Accounting Updates Accounting Updates

Southern Gas Southern Gas Association Accounting & Financial Association Accounting & Financial

Executives Conference Executives Conference

April 28, 2003April 28, 2003

Robert E. (Bob) JensenRobert E. (Bob) JensenTrinity UniversityTrinity University

San Antonio, TX 78212San Antonio, TX 78212http://www.trinity.edu/rjensen/http://www.trinity.edu/rjensen/

Accounting Updates Accounting Updates

Southern Gas Southern Gas Association Accounting & Financial Association Accounting & Financial

Executives Conference Executives Conference

April 28, 2003April 28, 2003

Robert E. (Bob) JensenRobert E. (Bob) JensenTrinity UniversityTrinity University

San Antonio, TX 78212San Antonio, TX 78212http://www.trinity.edu/rjensen/http://www.trinity.edu/rjensen/

Why are the fees of large Why are the fees of large accounting firms so huge?accounting firms so huge?

““Chatper 1: The Andersen Way,” by Barbara Chatper 1: The Andersen Way,” by Barbara Ley toffler, Page 1Ley toffler, Page 1

Robert stared at him, disgusted. “We don’t do anything for $50,000.” The manager looked as if he might melt into a puddle of shame. After giving me a pleading glance, he slunk out of the partner’s office, knowing that when he returned he had better have a generously padded price for his piece of the project.

Why Does Accounting Why Does Accounting Fraud Begin?Fraud Begin?

The main reason is that white collar crime pays even if you get caught and spend a The main reason is that white collar crime pays even if you get caught and spend a year or two in Club Fed!year or two in Club Fed!

Only idiots rob $150 from a gas station. Smart hoodlums get stock options for $250 Only idiots rob $150 from a gas station. Smart hoodlums get stock options for $250 million, cook the books, and exercise the options before the stock price plunges.million, cook the books, and exercise the options before the stock price plunges.

What is the history & culture?What is the history & culture?

Pipe Dreams: Greed, Ego, and the Death of Enron by Robert Bryce (The Perseus Books Group ISBN 1-58648-138-x, 2002)

Final Accounting: Ambition, Greed and the Fall of Arthur Andersen by Barbara Ley Toffler (Broadway Books, ISBN 0-7679-1382-5, 2003)

Power Failure: The Inside Story of the Collapse of Enron by Mimi Swartz and Sherron Watkins (Doubleday, ISBN 0-385-507887-9)

http://www.trinity.edu/rjensen/fraud.htm#References

How Does Accounting How Does Accounting Fraud Begin?Fraud Begin?

Answer: Cookin’ The BooksAnswer: Cookin’ The Books

• Starts with “making the numbers”

• Then, “Managing the Numbers”

• Ends with “making up the numbers”

Rationalization includes:Rationalization includes:

• “We need to make our projections…”

• “I’m getting pressure from the boss…”

• “We need to meet Street expectations…”

• “Our acquisition will fall through if we don’t…”

But, even a simple But, even a simple mistake can be turned mistake can be turned

into a financial fraud into a financial fraud through “cover-up” through “cover-up”

efforts.efforts.

Annual Caseload by Annual Caseload by Fiscal YearFiscal Year

0

100

200

300

400

500

600

19951996

19971998

19992000

20012002

Fiscal Year

SEC Enforcement: FY 2002SEC Enforcement: FY 2002

• 598 total cases

• Largest categories:– Financial fraud and issuer reporting (27%) – Offering fraud (20%) – Broker-dealer (14%) – Insider trading (10%)– Market manipulation (7%)– Investment adviser/company (8%)

Financial Reporting and Issuer Disclosure: Financial Reporting and Issuer Disclosure: Actions Filed Actions Filed

• 163 actions filed in FY 2002

– Compared to:

• 112 in FY 2001

• 103 in FY 2000

• 94 in FY 1999

• 79 in FY 1998

Why so many financial statementWhy so many financial statement frauds all of a sudden?frauds all of a sudden?

