Ethical Obligations

Business

Quiz 8 :

Ethical Leadership and Decision-Making in Accounting

Quiz 8 :

Ethical Leadership and Decision-Making in Accounting

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What are the fundamental principles of professional ethics for professional accountants identified by the IESBA and included in the IFAC Code of Ethics? How do these principles relate to the proposed standards for responding to suspected illegal acts in the IESBA exposure draft with respect to whistleblowing obligations of accountants and auditors?
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Fundamental principles for professional accountants:
The fundamental principles proposed by IESBA are as follows:
1. Integrity- The Accountants auditors work should contain a great deal of integrity. The integrity needs to be shown in terms of their compliance to the rules and regulations and conducting the audit procedure in such a manner not showing any sort of discrimination. 2. Objectivity- The accountants auditors work needs to be based on the right objectives, objectives such as, offering little scope for errors, probing the report for finding out data deficiencies, questioning the authorities to obtain sufficient evidence for the reports furnished etc. 3. Professional competence- They need to exhibit professional competence in terms of strict adherence to competency and in terms of exhibiting competence in identifying errors and potential data deficiencies. 4. Due care- While offering the Finance and audit report, the accountants auditors should take all the necessary care in preparing the audit report leaving no scope for omission of important facts and information. 5. Confidentiality- However, while preparing the reports the accountants and auditors needs to ensure confidentiality in protecting vital information while preparing the report from falling into wrong hands. 6. Professional behavior- The accountants and auditors need to exhibit professional behavior while conducting the audit or while preparing the report, this professionalism in terms of their behavior with clients not showing any lenience by accepting bribes etc. The importance of the fundamental principles in companies with respect to whistle blowing :
The principles cited above play huge role with respect to whistle blowing in the following manner:
1. In case the following principles are not in place then important financial information may be passed onto competitors by personnel. 2. Others may use important financial information for personal use. 3. Access to important financial records also may result in employees gaining undue advantage by using the report.

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Parmalat: Europe's Enron After the news broke about the frauds at Enron and WorldCom in the United States, there were those in Europe who used the occasion to beat the drum: "Our Principles-based approach to accounting standard-setting is better than your rules-based approach." Many in the U.S. started to take a closer look at the principles-based approach in the European Community, which relies less on bright-line rules to establish standards, as is the case in the U.S., but may have loopholes making it relatively easy to avoid the rules. As discussed in the chapter, a principles-based approach relies more on objective standards that guide decision making in the application of accounting standards, supported by ethical judgment to help implement the principles. The case of Parmalat illustrates why many question whether the principles-based approach leads to financial statements that more faithfully represent financial position and results of operations. Background Parmalat began as a family-owned entity founded by Calisto Tanzi in 1961. During 2003, Parmalat was the eighth-largest company in Italy and had operations in 30 countries. It was a huge player in the world dairy market and was even more influential within Italian business circles. It had a network of 5,000 dairy farmers who supplied milk products and 39,000 people who were directly employed by the company. The company eventually sold shares to the public on the Milan stock exchange. The Tanzi family always held a majority, controlling stake in the company, which in 2003 was 50.02 percent. Tanzi family members also occupied the seats of CEO and chair of the board of directors. 1 The structure of Parmalat was primarily characterized by the Tanzi family and the large amount of control that it wielded over company operations. It was not unusual for family members to override whatever internal controls existed to perpetrate the accounting fraud. The Parmalat scandal broke in late 2003, when it became known that company funds totaling almost €4 billion (approximately $5.64 billion) that were meant to be held in an account at the Bank of America did not exist. The Parmalat situation described here makes it clear that Europe is not isolated from financial fraud. It also proves that the quality of financial reporting and financial transparency are issues of global concern. At the end of the day, these issues may be more important than whether a principles-based or rules-based approach is used. The Italians Act On March 19, 2004, Milan prosecutors brought charges against Parmalat founder Calisto Tanzi, other members of his family, and an inner circle of company executives for their part in the Parmalat scandal. After three months of investigation, the prosecutors charged 29 individuals, the Italian branches of the Bank of America, and the accountants Deloitte Touche and Grant Thornton. The charges included market rigging, false auditing, and regulatory obstruction following the disclosure that €15 billion (approximately $21.15 billion) were found to be missing from the bank accounts of the multinational dairy group in December 2003. The company has since declared bankruptcy, and 16 suspects, including Carlos Tanzi, are in jail. Other suspects include Tanzi's son Stafano, his brother Giovanni, former Parmalat finance chief Fausto Tonna, and lawyer Liampaolo Zini. Former internal auditors and three former Bank of America employees also have been jailed for their roles in the fraud. 2 The judge also gave the go-ahead for Parmalat to proceed with lawsuits against the auditors. Bondi is also pursuing another lawsuit against Citigroup in New Jersey state courts. Despite all its troubles, Parmalat has recovered and today is a thriving multinational food group with operations in all five continents through either a direct presence or through license agreements. Parmalat Diverted Company Cash to Tanzi Family Members In transactions that might engender pride on the part of Dennis Kozlowski, the former CEO of Tyco, Parmalat transferred approximately €350 million (approximately $494 million) to various businesses owned and operated by Tanzi family members between 1997 and 2003. These family members did not perform any equivalent services for Parmalat that would warrant such payments. Further, Parmalat failed to disclose that the transfers were to related-party interests. U.S. Banks Caught in the Spotlight Italian magistrates and officials from the SEC examined the role of lenders to Parmalat, which collapsed into bankruptcy in late December 2003 following the disclosure of major holes in the financing of the company. The SEC's inquiries focused on up to approximately €1.05 billion ($1.5 billion) of notes and bonds issued in private placements with U.S. investors. The banks investigated included Bank of America, JP Morgan Chase, Merrill Lynch, and Morgan Stanley Dean Witter. Parmalat's administrator, Enrico Bondi, helped the authorities identify all the financing transactions undertaken by Parmalat from 1994 through 2003. During the investigation, it was noted that Parmalat's auditor from 1990 to 1999, Grant Thornton, did not have copies of crucial audit documents relating to the company's Cayman Islands subsidiary, Bonlat. The emergence of a €5.16 billion (approximately $7.28 billion) hole at Bonlat triggered the Parmalat collapse. The accounting firm has since handed over important audit documents to investigators. Accounting Fraud One of the most notable fraudulent actions was the creation of a completely fictitious bank account in the U.S. that supposedly contained $5 billion. After media reports exposing the account surfaced, the financial institution at which the deposit existed (Bank of America) denied any such account. The company's management fooled auditors by creating a fictitious confirmation letter regarding the account. In addition to misleading the auditors about this bank account, the company's CFO, Fausto Tonna, produced fake documents and faxed them to the auditors in order to hide the fact that many of the company's dealings were completely fictitious. 3 Parmalat's management also used "nominee" entities to transfer debt and sales in order to hide them from auditors and other interested parties. A nominee entity is a company created to hold and administer the assets or securities of the actual owner as a custodian. 4 These entities were clearly controlled by Parmalat and most existed only on paper. Using nominee entities, the Parmalat management created a method to remove uncollectible or impaired accounts receivable. The bad accounts would be transferred to one of the nominee entities, thus keeping the bad debt expense or write-off for the valueless accounts off the Parmalat income statement. The transfers to nominee entities also avoided any scrutiny of the accounts by external or statutory auditors (in this case, Italian- designated auditors under the country's laws). Creating revenues was another scheme in which the nominee or subsidiary entities were used; if a non-Italian subsidiary had a loss related to currency exchange rates, management would fabricate currency exchange contracts to convert the loss to a profit. Similar activities were undertaken to hide losses due to interest expense. Documents showing interest rate swaps were created to mislead the auditors or other parties. Interest rate swaps and currency exchange contracts are both instruments usually used to hedge on the financial markets, and sometimes to diversify the risk of certain investments. Parmalat abused these tools by creating completely fictitious contracts after the fact and claiming that they were valid and accurate. The understatement of debt was another large component of the Parmalat fraud, as was hidden debt. On one occasion, management recorded the sale of receivables as "non-recourse," when in fact Parmalat was still responsible to ensure that the money was collectible. There were many debt-disguising schemes in relation to the nominee entities. With one loan agreement, the money borrowed was touted as from an equity source. On another occasion, a completely fictitious debt repurchase by a nominee entity was created, resulting in the removal of a liability from the books, when the debt was still in fact outstanding. Parmalat management also incorrectly recorded many million euros' worth of bank loans as intercompany loans. This incorrect classification allowed for the loans to be eliminated in consolidation when they actually represented money owed by the company to outsiders. 5 The fraud methods did not stop at creating fictitious accounts and documents, or even with the establishment of nonexistent foreign nominee entities and hiding liabilities. Calisto Tanzi and other management were investigated by Italian authorities for manipulating the Milan stock market. On December 20, 1999, Parmalat's management issued a press release of an appraisal of the Brazilian unit. While this release appeared to be a straightforward action, what Tanzi and others failed to disclose were the facts relating to the appraisal itself. The appraisal came from an accountant at Deloitte Touche Tohmatsu (the international name of Deloitte Touche) and was dated July 23, 2008, nearly 19 months prior to the press release. 6 This failure to disclose information in a timely and transparent manner demonstrates yet another way that Parmalat was able to exert influence and mislead investors. Missing the Red Flags The fraud that occurred at Parmalat is a case of management greed with a lack of independent oversight and fraudulent financial reporting that was taken to the extreme. As an international company, Parmalat management had many opportunities to take advantage of the system and hide the fictitious nature of financial statement items. As with many frauds, the web of lies began to untangle when the company began to run out of cash. In a discussion with a firm in New York regarding a leveraged buyout of part of the Parmalat Corporation, two members of the Tanzi family revealed that they did not actually have the cash represented in their financial statements. 7 At the beginning of 2003, Lehman Brothers, Inc., issued a report questioning the financial status of Parmalat. Ironically, Parmalat filed a report with Italian authorities claiming that Lehman Brothers was slandering the company with the intention of hurting the Parmalat share price. 8 Financial institutions failed to examine the accusations thoroughly and continued to loan money to Parmalat due to the supposed strength and power wielded by the company throughout the world. (Notice the similarity with Enron, whereby U.S. banks and financial institutions bought into the fraud that was Enron and didn't want to upset what was then the seventh-largest company in the U.S.) As Luca Sala, former head of Bank of America's Italian corporate finance division, observed, "When you have a client like Parmalat, which is bringing in all that money and has industries all over the world, you don't exactly ask them to show you their bank statements." 9 This attitude and similar attitudes at Citibank led both banks, as well as many others, to write off millions of dollars of loans after the collapse. Several Bank of America employees were charged in the Parmalat fraud, mostly because of the nonexistent U.S. bank account, but also related to lending practices. Eventually, all the bank's employees were acquitted, leading the bank to state: "The crime of market manipulation with respect to BOA was found to be completely groundless." 10 Failure of Auditors Parmalat accused the auditors, Grant Thornton International and Deloitte Touche Tohmatsu, of contributing to its €14 billion collapse in December 2003. Parmalat filed suit against the auditors and other third parties, seeking $10 billion in damages for alleged professional malpractice, fraud, theft of assets and civil conspiracy. Paramalat argued that the headquarters for both Grant Thornton and Deloitte had "alter ego" relationships with their Italian subsidiaries that tied them inextricably to the alleged fraud. According to the complaint, the relationships are highlighted by the firms' own claims to being "integrated worldwide accounting organizations." Judge Lewis Kaplan in U.S. District Court for the Southern District of New York granted a motion by Deloitte USA to dismiss Parmalat's first amended complaint due to Parmalat's failure to show that poor auditing of Parmalat USA was equivalent to fraud at Parmalat in Italy. The frauds continued for many years due, in large part, to the failures of the auditors. Italian law requires both listed and unlisted companies to have a board of statutory auditors, as well as external auditors. The external auditor during the fraud, primarily Grant Thornton, SpA, failed to comply with many commonly accepted auditing practices and thus contributed to the fraud. The largest component of Parmalat's fraud that ultimately brought the company down was the nonexistent bank account with Bank of America. The auditors went through procedures to confirm this account, but they made one fatal mistake: they sent the confirmation using Parmalat's internal mail system. The confirmation request was intercepted by Parmalat employees and subsequently forged by Tonna or an agent acting on his behalf. The forgery consisted of creating a confirmation and printing it on Bank of America letterhead and then sending it back to the auditors. Failure of the Board The statutory board is intended to act as a fundamental monitor within the company and check that the board of directors is complying with laws in their actions and decisions. The Parmalat board of statutory auditors was composed of three members; the number is significant because had there been more than three seats on the statutory auditor board, minority shareholders would have had the ability to elect two of the members. 12 Parmalat's board never reported any irregularities or problems, despite receiving complaints, because of the influence of the Tanzi family. After the fraud was discovered and resolution of the issues began, it became clear that the statutory audit board did nothing to prevent or detect the fraud. Resolution of Outstanding Matters Following an investigation, the founder of Parmalat, Calisto Tanzi, was sentenced in Milan to 10 years in prison in December 2008 for securities laws violations in connection with the Italian dairy company's downfall in late 2003. Tonna, the CFO, was sentenced to 30 months in jail following a trial in 2005, and other officers reached plea bargain deals. 13 Bank of America settled a civil case brought by Parmalat bondholders for $100 million. 14 Bondholders in the U.S. and Italy had alleged the U.S. bank knew of Parmalat's financial troubles, but nevertheless sold investors Parmalat bonds that ultimately soured-allegations Bank of America denied. Both sides said the agreement cleared the way for future business between the companies. In a statement following the settlement, Bank of America stated that the record of court rulings in the case "makes it clear that no one at Bank of America knew or could have known of the true financial condition of Parmalat. We have defended ourselves vigorously in these cases and are satisfied with this outcome today." 15 After the accounting and business problems surfaced, a court battle ensued regarding who was responsible for the audit failures. The umbrella entities of Deloitte and Grant Thornton, Deloitte Touche Tohmatsu, and Grant Thornton International, along with the U.S. branches of both firms, were included in a lawsuit by Parmalat shareholders. Questions were raised as to whether or not the umbrella entities could be held liable for the failures of a country- specific branch of their firm. The courts held that due to the level of control that the international and U.S.-based branches wielded over the other portions of the firm, they could be included in the lawsuit. 16 The extension of liability was a huge issue for accounting firms, and the external auditors were ultimately held liable. Both groups of external auditors were fined large sums to settle a class- action lawsuit by U.S. equity investors over their roles in the Italian company's 2003 collapse; Deloitte Touche Tohmatsu and its U.S. unit, Deloitte Touche LLP, agreed to pay $8.5 million, while Grant Thornton International and its U.S. and Italian units agreed to pay $6.5 million. In addition, Deloitte agreed to pay $149 million to settle with Parmalat itself. 17 Legal Matters with Bank of America On February 2, 2006, a U.S. federal judge allowed Parmalat to proceed with much of its $10 billion lawsuit against Bank of America, including claims that the bank violated U.S. racketeering laws. Enrico Bondi was appointed as the equivalent of a U.S. bankruptcy trustee to pursue claims that financial institutions, including Bank of America, abetted the company in disguising its true financial condition. Bondi accused the bank of helping to structure mostly off-balance-sheet transactions intended to "conceal Parmalat's insolvency" and of collecting fees that it did not deserve. The lawsuit against Bank of America was dismissed. 18 Parmalat appealed the dismissal of its lawsuits, accusing Bank of America and the company's auditor, Grant Thornton LLP, of fraud in the Italian dairy company's 2003 collapse. Bondi filed notice of Parmalat's appeal to the U.S. Court of Appeals for the Second Circuit in New York. Bondi and the Parmalat Capital Finance Ltd. unit had accused Grant Thornton of helping set up fake transactions to allow insiders to steal from the company. Parmalat Capital made similar claims in a lawsuit against Bank of America. On September 18, 2009, U.S. District Judge Lewis Kaplan said Parmalat should not recover for its own fraud, noting that the transactions also generated millions of euros for the company. "The actions of its agents in so doing were in furtherance of the company's interests, even if some of the agents intended at the time they assisted in raising the money to steal some of it," Kaplan wrote. The SEC Charges The SEC filed an amended complaint on July 28, 2004, in its lawsuit against Parmalat Finanziaria SpA in U.S. District Court in the Southern District of New York. The amended complaint alleged that Parmalat engaged in one of the largest financial frauds in history and defrauded U.S. institutional investors when it sold them more than $1 billion in debt securities in a series of private placements between 1997 and 2002. Parmalat consented to the entry of a final judgment against it in the fraud. The complaint includes the following amended charges: 1. Parmalat consistently overstated its level of cash and marketable securities by at least $4.9 billion at December 31, 2002. 2. As of September 30, 2003, Parmalat had understated its reported debt by almost $10 billion through a variety of tactics, including: a. Eliminating about $6 billion of debt held by one of its nominee entities b. Recording approximately $1.6 billion of debt as equity through fictitious loan participation agreements c. Removing approximately $500 million in liabilities by falsely describing the sale of certain receivables as non-recourse, when in fact the company retained an obligation to ensure that the receivables were ultimately paid d. Improperly eliminating approximately $1.6 billion of debt through a variety of techniques including mis- characterization of bank debt as intercompany debt 3. Between 1997 and 2003, Parmalat transferred approximately $500 million to various businesses owned and operated by Tanzi family members. 4. Parmalat used nominee entities to fabricate nonexistent financial operations intended to offset losses of operating subsidiaries; to disguise intercompany loans from one subsidiary to another that was experiencing operating losses; to record fictitious revenue through sales by its subsidiaries to controlled nominee entities at inflated or entirely fictitious amounts; and to avoid unwanted scrutiny due to the aging of the receivables related to these sales: the related receivables were either sold or transferred to nominee entities. In the consent agreement, without admitting or denying the allegations, Parmalat agreed to adopt changes to its corporate governance to promote future compliance with the federal securities laws, including: • Adopting bylaws providing for governance by a shareholder-elected board of directors, the majority of whom will be independent and serve finite terms and specifically delineating in the bylaws the duties of the board of directors • Adopting a Code of Conduct governing the duties and activities of the board of directors • Adopting an Insider Dealing Code of Conduct • Adopting a Code of Ethics The bylaws also required that the positions of the chair of the board of directors and managing director be held by two separate individuals, and Parmalat must consent to having continuing jurisdiction of the U.S. District Court to enforce its provisions. Questions 1. In the case, Judge Kaplan dismissed Parmalat's lawsuit against Deloitte stating that Parmalat "did not show that poor auditing of Parmalat USA was equivalent to fraud." Comment on the judge's decision from the perspective of the auditor's obligation to identify fraud in the financial statements. 2. Based on the information in the case, classify the improper transactions engaged in by Parmalat into one of the seven financial shenanigans identified by Howard Schilit and discussed in Chapter 7. Explain why each transaction violated professional standards. 3. Who is to blame for the fraud at Parmalat: the company?; top management?; the auditors?; the Bank of America? How did each party violate its ethical obligations? 1 Available at www.madhyam.org.in/admin/tender/Parmalat's%20Fall,%20Europe's%20Enron(%20ASED).pdf. 2 Sophie Arie, "29 Named in Parmalat Case," The Guardian, March 19, 2004, www.guardian.co.uk/parmalat/story/0,1172990,00.html. 3 Securities and Exchange Commission, Securities and Exchange Commission v. Parmalat Finanziaria SpA, First Amended Complaint, www.sec.gov/litigation/complaints/comp18803.pdf. 4 Available at www.sec.gov/litigation/complaints/comp18803.pdf. 5 Parmalat Finanziaria SpA. 6 William D. Dobson, "Parmalat," http://purl.umn.edu/37555. 7 Available at www.sec.gov/litigation/complaints/comp18803.pdf, page 14. 8 Leonard J. Brooks and Paul Dunn, Business and Professional Ethics for Executives, Directors, and Accountants (Cincinnati, OH: South-Western Publishing, 2009). 9 Kavaljit Singh, www.madhyam.org.in/admin/tender/Parmalat's%20Fall,%20Europe's%20Enron(%20ASED).pdf. 10 Sara Gay Forden, "Parmalat's Tanzi Sentenced to 10 Years in Milan Trial," www.bloomberg.com/apps/news?pid520601087 sid5alrsQE4_kBPU refer54home. 11 Brooks and Dunn, pp. 398-399. 12 Andrea Melis, "Corporate Governance Failures: To What Extent Is Parmalat a Particularly Italian Case?" http://papers.ssrn.com/sol3/papers.cfm?abstract_id5563223. 13 Sara Gay Forden, "Parmalat's Tanzi Sentenced to 10 Years." 14 Andrew Longstreth, "Bank of America Makes Peace with Parmalat for $100 million," www.law.com/jsp/article.jsp7id51202432604858. 15 The Associated Press, "Bank of America settles Parmalat suit for $100M," July 28, 2009, Available at: http://www.utsandiego.com/news/2009/jul/28/us-bank-america-parmalat-072809/. 16 Thomas M. Beshere, "Questions for Accounting Firm Networks," http://mcguirewoods.com/news-resources/publications/Questions%20For%20International%20Accounting%20Firm%20Networks.pdf. 17 Chad Bray, http://online.wsj.com/article/BT-CO-20091119-713515.html. 18 Available at www.reuters.com/article/idUSN186214820090918, Cached.
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The case is of P, a European giant following the principles based approach in preparing its financial reports. The case brings a debate whether a principles based approach is better than a rule based approach. The case also brings up question whether principles based approach can actually be used to prepare a fair financial report which can show all the transactions fairly. 1. In the case of P, the judge's decision is fair because P has purposefully hidden information and did not offer much scope for the auditors to conduct a full fledged investigation to find out the truth. Auditor did not set up proper internal control measures to check into data deficiencies. Although D, failed to bring into notice the fraud of P, auditor did not actually commit the crime and hence Judge's decision in this case is valid. 2. There are following seven financial shenanigans identified by Mr. Howard Schilit:
• Recording revenue too soon,
• Recording bogus revenue,
• Boosting income with on time gains,
• Failing to disclose liabilities,
• Shifting current expense to a latter period,
• Shifting current income to a later period, and
• Shifting future expenses into the current period. In this case the fraud committed by P can be classified into that of failing to disclose liabilities because the company has purposefully hidden some of the major liabilities from its reports. 3. For the Fraud in the P case, all the people responsible for bringing the report out and are to be blamed.
• The major culprit is the top management; they have purposefully hidden major liabilities of the company to gain an undue advantage in the stock market.
• The company also is to be blamed because collectively all the employees together has let the company down and failed to furnish proper information.
• The auditors are also to be blamed because they did not seems to have offered a fair and valid audit report. Each of the above parties violated the code of ethics by neglecting their duties, by misrepresenting data, by offering false and fraudulent information.

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The Institute of Chartered Accountants in England and Wales (ICAEW) has adopted a code of ethics based on the IFAC Code. In commenting on the principles-based approach used in these codes, the ICAEW states that a principles approach "focuses on the spirit of the guidance and encourage responsibility and the exercise of professional judgment, which are key elements of professions." Explain what you believe this statement means.78
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Professionals unlike other employees do need to exhibit a certain code with which they need to standby. There are certain elements they need to abide by and they are as given below:
1. Integrity- The Accountants auditors work should contain a great deal of integrity. The integrity needs to be shown in terms of their compliance to the rules and regulations and conducting the audit procedure in such a manner not showing any sort of discrimination. 2. Objectivity- The accountants auditors work needs to be based on the right objectives, objectives such as, offering little scope for errors, probing the report for finding out data deficiencies, questioning the authorities to obtain sufficient evidence for the reports furnished etc. 3. Professional competence- They need to exhibit professional competence in terms of strict adherence to competency and in terms of exhibiting competence in identifying errors and potential data deficiencies. 4. Due care- While offering the Finance and audit report, the accountants auditors should take all the necessary care in preparing the audit report leaving no scope for omission of important facts and information. 5. Confidentiality- However, while preparing the reports the accountants and auditors needs to ensure confidentiality in protecting vital information while preparing the report from falling into wrong hands. 6. Professional behavior- The accountants and auditors need to exhibit professional behavior while conducting the audit or while preparing the report, this professionalism in terms of their behavior with clients not showing any lenience by accepting bribes etc. The statement given by the members of "IESBA" is true and appropriate in terms of its applicability to professionalism. Thus, these principles are required to guide the auditors through the audit procedures in the right direction.

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Do you believe that "one size fits all" with respect to corporate governance provisions in different countries around the world? Why or why not? How do legal and cultural factors influence corporate governance provisions in the U.S., Germany, China, and India?
