Transcript Fraud & Accounting Education
Accounting Updates Southern Gas Association Accounting & Financial Executives Conference April 28, 2003
Robert E. (Bob) Jensen Trinity University San Antonio, TX 78212
http://www.trinity.edu/rjensen/
Why are the fees of large accounting firms so huge?
“Chatper 1: The Andersen Way,” by Barbara Ley toffler, Page 1
Robert stared at him, disgusted. “We don’t do anything for $50,000.” The manager looked as if he might melt into a puddle of shame. After giving me a pleading glance, he slunk out of the partner’s office, knowing that when he returned he had better have a generously padded price for his piece of the project.
Why Does Accounting Fraud Begin?
The main reason is that white collar crime pays even if you get caught and spend a year or two in Club Fed!
Only idiots rob $150 from a gas station. Smart hoodlums get stock options for $250 million, cook the books, and exercise the options before the stock price plunges.
What is the history & culture?
Pipe Dreams: Greed, Ego, and the Death of Enron
Bryce (The Perseus Books Group ISBN 1-58648-138-x, 2002) by Robert
Final Accounting: Ambition, Greed and the Fall of Arthur Andersen
by Barbara Ley Toffler (Broadway Books, ISBN 0-7679-1382-5, 2003)
Power Failure: The Inside Story of the Collapse of Enron
by Mimi Swartz and Sherron Watkins (Doubleday, ISBN 0-385 507887-9)
http://www.trinity.edu/rjensen/fraud.htm#References
How Does Accounting Fraud Begin?
Answer: Cookin’ The Books
• Starts with “making the numbers” • Then, “Managing the Numbers” • Ends with “making up the numbers”
Rationalization includes:
• “We need to make our projections…” • “I’m getting pressure from the boss…” • “We need to meet Street expectations…” • “Our acquisition will fall through if we don’t…”
But, even a simple mistake can be turned into a financial fraud through “cover-up” efforts.
Annual Caseload by Fiscal Year
600 500 400 300 200 100 0 199 5 199 6 199 7 199 8 199 9 200 0 200 1 200 2 Fiscal Year
SEC Enforcement: FY 2002
• • 598 total cases Largest categories: – Financial fraud and issuer reporting (27%) – Offering fraud (20%) – Broker-dealer (14%) – Insider trading (10%) – Market manipulation (7%) – Investment adviser/company (8%)
Financial Reporting and Issuer Disclosure: Actions Filed • 163 actions filed in FY 2002 – Compared to: • • • 112 in FY 2001 • 103 in FY 2000 94 in FY 1999 79 in FY 1998
Why so many financial statement frauds all of a sudden?
Systemic Problems of Accounting That Cannot or Will Not Be Solved: http://www.trinity.edu/rjensen/FraudConclusion.htm
Behavior of CPA Firms: http://www.trinity.edu/rjensen/fraud.htm
Greed on Wall Street: Rotten to the Core http://www.trinity.edu/rjensen/fraud.htm#Cleland Washington DC Prostitutes: Representative
Fernand St Germain
(D-Rhode Island)
$32 Billion for 30 Years
Senator
Phil Gramm
(R-Texas) & Wife
Wendy $400 billion and counting http://www.trinity.edu/rjensen/fraud.htm#WarningSigns
Why so many financial statement frauds all of a sudden?
Good economy was masking many problems
Moral decay in society Executive incentives Wall Street expectations —rewards for short-term behavior
Why so many financial statement frauds all of a sudden?
Failure of Corporate Audit Committees Board of Directors Failures and Greed Financial Analyst Conflict of Interests and Greed: Rotten at the Core • Education Failures: Graduates of Greed Rather Than Professionalism
Good economy was masking problems
….
With increasing stock prices , profits and wealth for everyone, no one worried about potential problems
.
Detailed Complicated Rules
With Loop Holes Big Enough To Drive A Truck Through
Nature of Accounting Rules
Allows companies and auditors to be extremely creative when not specifically prohibited by standards
.
“rules-based”
vs.
“principles based” rhetorical nonsense
Loop Hole Examples Include : SPEs and other types of off balance sheet financing Revenue recognition approaches, Merger reserves Pension accounting Other accounting schemes.
