissible tax service."

After a 60-day comment period, the accounting board's proposal is set to take effect in October 2005. Here's a look at the highlights:

Corporate tax shelters: In the future, an accounting firm would be disqualified as a company's independent auditor if it sells the company a tax shelter already included on the IRS's published list of abusive tax-avoidance strategies -- or a shelter substantially similar to an IRS-listed strategy. Generally speaking, the rules wouldn't disqualify auditors in connection with tax services completed before Oct. 20, 2005.

The auditor also would be disqualified if it requires the client to sign a confidentiality agreement barring disclosure of the strategy. Additionally, firms selling tax strategies to audit clients would be disqualified if later found to have lacked a reasonable basis for believing that a given strategy "more likely than not" would pass muster with tax authorities.

Accounting firms also might be disqualified, depending on the circumstances, in other situations where they would be in the position of having to audit their own tax-shelter work. Such situations can arise when a firm sells an audit client a tax strategy that the IRS later adds to its list of abusive transactions and where the strategy's accounting effects have a material impact on the client's financial statements. The accounting board said it would seek further public comments on this point before deciding how to proceed.

Tax services for executives: Yesterday's proposal would impose an outright ban on selling tax services to an audit client's senior officers. Some big accounting firms, including Ernst, have said their clients' audit committees already have cut back substantially on letting them perform such work, in the wake of the Sprint episode.

Firms still would be allowed to sell tax services to an audit client's corporate directors -- even the audit-committee members to whom they report, a point likely to draw criticism from some investors. Additionally, the board decided not to propose a ban on preparing tax returns for audit-client employees working in foreign countries.

Contingent fees: Despite an existing SEC ban on such fee arrangements with audit clients, they remained standard practice until recently at some accounting firms. These firms based their tax-shelter fees on a percentage cut of clients' tax savings. Now, the accounting board says it wants to formally include the contingent-fee ban in its own auditing standards.

Bob Jensen's "Saga of Auditor Professionalism and Independence" is at 

Bob Jensen's threads on proposed reforms are at 

Guess who ultimately ends up paying the $510 million for accounting fraud?

"Time Warner to pay 510-million-dollar fraud settlement,", December 15, 2004 --- 

Time Warner, the world's largest media-entertainment company, said Wednesday it had agreed to pay a total of 510 million dollars to resolve federal probes into accounting irregularities at its America Online (AOL) units.

The company said 210 million dollars would be paid in agreement with the Department of Justice (DoJ), while a further 300-million-dollar penalty would be levied under a proposed settlement with the Securities and Exchange Commission (SEC).

Deputy US Attorney General James Comey said the Justice Department would file a criminal complaint against AOL that charges several employees with securities fraud.

However, the prosecution will be deferred for two years and then dismissed, so long as the company adheres to all stipulations of its deal with the government.

"If AOL fails to comply with the agreement, the deal is off. And they are in a world of trouble," Comey said.

As well as the 210-million-dollar payout, the agreement requires AOL to undertake a wide range of corporate reforms.

The charges levelled against AOL arose out of a scheme to falsify the financial results of a company called Purchase Pro -- a dot-come startup which is now bankrupt.

"As so often happens, during the dot-com bubble days, the revenues that AOL and Purchase Pro were counting on did not materialize, Comey said.

"And instead of confronting that harsh reality, AOL and Purchase Pro cooked up a scheme to inflate Purchase Pro's revenues," he added.

Four former Purchase Pro executives have agreed to plead guilty to felony charges based on their roles in the scheme.

The multi-million dollar settlement incorporates a 60-million-dollar fine and the establishment of a 150-million-dollar fund to settle any related shareholder or securities legislation.

The proposed 300-million-dollar settlement with the SEC would resolve an investigation by the securities watchdog into whether AOL improperly accounted for a 400-million-dollar payment made by German media company Bertelsmann, which used to own 50 percent of AOL Europe.

How can you "PUT" away your cares about clear-cut rules of accounting?

See how AOL did it in conspiracy with Goldman Sachs

With the AOL-Time Warner deal due to close in just three months, Bertelsmann needed to reduce its AOL Europe holding -- pronto. But the obvious buyer, AOL, didn't want to own more than 50% or more of the venture, either. Going above half might trigger a U.S. accounting rule that would force AOL to consolidate all the struggling unit's losses on its books when AOL was already grappling with deteriorating ad revenues and a declining stock price. Enter Goldman Sachs Group Inc. (GS ) Business Week has learned that the premier Wall Street bank agreed to buy 1% of AOL Europe -- half a percent from each parent -- for $215 million. AOL Europe, in return, agreed to a "put" contract promising Goldman that it could sell back the 1% by a specific date and at a set price. That simple transaction solved Bertelsmann's EU problem without trapping AOL in an accounting conundrum -- a perfect solution.

"Goldman's 1% Solution," by Paula Dwyer, Business Week, June 28, 2004 --- 

Goldman's 1% Solution
In 2000, it cut a questionable deal that smoothed the AOL-Time Warner merger. Will the SEC take action?

In more ways than one, the news from the European Union was bad. It was October, 2000, and the EU's executive arm, the European Commission, had just jolted America Online Inc. with a ruling that its pending acquisition of Time Warner Inc. (TWX ) could harm competition in Europe's media markets, especially the emerging online music business. The EC was concerned that AOL was a 50-50 partner with German media giant Bertelsmann in one of Europe's biggest Internet service providers, AOL Europe. Now the EC was ordering Bertelsmann to give up control over AOL Europe.

With the AOL-Time Warner deal due to close in just three months, Bertelsmann needed to reduce its AOL Europe holding -- pronto. But the obvious buyer, AOL, didn't want to own more than 50% or more of the venture, either. Going above half might trigger a U.S. accounting rule that would force AOL to consolidate all the struggling unit's losses on its books when AOL was already grappling with deteriorating ad revenues and a declining stock price.

Enter Goldman Sachs Group Inc. (GS ) Business Week has learned that the premier Wall Street bank agreed to buy 1% of AOL Europe -- half a percent from each parent -- for $215 million. AOL Europe, in return, agreed to a "put" contract promising Goldman that it could sell back the 1% by a specific date and at a set price. That simple transaction solved Bertelsmann's EU problem without trapping AOL in an accounting conundrum -- a perfect solution.


Or so it seemed at the time. But the deal also may have violated U.S. securities laws. The Securities A: Exchange Commission and the Justice Dept. have construed some deals involving promises to buy back assets at a specific time and price as share-parking arrangements designed to mislead investors. The former chief executive of AOL Europe says the Goldman deal may have kept up to $200 million in 2000 losses off of the combined AOL-Time Warner financials -- enough, he says, that Time Warner might have tried to change the terms of the $120 billion merger, since AOL wouldn't have looked as healthy. But as the deal moved toward consummation, the Goldman arrangement was never disclosed in public documents to AOL or Time Warner shareholders.

The AOL Europe transaction threatens to create problems for Goldman Sachs. But it could also prolong the legal headaches of Time Warner Inc., as the AOL-Time Warner combine is now called. For the past two years, Time Warner has been in heated negotiations with the SEC over AOL's accounting for advertising revenues (BW -- June 7). Just as the SEC is wrapping up that case -- it could warn Time Warner as early as this summer that it intends to bring civil fraud charges -- the Goldman transaction raises troubling new questions about AOL's financial dealings prior to the merger.

The SEC has not brought charges over the 1% solution, and an SEC spokesman would not comment on whether the agency is probing the deal. Time Warner spokeswoman Tricia Primrose Wallace says the company will not comment on any part of the Goldman arrangement. A lawyer for Stephen M. Case, AOL's chairman and CEO at the time of the deal, referred questions to Time Warner. Thomas Middelhoff, who was Bertelsmann's chairman at the time of the deal and negotiated the AOL Europe joint venture with Case in 1995, says through a spokesman that the sale of a 0.5% stake was "purely a financial technique" handled by others. And Lucas van Praag, a Goldman Sachs spokesman, says: "We handled this entirely appropriately. We don't believe there is anything untoward here."

Continued in the article

AOL's independent auditor was Ernst & Young.  You can read more about Ernst & Young's woes at 

PCAOB Board Member Doug Charmichael discussed issues of mergers (between such giants as AOL and Time Warner) and independence before the SEC on July 26,  2001 ---  

Will some clients be relegated to risk pools that reluctant auditing firms must serve?  High risk drivers are now assigned to a risk pool that insurance companies must serve (due to state laws requiring insurance) at higher rates even though they would rather not serve at any rate.  The same may happen with high risk clients of accounting firms.

"Big Four Accounting Firms Steering Clear of Risky Business," AccountingWeb, December 14, 2004 --- 

Statistics from research firm Audit Analytics indicate that the Big Four firms are dropping clients at record rates, and the trend is increasing. Since the auditing nightmares at Enron were exposed three years ago, audit firm resignations among the Big Four have increased from 18% of all departures from auditing assignments in 2001 to 34% in 2004. Just in the first three quarters of this year, the Big Four firms have resigned from a total of 157 U.S. audits.

The firms are attributing the resignations to a variety of factors, with limited resources as a result of Sarbanes-Oxley legislation being the most prominent reason. The Sarbanes-Oxley Act of 2002 placed additional burdens on auditors and is leaving accounting firms in a position of having to be more selective in choosing the clients whose audits can be performed most efficiently.

In addition, firms are weeding out clients with risk factors that can affect the reliability of financial statement information. Earlier this fall, PricewaterhouseCoopers resigned from the audit of Pegasus Communications Corp., citing "material weaknesses in the application of accounting principle and policies that led to the restatement of the Company's financial statements," as the reason for the resignation.

A side effect of the Big Four's paring down of its clients is the boon to second tier national firms such as Grant Thornton, BDO Seidman, and McGladrey & Pullen. USA Today reports that many of the companies being booted by the Big Four are turning to these smaller firms and finding a benefit in lower costs and better access to top accounting professionals.

In order to meet the added demands of Sarbanes-Oxley, the Big Four and the smaller accounting firms are scrambling to find and hire talent, which is good news for accountants seeking jobs. It's reported that both the types of jobs available for accountants and the starting salaries are improving. "More of [the accounting graduates] are getting jobs with the better firms than in the past few years," said Edward Ketz, an accounting professor at Penn State's Smeal College of Business. And Robert Half International anticipates starting salaries for auditors to increase from 5 percent to 13.4 percent in 2005.

December 14, 2004 reply from Robert Bowers [M.Robert.Bowers@WHARTON.UPENN.EDU

I feel I must reply here.

For some time I have felt that a CPA's worst nightmare is a crooked client. For audit, tax, whatever.

If I determine that a client is lying to me, I jettison them. They aren't worth the trouble.

But how about analogy to other criminal conduct?

By publishing audited statements, registration with SEC, etc, we are giving corporations access to probably the largest source of capital in the world.

Why not a 3 strikes you're out rule (like DWI for drivers)

Perhaps auditors should maintain a shared database (such as the CLUE report w/ insurance co's)

Whatever is done, I strongly feel the profession should take the lead.

Proper policing and control is OUR responsibility unless we want .... Sarbanes II (shudder)

Come on guys! Either we form a task force and clean things up, or Congress will be only too happy to "reform" things for us!

Bob Jensen's threads on professionalism and fees are at

Cost cutting practice that create moral hazards are discussed at 

The Pension Fund Consulting Racket

Nowhere are the conflicts of interest for financial services conglomerates more potentially lucrative - and more obscure - than in the management of pension assets.

"How Consultants Can Retire on Your Pension," by Gretchen Morgenson and Mary Williams Walsh, The New York Times, December 12, 2004 --- 

Nine years ago, William Keith Phillips, a top stockbroker at Paine Webber, met with the trustees of the Chattanooga Pension Fund in Tennessee to pitch his services as a consultant. He gave them an intriguing, if unusual, choice. They could pay for his investment advice directly, as pension funds often do, or they could save money by agreeing to allocate a portion of its trading commissions to cover his fees. Under a commission arrangement, Mr. Phillips told the trustees, the fund would be less likely to incur out-of-pocket expenses, leaving more money to invest for its 1,600 beneficiaries.

Seven and a half years later, Chattanooga's pension trustees discovered just how expensive that money-saving plan had been. According to an arbitration proceeding they filed against Mr. Phillips, the agreement cost the fund $20 million in losses, undisclosed commissions and fees. And since 2001, Chattanooga has had to raise nearly $3.7 million from taxpayers to keep the $180 million fund fiscally sound.

The Chattanooga trustees fired Mr. Phillips in 2003 and, last October, filed arbitration proceedings against him, UBS Wealth Management USA, formerly the Paine Webber Group, and his new firm, Morgan Stanley. The case, which is pending, accuses the consultant of, among other things, fraud and breach of fiduciary duty. The commission arrangement was central to the problem because it put Mr. Phillips's interests ahead of his client's, the fund said in its complaint.

"The very important and in many ways unique relationship that a pension fund board has with its consultant is based on trust," said David R. Eichenthal, finance officer and chairman of the general pension plan for the city of Chattanooga. "To the extent that Phillips breached that trust, we thought it was important for the pension fund to do everything possible to hold him accountable for the results."

Pension experts say the Chattanooga case is hardly rare among retirement funds. The Securities and Exchange Commission is concerned enough about conflicts of interest among consultants who advise pension funds on asset allocation, selection of money managers and other investment matters that it is conducting an industrywide inquiry. The results of the S.E.C.'s investigation are expected soon, and enforcement actions may follow.

Aubrey Harwell, a lawyer for Mr. Phillips, declined to make him available for this article. Mr. Harwell said: "No. 1, these are allegations and not proven facts. And No. 2, the performance during the days that Keith Phillips was consulting were well beyond the benchmarks." Details of the commission arrangement, he added, were fully disclosed to the pension fund. But this is not the first time a pension client has sued Mr. Phillips. In 2000, the Metro Nashville Pension Plan filed an arbitration based on similar accusations. That arbitration was settled two years later, with UBS paying $10.3 million to the pension fund.

As financial services conglomerates have added a wide array of operations in recent years, the possibility of conflicts of interest has also grown. And nowhere are the conflicts more potentially lucrative - and more obscure - than in the management of pension assets.

"Recommendations to pension funds regarding asset allocation, money manager selection and securities brokerage policies are frequently driven by undisclosed financial arrangements," said Edward A. H. Siedle, president of Benchmark Financial Services Inc., in Ocean Ridge, Fla., and a former lawyer for the S.E.C. "Pensions often accept that poor investment performance is attributable to unfortunate investment assumptions when, in fact, more sinister forces were at work. Investment performance often is compromised as the result of conflicts of interest, undisclosed financial arrangements, excessive fees and fraud."

An estimated $5 trillion sits in thousands of pension funds across the nation, run for the benefit of private company, state or municipal workers who rely on the funds for retirement income. Some funds are huge, with billions of dollars under management, and are overseen by a board of finance professionals. Many, however, are tiny, with just a few million dollars invested. These funds are often run by volunteers less versed in the ways of Wall Street.

Pension fund boards typically hire a consultant to advise them on investment strategies and the hiring of money managers. Problems can crop up when these pension consulting firms, which have a fiduciary duty to the fund, put their own interests first.

JUST as pension funds come in many sizes, so, too, do the consulting firms that serve them. Some are one-person operations while others work within a large financial-services firm. Among the biggest companies in pension consulting are Mercer Inc., a unit of Marsh & McLennan, and Callan Associates, a privately held company based in San Francisco.

In recent years, however, Wall Street firms have played an increasingly large role in the world of pension consulting. Merrill Lynch, Smith Barney and Morgan Stanley are all big in this field.

The potential for conflicts is greatest at firms with brokerage or trading operations, pension authorities say, and it almost always involves how the consultants are compensated.

The trouble is, much of a consultant's pay can be hidden from view. The Chattanooga complaint said Mr. Phillips and his colleagues controlled and manipulated the information given to the pension board, keeping it in the dark about excessive fees and conflicts inherent in the recommendations they made to the fund. Mr. Phillips's reports on the pension fund's performance were misleading, the complaint said, because they did not take into consideration all of the fees and commissions it paid.

Continued in article

Bob Jensen's "Rotten to the Core" threads are at 

Court Defies SEC, Upholds Limitations on Expiring Fraud Claims

Before Sarbanes-Oxley, the law stated that investors who were made aware of fraudulent activities had to file lawsuits against the misbehaving companies within one year of discovering the fraud and within three years of the actual fraudulent activity. 
AccountingWeb, December 9, 2004 --- 

Before Sarbanes-Oxley, the law stated that investors who were made aware of fraudulent activities had to file lawsuits against the misbehaving companies within one year of discovering the fraud and within three years of the actual fraudulent activity. The Sarbanes-Oxley Act of 2002 (SOX) extended the time period for filing claims to two years from the discovery and five years from the fraudulent activity.

Now some investors who have lost money as a result of the many corporate fraud cases that have been discovered in recent years, would like the extended time that SOX allows for filing investor lawsuits to be retroactive. For example, state pension funds in Washington, Georgia, and Ohio that are victims of alleged securities fraud at Enron Corp. in the late 1990s (pre-SOX) cannot file suit against Enron because the statute of limitations has expired. Were the SOX time periods made retroactive, lawsuits could still be filed.

Continued in the article

AICPA Launches Web Site to Promote Audit Quality --- 

In a landscape that has changed dramatically over the past few years by corporate finance scandals, stricter government oversight and regulation, the Center for Public Company Audit Firms provides you the timely, comprehensive technical and educational information you need to conduct high quality audits of SEC issuers.


Learn more about the Center and its mission.


For valuable resources and tools on subjects such as the SEC, PCAOB, and Sarbanes-Oxley, click on the Resources tab.


The saga of auditor professionalism and independence --- 

Bob Jensen's threads on proposed reforms are at 

Gallop's Honesty and Ethics Poll
Business executives, accountants, and stockbrokers are all rated lower than last year and lower than their historical averages.  Business executives have always been rated low.  Perceived ethics of the accounting profession has taken a huge hit in the past decade.

"Effects of Year's Scandals Evident in Honesty and Ethics Ratings Businesspeople, clergy ratings decline; nurses again top the list," by Jeffrey M. Jones, Gallup News Service, December 4, 2002 --- 

The effects of scandals in the business world and the Roman Catholic Church are apparent in Gallup's annual update of the public's ratings of the honesty and ethics of professions. Business executives, accountants, and stockbrokers are all rated lower than last year and lower than their historical averages. Ratings of the clergy took a significant hit this year as well, falling from 64% to a historical low of 52%. Nurses are once again the most highly rated profession, while telemarketers and car salesmen are at the bottom of the honesty and ethics scale.

Details are only available to paid subscribers.