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MicroStrategy, Inc. Background MicroStrategy, Inc., incorporated in Wilmington, Delaware, in November 1989, has offices all over the United States and around the world. Its headquarters are in McLean, Virginia. In its early years, the company provided software consulting services to assist customers in building custom software systems to access, analyze, and use information contained in large-scale, transaction-level databases. MicroStrategy began concentrating its efforts on the development and sale of data mining and decision support software and related products during 1994 and 1995. 1 A larger part of the company's revenues in 1996 resulted from software license sales. The company licensed its software through its direct sales force and through value-added resellers and original equipment manufacturers (OEMs). The total sales through the latter two avenues comprised more than 25 percent of the company's total revenues. Since 1996, the company revenues have been derived primarily from three sources: • Product licenses • Fees for maintenance, technical support, and training • Consulting and development services The company went public through an initial public offering (IPO) in June 1998. From the third quarter of 1998, the company began to take on a series of increasingly bigger and more complicated transactions, including the sale of software, extensive software application development, and software consulting services. In 1998 the company began to develop an information network supported by the organization's software platform. Initially known as Telepath but later renamed Strategy.com., the network delivers personalized finance, news, weather, traffic, travel, and entertainment information to individuals through cell phones, e-mail, and fax machines. For a fee, an entity could become a Strategy.com affiliate that could offer service on a co-branded basis directly to its customers. The affiliate shared with MicroStrategy the subscription revenues from users. By the end of 2004, MicroStrategy was the leading worldwide provider of business intelligence software. The story of MicroStrategy reflects the larger problems of the go-go years of the 1990s. The dream of many young entrepreneurs was to create a new software product or design a new Internet-based network and capitalize on the explosion in telecommunications network capacity and computer usage. Greed may have been the sustaining factor enabling the manipulation of stock value, as many chief executive officers (CEOs) and CFOs cashed in before the stock price tumbled. However, pressure to achieve financial analysts' estimates of earnings seems to have been the driving force behind the decision to "cook the books." Restatement of Financial Statements On March 20, 2000, MicroStrategy announced that it planned to restate its financial results for the fiscal years 1998 and 1999. MicroStrategy stock, which had achieved a high of $333 per share, dropped over 60 percent of its value in one day, going from $260 per share to $86 per share on March 20. The stock price continued to decline in the following weeks. Soon after, MicroStrategy announced that it would also restate its fiscal 1997 financial results, and by April 13, 2000, the company's stock closed at $33 per share. The share price was quoted at its lowest price during the unraveling of the fraud $3.15 per share as of January 16, 2002. The restatements (summarized in Table 1) reduced the company's revenues over the three-year period by about $65 million of the $312 million reported, or 21 percent. About 83 percent of these restated revenues were in 1999. The company's main reporting failures were derived from its early recognition of revenue arising from the misapplication of AICPA Statement of Position (SOP) 97-2. 2 The SEC states in the Accounting and Enforcement Release: "This misapplication was in connection with multiple-element deals in which significant services or future products to be provided by the company were not separable from the up-front sale of a license to the company's existing software products." The company also restated revenues from arrangements in which it had not properly executed contracts in the same fiscal period in which revenue was recorded from the deals. The company 10-K annual report filed with the SEC for the fiscal year ended December 31, 1998, states the following in item number 7 of Management Discussion and Analysis (MD A): Our revenues are derived from two principal sources (i) product licenses and (ii) fees for maintenance, technical support, education and consulting services (collectively, "product support"). Prior to January 1, 1998, we recognized revenue in accordance with Statement of Position 91-1, "Software Revenue Recognition." Subsequent to December 31, 1997, we began recognizing revenue in accordance with Statement of Position 97-2, "Software Revenue Recognition." SOP 97-2 was amended on March 31, 1998 by SOP 98-4 "Deferral of the Effective Date of a Provision of SOP 97-2." In December 1998, the AICPA issued SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition," which amends SOP 98-4, and is effective after December 31, 1998. Management has assessed these new statements and believes that their adoption will not have a material effect on the timing of our revenue recognition or cause changes to our revenue recognition policies. Product license revenues are generally recognized upon the execution of a contract and shipment of the related software product, provided that no significant company obligations remain outstanding and the resulting receivable is deemed collectible by management. Maintenance revenues are derived from customer support agreements generally entered into in connection with initial product license sales and subsequent renewals. Fees for our maintenance and support plans are recorded as deferred revenue when billed to the customer and recognized ratably over the term of the maintenance and support agreement, which is typically one year. Fees for our education and consulting services are recognized at the time the services are performed. The majority of MicroStrategy's sales closed in the final days of the fiscal period, which is common in the software industry and was as stated by the company in its 10-K. The following is an excerpt from the company's 10-K for the fiscal year December 31, 1998: The sales cycle for our products may span nine months or more. Historically, we have recognized a substantial portion of our revenues in the last month of a quarter, with these revenues frequently concentrated in the last two weeks of a quarter. Even minor delays in booking orders may have a significant adverse impact on revenues for a particular quarter. To the extent that delays are incurred in connection with orders of significant size, the impact will be correspondingly greater. Moreover, we currently operate with virtually no order backlog because our software products typically are shipped shortly after orders are received. Product license revenues in any quarter are substantially dependent on orders booked and shipped in that quarter. As a result of these and other factors, our quarterly results have varied significantly in the past and are likely to fluctuate significantly in the future. Accordingly, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily indicative of the results to be expected for any future period. SEC Investigation and Proceedings According to the SEC investigation, the problems for MicroStrategy began at the time of its IPO in June 1998 and continued through the announced restatement in March 2000. The software company materially overstated its revenues and earnings contrary to GAAP. The company's internal revenue recognition policy in effect during the relevant time period stated that the company recognized revenue in accordance with SOP 97-2. The company, however, had not complied with SOP 97-2 , instead recognizing revenue earlier than allowed under GAAP. The closing of a majority of the company's sales in the final days of the fiscal period resulted in the contracts department receiving numerous contracts signed by customers that needed (according to company policy) to be signed by MicroStrategy as well. To realize the desired quarterly financial results, the company held open, until after the close of the quarter, contracts that had been signed by customers but had not yet been signed by the company. After the company determined the desired financial results, the unsigned contracts were signed and given an "effective date" in the last month of the prior quarter. In some instances, the contracts were signed without affixing a date, allowing the company to assign a date at a later time. GAAP and MicroStrategy's own accounting policies required the signature of both the company and the customer prior to recognizing revenue. SEC regulations that were violated by MicroStrategy included reporting provisions, recordkeeping requirements, and the internal control provisions. The company was required to cease and desist from committing any further violations of the relevant rules, as well as take steps to comply with the rules already violated. Role of the Auditor The auditor of MicroStrategy in 1996 was Coopers Lybrand, and Warren Martin was the engagement partner. After Coopers merged with Price Waterhouse and became known as PricewaterhouseCoopers (PwC), Martin continued as the engagement partner until April 2000. The SEC filed administrative proceedings against him on August 8, 2003, and suspended him from practicing before the commission for two years. 3 Martin was in charge of the audit of MicroStrategy during the period of restatement and was directly responsible for the unqualified (i.e., unmodified) opinions issued on the company's inaccurate financial statements. The SEC charged him with a variety of violations of professional standards of practice, including lacking an attitude of professional skepticism, failing to obtain sufficient evidence to support revenue recognition, and demonstrating a lack of due care in carrying out professional responsibilities. Role of Officers of the Company The following officers came under investigation by the SEC: Michael Saylor, cofounder and CEO; Mark Lynch, the CFO; and Sanjeev Bansal, cofounder and chief operating officer (COO). The SEC filed administrative proceedings against Saylor, Lynch, and Bansal on December 14, 2000, charging that MicroStrategy "materially overstated its revenues and earnings from the sales of software and information services contrary to GAAP." Two other officials were cited for their role in drafting the revenue recognition policies that violated GAAP-Antoinette Parsons, the corporate controller and director of finance and accounting and vice president of finance; and Stacy Hamm, an accounting manager who reported to Parsons. 4 The SEC considered that all these officers should have been aware of the revenue recognition policies of the company. Lynch, as the CFO, had the responsibility to ensure the truthfulness of MicroStrategy's financial reports, and he signed the company's periodic reports to the SEC. Saylor also signed the periodic reports. The CEO, CFO, and COO paid approximately $10 million in disgorgement used to repay investors who were affected by this fraud, another $1 million in penalties, and they agreed to a cease-and-desist order regarding violations of reporting, bookkeeping, and internal controls. The controller and the accounting manager agreed to a cease-and-desist order that prohibited them from violating Rules 13a and 13b of the Securities and Exchange Act. In a separate action, Lynch was denied the right to practice before the commission for three years. On June 8, 2005, the SEC reinstated Lynch's right to appear before the commission as an accountant. Lynch agreed to have his work reviewed by the independent audit committee of any company for which he works. Post-Restatement Through 2004 MicroStrategy discontinued its Strategy.com business in 2001. It now has a single platform for business intelligence as its core business. Total revenues consist of revenues derived from the sale of product licenses and product support and other services, including technical support, education, and consulting services. The company's international market is rapidly developing, and it has positive earnings from operations since 2002. For the year ended December 31, 2004, the MD A identified its revenue recognition policy as described in Exhibit 1. In its early years, MicroStrategy stated its revenue recognition policy in a single paragraph, saying that it followed the relevant accounting policies. Now the company provides a detailed analysis in its MD A, as well as the notes to financial statements. The company has implemented all the requirements of the SEC. PwC continues as the auditors for MicroStrategy, and the firm has given an unqualified (i.e., unmodified) opinion on both the company's financial statements and its internal control report under SOX. Investors sued MicroStrategy and PwC in 2000, after the software maker retracted two years of audited financial results and its stock price plunged by 62 percent in a single day, wiping out billions of dollars in shareholder wealth. A report filed in court by the plaintiffs said the audit firm "consistently violated its responsibility" to maintain an appearance of independence. It cites e-mail evidence of a PwC auditor seeking a job at MicroStrategy while he was the senior manager on the team that reviewed the company's accounting. PwC also received money for reselling MicroStrategy software and recommending it to other clients. The accounting firm was working on setting up a business venture with its audit client, according to the plaintiff's report. Steven G. Silber, a PwC spokesman, said the company denies "all of their allegations about our independence and the work we performed." He added: "While we believe our defense against the class-action claim was strong and compelling, we ultimately made a business decision to settle in order to avoid the further costs and uncertainties of litigation." MicroStrategy's chief of staff, Paul N. Zolfaghari, said in a statement that PwC auditors "have consistently assured us that they have been in full compliance with all applicable auditor independence requirements." On May 8, 2011, PwC agreed to pay $55 million to settle a class action lawsuit alleging that it defrauded investors in MicroStrategy Inc. by approving financial reports that inflated the earnings and revenue of the company. 6 Online Resources Your instructor may ask you to delve deeply into the accounting standards and SEC actions in answering questions in the case. The following Web sites provide extensive information that may help in that regard. • AICPA ( SAS 55 and SOP 97-2 ): www.aicpa.org/members/div/auditstd/index.htm • Committee of Sponsoring Organizations (COSO): • Internal Control-Integrated Framework (Executive Summary): www.coso.org/publications/executive_summary_integrated_framework.htm • Report of the National Commission on Fraudulent Financial Reporting (Treadway Commission Report): www.coso.org/publications/NCFFR.htm • FASB: • CON 5: www.fasb.org/pdf/con5.pdf • Emerging Issues Task Force Pronouncement EITF 08-1, Revenue Arrangements with Multiple Deliverables: www.fasb.org • Emerging Issues Task Force Pronouncement 09-3, Appli cability of AICPA Statement of Position 97-2 to Certain Arrangements That Include Software Elements: www.fasb.org • Securities and Exchange Commission-Litigation Releases and Administrative Proceedings: • AAER 1350: December 14, 2000: www.sec.gov/litigation/admin/34-43724.htm • AAER 1351: December 14, 2000: www.sec.gov/litigation/admin/34-43725.htm • AAER 1352: December 14, 2000: www.sec.gov/litigation/litreleases/lr16829.htm • AAER 1359: January 17, 2001: www.sec.gov/litigation/admin/34-43850.htm • AAER 1835: August 8, 2003: www.sec.gov/litigation/admin/34-48311.htm • AAER 2255: June 8, 2005: www.sec.gov/litigation/admin/34-51802.pdf Questions 1. Evaluate the accounting decisions made by MicroStrategy from an earnings management perspective. What was the company trying to accomplish through the use of these accounting techniques? How did its decisions lead the company down the proverbial "ethical slippery slope?" 2. What motivated MicroStrategy and its management to engage in this fraud? Use the pressure and incentive side of the fraud triangle to help in answering the question. How would you characterize the company's actions in this regard with respect to ethical behavior, including a consideration of Kohlberg's stages of moral development? 3. Why is independence considered to be the bedrock of auditor responsibilities? Do you believe PwC and its professionals violated independence requirements in Rule 101 of the AICPA Code of Professional Conduct? Why or why not? Include in your discussion any threats to independence that existed. 1 Information about the case can be found at Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1351, December 14, 2000, In the Matter of MicroStrategy, Inc., December 18, 2000; www.sec.gov/litigation/admin/34-43724.htm. 2 Available at www.aicpa.org. 3 Securities and Exchange Commission, Accounting and Enforcement Release No. 1835, In the Matter of Warren Martin, CPA , August 8, 2003; www.sec.gov/litigation/admin/34-48311.htm. 4 U.S. Securities and Exchange Commission, "SEC Brings Civil Charges Against MicroStrategy, Three Executive Officers for Accounting Violations"; www.sec.gov/news/headlines/microstr.htm 6 "Accounting Firm to Settle Suit over Audits of MicroStrategy." Available at http://mailman.lbo-talk.org/2001/2001-May/008924.html.
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Critics of the IFRS argue that the more principles-based IFRS is not as precise as, and therefore is easier to manipulate than, the more rules-based GAAP. The reason for this is that IFRS requires more professional judgment from both auditors and corporate accountants with regard to the practical application of the rules. The application of professional judgment opens the door to increased opportunities for earnings management. Do you agree with these concerns expressed about principles- based IFRS? Relate your discussion to the research results discussed in this chapter.
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Navistar International In April 2011, Navistar International Corporation sued Deloitte Touche for $500 million, alleging "fraud, fraudulent concealment, breach of contract, and malpractice" on audits from 2002 to 2005. 1 One unusual aspect of this case is the claim by Navistar that Deloitte lied about its competency to provide audit services. "Deloitte lied to Navistar and, on information and belief, to Deloitte's other audit clients, as to the competency of its audit and accounting services," Navistar alleged in its complaint. Deloitte spokesman Jonathan Gandal expressed the firm's position as follows: A preliminary review shows it to be an utterly false and reckless attempt to try to shift responsibility for the wrongdoing of Navistar's own management. Several members of Navistar's past or present management team were sanctioned by the SEC for the very matters alleged in the complaint. Early in the fraud, Navistar denied wrongdoing and said the problem was with "complicated" rules under SOX. Cynics reacted by saying it is hard to see how the law can be blamed for Navistar's accounting shortcomings, including management having secret side agreements with its suppliers who received "rebates"; improperly booking income from tooling buyback agreements, while not booking expenses related to the tooling; not booking adequate warranty reserves; or failing to record certain project costs. Exhibit 1 contains a detailed description of the SEC charges against Navistar and management. In defense of Deloitte, we have to look at the bigger picture. Navistar employees committed fraud and actively took steps to avoid discovery by the auditors. The auditors did not discover the fraud, according to Navistar, and in retrospect, the company wants to hold the auditors responsible for that failure. Deloitte maintains that in each case, the fraudulent accounting scheme was nearly impossible to detect because the company failed to book items or provide information about them to the auditors. In this case, there is little dispute that management engaged in wrongdoing. In 2010, Navistar company employees Mark Schwetschenau (controller and vice president of finance), James McIntosh (vice president of finance for the Engine Division), Thomas Akers (director of purchasing for the Engine Division), James Stanaway (director of finance for the Engine Division), Ernest Stinsa (replaced Stanaway as the director of finance for the Engine Division), and Michael Schultz (the plant controller at Navistar's foundry in Waukesha, Wisconsin), agreed to a sanction by the SEC for their role in the fraud and cover-up Navistar and its employees did not admit to any wrongdoing in their settlement with the SEC (nothing surprising here), but the company did restate its financial statements and agree that each employee would pay a fine of $25,000 to $150,000. In addition, Navistar's CEO Daniel Ustain and CFO Robert Lannert agreed to clawbacks of $1.3 million and $1 million in bonuses that they got during the periods that Navistar's income was fraudulently inflated. It took Navistar five years to sue Deloitte. That seems like an unusually long period of time and raises suspicions whether the company waited until its own problems were resolved with the SEC. Perhaps Navistar thought if it had sued Deloitte while the SEC investigated, it might be misconstrued by the SEC as an admission of guilt. Deloitte may have been guilty of failing to consider adequately the risks involved in the Navistar audit. After the SOX was passed in mid-2002, all the large audit firms did some major cleanup of their audit clients and reassessed risk, an assessment that should have been done more carefully at the time of accepting the client. Big Four auditors in particular wanted to shed risky clients to protect themselves from new liability. Interestingly, to accomplish that goal with Navistar, Deloitte brought in a former Arthur Andersen partner to replace the engagement partner who might have become too close to Navistar and its management, thereby adjusting to the client's culture and modus operandi. Whether because of his experience with Andersen's failure, fear of personal liability, a "not on my watch" attitude, or possibly a heads-up on interest by the SEC in some of Navistar's accounting, this new partner cleaned house. Many prior agreements between auditor and client and many assumptions about what could or could not be gotten away with were thrown out. One problem for Navistar was that it was too dependent on Deloitte to hold its hand in all accounting matters, even after the SOX prohibited that reliance. According to Navistar's complaint, "Deloitte provided Navistar with much more than audit services. Deloitte also acted as Navistar's business consultant and accountant. For example, Navistar retained Deloitte to advise it on how to structure its business transactions to obtain specific accounting treatment under Generally Accepted Accounting Principles (GAAP)... Deloitte advised and directed Navistar in the accounting treatments Navistar employed for numerous complex accounting issues apart from its audits of Navistar's financial statements, functioning as a de facto adjunct to Navistar's accounting department.... Deloitte even had a role in selecting Navistar's most senior accounting personnel by directly interviewing applicants." The audit committee's role is detailed in the 2005 10-K filed in December 2007: The audit committee's extensive investigation identified various accounting errors, instances of intentional misconduct, and certain weaknesses in our internal controls. The audit committee's investigation found that we did not have the organizational accounting expertise during 2003 through 2005 to effectively determine whether our financial statements were accurate. The investigation found that we did not have such expertise because we did not adequately support and invest in accounting functions, did not sufficiently develop our own expertise in technical accounting, and as a result, we relied more heavily than appropriate on our then outside auditor. The investigation also found that during the financial restatement period, this environment of weak financial controls and under-supported accounting functions allowed accounting errors to occur, some of which arose from certain instances of intentional misconduct to improve the financial results of specific business segments. 3 The 2005 10-K also addresses the issue in its first material weakness on accounting personnel. We did not have a sufficient number of accounting personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP as it relates to accounting for receivable securitization transactions. This resulted in inadequate segregation of duties and insufficient review of the information pertaining to securitization accounting. Additionally, because of the lack of internal accounting personnel, we relied heavily on our prior independent registered public accounting firm to help us develop conclusions related to application of GAAP. The complaint against Deloitte also references audit discrepancies cited in Public Company Accounting Oversight Board (PCAOB) inspections 4 of Deloitte. Navistar believed the discrepencies related to Deloitte's audit of the company. However, the names of companies in PCAOB inspections are not made publicly available due to confidentiality and proprietary information concerns. SOX also expressly restricts it from identifying the names of companies in the public portions of its inspection reports. A closer look at the statute shows that the "Confidentiality" section of the act covers the handling of information that the board obtains through an inspection. It says that the board cannot be compelled to provide such information in court proceedings, including civil discovery. It also says the material is exempt from disclosure under the Freedom of Information Act. Another section of SOX says the public portions of the board's inspection reports "shall be made available in appropriate detail," subject to "the protection of such confidential and proprietary information as the board may determine to be appropriate." The bottom line is that the PCAOB is not legally barred from disclosing the information, but it is true that any such disclosure of client names could be overruled by the SEC. The PCAOB's position has been made somewhat clearer by chairman James R. Doty in testimony before the U.S. House of Representatives Committee on Financial Services, Subcommittee on Capital Markets and Government Sponsored Enterprises, on March 28, 2012: In the early years of a relationship the auditor might be trying to build a long-term relationship by pleasing the client. In later years, however, the incentive is to avoid being the engagement partner that lost the client. It is worth exploring how we can mitigate these incentives, and the answer may not be the same for both. The PCAOB's efforts to address these problems through inspections and enforcement are ongoing. But considering the disturbing lack of skepticism we continue to see, and because of the fundamental importance of independence to the performance of quality audit work, the Board is prepared to consider all possible methods of addressing the problem of audit quality including whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client. 5 Doty also addressed the issue of auditors keeping inspection results from audit committees or dismissing the importance of the results. In some cases, it seems, the PCAOB believe auditors have done both: I recognize that firms may approach such audit committee discussions with one eye on taking care not to waive any privilege the firm might have, in a different context, against compelled disclosure of inspection information. That caution, however, does not explain other more troubling assertions by firms such as that a particular audit deficiency cited by our inspectors is based on nothing more than incomplete documentation; or that it reflects merely a difference of professional judgment within a range of reasonable judgments... An audit committee armed with a proper understanding of our process would recognize that those kinds of assertions are seriously suspect. Those assertions are, without exception, directly at odds with the considered collective conclusion of a group of very experienced auditors on the inspection staff. Such a conclusion means that, in a concrete, identifiable respect that is not reducible to a mere difference in professional judgment, the inspections staff has determined that the firm failed to perform an audit that provides what the audit committee contracted for and what investors deserve-reasonable assurance about whether the financial statements are free of material misstatement. Questions 1. Would you characterize the Deloitte audit of Navistar a failed audit? Why or why not? 2. Discuss the weaknesses in internal controls and the corporate governance system at Navistar. How should these deficiencies have affected the Deloitte audit assuming the firm was aware of these deficiencies. 3. The PCAOB audit firm inspection program was discussed in Chapters 4 and 5. What is the purpose of that program with respect to ensuring that auditors meet their ethical and professional responsibilities and obligation to place the public interest above all else? As mentioned in the case, the name of a company (client) mentioned in specific inspection report is not made publicly available. Do you believe that PCAOB inspection reports on registered CPA firms should permit the disclosure of specific details about named clients? Why or why not? 4. What is the purpose of Section 304's clawback provision in SOX? Do you think the provision is an ethical one? Use ethical reasoning to support your answer. Optional Question 5. Answer the following questions as directed by your instructor: a. Vendor rebates: Do you believe Navistar was motivated by earnings management in its accounting for the vendor's rebates? b. Vendor tooling: Evaluate Deloitte's role with respect to ethics and professionalism in providing guidance to Navistar employees on accounting for the vendor tooling costs. c. Warranty reserve: Did the company's accounting for the warranty reserve comply with GAAP? d. Deferred start-up costs: Evaluate the accounting for the deferred start-up costs from a matching perspective. What was the nature of the accounting that should have taken place after the automaker cancelled the agreement with Navistar in October 2002? 1 The case and subsequent facts are taken from Navistar International Corp. v. Deloitte Touche LLP , 2011L004269, Cook County, Illinois, Circuit Court, Law Division (Chicago). 3 Available at http://files.shareholder.com/downloads/NAV/208119719x0x213905/97C07844-AC05-4F6A-A58CFE982490BC77/Navistar%202007%20Annual%20Report.pdf=. 4 The SOX authorizes the PCAOB to inspect registered firms for the purpose of assessing compliance with certain laws, rules, and professional standards in connection with a firm's audit work for clients that are "issuers." As of July 27, 2012, 2,398 public accounting firms, including U.S. firms and non-U.S. firms, are registered with the PCAOB. Until 2009, inspections of the Big Four CPA firms-Deloitte Touche, PwC, KPMG, and EY-did not disclose the proportion of audits reviewed that were deemed to be defective. Among the Big Four, the board found something wrong in nearly one in six audits that it reviewed that year. A year later, the proportion had doubled to one in three. 5 James R. Doty, chairman PCAOB, "Testimony Concerning Accounting and Auditing Oversight: Pending Proposals and Emerging Issues Confronting Regulators, Standard Setters and the Economy," U.S. House of Representatives Committee on Financial Services, Subcommittee on Capital Markets and Government Sponsored Enterprises, March 28, 2012. Available at http://pcaobus.org/News/Speech/Pages/03282012_DotyTestimony.aspx.
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Describe the different kinds of reserves that can be recorded. How do the reserves relate to the discretionary accruals discussed in Chapter 7? Can the accounting for reserves lead to a manipulation of earnings? Do you believe it would be more or less prevalent under IFRS or GAAP?