When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do
this…because it
GAAP…” isn’t
Unaccountable Contracts
Expect New Amendments in SFAS 149
What’s going on at the FASB Spring 2003 Prepared for the Southern Gas Association Executive Conference on April 28, 2002. Robert E. Jensen, Trinity University, San Antonio, TX 78212
Topics Selected for Discussion • Key Documents Effective 2002/2003 – Statements 143, 146, 147 and 148 – FINs 45 and 46 • Next Documents to be Issued – Statements 149 and 150 • Projects on the Agenda • Other Items – FASB Staff Positions (FSPs) – Improving Standards (Principle-based Standards) – Convergence
Who is the FASB?
• Private-sector standard setter that provides guidance for accounting and financial reporting by public and non public entities.
• Not an Oversight Body — no enforcement power.
• Formed in 1973 and recognized by the SEC and the AICPA as the creator of GAAP.
– Public Companies – Private Companies – Not-for-Profit Entities
FASB’s Mission • To establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.
• Accounting standards are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent and understandable financial information.
• Good financial and business reporting reduces the uncertainty premium charged by investors and lenders.
Impact of Sarbanes-Oxley • FASB expects to be Recognized as Private Sector Accounting Standard Setting Body.
• FAF selects members of FASB (unlike PCAOB).
• FASB is separate from the PCAOB and neither reports to the other.
• Public companies will be billed for the cost to operate the FASB and the PCAOB.
• SEC to Report to Congress on Principle-Based Standards and Off-Balance Sheet Entities.
Certain Documents Effective 2002/2003 • Statement 143,
Accounting for Asset Retirement Obligations
• Statement 146,
Accounting for Costs Associated with Exit or Disposal Activities
• Statement 147,
Acquisition of Certain Financial Institutions
• Statement 148,
Accounting for Stock-Based Compensation – Transition and Disclosure
• FIN 45,
Guarantor’s Accounting and Disclosure Requirements for Guarantees
• FIN 46,
Consolidation of Variable Interest Entities
Statement 143,
Accounting for Asset Retirement Obligations
• Reason issued – to recognize a disposal liability when it is incurred that previously was not recognized until later.
• Issued June 01; Effective – fiscal year beginning after 6-15-02.
• Initial application results in recognition of: – a liability (initially at fair value) – higher cost and accumulated depreciation amounts – cumulative effect of accounting change.
Statement 146,
Accounting for Costs Associated with Exit or Disposal Activities
• Reason issued – to replace Issue 94-3 and to recognize liabilities when they have been incurred and not before.
• Issued June 02; Effective for activities initiated after 12-31-02.
• Specific guidance for: – One-time Termination Benefits (usually a stay bonus) – Contract Termination Costs (lease termination) – Other associated costs.
• Extensive disclosure requirements.
Statement 147,
Acquisition of Certain Financial Institutions
• Reason issued – to remove all but mutual combinations from Statement 72 and FIN 9 and put certain customer relationship intangibles into the scope of Statement 144 (impairment of long-lived assets).
• Issued October 02; Effective October 1, 2002.
• The Statement 72 intangible asset is treated as goodwill under Statement 142. Branch acquisitions are discussed.
Statement 148,
Accounting for Stock-Based Compensation – Transition and Disclosure
• Reason issued – to provide additional transition alternatives for switching from the intrinsic method to the fair value method for stock-based employee compensation and to improve disclosures.
• Issued December 02; Alternatives and annual disclosures are effective for fiscal years ending after 12-15-02; interim disclosures are effective for interim periods beginning after 12-15-02.
FIN 45,
Guarantor’s Accounting and Disclosure Requirements for Guarantees
• Reason issued – to improve disclosures with respect to information about guarantees, the identification of what is a guarantee and to improve accounting by requiring recognition of a liability when incurred.
• Issued November 02; Disclosure requirements effective for interim or annual periods ending after 12-15-02; recognition effective for guarantees issued or modified after 12-31-02.
• Guarantees are initially recognized at their fair value. Discussion of subsequent accounting and what in the debit is provided.
FIN 46, Consolidation of Variable Interest Entities • Reason issued – to identify entities where applying the majority of voting interest approach is not effective (VIEs) and providing an approach to use for those entities.