Systemic Problems of Accounting That Cannot or Will Not Be Solved: http://www.trinity.edu/rjensen/FraudConclusion.htm

Behavior of CPA Firms: http://www.trinity.edu/rjensen/fraud.htm

Greed on Wall Street: Rotten to the Core http://www.trinity.edu/rjensen/fraud.htm#Cleland

Washington DC Prostitutes: Representative Fernand St Germain (D-Rhode Island) $32 Billion for 30 Years Senator Phil Gramm (R-Texas) & Wife Wendy $400 billion and counting

http://www.trinity.edu/rjensen/fraud.htm#WarningSigns

Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Good economy was masking many problemsGood economy was masking many problems

Moral decay in society

Executive incentives

Wall Street expectations—rewards for short-term behavior

Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Failure of Corporate Audit Committees

Board of Directors Failures and Greed

Financial Analyst Conflict of Interests and Greed: Rotten at the Core

•Education Failures: Graduates of Greed Rather Than Professionalism

Good economy was Good economy was masking problemsmasking problems….….

With increasing stock prices, profits and wealth for everyone, no one worried about potential problems.

Detailed Complicated RulesDetailed Complicated Rules

With Loop Holes Big Enough To Drive A Truck Through

RulesDetailed

Nature of Accounting RulesNature of Accounting RulesAllows companies and auditors to be

extremely creative when not specifically prohibited by standards.

“rules-based” vs. “principles based” rhetorical nonsense

Loop Hole Examples Include:SPEs and other types of off- balance sheet financing

Pension accounting

Merger reserves

Other accounting schemes.

Revenue recognition approaches,

When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…”

Unaccountable Unaccountable ContractsContracts

Expect New Amendments in SFAS 149

What’s going on at the FASBWhat’s going on at the FASBSpring 2003Spring 2003

Prepared for the Southern Gas Association Executive Conference on April 28, 2002. Robert E. Jensen, Trinity University, San Antonio, TX 78212

Topics Selected for DiscussionTopics Selected for Discussion

• Key Documents Effective 2002/2003– Statements 143, 146, 147 and 148– FINs 45 and 46

• Next Documents to be Issued– Statements 149 and 150

• Projects on the Agenda

• Other Items– FASB Staff Positions (FSPs)– Improving Standards (Principle-based Standards)– Convergence

Who is the FASB?Who is the FASB?• Private-sector standard setter that provides guidance for

accounting and financial reporting by public and non-public entities.

• Not an Oversight Body — no enforcement power.

• Formed in 1973 and recognized by the SEC and the AICPA as the creator of GAAP.

– Public Companies

– Private Companies

– Not-for-Profit Entities

FASB’s MissionFASB’s Mission• To establish and improve standards of financial

accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.

• Accounting standards are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent and understandable financial information.

• Good financial and business reporting reduces the uncertainty premium charged by investors and lenders.

Impact of Sarbanes-OxleyImpact of Sarbanes-Oxley

• FASB expects to be Recognized as Private Sector Accounting Standard Setting Body.

• FAF selects members of FASB (unlike PCAOB).

• FASB is separate from the PCAOB and neither reports to the other.

• Public companies will be billed for the cost to operate the FASB and the PCAOB.

• SEC to Report to Congress on Principle-Based Standards and Off-Balance Sheet Entities.

Certain Documents EffectiveCertain Documents Effective2002/20032002/2003

• Statement 143, Accounting for Asset Retirement Obligations

• Statement 146, Accounting for Costs Associated with Exit or Disposal Activities

• Statement 147, Acquisition of Certain Financial Institutions

• Statement 148, Accounting for Stock-Based Compensation – Transition and Disclosure

• FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees

• FIN 46, Consolidation of Variable Interest Entities

Statement 143, Statement 143, Accounting for AssetAccounting for AssetRetirement ObligationsRetirement Obligations

• Reason issued – to recognize a disposal liability when it is incurred that previously was not recognized until later.

• Issued June 01; Effective – fiscal year beginning after 6-15-02.

• Initial application results in recognition of:

– a liability (initially at fair value)

– higher cost and accumulated depreciation amounts

– cumulative effect of accounting change.