Nurses Top List in Honesty and Ethics Poll Gallup's annual survey on the honesty and ethical standards of various professions finds nurses at the top of the list, as they have been in all but one year since they were first added to the poll in 1999. More generally, this year's honesty and ethics poll shows that Americans continue to give their highest ratings to the public service professions, like the military, teachers, and members of the medical profession. Public protectors also rate highly. The lowest rated professions tend to be those connected with sales or big business, lawyers, elected officeholders, and reporters.

"Nurses Top List in Honesty and Ethics Poll Grade," by David W. Moore, Gallup News Service, December 8, 2004 --- 

PRINCETON, NJ -- Gallup's annual survey on the honesty and ethical standards of various professions finds nurses at the top of the list, as they have been all but one year since they were first added to the poll in 1999. Almost 8 in 10 Americans, 79%, give the nurses a "very high" or "high" rating, down slightly from 83% last year. In 2001, shortly after the Sept. 11 terrorist attacks, nurses were topped by firefighters, who received a very high/high rating from 90% of Americans.

More generally, this year's honesty and ethics poll shows that Americans continue to give their highest ratings to the public service professions, like the military, teachers, and members of the medical profession. Public protectors also rate highly. The lowest rated professions tend to be those connected with sales or big business, lawyers, elected officeholders, and reporters.

Grade school teachers come in second this year, given a very high/high rating by 73% of respondents, followed by pharmacists and military officers, who are tied at 72% each. Not all professions are asked every year, and this is the first year that "grade school teachers" have been included as a separate item. In prior years, Gallup asked about "grade school and high school teachers," which received significantly lower average ratings (59%) than what grade school teachers got this year. When Gallup asked about "high school teachers" in isolation in 2002, they received a very high/high ethical rating of 64% -- lower than the 73% for grade school teachers in isolation that was measured in this poll. This suggests that people have a higher opinion of grade-school teachers than high school teachers. Also, each group receives higher ratings when evaluated alone than when evaluated together.

Medical doctors come in next on the list at 67%, followed by policemen (60%), clergy (56%), judges (53%), and daycare providers (49%). Lowest on the list are car salesmen (9%) and advertising practitioners (10%). Lawyers (18%) and congressmen (20%) are only a little higher in rank.

3. Please tell me how you would rate the honesty and ethical standards of people in these different fields -- very high, high, average, low, or very low? First, ... Next, ...[RANDOM ORDER]

% Saying
"Very High/High"






















Grade school teachers








Druggists, pharmacists








Military officers








Medical doctors
































Day care providers
















Auto mechanics








Local officeholders








Nursing home operators








State officeholders








TV Reporters








Newspaper reporters








Business executives
























Advertising practitioners








Car salesmen







Politicians typically fare somewhat poorly in this survey. Local and state officeholders each score in the 24% to 26% range, about where senators and governors have scored in previous years.


Bob Jensen's threads on the accounting and finance scandals are at 


Although somewhat dated, Corporate Scandal provides a nice summary of many of the recent scandals --- 

"Judge Upholds Sarbanes-Oxley In Scrushy Fraud Case," AccounntingWeb, December 1, 2004 --- 

Arguments that the Sarbanes-Oxley corporate reform law is unconstitutionally vague did not convince a federal judge, who has rejected Richard Scrushy's claims in his HealthSouth fraud case. Attorneys for Scrushy, HealthSouth's former chief executive, said the law should not be part of the indictment accusing him of fraud, the Associated Press reported. U.S. District Judge Karon O. Bowdre said jurors - not a judge - should decide central questions raised in the case.

"If the jury finds that the reports did not fairly present, in all material aspects, the financial condition and results of operations of HealthSouth, the jury must then determine whether Mr. Scrushy willingly certified these reports knowing that the reports did not comport with the statute's accuracy requirements," she wrote.

Continued in the article

Bob Jensen's threads on the Health South and E&Y scandal are at 

Coke:  Gone Flat at the Bright Lines of Accounting Rules and Marketing Ethics
The king of carbonated beverages is still a moneymaker, but its growth has stalled and the stock has been backsliding since the late '90s.  Now it turns out that the company's glory days were as much a matter of accounting maneuvers as of marketing magic. 
Guizuenta's most ingenious contribution to Coke, the ingredient that added rocket fuel to the stock price, was a bit of creative though perfectly legal balance-sheet rejeiggering that in some ways prefigured the Enron Corp. machinations.  Known inside the company as the "49% solution," it was the brain child of then-Chief Financial Officer M. Douglas Ivester.  It worked like this:  Coke spun off its U.S. bottling operations in late 1986 into a new company known as Coca-Cola Enterprises Inc., retaining a 49% state for itself.  That was enough to exert de facto control but a hair below the 50% threshold that requires companies to consolidate results of subsidiaries in their financials.  At a stroke, Coke erased $2.4 billion of debt from its balance sheet.
Dean Foust, "Gone Flat," Business Week, December 20, 2004, Page 77.  
This is a Business Week cover story.
Coca Cola's outside independent auditor is Ernst & Young

There were other problems, some of which did not do the famed Warren Buffet's reputation any good.  See "Fizzy Math and Fishy Marketing Lawsuit, Probes Prove Damaging to Coke," by Margaret Webb Pressler, Washington Post, June 20, 2003 --- 

Coca Cola's marketing tactics were unethical and unhealthy for kids --- 

Also see "The Ten Habits of Highly Defective Corporations," From The Nation --- 

Two TIAA-CREF trustees quit amid SEC pressure over a business venture they formed with Ernst & Young, the firm's auditor  Note that one of them a the famous academic professor in mathematical economics and finance from MIT.  Steve Ross is probably best known for his writings on Arbitrage Pricing Theory (APT) --- 

Also note that, two the firm's credit, Ernst & Young reported this violation of auditor independence to TIAA-CREF.  My question would be why an auditing firm would engage in such a venture in the first place even if there was no conflict of interest with a client.  Ernst and Young was already in a deep hole with the SEC before this conflict of interest came to the attention of the SEC.

"Venture Snares TIAA-CREF, Ernst," by Jonathan Weil and JoAnn S. Lublin, The Wall Street Journal, December 3, 2004; Page A8 ---,,SB110204504468490286,00.html?mod=home_whats_news_us 

Two TIAA-CREF trustees have resigned amid pressure by the Securities and Exchange Commission over a business venture they formed last year with Ernst & Young LLP, the investing titan's independent auditor, in violation of SEC auditor-independence rules.

The nation's largest institutional investor, which manages $325 billion in assets, plans to disclose the resignations of William H. Waltrip and Stephen A. Ross in an SEC filing today, people familiar with the matter said.

The episode is likely to be a major embarrassment to TIAA-CREF, among the world's leading corporate-governance activists, and Ernst. This year the audit firm was suspended by the SEC from accepting new publicly held audit clients for six months over a business partnership it entered during the 1990s with PeopleSoft Inc., a former audit client.

According to federal auditor-independence rules, outside auditors are prohibited from forming business ventures with audit clients, including their executives, board members or trustees. According to people familiar with the matter, the SEC has agreed to allow Ernst to conclude its audit for this year, but TIAA-CREF will put its audit out for bidding by other firms next year and likely will hire a different accounting firm. Ernst has been TIAA-CREF's auditor for about seven years.

A board of overseers presides over TIAA-CREF's structure, which includes two other boards of trustees, one for the Teachers Insurance & Annuity Association of America and one for the College Retirement Equities Fund. Mr. Waltrip was a TIAA trustee, and Mr. Ross was a CREF trustee.

On Aug. 1, 2003, Ernst entered into an agreement with a company owned by Messrs. Waltrip and Ross, called Compensation Valuation Inc. Mr. Ross was CVI's chief executive and majority owner. Ernst formed the venture with the two trustees' company to sell services that help businesses determine the value of corporate stock options. Ernst paid the company $1.33 million, according to people familiar with the matter.

Ernst notified certain TIAA-CREF officials and the SEC about the independence violation Aug. 9, these people said. Aug. 20, the trustees' company ceased operations. However, the trustees' company wasn't actually dissolved until Nov. 17, and members of the TIAA-CREF board of overseers weren't told about the auditor-independence problem until this week, angering some of them, people familiar with the matter said.

Mr. Ross is a finance professor at Massachusetts Institute of Technology and a director at Freddie Mac. Mr. Waltrip is the former chairman of Technology Solutions Co. Neither man returned phone calls yesterday. Their resignations took effect Nov. 30. A TIAA-CREF spokeswoman, Stephanie Cohen-Glass, declined to comment yesterday. In a statement, Ernst said the firm had identified the matter itself and confirmed that it notified TIAA-CREF and the SEC. The Big Four accounting firm said it is "in the midst of implementing new independence procedures and identifying any client issues," but declined to discuss specifics.

Messrs. Waltrip and Ross were powerful trustees who played important roles in the recruitment of Herbert M. Allison Jr., the former Merrill Lynch & Co. president who became the huge fund's chairman, president and CEO in November 2002. Mr. Waltrip was chairman of the search committee, of which Mr. Ross was a member.

Continued in the article

TIAA-CREF Brass Failed to Inform Key Panel About Improper Deal With Ernst, Its Outside Auditor

The SEC's chief accountant, Donald Nicolaisen, last week told TIAA-CREF that Ernst could complete its 2004 audit, but that he would be very upset if it rehires Ernst for its 2005 audit, people close to TIAA-CREF said.  The saga marks yet another embarrassment for Ernst and its chairman and CEO, James Turley. In April, the SEC suspended the Big Four accounting firm from accepting new audit clients for six months because of a 1990s business venture with audit client PeopleSoft Inc. Under the SEC's auditor-independence rules, accounting firms aren't permitted to form business ventures with audit clients, including their officers, directors or trustees.
"TIAA-CREF Faces Question On Governance," by Jonathan Weil and Joann S, Lublin, The Wall Street Journal, December 6, 2004, Page C1 ---,,SB110229989626191715,00.html?mod=home_whats_news_us 


TIAA-CREF, a longtime standard bearer for the corporate-governance movement, now has a governance mess of its own, sparked by two trustees' improper business deal with outside auditor Ernst & Young LLP and a decision by the investing titan's top brass not to promptly inform the fund's powerful board of overseers about the problem.

The conflict centers on a contract that the two TIAA-CREF trustees entered into with Ernst in August 2003 to jointly sell valuation services for corporate stock options, in violation of federal auditor-independence rules. Last week, the two trustees resigned, amid pressure from the Securities and Exchange Commission's office of chief accountant. Separately, the SEC's enforcement division has opened an inquiry into the events surrounding the violation, people familiar with it say.

TIAA-CREF Chairman and Chief Executive Officer Herbert M. Allison Jr. knew about the independence violation as of Aug. 9, when Ernst first notified the company and the SEC. However, before late last week, he had informed only one of his six fellow members on TIAA-CREF's star-studded board of overseers about the matter. The panel is one of three boards at TIAA-CREF that share control of the nation's largest pension system, which manages $326 billion of assets for 3.2 million people.

TIAA-CREF's general counsel, George Madison, on Friday said the other two boards' trustees were told in August and that, under TIAA-CREF's unique corporate structure, Mr. Allison wasn't obligated until last week to notify the full board of overseers. Messrs. Allison and Madison did tell Stanley O. Ikenberry, the president of the board of overseers, in September. But Mr. Ikenberry didn't tell the other overseers either, among them, former SEC Chairman Arthur Levitt.

Instead, Mr. Ikenberry's colleagues were left in the dark until Thursday, one day before TIAA-CREF disclosed the violation in SEC filings. Corporate-governance activists long have pushed for companies to disclose any significant bad news as early and widely as possible.

Through a TIAA-CREF spokesman, Mr. Allison said: "I, along with my management team, continue to work for the best interests of the participants and our institutions to strengthen TIAA-CREF for the competitive challenges we are facing." He declined to comment further.

The saga marks yet another embarrassment for Ernst and its chairman and CEO, James Turley. In April, the SEC suspended the Big Four accounting firm from accepting new audit clients for six months because of a 1990s business venture with audit client PeopleSoft Inc. Under the SEC's auditor-independence rules, accounting firms aren't permitted to form business ventures with audit clients, including their officers, directors or trustees.

The SEC's chief accountant, Donald Nicolaisen, last week told TIAA-CREF that Ernst could complete its 2004 audit, but that he would be very upset if it rehires Ernst for its 2005 audit, people close to TIAA-CREF said.

Continued in Article

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

Bob Jensen's threads on frauds are at 

December 7, 2004 message from Ernst & Young

Happy Holidays from Ernst & Young!

Please click or copy and paste the address below into your web browser for a holiday greeting:

Another Audit Client Dumps Ernst & Young


"Best Buy to Dismiss Auditor Ernst, Citing Conflict of Interest," by Jonathan Weil, The Wall Street Journal, December 31, 2004, Page C1 ---,,SB110441683676412888,00.html?mod=todays_us_money_and_investing 

Best Buy Co. said it is dropping Ernst & Young LLP as its outside auditor next year, citing a conflict of interest stemming from a business relationship between the Big Four accounting firm and a former Best Buy director.

The nation's largest electronics retailer said its dismissal of Ernst will take effect upon the completion of its audit for the fiscal year ending Feb. 26, 2005. The Richfield, Minn., company said it will put work on its fiscal 2006 audit out for bids sometime next year.

The move by Best Buy is the latest in a series of recent auditor-independence controversies for Ernst. In April, the Securities and Exchange Commission imposed a six-month suspension on the firm, during which Ernst was barred from accepting new publicly held audit clients. The SEC case centered on an improper joint venture with former audit client PeopleSoft Inc. In her decision imposing the suspension, the SEC's chief administrative-law judge, Brenda P. Murray, wrote that Ernst "had no procedures in place that could reasonably be expected to deter violations and assure compliance with the rules on auditor independence with respect to business dealings with audit clients."

Since that decision, under an SEC-mandated independent review of its dealings with audit clients, Ernst has notified dozens of clients of auditor-independence violations, though few have been deemed serious enough to warrant Ernst's dismissal. The violations have included improperly taking custody of clients' cash when performing tax work overseas and engaging in direct business relationships with audit clients, among other things.

Generally, SEC rules prohibit direct business relationships between accounting firms and their audit clients, including officers, directors and trustees. The one exception is where a firm is acting as a consumer in the ordinary course of business.

This month, officials at TIAA-CREF, a large institutional investor that also is a prominent corporate-governance activist, said the fund probably would drop Ernst next year, once its 2004 audit is because of a business relationship that the accounting firm entered into last year with two of the fund's trustees. Both the TIAA-CREF and Best Buy matters remain the subjects of SEC inquiries.

In an SEC filing yesterday, Best Buy said its dismissal of Ernst was directly related to the May 4 resignation of Mark C. Thompson from the company's board. Mr. Thompson, a "leadership development" consultant and former Charles Schwab Corp. executive, was a member of Best Buy's audit committee from 2000 through 2003.

In a May 14 SEC filing disclosing Mr. Thompson's resignation, Best Buy said neither Ernst nor Mr. Thompson had disclosed their business relationship to the company until May 4. Ernst paid Mr. Thompson $377,500 plus expense reimbursements from December 2002 to April 2004, according to Best Buy filings. Ernst's payments to Mr. Thompson stem from audio interviews he conducted with leading corporate executives, industry executives and Ernst's own executives for the accounting firm's marketing materials. In regulatory disclosures, Best Buy has said Mr. Thompson had a "personal service agreement" with Ernst.

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

The executives who gave their external auditors low grades don't rate so high themselves!

"Few Audit Committees Are Implementing Key Practices, According to Report," AccountingWeb --- December 1, 2004 --- - Dec-1-2004 - As audit committees struggle implementing the requirements of Sarbanes-Oxley, fewer than one-third implement a majority of practices that lead to higher ratings of the financial audit process, according to the J.D. Power and Associates 2004 Audit Committee Best Practices Report(SM) released this week.

The report is a comprehensive, independent study of audit performance in the wake of the Sarbanes-Oxley Act of 2002, which established new compliance and procedural requirements for corporate financial accountability of public companies. The report, based on interviews with 1,007 audit committee chairs and 944 chief financial officers, examines audit committee practices and confidence levels in the accounting industry.

"Audit committee chairs are now feeling the weight of increased accountability while experiencing some confusion regarding what compliance exactly looks like," said Ron Conlin, partner at J.D. Power and Associates. "This has translated into a good deal of stress. Audit committees are seeking information that will assist them in strengthening their oversight process and improve committee effectiveness. However, understanding which practices work best continues to be a challenge for audit committees."

The report documents that while audit committees have improved compared to 2003, significant challenges remain.

Several practices being performed by audit committees are directly linked to higher performance ratings of audit firms and increased industry confidence. Examples of best practices include:

More frequent meetings between the audit committee and the external auditor improve performance ratings by the audit chair. External auditors who meet with the audit chair seven or more times per year receive the highest ratings. Most audit committees meet five or more times annually with the external auditor. Compared to 2003, audit committees of both small and large companies are meeting more frequently.

Excluding management from some meetings also increases ratings with the audit process. The majority of companies that meet four to six times annually frequently exclude management.

Audit committee chairs who spend between 16 and 20 hours annually attending audit committee meetings rate the audit experience higher than those spending fewer than 16 hours. Conversely, ratings begin to drop once the number of hours attending audit committee meetings exceeds 20. "Understanding audit committee practices is essential because the best practices, when applied, result in higher ratings of the audit process, which directly relates to confidence in the accounting industry," said Conlin. "More than 86 percent of respondents who give high ratings to their audit firms also say they are extremely or very confident in the accounting industry. However, only 31 percent of those who give their audit firms low ratings record the same levels of confidence in the industry." The J.D. Power and Associates Audit Committee Best Practices Report is based on the experiences and opinions of 1,951 audit committee chairs and chief financial officers at SEC-listed companies who were surveyed between July and October 2004. 

The report can be purchased at 

Bob Jensen's threads on proposed reforms are at 

Laying it on the Line at Enron (or getting Layed at Enron, Lay It on the Line, Lay's Chip Getting Bagged)

"Enron Inquiry Turns to Sales by Lay's Wife," by Kurt Eichenwald, The New York Times, November 17, 2004

Federal prosecutors are investigating whether the wife of Enron's former chairman, Kenneth L. Lay, engaged in insider trading in a sale of company stock shortly before it collapsed into bankruptcy, people involved in the case said yesterday.

The sale by Mr. Lay's wife, Linda, involved 500,000 shares of Enron stock and was done through a family foundation, according to records and people involved in the case. The proceeds, totaling $1.2 million, did not go to the Lays, but were distributed to charitable organizations, which had already received pledges of contributions from the foundation.

Already, several Enron officers, including Mr. Lay; Jeffrey K. Skilling, a former chief executive; and Richard L. Causey, the former chief accounting officer, have been indicted on fraud charges. Other executives including Andrew S. Fastow, the former chief financial officer, have pleaded guilty to crimes and are serving as government witnesses.