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Adelphia Communications Corporation On July 24,2009, the U.S. Court of Appeals for the District of Columbia upheld the finding of the Securities and Exchange Commission (SEC) that Gregory M. Dearlove, a certified public accountant (CPA) and formerly a partner with the accounting firm Deloitte Touche LLP (Deloitte), engaged in improper professional conduct within the meaning of Rule of Practice 102(e). Dearlove served as the engagement partner on Deloitte's audit of the financial statements of Adelphia Communications corporation. (Adelphia), a public company, for the fiscal year ended December 31, 2000. The SEC confirmed its original ruling that Adelphia's financial statements were not in accordance with generally accepted accounting principles (GAAP), and that Dearlove violated generally accepted auditing standards (GAAS). The administrative law judge (ALJ) also found that Dearlove was a cause of Adelphia's violations of the reporting and recordkeeping provisions of the Exchange Act. The ALJ permanently denied Dearlove the privilege of appearing or practicing in any capacity before the commission. The opinion for the court was filed by Judge Douglas H. Ginsburg of the U.S. Court of Appeals for the D.C. Circuit Court. The opinion states that the SEC concluded that Dearlove engaged repeatedly in unreasonable conduct resulting in violations of applicable accounting principles and standards while serving as Deloitte's engagement partner in charge of the 2000 audit of Adelphia. Dearlove had argued that the SEC committed an error of law, misapplied the applicable accounting principles and standards, and denied him due process. Because the SEC made no error of law, and substantial evidence supports its findings of fact, the court denied the petition. Background Issues John Rigas had founded Adelphia, Greek for brothers, in 1952, and Rigas and his children were the controlling shareholders in 2000. By the year 2000, Adelphia was one of the largest cable television companies in the United States. It had doubled the number of cable subscribers that it served by acquiring several other cable companies in late 1999. Although its assets were growing, Adelphia's debt grew substantially as well. The SEC found that prior to 2000, Adelphia, its subsidiaries, and some Rigas-affiliated entities entered as co-bor- rowers into a series of credit agreements. By 1999, Adelphia and the entities had obtained $1.05 billion in credit; in 2000, they tripled their available credit and drew down essentially all the funds available under the agreements. Deloitte audited Adelphia's financial statements from 1980 through 2002, with Dearlove as the engagement partner. Dearlove and the Deloitte team described the 2000 audit, like many prior audits of Adelphia, as posing "much greater than normal risk" because Adelphia engaged in numerous transactions with subsidiaries and affiliated entities, many of which were owned by members of the Rigas family. Deloitte issued its year 2000 independent auditor's report of Adelphia-signed by Dearlove-on March 29, 2001. In January 2002, in the wake of the Enron scandal, the SEC released a statement regarding the disclosure of related-party transactions. In March, Adelphia disclosed its obligations as co-debtor with the Rigas entities. Its share price declined from $30 in January 2002 to $0.30 in June, when it was delisted by the National Association of Securities Dealers (NASDAQ). In September 2002, the Department of Justice brought criminal fraud charges against Adelphia officials, including members of the Rigas family, and Adelphia agreed to pay $715 million into a victims' restitution fund as part of a settlement with the government. In April 2005 the SEC brought and settled civil actions against Adelphia, members of the Rigas family, and Deloitte. SEC Charges In September 2005, the SEC charged Dearlove with improper conduct resulting in a violation of applicable professional standards, including his approval of Adelphia's method of accounting for transactions between itself and one or more Rigas entities (i.e., related-party transactions). The matter was referred to the ALJ, who presided at an administrative trial-type hearing to resolve the dispute between the SEC and Adelphia. The ALJ determined Dearlove had engaged in one instance of "highly unreasonable" conduct and repeated instances of "unreasonable" conduct, and permanently denied Dearlove the right to practice before the SEC, Adelphia, and Dearlove. Upon review of the ALJ's decision, the SEC held Dearlove had engaged in repeated instances of unreasonable conduct as defined under Rule 102 and denied him the right to practice before the SEC, but provided him the opportunity to apply for reinstatement after four years. Dearlove petitioned for review of that decision, which was denied by the U.S. Court of Appeals. 1 SEC Rule 102(e) provides the SEC may "deny, temporarily or permanently, the privilege of appearing or practicing before [the SEC] in any way to any person who is found by the Commission... to have engaged in unethical or improper professional conduct." The rule defines three classes of "improper professional conduct" for accountants: (1) "Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards," (2) "a single instance of highly unreasonable conduct that results in a violation of applicable professional standards," and (3) "repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission." The court supported the SEC's determination that Dearlove repeatedly engaged in unreasonable conduct. While most of the alleged fraud at Adelphia took its form in hidden debt, the trial was also notable for examples of the eye-popping personal luxury that has marked other white- collar trials such as at Tyco. In the court case, prosecutor Christopher Clark led off his closing argument by saying John Rigas had ordered two Christmas trees flown to New York, at a cost of $6,000, for his daughter. Rigas also ordered up 17 company cars and the company purchase of 3,600 acres of timberland at a cost of $26 million to preserve the pristine view outside his Coudersport home in Buffalo, New York. Timothy Rigas, the CFO, had become so concerned that he limited his father to withdrawals of $1 million per month. Deloitte's Audit Deloitte served as the independent auditor for Adelphia, one of its largest audit clients, from 1980 through 2002. The audits were complex. Several of Adelphia's subsidiaries filed their own Forms 10-K annual reports with the SEC. For several years, Deloitte had concluded that the Adelphia engagement posed a "much greater than normal" risk of fraud, misstatement, or error; this was the highest risk category that Deloitte recognized. Risk factors that Deloitte specifically identified in reaching this assessment for the 2000 audit included the following: 2 • Adelphia operated in a volatile industry, expanded rapidly, and had a large number of decentralized operating entities with a complex reporting structure. • Adelphia carried substantial debt and was near the limit of its financial resources, making it critical that the company comply with debt covenants. • Management of Adelphia was concentrated in a small group without compensating controls. • Adelphia management lacked technical accounting expertise but nevertheless appeared willing to accept unusually high levels of risk, tended to interpret accounting standards aggressively, and was reluctant to record adjustments proposed by auditors. • Adelphia engaged in significant related-party transactions with affiliated entities that Deloitte would not be auditing. To help manage the audit risk, Deloitte planned, among other things, to increase Deloitte's management involvement at all stages of the audit "to ensure that the appropriate work is planned and its performance is properly supervised." It also proposed to heighten professional skepticism "to ensure that accounting estimates, related-party transactions and transactions in the normal course of business appear reasonable and are appropriately identified and disclosed." On March 29, 2001, Deloitte issued its independent auditor's report, signed by Dearlove, which stated that it had conducted its audit in accordance with GAAS and that such audit provided a reasonable basis for its opinion that Adelphia's 2000 financial statements fairly presented Adelphia's financial position in conformity with GAAR Charges against Rigas Family and Deloitte In the wake of Adelphia's decline, the U.S. Department of Justice (DOJ) brought criminal fraud charges against several members of the Rigas family and other Adelphia officials. The DOJ declined to file criminal charges against Adelphia as part of a settlement in which Adelphia agreed to pay $715 million in stock and cash to a victims' restitution fund once the company emerged from bankruptcy. The SEC brought several actions related to the decline of Adelphia. On April 25, 2005, Adelphia, John Rigas, and Rigas's three sons settled a civil injunctive action in which the respondents, without admitting or denying the allegations against them, were enjoined from committing or causing further violations of the antifraud, reporting, recordkeeping, and internal controls provisions of the federal securities laws. 3 The next day, the commission instituted and settled administrative proceedings against Deloitte under Rule 102(e). Without admitting or denying the commission's allegations, Deloitte consented to the entry of findings that it engaged in repeated instances of unreasonable conduct with respect to the audit of Adelphia's 2000 financial statements. Deloitte also consented to a finding that it caused Adelphia's violations of those provisions of the Securities and Exchange Act that require issuers to file annual reports, make and keep accurate books and records, and devise and maintain a system of sufficient internal controls. Deloitte agreed to pay a $25 million penalty and to implement various prophylactic policies and procedures. The commission also settled a civil action, based on the same conduct, in which Deloitte agreed to pay another $25 million penalty. Senior manager William Caswell consented to commission findings that he committed repeated instances of unreasonable conduct and agreed to a bar from appearing or practicing as an accountant before the commission with a right to apply for reinstatement after two years. 4 Violation of GAAS: General, Fieldwork, and Reporting Standards In determining whether to discipline an accountant under Rule 102(e)(l)(iv), the commission has consistently measured auditors' conduct by their adherence to or deviation from GAAS. Certain audit conditions require auditors to increase their professional care and skepticism, as when the audit presents a risk of material misstatement or fraud. When an audit includes review of related-party transactions, auditors must tailor their examinations to obtain satisfaction concerning the purpose, nature, and extent of those transactions on the financial statements. Unless and until an auditor obtains an understanding of the business purpose of material related-party transactions, the audit is not complete. These standards can overlap somewhat, and one GAAS failure may contribute to another. Dearlove asked the court to compare the reasonableness of his conduct to a standard used by New York state courts in professional negligence cases, that the standard for determining negligence by an accountant should be based on whether the respondent "use[d] the same degree of skill and care that other [accountants] in the community would reasonably use in the same situation." Dearlove believed that his actions should be judged in the context of the large, complex Adelphia audit and to determine whether he exercised the degree of skill and care, including professional skepticism, that a reasonable engagement partner would have used in similar circumstances. Dearlove contended that this analysis "necessarily includes... conclusions previously reached by other professionals," a reference to the Adelphia audits that Deloitte conducted from 1994 through 1999. Dearlove asserted that he could place some reliance on audit precedent. Moreover, in his view, the fact that prior auditors reached the same conclusions is "compelling evidence" that Dearlove acted reasonably. The court rejected any suggestion that the conduct of prior auditors should be a substitute for the standards established by GAAS, ruling that "these standards apply to audits of all sizes and all levels of complexity and describe the conduct that the accounting profession itself has established as reasonable, providing] a measure of audit quality and the objectives to be achieved in an audit." The court, therefore, declined to create a separate standard of professional conduct for auditors that depends in each case on the behavior of a particular auditor's predecessors. The SEC found that prior Deloitte audits offered little support for the conclusions reached in the 2000 audit. The record did not describe how the audits of prior financial statements were performed or what evidential matter supported those audit conclusions. Moreover, Dearlove's expert, while arguing that partner rotation does not require the new auditor to perform a "de novo audit of the client," nevertheless explained that an engagement partner "would perform... new audit procedures or GAAP research and consultation... to address changed conditions or professional standards." In 2000, Dearlove was presented with markedly different circumstances from those presented to prior teams: since 1999, Adelphia had tripled its coborrowed debt, doubled its revenues and operating expenses, and acquired more cable subscribers. The changes implicated areas of the Adelphia audit that Deloitte had specifically identified as posing high risk-namely, its rapid expansion, substantial debt load, and significant related-party transactions. Therefore, the court rejected Dearlove's argument that the similarity of prior audit conclusions lends reasonableness to his own audit and found no reason to reject GAAS as the standard by which we judge all audits. Violation of Accounting and Reporting Standards Having determined that Dearlove's conduct was unreasonable, the SEC turned to the applicable professional accounting and reporting standards. The GAAS required that when an audit posed greater than normal risk-as Dearlove had determined the Adelphia audit did-there must be "more extensive supervision by the auditor with final responsibility for the engagement during both the planning and conduct of the engagement." The SEC found no evidence in the audit workpapers or elsewhere else in the record that Dearlove gave any consideration to the propriety of at least three separate transactions: (1) offsetting receivables and payables, (2) reporting of coborrowed debt, and (3) direct placement of stock transactions. Offsetting Receivables and Payables Accounting Principles Board Opinion No. 10 states that "it is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists." Rule 5-02 of the commission's Regulation S-X requires that issuers "state separately" amounts payable and receivable. Interpretation 39, Offsetting of Amounts Related to Certain Contracts, defines a right of setoff as "a debtor's legal right, by contract or otherwise, to discharge all or a portion of the debt of another party by applying against the debt an amount that the other party owes to the debtor. The Interpretation is consistent with Rule 5-02. The court had concluded that Adelphia's presentation of a net figure for its related-party payables and receivables violated GAAP. Because Adelphia netted the accounts payable and receivable of its various subsidiaries against the accounts payable and receivable of various Rigas entities on a global basis, it did not comport with Interpretation 39's basic requirement that netting is appropriate only when two unrelated parties are involved. The SEC held Adelphia violated GAAP because its netting involved more than two parties: "Adelphia netted the accounts payable and receivable of its various subsidiaries against the accounts payable and receivable of various Rigas Entities on a global basis... [and] netting is appropriate only when two parties are involved." The SEC analyzed the record and determined that Dearlove's conduct was unreasonable in the circumstances and that it resulted in a violation of professional standards-both GAAS and GAAP. Because GAAS focuses upon an auditor's performance and requires him to exercise due professional care, the commission rejected Dearlove's attempt to fault the SEC for marshaling the same evidence to show that his conduct was unreasonable and that he failed to exercise due professional care in performing the audit. Co-borrowed Debt Between 1996 and 2000, several Adelphia subsidiaries and some of the Rigas entities had entered as co-borrowers into a series of three credit agreements with a consortium of banks. Although the agreements differed in the amount of credit available, their terms were substantially the same: each borrower provided collateral for the loan; each could draw funds under the loan agreement; and each was jointly and severally liable for the entire amount of funds drawn down under the agreement, regardless of which entity drew down the amount. By year-end 2000, the total amount of coborrowed funds drawn under the credit agreements was $3,751 billion, more than triple the $1,025 billion borrowed at year-end 1999. Of this amount, Adelphia subsidiaries had drawn approximately $2.1 billion, and Rigas entities had drawn $1.6 billion. Generally, an issuer must accrue on its balance sheet a debt for which it is the primary obligor. However, when an issuer deems itself to be merely contingently liable for a debt, Statement of Financial Accounting Standards (SFAS) 5 provides the appropriate accounting and reporting treatment for that liability. SFAS 5 establishes a three-tiered system for determining the appropriate accounting treatment of a contingent liability, based on the likelihood that the issuer will suffer a loss-that is, be required to pay the debt for which it is contingently liable. If a loss is probable (i.e., likely) and its amount can be reasonably estimated, the liability should be accrued on the issuer's financial statements as if the issuer were the primary obligor for the debt. If the likelihood of loss is only reasonably possible (defined as more than remote but less than likely), or if the loss is probable but not estimable, the issuer need not accrue the loss but should disclose the nature of the contingency and give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. The issuer still must disclose the "nature and amount" of the liability, even if the likelihood of loss is only remote (slight). 5 From 1997 through 1999, Adelphia had included in the liabilities recorded on its balance sheet the amount that its own subsidiaries had borrowed, but it did not consider itself the primary obligor for the amount that the Rigas entities had borrowed and therefore did not include that amount on its balance sheet. Instead, Adelphia accounted for the amounts borrowed by the Rigas entities by making the following disclosure in the footnotes to its financial statements: Certain subsidiaries of Adelphia are co-borrowers with Managed Partnerships (i.e., Rigas entities) under credit facilities for borrowings of up to [the total amount of all co-borrowed debt available to Adelphia and the Rigas entities that year]. Each of the co-borrowers is liable for all borrowings under this credit agreement, although the lenders have no recourse against Adelphia other than against Adelphia's interest in such subsidiaries. Deloitte had approved this treatment in the audits it conducted from 1997 to 1999. Dearlove knew that Adelphia considered the Rigas entities debt to be a contingent liability for which its chances of suffering a loss were merely remote, making accrual on the balance sheet unnecessary pursuant to SFAS 5. Deloitte created no workpapers documenting its examination of Adelphia's decision. However, from the record, it appears that Deloitte considered the matter and focused its review on the likelihood, as defined by SFAS 5 , that Adelphia would have to pay Rigas entities's share of co-borrowed debt. Dearlove also believed that, although the Rigas family was not legally obligated to contribute funds in the event of a default by the co-borrowers, the family would be economically compelled to protect their Adelphia holdings by stepping in to prevent a default by the entities. Dearlove did not, however, conduct any inquiry into whether the family would, in fact, use their personal assets to prevent a default by Adelphia. Dearlove estimated the value of the Rigas family's holdings of Adelphia stock by multiplying the number of shares the Rigases owned by the price per Class A share, resulting in a figure of approximately $2.3 billion, which he concluded was by itself ample to cover the debt and conclude his SFAS 5 analysis. However, Dearlove did not determine if these Rigas family assets were already encumbered by other debt; he saw no financial statements or other proof of the family's financial condition other than local media reports that the Rigases "were billionaires." Dearlove testified that he "never asked them: Are you worth $2 billion, $3 billion, or $10 billion?" Dearlove also did not consider whether disposing of some or all of the family's stock in Adelphia might result in a downward spiral in the stock's value or in a change in their control of the company, in the event of a default by the entities under the co-borrowing agreements. Dearlove testified that, at the end of the 2000 audit, he spoke to senior manager Caswell for about 15 minutes regarding the requirements of SFAS 5. During this meeting, they concluded that "the assets of the cable systems and the Adelphia common stock that the Rigases owned exceeded the amount of debt that was on the co-borrowed entities, and the overhang... exceeded the co-borrowing by hundreds of millions if not billions of dollars." Dearlove testified that, although other assets could have been included in an SFAS 5 analysis, these two assets alone were sufficient to allow the auditors to conclude that Adelphia's contingent liability was remote. Deloitte therefore approved Adelphia's decision to exclude Rigas entities's $1.6 billion in co-borrowed debt from its balance sheet and to instead disclose the debt in a footnote to the financial statements. When it reviewed the adequacy of the note disclosure that Adelphia planned to use (which was identical to the language it had used in previous years), the audit team initially believed the disclosure should be revised. During the 2000 quarterly reviews, audit manager Ivan Hofmann and others had repeatedly encouraged Adelphia management to disclose the specific dollar amount of Rigas entities's co-borrowings, but Adelphia continually ignored Deloitte's suggestions. Although Deloitte was unaware of it at the time, Adelphia management was working purposefully to obfuscate the disclosure of Rigas entities's co-borrowed debt. In November 2000, at a third-quarter wrap-up meeting attended by Dearlove, Caswell, and Hofmann, Adelphia management (including Adelphia's vice president of finance, James Brown) agreed to make disclosures regarding the amounts borrowed by the Rigas entities under the co-borrowing agreements. Caswell and Hofmann subsequently suggested improvements to the note disclosure in written comments on at least six drafts of the 10-K; they proposed adding language that would distinguish the amount of borrowings by Adelphia subsidiaries and Rigas entities, such as the following: "A total of $_____ related to such credit agreements is included in the company's consolidated balance sheet at December 31, 2000. The [Rigas] entities have outstanding borrowings of $_____ as of December 31, 2000 under such facilities." At the end of March 2001, as Deloitte was concluding its audit of the 2000 financials, Brown-despite his agreement in November 2000 to disclose the amount of Rigas entities borrowing-informed the audit team that he did not think that the additional disclosure was necessary. Instead, Brown proposed adding a phrase explaining that each of the co-borrowers "may borrow up to the entire amount available under the credit facility." Brown argued that his proposed language was more accurate than Deloitte's proposal because the lines of credit could fluctuate and, as a result, it would be better to disclose Adelphia's maximum possible exposure. Caswell agreed to take Brown's language back to the engagement team, but he told Brown that he did not agree with Brown and did not think that Deloitte would accept his proposed language. Notwithstanding Caswell's reaction, Brown soon afterward presented his proposed language to the audit team, including Dearlove, Caswell, and Hofmann, during the audit exit meeting on March 30, 2001. Brown claimed that his proposed disclosure language had been discussed with, and approved by, Adelphia's outside counsel. Although Dearlove characterized the disclosure issue as "really one of the more minor points that [the audit team was] trying to reconcile at that point," the ALJ did not accept this testimony. Dearlove testified that he was "concerned" about "making it clear to the reader how much Adelphia could be guaranteeing," and that Brown's language was "more conservative" but "wasn't necessarily what we were attempting to help clarify." Dearlove also testified that he told Brown, "I don't understand how that [proposed change] enhances the note" but that, after "an exchange back and forth relative to that," Dearlove "couldn't persuade him as to what he wanted." Nevertheless, Dearlove told Brown that he agreed with the proposal and approved the change. Caswell and Hofmann also indicated their agreement. Adelphia's note disclosure of the co-borrowed debt, as it appeared in its 2000 Form 10-K with Brown's added language, read as follows: Certain subsidiaries of Adelphia are co-borrowers with Managed Entities under credit facilities for borrowings of up to $3,751.250.000. Each of the co-borrowers is liable for all borrowings under the credit agreements, and may borrow up to the entire amount of the available credit under the facility. The lenders have no recourse against Adelphia other than against Adelphia's interest in such subsidiaries. Adequacy of the Note Disclosure of Adelphia's Contingent Liability The SEC also considered whether Adelphia's footnote disclosure of Rigas entities's co-borrowings was appropriate under GAAP. Adelphia disclosed the total amount of credit available to the co-borrowers ("up to" $3.75 billion) without indicating whether any portion of that available credit had actually been drawn down, much less that all of it had. This disclosure was inadequate to inform the investing public that Adelphia was already primarily liable for $2.1 billion and a guarantor for the remaining $ 1.6 billion that had been borrowed by Rigas entities. Therefore, it did not comply with the requirement in SFAS 5 to disclose the amount of the contingent liability. The SEC concluded that Dearlove acted unreasonably in his audit of Adelphia's note disclosure, resulting in several violations of GAAS. In high-risk audit environments such as that presented by the Adelphia engagement, GAAS specifically recommend "increased recognition of the need to corroborate management explanations or representations concerning material matters-such as further analytical procedures, examination of documentation, or discussion with others within or outside the entity" when audit risk increases. The accounting for Adelphia's co-borrowed debt implicated the extensive related-party transactions and high debt load that were part of the basis for Deloitte's high-risk assessment for the Adelphia audit. Management's insistence on its own accounting interpretation was precisely the behavior identified by the audit plan as presenting a much higher than normal risk of misstatement in the audit. Moreover, Dearlove knew that the audit team believed that the footnote disclosure in previous years was inadequate and had urged additional disclosure that would have made clear the extent of Rigas entities's actual borrowings and Adelphia's resulting potential liability. Dearlove did not think that Brown's language helped achieve Deloitte's goal of clarifying the extent of Rigas entities's debt and Adelphia's obligation as guarantor. Yet Dearlove accepted Brown's language without probing his reasons for the change, without understanding Adelphia's reasons for rejecting Deloitte's language and without discussing the issue with the concurring or risk review partners assigned to the audit. This unquestioning acceptance of Brown's proposed disclosure language was a clear-and at least unreasonable-departure from the requirements of GAAS to apply greater than normal skepticism and additional audit procedures in order to corroborate management representations in a high- risk environment. Dearlove's conduct resulted in violations of applicable professional standards. Dearlove asserted that disclosure of the amount that Rigas Entities could theoretically borrow (up to $3.75 billion) was more conservative than disclosure of the $1.6 billion that it had actually borrowed. The SEC concluded that the footnote disclosure was materially misleading to investors: "Materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information." If "there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision," the information is material. A reasonable investor would think it significant that the footnote disclosure spoke only in terms of potential debt when, in fact, the entire line of credit had been borrowed and $1.6 billion of it was excluded from Adelphia's balance sheet but potentially payable by Adelphia. It was especially important for this information to appear in Adelphia's financial statements because investors had no access to the financial statements of the privately held Rigas entities. The SEC rejected Dearlove's argument that Adelphia's note complied with SFAS 5's requirement to disclose the amount of debt that Adelphia guaranteed. Debt Reclassification After the end of the second, third, and fourth quarters of 2000, Adelphia's accounting department transferred the reporting of approximately $296 million of debt from the books of Adelphia's subsidiaries to the books of various Rigas entities. In exchange, Adelphia eliminated from its books receivables owed to it by the respective Rigas entities in the amount of debt transferred. The three transfers were in the amounts of $36 million, approximately $222 million, and more than $38 million, respectively. In each instance, the transaction took place after the end of the quarter, and each transfer involved a postclosing journal entry that was retroactive to the last day of the quarter. A checklist prepared by Deloitte in anticipation of the 2000 audit showed that Deloitte was aware of a significant number of related-party transactions that had arisen outside the normal course of business and that past audits had indicated a significant number of misstatements or correcting entries made by Adelphia, particularly at or near year-end. An audit overview memorandum recognized as a risk area that "Adelphia records numerous post-closing adjusting journal entries" and provided as an audit response, "[Deloitte] engagement team to review post-closing journal entries recorded and review with appropriate personnel. Conclude as to reasonableness of entries posted." An audit planning memorandum provided that "professional skepticism will be heightened to ensure that... related party transactions... are appropriately identified and disclosed" and that auditors should "increase professional skepticism in [areas] where significant related party transactions could occur." Dearlove testified that Deloitte had identified the Rigas family's control of both Adelphia and Rigas entities as posing a special risk. Dearlove also testified that he believed that