• Issued January 03; Effective for new VIEs upon issuance and for existing VIEs at the beginning of the first interim or annual period beginning after 6-15-03. For nonpublic entities it is effective for existing VIEs at the end of the annual period beginning after 6-15-03.
• VIEs do not have sufficient equity investment at risk to permit the entity to finance its activities without additional financial support or the holders of the equity investment lack any one of the the 3 characteristics of a controlling financial interest.
FIN 46, Consolidation of Variable Interest Entities (cont’d.) • An enterprise that has variable interests that will : – absorb a majority of the VIE’s variability in its expected losses (tie breaker), – receive a majority of the variability in its expected residual return, or – both is the VIE’s Primary Beneficiary and must consolidate.
Next Documents to be Issued • SFAS 149,
Amendments to Statement 133
– Incorporates various DIG issues into the Statement.
– Clarifies the definition of a derivative (paragraph 66).
– Effective 6-30-03.
Next Documents to be Issued (cont’d.) • SFAS 150,
Liability and Equity Instruments
– The following instruments that have been treated as equity will be treated as liabilities: (1) Instruments that are mandatorily redeemable on a fixed or determinable date or upon an event certain to occur.
(2) Obligations to repurchase an issuer’s equity shares (forward purchase contract or written puts) that must be physically or net cash settled.
Next Documents to be Issued (cont’d.) (3) Obligations that the issuer must or could settle by issuing a variable number of its equity shares when the obligation’s monetary value is fixed or varies on something other than equity values (accounts payable or accrued expense) or the variation is not in the same direction as equity values (written puts with net share settlement.
– For public companies SFAS 150 probably will be effective for annual or interim periods beginning after 6-15-03. For nonpublic companies mandatorily redeemable instrument probably will be effective for annual periods beginning after 12-15-03.
Projects on the FASB’s Agenda • Stock-Based Compensation • Pension Disclosures • Disclosures about Fair Value of Financial Instruments • Liabilities and Equity (Phase II) • Financial Performance Reporting • Revenue Recognition • Short-term International Convergence • Purchase Method Procedures • Combinations of Not-for-Profit Organizations • Combinations of Mutuals • Consolidation • What can a QSPE do with respect to Reissuance of BI • What does “legally released from being the primary obligator” mean?
Selected Projects • Share-Based Compensation – working with IASB; goal is to get the same approach and have it effective as of 1-1-04.
• Pension Disclosures – will focus on information about plan assets and the population of persons to receive pension payments. Also, some quarterly information and where the expense is recorded in the I/S.
• Liabilities and Equity (Phase II) – how to treat instruments with both liability and equity elements; try to get convergence.
FASB Staff Positions (FSPs) • New way to provide guidance on applying GAAP.
• Provides for due process and access.
• Look for FSPs website and get notice of posting from the e-mail
Action Alert.
Improving Standards • Document on Principles-Based Standards issued fall 2002; Roundtables held and comment letters received.
• Shifting focus to “how to improve standards” by addressing issues raised by our constituents.
• SEC doing a study
.
• Changing relationship of FASB with EITF and AcSEC.
Convergence • Working with the IASB on the following joint projects and parallel projects.
– Revenue Recognition – Purchase Method Procedures – Stock-Based Compensation – Reporting Financial Performance. • Both the FASB and IASB have a short-term convergence project to focus on matters not otherwise covered in a major project.
• All FASB projects and EITF issues consider convergence.
GAAP CRITICISM
Fosters Short-Term Earnings Manipulations Does Not Show Value Creation
Executive Incentives
•
Meeting Wall Street’s Expectations
• Performance is based on earnings & stock price –Focus is on short-term (quarterly) performance only –Stock prices are tied to meeting Wall Street’s earnings forecasts –Moral Hazard: Employee Stock Options
Did you ever hear the name Lou Pai?
Companies are heavily punished for not meeting forecasts
Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999.
Princeton University
Stock Fell 13% With This Revelation Jack Welch, Former General Electric Chairman GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... "
Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land. Mostly he flew to his 77,000 acre ranch in Colorado.