By focusing on the transaction involving Mrs. Lay, the government could be trying to turn up the pressure on her husband in hopes of securing a guilty plea. Prosecutors used such tactics against Mr. Fastow, by starting an investigation into a comparatively minor tax violation committed by his wife, Lea.

People involved in the case said that Mr. Fastow was offered the opportunity to prevent his wife from being charged by pleading guilty; at the time he refused. Mr. Fastow did not reverse himself until his wife was indicted; she also pleaded guilty and is serving a prison term.

Andrew Weissmann, head of the Justice Department's Enron Task Force, declined to comment yesterday. A lawyer for the Lays, Michael Ramsey, confirmed the investigation, and criticized it as trying to criminalize innocent behavior to bring pressure against Mr. Lay.

"This is the last gasp of a dying prosecution,'' Mr. Ramsey said. "This is an attempt at extortion. If I tried something like this, I would be indicted.''

He said that the sale was based on information in the market and that the proceeds went to charity. Neither Ken nor Linda Lay sold any personal shares that morning, he said.

The investigation of Mrs. Lay is focusing on Nov. 28, 2001, the day investors realized that Enron was probably heading for bankruptcy.

That morning, Mrs. Lay placed an order for the foundation to sell its Enron shares sometime between 10 and 10:20, people involved in the case said. For days up until that morning, Enron had been negotiating a possible merger with a rival, Dynegy, and details of the talks had been leaking out in media reports.

The evening before, people involved said, Chuck Watson, then chairman and chief executive of Dynegy, told Mr. Lay and others at Enron that he had doubts about the merger. While Mr. Watson agreed to consult with his board and his merger team before reaching a decision, the prospects for a deal were dim.

Records show that Mr. Lay returned home that night and was in the office early the next morning. The government is investigating whether he told his wife about the falling prospects for the merger before she placed the sell order.

Before the market opened that morning, there were already rumors of problems with the deal. The news emerged at about 10:30 a.m., when Standards & Poor's announced that it was cutting its credit rating for Enron. That put Enron on the hook for making good on some $3.9 billion in debt in a matter of months.

The market reacted swiftly, knocking Enron shares down by more than $1.50 a share. Shortly after the market became aware of the downgrade, Enron shares were selling at $2.60 to $2.70, according to a transcript of a CNNfn market news broadcast that morning. Brokerage records from First Union Securities, where the foundation maintained its account, show that the shares were sold at $2.38, for proceeds of about $1.2 million. Enron shares closed at about 60 cents that day.

While the timeline of events is difficult for Mrs. Lay, the case presents numerous hurdles for the government. The largest of those is that the Lays did not profit from the sale; while their charitable group, the Linda and Ken Lay Family Foundation, did not have the assets to meet its pledges, the obligation for those commitments would remain with the foundation, not the family. Records show that, in the months after the sale, the proceeds were given away.

The second difficulty is evidentiary. If Mr. Lay did inform his wife of the imploding merger, such communication is protected as a marital confidence and its disclosure cannot be compelled. That means that the government must find a third-party witness who heard from Mr. or Mrs. Lay about any discussion to prove that she had insider knowledge at the time of the trade.

Continued in article

Tattle Tale Games Lawyers Play:  Skilling Seeks to Name Names
Former Enron Corp. President and CEO Jeffrey Skilling is trying to pull dozens of ex-colleagues and business associates into the public glare of his criminal conspiracy case. The move sheds light on both the breadth of alleged fraud at the fallen energy giant and the legal strategy of Mr. Skilling.

"Lawyers for Enron Ex-President Ask Judge in Case to Make Public List of 114 Alleged Co-Conspirators," by John R. Emshailler, The Wall Street Journal, December 10, 2004, Page C1 ---,,SB110264771262096639,00.html?mod=home_whats_news_us 

Former Enron Corp. President and CEO Jeffrey Skilling is trying to pull dozens of ex-colleagues and business associates into the public glare of his criminal conspiracy case. The move sheds light on both the breadth of alleged fraud at the fallen energy giant and the legal strategy of Mr. Skilling.

Attorneys for Mr. Skilling have asked Houston federal judge Sim Lake to make public the names of 114 people who the government alleges in a sealed document were co-conspirators.

Mr. Skilling and his co-defendants, former Enron Chairman Kenneth Lay and former Chief Accounting Officer Richard Causey, are charged in a wide-ranging federal conspiracy indictment stemming from Enron's collapse into bankruptcy proceedings in December 2001. Prosecutors allege that Mr. Skilling, indicted earlier this year, "spearheaded" the conspiracy. All three have pleaded not guilty; a trial date hasn't been set.

Mr. Skilling's attorneys, who like the other defense attorneys have a copy of the list, say it includes former Enron officials -- likely including former Chief Financial Officer Andrew Fastow and others who already have pleaded guilty to some Enron-related crimes -- and individuals from some of the big financial institutions, law firms and other businesses with which Enron fostered close ties. The majority haven't been charged with any Enron-related crimes.

Prosecutors have cited federal confidentiality rules in keeping the 114 names under seal, in a typical move in such cases. The rationale for the rules is that even individuals accused of participating in a criminal conspiracy have a right to privacy if they haven't been formally charged.

But Mr. Skilling's legal strategy rests partly on broadly defending Enron's business practices while portraying federal prosecutors as overzealously criminalizing commonplace and legitimate business practices.

In a recent court filing, Mr. Skilling's attorneys argued that by keeping sealed 114 names the government hopes to avoid scrutiny of how "inherently implausible" it is to assert that such a large number of successful, law-abiding individuals could "participate in a vast criminal conspiracy."

Continued in the article

Bob Jensen's threads on the Enron scandal are at 

"WorldCom Case Against Banks To Go to Trial," by Diya Gullapalli, The Wall Street Journal, December 16, 2004; Page C4 ---,,SB110315786738701568,00.html?mod=technology%5Fmain%5Fwhats%5Fnews 

In a decision that threatens to keep the underwriters of two bond offerings from WorldCom Inc. embroiled in litigation, a federal judge yesterday rejected a motion to dismiss a class-action case by the remaining defendants.

While the firms said they had relied upon auditor Arthur Andersen LLP's clean bill of health on WorldCom when selling the bonds, the judge said the underwriters should have done their own legwork to size up the telecommunications company, which filed for bankruptcy after a massive accounting fraud.

Continued in the article

Bob Jensen's threads on the Worldcom fraud are at

At least 55% are being "honest."
In a speech to an audience of business leaders, students and the media at the Millenium Biltmore, Quigley
(Deloitte and Touche CEO) said compliance with the new laws and regulations is required but will not be enough. The new age demands "principle-centered leadership and a values-based approach to individual action." Quigley summarized a survey of high school students conducted in conjunction with Junior Achievement. In the survey, students were asked "would you act unethically if you were sure you would never be caught?" Fifty-five percent of the students responded "yes," or "they were not sure."
SmartPros, "Deloitte CEO Outlines Direction for 'New Age of Accountability'," November 18, 2004 --- 

What grades do nearly 2,000 clients give to their outside auditors?

Nothing higher than a low C average.  The marks of all Big Four firms are shown below.

"Auditing The Auditors," Business Week, November 22, 2004, Page 160 --- 

In a world informed by the accounting scandals that engulfed Enron (ENRNQ ), Time Warner (TWX ), Freddie Mac (FRE ), and other formerly trusted giants, J.D. Power & Associates is now evaluating the very audit firms that are supposed to protect investors from such improprieties. And it's a report card no grade-schooler would want to take home to Mom and Dad.

Power surveyed nearly 2,000 chief financial officers and audit committee chairmen, asking them to rate auditing firms on 13 traits essential to reviewing the books properly. Among larger companies, Deloitte & Touche gets top marks, Ernst & Young comes in second, and PricewaterhouseCoopers and KPMG are third and fourth. But even at No. 1, Deloitte can't exactly celebrate. Out of a possible 1,000 points, it got 734, or roughly a "C." KPMG, which ranked last of the big firms, barely passed with a 673. Among smaller companies with under $1 billion in sales, Grant Thornton International and BDO Seidman LLP finished on top, with the smaller firms getting points for industry and company knowledge.

Most worrisome, only 44% of those surveyed said they were "extremely" or "very" confident in the accounting profession, down from 53% last year. Ron Conlin, the J.D. Power partner who headed up the survey, blames the fact that auditors are expected to do more work these days to comply with Sarbanes-Oxley and are getting stretched too thin. Auditors reached for comment say they're committed to boosting quality.

Deloitte did well largely because its most senior personnel handle its largest clients, and its auditors have the deepest knowledge of each customer's business and industry. Conlin, who hopes to sell the report to the audit firms, says there is a strong correlation between auditors that clients say ask the toughest questions and those that got the highest scores. That sounds good, but how would Enron's CFO and audit chair have rated their auditor?

Bob Jensen's threads on on how poor quality audits have become routine are at 

Bob Jensen's threads on scandals in the large auditing firms are tracked at 

Is this professor being ethical?
In one such case, the U.S. steel company Nucor Corp. hired Peter Morici, a business professor at the University of Maryland, to argue in favor of steel tariffs put in place by the Bush administration. As a debate raged in 2003 about whether the steel tariffs should be kept in place, Mr. Morici, a former chief economist at the International Trade Commission, was quoted in scores of newspaper articles and wrote about two dozen letters to editors. He was most active in promoting his research showing that tariffs benefited the domestic steel industry and economy. In the vast majority of cases his role as a paid consultant to Nucor wasn't disclosed.
Michael Schroeder (See below)

"Some Professors Take Payments To Express Views," Michael Schroeder, The Wall Street Journal, December 10, 2004, Page B1

If a professor takes money from a company and then argues in the media for a position the company favors, is he an independent expert -- or a paid shill?

It's not an academic question. Some companies have been paying professors to promote their points of view on TV shows, in newspaper and magazine articles and in letters to the editor. In many cases the arrangement between the professor and the company isn't disclosed.

In one such case, the U.S. steel company Nucor Corp. hired Peter Morici, a business professor at the University of Maryland, to argue in favor of steel tariffs put in place by the Bush administration. As a debate raged in 2003 about whether the steel tariffs should be kept in place, Mr. Morici, a former chief economist at the International Trade Commission, was quoted in scores of newspaper articles and wrote about two dozen letters to editors. He was most active in promoting his research showing that tariffs benefited the domestic steel industry and economy. In the vast majority of cases his role as a paid consultant to Nucor wasn't disclosed.

While it's difficult to ascertain how widespread the practice is, several Washington-based public-relations executives privately acknowledge that they routinely pay academics to speak on behalf of companies or issues, usually hiring experts who already espouse a certain viewpoint. A particularly popular tool is for PR firms to ghost-write opinion pieces to run on newspaper editorial pages and then solicit experts to lend their name to the articles.

Not all academics who speak out for company positions are paid for doing such work. When they are, the money changes hands either by direct cash payment or indirectly through sponsorship of an academic conference or contributions to a university.

The academics argue that there's nothing wrong with working with PR firms or interest groups when the opinions expressed match their views. In addition, they regard their newspaper quotes or opinion articles as a good plug for their research or university.

Continued in the article


"Infineon Officials Get Prison Time In Antitrust Case," by Matthew Karnitschnig, The Wall Street Journal, December 3, 2004, Page A9 ---,,SB110201181195389382,00.html?mod=technology%5Fmain%5Fwhats%5Fnews 

In a further sign that the U.S. is taking a hard line on criminal antitrust cases, four senior Infineon Technologies AG executives agreed to serve prison terms and pay hefty fines for their role in a scheme to fix prices in the computer-memory-chip market, the Department of Justice said.

Under their plea agreement, the four agreed to pay $250,000 (€187,675) each and serve prison times between four and six months. The four, all vice presidents, include three Germans, Heinrich Florian, Peter Schaefer and Günter Hefner, and one American, T. Rudd Corwin.

The plea agreement is the latest twist in a Justice Department investigation into what officials say was a global conspiracy to fix prices in the $16 billion market for random-access memory chips, which are used in a wide range of products, including personal computers, digital cameras and game consoles. Officials said the probe would continue.

"This case reinforces our commitment to investigate and hold accountable all conspirators, whether domestic or foreign, that harm American consumers through their collusive conduct," said R. Hewitt Pate, assistant attorney general in charge of the department's antitrust division. "True deterrence occurs when individuals serve jail terms, and not just when corporations pay substantial criminal fines."

Continued in the article

Bob Jensen's threads on corporate governance are at 

Deloitte Got Lost in the "Forest"
Deloitte faces a potential $2 billion legal claim over audits of Forest Re, an aviation reinsurer that failed after 2001's terror attacks.

"Deloitte Faces $2 Billion Claim Over Audits of Reinsurance Firm," by Mark Maremont, The Wall Street Journal, November 11, 2004, Page A1 ---,,SB110012218459670519,00.html?mod=home_whats_news_us 

In a case that shows how the insurance industry's woes could spread to its auditors, Deloitte & Touche LLP faces a potential $2 billion legal claim related to the type of earnings-management insurance products that are the subject of government investigations at other companies.

The dispute involves Deloitte's audits of Fortress Re Inc., a closely held North Carolina insurance company. Fortress, which specialized in reinsurance for aviation risk, collapsed after the Sept. 11, 2001, terrorist attacks. Two Japanese insurers that had relied on Fortress to minimize their risk with additional insurance charge that its use of unconventional coverage and its fraudulent accounting resulted in an estimated $3.5 billion in total losses for them and for a third insurer that was forced into bankruptcy. Deloitte denies any liability in the dispute.

The case, which is entering court-ordered mediation this week, could be one of the most troublesome legal claims Deloitte faces. The accountant also is being sued in connection with its audits of Italy's scandal-plagued Parmalat SpA and cable-TV firm Adelphia Communications Corp.

In the broad crackdown on corporate fraud of recent years, the trail often has led to legal problems for auditors. Arthur Andersen LLP essentially dissolved after being convicted of criminal behavior in connection with its audits of Enron Corp.

The current probes into the insurance industry are at a relatively early stage, but they already have touched on the accounting profession. The Securities and Exchange Commission, the Justice Department and New York Attorney General Eliot Spitzer recently have launched investigations into the industry's use of products similar to those involved in the Deloitte case.

Last year, now-defunct Andersen was faulted by an Australian government investigator for an "insufficiently rigorous" audit in connection with the 2001 collapse of HIH Insurance, Australia's largest bankruptcy. Andersen wasn't directly blamed in the case, in which Australian authorities found that "audacious" and suspect insurance transactions played a role in the bankruptcy.

Continued in article

Bob Jensen's threads on Deloitte's scandals are at 

"S.E.C. Names 8 in Kmart Accounting Case," by Eric Dash, The New York Times, December 2, 2004

The Securities and Exchange Commission brought accounting fraud charges yesterday against three former Kmart executives and five representatives of companies that supplied Kmart with brand-name products.

Federal regulators accused the Kmart executives of prematurely booking promotional allowances from suppliers like Coca-Cola Enterprises, PepsiCo and Eastman Kodak, allowing it to increase profits for the fourth quarter of 2001 by $24 million. Representatives of at least four companies selling to Kmart participated in the accounting scheme, the complaint said, by furnishing misleading documents and making side agreements that hid the true nature of their deals from Kmart's auditors and investors.

Five of the eight people named in the complaint have reached separate settlements with the S.E.C., each accepting civil penalties of up to $55,000 without admitting or denying wrongdoing. The others said that they should not be named in the complaint, which raised questions about six separate financial arrangements.

"There are lots of nuances to these cases, but the message is the same: the conduct should not happen," said Cheryl Scarboro, an assistant director in the S.E.C.'s enforcement division. "Kmart could not do this without the help of these vendors."

Continued in the article

U.S. companies must do a far better job of disclosing financial information, the chief of a federal accounting oversight board said Thursday.
SmartPros, November 5, 2004 --- 

U.S. companies must do a far better job of disclosing financial information, the chief of a federal accounting oversight board said Thursday.

"Some companies are doing the right thing and some business groups are saying the right thing," William McDonough, the chairman of the Public Company Accounting Oversight Board, told a conference of the Securities Industry Association.

But he added that "vastly more needs to be done, and soon."

McDonough, a former president of the New York Federal Reserve Bank, began his speech by saying "potential accounting abuses at public companies are still a threat to public trust."

With a Nov. 15 deadline for meeting financial reporting requirements under the Sarbanes-Oxley Act, McDonough said that now is the time to start thinking about how investors will react to auditors' assessments of companies' "internal controls."

Internal controls are procedures a company must have in place to make sure financial data like assets and transactions is correctly reflected on its statements.

The audit board was created by the Sarbanes-Oxley Act in the wake of Enron's 2001 and WorldCom's 2002 collapse. Accounting fraud forced both the corporate debacles.

The board essentially audits company auditors to make certain financial information is accurately represented and investors get a clear picture of a given company.

Several corporations have struggled to meet the demands of the Sarbanes-Oxley Act, and McDonough appeared to predict that some will not meet them by the deadline.

"I am encouraging executives to begin considering now their responses to deficiencies within their companies' internal controls -- not just in making plans to correct those deficiencies, but in deciding how to communicate those corrections to investors and the larger public that relies on transparency in our markets," he said.

Bob Jensen's conclusions on the future of accounting are at 

"Givers and Colleges Clash on Spending," by Greg Winter and Jonathan Cheng, The New York Times, November 27, 2004 ---  

Ever since he sued the University of Southern California for fraud four years ago, accusing it of misusing his $1.6 million gift for biological research on aging and then lying about it, Paul F. Glenn has put his beneficiaries on a short leash.

He still gives, but he tries not to call it that. Instead, he likes to say that he strikes deals with universities for the betterment of humanity, then polices them with all the ardor of a businessman who has been burned, badly.

"We were assuming the honesty and integrity of everyone involved," said Mr. Glenn, who settled his case against U.S.C. this year. "We now know that there's got to be a quid pro quo here. This is not a donation. It's a contract, and both parties have to live up to it."

In the genial world of university fund-raising, clashes between donors and beneficiaries are rare, and such public animosity is rarer still. But in recent years a few noisy disputes at major universities like Yale and Princeton - where $600 million is at stake -have had a powerful effect on the fund-raising game, prodding donors to become more vigilant and universities to become unusually careful about accepting gifts at a time when institutions are particularly hungry for them.

"Universities have rightly paid close attention to these cases," said John Lippincott, president of the Council for Advancement and Support of Education, which represents college fund-raisers. "Even though they may be few and far between, they are not situations that any university would want to face."

To avoid them, colleges and donors are drawing up painstaking agreements to prevent future disputes over how the money should be spent. Instead of turning over the entire gift at once, donors like Mr. Glenn sometimes parcel it out over time, with regular checkups along the way. Universities are often equally exacting, in hope of keeping down unrealistic expectations of how much power a benefactor might have.