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Olympus Summary of the Case On September 25, 2012, Japanese camera and medical equipment maker Olympus Corporation and three of its former executives pleaded guilty to charges related to a $1.7 billion accounting cover-up in one of Japan's biggest corporate scandals. Olympus admitted that it tried to conceal investment losses by using improper accounting under a scheme that began in the 1990s. The scandal was exposed in 2011 by Olympus's then- CEO, Michael C. Woodford, who was fired by the company's board after asking about deals that were later found to have been used to conceal the losses. "The full responsibility lies with me and I feel deeply sorry for causing trouble to our business partners, shareholders and the wider public," the former chairman, Tsuyoshi Kikukawa, told the Tokyo district court. "I take full responsibility for what happened." 1 Prosecutors charged Kikukawa; a former executive vice president, Hisashi Mori; and a former internal auditor, Hideo Yamada, with inflating the company's net worth in financial statements for five fiscal years to March 2011 due to accounting for risky investments made in the late-1980s bubble economy. The three former executives had been identified by an investigative panel, commissioned by Olympus, as the main suspects in the fraud. An Olympus spokesman said the company would cooperate fully with the investigative authorities. It is under investigation by law enforcement agencies in Japan, Britain, and the United States. In December 2011, Olympus filed five years' worth of corrected financial statements plus overdue first-half results, revealing a $1.1 billion hole in its balance sheet. This development led to speculation that it would need to merge or forge a business tie-up to raise capital. Olympus Spent Huge Sums on Inflated Acquisitions, Advisory Fees to Conceal Investment Losses Olympus's cover-up of massive losses has shed light on several murky methods that some companies employed to clean up the mess left after Japan's economic bubble burst. Many companies turned to speculative investments as they suffered sluggish sales and stagnant operating profits. The company used "loss-deferring practices" to make losses look smaller on the books by selling bad assets to related companies. To take investment losses off its books, Olympus spent large sums of money to purchase British medical equipment maker Gyrus Group PLC and three Japanese companies and paid huge consulting fees. According to their records, Olympus paid about ¥66 billion (yen) (about $660 million), mainly in advisory fees, for their purchase of Gyrus, an apparent manipulation to conceal losses. Olympus is suspected of having deliberately acquired Gyrus at an inflated price, and in the year following the purchases, it booked impairment losses as a result of decreases in the companies' value. To avert a rapid deterioration of its financial standing, Olympus continued corporate acquisitions and other measures for many years, booking impairment losses to improve its balance sheet. Losses on the purchases of the three Japanese companies amounted to ¥55.7 billion. With money paid on the Gyrus deal included, Olympus may have used more than ¥100 billion in funds for past acquisitions to conceal losses on securities investments. Olympus Reported Only ¥17 Billion of ¥100 Billion in Losses Olympus reported only about ¥17 billion in losses in its annual securities report for the year ending March 2000, despite the fact that its losses totaled nearly ¥100 billion at that time. Japanese accounting standards were revised in 2000 to require latent losses of financial products to be specified in annual securities reports. Olympus should have reported the actual latent losses in its report for the year ending March 2001. The previous method that recorded stocks and other financial products by book value-the price when they were purchased-was abolished. The new method listed them by market value (mark-to-market accounting). Under this change, Olympus had to report all the losses in its March 2001 report. However, Olympus anticipated this change a year in advance and posted only about ¥17 billion of the nearly 100 billion yen as an extraordinary loss for the March 2000 settlement term. The company did not post the remainder as a deficit; rather, it deferred it using questionable measures. Olympus's Tobashi Scheme At the heart of Olympus's action, was a once-common technique to hide losses called tobashi, which Japanese financial regulators tolerated before clamping down on the practice in the late 1990s. Tobashi, translated loosely as "to blow away," enables companies to hide losses on bad assets by selling those assets to other companies, only to buy them back later through payments, often disguised as advisory fees or other transactions, when market conditions or earnings improve. Tobashi allows a company with the bad assets to mask losses temporarily, a practice banned in the early 2000s. The idea is that you pay off the losses later, when company finances are better. Olympus appears to have pushed to settle its tobashi amounts from 2006 to 2008, when the local economy was picking up and corporate profits rebounding, in an effort to "clean up its act." Business was finally strong enough to be able to withstand a write-down. It was during those years that the company engineered the payouts that came under scrutiny: $687 million in fees to an obscure financial adviser over Olympus's acquisition of Gyrus in 2008, a fee that was roughly a third of the $2 billion acquisition price, more than 30 times the norm. Olympus also acquired three small Japanese companies from 2006 to 2008 with little in common with its core business for a total of $773 million, only to write down most of their value within the same fiscal year. Olympus Scandal Raises Questions about the "Japan Way" of Doing Business The scandal rocked corporate Japan, not least because of the company's succession of firings, denials, admissions, and whistleblowing. It also exposed weaknesses in Japan's financial regulatory system and corporate governance. "This is a case where Japan's outmoded practice of corporate governance remained and reared its ugly head," according to Shuhei Abe, president of Tokyo-based Sparx Group Company. "With Olympus's case, it will no longer be justifiable for Japan Inc. to continue practicing under the excuse of the 'Japan way of doing things.'" "The Japanese market is already looking unattractive to foreign investors," said Hideaki Tsukuda, managing partner at Egon Zehnder International's Tokyo office. "Japanese companies really have to get their acts together, taking this opportunity to strengthen their corporate-governance practices." 2 On the surface, Olympus seemed to have checks on its management. For example, it hired directors and auditors from outside the company, as well as a British president who was not tied to corporate insiders. In reality, however, the company's management was ruled by former chairman Tsuyoshi Kikukawa and a few other executives who came from its financial sections. The company's management is believed to have been effectively controlled by several executives who had a background in financial affairs, including Kikukawa and former vice president Hisashi Mori, both of whom were involved in the cover-up of past losses. Olympus's board of auditors, which is supposed to supervise the board of directors, includes full-time auditor Hideo Yamada, who also had financial expertise. In some ways, the Olympus episode harks back to an older-and more freewheeling-era of Japanese deal-making, before the bursting of the country's economic bubble in the 1990s and subsequent regulatory reform efforts. Back then, small Japanese shareholders would threaten to cause problems at corporate annual meetings unless they were paid to be silent. In other cases, companies would pay politicians to secure government business. Culturally, you trust intermediaries and relationships so due diligence often is shortchanged. How Woodford Rocked the Boat at Olympus Olympus initially said that it fired Woodford, one of a handful of foreign executives at top Japanese companies, over what it called his aggressive Western management style. Woodford disclosed internal documents to show he was dismissed after he raised questions about irregular payouts related to mergers and acquisitions. Woodford later made a bid to return to the company with a fresh slate of directors, but he abandoned that effort after Japanese institutional investors continued to back Olympus's current management. Woodford had officially raised his concerns in a series of letters to the Olympus vice chairman, Hisashi Mori, beginning in mid-September 2011. The letters painted a picture of an increasingly frustrated Woodward as he demanded more disclosure over the acquisitions. In his fifth letter, dated September 27, he set the first of his ultimatums: Mori must, he insisted, produce documents before his return to Tokyo from London the next day and agree to a three-way summit with chairman Kikukawa. But Kikukawa and Mori then made what seemed at the time as a puzzling move: they offered Woodford the position of CEO, to add to his post as president. The promotion was announced in a news release filled with glowing praise for Woodford, championing his cost-cutting drive and presenting him as the new global face of Olympus. If the promotion was meant to give Woodford a greater stake in the company's future, and a greater sense of loyalty to the board, Woodford interpreted it as giving him even more ability to investigate the deals. Without the board's knowledge, he commissioned a report by PricewaterhouseCoopers (PwC) into the Gyrus deal, including the unusually high advisory fee and apparent lack of due diligence. On October 11, 2011, he circulated the report to the board and called on Kikukawa and Mori to resign. Three days later, the board fired him. Losses for Financial Year 2011-2012 Olympus said it posted a bigger-than-expected Group (consolidated) net loss for the fiscal year to March 2012. The consolidated net loss stood at ¥48.985 billion, compared with its projected loss of ¥32 billion and the ¥3.866 billion profit that it logged the previous year. The weaker result stemmed from additional special losses that the optical equipment maker booked to liquidate three companies that it used to conceal massive investment losses from the bubble economy. In December 2011, Olympus filed five years' worth of corrected earnings statements to restate its accounts. It said that as of the end of September, net assets were ¥46 billion, down from a restated ¥225 billion in March 2007. It also withdrew its forecast for a ¥18 billion net profit in the current business year. Accounting Explanations Olympus hid a $1.7 billion loss through an intricate array of transactions. A one paragraph summary of what it did appears in the investigation report: The lost disposition scheme is featured in that Olympus sold the assets that incurred loss to the funds set up by Olympus itself, and later provided the finance needed to settle the loss under the cover of the company acquisitions. More specifically, Olympus circulated money either by flowing money into the funds by acquiring the entrepreneurial ventures owned by the funds at the substantially higher price than the real values, or by paying a substantially high fees to the third party who acted as the intermediate in the acquisition, resulting in recognition of large amount of goodwill, and subsequently amortized goodwill recognized impairment loss, which created substantial loss. 3 Here is a more understandable version of the event: Olympus indirectly loaned money to an off-the-books subsidiary and then sold the investments that had the huge losses to the subsidiary at historical cost, eventually paying a huge premium to buy some other small companies and writing off the underwater investments as if they were goodwill impairments. A more detailed bookkeeping analysis of the complicated transactions appears in Exhibit 1. Auditor Responsibilities Arthur Andersen was the external auditor through March 31, 2002, after which Andersen was forced out of business by a U.S. DOJ investigation due to its role at Enron. Then KPMG AZSA LLC was the auditor through March 31, 2009. The 2009 and 2011 fiscal years were audited by Ernst Young ShinNihon LLC. The investigative report noted that the fraud was hidden quite well. Three banks were involved in hiding information from the auditors. The summary report said that all three of them agreed not to tell auditors the information that would normally be provided on an audit confirmation. KPMG did come across one of the tobashi schemes carried out through one of the three different routes that had been set up. According to the investigative report: Not everything was going smoothly. The report said that in 1999, Olympus's then-auditor, KPMG AZSA LLC, came across information that indicated the company was engaged in tobashi, which recently had become illegal in Japan. Mori and Yamada initially denied KPMG's assertion, but the auditor pushed them that same year to admit to the presence of one fund and unwind it, booking a loss of ¥16.8 billion. The executives assured KPMG that that was the only such deal, the report said. 4 Questions about the auditor's role include: How do you perform an audit for a global investor audience in a local economy where intentionally hiding losses is legal? How do you function in a business environment where that is acceptable and normative? On the other hand, notice how one audit team, from KPMG in 1999, did find one part of the scheme. Management lied by denying that it even existed. After agreeing to write it off, Olympus senior management lied again, saying that it was the only one. But the scheme expanded, without detection, for another six years or so and was in place, without detection, until the last component was unwound at the end of fiscal year 2010. Olympus Finally Had Enough of the Deception The last part of the bad investments was finally written off in March 2010. That was the last month of the fiscal year, when Ernst Young took over the audit from KPMG. Mori and Yamada had finally decided to unwind and write off the underwater financial assets and repay the loans that it had made through its unconsolidated subsidiary. Of course, by then, the financial press had gotten wind of what was going on at Olympus. Questions 1. In the Olympus case, Michael Woodford was abruptly fired on October 14, 2011, by the company's executive board because of what the board cited as a "management culture clash." Explain what you think this statement means in the context of the facts of the case and our discussion about the role of culture in business operations. 2. Do you think the practice of "tobashi" is a form of earnings management? Why or why not? 3.Explain the ethical issues and corporate governance failings that contributed to the fraud at Olympus, including the role of the auditors. Optional Question 4. What are the similarities between the actions taken in the Olympus case and those of Enron with respect to its special-purpose-entities (SPEs)? 1 Reuters, "Olympus and Ex-Executives Plead Guilty in Accounting Fraud," September 25, 2012. Available at http://www.reuters.com/article/2012/09/25/us-olympus-trial-idUSBRE88001920120925. 2 "0lympus Scandal: $1.5 billion in Losses Hidden in Dodgy Acquisitions," Available at http://factsanddetails.com/japan.php?itemid=2305 catid=24 subcatid=157. 3 Reuters, "Olympus and Ex-Executives Plead Guilty in Accounting Fraud," September 25, 2012. Available at http://www.reuters.com/article/2012/09/25/us-olympus-trial-idUSBRE88O01920120925. 4 "Olympus Scandal: $1.5 billion in Losses Hidden in Dodgy Acquisitions," Available at http://factsanddetails.com/japan.php?itemid=2305 catid=24 subcatid=157.
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Satyam: India's Enron Satyam Computer Services, now Mahindra Satyam, is an India-based global business and information technology services company that specializes in consulting, systems integration, and outsourcing solutions. The company was the fourth-largest software exporter in India until January 2009, when the CEO and cofounder, Ramalinga Raju, confessed to inflating the company's profits and cash reserves over an eight-year period. The accounting fraud at Satyam involved dual accounting books, more than 7,000 forged invoices, and dozens of fake bank statements. The total amount of losses was Rs (rupees) 50 billion (equal to about $1.04 billion). 1 This represented about 94 percent of the company's cash and cash equivalents. The global scope of Satyam's fraud led to the labeling of it as "India's Enron." Ironically, the name "Satyam" is derived from the Sanskrit word satya, which translates to "truth." Although headquartered in Hyderabad, India, Satyam's stock was listed on the NYSE since 2001. When the news of the fraud broke, Satyam's stock declined almost 90 percent in value on both the U.S. and Indian stock exchanges. Several top managers either resigned or were fired and jail terms were given to Raju, the co-founder and CEO, and Sirinivas Vadlamani, the CFO. The auditors-PricewaterhouseCoopers (PwC)-were also implicated in the fraud, and investigations against it are continuing by the Securities and Exchange Board of India (SEBI). As of June 2013, PwC was cooperating with the investigation in an attempt to fast-track a settlement ahead of protracted legal cases against the firm that are expected to take years to unravel because Satyam was India's largest-ever accounting fraud. Fraudulent Actions by Raju Raju stepped down in early January 2009, admitting to falsifying financial figures of the company with respect to nonexistent cash and bank balances. Stunning his well-wishers and investors, Raju revealed the real motive behind the December 16 bid to acquire Maytas companies for $1.6 billion: to swap the fictitious cash reserves of Satyam built over years with the Maytas assets. Raju thought that the payments to Maytas could be delayed once Satyam's problem was solved. What had started as a marginal gap between actual operating profit and the one reflected in the books continued to grow over the years. It had attained unmanageable proportions as the size of the company's operations grew over the years. One lie led to another. The problem further worsened as the company had to carry additional resources and assets to justify a higher level of operations, leading to increased costs. As things went out of hand, Raju was forced to raise Rs 1.23 billion (approximately $25.58 million) more by pledging the family-owned shares to keep the operations going. His woes were compounded with amounts due to vendors, fleet operators, and construction companies. The offloading of the pledged shares by IL FS Trust Company, a Mumbai-based financial institution, and others brought down the promoters' stake from 8.65 percent to a fragile 3.6 percent. By the end of the day, Raju was left facing charges from several sides. The Ministry of Corporate Affairs, the state government, and the market regulator, SEBI, decided to probe the affairs of the company and Raju's role, as well as corporate governance issues. Going by his confessional statement to the board of Satyam in January 2009, what Raju had done over the years appears to be rather simple manipulation of revenues and earnings to show a superior performance than what was actually the case. For this, he resorted to the time-tested practice of creating fictitious billings for services that were never rendered. The offset was either an inflation of receivables or the cash in bank balance. The following is a summary of the way financial statement amounts were manipulated: • 94 percent (Rs 5.04 billion/approximately $10.5 million) of the cash in bank account balance in the September 30, 2008, balance sheet was inflated, due largely to exaggerated profits and fictitious assets. • An accrued interest of Rs 376 million (approximately $7.82 million) was nonexistent. • An understated liability of Rs 1.23 billion (approximately $25.58 million) resulting from Raju's infusion of personal funds into the company was recorded as revenue. • Inflated revenues of Rs 588 million (approximately $12.23 million) went straight to the bottom line. Acquisition of Maytas Properties and Maytas Infrastructure In December 2008, Raju tried to buy two firms owned by his sons, Maytas Properties and Maytas Infrastructure (Satyam spelled backward is Maytas) for $1.6 billion. Raju tried to justify the purchase by stating that the company needed to diversify by incorporating the infrastructure market to augment its software market. However, many investors thought that the purchases of two firms were intended to line the pockets of the Raju family. Raju owned less than 10 percent of Satyam, whereas Raju's family owned 100 percent of the equity in Maytas Properties and about 40 percent of Maytas Infrastructure. Stock prices plunged dramatically after the announcement, so Raju rescinded his offer to buy the two companies. With the prices of Satyam stock and the health of the company declining, four members of the board of directors of Satyam resigned within one month. In his confession, Raju took full responsibility for the accounting fraud and stated that the board knew nothing about the manipulation of financial statements. He indicated a willingness to accept the legal consequences of his actions. An important question is how independently did the "independent" directors of Satyam act in the now highly questioned and failed decision to acquire the Maytas companies? One board member, M. Rammohan Rao, dean of the prestigious Indian School of Business (ISB) with campuses in Hyderabad and Mohali, claimed that the board had taken an independent view and raised concerns about the unrelated diversification, valuation, and other issues. Two views emerged. The first was, why not stick to our core competencies and why venture into a risky proposition? The second issue was related to the valuation of the companies. Maytas Properties was valued much higher than $1.3 billion, the amount that Satyam's management came up with for the acquisition price. When asked whether the fact that the target companies-Maytas Properties and Maytas Infrastructure-were led by Raju's two sons made any difference to the board, Rao said, "We felt the valuation proposed by the Satyam management was lower and conservative, despite the family ties. We took an independent view on this." 2 When asked if the board had taken into consideration the possible impact of the purchase of the two companies on shareholders' interests and the market reaction, the ISB dean responded, "There were concerns on these grounds as well, especially the market reaction for such an unrelated diversification." However, according to Rao, there was no way that they could gauge the market reaction at first, so they decided to take a risk. But the way the market reacted was a bit unanticipated, he added. Questions can be raised about corporate governance with respect to the failed acquisition of the Maytas companies. A conflict of interest arose when Satyam's board agreed to invest $1.6 billion to acquire a 100 percent stake in Maytas Properties and a 51 percent stake in Maytas Infrastructure. The Raju family, which ran the Maytas companies also invited family or close friends to serve on the board of directors. These bonds created independence issues and questions about whether directors would be confrontational with top management when warranted. Litigation in the U.S. Securities fraud class action lawsuits were filed on behalf of a class of persons and entities who purchased or acquired the American Depositary Shares (ADSs) 3 of Satyam on the NYSE and/or were investors residing in the United States who purchased or acquired Satyam common stock traded on Indian exchanges between January 6, 2004, and January 6, 2009 (the class period). The complaint alleged that Satyam, certain of its directors and officers, and the company's outside auditors (PwC) made false and misleading public statements regarding Satyam's financial condition and performance, which artificially inflated the stock price. On January 7, 2009, Satyam's chair, Ramalinga Raju, sent a letter to the company's board confessing to a massive accounting fraud. Raju admitted that the company's balance sheet and other public disclosures contained numerous false statements. For example, Raju wrote that as of September 30, 2008, the company overstated revenue by approximately 22 percent and reported cash and bank balances of Rs 53.61 billion (approximately $1.1 billion), of which Rs 50.4 billion (over $1 billion) did not exist. 4 Reports issued since the January 7 confession indicate that Raju likely understated the scope of the fraud, and that he and members of his family engaged in widespread theft of Satyam's funds through a complex web of intermediary entities. The complaint also asserted claims against Pricewater- houseCoopers International Ltd. and its Indian partners and affiliates including Price Waterhouse Bangalore, PricewaterhouseCoopers Private Limited, and Lovelock Lewes (PW India firms). Satyam's outside auditors from the PW India firms were aware of the fraud but still certified the company's financial statements as accurate. A document (the charge sheet) filed in a Hyderabad court by the Indian Central Bureau of Investigation (the equivalent of the U.S. Federal Bureau of Investigation), detailing charges against numerous Satyam employees and two partners of PW India firms, alleged that the auditors received documentation from Satyam's banks that showed that the company's disclosed assets were greatly overstated. The charge sheet further alleged that these auditors received fees from Satyam that were exorbitantly higher than the fees similarly situated Indian companies paid to their outside auditors; the Central Bureau of Investigation cited these fees as evidence of a "well-knit criminal conspiracy" between Satyam and the auditors. The complaint asserted claims against other defendants as well. In particular, the complaint alleged that members of the audit committee of the Satyam board of directors-who were responsible for overseeing the integrity of the company's financial statements, the performance and compensation of the outside auditors from PW India firms, and the adequacy and effectiveness of internal accounting and financial controls-were responsible for the publication of false and misleading public statements due to their extreme recklessness in discharging their duties and their resulting failure to discover and prevent the massive accounting fraud. The complaint also alleged that Maytas Infrastructure and Maytas Properties and Raju's two sons were responsible for the false and misleading public statements. The Raju sons' false and misleading statements concerning Satyam's financial condition and performance artificially inflated the prices of the company's publicly traded securities during the class period, and caused significant damages to investors when the prices of the company's securities both in the United States. and in India experienced severe declines as a direct result of disclosures regarding Satyam's true condition. Actions Against PwC PwC and its Indian affiliates initially hid behind "client confidentiality" and stated that it was "examining the contents of the statement." Realizing that this was not enough, PwC came up with a second statement claiming that "the audits were conducted in accordance with applicable auditing standards and were supported by appropriate audit evidence." This is somewhat troublesome because an audit in accordance with generally accepted auditing standards (GAAS) calls for examining the contents of the financial statements. Given that the firm did not identify the financial wrongdoing at Satyam, it would appear that the firm, at the very least, was guilty of professional negligence. At a minimum, the firm missed or failed to do the following: • Fictitious invoices with customers were recorded as genuine. • Raju recorded a fictional interest credit as income. • The auditors didn't ask for a statement of confirmation of balance from banks (for cash balances) and debtors (for receivables), a basic procedure in an audit. On January 26, 2009, Indian police arrested two partners of the Indian arm of PwC on charges of criminal conspiracy and cheating in connection with the fraud investigation at Satyam. Furious Indian investors had pressured the authorities to take such an action in light of the more than $1 billion fraud. Investors couldn't understand how a reported $1 billion in cash was really only $78 million, and how it wasn't detected by PwC. The company's financial statements were signed off by PwC on March 31, 2008. 5 Class Action Lawsuits in the U.S. On January 11, 2010, India asked the authorities in the U.S. to not take any action against Satyam, as it would amount to punishing shareholders twice. Satyam can face punitive action in the United States because the company's shares are listed and traded on United States exchanges. Satyam also is contending about a dozen class action lawsuits in U.S. courts. It is also possible that the company will face charges from the SEC. As many as 12 class action lawsuits were filed against the company by January 2009, and more are expected to be filed. The lawsuits were filed by investors in the ADS ever since Raju confessed to having fudged the accounts of the company for at least seven years. The charges alleged against the defendants in the lawsuits filed to date are: 1. The defendants issued misleading financial information about the company including information contained in its annual reports, which were signed by the defendants and contained fairness opinions issued by Satyam's auditor, PwC. 2. A letter was sent by Ramalinga Raju to the board of directors of Satyam and SEBI admitting to falsification of accounts, overstatement of profits and debt owed to the company, and understatement of liabilities. The purchasers of Satyam's ADSs were injured through their purchase of stock at inflated prices because they relied on the false and misleading information provided by the defendants. 3. None of the statements made by the defendants that have been alleged to be false in the lawsuit had any qualifying cautionary statements identifying factors that could cause results to differ materially from that stated. Are Big-Four U.S. Accounting Firms One Global Firm or Independent Entities? An interesting aspect of the Satyam case is whether Big-Four international CPA firms truly operate as one firm across the globe, or whether each PwC affiliated-entity is separate and apart from the U.S. firm. The issue is important because PwC in the U.S. initially claimed it should not be held legally liable for the actions of its affiliates. Although audit firms around the world use similar names and are part of global networks, the firms say they are legally independent. The international networks say they have procedures to assure that their affiliates perform high-quality audits, but those procedures appear to have broken down in this case. Those procedures include having partners from different firms in the network review audits. While the 2008 audit was being conducted, the U.S. S.E.C. said, a partner from a different PwC firm "alerted members of the Satyam engagement team that its cash confirmation procedures appeared substantially deficient," but the Indian firm did nothing to correct the procedures. Had the firm done as the foreign partner advised was proper, the commission said, "Satyam's fraud could have been uncovered in the summer of 2008." Questions 1. Madan Bahsin concludes in her research paper that examined the fraud at Satyam that "the scandal brought to light the importance of ethics and its relevance to corporate culture." Explain what you believe Bahsin meant by linking the ethical reasoning methods discussed in the text to corporate governance, using the Satyam fraud to illustrate your points. 6. 2. Hofstede's cultural values that were discussed in Chapter 1 reflect the following scores with respect to India and the U.S. Do you believe these differences in cultural values and the discussion in this chapter about corporate governance in India can be used to explain the nature and scope of the fraud at Satyam including the involvement of Raju in the acquisition of two companies owned by his sons? 3. Briefly discuss the audit failures of PwC and its affiliates with respect to the accounting issues raised in the case including fraud risk assessment. What rules of professional conduct in the AICPA Code that was discussed in Chapter 4 were violated? Optional Question 4. Research the current status of all legal action against Satyam, its officers, and the PwC auditors. What changes have occurred in the facts of the case since June 2013? 1 $1 = Rs 44 (approximately) at December 31, 2009. 2 Available at www.blonnet.com/2008/12/19/stories/20081219=1600400.htm. 3 ADSs are U.S. dollar-denominated equity shares of a foreign-based company available for purchase on a United States stock exchange. ADSs are issued by depository banks in the United States under agreement with the issuing foreign company; the entire issuance is called an American Depositary Receipt (ADR), and the individual shares are referred to as ADSs. 4 In re Satyam Computer Services, Ltd., Securities Litigation, U.S. District Court, Southern District of New York, 09-MD-02027, January 2009. 5 Ronald Fink, "Doubt Cast on Satyam Executives' Accusations against PwC," Financial Week, www.financialweek.com/apps/pbcs/dll/article=/20090127/REG/901279970/10.
