12. 1 LIVENT PRODUCES AN ACCOUNTING THEATRICALConcept : Impact Of Financial Fraud On The Auditors OpinionStory:Based out of Toronto, Livent was a company that produced live theatrical entertainment, such as Ragtime, The Phantom of the Opera, Show Boat, Sunset Boulevard and Fosse. It owned and operated theaters in Toronto, Vancouver, Chicago and New York in the 1990s. On May 1993, Livent became a public company in Canada, in May 1995 it began trading on the NASDAQ national stock market and on the Toronto Stock Exchange. (SEC January 13, 1999) An accounting fraud perpetrated by CEO Garth Drabinski, President Myron Gootlieb, and Tony Fiorino, CA, the Theater Controller, led to Livent declaring bankruptcy in the USA and Canada on November 18 and 19, 1998, respectively. (SEC 1999a) In August 1998, a new management team at Livent discovered the vague, false and misleading financial statements and disclosures from former senior management. KPMG Peat Marwick conducted an independent investigation of the fraud. In November 1998, KPMG reported that Livent had submitted at least 17 false filings with the SEC which materially overstated income and operating cash flows throughout the relevant period. As a result of the scheme, Livents restatements reported in a cumulative adverse effect on net income in excess of $98 million in Canadian dollars. (SEC 1999b) The fraud included: a multi-million dollar kick-back scheme designed to misappropriate funds for managements own use; the improper shifting of preproduction costs, such as advertising for Ragtime, to fixed assets, such as the construction of theaters in Chicago and New York; and the improper recording of revenue for transactions that contained side agreements purposefully concealed from Livents independent auditors. (SEC 1999a) Livents accounting staff used four basic forms of manipulation. First, the staff transferred preproduction costs for shows to fixed asset accounts such as the construction of theaters, in order to delay the amortization of those costs. Theater Controller Fiorino created dummy accounts for the amounts that were improperly transferred to fixed assets Second, the accounting staff, at the end of each quarter, simply removed certain expenses and the related liabilities from the general ledger. These items were literally erased from the companys books. Third, the accounting staff transferred costs from one show currently running to another show that had not yet been opened or that had a longer amortization period, again in order to delay the amortization of those costs. Finally, senior management entered into various revenue-producing contracts containing purposefully concealed side agreements that, in effect, required Livent to pay back to the ticket buyers the amount originally advanced. From September 30, 1997 to December 31, 1997, the first vendor purchased tickets totaling $381,015 (US) from the box office at the Schubert Theater in Los Angeles. These purchases were made using the vendors personal credit card or the vendor issued checks from one of his companies. Livent then reimbursed the vendor or his companies based on false invoices the vendor submitted for construction services to Livent. These transactions should have been booked as loans payable rather than as revenue. (SEC 1999a) Livents former senior officers directed that various improper adjustments be made to Livents books, records, and accounts in order to manage income for each quarter to achieve a predetermined level. (SEC 1999b) Senior management instructed the accounting staff to regularly process the adjustments to the books, records and accounts in such a way as to conceal their existence from the auditors and then prepared financial statements incorporating the adjustments. Adjusting journal entries would have left a trail of red flags for the auditors, something Livents senior management did not want to create. Consequently, starting in at least 1994, the manager of Livents information services department wrote a program that would enable the accounting staff to override the accounting system without a paper or transaction trail. That manager then wrote programs to enable the accounting staff to execute changes on a batch, or volume, basis. This process had the effect of falsifying the books, records and accounts of the company so completely that the adjustments appeared as original transactions, and no trace of the actual original entries remained in the companys general ledger. (SEC 1999a) As a result of the scheme, Livents financial statements for fiscal years 1991 and 1992, prior to Livent becoming a US public company, were materially false and misleading in that Livent overstated pre-tax earnings, or understated pre-tax losses, in each of those years. For fiscal 1991, Livent reported a pre-tax loss of $1.2 million. In fact, Livents loss in that year was approximately $4.6 million. For fiscal 1992, Livent reported pre-tax earnings of $2.9 million. In fact, the companys true earnings were approximately $100,000. (SEC 1999a) As a further result of the scheme, Livent reported inflated pre-tax earnings, or understated pre-tax losses, for each of its fiscal years as a US public company, 1995 through 1997. For fiscal 1995, Livent reported pre-tax earnings of $18.2 million. In fact, the companys true earnings were approximately $15 million. For fiscal 1996, Livent reported pre-tax earnings of $14.2 million. In fact, the company incurred a loss of more than $20 million in that year. For fiscal 1997, Livent reported a pre-tax loss of $62.1 million. In fact, the companys true loss in fiscal 1997 was at least $83.6 million. (SEC 1999a).Discussion Questions How did each one of the four accounting fraud schemes impact Livants financial statements? What audit procedures might be used to discover these misstatements?