In its most recent $2.6 billion fund-raising campaign, for example, Duke tried to make it clear that no matter how generous donors were, they would not be able to orchestrate how the university was run - a central point of contention in donor clashes at Yale in the mid-1990's and at Case Western Reserve two years ago.

"We all watch, and we learn from these things," said John Burness, a spokesman for Duke.

The universities recognize that they are dealing with a new breed of philanthropists who are demanding a more active role in shaping the outcomes of their gifts, a result both of their entrepreneurial wealth and an emerging belief that institutions need to be scrutinized more closely.

In the dispute with the University of Southern California, for instance, Mr. Glenn accused the university of surreptitiously withholding his money from a researcher he wanted to support while spending it on another one whom he considered ineligible.

"Too often, it was that the universities wanted alums or donors to put up and shut up," said Anne Neal, president of the American Council of Trustees and Alumni, which was formed in 1995 after Yale agreed to return a $20 million gift from Lee M. Bass, a billionaire alumnus. "There's a feeling that that was inappropriate, that in fact there was absolutely nothing wrong for a donor to insist that their intent was followed."

At the same time, universities are under growing pressure to raise money for as general a purpose as they can manage. Donations to educational institutions dropped last year for the second year in a row, though universities say the economy, not any bad blood, is to blame.

Beyond that, university endowments have shrunk in recent years, while expenses have grown. Having money set aside that colleges can use in any way they please not only eases that pressure, but it also improves their creditworthiness at a time when university debts are soaring.

"We're reaching more of a crossroads than we've been at in the past," said Richard A. Raffetto, a managing director at the Bank of New York. "Universities want to be more and more vague about how they use money, but donors want their agreements to be less and less vague." Some battles have a way of outlasting the original combatants. In the four decades since Charles and Marie D. Robertson gave Princeton $35 million to prepare graduate students for government service, the gift has romped through a series of investments and blossomed into a $600 million fund that dwarfs the entire endowments of most other universities.

The Robertsons have since died, but their children want the money back. All of the $600 million - and then some.

Bob Jensen's threads on governance are at 

Some executives who long dreamt of seeing the title "Chief Financial Officer" on their business cards are starting to wonder why they ever wanted the job in the first place. The CFO job, thanks to regulatory changes and a push for greater accountability in corporate America, has changed dramatically over the last few years.  The CFO job, thanks to regulatory changes and a push for greater accountability in corporate America, has changed dramatically over the last few years. More scrutiny, more pressure, a huge workload and the stress that goes along with it are causing some professionals to leave the fancy title behind, the New York Times reported.
AccountingWeb, November 30, 2004 --- 

"Where Have All the Chief Financial Officers Gone?," by Claudia H. Deutsch, The New York Times, November 28, 2004 ---  

It took Thomas B. Sager 17 years and five employers to attain his dream of becoming a chief financial officer; it took him five years and two chief finance posts to realize that he did not like the job. "I got tired of spending years defending strategies I knew were flawed, of working with values that weren't my own, of being responsible to chief executives and boards that were under huge pressure to perform," he said.

Two years ago, Mr. Sager, 45, quit as the chief financial officer of Zoots, a national chain of dry cleaners, and bought Tri-Valley Sports, a small sporting goods business in Medway, Mass., eight miles from his home.

Kenneth S. Goldman loved being a chief financial officer, a role he played at six companies over 20 years. But his next-to-last employer, Student Advantage, fell apart during the dot-com implosion. He had a "difference of philosophies" with the chief executive of Lodestar, his last employer. And he watched with dismay as a growing number of chief financial officers "fell on their swords" in the post- Enron glare of regulatory scrutiny.

In July 2002, Mr. Goldman became an investment banker at Mirus Capital Advisors. He has several clients, so he does not feel the pressure to be loyal to one boss at all costs. He can eat dinner with his children more often. And he is not in a harsh public spotlight.

"Every C.F.O. has been pushed at times to take something that is clearly black and white and color it a shade of gray," Mr. Goldman, 46, said. "But when the chief executive is shot at, he uses the chief financial officer as a human shield. Being a C.F.O. has become one of the riskiest jobs in America."

The push for better ethics and transparent accounting in corporate America, including the drive to pass the Sarbanes-Oxley law in 2002, has had an unexpected side effect: more finance chiefs are calling it quits.

"Coping with the pressures of Sarbanes-Oxley even as they try to guide companies through a recession has put an enormous strain on C.F.O.'s and their staffs," said Julia Homer, editor in chief of CFO magazine.

It has also taken the fun out of the job. "Sarbanes-Oxley has turned C.F.O.'s into scorekeepers rather than players, and they just can't be strategic anymore," said Eleanor Bloxham, co-president of the Corporate Governance Alliance, a consulting firm in Westerville, Ohio.

E. Peter McLean, a vice chairman at Spencer Stuart, the executive search firm, said that this year through mid-November, 62 chief financial officers at Fortune 500 companies had left their jobs; by year-end, he expects that total to reach nearly 70, a number that would mirror last year's. Over the last three years, more than 225 C.F.O.'s of the Fortune 500 companies have left.

Continued in the article

November 28, 2004 reply from David Fordham, James Madison University [fordhadr@JMU.EDU

Bob, as much as it might ruin my (dubious) reputation on this list, I have to agree wholeheartedly with you. This sad situation is exactly why I'm the thorn in this list's paw today!

My only comment is: this isn't news.

It was 1989, when I was CFO at one of North America's top ten packaging companies (now bought out and defunct), when I resigned upon being asked to "make a mistake" in the accounting records to overstate earnings so that the company would be eligible for a Canadian government bond guarantee.

The board of directors of the private company suggested I make a mistake in the depreciation tables which would result in overstated earnings on the UNauditied financials. These would be submitted to the government the week after the fiscal year-end, the bond guarantee would come through a couple of weeks later, after which I was to "discover" the error, and fix the books before the auditors arrived to perform their detailed testing about 60 days after closing.

"This isn't really lying, because you'll fix the books before the auditors see it, and everyone is warned that these are unaudited financials and subject to correction," was the justification I was given in the 9:00 am meeting.

I had cleaned out my desk before lunchtime.

(For those with an unsatiable curiosity, no, my successor and his successor and his successor all refused, too, as did the CFO's of the Scottish, Australian, and South Africa affiliates, whereas the Canadian, English, and Scandinavian affiliates all agreed... probably more because of the individuals involved than the national cultures. The bond issue never went through, so the pursuit of the guarantee was dropped.)

Although I gave up a six-figure salary, company car, and five-figure expense account (and a six-figure bonus (in 1989 dollars!) had I agreed!), the end justifies the means: I went back to the company a year later just to say "hi" to some of my employees, and found out that of the nine men (the board) who had sat around the table a year earlier, two were in Canadian prison -- for fraud and embezzlement related to OTHER companies (not mine!) that they were directors of. Four more had left the company, and two were under investigation, again for activities unrelated to my company.

The former CFO of the Canadian holding company, the last I heard, was working as a clerk in a video rental store in Toronto!

These were closely held companies, not publicly-traded ones. They were getting in trouble for falsification of the books to obtain governmental funding, or more accurately, governmental guarantees of funding. The company never defaulted, to the best of my knowledge, but just the whole attitude that it is "okay" to do this soured me on working for such people.

I fully intended to find another CFO job, but the first three interviews I had convinced me that these sort of attitudes were commonplace (remember, this was back in 1989!) and my naivete about it was embarrasssing.

Contemporaneous with this situation, I had a very touching event with my five-year-old son, which convinced me I needed a job with more predictability. So I figured I'd go into academe where (silly me!) I figured that the quality of individual ethics would be a little higher.

Guess we all make mistakes, don't we!

David Fordham

Bob Jensen's threads on corporate governance are at 

More on How Large Stock Brokerages are Rotten to the Core:   

Morgan Stanley
Merrill Lynch
Ameritrade Holdings
Charles Schwab

E.Trade Financial Corp. 

The Securities and Exchange Commission is looking at brokerage firms suspected of failing to get customers the best stock prices, people briefed on the inquiry said.
"SEC said to eye broker trading," CNN Money, November 8, 2004 --- 

The Securities and Exchange Commission is investigating about a dozen brokerage firms that may have failed to obtain the best price for stocks traded for customers, the New York Times reported Monday, citing people briefed on the inquiry.

The brokers under scrutiny include Morgan Stanley (down $0.03 to $53.75, Research), Merrill Lynch (up $0.22 to $56.42, Research), Ameritrade Holdings (Research), Charles Schwab (up $0.10 to $9.72, Research) and E.Trade Financial Corp. (down $0.25 to $13.19, Research), the report said.

Regulators are looking specifically at the way these companies traded Nasdaq-listed stocks during early morning trade, the report said.

After examining trading data from the last four years, the investigation found evidence that trades were often processed in ways that favored the firms over their clients, the Times said, citing unnamed sources.

The newspaper's sources said regulators are examining two methods of executing trades known as internalization and payment for order flow.

Internalization is when a broker executes an order from securities in its own account rather than from a market order. Payment for order flow occurs when retail brokers send aggregated small orders to market makers. In some instances, some stock exchanges or market makers will pay for routing the order

Bob Jensen's rotten to the core threads are at 

I vote for monetary fine in place of time outs!

"Wall St. Turns to the Time Out as Punishment," by Jenny Anderson, The New York Times, December 8, 2004 --- 

Regulators are wielding a new weapon against Wall Street firms in the hope that it might hurt more than multimillion-dollar fines: temporarily shutting down certain business lines.

Last week, NASD prohibited Merrill Lynch and Wachovia Securities from registering brokers for five business days on top of fining the firms: $1.6 million for Merrill Lynch and $650,000 for Wachovia. Each firm had failed to report to NASD on-time information including customer complaints, regulatory actions and criminal charges and convictions about its brokers. Twenty-seven other firms were charged with the same late reporting, but Merrill and Wachovia faced the five-day suspension for both the sheer number of reporting violations as well as the two firms' track record of regulatory actions.

Merrill and Wachovia were not the first to incite the regulators' ire over late reporting. In July, Morgan Stanley was fined $2.2 million for being late with more than 1,800 incidents of late reporting about its brokers. NASD imposed a five-day suspension for registering new brokers, saying in a public statement that the severity of the punishment was related to the number of late filings and the fact that the tardiness impaired its ability to conduct other investigations. Wachovia, Merrill and Morgan Stanley all agreed to the sanctions while neither admitting nor denying the allegations.

Continued in the article

Bob Jensen's threads on white collar crime and punishment (or lack thereof) are at 

In the largest civil settlement in United States history (prior to 1998), a federal judge on November 9, 1998 approved a US$1.03 billion settlement requiring dozens of brokerage houses (including Merrill Lynch, Goldman Sachs, and Salomon Smith Barney) to pay investors who claimed they were cheated in a wide-spread price-fixing scheme on the NASDAQ.
Wikipedia ---

From Orange County to Enron and Beyond
Whenever a huge financial scandal surfaces, more often than not Merrill Lynch pays up.
Eliott Spitzer once said that his smoking gun could have shot Merrill completely out of the water if the economic consequences would not have been so enormous.  When will Merrill ever clean up its act?
A jury has convicted four former Merrill Lynch executives and a former Enron finance executive for helping push through a sham deal to pad the energy company's earnings
"5 Executives Convicted of Fraud in First Enron Trial," The New York Times,
November 3, 2004 --- 

Two months ago, shortly before Japan ordered Citigroup to close its private banking unit there for, among other things, failing to guard against money laundering, Charles O. Prince, the chief executive, commissioned an independent examination of his bank's lapses. When he received the assessment in mid-October, he got an eyeful.
"It's Cleanup Time at Citi," by Timothy L. O'Brien and Landon Thomas, Jr., The New York Times, November 7, 2004 ---  

Citibank CEO blames incompetent auditors!
Dismissed Former Executive Says Auditors Failed to Flag Problems in Japanese Operations  

"Citigroup's Jones Denies Blame," by Mitchell Pacelle, The Wall Street Journal, November 19, 2004, Page C1 ---,,SB110081710259278531,00.html?mod=home%5Fwhats%5Fnews%5Fus 

Thomas W. Jones, one of the three top Citigroup Inc. executives dismissed last month, accused his former employer of unfairly holding him accountable for a private-banking scandal in Japan.

"Do I feel there's anything more I could have done?" asked Mr. Jones, former chief executive of Citigroup investment and asset-management units, in reference to the private-banking problems in Japan. "The answer is 'no.' "

In an interview, Mr. Jones, dressed in a dark, pin-striped suit, attributed the regulatory actions in Japan to problems that stretched across business lines, and said that Citigroup auditors in New York had failed to flag the problems for him and other executives at the financial-services firm's Park Avenue headquarters.

"Given the responsibilities and seniority of the three individuals, it was appropriate for each of them to leave the company," a Citigroup spokeswoman responded. "The decision was made after a thorough and thoughtful review that was supported by, among other things, the work of an independent, outside adviser." She declined to comment further on Mr. Jones's comments.

In September, Japanese regulators yanked Citigroup's private-banking license and charged the company with violations ranging from failure to implement safeguards against money laundering to misleading customers about the risks of investments. The then-head of Citigroup's global private bank, Peter Scaturro, reported to Mr. Jones.

On an Oct. 19 internal memorandum, Chief Executive Officer Charles Prince said that Messrs. Jones and Scaturro and Vice Chairman Deryck Maughan would leave Citigroup. In announcing the departures, Citigroup said nothing about the involvement of the three executives in the problems in Japan. But people familiar with the dismissals linked the departures to the report on the private-banking problem, which was prepared by former U.S. Comptroller of the Currency Eugene Ludwig.

The 55-year-old Mr. Jones said the report by Mr. Ludwig's Promontory Financial Group attributed the Japan problems to a host of factors, including Citigroup's overall control structure. Mr. Jones said his name came up in Mr. Ludwig's report only in two footnotes, and didn't appear at all in a Citigroup filing to Japanese regulators that identified "responsible" managers.

Continued in article

Bob Jensen's threads on banking scandals are at 

Insurance Scandal Updates

AIG said it would pay $126 million and unveil four years of transactions to a reviewer under a tentative accounting settlement.
Theo Francis, "AIG to Pay $126 Million in Deals With Federal Prosecutors, SEC," The Wall Street Journal, November 26, 2004, Page C3 ---,,SB110130661333082996,00.html?mod=home_whats_news_us 

Under terms paralleling those of other recent financial-sector settlements, American International Group Inc. said its tentative pacts with federal prosecutors and securities regulators will cost it $126 million and require it to unveil four years' of transactions to an outside reviewer.

AIG said Wednesday that it expects a subsidiary to pay an $80 million "penalty" to the Justice Department to settle criminal inquiries into the New York insurer's dealings with PNC Financial Services Group Inc. and Brightpoint Inc. In addition, AIG would pay $46 million into a disgorgement-of-fees fund at the Securities and Exchange Commission to settle that agency's civil inquiry into the PNC transactions.

An "independent consultant" agreed upon by both agencies and AIG will "review certain transactions entered into between 2000 and 2004" to determine if the buyers used them to violate accounting rules or "obtain a specified accounting or reporting result," the insurer said. AIG also must establish a "transaction review committee," overseen by the reviewer. The terms disclosed by AIG are similar to those reported in The Wall Street Journal on Wednesday.

Bob Jensen's threads on insurance corruption are at 

HANK GREENBERG IS BEING investigated by U.S. prosecutors as to whether the AIG chairman manipulated the insurer's share price in 2001 to save money on its deal for American General. AIG said that it reached tentative settlements with the Justice Department and SEC over transactions that allegedly helped clients commit accounting fraud.
Kate Kelly and Kara Scannell, "Hank Greenberg Probed By U.S. Over Stock Deal," The Wall Street Journal, November 24, 2004, Page C1 ---,,SB110126378958082699,00.html?mod=home_whats_news_us 

Consumers End Up Paying More, State Attorney General Testifies; Guilty Pleas Grow in Manhattan 

"Spitzer Decries Lax Regulation Over Insurance," by Deborah Solomon and Ian McDonald, The Wall Street Journal, November 17, 2004, Page C1 ---,,SB110062060600975508,00.html?mod=us_business_whats_news 

New York Attorney General Eliot Spitzer told federal lawmakers that Congress needs to look into the insurance industry's "Pandora's box" of problems, saying that lack of federal oversight and disclosure has padded consumers' insurance costs.

While Mr. Spitzer was testifying on Capitol Hill, two more low-level insurance executives in New York surrendered to police and made their way to a courthouse in lower Manhattan, where they pleaded guilty to criminal charges for their roles in alleged bid-rigging and steering.

Five individuals have pleaded guilty as part of the probe kicked off Oct. 14 by Mr. Spitzer's civil suit against Marsh & McLennan Cos.' Marsh Inc. insurance-brokerage unit. In it, he alleged that Marsh brokers cheated clients by rigging bids for insurance contracts and steering business to insurers that paid Marsh millions of dollars in so-called contingent-fee commissions, which Mr. Spitzer likened to kickbacks.

As the number of guilty pleas rises, it is likely that the scope of the insurance probe and the profile of individuals charged will grow. Following a traditional prosecutorial pattern, regulators are accepting guilty pleas from lower-level employees in return for their cooperation in strengthening cases against companies and higher-ranking individuals, according to people familiar with the investigation.

Mr. Spitzer and Connecticut Attorney General Richard Blumenthal, who also is probing insurance-industry abuses, told a Senate governmental affairs subcommittee that many of the conflicts now being uncovered stem from regulatory "gaps" that let the industry escape tough oversight.

"It is clear that the federal government's hands-off policy with regard to insurance, combined with uneven state regulation, has not entirely worked," Mr. Spitzer said. "Many state regulators have not been sufficiently aggressive in terms of supervising this industry."

For its part, the National Association of Insurance Commissioners proposed requiring better disclosure of brokers' compensation, coordinating state investigations and regulatory efforts, and establishing an online fraud-reporting system. The group coordinates insurance regulation among the states.

Mr. Spitzer said his probe has turned up widespread evidence of undisclosed payments between insurers and insurance brokers. A new conflict, he said, involves insurers who made loans and gave company stock to individual brokers who steered business their way. He declined to discuss which companies engaged in the practice, which could be improper if it was undisclosed and if it influenced a broker's decision about where to steer business.

A person familiar with the inquiry said the biggest brokers don't appear to have provided such loans. However, smaller brokers borrowed significant amounts, with interest on the loans forgiven as the broker directed business to the lending insurers, this person said, declining to name the brokers.

In New York, Zurich Financial Services underwriters John Keenan and Edward Coughlin pleaded guilty to a misdemeanor violation of New York state antitrust law. Both face a maximum of one year in state prison and are cooperating with Mr. Spitzer's probe. Attorneys for Messrs. Keenan and Coughlin declined to comment.