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SEC v. Siemens Aktiengesellschaft On December 15, 2008, the SEC filed a lawsuit against Siemens Aktiengesellschaft (Aktiengesellschaft is German for "corporation"), charging the Munich, Germany-based manufacturer of industrial and consumer products with violations of the antibribery, books and records, and internal controls provisions of the FCPA. The SEC has the authority to bring this action because Siemens stock is listed on the NYSE. Siemens agreed to pay a total of $1.6 billion in disgorgement and fines, which is the largest amount a company has ever paid to resolve corruption-related charges. The company also agreed to pay $350 million in disgorgement to the SEC. In related actions, Siemens will pay a $450 million criminal fine to the U.S. Department of Justice (DOJ) and a fine of $569 million to the Office of the Prosecutor General in Munich, Germany. Siemens previously paid a fine of $285 million to the Munich prosecutor in October 2007. The SEC released a summary of its litigation in this matter, which is summarized in the following paragraphs. 1 Summary of Litigation Between March 12, 2001, and September 30, 2007, Siemens violated the FCPA by engaging in a widespread and systematic practice of paying bribes to foreign government officials to obtain business. Siemens created elaborate payment schemes to conceal the nature of its corrupt payments, and the company's inadequate internal controls allowed the conduct to flourish. The misconduct involved employees at all levels, including former senior management, and revealed a corporate culture long at odds with the FCPA. During this period, Siemens made thousands of payments to third parties in ways that obscured the purpose for, and the ultimate recipients of, the money. At least 4,283 of those payments, totaling approximately $1.4 billion, were used to bribe government officials in return for giving business to Siemens around the world. Among others, Siemens paid bribes on transactions to design and build metro transit lines in Venezuela; metro trains and signaling devices in China; power plants in Israel; high-voltage transmission lines in China; mobile telephone networks in Bangladesh; telecommunications projects in Nigeria; national identity cards in Argentina; medical devices in Vietnam, China, and Russia; traffic control systems in Russia; refineries in Mexico; and mobile communications networks in Vietnam. Siemens also paid kickbacks to Iraqi ministries in connection with sales of power stations and equipment to Iraq under the Oil for Food Program of the United Nations (UN). Siemens earned over $1.1 billion in profits on these transactions. An additional 1,185 separate payments to third parties were made totaling approximately $391 million, These payments were not properly controlled and were used, at least in part, for illicit purposes, including commercial bribery and embezzlement. From 1999 to 2003, Siemens's Management Board was ineffective in implementing controls to address constraints imposed by Germany's 1999 adoption of the Organization for Economic Co-operation and Development (OECD) anti-bribery convention that outlawed foreign bribery. The Management Board was also ineffective in meeting the U.S. regulatory and antibribery requirements that Siemens was subject to following its March 12, 2001, listing on the NYSE. Despite knowledge of bribery at two of its largest groups-Communications and Power Generation-top management was tone-deaf to the internal environment it had developed and created a corporate culture in which bribery was tolerated (and even rewarded) at the highest levels of the company. Employees obtained large amounts of cash from cash desks, which were sometimes transported in suitcases across international borders for bribery. Written authorizations for payments were removed later to eradicate any permanent record. Siemens used numerous slush funds, off-books accounts maintained at unconsolidated entities, and a system of business consultants and intermediaries to facilitate the corrupt payments. Siemens failed to implement adequate internal controls to detect and prevent violations of the FCPA. Elaborate payment mechanisms were used to conceal the fact that bribe payments were made around the globe to obtain business. False invoices and payment documentation were created to make payments to business consultants under false business consultant agreements that identified services that were never intended to be rendered. Illicit payments were falsely recorded as expenses for management fees, consulting fees, supply contracts, room preparation fees, and commissions. Siemens inflated contracts with the United Nations (UN), signed side agreements with Iraqi ministries that were not disclosed to the UN, and recorded the after-sale-service- charge (ASSF) payments as legitimate commissions despite UN, U.S., and international sanctions against such payments. In November 2006, Siemens's current management began to implement reforms to the company's internal controls. These reforms substantially reduced, but did not entirely eliminate, the corrupt payments. All but $27.5 million of the corrupt payments occurred before November 15, 2006. The company conducted a massive internal investigation and implemented an amnesty program to its employees to gather information. The success of Siemens's bribery system was maintained by lax internal controls over corruption-related activities and an acceptance of such activities by members of senior management and the compliance, internal audit, legal, and finance departments. Siemens violated Section 30A of the Securities Exchange Act of 1934 by making illicit payments to foreign government officials in order to obtain or retain business. Siemens violated Section 13(b)(2)(B) of the Exchange Act by failing to have adequate internal controls to detect and prevent the payments. Siemens violated Section 13(b)(2)(A) of the Exchange Act by improperly recording the payments in its books. Without admitting or denying the commission's allegations, Siemens consented to the entry of a court order permanently enjoining it from future violations of the Exchange Act; ordering it to pay $350 million in disgorgement of wrongful profits, which does not include profits factored into Munich's fine; and ordering it to comply with certain undertakings regarding its FCPA compliance program, including an independent monitor for a period of four years. On December 15, 2008, the court entered the final judgment. Since being approached by SEC staff, Siemens has cooperated fully with the ongoing investigation, and the SEC considered the remedial acts promptly undertaken by Siemens. Siemens's massive internal investigation and lower-level- employee amnesty program were essential in gathering facts regarding the full extent of Siemens's FCPA violations. Charges Against the Management Board The following charges were made against Siemens's Management Board: 1. The board was ineffective in meeting the U.S. regulatory and antibribery requirements that Siemens was subject to following its listing on the NYSE on March 12, 2001. 2. The board failed to adopt meaningful compliance measures, failed to staff Siemens's compliance function adequately, and, at times failed to adopt reasonable recommendations designed to ensure compliance procedures at the company. 3. The company failed to respond to red flags, including ignoring substantial cash payments in Nigeria by senior- level employees within one of its business groups and ignoring Siemens's outside auditor KPMG's identification of approximately $5.81 million in cash that was brought to Nigeria by a Siemens employee. The FCPA compliance report prepared on the foregoing matters in November 2003 by Siemens's then-CFO did not lead to any disciplinary actions against those employees involved in the bribery, and the report was not provided to or discussed with the Management Board or the company's audit committee. Illicit Payment Mechanisms Used to Pay Bribes Siemens made thousands of payments to third parties in ways that obscured the purpose for, and ultimate recipient of, the money. The principal mechanisms used to facilitate illicit payments were business consultants, payment intermediaries, slush funds, cash, and intercompany accounts. Through its use of business consultants and payment intermediaries, Siemens funneled more than $982.7 million to third parties, including government officials. Business consultants were typically hired pursuant to business consultant agreements, contracts that on their face obligated Siemens to pay for legitimate consulting services. In reality, many business consultant agreements were shams, in that the consultants performed no services beyond funneling bribes. One business group had specific instructions on how to use a "confidential payment system" to conceal payments to business consultants. Payment intermediaries were additional entities and individuals through which Siemens funneled bribes. In many cases, Siemens would pay the intermediary an amount and simultaneously direct that the money be transferred to a third-party bank account, less a small portion as the intermediary's fee. Siemens also funneled more than $211 million through slush funds for use as bribes. Slush funds were bank accounts held in the name of current or former senior Siemens employees, third parties, or affiliated entities. These payments were made before September 30, 2004. The most notable slush funds were maintained by a former group (i.e., consolidated entity) manager who has been convicted in Germany for his role in the payment of bribes to foreign officials, which included several slush funds held in the name of U.S. shell companies. Siemens also used cash and cash equivalents to funnel more than $160.4 million to third parties. Its employees used "cash desks" maintained by the Siemens Real Estate Group to obtain large amounts of cash to pay bribes. Often, employees would obtain hundreds of thousands of dollars and, at times, even $1 million in various currencies from the cash desks in Germany. At times, the cash was then stored in safes maintained by Siemens employees to ensure ready access to cash to pay bribes. As early as 2004, a Siemens corporate financial audit employee raised concerns about the use of intercompany accounts. He was phased out of his job and assigned to work on "special projects" from his home until leaving the company in 2005. Siemens thereafter began closing some of the accounts and eventually closed all of them. Another type of internal account that employees abused was Siemens internal commission accounts. These balance- sheet accounts were intended to be used to record commissions at a business group earned on transactions with other Siemens entities. These accounts were used to make third- party payments. Many of the intercompany account payments and the internal commission account payments were done manually to bypass Siemens's automated payment system. The manual payments, executed through the system, did not require the submission of documentation in support of a payment. Siemens used a host of other schemes to make more than $25.3 million in payments to third parties. In particular, Siemens used sham supplier agreements, receivables, and other write-offs to generate payments. In total, Siemens made bribery payments directly or indirectly to foreign government officials in connection with at least 290 projects or individual sales involving business in a variety of countries. Siemens Failed to Maintain Its Books, Records, and Internal Controls Siemens failed to implement adequate internal controls to comply with the company's NYSE listing, including the detection and prevention of violations of the FCPA. As already stated, Siemens made thousands of payments to third parties in ways that obscured the purpose for, and the ultimate recipients of, the payments. Despite a policy that required two signatures on company documents to authorize transactions, a significant number of business consultant agreements were entered into and a significant number of payments were authorized in violation of the policy. Siemens paid approximately $1.4 billion in bribes to foreign government officials. Doing so involved the falsification of Siemens's books and records by employees throughout the company. Specifically, Siemens failed to keep accurate books and records by (1) establishing and funding secret, off-books accounts; (2) establishing and using a system of payment intermediaries to obscure the source and destination of funds; (3) making payments pursuant to business consultant agreements that inaccurately described the services provided; (4) generating false invoices and other false documents to justify payments; (5) disbursing millions in cash from cash desks with inaccurate documentation authorizing or supporting the withdrawals; (6) concealing the identity of persons authorizing illicit payments; (7) recording illicit ASSF payments as legitimate commissions in Oil for Food transactions; (8) falsifying UN documents in connection with the Oil for Food program; and (9) recording bribes as payments for legitimate services. Siemens failed to establish controls over cash disbursements, allowed manual payments without documentation, and failed to ensure the proper use of intercompany accounts. In addition, the company failed to establish an effective central compliance function. The compliance office lacked independence and was severely understaffed. Siemens's tone at the top was inadequate for a law-abiding entity, and employees engaged in bribery and other misconduct on behalf of the company were not disciplined adequately. Siemens also failed to conduct appropriate antibribery and corruption training. Questions 1. Evaluate the ethics of actions taken by Siemens with respect to Josephson's Six Pillars of Character and virtue- based decision making, as discussed in Chapter 1. 2. Under the German Criminal Code, much like the U.K. Bribery Act, all bribes are prohibited including facilitating payments. The Foreign Corrupt Practices Act (FCPA) in the U.S. makes a distinction between the two and permits facilitating payments made to induce a government official to carry out her designated responsibilities. From an ethical perspective, which of these two approaches are more consistent with virtue theory? 3. Comment on the following statement from an ethics perspective: Companies that make the mistake of trying to follow the bottom limits of legal behavior without championing ethics should learn from the Siemens case that once a culture of taking short cuts and ignoring values is in place, it is only a matter of time before employees cross the line into illegal conduct. Optional Question 4. Review the 13 cases on bribing foreign government officials described in the SEC complaint referenced below. 2 Summarize the accounting issues involved in each case and explain how the payments described violated the FCPA. 1 Securities and Exchange Commission v. Siemens Aktiengesellschaft, Case 1.08-cv-02167, Litigation Release No. 20829, Accounting and Enforcement Release No. 2911, December 15, 2008, www.sec.gov/litigation/litreleases/2008/lr20829.htm. 2 Securities and Exchange Commission v Siemens Aktiengesellschaft, Case 1.08-cv-02167, Litigation Release No. 20829, Accounting and Enforcement Release No. 2911, December 15, 2008, www.sec.gov/litigation/complaints/2008/comp20829.pdf.
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In this chapter, we discuss problems encountered by the PCAOB in gaining access to inspect work papers of audits by U.S. international accounting firms of Chinese companies. Explain why these problems exist, including cultural, legal, and ethical considerations.
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Cendant Corporation 1 The Merger of HFS and CUC HFS Incorporated (HFS) was principally a controller of franchise brand names in the hotel, real estate brokerage, and car rental businesses, including Avis, Ramada Inn, Days Inn, and Century 21. Comp-U-Card (CUC) was principally engaged in membership-based consumer services such as auto, dining, shopping, and travel "clubs." Both securities were traded on the NYSE. Cendant Corporation was created through the December 17, 1997, merger of HFS and CUC. Cendant provided certain membership-based and Internet-related consumer services and controls franchise brand names in the hotel, residential real estate brokerage, car rental, and tax preparation businesses. Overview of the Scheme The Cendant fraud was the largest of its kind until the late 1990s and early 2000s. Beginning in at least 1985, certain members of CUC's senior management implemented a scheme designed to ensure that CUC always met the financial results anticipated by Wall Street analysts. The CUC senior managers used a variety of means to achieve their goals, including: • Manipulating recognition of the company's membership sales revenue to accelerate the recording of revenue • Improperly using two liability accounts related to membership sales that resulted from commission payments • Consistently maintaining inadequate balances in the liability accounts, and on occasion reversing the accounts directly into operating income With respect to the last item, to hide the inadequate balances, senior management periodically kept certain membership sales transactions off the books. In what was the most significant category quantitatively, the CUC senior managers intentionally overstated merger and purchase reserves and subsequently reversed those reserves directly into operating expenses and revenues. CUC senior management improperly wrote off assets-including assets that were unimpaired-and improperly charged the write-offs against the company's merger reserves. By manipulating the timing of the writeoffs and by improperly determining the nature of the charges incurred, the CUC senior managers used the write-offs to inflate operating income at CUC. As the scheme progressed over the course of several years, larger and larger year-end adjustments were required to show smooth net income over time. The scheme added more than $500 million to pretax operating income during the fiscal years ended January 31, 1996; January 31, 1997; and December 31, 1997. SEC Filings against CUC and Its Officers SEC complaints filed on June 14, 2000, alleged violations of the federal securities laws by four former accounting officials, including Cosmo Corigliano, CFO of CUC; Anne M. Pember, CUC controller; Casper Sabatino, vice president of accounting and financial reporting; and Kevin Kearney, director of financial reporting. The allegations against Corigliano included his role as one of the CUC senior officers who helped engineer the fraud, and he maintained a schedule that management used to track the progress of their fraud. Corigliano regularly directed CUC financial reporting managers to make unsupported alterations to the company's quarterly and annual financial results. The commission alleged that Corigliano profited from his own wrongdoing by selling CUC securities and a large number of Cendant securities at inflated prices while the fraud he helped engineer was under way and undisclosed. The commission alleged that Pember was the CUC officer most responsible for implementing directives received from Corigliano in furtherance of the fraud, including implementing directives that inflated Cendant's annual income by more than $100 million, primarily through improper use of the company's reserves. According to the SEC, Pember profited from her own wrongdoing by selling CUC and Cendant stock at inflated prices while the fraud she helped implement was under way and undisclosed. Sabatino and Kearney, without admitting or denying the commission's allegations, consented to the entry of final judgments settling the commission's action against them. The commission's complaint alleged that Sabatino was the CUC officer most responsible for directing lower-level CUC financial reporting managers to make alterations to the company's quarterly financial results. In the first of the three separate administrative orders, the commission found that Steven Speaks, the former controller of CUC's largest division, made or instructed others to make journal entries that effectuated much of the January 1998 income inflation directed by Pember. In a second separate administrative order, the commission found that Mary Sattler Polverari, a former CUC supervisor of financial reporting, at the direction of Sabatino and Kearney, regularly and knowingly made unsupported alterations to CUC's quarterly financial results. In a third administrative order, the commission found that Paul Hiznay, a former accounting manager at CUC's largest division, aided and abetted violations of the periodic reporting provisions of the federal securities laws by making unsupported journal entries that Pember had directed. Hiznay consented to the issuance of the commission's order to cease and desist from future violations of the provisions. In a fourth and separate administrative order the commission found that Cendant violated the periodic reporting, corporate recordkeeping, and internal controls provisions of the federal securities laws, in connection with the CUC fraud. Among other things, the company's books, records, and accounts had been falsely altered, and materially false periodic reports had been filed with the commission, as a result of the long-running fraud at CUC. Simultaneous with the institution of the administrative proceeding, and without admitting or denying the findings contained therein, Cendant consented to the issuance of the commission order, which ordered Cendant to cease and desist from future violations of the provisions. On February 28, 2001, the SEC filed a civil enforcement action in the U.S. District Court for the District of New Jersey against Walter A. Forbes, the former chair of the board of directors at CUC, and E. Kirk Shelton, the former vice chair, alleging that they directed a massive financial fraud while selling millions of dollars' worth of the company's common stock. For the period 1995-1997 alone, pretax operating income reported to the public by CUC was inflated by an aggregate amount of over $500 million. Specific allegations included: • Forbes, CUC's chair and CEO, directed the fraud from its beginnings in 1985. From at least 1991 on, Shelton, CUC's president and COO, joined Forbes in directing the scheme. • Forbes and Shelton reviewed and managed schedules listing fraudulent adjustments to be made to CUC's quarterly and annual financial statements. CUC senior management used the adjustments to pump up income and earnings artificially, defrauding investors by creating the illusion of a company that had ever-increasing earnings and making millions for themselves along the way. • Forbes and Shelton undertook a program of mergers and acquisitions on behalf of CUC in order to generate inflated merger and purchase reserves at CUC to be used in connection with the fraud. Forbes and Shelton sought out HFS as a merger partner because they believed that the reserves that would be created would be big enough to bury the fraud. To entice HFS management into the merger, Forbes and Shelton inflated CUC's earnings and earnings projections. • Forbes and Shelton profited from their own wrongdoing by selling CUC and Cendant securities at inflated prices while the fraud they had directed was under way and undisclosed. The sales brought Forbes and Shelton millions of dollars in ill-gotten gains. • After the Cendant merger, Forbes served as Cendant's board chair until his resignation in July 1998. At the time of the merger, Shelton became a Cendant director and vice chair. Shelton resigned from Cendant in April 1998. Specific Accounting Techniques Used to Manage Earnings Making Unsupported Postclosing Entries In early 1997, at the direction of senior management, Hiznay approved a series of entries reversing the commissions payable liability account into revenue at CUC. The company paid commissions to certain institutions on sales of CUC membership products sold through those institutions. Accordingly, at the time that it recorded revenue from those sales, CUC created a liability to cover the payable obligation of its commissions. CUC senior management used false schedules and other devices to support their understating of the payable liability of the commissions and to avoid the impact that would have resulted if the liability had been properly calculated. Furthermore, in connection with the January 31, 1997, fiscal year-end, senior management used this liability account by directing post-closing entries that moved amounts from the liability directly into revenue. 2 In February 1997, Hiznay received a schedule from the CUC controller setting forth the amounts, effective back dates, and accounts for a series of postclosing entries that reduced the commissions payable account by $9.12 million and offsetting that reduction by increases to CUC revenue accounts. Hiznay approved the unsupported entries and had his staff enter them. They all carried effective dates spread retroactively over prior months. The entries reversed the liability account directly into revenues, a treatment that, under the circumstances, was not in accordance with GAAP. Keeping Rejects and Cancellations Off-Books: Establishing Reserves During his time at CUC, Hiznay inherited, but then supervised, a longstanding practice of keeping membership sales cancellations and rejects off CUC's books during part of each fiscal year. Certain CUC membership products were processed through various financial institutions that billed their members' credit cards for new sales and charges related to the various membership products. When CUC recorded membership sales revenue from such a sale, it would allocate a percentage of the recorded revenue to cover estimated cancellations of the specific membership product being sold, as well as allocating a percentage to cover estimated rejects and chargebacks. 3 CUC used these percentage allocations to establish a membership cancellation reserve. Over the years, CUC senior management had developed a policy of keeping rejects and cancellations off the general ledger during the last three months of each fiscal year. Instead, during that quarter, the rejects and cancellations appeared only on cash account bank reconciliations compiled by the company's accounting personnel. The senior managers then directed the booking of those rejects and cancellations against the membership cancellation reserve in the first three months of the next fiscal year. Because rejects and cancellations were not recorded against the membership cancellation reserve during the final three months of the fiscal year, the policy allowed CUC to hide the fact that the reserve was understated dramatically at each fiscal year-end. At its January 31, 1997, fiscal year-end, the balance in the CUC membership cancellation reserve was $29 million; CUC accounting personnel were holding $100 million in rejects and $22 million in cancellations off the books. Failing to book cancellations and rejects at each fiscal year-end also had the effect of overstating the company's cash position on its year-end balance sheet. Accounting and Auditing Issues Kenneth Wilchfort and Marc Rabinowitz were partners at Ernst Young (EY), which was responsible for audit and accounting advisory services provided to CUC and Cendant. During the relevant periods, CUC and Cendant made materially false statements to the defendants and EY about the company's true financial results and its accounting policies. CUC and Cendant made these false statements to mislead the defendants and EY into believing that the company's financial statements conformed to GAAP. For example, as late as March 1998, senior Cendant management had discussed plans to use over $100 million of the Cendant reserve fraudulently to create fictitious 1998 income, which was also concealed from the defendants and EY. CUC and Cendant made materially false statements to the defendants and EY that were included in the management representation letters and signed by senior members of CUC's and Cendant's management. The statements concerned, among other things, the creation and utilization of merger-related reserves, the adequacy of the reserve established for membership cancellations, the collectability of rejected credit card billings, and income attributable to the month of January 1997. 4 The written representations for the calendar year 1997 falsely stated that the company's financial statements were fairly presented in conformity with GAAP and that the company had made available all relevant financial records and related data to EY. Those written representations were materially false because the financial statements did not conform to GAAP and, as discussed further, the company's management concealed material information from the defendants and EY. In addition to providing the defendants and EY with false written representations, CUC and Cendant also adopted procedures to hide its income-inflation scheme from the defendants and EY. Some of the procedures that CUC and Cendant employed to conceal its fraudulent scheme included (1) backdating accounting entries; (2) making accounting entries in small amounts and/or in accounts or subsidiaries the company believed would receive less attention from EY; (3) in some instances ensuring that fraudulent accounting entries did not affect schedules already provided to EY; (4) withholding financial information and schedules to ensure that EY would not detect the company's accounting fraud; (5) ensuring that the company's financial results did not show unusual trends that might draw attention to its fraud; and (6) using senior management to instruct middle- and lowerlevel personnel to make fraudulent entries. Notwithstanding CUC and Cendant's repeated deception, defendants improperly failed to detect the fraud. They were aware of numerous practices by CUC and Cendant indicating that the financial statements did not conform to GAAP and, as a consequence, they had a duty to withhold their unqualified opinion and take appropriate additional steps. Improper Establishment and Use of Merger Reserves The company completed a series of significant mergers and acquisitions and accounted for the majority of them using the pooling-of-interests method of accounting. 