Enron’s CEO of Enron Broadband Services, Ken Rice, had a $33,000 customized Hellcat motorcycle in his office just for a distinctive decoration.
Jeff Skilling’s secretary, Rebecca Carter, got a Salary of $600,000 per year plus other perks, including the perky Jeff Skilling according to Schwartz and Watkins.
Rebecca Mark, who’s bonuses ranged in the $40 million range at Enron, had a $6 million private jet budget that often flew her to her “tres chic vacation home in Taos.” according to Robert Bryce, p. 262.
Beat The Numbers
How To Play Numbers Game Aggressive Accounting
Earnings Management Income Smoothing Fraudulent Financial Reporting Creative Accounting Practices
Rewards of The Game
Share Price Effect
Borrowing Cost Effect
Bonus Plan Effect
Political Cost Effect
Auditors —the CPAs
• Failed to accept responsibility for fraud detection (SEC, Supreme Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is?
• Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting rich • Audit became a loss leader –Easier to sell lucrative consulting services from the inside –Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture • A few auditors got too close to their clients • Tradition of sending puppies out to yap at the receivables
In a separate case in late September, a judge's divorce ruling unsheathed guarded financial information about accounting firm Ernst & Young, which is a private partnership that does not file public financial reports. In divorce papers for Ernst & Young chief executive officer Richard S. Bobrow, a 45-page judge's opinion revealed how much the CEO was paid and put a dollar value on the company for the first time, giving competitors a rare peek into the firm's finances.
Annual Salary $ 3 Million $25 million in salary $US29 million in partnership earnings over the next decade.
Pension worth $1 million a year for life and had access to a corporate jet owned by Ernst & Young and a New York apartment.
$ 24 million to Janet Bobrow
“Jan Bobrow, the ex-wife of Ernst & Young CEO Richard Bobrow, says she would have settled their divorce for a little more than $2 million. Richard Bobrow offered $1.2 million.”
USA Today
, October 15, 2002
Moral Decay
• Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed: –67% of CFOs said they had been asked by senior company executives to misrepresent corporate financial results –12% of CFOs admitted they had actually misrepresented financial results…55% said they had fought off requests to “cook the books ” • Honesty studies –1961: 12% –1986: 31% –2002: ???
•
Current Executive Fraud Related Problems
Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc.
•
Executive Loans and Corporate Looting: John Rigas (Adelphia), Dennis Kozlowski (Tyco--$170 million —the $15,000 umbrella stand) IPO Favoritism: Bernie Ebbers ($11 million)
• CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM (Consulting Contracts, Use of Corporate Planes, Executive Apartments with meals, maids, etc.)
Current Executive Fraud-Related Problems
•
Exorbitant Stock Options
Who owns his own 14,000-foot mountain in Colorado?
Largest Bankruptcy Filings
(1980 to Present) Company 1. WorldCom 2. Enron 3. Texaco 4. Financial Corp of America 5. Global Crossing 6. Adelphia 7. PG&E 8. MCorp 9. Kmart 10. NTL Assets (Billions) $101.9
$63.4
$35.9
$33.9
$25.5
$24.4
$21.5
$20.2
$17.0
$16.8
When Filed July, 2002 Dec., 2001 April, 1987 Sept., 1988 Jan., 2002 June, 2002 April, 2001 March, 1989 Jan., 2002 May, 2002
Recent Financial Statement Frauds
• Enron • • WorldCom Adelphia • • Global Crossing • • Xerox Qwest Many others
Let’s Get Back to the Basics
Back to the Basics…
• Know your audit client – Understand the key reports used by management – Understand the budget process – Understand the source of growth • Know your client’s industry
Professional Skepticism
• Should be displayed by all members of the team throughout the audit and review engagements
Back to the Basics…
• Vary the audit testing performed • Prepare a detailed audit program • Understand the client’s closing process • Don’t forget the general ledger
The Closing Process
• Follow-up on all questionable items during the final analytical review • Examine all consolidating financial statements – Including, all post closing and top-side entries
Back to the Basics…
• Issues encountered during the audit -- – Deal with the issue at hand – Don’t try to “paper over” the problem – Management letter comment is not enough – Don’t make the client’s problem your own