They admitted to providing phony so-called B bids for insurance contracts at the request of Marsh brokers from August 2002 through September 2004. These fake bids helped ensure that a company favored by Marsh would get the contact. They worked in the Specialty Excess Casualty unit at Zurich American Insurance Co., a unit of Zurich Financial Services, the fourth-largest player in the U.S. property-and-casualty insurance market.

Mr. Coughlin's felony complaint cites an e-mail in which Marsh insurance broker Nicole Michaels writes "please email me a B quote" in bidding for a particular contract. It also cites an e-mail in which another Marsh employee, Edward Keane, advises Ms. Michaels to ask Zurich for a bid at a price between two existing bids. The complaint also notes an e-mail from Mr. Coughlin to his boss, Jim Spiegel, that references training material with subsections headed "How Marsh Global Broking Works" and "B Quotes."

Continued in the article

Insurance companies historically have been rancid with white collar crime and consumer rip offs.  Bob Jensen's threads on insurance company scandals are at 

"Spitzer says insurers inflated cost of benefits," by Ellen Kelleher, The New York Times, November 12, 2004

Some of the biggest insurers in the US, including MetLife and Prudential, colluded to inflate the cost of employees benefits coverage, according to a suit filed on Friday by Eliot Spitzer.

The New York attorney-general alleges that the insurers paid higher commissions to a broker, San Diego-based Universal Life Resources, in exchange for business from companies including Viacom, Marriott, Colgate Palmolive and United Parcel Service.

ULR also allegedly received hefty fees from insurers for “communications services”, such as printing informational materials and other activities.

Combined, these payments last year accounted for more than $17m of ULR's total revenues of $25.3m.

The civil lawsuit is the second legal action filed by Mr Spitzer in his widening investigation into alleged corruption in the insurance industry.

Continued in the article

Insurance companies historically have been rancid with white collar crime and consumer rip offs.  Bob Jensen's threads on insurance company scandals are at 

The SEC and Eliot Spitzer have launched probes into sales by insurance firms of products that help customers burnish results.  Industry executives say companies can reap distinct accounting benefits by obtaining loans dressed up as insurance products. Under U.S. generally accepted accounting principles, companies are allowed to use insurance recoveries to offset losses on their income statements -- often without disclosing them. To qualify as insurance under the accounting rules, financial contracts must involve a significant transfer of risk from one party to another.

"Fresh Probes Target Insurers' Earnings Role," by Theo Francis and Jonathan Weil, The Wall Street Journal, November 8, 2004, Page C1 ---,,SB109988032427267296,00.html?mod=home_whats_news_us 

The Securities and Exchange Commission and New York Attorney General Eliot Spitzer each have launched investigations into sales by insurance companies of questionable financial products that help customers burnish their financial statements, according to people familiar with the matter.

The SEC's enforcement division is conducting an industrywide investigation into whether a variety of insurance companies may have helped customers improperly smooth their earnings by selling them financial-engineering products that were designed to look like insurance but in some cases were little more than loans in disguise, people familiar with the matter say. The agency is focusing on a universe of products that are intended to achieve desired accounting results for customers' financial statements, as opposed to traditional insurance, whose primary goal is transferring risk of losses from a policyholder to the insurer selling the coverage.

Meanwhile, New York state investigators are preparing to issue subpoenas as soon as this week to several large insurance companies. After months of combing through industry documents in its continuing probe of insurance-broker compensation, Mr. Spitzer's office has grown increasingly concerned about insurance-industry products, detailed in The Wall Street Journal last month, that customers can use to manipulate their income statements and balance sheets.

Although Mr. Spitzer's office and the SEC began looking into the issue separately, they have discussed sharing information and resources, according to a person familiar with the probes.

Normally, an insurer is paid a specific amount of premiums to take on a risk of uncertain size and timing. In the "insurance" at issue, the risk of loss to the insurer selling the policy is limited and sometimes even eliminated -- partly because, in these policies' simplest form, the premiums are so high; other times, the loss already has occurred.

Industry executives say companies can reap distinct accounting benefits by obtaining loans dressed up as insurance products. Under U.S. generally accepted accounting principles, companies are allowed to use insurance recoveries to offset losses on their income statements -- often without disclosing them. To qualify as insurance under the accounting rules, financial contracts must involve a significant transfer of risk from one party to another.

Continued in the article

Bob Jensen's threads on off balance sheet debt schemes are at 

Insurance companies historically have been rancid with white collar crime and consumer rip offs.  Bob Jensen's threads on insurance company scandals are at 

"Company Settles Charges on Funds Sold to Soldiers," by Diana B. Henriques, The New York Times, December 16, 2004 --- 

First Command Financial Services, one of the best-known companies marketing financial products to military families, agreed yesterday to pay $12 million to settle accusations that it used misleading information to sell mutual funds to thousands of military officers over the last five years.

NASD and the Securities and Exchange Commission said that First Command exaggerated the track record of its high-cost fund products - with fees that ate up 50 percent of an investor's first-year contributions - and misrepresented the costs and availability of cheaper investment alternatives.

The company neither admitted nor denied the accusations, but accepted the punishments, which included a formal censure.

We at First Command look forward to returning our full focus and attention to helping families pursue their financial goals," the chief executive, Lamar C. Smith, said. "We believe in the integrity of our company, our agents and the products we sell."

The settlement requires First Command to compensate any customer who paid an effective sales charge of more than 5 percent on investments made since January 1999. The remaining money, estimated by regulators at $8 million, will be spent on a financial education program for military families. The company also agreed to hire an independent consultant to review sales practices.

"It is important to note," said Lanny J. Davis, a lawyer for the company, that the regulatory complaints focused on sales practices "and not on the financial investment product that First Command sold."

Continued in the article

Bob Jensen's threads on mutual fund frauds are at 

More Bad News for Ernst &Young

"Former E&Y Audit Partner Faces Five Years on Obstruction Charges," AccountingWeb, November 4, 2004 --- - Nov-4-2004 - Former Ernst & Young audit partner Thomas Trauger went to great lengths to keep from being “second-guessed” and last week pleaded guilty to charges he obstructed a federal investigation. The subject of the government's probe was NextCard Inc., a San Francisco company that distributed credit cards via the Internet. The company's troubles began when it handed out too many cards to unqualified holders, the Associated Press reported. Federal regulators shut down the company's banking unit in early 2002.

Trauger admitted to knowingly altering, destroying and falsifying records with the intent to impede and obstruct an investigation by the U.S. Attorney's Office, reported, but at heart, his goal was seemingly to avoid being "second-guessed" for failing to recognize red flags at a company that he had audited.

SEC official Robert Mitchell was interviewed at 

the time of Trauger's September 2003 arrest and said the audit partner was trying to "downplay or eliminate evidence of problems" that would have been red flags, according to USA Today, adding that he had previously given the company a clean bill of health.

An FBI affidavit showed that Trauger wanted to give the appearance that E&Y's audit of NextCard had been "right on the mark" so that "some smart-ass lawyer" wouldn't be able to second-guess him, the San Francisco Recorder, a legal newspaper, reported.

Trauger admitted last week that when testifying before the SEC he had failed to disclose that NextCard documents and quarterly working papers had been tampered with.

Continued in the article

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

It's not clear who got the earnings game going (meeting earnings forecasts by one penny): executives or investors. But it's past time for it to stop. As the Progressive example shows, those companies that continue the charade do it by choice.
Gretchen Morgenson, "Pennies That Aren't From Heaven," The New York Times, November 7, 2004 ---

Ask any chief executive officer if he or she practices the art of earnings management and you will undoubtedly hear an emphatic "Of course not!" But ask those same executives about their company's recent results, and you may very well hear a proud "we beat the analysts' estimate by a penny."

While almost no one wants to admit to managing company earnings, the fact is, almost everybody does it. How else to explain the miraculous manner in which so many companies meet or beat, by the preposterous penny, the consensus earnings estimates of Wall Street analysts?

After years of such miracles, investors finally seem to be wising up to the fact that an extra penny of profit is not only meaningless but may also be evidence of earnings management and, therefore, bad news. After all, the practice can hide

what's genuinely going on in a company's books.

A study by Thomson Financial examined how many of the 30 companies in the Dow Jones industrial average missed, met or beat analysts' consensus earnings estimates during each quarter over the last five years. It also looked at how the companies' shares responded to the results.

Over the period, on average, almost half of the companies - 46.1 percent - met consensus estimates or beat them by a penny.

Pulling off such a feat in an uncertain world smacks of earnings management. "It is not possible for this percentage of reporting companies to hit the bull's-eye," said Bill Fleckenstein, principal at Fleckenstein Capital in Seattle. "Business is too complicated; there are too many moving parts."

The precision has a purpose, of course: to keep stock prices aloft. According to Thomson's five-year analysis, companies whose results came in below analysts' estimates lost 1.08 percent of their value, on average, the day of the announcement. The loss averaged 1.59 percent over five days.

Executives have lots of levers to pull to make their numbers. Lowering the company's tax rate is a favorite, as is recognizing revenues before they actually come in or monkeying with reserves set aside to cover future liabilities.

If all else fails and a company faces the nightmare of an earnings miss, its spinmeisters can always begin a whispering campaign to persuade Wall Street analysts to trim their estimates, making them more attainable. Their stock might drift downward as a result, but the damage is not usually as horrific as it is when earnings miss the target unexpectedly.

So it is not surprising that the strategy has become so widespread and that fewer companies in the Thomson study are coming in below their target these days. For the first three quarters of 2004, 10.9 percent missed their expected results, down from 11.7 percent in 2003 and 25 percent in 2002.

At the heart of earnings management is - what else? - executive compensation. The greater the percentage of pay an executive receives in stock, the bigger the incentive to produce results that propel share prices.

Continued in the article

Bob Jensen's threads on earnings management are at 

Sharing Site of the Week --- 
Thank you Mark Simmons at Dartmouth for sharing internal auditing and fraud investigation resources.

Web Site of Mark R. Simmons, CIA CFE


This site focuses on topics that deal with Internal Auditing and Fraud Investigation with certain links to other associated and relevant sources. It is dedicated to sharing information.

Internal Auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations.  It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. (Institute of Internal Auditors)

Fraud Investigation consists of the multitude of steps necessary to resolve allegations of fraud — interviewing witnesses, assembling evidence, writing reports, and dealing with prosecutors and the courts. (Association of Certified Fraud Examiners)

Bob Jensen's threads on fraud are at 

Bob Jensen's threads on fraud detection and reporting are at 

Qwest Engaged in Fraud, SEC Says"  Regulator Claims Misdeeds Were Led by Top Officials
Firm to Pay $250 Million
by Shawn Young, Deborah Solomon, and Dennis Berman
The Wall Street Journal, October 22, 2004,,SB109836893305151847,00.html?mod=technology%5Fmain%5Fwhats%5Fnews 

Qwest Communications International Inc. engaged in pervasive fraud led by top management that extended to almost every part of its business, according to a complaint by the Securities and Exchange Commission.

The complaint, filed in federal court yesterday as Qwest agreed to pay a $250 million penalty, said the telecommunications company was riddled with accounting fraud between 1999 and 2002. The fraud included generating phony revenue through sham transactions, booking inflated results for its phone-directory business and even the way Qwest accounted for employee vacation time, according to the complaint. The SEC said Qwest fraudulently recognized more than $3.8 billion in revenue and excluded $231 million in expenses as part of a multifaceted accounting scheme. (Read the full text of the complaint.)

The 56-page document depicts Qwest as a company so desperate to satisfy Wall Street that it used any means necessary to meet "outrageously optimistic revenue projections." As its financial condition deteriorated, the SEC says Qwest began to rely on one-time sales contracts that one employee described as a kind of fiscal "heroin" that filled revenue gaps but were increasingly difficult to maintain.

"This was definitely orchestrated from the top down," said Mary Brady, assistant regional director for the SEC's Denver office. The SEC said the fraud was "directed by Qwest's senior management" and implemented by "numerous" other managers and employees.

Though the SEC didn't name specific Qwest executives, the agency continues to investigate former top officials, including Joseph P. Nacchio, the tough-talking executive who led Qwest until 2002. Mr. Nacchio recently received a so-called Wells notice from the SEC, indicating it soon may file civil charges against him, people familiar with the matter have said.

A spokesman for Mr. Nacchio said in a statement that "Mr. Nacchio never did anything improper or illegal -- nor instructed anyone else to do anything improper or illegal -- during his tenure as CEO of Qwest."

A few other former top executives also have received Wells notices, according to people familiar with the matter. In addition, a dozen former Qwest executives have faced either civil or criminal charges or have settled allegations.

The $250 million penalty, which Qwest agreed to without admitting or denying wrongdoing, is the second-largest resulting from a SEC action, following only the mammoth $750 million levied against the former WorldCom Inc., now MCI Inc., after that company's $11 billion accounting fraud, the largest in U.S. history.

Continued in the article


Former Qwest Communications auditor Arthur Andersen may have destroyed documents including those related to the Denver telco's controversial fiber-optic capacity swaps, a prosecutor and defense attorneys indicated Tuesday. A discussion about the possible destruction of documents by Arthur Andersen emerged after the government turned over hundreds of pages of additional discovery in connection with the trial of four former midlevel Qwest executives accused of conspiring to inflate revenue.
Denver Rocky Mountain News, March 10, 2004 --- 

Bob Jensen's threads on the Andersen scandals are at 

What CPA auditing firm has the dubious honor of having been the auditor for the company that is now designated as the largest bankruptcy case in the history of the world?

Deloitte Touche Tomatsu

Creditor claims against Adelphia Communications Corp. total a staggering $3 trillion, or close to 40 percent of the national debt, Dow Jones Newswires reported. But many of the claims pending against the nation's fifth-largest cable company could turn out to be duplicates, and may be more like $18.6 billion

"Adelphia's Complex Bankruptcy: Claims Total $3 Trillion," AccounntingWeb, October 13, 2004 --- 

It is what some are calling the most complicated bankruptcy case in history.

Creditor claims against Adelphia Communications Corp. total a staggering $3 trillion, or close to 40 percent of the national debt, Dow Jones Newswires reported. But many of the claims pending against the nation's fifth-largest cable company could turn out to be duplicates, and may be more like $18.6 billion when all is said and done.

Regardless, the company's structure is extremely complex and more than 60 accountants are wading through mountains of documents trying to reconcile claims against the Colorado company's 243 separate entities.

Company spokesman Paul Jacobson told Dow Jones that Adelphia's case is "arguably the most complex bankruptcy in U.S. business. It is a strange animal."

"A person is only entitled to be paid once, but trying to sort that out turns into an accounting nightmare," Paul Rubner, a Denver bankruptcy lawyer, told Dow Jones. He said creditors must correctly identify the entity that owes them.

"The good news is that you have to be specific about where you file it," Rubner said. "The bad news is that if the client is unsure, the lawyer is apt to file it in every possible case."

With more than 5 million subscribers, the cable company filed for bankruptcy in 2002 and expects to restate its financial statements from 1999 through 2001.

The company's founder John Rigas, and his son Timothy were convicted this year of conspiracy, bank fraud and securities fraud for looting the company and lying about its finances before the bankruptcy, Dow Jones reported.

Bob Jensen's threads on Deloitte and Touche auditing scandals are at 

Former KPMG Consultant Pleads in Conspiracy Case 

In a case of aiding and abetting a corporate fraud, former KPMG consultant Larry Alan Rodda pleaded guilty to federal fraud charges Tuesday, admitting he signed phony contracts with Peregrine Systems intended to boost Peregrine's earnings, the San Diego Union-Tribute reported.

Bob Jensen's threads on KPMG's many, many woes are at 

When Four Just Isn't Enough!

When audits go bad, the clients just get traded around.  It appears that Deloitte may take the Fannie Mae audit from KPMG due to SEC pressures.  But Deloitte is not facing a life-threatening lawsuit.  The SEC is pressuring TIAA-CREF to drop E&Y due to violation of auditor independence.  The SEC is acting on bad audits but appears to be limited in how to correct the situation since there are only four in the Big Four.

"Fannie Restatement Sparks Debate Over Fate of Auditor:  Investors, Experts Question Quality of KPMG's Work; Checking the Annual Fees," bu Jonathan Weil and Diya Gullapalli, The Wall Street Journal, December 17, 2004; Page C3 ---,,SB110324068628902772,00.html?mod=todays_us_money_and_investing 

The Securities and Exchange Commission's decision directing Fannie Mae to restate its earnings is sparking a debate among investors, proxy advisers and accounting experts about whether the mortgage titan should dump outside auditor KPMG LLP.

And as demonstrated by the recent experience of Fannie's government-chartered cousin, Freddie Mac, once a company gets a fresh set of eyes to pore over its books and records, there's no telling what other accounting issues may pop up.

A proposal by the Office of Federal Housing Enterprise Oversight could require Fannie to change its auditor by Jan. 1, 2006, and rotate its auditor at least every 10 years after that. The proposal is under review by the White House Office of Management and Budget.

With both the SEC and Ofheo agreeing that Fannie violated the accounting rules for derivative financial instruments, "they should immediately change auditors given this apparent lack of quality in the audit work," says Mike Lofing, an analyst in Broomfield, Colo., at Glass Lewis & Co., one of the nation's most prominent proxy-advisory firms. If Fannie doesn't replace KPMG, he says, his firm likely would advise its institutional-investor clients to oppose the ratification of KPMG as Fannie's auditor at the company's annual meeting next spring.

A Fannie spokeswoman declined to comment on any possible change in auditors. In a statement, KPMG said: "We accept the company's decision to follow the direction of the [SEC's] Office of the Chief Accountant with respect to Fannie Mae's prior financial statements." A KPMG spokesman declined to respond to suggestions that Fannie should replace KPMG as its auditor.

To be sure, not all investors believe an immediate auditor switch is necessary. "I'd like to get more information about why [the SEC's staff] made their interpretation" before deciding on whether KPMG should be replaced, says David Dreman, chairman of investment firm Dreman Value Management LLC, which held about eight million shares as of Sept. 30.

Still, two years ago, Freddie Mac's decision to replace the imploding Arthur Andersen LLP with PricewaterhouseCoopers LLP helped the company turn over a new leaf. Shortly after the switch, the new auditor found widespread accounting manipulations, including false asset valuations. After restating financials and ousting its chief executive officer last year, Freddie's stock has risen over 20% this year and the firm is gaining market share from Fannie.

In the same vein, a new auditor at Fannie might identify potentially bigger issues than the ones identified by Ofheo and the SEC. Fannie's estimate last month that a restatement could reduce its past earnings and regulatory capital by $9 billion is based on the assumption that the derivatives and other assets and liabilities on Fannie's balance sheet already were being valued appropriately as of Sept. 30. Conceivably, a new auditor might find they weren't.