Statement 146, Statement 146, Accounting for CostsAccounting for CostsAssociated with Exit orAssociated with Exit or

Disposal ActivitiesDisposal Activities• Reason issued – to replace Issue 94-3 and to recognize

liabilities when they have been incurred and not before.

• Issued June 02; Effective for activities initiated after 12-31-02.

• Specific guidance for: – One-time Termination Benefits (usually a stay-

bonus) – Contract Termination Costs (lease termination) – Other associated costs.

• Extensive disclosure requirements.

Statement 147, Statement 147, Acquisition ofAcquisition ofCertain Financial InstitutionsCertain Financial Institutions

• Reason issued – to remove all but mutual combinations from Statement 72 and FIN 9 and put certain customer-relationship intangibles into the scope of Statement 144 (impairment of long-lived assets).

• Issued October 02; Effective October 1, 2002.

• The Statement 72 intangible asset is treated as goodwill under Statement 142. Branch acquisitions are discussed.

Statement 148, Statement 148, Accounting forAccounting forStock-Based Compensation –Stock-Based Compensation –

Transition and DisclosureTransition and Disclosure

• Reason issued – to provide additional transition alternatives for switching from the intrinsic method to the fair value method for stock-based employee compensation and to improve disclosures.

• Issued December 02; Alternatives and annual disclosures are effective for fiscal years ending after 12-15-02; interim disclosures are effective for interim periods beginning after 12-15-02.

FIN 45, FIN 45, Guarantor’s Accounting andGuarantor’s Accounting andDisclosure Requirements for Disclosure Requirements for

GuaranteesGuarantees

• Reason issued – to improve disclosures with respect to information about guarantees, the identification of what is a guarantee and to improve accounting by requiring recognition of a liability when incurred.

• Issued November 02; Disclosure requirements effective for interim or annual periods ending after 12-15-02; recognition effective for guarantees issued or modified after 12-31-02.

• Guarantees are initially recognized at their fair value. Discussion of subsequent accounting and what in the debit is provided.

FIN 46, Consolidation of VariableFIN 46, Consolidation of VariableInterest EntitiesInterest Entities

• Reason issued – to identify entities where applying the majority of voting interest approach is not effective (VIEs) and providing an approach to use for those entities.

• Issued January 03; Effective for new VIEs upon issuance and for existing VIEs at the beginning of the first interim or annual period beginning after 6-15-03. For nonpublic entities it is effective for existing VIEs at the end of the annual period beginning after 6-15-03.

• VIEs do not have sufficient equity investment at risk to permit the entity to finance its activities without additional financial support or the holders of the equity investment lack any one of the the 3 characteristics of a controlling financial interest.

FIN 46, Consolidation of VariableFIN 46, Consolidation of VariableInterest Entities (cont’d.)Interest Entities (cont’d.)

• An enterprise that has variable interests that will :– absorb a majority of the VIE’s variability in its expected

losses (tie breaker),– receive a majority of the variability in its expected residual return, or– bothis the VIE’s Primary Beneficiary and must consolidate.

Next Documents to be IssuedNext Documents to be Issued

• SFAS 149, Amendments to Statement 133

– Incorporates various DIG issues into the Statement.

– Clarifies the definition of a derivative (paragraph 66).

– Effective 6-30-03.

Next Documents to be Issued Next Documents to be Issued (cont’d.)(cont’d.)

• SFAS 150, Liability and Equity Instruments

– The following instruments that have been treated as equity will be treated as liabilities:

(1) Instruments that are mandatorily redeemable on a fixed or determinable date or upon an event certain to occur.

(2) Obligations to repurchase an issuer’s equity shares (forward purchase contract or written puts) that must be physically or net cash settled.

Next Documents to be Issued Next Documents to be Issued (cont’d.)(cont’d.)

(3) Obligations that the issuer must or could settle by issuing a variable number of its equity shares when the obligation’s monetary value is fixed or varies on something other than equity values (accounts payable or accrued expense) or the variation is not in the same direction as equity values (written puts with net share settlement.