5 In connection with this merger and acquisition activity, Company management purportedly planned to restructure its operations. GAAP permits that certain anticipated costs may be recorded as liabilities (or reserves) prior to their incurrence under certain conditions. However, here CUC and Cendant routinely overstated the restructuring charges and the resultant reserves and would then use the reserves to offset normal operating costs-an improper earnings management scheme. The company's improper reversal of merger and acquisition-related restructuring reserves resulted in an overstatement of operating income by $217 million. The EY auditors provided accounting advice and auditing services to CUC and Cendant in connection with the establishment and use of restructuring reserves. The auditors excessively relied on management representations concerning the appropriateness of the reserves and performed little substantive testing, despite evidence that the reserves were established and utilized improperly. One example of auditor failures with reserve accounting is the Cendant reserve. Cendant recorded over $500 million in merger, integration, asset impairment, and restructuring charges for the CUC-side costs purportedly associated with the merger of HFS and CUC. The company recorded a significant portion of this amount for the purpose of manipulating its earnings for December 31, 1997, and subsequent periods and, in fact, Cendant had plans, which it did not disclose to defendants and EY, to use a material amount of the reserve to inflate income artificially in subsequent periods. In the course of providing accounting and auditing services, the auditors failed to recognize evidence that the company's establishment and use of the Cendant reserve did not conform to GAAP. For example, CUC and Cendant provided EY with contradictory drafts of schedules when EY requested support for the establishment of the Cendant reserve. The company prepared and revised these various schedules, at least in part as a result of questions raised and information provided by the defendants. The schedules were inconsistent with regard to the nature and amount of the individual components of the reserve (i.e., component categories were added, deleted, and changed as the process progressed). While the component categories changed over time, the total amount of the reserve never changed materially. Despite this evidence, the auditors did not obtain adequate analyses, documentation, or support for changes that they observed in the various revisions of the schedules submitted to support the establishment of the reserves. Instead, they relied excessively on frequently changing management representations. The company planned to use much of the excess Cendant reserve to increase operating results in future periods improperly. During the year ended December 31, 1997, the company wrote off $104 million of assets that it characterized as impaired as a result of the merger. Despite the size and timing of the write-off, the defendants never obtained adequate evidence that the assets were impaired as a result of the merger and, therefore, properly included in the Cendant reserve. In fact, most of the assets were not impaired as a result of the merger. Cash Balance from the Membership Cancellation Reserve CUC and Cendant also inflated income by manipulating their membership cancellation reserve and reported cash balance. Customers usually paid for membership products by charging them on credit cards. The company recorded an increase in revenue and cash when it charged the members' credit card. Each month, issuers of members' credit cards rejected a significant amount of such charges. The issuers would deduct the amounts of the rejects from their payments to CUC and Cendant. CUC and Cendant falsely claimed to EY auditors that when it resubmitted the rejects to the banks for payment, it ultimately collected almost all of them within three months. CUC and Cendant further falsely claimed that for the few rejects that were not collected after three months, it then recorded them as a reduction in cash and a decrease to the cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period and were entitled to a refund of at least a portion of the membership fee, as well as members who joined and were billed, but never paid for their memberships. At the end of each fiscal year, the company failed to record three months of rejects (i.e., it did not reduce its cash and decrease its cancellation reserve for these rejects). CUC and Cendant falsely claimed to the defendants and EY that it did not record rejects for the final three months of the year because it purportedly would collect most of the rejects within three months of initial rejection. According to CUC and Cendant, the three months of withheld rejects created a temporary difference at year-end between the cash balances reflected in the company's general ledger and its bank statements. The rejects were clearly specified on reconciliations of the company's numerous bank accounts, at least some of which were provided to EY and retained in its workpapers. CUC and Cendant falsely claimed to the defendants and EY that the difference between the general ledger balance and bank statement balance did not reflect an overstatement of cash and understatement in the cancellation reserve since it collected most rejects. In fact, the majority of rejects were not collected. By not recording rejects and cancellations against the membership cancellation reserve during the final three months of each fiscal year, CUC and Cendant dramatically understated the reserve at each fiscal year-end and overstated its cash position. CUC and Cendant thus avoided the expense charges needed to bring the cancellation reserve balance up to its proper amount and the entries necessary to record CUC and Cendant's actual cash balances. The rejects, cancellation reserve balance, and overstatement of income amounts for the period 1996 to 1997 are as follows: img The EY defendants did not adequately test the collectibility of these rejects and the adequacy of the cancellation reserve and instead relied primarily on management representations concerning the company's successful collection history and inconsistent statements concerning the purported impossibility of substantively testing these representations. Membership Cancellation Rates The company also overstated its operating results by manipulating its cancellation reserve. The cancellation reserve accounted for members who canceled during their membership period. A large determinant of the liability associated with cancellations was CUC and Cendant's estimates of the cancellation rates. During the audits, CUC and Cendant intentionally provided EY with false estimates that were lower than the actual estimated cancellation rates. This resulted in a significant understatement of the cancellation reserve liability and an overstatement of income. To justify its understated cancellation reserve, CUC and Cendant provided to EY small, nonrepresentative samples of cancellations that understated the actual cancellation rates. The defendants allowed the company to choose the samples. EY did not test whether the samples provided were representative of the actual cancellations for the entire membership population. Audit Opinion EY issued audit reports containing unqualified (i.e., unmodified) audit opinions on, and conducted quarterly reviews of, the company's financial statements that, as already stated, did not conform to GAAP. The Securities Exchange Act requires every issuer of a registered security to file reports with the commission that accurately reflect the issuer's financial performance and provide other information to the public. For the foregoing reason, the firm aided and abetted violations of the securities laws. Legal Issues SEC Settlements Between Hiznay's arrival at CUC in July 1995 and the discovery of the fraudulent scheme by Cendant management in April 1998, CUC and Cendant filed false and misleading annual reports with the commission that misrepresented their financial results, overstating operating income and earnings and failing to disclose that the financial results were falsely represented. The commission's complaint alleged that Sabatino, by his actions in furtherance of the fraud, violated, or aided and abetted violations of, the antifraud, periodic reporting, corporate recordkeeping, internal controls, and lying to auditors provisions of the federal securities laws. Sabatino consented to entry of a final judgment that enjoined him from future violations of those provisions and permanently bar him from acting as an officer or director of a public company. Kearney consented to entry of a final judgment that enjoined him from future violations of those provisions, ordered him to pay disgorgement of $32,443 in ill-gotten gains (plus prejudgment interest of $8,234), and ordered him to pay a civil money penalty of $35,000. Kearney has also agreed to the issuance of a commission administrative order that barred him from practicing before the commission as an accountant, with the right to reapply after five years. Corigliano, Pember, and Sabatino each pleaded guilty to charges pursuant to plea agreements between those three individuals and the SEC. Pursuant to his agreement, Corigliano pleaded guilty to a charge of wire fraud, conspiracy to commit mail fraud, and causing false statements to be made in documents filed with the commission, including signing CUC's periodic reports filed with the commission and making materially false statements to CUC's auditors. Pember pleaded guilty to a charge of conspiracy to commit mail fraud and wire fraud. Sabatino, pursuant to his agreement, pleaded guilty to a charge of aiding and abetting wire fraud. In another administrative order, the commission found that Paul Hiznay aided and abetted violations of the periodic reporting provisions of the federal securities laws, in connection with actions that he took at the direction of his superiors at CUC. Among other things, the commission alleged that Hiznay made unsupported journal entries that Pember had directed. Additional orders were entered against lower-level employees. The commission found that Cendant violated the periodic reporting, corporate recordkeeping, and internal controls provisions of the federal securities laws, in connection with the CUC fraud in that the company's books, records, and accounts had been falsely altered, and materially false periodic reports had been filed with the SEC. On December 29, 2009, the SEC announced a final judgment against Forbes, the former chair of Cendant, arising out of his conduct in the Cendant fraud. 6 The commission alleged that Forbes orchestrated an earnings management scheme at CUC to inflate the company's quarterly and annual financial results improperly during the period 1995 to 1997. CUC's operating income was inflated improperly by an aggregate amount exceeding $500 million. The final judgment against Forbes, to which he consented without admitting or denying the commission's allegations, enjoined him from violating relevant sections of the securities laws and bars him from serving as an officer or director of a public company. Class Action Lawsuits A class action suit by stockholders against Cendant and its auditors, led by the largest pension funds, alleged that stockholders paid more for Cendant stock than they would have had they known the truth about CUC's income. The lawsuit ended in a record $3.2 billion settlement. Details of the settlement follow. By December 1999, a landmark $2.85 billion settlement with Cendant, was announced which far surpassed the recoveries in any other securities law class action case in history. Until the settlements reached in the WorldCom case in 2005, this stood as the largest recovery in a securities class action case, by far, and clearly set the standard in the field. In addition to the cash payment by Cendant, which was backed by a letter of credit that the company secured to protect the class, the Cendant settlement included two other very important features. First, the settlement provided that if Cendant or the former HFS officers and directors were successful in obtaining a net recovery in their continuing litigation against EY, the class would receive half of any such net recovery. As it turned out, that litigation lasted another seven years-until the end of 2007-when Cendant and EY settled their claims against each other in exchange for a payment by EY to Cendant of nearly $300 million. Based on the provision in the Cendant settlement agreement and certain further litigation and a court order, in December 2008, the class received another $132 million. This brought the total recovered from the Cendant settlement to $2.982 billion. Second, Cendant was required to institute significant corporate governance changes that were far-reaching and unprecedented in securities class action litigation. Indeed, these changes included many of the corporate governance structural changes that would later be included within the Sarbanes- Oxley Act of 2002 (SOX). They included the following: • The board's audit, nominating, and compensation committees would be comprised entirely of independent directors (according to stringent definitions, endorsed by the institutional investment community, of what constituted an independent director). • The majority of the board would be independent within two years following final approval of the settlement. • Cendant would take the steps necessary to provide that, subject to amendment of the certificate of incorporation declassifying the board of directors by vote of the required supermajority of shareholders, all directors would be elected annually. • No employee stock option could be "repriced" following its grant without an affirmative vote of shareholders, except when such repricings were necessary to take into account corporate transactions such as stock dividends, stock splits, recapitalization, a merger, or distributions. The Settlement with EY On December 17, 1999, it was announced that EY had agreed to settle the claims of the class for $335 million. This recovery was and remains today as the largest amount ever paid by an accounting firm in a securities class action case. The recovery from EY was significant because it held an outside auditing firm responsible in cases of corporate accounting fraud. The claims against EY were based on EY's "clean" (i.e., unmodified) audit and review opinions for three sets of annual financial statements, and seven quarterly financial statements, between 1995 and 1997. The district court approved the settlements and plan of allocation in August 2000, paving the way for Cendant and EY to fund the settlements. Approximately one year later, in August 2001, the settlements and plan of allocation were affirmed on appeal by the U.S. Third Circuit Court of Appeals. And in March 2002, the U.S. Supreme Court determined that it would not hear any further appeals in the case. Questions 1. A statement is made in the case that Cendant manipulated the timing of write-offs and improperly determined charges in an attempt to smooth net income. Is income smoothing an ethical practice? Are there circumstances where it might be considered ethical and others where it would not? What motivated Cendant to engage in income smoothing practices in the case? 2. Representational faithfulness is a critical component of having a high quality of financial reporting. Evaluate the accounting techniques used by Cendant from the perspective of representational faithfulness and the usefulness of the financial information to the users of its financial statements. 3. Describe the failings of EY with respect to conducting an audit in accordance with GAAS. Include in your discussion any ethical violations of the AICPA Code of Professional Conduct? 4. Trust is a basic element in the relationship between auditor and client. Explain why and how trust broke down in the Cendant case including shortcomings in corporate governance. 1 The information for this case comes from a variety of litigation releases on the SEC Web site, including www.sec.gov/litigation/admin/34-42935.htm (June 14, 2000); www.sec.gov/litigation/admin/34-42934.htm (June 14, 2000); www.sec.gov/litigation/admin/34-42933.htm (January 24, 2001); www.sec.gov/litigation/litreleases/lr16587.htm (April 30, 2003); and www.sec.gov/litigation/complaints/comp18102.htm (April 30, 2003). 2 Post-closing journal entries means entries that are made after a reporting period has ended, but before the financial statements for the period have been filed, and that have effective dates spread retroactively over prior weeks or months. 3 Rejects resulted when the credit card to be charged was over its limit, closed, or reported as lost or stolen. Chargebacks resulted when a credit card holder disputed specific charges related to a particular membership program. 4 Available at www.sec.gov/litigation/complaints/comp18102.htm. 5 Statement of Financial Accounting Standards (SFAS) 141, Business Combinations , which eliminated the pooling methods for business combinations. The purchase method now must be used for all acquisitions. 6 Securities and Exchange Commission v. Walter A. Forbes et al., District Court N.J. filed February 28, 2001.
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Royal Dutch Shell plc 1 From 1907 until 2005, Royal Dutch Petroleum Company, a Netherlands-based company, and the Shell Transport and Trading Company, plc., a U.K.-based company, were the two public parent companies of a group of companies known collectively as the Royal Dutch/Shell Group (the Group). 2 Operating activities were conducted through the subsidiaries of Royal Dutch and Shell Transport. In 2005, Royal Dutch Shell plc became the single parent company of Royal Dutch and Shell Transport. Today, Shell is one of the world's largest independent oil and gas companies in terms of market capitalization, operating cash flow, and oil and gas production. Proved Reserves Petroleum resources represent a significant part of the group's upstream assets and are the foundation of most of its current and future activities. The group's exploration and production business depends on its effectiveness in finding and maturing petroleum resources to sustain itself and drive profitable production growth. The Group reports its proved reserves of oil and gas to the SEC as part of its 20-F filing for a foreign company selling stock on the NYSE. Reporting internal and external volumes properly is very important to Shell. This is based on the SEC-compliant proved reserves estimation and reporting process that enables access to the funds needed for the group's capitalintensive business. The SEC requirement of "reasonable certainty" represents the high standard of evidence/confidence consistent with the meaning of the word proved. Proved oil and gas reserves are the estimated quantities of crude oil, natural gas, and natural gas liquids that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions (i.e., prices and costs as of the date the estimate is made). Prices include consideration of changes in existing prices provided by contractual arrangements, but not on escalations based upon future conditions. 3 In 2004, Shell amended its annual report on Form 20-F/A for the calendar year 2003 financial statements following an agreement with the SEC reached on August 24, 2004, with respect to the amount of proved reserves. The SEC had charged that 4.47 billion barrels of oil equivalent (boe), or approximately 23 percent of previously reported proved reserves, did not meet the standard set by law. 4 Shell also reduced its reserves replacement ratio (RRR)-the rate at which production was replaced by new oil discoveries. According to the SEC complaint, Shell's overstatement of proved reserves, and its delay in correcting the overstatement, resulted from (1) its desire to create and maintain the appearance of a strong RRR, a key performance indicator in the oil and gas industry; (2) the failure of its internal reserves estimation and reporting guidelines to conform to applicable regulations; and (3) the lack of effective internal controls over the reserves estimation and reporting process. 5 Reduction of RRR In a series of announcements between January 9 and May 24, 2004, Shell disclosed that it had recategorized 4.47 billion boe, or approximately 23 percent, of the proved reserves it reported as of year-end 2002 because they were not proved reserves as defined in Commission Rule 4-10 of Regulation S-X. This recategorization reduced the standard measure of future cash flows by approximately $6.6 billion, as reported in Shell's original 2002 Form 20-F Supplemental Information under SFAS 69. 6 On July 2, 2004, Shell filed an amended 2002 Form 20-F that reflected the restatement of its proved reserves and standard measure of future cash flows for the years 1999 to 2002, as follows: img As a result of the overstatement of proved reserves, Shell also announced a reduction in its RRR for 1998 through 2002, from the previously reported 100 percent to approximately 80 percent. Had Shell reported proved reserves properly, its annual and three-year RRR over this span would have been as follows: img According to the SEC complaint, these failures led Shell to record and maintain proved reserves that it knew, or was reckless in not knowing, did not satisfy applicable regulations and to report for certain years a stronger RRR than it actually had achieved in supplemental information filed along with its 10-K report. The SEC had warned about the proved reserves, but Shell either rejected the warnings as immaterial or unduly pessimistic, or attempted to manage the potential exposure by, for example, delaying the debooking of improperly recorded proved reserves until new, offsetting proved reserves bookings materialized. Failure to Maintain Adequate Internal Controls The charges against Shell include the failure to implement and maintain internal controls sufficient to provide reasonable assurance that it was estimating and reporting proved reserves accurately and in compliance with applicable requirements. These failures arose from inadequate training and supervision of the operating unit personnel responsible for estimating and reporting proved reserves and deficiencies in the internal reserves audit function. Shell's decentralized system required an effective internal reserves audit function. To perform this function, Shell historically had engaged as Group reserves auditor a retired Shell petroleum engineer who worked only part-time and was provided limited resources and no staff to audit its vast worldwide operations. Although the Group reserves auditor was an experienced reservoir engineer, he received little, if any, training on such critical matters as how to conduct his work and the rules and standards on which his opinions should be based. He also lacked the authority to require operating unit compliance with either commission rules or group reserves guidelines. Moreover, he reported to the management of Shell's exploration and production division, which were the same people he audited. The Group reserves auditor visited each operating unit only once every four or more years. Subsequent to his visits, he issued reports rating the operating unit's systems, compliance with Group guidelines, and audit response as "good?," "satisfactory," or "unsatisfactory," opining whether the operating unit's reported reserves met Group guidelines. From the start of his tenure in January 1999 until September 2003, the Group reserves auditor did not issue a single "unsatisfactory" rating. The Group reserves auditor also issued an annual report on the reasonableness of Shell's year-end total reserves summary. Until his February 2004 report on Shell's 2003 proved reserves, the Group reserves auditor focused as much on whether group proved reserves complied with group guidelines as he did on whether they complied with SEC requirements. Further, the group reserves auditor failed to act independently in several respects. At times, he allowed proved reserves associated with a project to remain booked because he was more "bullish" on its prospects than the local management responsible for the project. At other times, solely to support booking proved reserves for otherwise uneconomic projects, he advised local management to submit development plans that were unlikely ever to be executed. This lack of independence facilitated the booking of questionable reserves well after they should have been debooked. Finally, the nonexecutive directors of Royal Dutch and Shell Transport, including the members of the Group audit committee, were not provided with the information necessary for the boards of the two companies to ensure that timely and appropriate action was taken with respect to the proved reserves estimation and reporting practices. Group Reserves Auditor's Report In January 2002, the Group reserves auditor's report on Shell's 2001 proved reserves stated that "recent clarifications of FASB reserves guidelines by the SEC have shown that current Group reserves practice regarding the first time booking of Proved reserves in new fields is in some cases too lenient." The auditor stated that the "g[G]roup guidelines should be reviewed [and] first-time bookings should be aligned closer with SEC guidance and industry practice and they should be allowed only for firm projects with technical maturity and full economic viability." On February 11, 2002, an internal note addressed the divergence between Shell's guidelines and the commission's rules and estimated the possible impact of this divergence on Shell's reported proved reserves. The note explicitly stated that "recently the SEC issued clarifications that make it apparent that the Group guidelines for booking Proved Reserves are no longer fully aligned with the SEC rules." Potential exposures identified in the note included approximately 1 billion boe of proved reserves relating to projects. The note failed to recommend debookings, and Shell did not take action to debook any of these proved reserves at that time. By September 2002, the CEO of the Exploration and Production (EP) Division internally spoke in blunt terms of his perception of the operational and performance problems facing EP, noting to his colleagues that "we are struggling on all key criteria" and that "RRR remains below 100% mainly due to aggressive booking in 1997-2000." He further observed that "we have tried to adhere to a bunch of criteria that can only be managed successfully for so long" and admonished that "given the external visibility of our issues... , the market can only be 'fooled' if: (1) credibility of the company is high; (2) medium and long-term portfolio refreshment is real; and/or (3) positive trends can be shown on key indicators." A month later, the group chair e-mailed the EP CEO that he was "not contemplating a change in the external promise." The next day, the EP CEO responded, "I must admit that I become sick and tired about arguing about the hard facts and also can not perform miracles given where we are today. If I was interpreting the disclosure requirements literally under the Sarbanes-Oxley Act and legal requirements we would have a real problem." None of these events prompted Shell to debook significant volumes. To the contrary, Shell continued to make large, questionable proved reserves bookings during this period. By the summer of 2003, Shell's analysis of reserves exposures had progressed, but still no debookings were recommended, even though internal information indicated that "some 1040 million boe (5%) is considered to be potentially at risk." The note concluded, however, that "at this stage, no action in relation to entries in the [proved reserves exposure] Catalogue is recommended.... It should be noted that the total potential exposure is broadly offset by the potential to include gas fuel and flare volumes in external reserves disclosures." The note apprised the committee of steps taken to address possible noncompliance with the SEC's regulations. However, management was advised that "much, if not all, of the potential exposure is offset by Shell's practice of not disclosing reserves in relation to gas production that is consumed on site as fuel or (incidental) flaring and venting." According to the SEC complaint, Shell had undertaken substantial remedial efforts in connection with the reserves recategorization and had cooperated with the commission in its investigation. Specific SEC Charges The SEC complaint alleged the following: 7 1. As a result of Shell's knowing or reckless overstatement of its oil and gas reserves in its financial statements, the group's commission filings, specified previously, as well as other public statements, contained materially false and misleading statements and disclosures. These filings contained untrue statements of material fact concerning the company's reported proved reserves and omitted to state facts necessary to make the statements made, in light of the circumstances under which they were made, not misleading. These statements constituted a violation of Rule 10b-5 of the Securities Exchange Act. 2. Section 13(a) of the Exchange Act requires issuers to file such annual and quarterly reports as the commission may prescribe and in conformity with such rules as the commission may promulgate. Rule 13a-1 requires the filing of accurate annual reports that comply with the SEC's Regulation S-X. Rule 12b-20 requires an issuer to include material information as may be necessary to make the required statements, in light of the circumstances under which they were made, not misleading. The following periodic reports that Royal Dutch and Shell Transport filed with the commission were not prepared in accordance with rules promulgated by the commission: Form 20-F for fiscal years 1997-2002. 3. Shell violated Section 12 of the Exchange Act, in that it failed to (1) make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflected the transactions and dispositions of its assets; (2) devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that (a) transactions were executed in accordance with management's general or specific authorization; (b) transactions were recorded as necessary to permit preparation of financial statements in conformity with GAAP or any other criteria applicable to such statements, and to maintain accountability for assets; (c) access to assets was permitted only in accordance with management's general or specific authorization; and (d) the recorded accountability for assets was compared with the existing assets at reasonable intervals and appropriate action was taken with respect to any differences. Royal Dutch and Shell Transport agreed to settle the charges by consenting to a cease-and-desist order finding violations of the antifraud, internal controls, recordkeeping, and reporting provisions of the federal securities laws, and by paying $1 disgorgement and a $120 million penalty in a related action. Shell also committed an additional $5 million to develop and implement a comprehensive internal compliance program under the direction and oversight of the group's legal director. The companies settled without admitting or denying the commission's substantive findings. 8 Questions 1. Use ethical reasoning to evaluate the actions of Shell management in this case with respect to accounting for and disclosing information about proved reserves. 2. In Chapter 7 we discussed aggressive accounting and earnings management techniques. Apply your knowledge from that chapter to the facts of the Shell case with respect to its proved reserves. Be sure to address specific actions taken that illustrate aggressive accounting and earnings management. 3. Given the facts of the case, describe the failures in corporate governance including internal controls and the relationship between the Group auditor and management and explain how they contributed to the reporting problems with proved reserves at Shell. Optional Question 4. The following note to the financial statements of Shell for the fiscal year end December 31, 2008, appeared in its 20-F filing with SEC. img Compare the standards followed by Shell with respect to generally accepted in the U.S. Explain any differences and asset impairments that are consistent with IFRS with those how such differences might impact the financial statements. 1 The letters plc refer to a "public limited company." The company operates on the basis that liability of shareholders toward the public is limited to its shareholding and that they are not personally liable for debts of the company. If the company goes into bankruptcy, the personal assets of directors/ shareholders are not liable for attachment. 2 In the U.S., this would be comparable to the consolidated entity that comprises two or more separately operating subsidiaries. As in the U.S., each subsidiary would issue separate financial statements and those statements would be consolidated and combined statements would be issued in the annual report. In the Royal Dutch Shell case, all references to the financial statements are to the consolidated (Group) statements. We use a capital "G" to emphasize the business entity nature of Shell and not to confuse it with common group meanings. 3 Petroleum Resource Volume Requirements for Resource Classification and Value Realization, www.shell.com/...and.../reserves_announcement_0906200.html. 4 0il equivalent refers to the conversion of gas volumes to their oil equivalent and is a measure of petroleum reserves. 5 Securities and Exchange Commission v. Royal Dutch Petroleum Company and the Shell Transport and Trading Company, P.L.C., Complaint H-04-33 9, August 24, 2004, www.sec.gov/litigation/litreleases/lr18844.htm. 6 Statement of Financial Accounting Standards (SFAS) No. 69, Disclosures About Oil and Gas Producing Activities. This standard requires that publicly traded enterprises that have significant oil- and gas-producing activities should disclose, among other things, "proved oil and gas reserves" as of the beginning and end of the year. Revisions of previous estimates must be disclosed separately, with appropriate explanation of significant changes. 7 Securities and Exchange Commission v. Royal Dutch Petroleum Company and the "Shell" Transport and Trading Company, P.L.C., Complaint H-04-3359, August 24, 2004, www.sec.gov/litigation/litreleases/lr18844.htm. 8 U.S. Securities and Exchange Commission, Litigation Release No. 18844, August 24, 2004, www.sec.gov/litigation/litreleases/lr18844.htm.