"It would be astute for Fannie to contemplate whether an auditor that was not involved with the prior circumstance might not bring more credibility to their future financial statements," adds Tom Linsmeier, an accounting professor and derivatives specialist at Michigan State University, who testified last year before Congress on Fannie's accounting practices.

The audit fees that Fannie paid KPMG in recent years were paltry, raising questions among investors and analysts about just how much audit work KPMG could have been performing. Last year Fannie paid KPMG $2.7 million to audit its financial statements. It paid even less in years before -- just $1.4 million in 2001. By himself, Fannie Mae Chief Financial Officer Tim Howard got $5.4 million in compensation last year, including stock options. By comparison, Freddie Mac, with roughly $800 billion of assets at Dec. 31, paid PricewaterhouseCoopers more than $46 million for its 2003 audit.

The Fannie debacle comes at a critical time for KPMG, which has been in crisis-management mode for the past few years over a host of audit failures and government investigations. Among other things, the firm's sales of allegedly abusive tax shelters remain the focus of a criminal grand-jury investigation that began about a year ago.

If Fannie wants a new Big Four auditor, the least likely choice would appear to be Ernst & Young LLP, which is advising Fannie's audit committee in responding to the government probes. Conceivably, Fannie could hire Deloitte & Touche LLP, which has been assisting Ofheo's examination.

Continued in the article

Bob Jensen's threads on troubles of big accounting firms are at 

Bob Jensen's threads on how "A Bad Audit is Becoming the Rule Rather Than the Exception are at

Bob Jensen's threads on the Fannie Mae accounting scandals are at 

"Fannie Mae Warns of Possible $9B Loss, KPMG Won't Sign Off," AccountingWeb, November 18, 2004 --- 

Bob Jensen's threads on Fannie and Freddie fun and games are at 

Unlike recent financial scandals, issues raised by Fannie Mae's regulators pertain to unwieldy accounting rules that are open to widely divergent interpretations.
"A Seismic Shift Under the House of Fannie Mae," by Timothy L. O'Brien and Jennifer S. Lee, The New York Times, October 3, 2004 --- 

From a compulsively neat desk inside a company that routinely jousts with powerful critics from the White House, Congress, the Federal Reserve and Wall Street, J. Timothy Howard has been the financial architect of one of the world's most formidable and most elegantly designed corporate money machines. He also holds a corporate title that in recent years has emerged as one of the most treacherous in American business: chief financial officer.

The winds of scandal that uprooted Enron, WorldCom, Tyco and other companies often blew hardest through C.F.O. suites. Now, with controversy engulfing his employer - the mortgage giant Fannie Mae - Mr. Howard finds himself in legal and regulatory cross hairs that threaten to upend his career, throw the company's operations into turmoil and escalate a long-running battle between Fannie Mae and its enemies.

Eleven days ago, a federal regulator issued a scathing report that accused the company, and Mr. Howard in particular, of accounting and managerial lapses that presented a false public portrait of its financial well-being and enriched its executives. Then, late last week, amid a mounting tempest of Congressional criticism, Fannie Mae became the subject of a criminal investigation by the Justice Department; that investigation is likely to take precedence over a continuing Securities and Exchange Commission inquiry.

The stakes in all of this are large. Fannie Mae provides much of the glue that helps hold the American mortgage market together, and if the company encounters serious setbacks, the impact on homeowners and the world's financial markets could be unpleasant. Nor are the accusations of improprieties necessarily unique to Fannie Mae. Wall Street analysts say that if the same regulatory magnifying glass were used to examine the operations of most other sizable mortgage concerns in America, a case for dubious accounting could probably be made for many of them.

Unlike the problems in recent financial scandals, issues raised by Fannie Mae's regulators appear largely to pertain to unwieldy accounting rules that are open to widely divergent interpretations - not to sham transactions designed to cloak corporate malfeasance. More serious accounting problems may yet emerge, and the company has already been forced to consider outsized financial restatements as a result of the regulatory inquiry. And as the Justice Department investigation of Fannie Mae continues, other problems may surface.

Few longtime observers of Fannie Mae and of Mr. Howard expect that crimes will be found. "The guy is as honest as the day is long and the targeting of Tim Howard is an unfortunate byproduct of larger events," said Martin D. Eakes, chief executive of the Self-Help Credit Union, a lender to low-income borrowers based in Durham, N.C., who has alternately worked closely with and battled Fannie Mae on various mortgage issues. "This will never, ever be like Enron. Mark my words."

Maybe so. But the confrontation between Fannie Mae and its critics already amounts to a clash of titans, both in Washington and New York, where Fannie Mae's lobbyists and its executives are accustomed to striding unencumbered through the halls of Congress, the financial byways of Wall Street and the finest dining rooms and clubs.

For at least the last decade, the company has been criticized in Congress and by Washington research groups. Detractors accuse it of benefiting unfairly from its status as a quasi-public enterprise, of not truly meeting its mission of providing affordable housing, and of being too loosely regulated. More recently, Fannie Mae's explosive growth has drawn the attention of Alan Greenspan, the Federal Reserve chairman, who raised concerns earlier this year that a collapse or trouble for the company posed threats to the economy. Mr. Greenspan advocated the complete privatization of the company, a view that has been pressed elsewhere in Washington as well.

"It's a resistance to Fannie in Washington that is one part mortgage industry civil war, one part conservative ideological crusade to try to rein them in or force them to privatize," said Charles A. Gabriel Jr., senior Washington analyst at Prudential Securities. "Having faced down the mortgage industry civil war and the ideologues, what finally tripped them up is they ran afoul of the shifting zeitgeist on accounting."

Still, the most damaging legacy of Fannie Mae's years of unchecked growth may not be evident until the next significant economic slump. Only then, argued Josh Rosner, an analyst at Medley Global Advisors in New York, will the effects of Fannie Mae's relaxed mortgage underwriting standards be felt. A result could be a more pronounced downturn in the real estate market and more stress on the consumer.
Gretchen Morgenson, A Coming Nightmare of Homeownership?" The New York Times, October 3, 2004 --- 

Bob Jensen's threads on accounting scandals at Fannie Mae and Freddie Mac are at 

From The Wall Street Journal Accounting Weekly Review on October 29, 2004

TITLE: First Marblehead: Brilliance or Grade Inflation? 
REPORTER: Karen Richardson 
DATE: Oct 25, 2004 
TOPICS: Advanced Financial Accounting, Allowance For Doubtful Accounts, Financial Statement Analysis, Securitization, Valuations

SUMMARY: First Marblehead securitizes student loans and records assets based on significant estimates. Investors have significantly increased short selling on the stock because of concern over when the receivables recorded through securitization will ultimately be collected.

1.) Define the term securitization. What purpose does securitization serve?

2.) What does the author mean by "gain-on-sale" accounting? When are gains recognized in securitization transactions?

3.) What standard governs the accounting requirements for securitization transactions? Why does that standard focus on a question of discerning liabilities from sales? Is that accounting question a point of difficulty in the case described in this article? Explain.

4.) Why are critics arguing that "it will be at least five years before any significant cash starts rolling in" on First Marblehead's assets?

5.) According to what is listed in the article, how many factors must be estimated to record the assets and revenues under First Marblehead's business model? How uncertain do you think the company may be in its estimates of these of these items?

6.) Why will it take time until "the company's massive earnings growth can be verified"? What evidence will help to evaluate the validity of the estimates made in First Marblehead's revenue recognition process?

7.) What is the process of short selling? Why is it telling that there has been a significant increase in the number of short-sellers on First Marblehead's stock?

Reviewed By: Judy Beckman, University of Rhode Island

Bob Jensen's threads on debt versus equity are at 

Fannie Gets in in the Fanny (Again)

Our review indicates that during the period under our review, from 2001 to mid-2004, Fannie Mae's accounting practices did not comply in material respects with the accounting requirements in Statement Nos. 91 and 133. 

Donald T. Nicolaisen, Chief Accountant for the Securities and Exchange Commission (Commission), issued the following statement regarding the compliance of the Federal National Mortgage Association's (Fannie Mae) accounting practices for deferred purchase price adjustments and for derivatives and hedging activities with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases" (Statement No. 91), and Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (Statement No. 133):

Our review indicates that during the period under our review, from 2001 to mid-2004, Fannie Mae's accounting practices did not comply in material respects with the accounting requirements in Statement Nos. 91 and 133.

Regarding Statement No. 91, during the period under the SEC staff's review, Fannie Mae failed to record timely adjustments to the recorded amount of its loans based on changes in the estimated speed with which those loans would be prepaid. Among other requirements, Statement No. 91 provides that when applying the method used by Fannie Mae an entity should use its best estimate of expected prepayment rates in calculating the carrying amount of its loans. Fannie Mae previously had concluded that its methodology for performing these calculations for interim balance sheet dates in the periods 2001 through 2002 was not consistent with Statement No. 91, and has stated that it has changed its accounting policies to, among other things, calculate the amounts based on quarter-end positions rather than projected year-end positions.

It also appears that, contrary to Statement No. 91, Fannie Mae recognized adjustments to the carrying amount of its loans only if they exceeded a self-defined materiality limit, referred to as a "precision threshold." Fannie Mae has represented to the Commission staff that it has initiated further changes to eliminate the "precision threshold" and is working with OFHEO to further amend its accounting practices under Statement No. 91.

Regarding Statement No. 133, one of the principles underlying the statement is that derivative instruments are to be recorded at their fair value with changes in fair value reported in earnings. If certain hedge criteria are met, however, Statement No. 133 affords special accounting for the hedge relationship. If the specific hedging requirements are not met, then special hedge accounting is not appropriate.

Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae's methodology, however, did not qualify for hedge accounting because of deficiencies in its application of Statement No. 133. Among other things, Fannie Mae's methodology of assessing, measuring, and documenting hedge ineffectiveness was inadequate and was not supported by the Statement.

We understand that Fannie Mae is working with an outside adviser to amend its hedge accounting practices and develop an appropriate approach to hedge accounting under Statement No. 133.

This evening, therefore, I have advised Fannie Mae that, to be consistent with Statement Nos. 91 and 133 and to provide investors with appropriate information, Fannie Mae should:

* Restate its financial statements filed with the Commission to eliminate the use of hedge accounting. * Evaluate the accounting under Statement No. 91 and restate its financial statements filed with the Commission if the amounts required for correction are material. * Re-evaluate the information prepared under generally accepted accounting principles (GAAP) and non-GAAP information that Fannie Mae previously provided to investors, particularly in view of the decision that hedge accounting is not appropriate.

I appreciate the cooperation extended by Fannie Mae and OFHEO during our review and their willingness to provide us with information and detailed explanations of their views. It is my understanding that investigations into these and related matters by Fannie Mae's special review committee, the Commission, and others are continuing.

This is only an excerpt from the entire statement ---


Bob Jensen's threads on Fannie Mae and Freddie Mac accounting scandals are at 

FAS 133 says Fannie can't get hedge accounting for non-homogenious portfolios.  Will the SEC let they (and auditor KPMG) get way with it anyway?
Fannie Mae estimated it will have to post a $9 billion loss if the SEC finds it has been accounting improperly for derivatives. Ofheo, the mortgage firm's regulator, said Fannie incorrectly applied accounting rules in a way that let it spread out losses over many years rather than taking an immediate hit.
James R. Hagerty, "Fannie Warns of $9 Billion Loss If Derivatives Ruling Is Adverse," The Wall Street Journal, November 16, 2004, Page A3 ---,,SB110055804528874668,00.html?mod=home_whats_news_us 

It just gets deeper and deeper for KPMG, the auditing firm that approved some the Fannie Mae's earnings smoothing with questionable allowance of hedge accounting for speculations under FAS 133 rules.  Fannie's outside auditor, KPMG, certified its results knowing OFHEO's concerns.

Macro Hedging is Probably the Main Weakness of FAS 133, and Fannie Mae is Taking it in the Fanny

The bottom line is that both the FASB and the IASB must someday soon take another look at how the real world hedges portfolios rather than individual securities.  The problem is complex, but the problem has come to roost in Fannie Mae's $1 trillion in hedging contracts.  How the SEC acts may well override the FASB.  How the SEC acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie violate the rules of IAS 133.

You can read more about macro hedges at 

On October 4, 2004 the main editorial in The Wall Street Journal presented a scathing attack on Fannie Mae (and outside auditor KPMG by implication) for simply ignoring FAS 133 explicit rules for testing hedging effectiveness and improperly keeping over $1 billion in hedging gains and losses in AOCI (accumulated other comprehensive income) rather than current earnings.

"Fannie Mae Enron?" Editorial in The Wall Street Journal
October 4, 2004; Page A16

For years, mortgage giant Fannie Mae has produced smoothly growing earnings. And for years, observers have wondered how Fannie could manage its inherently risky portfolio without a whiff of volatility. Now, thanks to Fannie's regulator, we know the answer. The company was cooking the books. Big time.

We've looked closely at the 211-page report issued by the Office of Federal Housing Enterprise Oversight (Ofheo), and the details are more troubling than even the recent headlines. The magnitude of Fannie's machinations is stunning, and in two key areas in particular they deserve to be better understood. By improperly delaying the recognition of income, it created a cookie jar of reserves. And by improperly classifying certain derivatives, it was able to spread out losses over many years instead of recognizing them immediately.

In the cookie-jar ploy, Fannie set aside an artificially large cash reserve. And -- presto -- in any quarter its managers could reach into that jar to compensate for poor results or add to it to dampen good ones. This ploy, according to Ofheo, gave Fannie "inordinate flexibility" in reporting the amount of income or expenses over reporting periods.

This flexibility also gave Fannie the ability to manipulate earnings to hit -- within pennies -- target numbers for executive bonuses. Ofheo details an example from 1998, the year the Russian financial crisis sent interest rates tumbling. Lower rates caused a lot of mortgage holders to prepay their existing home mortgages. And Fannie was suddenly facing an estimated expense of $400 million.

Well, in its wisdom, Fannie decided to recognize only $200 million, deferring the other half. That allowed Fannie's executives -- whose bonus plan is linked to earnings-per-share -- to meet the target for maximum bonus payouts. The target EPS for maximum payout was $3.23 and Fannie reported exactly . . . $3.2309. This bull's-eye was worth $1.932 million to then-CEO James Johnson, $1.19 million to then-CEO-designate Franklin Raines, and $779,625 to then-Vice Chairman Jamie Gorelick.

That same year Fannie installed software that allowed management to produce multiple scenarios under different assumptions that, according to a Fannie executive, "strengthens the earnings management that is necessary when dealing with a volatile book of business." Over the years, Fannie designed and added software that allowed it to assess the impact of recognizing income or expense on securities and loans. This practice fits with a Fannie corporate culture that the report says considered volatility "artificial" and measures of precision "spurious."

This disturbing culture was apparent in Fannie's manipulation of its derivative accounting. Fannie runs a giant derivative book in an attempt to hedge its massive exposure to interest-rate risk. Derivatives must be marked-to-market, carried on the balance sheet at fair value. The problem is that changes in fair-value can cause some nasty volatility in earnings.

So, Fannie decided to classify a huge amount of its derivatives as hedging transactions, thereby avoiding any impact on earnings. (And we mean huge: In December 2003, Fan's derivatives had a notional value of $1.04 trillion of which only a notional $43 million was not classified in hedging relationships.) This misapplication continued when Fannie closed out positions. The company did not record the fair-value changes in earnings, but only in Accumulated Other Comprehensive Income (AOCI) where losses can be amortized over a long period.

Fannie had some $12.2 billion in deferred losses in the AOCI balance at year-end 2003. If this amount must be reclassified into retained earnings, it might punish Fannie's earnings for various periods over the past three years, leaving its capital well below what is required by regulators.

In all, the Ofheo report notes, "The misapplications of GAAP are not limited occurrences, but appear to be pervasive . . . [and] raise serious doubts as to the validity of previously reported financial results, as well as adequacy of regulatory capital, management supervision and overall safety and soundness. . . ." In an agreement reached with Ofheo last week, Fannie promised to change the methods involved in both the cookie-jar and derivative accounting and to change its compensation "to avoid any inappropriate incentives."

But we don't think this goes nearly far enough for a company whose executives have for years derided anyone who raised a doubt about either its accounting or its growing risk profile. At a minimum these executives are not the sort anyone would want running the U.S. Treasury under John Kerry. With the Justice Department already starting a criminal probe, we find it hard to comprehend that the Fannie board still believes that investors can trust its management team.

Fannie Mae isn't an ordinary company and this isn't a run-of-the-mill accounting scandal. The U.S. government had no financial stake in the failure of Enron or WorldCom. But because of Fannie's implicit subsidy from the federal government, taxpayers are on the hook if its capital cushion is insufficient to absorb big losses. Private profit, public risk. That's quite a confidence game -- and it's time to call it.


FAS 133 (and IAS 39) do not deal well with macro (portfolio) hedges in that hedge accounting is denied unless all of the securities in a portfolio are identical in terms of the risk being hedged.  IAS 39 was recently amended (largely for political rather than theory reasons) to allow for macro hedges of interest rate risk when the maturity dates or possible early payoff dates are not identical.  But the IAS 39 amendment  is only a very small step toward solving a very large problem.  Companies like Fannie Mae and Freddie Mac find it impractical (actually impossible) to hedge individual securities (or homogeneous portfolios) as required under FAS 133.

The large problem is that when non-homogeneous portfolios are being hedged for only one of several risks, there can be a huge mismatch in terms of value changes of the portfolio versus value change of the hedging derivatives.  When writing the hedge accounting standards, standard setters took a conservative approach that virtually denies hedge accounting for non-homogeneous portfolios.  This long been known as the "macro hedging" problem of FAS 133.  By denying hedge accounting to financial institutions with large non-homogeneous portfolios, those institutions are going to show huge fluctuations in net earnings by having to mark-to-market all macro hedging derivatives with offsetting value changes being charged to current earnings rather than some offset such as AOIC for cash flow hedges or the macro portfolio itself for fair value hedges.

One of the better media articles about this controversial problem is the following article by Michael MacKenzie.  What MacKenzie does is explain just how Fannie Mae covers her fanny with macro hedging strategy that really is not eligible for hedge accounting under FAS 133.  However, the problem is with FAS 133.

:"Sometimes the Wrong 'Notion':   Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio," by Michael MacKenzie, The Wall Street Journal, October 5, 2004, Page C3 

Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio

What exactly did Fannie Mae do wrong?

Much has been made of the accounting improprieties alleged by Fannie's regulator, the Office of Federal Housing Enterprise Oversight.

Some investors may even be aware the matter centers on the mortgage giant's $1 trillion "notional" portfolio of derivatives -- notional being the Wall Street way of saying that that is how much those options and other derivatives are worth on paper.