– For public companies SFAS 150 probably will be effective for annual or interim periods beginning after6-15-03. For nonpublic companies mandatorily redeemable instrument probably will be effective for annual periods beginning after 12-15-03.

Projects on the FASB’s AgendaProjects on the FASB’s Agenda

• Stock-Based Compensation• Pension Disclosures• Disclosures about Fair Value of Financial Instruments• Liabilities and Equity (Phase II)• Financial Performance Reporting• Revenue Recognition• Short-term International Convergence• Purchase Method Procedures• Combinations of Not-for-Profit Organizations• Combinations of Mutuals• Consolidation• What can a QSPE do with respect to Reissuance of BI• What does “legally released from being the primary

obligator” mean?

Selected ProjectsSelected Projects

• Share-Based Compensation – working with IASB; goal is to get the same approach and have it effective as of 1-1-04.

• Pension Disclosures – will focus on information about plan assets and the population of persons to receive pension payments. Also, some quarterly information and where the expense is recorded in the I/S.

• Liabilities and Equity (Phase II) – how to treat instruments with both liability and equity elements; try to get convergence.

FASB Staff Positions (FSPs)FASB Staff Positions (FSPs)

• New way to provide guidance on applying GAAP.

• Provides for due process and access.

• Look for FSPs website and get notice of posting from the e-mail Action Alert.

Improving StandardsImproving Standards

• Document on Principles-Based Standards issued fall 2002; Roundtables held and comment letters received.

• Shifting focus to “how to improve standards” by addressing issues raised by our constituents.

• SEC doing a study.

• Changing relationship of FASB with EITF and AcSEC.

ConvergenceConvergence• Working with the IASB on the following joint projects

and parallel projects.

– Revenue Recognition– Purchase Method Procedures– Stock-Based Compensation– Reporting Financial Performance.

• Both the FASB and IASB have a short-term convergence project to focus on matters not otherwise covered in a major project.

• All FASB projects and EITF issues consider convergence.

GAAP CRITICISM

Fosters Short-Term Earnings Manipulations

Does Not Show Value Creation

Executive IncentivesExecutive Incentives•Meeting Wall Street’s ExpectationsMeeting Wall Street’s Expectations•Performance is based on earnings & stock price

–Focus is on short-term (quarterly) performance only

–Stock prices are tied to meeting Wall Street’s earnings forecasts

Companies are heavily punished for not meeting forecasts

–Moral Hazard: Employee Stock OptionsDid you ever hear the name Lou Pai?

Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999.

Princeton University

GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... "

Jack Welch,Former General Electric Chairman

Stock Fell 13% With This Revelation

Stock Fell 13% With This Revelation

Enron’s CEO of Enron Broadband Services, Ken Rice, had a $33,000 customized Hellcat motorcycle in his office just for a distinctive decoration.

Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land. Mostly he flew to his 77,000 acre ranch in Colorado.

Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land. Mostly he flew to his 77,000 acre ranch in Colorado.

Rebecca Mark, who’s bonuses ranged in the $40 million range at Enron, had a $6 million private jet budget that often flew her to her “tres chic vacation home in Taos.” according to Robert Bryce, p. 262.

Jeff Skilling’s secretary, Rebecca Carter, got a Salary of $600,000 per year plus other perks, including the perky Jeff Skilling according to Schwartz and Watkins.

Jeff Skilling’s secretary, Rebecca Carter, got a Salary of $600,000 per year plus other perks, including the perky Jeff Skilling according to Schwartz and Watkins.

Beat The Numbers

How To Play

Numbers Game

Aggressive AccountingAggressive Accounting

Earnings ManagementEarnings Management

Income SmoothingIncome Smoothing

Fraudulent Financial ReportingFraudulent Financial Reporting

Creative Accounting PracticesCreative Accounting Practices

Rewards of Rewards of The GameThe Game

Share Price EffectShare Price Effect

Borrowing Cost EffectBorrowing Cost Effect

Bonus Plan EffectBonus Plan Effect

Political Cost EffectPolitical Cost Effect

Auditors—the CPAsAuditors—the CPAs• Failed to accept responsibility for fraud detection (SEC, Supreme

Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is?