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Background On November 20, 2012, Hewlett-Packard (HP) disclosed that it discovered an accounting fraud and has written down $8.8 billion of the value of Autonomy, the British software company that it bought in 2011 for $11.1 billion, after discovering that Autonomy misrepresented its finances. In May 2012, HP had fired former Autonomy CEO, Dr. Michael Lynch, citing poor performance by his unit. According to HP, its internal probe and forensic review had uncovered that the majority of the impairment charge, over $5 billion, is linked to serious accounting improprieties, disclosure failures, and outright misrepresentations discovered by HP's internal investigation into Autonomy's practices prior to and in connection with the acquisition. The investigation began after an unnamed "senior member" of Autonomy's leadership alleged there had been a "series of questionable accounting and business practices" prior to the acquisition. HP said that the whistleblower gave "numerous details" that HP previously had no "knowledge or visibility" of. HP said it has discovered "extensive evidence" that an unspecified number of former employees of Autonomy had cooked the books prior to HP's $11.1 billion acquisition of the software company. The probe determined that Autonomy was "substantially overvalued at the time of its acquisition" due to misstatements of financial performance, including revenue, core growth rate, and gross margins. HP added that it was co-operating with the U.S. DOJ, the U.S. SEC, and the United Kingdom's Serious Fraud Office. The Autonomy disclosures are the latest efforts by CEO Meg Whitman to clean up the mess that she inherited from former CEO Leo Apotheker, who HP reminded shareholders presided over the disastrous Autonomy deal. In a statement, Apotheker said he is both "stunned and disappointed to learn" of the alleged accounting improprieties, and the developments "are a shock to the many who believed in the company, myself included." Apotheker said the due diligence process was "meticulous and thorough" and "it's apparent that Autonomy's alleged accounting misrepresentations misled a number of people over time-not just HP's leadership team, auditors, and directors." Autonomy's Position A spokeswoman for fired CEO Lynch told Reuters that the HP allegations are "false" and Autonomy's management was "shocked to see" the fraud charges. Lynch said that HP's due diligence was intensive and the larger company's senior management was "closely involved with running Autonomy for the past year." Lynch further commented that 1 • HP is using this as a ruse to distract investors from its bigger problems: "People certainly realize I'm not going to be used as Hewlett-Packard's scapegoat when it's got itself in a mess." • HP's numbers don't add up. It's questioning about $100 million in revenues, yet blaming $5 billion of the write-off on fishy accounting. • He wants HP to explain in detail how it came up with the $5 billion in write-offs from alleged fraud. • He not only denies all wrongdoing, but he says he has backup because Autonomy was audited quarterly and every invoice over €100,000 euros ($129,000) was approved by auditors. Lynch also said that some of the accusations are misleading because Autonomy was following IFRS, as British companies do, not the GAAP standard used by HP, which means it recognizes revenue differently in certain situations from U.S. practices. Exhibit 1 contains statements made by HP and Lynch in the Autonomy matter. Accounting and Auditing Issues Interviews in California and England with former Autonomy employees, business partners and attorneys close to the case paint a picture of a hard-driving sales culture shaped by Lynch's desire for rapid growth. They describe him as a domineering figure, who on at least a few occasions berated employees he believed weren't measuring up. Along the way, these people say, Autonomy used aggressive accounting practices to make sure revenue from software licensing kept growing-thereby boosting the British company's valuation. The firm recognized revenue upfront that under U.S. accounting rules would have been deferred, and struck "round-trip transactions"-deals where Autonomy agreed to buy a client's products or services while at the same time the client purchased Autonomy software, according to these people. "The rules aren't that complicated," said Dan Mahoney of the accounting research business organization-Center for Financial Research and Analysis (CFRA), 2 who covered Autonomy until it was acquired. He said that Autonomy had the hallmarks of a company that recognized revenue too aggressively. He said neither U.S. nor international accounting rules would allow companies to recognize not-yet collected revenue from customers that might be at risk. In a statement issued on November 30, 2012, HP said its ongoing investigation into the activities of certain former Autonomy employees had uncovered numerous transactions clearly designed to inflate the underlying financial metrics of the company before its acquisition. The company said it is confident the deals are improper even under the international accounting standards Lynch cites. In an interview with the British publication, The Guardian, on April 10, 2013, 3 Meg Whitman said that the board, which approved the Autonomy transaction, relied on audited information from Deloitte Touche and additional auditing from KPMG, though she said that she's not blaming the accountants. "Neither of them saw what we now see after someone came forward to point us in the right direction," Whitman said. Deloitte, which served as Autonomy's auditor in the U.K., and KPMG, which performed the acquisition work for HP, are under fire for allegedly failing to detect the accounting issues. Deloitte, said in a statement that it cannot comment further on this matter due to client confidentiality and that it will cooperate with the relevant authorities with any investigations into the allegations." 4 Questions 1. What is meant by "earnings management" and how does it relate to the accounting techniques followed by Autonomy? 2. In an analysis by the Association of Certified Financial Crime Specialists (ACFCS) about the Autonomy merger with HP, the following statement is made: "The scandal is prompting questions about who is to blame for the soured merger. As details emerge, the case is spotlighting the difficulties that accountants and lawyers face in complex mergers and acquisitions and business deals. The case also raises the issue of what responsibility these professionals have for detecting potentially fraudulent business records where the line between accounting discrepancies and financial crime is blurred." 5 Given the facts of the case, evaluate the ethical and professional responsibilities of the external auditors with respect to the AICPA Code of Professional Conduct. 3. Meg Whitman is quoted in the case as saying that the board, which approved the Autonomy transaction, relied on audited information from Deloitte Touche and additional auditing from KPMG. Given that auditing standards and legal requirements dictate that auditors are responsible for detecting material fraud in the financial statements of audit clients, would you blame the auditors for failing to uncover the improper accounting for revenue at Autonomy? Which audit standards are critical in making that determination? Optional Question 4. Revenue recognition transactions such as those described in question 2 are referred to as "linked transactions" under IFRS. Research the revenue recognition rules for linked transactions and compare them to what Autonomy did. Does it seem that Lynch's position is valid as stated in the case that the accusations against him and Autonomy for improper revenue recognition practices was not fair because Autonomy was following IFRS and they are different than the GAAP standard used by HP, which means it recognizes revenue differently in certain situations from U.S. practices? 1 Reuters, "HP alleges Autonomy wrongdoing, takes $8.8 billion charge," November 20, 2012. Available at www.reuters.com/article/2012/11/20/us-hp-results-idUSBRE8AJ00B20121120. 2 Association of Certified Financial Crime Specialists, "HP-Autonomy debacle shines light on auditors, lawyers in financial crime cases," December 4, 2012, Available at www.acfcs.org/hp-autonomy-debacle-shines-light-on-auditors-lawyers-in-financial-crime-cases/. 3 Juliette Garside, "HP's Meg Whitman: 'we had to be straight' on Autonomy," The Guardian, April 10, 2013, Available at www.guardian.co.uk/business/2013/apr/10/hp-autonomy-deal-meg-whitman. 4 Francine McKenna, "Hewlett-Pckard's Allegations: A Material Writedown and all Four Audit Firms on the Spot," November 20, 2012. Available at www.forbes.com/sites/francinemckenna/2012/11/20/hewlett-packards-autonomy-allegations-a-materialwritedown-puts-all-four-audit-firms-on-the-spot/. 5 HP-Autonomy debacle shines light on auditors, lawyers in financial crime cases, Available at http://www.acfcs.org/hp-autonomy-debacle-shines-light-on-auditors-lawyersin-financial-crime-cases/#sthash.gffH55Iz.dpuf.
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Royal Ahold N.V. (Ahold) Note: Case 5-9 in Chapter 5 covers many of the accounting and auditing facts of the case. We review these issues and go on to analyze the accountants' ethical and professional responsibilities in this case. Summary of Court Ruling The U.S. Court of Appeals for the Fourth Circuit affirmed the lower court ruling in the case Public Employees Retirement Association of Colorado; Generic Trading of Philadelphia, LLC v. Deloitte Touche, LLP that Deloitte defendants lacked the necessary scienter to conclude that they knowingly or recklessly perpetrated a fraud on Ahold's investors. This class action securities fraud lawsuit arose out of improper accounting by Royal Ahold N.V., a Dutch corporation, and U.S. Foodservice, Inc. (USF), a Maryland-based Ahold subsidiary. The misconduct of Ahold and USF was not disputed in this appeal. The main issue is the liability of Ahold's accountants, Deloitte Touche LLP (Deloitte U.S.) and Deloitte Touche Accountants (Deloitte Netherlands), for their alleged role in the fraud perpetrated by Ahold and USF. Under the Private Securities Litigation Reform Act of 1995 (PSLRA), plaintiffs must plead facts alleging a "strong inference" that the defendants acted with the required scienter. As explained by the Supreme Court in Tellabs, Inc. v. Makor Issues Rights, Ltd., a strong inference "must be more than merely plausible or reasonable-it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." The Appeals Court found that Deloitte, like the plaintiffs, were victims of Ahold's fraud rather than its enablers. In its decision, the court relied on the PSLRA and the decision in Tellabs. Circuit Judge Wilkinson wrote the conclusion for the court. 1 The court ruling will be explained later on. ERISA Class Action Settlement Class action lawsuits are common in cases such as Ahold where dozens of separate private class action securities are combined. In this case the Employee Retirement Income Security Act (ERISA) of 1974 actions were filed against Ahold, Deloitte, and other defendants. On June 18, 2003, the Judicial Panel on Multidistrict Litigation transferred these actions to the U.S. District Court for the District of Maryland, In re Royal Ahold N.V. Securities "ERISA" Litigation. Following the certification of the class action lawsuit, the U.S. District Court in Maryland ruled in favor of the ERISA plaintiffs on November 2, 2006, and awarded them $1.1 billion in the securities fraud case against Royal Ahold. 2 Summary of Accounting Fraud Beginning in the 1990s, and continuing until 2003, Ahold and USF perpetrated frauds that led it to overstate its earnings on financial reports significantly: The frauds included: • Ahold improperly "consolidated" the revenue from a number of joint ventures (JVs) with supermarket operators in Europe and Latin America. That is, for accounting purposes, Ahold treated these JVs as if it fully controlled them-and thus treated all revenue from the ventures as revenue to Ahold-when in fact, Ahold did not have a controlling stake. Under Dutch and U.S. GAAP, 3 Ahold should have consolidated only the revenue proportionally to Ahold's stake in the ventures. • USF falsely reported its income from promotional allowances (PAs). Also known as vendor rebates , PAs are payments or discounts that manufacturers and vendors provide to retailers like USF to encourage the retailers to promote the manufacturers' products. To increase its stated income, USF prematurely recognized income from PAs and inflated its reported PA income beyond amounts actually received. • On February 24, 2003, Ahold announced that its earnings for fiscal years 2001 and 2002 had been overstated by at least $500 million as a result of the fraudulent accounting for promotional allowances at USF, and that Ahold would be restating revenues because it would cease treating the joint ventures as fully consolidated. After this announcement, Ahold common stock trading on the Euronext stock exchange 4 and Ahold American Depositary Receipts 5 trading on the NYSE lost more than 60 percent of their value. Subsequent to the February 2003 announcement, Ahold made further restatements to its earnings totaling $24.8 billion in revenues and approximately $1.1 billion in net income. Ahold Fraud-Joint Ventures With respect to the JV fraud, both Deloittes advised Ahold on the consolidation of the joint ventures. Five joint ventures were at issue in this litigation: JMR, formed in August 1992; Bompreço, formed in November 1996; DAIH, formed in January 1998; Paiz-Ahold, formed in December 1999; and ICA, formed in February 2000. Ahold had a 49 percent stake in JMR and a 50 percent share of each of the other ventures at their respective times of formation. Prior to Ahold's entering into the first joint venture, Deloitte Netherlands and Deloitte U.S. gave Ahold advice about revenue consolidation under Dutch and U.S. GAAP. A memo explained that control of a joint venture is required for consolidation of the venture's revenue and discussed what situations are sufficient to demonstrate control. The memo indicated that control could be shown by a majority voting interest, a large minority voting interest under certain circumstances, or a contractual arrangement. Ahold began consolidating the joint ventures as they were formed. The various JV agreements did not indicate that Ahold controlled the ventures. For example, the JMR joint venture agreement specified that decisions would be made by a board of directors, "deciding unanimously," and that the board would consist of three members appointed by Ahold and four members appointed by JMH, Ahold's partner in the venture. However, Ahold represented to Deloitte Netherlands that it nonetheless possessed the control requisite for consolidation. Deloitte Netherlands initially accepted these representations for the consolidation of JMR and Bompreço. But as consolidation continued, Deloitte became concerned that Ahold lacked the control necessary to consolidate these first two joint ventures. On August 24, 1998, Deloitte Netherlands partner John van den Dries sent a letter to Michiel Meurs, Ahold's chief financial officer (CFO), advising him that Ahold's representations of control would no longer suffice-that Ahold would need to produce more evidence of control in order to justify continuing consolidation of joint venture revenue under U.S. GAAP, and that without such evidence, a financial restatement would be required. In response to Deloitte Netherlands's requests, Ahold drafted a "control letter" addressed to BompreçoPar S.A., its partner in the Bompreço joint venture. The letter stated that the parties agreed that if they were unable to reach a consensus on a particular issue, "Ahold's proposal to solve that issue will in the end be decisive." After reviewing the draft letter, Deloitte Netherlands advised Ahold that if countersigned by the JV partner, the letter would be sufficient evidence to consolidate the venture. The letter was signed by Ahold and BompreçoPar in May 1999. By late 2000, Ahold had obtained similar countersigned control letters for the ICA, DAIH, and Paiz-Ahold joint ventures. Based on these letters and other evidence, Deloitte Netherlands concluded that consolidation was appropriate. However, in October 2002, Deloitte learned of a "side letter" sent to Ahold in May 2000 by one of Ahold's ICA joint venture partners, Canica. The letter stated that Canica did not agree with the interpretation of the shareholder agreement stated in the ICA control letter. At this point, Deloitte Netherlands and Deloitte U.S. began trying to get Ahold to obtain an amendment to the shareholder agreement in order to justify ongoing consolidation. At a February 14, 2003, meeting, Deloitte Netherlands and Deloitte U.S. told Ahold that Ahold lacked the necessary control for consolidation. On February 22, 2003, Ahold revealed to Deloitte Netherlands side letters contradicting the Bompreço, DAIH, and Paiz-Ahold control letters. Two days later, Ahold announced that it had consolidated its joint ventures improperly and would be restating its revenues. USF Fraud-Promotional Allowances Ahold acquired USF in early 2000. Prior to the acquisition, Deloitte U.S. participated in Ahold's due diligence on USF. In a February 2000 memo, Deloitte U.S. noted that USF's internal system for recording promotional allowances received was weak because it heavily relied on vendors' figures, and that the system could "easily result in losses and in frauds." Deloitte U.S. also noted in the memo that USF's use of value added service providers, special-purpose entities that bought products from vendors and then resold them to USF for a higher price, needed to be evaluated for their "tax and legal implications and associated business risks." After Ahold's acquisition of USF was finalized, Deloitte U.S. became USF's external auditor. When performing an opening balance sheet audit of USF, Deloitte U.S. discovered that a USF division in Buffalo, New York, had been fraudulently accounting for PA income. This fraud required a restatement of $11 million of PA income. USF also downwardly adjusted its income by $90 million as a result of Deloitte U.S.'s advice that it be less aggressive in its method for recognizing PA income. USF used at interim periods a method known as the "PA recognition rate" to estimate promotional allowance income, in which PAs were estimated as a percentage of USF's total sales. The rate used by USF was 4.58 percent at the time of Ahold's acquisition of USF, but it rose as high as 8.51 percent in 2002. When USF booked final numbers, Deloitte U.S. in its audits tested USF's recognition of PAs by requesting written confirmation of PA amounts from vendors and by performing cash receipt tests. Using this confirmation process, Deloitte U.S. was able to test between 65 and 73 percent of PA receivables in its audits for 2000 and 2001. Auditing Issues Because USF lacked an internal auditing department, in April 2000, Ahold hired Deloitte U.S. to perform internal auditing services at USF. The internal auditors did not report to the Deloitte U.S. external auditors. 6 Instead, they reported initially to Ahold USA's internal audit director and, later, to USF's internal audit director after he was hired. The audit was managed by Jennifer van Cleave under the supervision of Patricia Grubel, a Deloitte U.S. partner. One of the internal audit's objectives was to determine whether USF's tracking of PAs was adequate. In van Cleave's attempt to verify USF's PA numbers, she requested a number of documents from USF management, including vendor contracts. Management refused to produce a number of the requested documents. Several members of management also refused to meet with van Cleave when she asked to conduct exit meetings. Van Cleave was thus unable to complete all the audit's objectives. In a February 5, 2001, draft report, van Cleave described how management's failure to produce requested documents resulted in her inability to complete some of the goals of the audit. Grubel instructed van Cleave to soften the report's language, and the version submitted to Michael Resnick, director of USF's Internal Audit Department, simply stated that Deloitte U.S. "was unable to obtain supporting documentation for some of the promotional allowance sample items," without more specifically detailing management's failures and lack of cooperation. In its February 2003 external audit for 2002, Deloitte U.S. discovered through the PA confirmation process that USF had been inflating its recorded PA income. An investigation ensued. Ultimately, USF's former chief marketing officer (CMO), Mark Kaiser, was convicted on all counts of a federal indictment that alleged that he had induced USF's vendors to report PA income amounts and receivable balances falsely to Deloitte U.S., and that he had concealed the existence of written contracts with USF vendors from Deloitte U.S. Two other USF executives pled guilty to federal securities fraud charges; in their plea statements, they admitted that USF lied to and deceived Deloitte U.S., and that they induced vendors to sign false audit confirmation letters that falsely overstated PA payments. In addition, 17 individuals associated with USF vendors pled guilty to various charges and admitted that they signed false audit confirmation letters in order to conceal the PA fraud from Deloitte U.S. PSLRA: Fraud and Scienter In passing the PSLRA in 1995, Congress imposed heightened pleading requirements for private securities fraud actions. As a general matter, heightened pleading is not the norm in federal civil procedure. Frequently stated reasons include protecting defendants' reputations from baseless accusations, eliminating unmeritorious suits that are brought only for their nuisance value, discouraging fishing expeditions brought in the slight hope of discovering a fraud, and providing defendants with detailed information in order to enable them to defend effectively against a claim. When "alleging fraud or mistake," plaintiffs "must state with particularity the circumstances constituting fraud or mistake." The PSLRA imposed a number of requirements designed to discourage private securities actions lacking merit. Among them is the requirement that in a private securities action "in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission... , state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." Complaints that do not plead scienter adequately are to be dismissed. Because the PSLRA did not define "a strong inference," the courts of appeals disagreed on how much factual specificity plaintiffs must plead in private securities actions. The Supreme Court resolved that issue in Tellabs , in which the Court prescribed the following analysis for Rule 12(b)(6) motions to dismiss Section 10(b) actions: • First, courts must, as with any motion to dismiss for failure to plead a claim on which relief can be granted, accept all factual allegations in the complaint as true. • Second, courts must consider the complaint in its entirety, as well as other sources that courts ordinarily examine, when ruling on Rule 12(b) motions to dismiss. The inquiry, as several Courts of Appeals have recognized, is whether all the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard. • Third, in determining whether the pleaded facts give rise to a "strong" inference of scienter, the court must take into account plausible opposing inferences. The strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative. The inference of scienter must be more than merely "reasonable" or "permissible"-it must be cogent and compelling, thus strong in light of other explanations. Legal Reasoning The "strong inference" requirement and the comparative analysis of inferences still leave unanswered the question of exactly what state of mind satisfies the scienter requirement of a 10b-5 action. In Ernst Ernst v. Hochfelder , 7 the Supreme Court held that a plaintiff must show that the defendant possessed the "intent to deceive, manipulate, or defraud" in an action brought under Rule 10b-5 of the Securities and Exchange Act of 1934. However, the Court never made clear what mental state suffices to meet this requirement. ("We need not address here the question whether, in some circumstances, reckless behavior is sufficient for civil liability under Rule 10b-5."). The U.S. Court of Appeals held in Ottman v. Hanger Orthopedic Group, Inc. that "a securities fraud plaintiff may allege scienter by pleading not only intentional misconduct, but also recklessness." 8 The court defined a reckless act as one "so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it" (quoting Phillips v. LCI Int'l, Inc.(. 9 A showing of mere negligence, however, will not suffice to support a 10(b) claim. 10 Thus, the court ruled, the question is whether the allegations in the complaint, viewed in their totality and in light of all the evidence in the record, allow us to draw a strong inference, at least as compelling as any opposing inference, that the Deloitte defendants either knowingly or recklessly defrauded investors by issuing false audit opinions in violation of Rule 10b-5(b) or 10b-5(a) and (c). On the other hand, if it found the inference that defendants acted innocently, or even negligently, more compelling than the inference that they acted with the requisite scienter, it must affirm the lower court's ruling. Plaintiffs must show that defendants actually made a misrepresentation or omission in their audit opinions on which investors relied. In light of the foregoing standards, the court considered first the JV fraud. The plaintiffs alleged that Deloitte U.S. and Deloitte Netherlands allowed Ahold to consolidate the joint ventures despite knowing, or being reckless with regard to the risk, that Ahold lacked the control required for consolidation. The thrust of their argument was that the control letters and Ahold's oral representations were insufficient evidence of control under Dutch and U.S. GAAP. Thus, they argued, the defendants were complicit in the fraud. According to the plaintiffs, the secret side letters, in which the JV partners contradicted Ahold's interpretations of the JV agreements in the control letters, were irrelevant because the control letters themselves did not amend the JV agreements. The plaintiffs' arguments did not provide a basis for a strong inference that either Deloitte U.S. or Deloitte Netherlands acted knowingly or recklessly in relation to the JV fraud. The most plausible inference that one can draw from the fact that Ahold concealed the side letters from its accountants is that the accountants were uninvolved in the fraud. Ahold produced letters attesting to Ahold's control countersigned by Ahold's partners for the ICA, Bompreço, DAIH, and Paiz-Ahold joint ventures at the Deloitte defendants' request, all the while concealing the side letters from those same defendants. These facts led to a strong inference that the Deloitte defendants were attempting to ensure that Ahold had sufficient control over the joint ventures for consolidation and that Ahold was determined to prevent them from discovering otherwise. With perfect hindsight, one might posit that the defendants should have required stronger evidence of control from Ahold. Indeed, as the district court noted, it may have been negligent for the defendants to accept as the only evidence of control Ahold's repeated representations that it controlled JMR, the one joint venture for which Ahold never produced a control letter. 11 Nonetheless, the evidence as a whole leads to the strong inference that defendants were deceived by their clients into approving the consolidation. Ahold would not have needed to go out of its way to produce false evidence of control had Deloitte been complicit in the fraud, or had they been so reckless in their duties that their audit "amounted to no audit at all," as the Southern District of New York has described the standard in SEC v. Price Waterhouse. 12 To establish a strong inference of scienter, plaintiffs must do more than merely demonstrate that defendants should or could have done more. They must demonstrate that Deloitte was either knowingly complicit in the fraud, or so reckless in its duties as to be oblivious to malfeasance that was readily apparent. The inference that we find most compelling based on the evidence in the record is not that the defendants were knowingly complicit or reckless, but that they were deceived by their client's repeated lies and artifices. Perhaps their failure to demand more evidence of consolidation was improper under accounting guidelines, but that is not the standard, which "requires more than a misapplication of accounting principles." 13 The court then examined the PA fraud. The plaintiffs argued that Deloitte U.S. was knowingly complicit in the fraud when it ignored several red flags, including USF's lack of internal controls to track PA income and USF management's obstruction of the internal audit and the facts and the circumstances of USF CFO Ernie Smith's resignation. With respect to USF's problems with tracking income with PAs, it is not the case that Deloitte U.S. simply ignored the weak internal controls, as the plaintiffs alleged. Rather, Deloitte U.S. raised this issue numerous times with Ahold and USF management. Deloitte U.S. designed a confirmation process to verify USF's reported PA income in which it contacted third-party vendors and received letters from them confirming PA amounts. The plaintiffs described the confirmation process as one that "confirmed nothing." Yet instead of merely relying on USF representations, as the plaintiffs asserted, Deloitte U.S. obtained corroboration from vendors for the figures provided by USF. Deloitte U.S. would not have attempted to verify USF's figures with third parties if it were complicit in the scheme, nor can it be said that it was anything but proper to attempt to check the accuracy of representations made by USF management. The plaintiffs attempted to suggest that the confirmation process was unsound because, for example, Deloitte U.S. accepted confirmation letters via fax and the letters were sent to brokers or sale executives instead of financial officers. But even if the confirmation process was somewhat flawed-which the defendants contested-the larger fact remains that the PA fraud went undetected initially only because USF and its vendors conspired to lie to Deloitte U.S. and to conceal important documents. Indeed, it was Deloitte U.S.'s confirmation process itself that ultimately revealed the fraud. In the course of the 2002 audit, Deloitte U.S. learned in early 2003 from a vendor from which it had requested PA confirmations that employees had signed inaccurate confirmation letters. Shortly thereafter, Ahold authorized an internal investigation that revealed the extent of the fraud. No doubt it would have been better had the fraud been discovered earlier, but the strongest inference that one can draw from the evidence is that the fraud initially went undetected because of USF's collusion with the vendors, not because of wrongdoing by Deloitte U.S. As to the internal audit, the internal auditors reported not to the Deloitte U.S. external auditors but to USF, as was consistent with professional standards. 14 The rest of the supposed red flags pointed to by the plaintiffs also failed to create a strong inference of scienter. With respect to the plaintiffs' allegations that Smith told Deloitte U.S. about the vendor rebate fraud, the district court twice concluded that this claim had no support in the record, and we see no reason to disagree with its conclusion. The plaintiffs alleged that facts like the high CFO turnover at USF and USF's rapid growth should have alerted Deloitte U.S. that there was fraud afoot, but they failed to explain why this was the only conclusion that Deloitte could make. Conclusion "Seeing the forest as well as the trees is essential." With respect to both frauds, the plaintiffs pointed to ways that the defendants could have been more careful and perhaps discovered the frauds earlier. But the plaintiffs could not escape the fact that Ahold and USF went to considerable lengths to conceal the frauds from the accountants and that it was the defendants that ultimately uncovered the frauds. The strong inference to be drawn from this fact is that Deloitte U.S. and Deloitte Netherlands lacked the requisite scienter and instead were deceived by Ahold and USF. That inference is significantly more plausible than the competing inference that defendants somehow knew that Ahold and USF were defrauding their investors. The court reiterated that it is not an accountant's fault if its client actively conspires with others in order to deprive the accountant of accurate information about the client's finances. It would be wrong and counter to the purposes of the PSLRA to find an accountant liable in such an instance. The court concluded that it had found no version of the facts that would create a strong inference that the Deloitte defendants had the scienter required for a cause of action under Section 10(b); the district court rightly denied the plaintiffs' motion for leave to amend their complaint. Questions 1. In most of the cases in this book, the auditors have been taken to task by the courts for failing to follow generally accepted auditing standards (GAAS) and violating their ethical and professional responsibilities. The Royal Ahold case is different because the court essentially found that Deloitte should not be held liable for the efforts of the client to deprive the auditors of accurate information needed for the audit and masking the true nature of other evidence. Still, the facts of the case do raise questions about whether Deloitte compromised its ethical and professional responsibilities in accepting evidence and explanations provided by the client for the joint venture and promotional allowance transactions. Identify those instances and explain why you believe ethical and professional standards may have been violated. 2. Evaluate the decisions made by Deloitte from an ethical reasoning perspective. Be sure to consider the effects of its decisions on the stakeholders. 3. A shareholder may file a securities fraud claim in federal court to recover damages sustained as a result of a financial fraud. Before the PSLRA, plaintiffs could file a lawsuit simply because a stock price changed significantly and hope that the discovery process would reveal potential fraud. After the PSLRA, plaintiffs were required to bring forth particular fraudulent statements made by the defendant, to allege that the fraudulent statements were reckless or intentional and to prove that they suffered a financial loss as a result of the alleged fraud. The Ahold case is an example of how the courts have, sometimes, ruled more liberally with respect to auditors' legal obligations since the passage of the PSLRA. In the wake of Enron, WorldCom, Adelphia, and other high profile securities frauds, critics suggest that the law made it too easy to escape liability for securities fraud and thus created a climate in which frauds are more likely to occur. Comment on that statement with respect to the fraud at Royal Ahold. Optional Question 4. Explain the legal liability of auditors under SEC regulations and the Telltabs ruling relied on by the Court. Include in your discussion how scienter is determined. Do you agree with the commission's conclusion that the Deloitte auditors did not violate their legal obligations to shareholders? Why or why not? 1 U.S. Court of Appeals for the Fourth Circuit, Public Employees Retirement Association of Colorado; Generic Trading of Philadelphia, LLC v. Deloitte Touche, LLP , January 5, 2009; www.pacer.ca4.uscourts.gov/opinion.pdf/071704.P.pdf. 2 In Re Royal Ahold N.V. Securities ERISA Litigation., 461 F.Supp.2d 383 (2006), Available at http://www.leagle.com/xmlResult.aspx?xmldoc=2006844461FSupp2d383_1796.xml. 3 Starting in 2005, members of the European Union (EU), including the Netherlands, adopted International Financial Reporting Standards (IFRS) as the only acceptable standards for EU companies when filing statements with securities regulators in the EU. 4 NYSE Euronext is the result of a merger on April 4, 2007, between the NYSE and stock exchanges in Paris, Amsterdam, Brussels, and Lisbon, as well as the NYSE Liffe derivatives markets in London, Paris, Amsterdam, Brussels, and Lisbon. NYSE Euronext is a U.S. holding company that operates through its subsidiaries, and it is a listed company. NYSE Euronext common stock is dually listed on the NYSE and Euronext Paris under the symbol "NYX." 5 An American Depositary Receipt (ADR) represents ownership in the shares of a non-U.S. company and trades in U.S. financial markets. The stock of many non-U.S. companies trade on U.S. stock exchanges through the use of ADRs. ADRs enable U.S. investors to buy shares in foreign companies without the hazards or inconveniences of cross-border and cross-currency transactions. ADRs carry prices in U.S. dollars, pay dividends in U.S. dollars, and can be traded like the shares of U.S.-based companies. 6 Under the professional standards then in effect, an auditing firm could provide both internal and external auditing services to the same client. The Sarbanes-Oxley Act of 2002 (SOX) subsequently prohibited internal audit services for external audit clients because of independence concerns. 7 U.S. Supreme Court, Ernst Ernst v. Hochfelder , 425 U.S. 185 (1976). 8 U.S. Court of Appeals, Ottman v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 344 (4th Cir. 2003). 9 U.S. Court of Appeals, Phillips v. LCI Int'l, Inc., 190 F.3d 609, 621 (4th Cir. 1999). 10 Ernst Ernst v. Hochfelder. 11 U.S. Court of Appeals, In re Royal Ahold , 351 F.Supp. 2d. 12 SEC v. Price Waterhouse , 797 F.Supp. 1217, 1240 (S.D.N.Y. 1992) [citing McLean v. Alexander , 599 F.2d 1190, 1198 (3d Cir. 1979)]. 13 SEC v. Price Waterhouse. 14 Institute of Internal Auditors, Standards for the Professional Practice of Internal Auditing, Statement on Internal Auditing Standards 1-18.
