Q 18Q 18
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:
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:
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:
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.
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:
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.
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.