•Tradition of sending puppies out to yap at the receivables

•A few auditors got too close to their clients

•Audit became a loss leader–Easier to sell lucrative consulting services from the inside

–Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture

•Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting rich

In a separate case in late September, a judge's divorce ruling unsheathed guarded financial information about accounting firm Ernst & Young, which is a private partnership that does not file public financial reports.

In divorce papers for Ernst & Young chief executive officer Richard S. Bobrow, a 45-page judge's opinion revealed how much the CEO was paid and put a dollar value on the company for the first time, giving competitors a rare peek into the firm's finances.

Annual Salary $ 3 Million

$25 million in salary $US29 million in partnership earnings over the next decade.

Pension worth $1 million a year for life and had access to a corporate jet owned by Ernst & Young and a New York apartment.

$ 24 million to Janet Bobrow$ 24 million to Janet Bobrow

“Jan Bobrow, the ex-wife of Ernst & Young CEO Richard Bobrow, says she would have settled their divorce for a little more than $2 million. Richard Bobrow offered $1.2 million.” USA Today, October 15, 2002

“Jan Bobrow, the ex-wife of Ernst & Young CEO Richard Bobrow, says she would have settled their divorce for a little more than $2 million. Richard Bobrow offered $1.2 million.” USA Today, October 15, 2002

Moral DecayMoral Decay•Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed:

–67% of CFOs said they had been asked by senior company executives to misrepresent corporate financial results–12% of CFOs admitted they had actually misrepresented financial results…55% said they had fought off requests to “cook the books”

•Honesty studies–1961: 12%

–1986: 31%

–2002: ???

Current Executive Fraud-Current Executive Fraud-Related ProblemsRelated Problems

• Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc.

•Executive Loans and Corporate Looting: John Rigas (Adelphia), Dennis Kozlowski (Tyco--$170 million—the $15,000 umbrella stand)

IPO Favoritism: Bernie Ebbers ($11 million)

•CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM (Consulting Contracts, Use of Corporate Planes, Executive Apartments with meals, maids, etc.)

Current Executive Fraud-Related Current Executive Fraud-Related ProblemsProblems

•Exorbitant Stock Options

Who owns his own 14,000-foot mountain in Colorado?

Largest Bankruptcy FilingsLargest Bankruptcy Filings

(1980 to Present)(1980 to Present)

Company Assets (Billions) When Filed

1. WorldCom $101.9 July, 2002

2. Enron $63.4 Dec., 2001

3. Texaco $35.9 April, 1987

4. Financial Corp of America

$33.9 Sept., 1988

5. Global Crossing $25.5 Jan., 2002

6. Adelphia $24.4 June, 2002

7. PG&E $21.5 April, 2001

8. MCorp $20.2 March, 1989

9. Kmart $17.0 Jan., 2002

10. NTL $16.8 May, 2002

Recent Financial Statement Recent Financial Statement FraudsFrauds

• Enron

• WorldCom

• Adelphia

• Global Crossing

• Xerox

• Qwest

• Many others

Let’s Get Back to the Let’s Get Back to the BasicsBasics

Back to the Basics…Back to the Basics…

•Know your audit client– Understand the key reports used by management

– Understand the budget process

– Understand the source of growth

•Know your client’s industry

Professional SkepticismProfessional Skepticism

• Should be displayed by all members of the team throughout the audit and review engagements

Back to the Basics…Back to the Basics…

• Vary the audit testing performed

• Prepare a detailed audit program

• Understand the client’s closing process

• Don’t forget the general ledger

The Closing ProcessThe Closing Process

• Follow-up on all questionable items during the final analytical review

• Examine all consolidating financial statements– Including, all post closing and top-side entries

Back to the Basics…Back to the Basics…

•Issues encountered during the audit ---

– Deal with the issue at hand

– Don’t try to “paper over” the problem

– Management letter comment is not enough

– Don’t make the client’s problem your own

Key Elements of Public TrustKey Elements of Public Trust

Spirit of Transparency

Culture of Accountability

People of Integrity