But understanding exactly what is supposed to be wrong with Fannie's handling of these instruments takes some doing. Herewith, an effort to touch on what's what -- a notion of the problems with that notional amount, if you will.

Ofheo alleges that, in order to keep its earnings steady, Fannie used the wrong accounting standards for these derivatives, classifying them under complex (to put it mildly) requirements laid out by the Financial Accounting Standards Board's rule 133, or FAS 133.

For most companies using derivatives, FAS 133 has clear advantages, helping to smooth out reported income. However, accounting experts say FAS 133 works best for companies that follow relatively simple hedging programs, whereas Fannie Mae's huge cash needs and giant portfolio requires constant fine-tuning as market rates change.

A Fannie spokesman last week declined to comment on the issue of hedge accounting for derivatives, but Fannie Mae has maintained that it uses derivatives to manage its balance sheet of debt and mortgage assets and doesn't take outright speculative positions. It also uses swaps -- derivatives that generally are agreements to exchange fixed- and floating-rate payments -- to protect its mortgage assets against large swings in rates.

Under FAS 133, if a swap is being used to hedge risk against another item on the balance sheet, special hedge accounting is applied to any gains and losses that result from the use of the swap. Within the application of this accounting there are two separate classifications: fair-value hedges and cash-flow hedges.

Fannie's fair-value hedges generally aim to get fixed-rate payments by agreeing to pay a counterparty floating interest rates, the idea being to offset the risk of homeowners refinancing their mortgages for lower rates. Any gain or loss, along with that of the asset or liability being hedged, is supposed to go straight into earnings as income. In other words, if the swap loses money but is being applied against a mortgage that has risen in value, the gain and loss cancel each other out, which actually smoothes the company's income.

Cash-flow hedges, on the other hand, generally involve Fannie entering an agreement to pay fixed rates in order to get floating-rates. The profit or loss on these hedges don't immediately flow to earnings. Instead, they go into the balance sheet under a line called accumulated other comprehensive income, or AOCI, and are allocated into earnings over time, a process known as amortization.

Ofheo claims that instead of terminating swaps and amortizing gains and losses over the life of the original asset or liability that the swap was used to hedge, Fannie Mae had been entering swap transactions that offset each other and keeping both the swaps under the hedge classifications. That was a no-go, the regulator says.

"The major risk facing Fannie is that by tainting a certain portion of the portfolio with redesignations and improper documentation, it may well lose hedge accounting for the whole derivatives portfolio," said Gerald Lucas, a bond strategist at Banc of America Securities in New York.

The bottom line is that both the FASB and the IASB must someday soon take another look at how the real world hedges portfolios rather than individual securities.  The problem is complex, but the problem has come to roost in Fannie Mae's $1 trillion in hedging contracts.  How the SEC acts may well override the FASB.  How the SEC acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie violate the rules of IAS 133.

November 29, 2004 message from Dennis Beresford [


I tried to forward a Barron's article on derivatives to you yesterday. In case it didn't get through, you can access it at:

It includes some interesting perspectives on SFAS 133 and Freddie Mac and Fannie Mae.


November 29, 2004 reply from Bob Jensen

Hi Denny,

The Barron's article is somewhat balanced and makes some very good points.

However, the capital market vested interests either do not or will not remember the bad stuff that was happening prior to FAS 133 (Orange County, Procter & Gamble, LT Capital, etc.) --- 

Advocates of full disclosure in place of booking forget the "full disclosure" obfuscation about put options and SPEs in Enron's infamous Footnote 16 compliance --- 

It's a never ending cycle of patch and unpatch when it comes to regulation versus corruption. When the scandals die out, the lobbyists buy off the cops to where industry owns the FDA, agribusiness owns the Department of Agriculture, power companies own the FPA, and Wall Street more or less owns the SEC (in spite of Donaldson's futile efforts). These agencies rise up when scandals surface and faith in the system is at stake. But when the media lays off, industry crawls back in the dead of night and takes over once again to rip off consumers and investors. Where was Levitt when all the Wall Street scandals were taking place in mutual funds, insurance companies, and investment banking? Where will the new head of the SEC be when they same companies once again commence to take advantage reduced incentives to play fair? Now that the FASB is more dependent upon government funding, I suspect that it too will water down controversial standards.

In the table below, I try to counter or elaborate on some of the claims made by Ales Pollock in the Baron's article.  I might note that Mr. Pollock was President of the Federal Home Loan Bank of Chicago until 2004.

"No Accounting for Hedging:  FAS 133 led Fannie Mae and Freddie Mac astray," 
by Alex J. Pollock, Barron's, November 29, 2004

Pollock:  Since the time it was first proposed, many financial experts have criticized the fundamental concepts of FAS 133, which often push the accounting representation and the economic reality farther apart than before they were applied.

Point 1
Pollock:  FAS 133 marks to market only one side of what in fact are two-sided positions.

Jensen: This begs the question about what one means by "one sided."  Two-sided positions may be cash flow or fair value hedges.  A cash flow hedge inevitably gives rise to fair value risk.  Prior to FAS 133, such fair value risk of a cash flow hedge was simply ignored (except in the case of futures contract hedges that clear for cash daily).  I would call the ignoring of fair value risk enormously one sided.  For example, when a farmer locked in the forward price of a corn crop with a forward contract, it eliminated the farmer's cash flow risk, but but the spot value of the crop could ultimately be much higher or lower than the locked in (forward) price.  Prior to FAS 133, neither the future sale nor the forward contract was booked.  Cash flow was hedged, but value risk was ignored.  Subsequent to FAS 133, the forward contract must be booked (usually at zero to begin with) and then revised to fair value for interim reporting prior to expiration.  FAS 133 allows a hedge accounting offset to OCI to the extent the hedge is effective.  Hence there is a "two sided" accounting that was non-existent before FAS 133.  If the farmer later on takes a second forward contract counter position to eliminate value risk, he must thereby create cash flow risk.  To the extent that the second hedge is effective, the value changes in the two forward contracts should perfectly offset.  Fannie Mae and Freddie Mac would like to go back to the old days where fair value risk is ignored in the case of cash flow hedges and cash flow risk is ignored in the case of value hedges.  I would call this enormously one sided.

Point 2
It treats positions with identical net cash flows differently for accounting purposes.

This depends upon why FAS 133 treats something "differently."  Suppose an option perfectly hedges a hedged item such as a call option on the future price of fuel.  Both items have identical offsetting cash flows.  But the value of change of the hedged item may not be identical with the value change of the hedge.  For example, fuel prices are set in the commodities market.  Option prices are set in the options market.  Both are obviously correlated, but such value changes are rarely identical in the case of options due to inherent differences in the make up of buyers and sellers in both markets.  Hence a perfect cash flow hedge may not be perfect in terms of the changes in current values.  Similarly a perfect value hedge may not be perfect in terms of changes in cash flow risk.  Hence, looking at only "identical cash flows" may ignore value risks and vice versa.  FAS 133 tries to look at both cash flow and risk.

Point 3
It requires the pretense that all hedging is "micro" hedging of specific items, while the reality is macro hedging of combined balance sheet risks.

This is an enormous problem that I deal with at
Macro hedging is complicated when only a subset of the risks of the hedged item is hedged.  For example, interest rate risk may be the only hedged item in a portfolio of mortgage investments having varied termination risks, credit risks, etc.

Point 4
It requires assigning hedges to specific assets or liabilities, although the real risk is the relationship between assets and liabilities.

Ultimately we would like to have hedge accounting rules for hedging entire balance sheets or entire income statements.  Accounting for this becomes so complex that at the moment no hedge accounting standards have evolved other than the FAS 133 requirement that specific derivative instrument contracts be carried at fair value.

Point 5
It requires direct debits and credits to the capital accounts, bypassing the profit and loss statement.

If the FASB had its druthers this would not be the case.  Initially the FASB wanted to book all financial instruments, including derivatives, at market.  But opponents of fair value accounting, particularly bankers, put enormous pressures on the FASB to allow hedge accounting relief for effective hedges.  Hence, changes in the value of a perfect cash flow hedge may bypass the earnings statement and be charged to OCI in the capital accounts.  This arises from reluctance of the financial industry to market all assets to fair value.

Point 6
It can cause overstatement or understatement of capital.

This is like arguing religion.  Mr. Pollock implies anybody can tell what the true statement of capital should be.  No such definitions exist operationally. 

Point 7
It requires deferral of certain realized cash losses.

FAS 133 is no different that most other accrual accounting standards in this regard.  If American Airlines pays $100 million for a new airplane in cash, the airplane's cash cost is deferred by depreciation the $100 million over the expected life of the airplane.  It would very misleading to write off cash payments with no consideration of the estimated timing of expenses and revenues.

Point 8
It moves accounting further away from cash flows.

One of the required financial statements is a cash flow statement.  If that alone were sufficient, financial analysts would simply ignore the accrual balance sheets and income statements.  The sad fact of the matter is that if the only statement was a cash flow statement, cheaters would really begin to cheat.  For example, cash payment and collection contracts would be easily manipulated for evil purposes.

Point 9
It diverts organizational effort from risk management to complicated bookkeeping.

In some of my FAS 133 seminars given to CFOs, some of them admitted that they really did not understand some types of hedging until they had to deal with FAS 133.

Point 10
Thus it obscures financial performance.

Andy Fastow said the same thing.


Bob Jensen's tutorials on hedge accounting are at 

From The Wall Street Journal Accounting Weekly Review on October 29, 2004

TITLE: Probe Into Fannie's Accounting May Last for Months, SEC Says 
REPORTER: John Connor 
DATE: Oct 25, 2004 
TOPICS: Accounting, Advanced Financial Accounting, Auditing, Derivatives, Earnings Management, Financial Accounting

SUMMARY: The SEC acknowledged that Fannie Mae's accounting issues are a complex matter and are not black and white, in apparent contrast to the assertions made by Office of Federal Housing Enterprise Oversight (Ofheo). The related article discusses recent congressional testimony by Franklin Raines, Fannie Mae's chairman and chief executive, designed direct focus on the SEC's assessment of their accounting practices, rather than Ofheo's.

1.) Summarize the description of Fannie Mae's circumstances from this article and the related one.

2.) Why are the issues associated with accounting for derivative security transactions "not black and white"?

3.) Why would the Office of Federal Housing Enterprise Oversight (Ofheo) acknowledge "that Generally Accepted Accounting Principles is (sic) within the SEC's 'purview'"? Does the SEC establish accounting principles? Does any other entity do so?

4.) Why might it be particularly difficult to show that any entity undertakes accounting for derivatives with a view to smoothing income or to meet bonus targets for earnings? What evidence do you think would be necessary to demonstrate that intent?

Reviewed By: Judy Beckman, University of Rhode Island

TITLE: Fannie Mae Seeks an Ally in SEC 
REPORTER: Jonathan Weil and John D. McKinnon 
ISSUE: Oct 12, 2004 

Bob Jensen's threads on the Fannie Mae and Freddie Mac scandals are at 

Bob Jensen's threads on macro hedging are at 

FEDERATION BANCAIRE DE L'UNION EUROPEENNE Provides a great free document on macro hedging with references to IAS 39.  The article also discusses prospective and retrospective effectiveness testing. For a link to the document go to the term "ineffectiveness" at 

From The Wall Street Journal Accounting Weekly Review on October 8, 2004

TITLE: Fannie Mae Probe Into Accounting Faces a High Bar 
REPORTER: John D. McKinnon 
DATE: Oct 01, 2004 
TOPICS: Accounting, Accounting Fraud, Financial Accounting, Financial Accounting Standards Board, Securities and Exchange Commission

SUMMARY: Ofheo issued a reported last week critical of Fannie Mae's accounting practices as being designed to smooth earnings and, in at least one case, increase earnings from "cookie jar reserves" to support executives' receipt of bonuses. The Justice Department has now opened an an investigation of possible accounting fraud.

1.) What are "aggressive interpretations of accounting rules"? How can these interpretations be used with "specific intent to deceive" financial statement users? What other motives might lead an entity to produce financial statements which reflect an aggressive approach?

2.) "Prosecutors' problems are...compounded because accounting standards are often so vague..." Describe a standard which you think is written in a vague manner. How do preparers have difficulty in applying the standard because of this vagueness? How might they use such vagueness to apply an aggressive approach to recording transactions?

3.) Contrast your answer to the question above with an example of an accounting standard which contains clear rules rather than vague requirements. What are some concerns with accounting standards written in that fashion?

4.) In the article, the author writes, "...the ultimate arbiters of the accounting rules are the Securities and Exchange Commission and the newly-created Public Company Accounting Oversight Board." Do you agree with that statement? Support your answer with reference to the role of each entity having authority to establish accounting and auditing standards.

5.) The last sentence in the article refers to Sarbanes-Oxley requirements regarding executive bonuses. How do those requirements relate to the discussion in the article?

Reviewed By: Judy Beckman, University of Rhode Island

TITLE: Fannie Mae Board Agrees to Changes It Long Resisted 
REPORTER: James R. Hagerty and John D. McKinnon 
ISSUE: Sep 28, 2004 LINK:,,SB109628948468528709,00.html 

TITLE: Fannie Voice of Calm Now Is in Storm 
REPORTER: John D. McKinnon PAGE: A6 ISSUE: Sep 28, 2004 


Bob Jensen's threads on the Fannie Mae and Freddie Mac scandals are at 

Bob Jensen's threads on KPMG scandals are at

"Ernst & Young Releases Landmark Corporate Development Officer Study," AccountingWeb, October 12, 2004 --- 

Is there room for yet another "C" in the C-suites of Corporate America? According to a new study by Ernst & Young, one of the world's largest accounting firms, the answer is yes -- especially for companies actively engaged in transactions such as mergers & acquisitions.

According to the Ernst & Young study, "Striving for Transaction Excellence: The Emerging Role of the Corporate Development Officer," the corporate development officer, or "CDO," is emerging as the newest class of C-suite executive as a direct result of increased investor scrutiny and a renewed commitment to corporate governance throughout the transaction lifecycle.

The study is the most comprehensive examination of the CDO role ever completed. E&Y's Transaction Advisory Services practice conducted over 175 in-depth interviews with executives bearing responsibility for corporate development. Participants were drawn from a diverse range of companies, including 89 Fortune 1000 companies -- 26 of which represented the Fortune 100.

"There is a shift in how companies are approaching corporate development, and the emergence of the CDO role is at the center of that change," said Kerrie MacPherson, Americas Markets


Continued in article

The main E&Y link about this study is at 

Excerpts can be downloaded from 

Bob Jensen's threads on corporate governance are at 

"DaimlerChrysler Is Named In Second Whistleblower," The Wall Street Journal, November 19, 2004 ---,,SB110087841886279303,00.html?mod=home%5Fwhats%5Fnews%5Fus 

A second former employee of DaimlerChrysler AG has filed a federal lawsuit against the auto maker, accusing it of firing her after it ignored reports of accounting fraud.

Christine Holtzmann filed the whistleblower lawsuit Thursday in U.S. District Court in Detroit. She claimed she was fired in December 2003 after working 18 years at DaimlerChrysler and its predecessor unit in the U.S., Chrysler Corp.

Ms. Holtzmann claims in court documents that during an 18-month period ending in September 2003, DaimlerChrysler neither conducted preliminary investigations nor disclosed a dozen complaints to the auto maker's audit committee.

Ms. Holtzmann at the time was administrator of Chrysler's Business Practices Office, which reviews allegations of improper business practices and is responsible for filing reports to DaimlerChrysler's audit committee about its activities.

"There were some high-level cases that were being kept in a separate file cabinet," Laura Fentonmiller, a Royal Oak, Mich., lawyer representing Ms. Holtzmann, told the Detroit News. Some complaints were falsely backdated as closed years before they were actually opened, she said. "These cases were intentionally being removed from the radar," Ms. Fentonmiller said. "Shareholders needed to know that."

The Securities and Exchange Commission is investigating Ms. Holtzmann's allegations and those of a second former Chrysler employee, David Bazzetta.

Mr. Bazzetta, a former company auditor fired in January after 21 years with the company, filed a similar whistleblower lawsuit on Sept. 28. He claimed DaimlerChrysler maintained at least 40 secret bank accounts to bribe government officials in South America in violation of U.S. securities laws, and was fired after he notified senior company officials about the accounts.

Continued in the article

Bob Jensen's threads on whistle blowing are at 

"MCI Inc. Posts $3.4 Billion Loss For 3rd Quarter," by Shawn Young, The Wall Street Journal, November 5, 2004, Page B2 ---,,SB109956924948864745,00.html?mod=technology_main_whats_news 

Results Reflect Write-Off Of $3.5 Billion on Assets; Revenue in 2004 to Drop 

Results Reflect Write-Off Of $3.5 Billion on Assets; Revenue in 2004 to Drop By SHAWN YOUNG Staff Reporter of THE WALL STREET JOURNAL November 5, 2004; Page B2

MCI Inc. reported a $3.4 billion third-quarter loss, reflecting a $3.5 billion write-off the phone giant has said it is taking on assets that have lost value.

The company also cautioned that 2004 revenue will be slightly below the $21 billion to $22 billion it had projected early in the year.

"Slightly means slightly," said Chief Executive Michael Capellas. He noted that the company hadn't changed its projections since a regulatory setback led MCI and larger rival AT&T Corp. to virtually abandon marketing of home phone service to consumers. Both companies are now focused almost exclusively on business customers.

Despite the revenue decline, MCI projects a fourth-quarter profit, the result of improving margins, lower costs and a little stabilization in the price wars that have wracked the long-distance industry. The profit would be the first for the former WorldCom Inc. in years. The company filed for Chapter 11 bankruptcy protection in 2002 in the wake of a massive accounting fraud. It emerged under the name MCI in April.

The improving trends that could produce a fourth-quarter profit were also evident in operating results for the third quarter, which largely met investor expectations.

Continued in the article

Bob Jensen's threads on the Worldcom and MCI scandals are at

MARSH'S CEO IS EXPECTED to resign as the insurance-brokerage firm faces bid-rigging and civil fraud charges. The full board is set to meet this morning to discuss, and possibly approve, a new chief executive to succeed Jeffrey Greenberg, as well as corporate safeguards aimed at preventing improper behavior.

"Marsh's Chief Is Expected To Step Down," by Monica Langley and Ian McDonald, The Wall Street Journal, October 25, 2004, Page C1 ---,,SB109865866975754136,00.html?mod=home_whats_news_us 

Marsh & McLennan Cos. Chairman and Chief Executive Officer Jeffrey W. Greenberg, bowing to pressure from regulators and investors, is expected to resign this morning, people familiar with the situation say.