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Consider the practice of making "facilitating payments" to foreign officials and others as part of doing business abroad in the context of the following statement: International companies are confronted with a variety of decisions that create ethical dilemmas for the decision makers. "Right-wrong," "just-unjust" derive their meaning and true value from the attitudes of a given culture. Some ethical standards are culture-specific, and we should not be surprised to find that an act that is considered quite ethical in one culture may be looked upon with disregard in another. Explain how culture interacts with the acceptability of making facilitating payments in a country. Use Rights Theory and Justice reasoning to analyze the ethics of allowing facilitating payments such as under the FCPA in the U.S. and prohibiting them as under the U.K. Bribery Act.
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What are the costs and benefits of establishing one set of accounting standards (i.e., IFRS) around the world? How do cultural factors, legal systems, and ethics influence your answer? Apply a utilitarian approach in making the analysis.
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Waste Management Case Overview This case focuses on improper accounting and management decision making at Waste Management, Inc., during the period of its accounting fraud from 1992 to 1997, and the role and responsibilities of Arthur Andersen LLP (Andersen), the Waste Management auditors, with respect to its audit of the company's financial statements. The case illustrates the kinds of financial statement frauds that were common during the late 1990s and early 2000s. The key accounting issue was the existence of a series of Proposed Adjusting Journal Entries (PAJEs) recommended by Andersen to correct errors that understated expenses and overstated earnings in the company's financial statements. These were not recorded even though the company had promised to do so. Andersen developed a "Summary of Action Steps" that were designed to change accounting in the future in order to comply with GAAP but did not require retroactive adjustments to correct past errors. In essence, it was an agreement to do something in the future that should have been done already, with no controls or insistence by Andersen that the proposed changes would in fact, occur According to SEC Litigation Release 17435: Management consistently refused to make the adjustments called for by the PAJEs. Instead, defendants secretly entered into an agreement with Andersen fraudulently to write off the accumulated errors over periods of up to ten years and to change the underlying accounting practices, but to do so only in future periods. The action steps were not followed by Waste Management. The company promised to look at its cost deferral, capitalization, and reserve policies and make needed adjustments. It never followed through, however, and the audit committee was either inattentive to the financial reporting implications or chose to look the other way. According to Litigation Release 17345, writing off the errors and changing the underlying accounting practices as prescribed in the agreement would have prevented the company from meeting earnings targets and defendants from enriching themselves. Defendants got performance-based bonuses based on the company's inflated earnings, retained their high-paying jobs, and received stock options. Some also received enhanced retirement benefits based on the improper bonuses, and some received lucrative employment contracts. Dean Buntrock, the chief executive officer (CEO) and chair of the board, Philip Rooney, director, president, and chief operating officer (COO), and James Koening, executive vice president and chief financial officer (CFO), also avoided losses by cashing in their Waste Management stock while the fraud was ongoing. Just prior to the public disclosure of the accounting irregularities, Buntrock enriched himself by obtaining a tax benefit by donating inflated company stock to his college alma mater to fund a building in his name. Waste Management today is a leading international provider of waste management services, with 45,000 employees serving over 20 million residential, industrial, municipal, and commercial customers; and it earned about $15 billion of revenues in 2012. It was ranked number 203 in the 2012 Fortune 500 listing of the largest companies in the United States. Here is a brief description of how and why the company committed fraud. Dean Buntrock founded Waste Management in 1968 and took the company public in 1971. During the 1970s and 1980s, Buntrock built a vast waste disposal empire by acquiring and consolidating local waste hauling companies and landfill operators. At one point, the company was performing close to 200 acquisitions a year. It experienced tremendous growth in its first 20 years. From the IPO in 1971 until the end of 1991, Waste Management enjoyed 36 percent average annual growth in revenue and 36 percent annual growth in net income. The company grew from $16 million in revenue in 1971 to become the largest waste removal business in the world, with revenue of more than $7.5 billion in 1991. Despite being a leader in the industry, Waste Management was under increasing pressure from competitors and from changes in the environmental industry. Its 1996 financial statements showed that even though its consolidated revenue for the period from December 1994 to 1996 increased 8.3 percent, its net income declined during that period by 75.5 percent. The truth was that the income numbers had been manipulated to minimize the declines over time. The term ill-gotten gains refer to amounts received either dishonestly or illegally. Litigation Release 17345 identifies the following "ill-gotten gains" at Waste Management: img These ill-gotten gains were included in a lawsuit filed by the SEC on March 26, 2002, against the six former top officers of Waste Management Inc., charging them with perpetrating a massive financial fraud lasting more than five years. The complaint, filed in U.S. District Court in Chicago, charged that defendants engaged in a systematic scheme to falsify and misrepresent Waste Management's financial results between 1992 and 1997. According to the complaint, the defendants violated, and aided and abetted violations of, antifraud, reporting, and recordkeeping provisions of the federal securities laws. The SEC successfully sought injunctions prohibiting future violations, disgorgement of defendants' ill-gotten gains, civil money penalties, and officer and director bars against all defendants. The complaint first identified the roles played by top management. Buntrock set earnings targets, fostered a culture of fraudulent accounting, personally directed certain of the accounting changes to make the targeted earnings, and was the spokesperson who announced the company's phony numbers. Rooney ensured that required write-offs were not recorded and, in some instances, overruled accounting decisions that would have a negative impact on operations. He reaped more than $9.2 million in ill-gotten gains from, among other things, performance-based bonuses, retirement benefits, and selling company stock while the fraud was ongoing. Koenig was primarily responsible for executing the scheme. He also ordered the destruction of damaging evidence, misled the company's audit committee and internal accountants, and withheld information from the outside auditors. He profited by more than $900,000 from his fraudulent acts. Hau was the principal technician for the fraudulent accounting. Among other things, he devised many one-off accounting manipulations to deliver the targeted earnings and carefully crafted the deceptive disclosures. The explanation of these manipulations is that to reduce expenses and inflate earnings artificially, management primarily used adjusting entries to conform the company's actual results to the predetermined earnings targets. The inflated earnings of prior periods then became the floor for future manipulations. The consequences created what Hau referred to as the oneoff problem. To sustain the scheme, earnings fraudulently achieved in one period had to be replaced in the next. Hau profited by more than $600,000 from his fraudulent acts. Tobecksen was enlisted in 1994 to handle Hau's overflow. He profited by more than $400,000 from his fraudulent acts. Getz was the company's general counsel. He blessed the company's fraudulent disclosures and profited by more than $450,000 from his fraudulent acts. The defendants fraudulently manipulated the company's revenues, because they were not growing enough to meet predetermined earnings targets, by manipulating current and future asset values failing to write off asset impairments, using reserve accounting to mask operating expenses, implementing improper capitalization policies, and failing to establish reserves (liabilities) to pay for income taxes and other expenses. Overview of Accounting and Financial Reporting Fraud Improper Accounting Practices The accounting fraud involved a variety of practices, including improperly eliminating or deferring current period expenses in order to inflate earnings. For example, the company avoided depreciation expenses by extending the estimated useful lives of its garbage trucks while at the same time making unsupported increases to the trucks' salvage values. In other words, the more the trucks were used and the older they became, the more the defendants said they were worth. Other improper accounting practices include: • Making unsupported changes in depreciation estimates • Failing to record expenses for decreases in the value of landfills as they were filled with waste • Failing to record expenses necessary to write off the costs of impaired and abandoned landfill development projects • Improper capitalization of interest on landfill development • Establishing inflated environmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated environmental and other expenses • Netting one-time gains against operating expenses • Manipulating reserve account balances to inflate earnings In February 1998, Waste Management announced that it was restating its financial statements for the five-year period 1992-1996 and the first three quarters of 1997. 1 The company admitted that through 1996, it had materially overstated its reported pretax earnings by $1.43 billion and that it had understated certain elements of its tax expense by $178 million, as reported in Accounting and Auditing Enforcement Release (AAER) 1405: img Andersen audited and issued an unqualified (i.e., unmodified) report on each of Waste Management's original financial statements and on the financial statements in the restatement. In so doing, Andersen acknowledged that the company's original financial statements for the periods 1992 through 1996 were materially misstated and that its prior unqualified reports on those financial statements should not be relied upon. In the restatement, the company admitted that it had overstated its net after-tax income as follows: img Netting Top management concealed their scheme in a variety of ways, including making false and misleading statements about the company's accounting practices, financial condition, and future prospects in filings with the SEC, reports to shareholders, and press releases, and using an accounting manipulation known as netting to make reported results appear better than they actually were. The netting eliminated approximately $490 million in current period operating expenses and accumulated prior period accounting misstatements by offsetting them against unrelated, one-time gains on the sale or exchange of assets. Andersen repeatedly issued unqualified audit reports on the company's materially false and misleading annual financial statements. At the outset of the fraud, management capped Andersen's audit fees and advised the Andersen engagement partner that the firm could earn additional fees through "special work." Andersen nevertheless identified the company's improper accounting practices and quantified much of the impact of those practices on the company's financial statements. Andersen annually presented company management with PAJEs to correct errors that understated expenses and overstated earnings in the company's financial statements. PAJEs Management consistently refused to make the adjustments called for by the PAJEs, and Andersen accepted management's decision even though the firm knew (or should have known) that it was not in accordance with GAAP. To placate management and ease its conscience, Andersen entered into an agreement with top management to write off the accumulated errors fraudulently over periods of up to 10 years and to change the underlying accounting practices, but to do so only in future periods. The four-page agreement or "treaty," called a Summary of Action Steps, identified improper accounting practices and prescribed 32 "must-do" steps for the company to follow to change those practices. The action steps constituted an agreement between the company and Andersen to cover up past frauds by committing additional frauds in the future. It was the smoking gun proving that Andersen knowingly participated in a fraudulent act in violation of securities laws. Over time, the fraudulent scheme unraveled. An internal review in mid-July 1997 identified improper accounting and led to the restatement of the company's financial statements for 1992 through the third quarter of 1997. In its restated financial statements in February 1998, the company acknowledged that it had misstated its pretax earnings by approximately $1.7 billion. At the time, the restatement was the largest in corporate history. As news of the company's overstatement of earnings became public, Waste Management's shareholders (other than the top management, who sold company stock and thus avoided losses) lost more than $6 billion of the market value of their investments when the stock declined following the public disclosure of fraud. SEC Sanctions against Andersen and Waste Management Officers As for the Andersen auditors, the SEC found that the firm and four of its auditors violated the anti-fraud provisions of Rule 10b-5 of the Securities Exchange Act of 1934. These provisions make it unlawful for a CPA to (1) employ any device, scheme, or artifice to defraud; (2) make an untrue statement of material fact or omit a material fact; and (3) engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of the security. Litigation Release No. 17039 details the charges against four partners: img The SEC charged that Kutsenda knew or should have known that the netting violated GAAP, that prior misstatements that he knew about would not be disclosed to investors, that the impact of the netting on the company's 1995 financial statements was material, and that an unqualified audit report was not warranted (http://www.sec.gov/litigation/admin/34-44448.htm). On August 29, 2005 the SEC issued Litigation Release 19351, announcing that the U.S. District Court for the Northern District of Illinois entered final judgments as to defendants Dean L. Buntrock, Phillip B. Rooney, Thomas C. Hau, and Herbert A. Getz, all of whom consented to the judgments without admitting or denying the allegations. The judgments permanently barred Buntrock, Rooney, Hau, and Getz from acting as an officer or director of a public company, enjoined them from future violations of the antifraud and other provisions of the federal securities laws, and required payment of $30,869,054 in disgorgement, prejudgment interest, and civil penalties. The specific provisions of the securities acts that were violated include rules 10b-5, 12b-20, 13a-1, and 13a-13 of Sections 10(b) of the Securities Exchange Act of 1934 and Section 17(a) of the Securities Act of 1933 (http://www.sec.gov/litigation/litreleases/lr19351.htm). The distribution of the penalty was as follows: • Buntrock-$19,447,670 total, comprised of $10,708,032 in disgorgement, $6,439,638 of prejudgment interest, and a $2,300,000 civil penalty • Rooney-$8,692,738 total, comprised of $4,593,764 in disgorgement, $2,998,974 of prejudgment interest, and a $1,100,000 civil penalty • Hau-$1,578,890 total, comprised of $641,866 in disgorgement, $507,024 of prejudgment interest, and a $430,000 civil penalty • Getz-$1,149,756 total, comprised of $472,500 in disgorgement, $477,256 of prejudgment interest, and a $200,000 civil penalty On November 7, 2001, Connecticut attorney general Richard Blumenthal and treasurer Denise L. Nappier an nounced a $457 million settlement with Waste Management in a class action securities fraud case that provided monetary benefits for shareholders; it was the third-largest securities class action settlement in U.S. history at the time. Waste Management agreed to institute important changes in its corporate governance structure, including greater independence for the company's audit committee and enhanced accountability for shareholders with respect to corporate management. Members of the audit committee were required to be five years removed from employment with the company, rather than the current three years. The company also agreed to recommend to shareholders that their entire board of directors be elected annually, replacing the current system of staggered terms, with one-third of the board being elected each year (http://www.ct.gov/AG/cwp/view.asp?a=1776 q=283444). The corporate governance changes are consistent with requirements of the SOX that calls for greater independence for the audit committee and meaningful involvement in financial reporting oversight. On June 19, 2001, the SEC announced a settlement with Arthur Andersen and the four partners in connection with the firm's audits of the annual financial statements of Waste Management for the years 1992 through 1996. The commission had alleged that Andersen and its partners failed to stand up to company management and betrayed their ultimate allegiance to Waste Management's shareholders and the investing public by sanctioning false and misleading audit reports. Thus, the firm violated its public interest obligation. As for top management at Waste Management, it failed in its fiduciary responsibilities to safeguard company assets and knowingly condoned fraudulent financial reporting. Details of Andersen's Involvement in the Fraud As previously mentioned, in order to conceal the understatement of expenses, top officials resorted to an undisclosed practice known as netting. They used one-time gains realized on the sale or exchange of assets to eliminate unrelated current period operating expenses and accounting misstatements that had accumulated from prior periods. These onetime gains were offset against items that should have been reported as operating expenses in current or prior periods, and thus concealed the impact of their fraudulent accounting and the deteriorating condition of the company's core operations. Although Andersen advised company management that the use of " 'other gains' to bury charges for balance sheet cleanups... and the lack of disclosure... [was] an area of SEC exposure," the practice persisted. In fact, Andersen prepared a PRJE (post-reclassification journal entry) to reduce pretax income from continuing operations, but the company refused to record it. Over the course of the fraud, Waste Management used netting secretly to erase approximately $490 million in current period expenses and prior-period misstatements. The netting procedure effectively acknowledged that the company's accounting practices were wrong and that the netted prior period items were, in fact, misstatements (http://www.sec.gov/litigation/litreleases/lr18913.htm). Andersen's Relationship with Waste Management The SEC was very critical of Andersen's relationship with Waste Management. Litigation Release 17039 notes that the firm had audited Waste Management since before it became a public company in 1971 and considered the client its "crown jewel." Until 1997, every CFO and chief accounting officer (CAO) in Waste Management's history as a public company had previously worked as an auditor at Andersen. During the 1990s, approximately 14 former Andersen employees worked for Waste Management, most often in key financial and accounting positions. Andersen selected Allgyer to be the managing partner of the Waste Management audit because he had demonstrated a "devotion to client service" and had a personal style that "fit well with Waste Management officers." During the time of the audit, Allgyer held the title of "Partner in Charge of Client Service" for Andersen's Chicago office and served as "marketing director." He coordinated marketing efforts of the office including, among other things, cross-selling non-attest services to audit clients. Shortly after Allgyer's appointment as engagement partner, Waste Management capped Andersen's corporate audit fees at the prior year's level but allowed the firm to earn additional fees for "special work." Andersen reported to the audit committee that it had billed Waste Management approximately $7.5 million in audit fees. Over the seven-year period, while Andersen's corporate audit fees remained capped, Andersen also billed the company $11.8 million in other fees. A related entity, Andersen Consulting, also billed Waste Management approximately $6 million in additional non-audit fees, $3.7 million of which were related to a strategic review that analyzed the company's overall business structure. The firm ultimately made a recommendation on implementing a new operating model designed to "increase shareholder value." Allgyer was a member of the steering committee that oversaw the strategic review, and Andersen Consulting billed his time for these services to the company. In setting Allgyer's compensation, Andersen took into account, among other things, the firm's billings to Waste Management for audit and non-audit services (http://www.sec.gov/litigation/litreleases/lr17435.htm). SEC Charges and Sanctions against Andersen and Partners Allgyer was charged in connection with Andersen's audit of Waste Management's 1992 financial statements. The SEC alleged that he knew or was reckless in not knowing that the firm's audit report on the company's 1992 financial statements was materially false and misleading because in addition to quantified misstatements totaling $93.5 million, which, if corrected, would have reduced the company's net income before accounting changes by 7.4 percent, there were additional known and likely misstatements that had not been quantified and estimated. Allgyer further knew that the company had netted, without disclosure, $111 million of current-period expenses and prior-period misstatements against a portion of a one-time gain from an unrelated IPO of securities, which had the effect of understating Waste Management's 1992 operating expenses and overstating the company's income from operations. The SEC further alleged that Allgyer engaged in similar conduct in connection with the 1993 through 1996 audits. That is, he knew or was reckless in not knowing that Andersen's unqualified audit report for each of the years 1993 through 1996 was materially false and misleading [ In the Matter of Robert E. Allgyer, CPA (Release Nos. 33-7986, 34-44445) June 19, 2001]. Allgyer, the partner responsible for the Waste Management engagement, consented (1) to the entry of a permanent injunction enjoining him from violating section 10(b) of the Exchange Act and rule 10b-5 thereunder and section 17(a) of the Securities Act of 1933; (2) to pay a civil money penalty of $50,000; and (3) in related administrative proceedings pursuant to rule 102(e), to the entry of an order denying him the privilege of appearing or practicing before the SEC as an accountant, with the right to request his reinstatement after five years. The SEC charged that Kutsenda, the central region audit practice director responsible for Andersen's Chicago, Kansas City, Indianapolis, and Omaha offices, engaged in improper professional conduct within the meaning of rule 102(e)(1) (ii) of the commission's rules of practice with respect to the 1995 audit. During that audit, he was informed of the non-GAAP netting of a $160 million one-time gain against unrelated expenses and prior-period misstatements and that the amount represented 10 percent of Waste Management's 1995 pretax earnings. Although not part of the engagement team, Kutsenda was consulted by two of the engagement partners and, therefore, he was required under GAAS to exercise due professional care so that an unqualified audit report was not issued on financial statements that were materially misstated [ In the Matter of Robert G. Kutsenda, CPA (Release No. 34-44448), June 19, 2001]. Kutsenda consented in administrative proceedings pursuant to rule 102(e) to the entry of an order, based on the commission's finding that he engaged in improper professional conduct, that denied him the privilege of appearing or practicing before the SEC as an accountant, with the right to request reinstatement after one year. AAER 1410 was issued on June 19, 2001 and details the sanctions against Andersen and its partners. The following discussion describes the sanctions imposed on the firm (http://www.sec.gov/litigation/litreleases/lr17039.htm). The SEC complaint against Andersen charged that the firm knew of Waste Management's exaggerated profits during its audits of the financial statements from 1992 through 1996 and repeatedly pleaded with the company to make changes. Each year, Andersen gave in and issued unqualified opinions on the company's financial statements even though they did not conform to GAAP. A summary of the findings against Andersen follows (http://www.sec.gov/litigation/litreleases/lr17435.htm): • Knowingly or recklessly issuing false and misleading unqualified audit reports on Waste Management's annual financial statements for the years 1993 through 1996. • Failing to quantify and estimate all known and likely misstatements due to non-GAAP accounting practices. • In 1995, the company did not implement the action steps and continued to utilize accounting practices that did not conform with GAAP; Andersen knew but did nothing about it. • Determining the materiality of misstatements improperly; failing to record or disclose information about such transactions; issuing an unqualified audit report. • Written recognition in a memorandum prepared by Andersen of the company's improper netting practices and identification of SEC exposure; monitored continuing practice but failed to adequately disclose the effect on current earnings. Andersen consented to a (1) permanent injunction enjoining it from violating section 10(b) of the Securities Exchange Act of 1934 and rule 10b-5 thereunder; (2) to pay a civil penalty of $7 million; and (3) in related administrative proceedings, to the entry of an order pursuant to rule 102(e) censuring it based upon the SEC's finding that it engaged in improper professional conduct and the issuance of the permanent injunction. The ink on the agreement barely had time to dry when, on December 2, 2001, Enron, Andersen's most infamous client, filed for Chapter 11 protection in the United States after getting embroiled in its own financial scandal. Corporate Governance at Waste Management The fraud at Waste Management was perpetrated by top management. The board of directors either did not know about it or chose to look the other way. Members of top management had signed agreements with Andersen that included action steps to correct for past improper accounting by adjusting future income and adopting proper accounting procedures. Top management failed to live up to any of its agreements. As the Waste Management fraud progressed over the years, the inflated earnings of prior periods became the floor for future manipulations-one-time adjustments made to achieve a number in one period had to be replaced in the next-and created the one-off accounting problem. In early 1997, Hau explained to the audit committee that "we've had one-off accounting every year that has to be replaced the next year. We've been doing this long enough that the problem has mounted."... (http://www.sec.gov/litigation/complaints/complr17435.htm). Essentially, the company created a fiction of inflated earnings and had to duplicate the fiction in subsequent years. Perhaps not surprisingly, greed ruled the day, and the company wasn't simply satisfied with meeting fictitious earnings levels in subsequent years. Instead, there needed to be a higher earnings level to keep the stock price growing and enhance stock option values for top company officials each year. In essence, the company took the first step down the ethical slippery slope in 1992 and couldn't (or wouldn't) find its way back up to the high road. It hit rock bottom in 1997, when the fraud eventually unraveled. In mid-1997, the company's board of directors brought in a new CEO, who ordered a review of the accounting and then resigned after barely four months because, reportedly, he thought that the accounting was "spooky." At that time, the proverbially red flag was raised for the public to see, and Andersen's negligence came to the forefront. In February 1998, Waste Management acknowledged "past mistakes" and announced that it would restate its financial statements for the period 1992-1996 and the first three quarters of 1997. It concluded that, for this period, the company had overstated its reported pretax earnings by approximately $1.7 billion and understated certain elements of its income tax expense by approximately $190 million. In restating its financial statements, the company revised every accounting practice identified in the action steps-practices that defendants had agreed, but had failed, to change four years earlier. As news of the company's overstatement of earnings became public, Waste Management's shareholders lost over $6 billion in the market value of their investments when the stock price plummeted from $35 to $22 per share. Although shareholders lost billions of dollars, top company officials profited handsomely from their fraud. Questions 1. The SEC charged Andersen with failing to quantify and estimate all known and likely misstatements due to non- GAAP practices. What is the purpose of doing this from an auditing perspective? 2. Classify each of the accounting techniques described in the case that contributed to the fraud into one of Schilit's accounting shenanigans. Include a brief discussion of how each technique violated GAAP. 3. Review the facts of the case with respect to Andersen's role in the fraud and describe the provisions of the AICPA Code of Professional Conduct that you believe were violated by the firm. Comment on Andersen's risk assessment as part of its audit procedures. 1 The amount for the first three-quarters of 1997 is $180,900.
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