The full board of the world's largest insurance-brokerage company also is set to meet this morning to discuss -- and possibly approve -- a new chief executive, as well as corporate safeguards aimed at preventing improper behavior at the company.

The climactic meeting follows days of marathon conference calls by the board's 10 outside directors, including one call yesterday, aimed at resolving a crisis that began more than a week ago when New York Attorney General Eliot Spitzer brought bid-rigging and civil fraud charges against the New York company. In unveiling his suit, Mr. Spitzer all but set Mr. Greenberg's departure as a condition of any settlement. Big investors added to the pressure late last week, calling for the ouster of the 53-year-old Mr. Greenberg.

Since then, Marsh & McLennan has suspended several employees and replaced the head of its insurance-brokerage unit. But its shares have fallen 42% through Friday, hacking billions of dollars off the company's value. On Friday, Marsh shares jumped nearly 8% to $26.79 on reports that Mr. Greenberg was about to resign, giving the board a glimpse of how receptive Wall Street would be to his ouster.

"They have to get a new manager to replace Greenberg," said Jim Huguet, manager of the Great Companies Fund, in which he had owned Marsh shares for more than two years before selling the position last week.

Mr. Spitzer was informed of the meeting, but wasn't told who might succeed Mr. Greenberg. In addition to management changes, Mr. Spitzer wants Marsh to overhaul its systems of compliance with laws and regulations. "Where was Marsh's compliance office?" the attorney general had asked Marsh officials when reviewing the alleged bid-rigging and steering of business to insurance companies that paid it high commissions that Mr. Spitzer calls kickbacks. When Marsh's general counsel asked what Mr. Spitzer's investigators had found, Mr. Spitzer retorted that the company should have uncovered the problems itself.

The 10 outside directors on the 16-member Marsh board have complained about being caught flat-footed and blame management for not apprising them of the gravity of Mr. Spitzer's investigation, people close to the situation say.

Lewis W. Bernard, a retired Morgan Stanley executive and a Marsh board member, has taken a leading role, and his experience in the securities business has been useful in dealing with investigators. Because Mr. Bernard comes from the highly regulated securities industry where compliance officers are standard, his advice to his colleagues has been useful, said a person close to the situation.

In recent days, Marsh effectively has been without leadership. The outside directors, in daily meetings and conference calls, have focused entirely on the crisis. While Mr. Greenberg has come to the office since the scandal broke, he largely was shut out of decision-making, people familiar with the situation said. Operations at the global company are largely in the hands of the firm's lower layers of management, even as many are paralyzed over whether they will lose their jobs in the house-cleaning that is likely to follow.


"We are working very hard on the problems," said Marsh director Oscar Fanjul, who didn't want to comment further for the sake of "order and discipline."

Mr. Greenberg decided to resign because "he doesn't want to be part of the problem," according to a person close to the situation. "He's putting the company's interest above his own."

Mr. Greenberg is a member of an insurance family dynasty headed by his father, Maurice "Hank" Greenberg, who is chairman and chief executive of American International Group Inc. But the Marsh CEO has no employment contract or severance agreement in place, according to the company's most recent proxy filings with the Securities and Exchange Commission.

Mr. Greenberg's exit package was being negotiated over the weekend. Last year, he was paid more than $5 million in salary, bonuses and other cash compensation, according to recent regulatory filings. He also received more than $9 million of restricted Marsh shares that don't vest for a decade, in addition to 500,000 options to buy Marsh shares at $42.99, well above their current price.

Mr. Greenberg had no comment, according to his attorney, Richard Beattie.

How Mr. Greenberg's expected departure is presented and the wording of any settlement with Mr. Spitzer are key because of the near certainty of civil litigation over the allegedly corrupt practices, said a person close to the company, which is bracing for lawsuits from shareholders and customers.

In their hunt for a new leader, the directors have a limited pool of insiders to choose from because it still is unclear how far up the corporate ladder knowledge of the bid-rigging and steering of customers to certain insurance companies went. The only executive who has been elevated during the crisis is Michael G. Cherkasky, formerly head of Kroll Inc., the investigative firm Marsh acquired in July, who took over Marsh's insurance brokerage unit the day after Mr. Spitzer's suit was filed. Mr. Cherkasky was Mr. Spitzer's boss for a time in the Manhattan district attorney's office.

Among those hit by the drop in Marsh's stock price are company employees. At the start of the year, they held more than 27.4 million Marsh shares, 5.2% of those outstanding, through a stock investment plan, according to regulatory filings. The company has encouraged employees to buy its shares by matching those purchases with company stock. Effective today, the company will lift remaining restrictions on employees' ability to sell that stock and choose another investment, a spokesman said.

Bob Jensen's threads on insurance industry fraud are at 

Payola By Any Other Name

"Spitzer Probes How Music Labels Get Radio Airplay," by Ethan Smith, The Wall Street Journal, October 22, 2004 ---,,SB109841815127552985,00.html?mod=home%5Fwhats%5Fnews%5Fus 

The office of New York Attorney General Eliot Spitzer has opened an investigation into the ways global music companies secure radio airplay for their releases, according to people familiar with the matter.

Beginning shortly after Labor Day, the attorney general began requesting documents and information from Warner Music Group; EMI Group PLC; Vivendi Universal SA's Universal Music Group; and Sony Corp. and Bertelsmann AG's Sony BMG Music Entertainment.

Warner Music was served with a subpoena; it is unclear whether the other companies received subpoenas also.

The inquiry concerns the use of so-called independent promoters, middlemen between record companies and radio stations, whom the labels pay -- sometimes handsomely -- to help them secure better airplay for their releases.

This isn't the first time Mr. Spitzer has gone after the global music companies. Over the summer, his office announced a plan to distribute royalty payments the music companies owed to musicians -- some of them very high-profile -- the music companies said they couldn't locate.

People familiar with the matter said they weren't sure how much progress the investigation had made in the nearly two months it has been under way. The inquiry was reported late yesterday by the New York Times' Web site.

Officials from Mr. Spitzer's office couldn't be reached to comment.

The independent-promotion system has long been viewed as a way around laws against payola, which is undisclosed cash payments to individuals in exchange for airplay. If station owners charge money directly for airplay, they must disclose the transaction over the air. The illegal practice of payola resulted in a series of scandals that shook the music and radio worlds in the 1950s and 1960s.

Continued in the article

The Future of Auditing

Forwarded on November 24, 2004 by Dave Storhaug [storhaug@BTINET.NET

Called to account - The future of auditing
THE ECONOMIST via NewsEdge Corporation : ** NOTE: TRUNCATED STORY **

The auditing industry has yet to recover from the damage inflicted by an era of corporate scandals

NO ONE becomes an auditor because the job is adventurous. In recent years, however, the profession has been really rather racy. Auditors have been implicated in fraud after fraud. The Enron scandal brought down Arthur Andersen, which had been one of the profession's five giant firms. Now a scandal at Italy's Parmalat that was uncovered in late 2003 threatens Deloitte & Touche, another global giant, as well as Grant Thornton, an important second-tier firm. And new scandals are still emerging: most recently, financial manipulation was discovered at Fannie Mae, America's quasi-governmental mortgage lender, and at Nortel Networks, a telecoms-equipment group.

 Investors depend on the integrity of the auditing profession. In its absence, capital markets would lack a vital base of trust. So it is no surprise that scandals have triggered changes in the profession. In America it has seen self-regulation dissolved in favour of the Public Company Accounting Oversight Board (PCAOB), in effect, a new regulator. It has been deluged with new rules, restrictions and requirements as part of the Sarbanes-Oxley act. In Europe the Eighth Company Law Directive, which, among other things, deals with the auditing profession, is progressing, albeit slowly, towards enactment.

 Britain's Office of Fair Trading is in the midst of scrutinising its audit industry. One consequence of all this change is that audits have become tougher. The requirement introduced by Sarbanes-Oxley that auditors report to independent non-executive board directors rather than company management has reduced one overt conflict of interest. The certification of financial reports by chief executives and chief financial officers has focused minds. And the PCAOB has begun its inspections of audit quality and internal controls at auditing firms.  Its first, mostly reassuring, reports were published in August.

Auditors themselves say they have toughened their standards and beefed up internal controls. And checks-and-balances in the financial system have been working better. Audit committees are taking their roles more seriously and asking tougher questions of management and auditors; activist shareholder groups, such as Calpers, are holding company auditors to standards that are higher even than those required by law, especially when it comes to their provision of non-audit services.

Auditors even have more business, thanks to the new rules they must implement.  Yet despite this flurry of activity, behind the scenes there is  a feeling among auditors that they are still a long way from meeting all the challenges they face. True, there are promising solutions to, say, the problem of conflicts of interest. But leading auditors point to one central concern: what, if anything, can be done to reduce the industry's alarming concentration? That problem seems almost intractable.

The world's biggest companies rely for their annual audits on a tight oligopoly of just four accounting firms. According to the General Accounting Office, a congressional watchdog, the Big Four - Deloitte & Touche, PricewaterhouseCoopers (PWC), Ernst & Young (E&Y) and KPMG audit 97% of all public companies in America with sales over $250m.  They audit more than 80% of public companies in Japan, two-thirds of those in Canada, all of Britain's 100-biggest public companies and, according to International Accounting Bulletin, they hold over 70% of the European market by fee income.

> This dominance raises two concerns. Is concentration stifling competition and lowering the quality of audits? More alarming, if one of these firms were to buckle, could the system cope with only a Big Three? The dilemma is that these firms are too important to fail - but there are mechanisms by which they could fail, says Paul Danos, dean of Dartmouth College's Tuck Business School. These are shaky foundations for financial markets.

The concentration of the audit industry is a relatively new phenomenon. Until the Great Depression, company audits were voluntary. But as part of the Securities Acts of 1933 and 1934, listed companies were required to disclose audited financial information to the public.  The franchise was given to the private sector, and so the auditing  industry was born.

For several decades, hundreds of auditors plied their services to public companies without much ado. A big change came in the industry in the 1970s, when rules restricting auditors from advertising and competitive bidding were loosened, unleashing fierce competition - often on price as much as audit quality. Around this time, audit firms began to move more heavily into consulting, starting their transformation into multi-disciplinary conglomerates peddling everything from legal and strategic advisory services to the installation of computer systems.

As listed companies grew bigger and more global, audit firms did too through a series of mergers and acquisitions. By the 1980s, eight firms dominated the American auditing industry. By 1998, this was down to five. After the SEC's criminal indictment of Andersen in 2002 for obstruction of justice in the Enron fiasco, the Big Five became the Big Four.

Big, bigger, biggest

There are arguments in favour of such scale, at least where the world's biggest companies are concerned. Unlike looser alliances of disparate accounting firms, which find it difficult to monitor audit quality across countries, the truly international audit firms spend piles of cash on common training, internal inspections and the like, spreading the substantial costs for these procedures across their relatively big capital bases.

Also in theory, although this is perhaps more arguable in practice, big firms can be tougher auditors because they are not overly dependent on the profits they derive from a single client. They can also develop the specialised expertise needed to audit increasingly complicated clients - Citigroup and HSBC, for example, have banking activities spanning derivatives trading to syndicated loans, spread across dozens of jurisdictions.

The question facing the industry is how few firms would be too few?  In 2003, after the implosion of Andersen, the General Accounting Office addressed this question at the behest of a worried Congress. It found  no evidence of collusion among the top firms.  Nor was there evidence that the audit profession's concentration hurt the quality of big-company audits (although this is an inexact exercise).

The real concern is not so much that four firms are too few, but that four could fall to three. According to a report by Glass Lewis, a research consultancy specialising in corporate-governance issues, Andersen's collapse prompted approximately 1,300 firms to scramble to find new auditors. Today the Big Four already have their hands full dealing with the PCAOB's new rules. Cono Fusco, a partner with Grant Thornton in America, says that a further collapse could cause paralysis in financial markets, especially if it were to occur near the end of the year when companies file their financial reports.

More importantly, a Big Three would almost certainly be too few to  ensure an adequate degree of competition in large-company audits. As it is, some firms are already finding it tricky to comply with the PCAOB's new rules, which restrict the provision of certain non-audit services by auditors. This is particularly the case because of Section 404, a new rule that requires public companies to have their internal controls, as well as their financial reports, checked by an independent auditor.

 Take Sun Microsystems, which has annual sales of $11 billion and operates in 100 countries. It uses KPMG, Deloitte and PWC for work on internal controls, valuation, tax and internal audit, while E&Y is its external auditor. Trying to juggle these relationships is a time-consuming pain, says Lynn Turner, a former SEC chief accountant who sits on Sun's audit committee. Yet Sun is too far-flung for it to be able to appoint a second-tier firm.

This problem is especially acute in certain industries. According to the Public Accounting Report, an industry newsletter, the market share of three of the Big Four firms (E&Y, KPMG and PWC) in the oil and gas industry was 97.3% by revenue audited. In the casino industry, just two firms (Deloitte and E&Y) audited 88.2% of the industry by the same measure in 2004. Similar concentration exists in the air transportation, coal and other industries.

 Given this, regulators might feel constrained in how they respond to sloppy or unscrupulous behaviour on the part of the Big Four. Almost everyone agrees that Andersen's collapse made the financial system more vulnerable. So far, regulators have dealt with those improprieties that have come to light with narrow, targeted bans. For example, earlier this year E&Y was handed a six-month ban on taking on new, listed clients. It was found to have violated conflict-of-interest rules by forming a business partnership with PeopleSoft, a software firm that was also one of its audit clients.  But who can say that another scandal on the same scale as Enron or Parmalat will not surface? The reality is that the Big Four is very likely too big to fail. Regulators know this - and that is a huge moral hazard, says Jim Cox of Duke University.

 A naked option

The mountain of litigation facing the profession as a whole, and the Big Four in particular, injects real bite into these concerns. Neil Lerner of KPMG says there is an estimated $50 billion in claims outstanding against the Big Four. Settlements can be enormous (see chart). And the worry is that even the likelihood of a big payout could trigger a mass exodus of accounting partners, followed by clients, then by more partners. Andersen didn't die because of the SEC's indictment per se, says Mr Lerner, but because its international network unravelled. It was a death spiral.

The cost of litigation and size of claims have mounted steadily over decades, but in the post-Enron era both have spiked like a hockey stick, says Bill Parrett, boss of Deloitte in America. Some 10-20% of  the Big Four's audit revenues are routinely funnelled into litigation costs (settlements, insurance and the like), which are then passed on to consumers. The Big Four have huge problems getting insurance, particularly against unpredictable catastrophic risks. Ten years ago, there were 150 commercial insurers providing indemnity to the major auditors, says Tom McGrath, a senior partner at E&Y: Now there are ten.

In theory, such pressure is a disciplining force on the profession.  The Big Four concede that they should pay something if they are to blame for their part in accounting fraud. But ultimately, they argue, fraud is perpetrated by company managers, not their auditors. Auditors claim they bear the brunt of any financial damages sought because they have deep pockets and are often the last man standing, says Sam DiPiazza, chief executive of PWC. In effect, auditors have become the insurers of financial statements, writing what Mr Fusco likens to a naked (ie, unhedged) option: You get unlimited exposure for a limited reward, he says. Critics see that as special pleading - after all, the whole point of auditing financial statements is to give some form of guarantee that they are credible.

But the unintended consequence of litigation run amok, argues the profession, is that audit quality is worse. Accounting rules are increasingly interpreted prescriptively rather than based on broad principles that are seen as too fuzzy to hold up in court. Auditors themselves, fearful of lawsuits, are inclined to adopt a check-the-box approach, adhering strictly to accounting rules rather than exercising (necessarily subjective) judgment. And the looming threat of litigation, argues the profession, hurts the recruitment and retention of the best and brightest talent. Who wants to be a partner in a firm that faces billions of dollars in lawsuits? asks one company boss.

 The cap doesn't fit

Arguably the litigation problem worsens the issue of industry concentration, because only auditors with deep pockets can afford to take on the risk of making a mistake with a large public company. The Big Four point out that some European countries have caps on auditor liability. As a consequence, they say, there is significantly less concentration in these markets, an outcome they seem willing to contemplate. In Germany, for example, where auditor exposure is capped at euro4m ($5.2m), 67 of the biggest 300 listed companies are audited by firms outside the ranks of the Big Four. In Greece, where the audit cap is set, bizarrely, at five times the salary of the president of the Supreme Court, 27 of the 60 companies listed on the Athens stock exchange are audited by firms outside the Big Four.

>But these arguments have failed to sway regulators in America and Britain, where auditor-liability reform is most debated. Britain's Office of Fair Trading recently considered and rejected auditor caps, saying that it found little evidence that caps encouraged competition or would do anything to reduce the risk of the collapse of a Big Four firm. Indeed, caps might make concentration worse, since they would help the Big Four, who are already most exposed, more than smaller outfits. As for recruitment, figures show that, in America at least, the number of students taking accounting courses has risen sharply since the scandals at Enron and WorldCom were uncovered.

 Can anything be done to shore up the audit profession's latent instability? Ideally, the market would self-correct. Where profits are to be made, you should find new entrants, says Peter Wallison of the American Enterprise Institute, a think-tank. But the barriers to entry in the audit of the biggest companies are exceedingly high. Building huge international networks is difficult and expensive. And legal rules in many countries mean that audit firms have to be partnerships, so cannot raise funds on the capital markets.

 Regulation is another big barrier. The cost of doing public audits has increased dramatically, stretching capacity thin. As an indication of increased regulatory costs, E&Y's Mr McGrath says that so far this year, his firm has spent nearly 400,000 man-hours on training and education on Section 404 alone. Given how expensive it is to comply with the new regulations in order to do audits of public companies, and the significant downside from litigation, why would a smaller firm want to take this on? asks Mr Wallison.

** NOTE: This story has been truncated

December 15, 2004 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU

In a recent issue of Golf World, a letter writer was commenting on the need for professional golfers to be more "entertaining."  He went on to say:

"Fans pay top dollar to attend tournaments and to subscribe to cable coverage.  Not many would pay to see an accountant work in his office or watch The Audit Channel."

That's probably a true comment.  On the other hand, wouldn't at least some of us have liked to watch The Audit Channel and see what was being done on Enron, WorldCom, HeathSouth, or some of the other recent interesting situations?

Denny Beresford

December 15, 2004 reply from Bob Jensen

You know better than the rest of us, Denny, that academic accounting researchers won't tune in to watch practitioners on The Audit Channel. They're locked into the SciFi Channel.

Bob Jensen

Bob Jensen's threads on Academics Versus the Accounting Profession (including the first tee shot by Denny Beresford) are at 

Bob Jensen's Home Page is at

Bob Jensen's Main Fraud Document --- 

Other Documents

Many of the scandals are documented at 

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

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

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

Updates on the leading books on the business and accounting scandals --- 

I love Infectious Greed by Frank Partnoy ---