12.2 CENDANT MERGER GOES BADLYConcept: Management Representations As A Basis For An Unqualified OpinionStory:Cendant Corporation was created through the 1997 merger of CUC, a company engaged in membership-based consumer services, such as auto, dining, shopping, and travel clubs and HFS international (franchiser of Avis, Ramada Inns, and Century 21). CUCs largest division, Comp-U-Card, marketed individual memberships in these clubs. Based in New York City, and with around 90,000 employees, Cendant today is a multi-billion dollar global franchiser and provider of consumer and business services in over 100 countries. Cendant Corporations core operations today include franchising real estate (including Coldwell Banker, Century 21), hospitality (including Ramada, Howard Johnson, Days Inn, and Travelodge with over 6,400 hotels, around 540,000 rooms, and 5,200 lodging franchises), vehicle (Avis), financial (Jackson Hewitt (tax preparation)), and travel distribution services (cendant.com 2004).On April 15, 1998, Cendant announced that it had uncovered accounting irregularities and would need to restate its financial statements. On September 29, 1998, Cendant filed restated financial statements reducing the Companys operating income for the years ending January 31, 1996, January 31, 1997 and December 31, 1997 by over $500 million. (SEC 2000)From 1995 to 1998, CUC and Cendants management engaged in various schemes to fraudulently inflate Cendants reported income. These included manipulation of: (1) merger-related restructuring charges and reserves; (2) reported cash balances; (3) membership cancellation rates; and (4) intentional overstatement of income included in the 1997 financial statements. The first method became increasingly significant during the last years of the scheme, when the ever-larger adjustments were made in order to keep annual earnings to the levels expected by Wall Street analysts. (SEC 2000)CUC and Cendant made false statements to their auditor, Ernst &Young, about financial results and accounting methods. False statements were made in management representation letters about, for instance, utilization of merger-related reserves, the adequacy of the reserve for membership cancellations, and the collectabilty of rejected credit card billings. (SEC 2003)Some of the procedures that CUC and Cendant employed to conceal its fraudulent scheme from the auditors 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 the auditor; (3) in some instances ensuring that fraudulent accounting entries did not affect schedules already provided to the auditor; (4) withholding financial information and schedules to ensure that the auditor would not detect Cendants accounting fraud; (5) ensuring that the companys financial results did not show unusual trends that might draw attention to its fraud; and (6) using senior management to instruct middle and lower level personnel to make fraudulent entries. (SEC 2003)

An SEC suit alleges that the two of the audit partners from E&Y were aware of numerous practices by CUC and Cendant. As a consequence, they had a duty to withhold their unqualified opinion and take appropriate additional steps. (SEC 2003)E&Y provided accounting advice as well as audit services to CUC and Cendant in connection with the establishment and use of restructuring reserves. For example, they advised Cendant about cost categories that were typical components in corporate restructurings, including those cost categories that the audit partners knew were subjective in nature and for which audit evidence, other than managements representation, was difficult to obtain. For their opinion, the audit partners excessively relied on management representations concerning the appropriateness of the reserves and performed little substantive testing. (SEC 2003)CUC and Cendant provided the audit partners with contradictory drafts of schedules when asked for support for the establishment of the Cendant Reserve. 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 audit partners did not obtain adequate analyses, documentation or support for changes 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. (SEC 2003)Discussion Questions To what extent is it possible for an auditor to rely on management claims in the managementrepresentations letter to determine the appropriateness of a material account balance? If evidence is inconsistent with management representations what additional auditprocedures should the auditor consider?

12.3 TYCO INTERNATIONAL LTD. MANAGEMENTS PIGGY BANKConcept: Financial Statement Disclosure, Corporate Governance, And LoansStory:Tyco is a US company that manufactures a wide variety of products, from electronic components to healthcare products. It operates in over 100 countries around the world and employs more than 240,000 people.In 2002, three former top executives of Tyco (former CEOs Dennis Kozlowski, Mark Swartz, and the chief legal officer Mark Belnick) were sued by the SEC. Kozlowski and Swartz granted themselves hundreds of millions of dollars in secret low interest and interest-free loans from Tyco that they used for personal expenses. They later caused Tyco to forgive tens of millions of dollars they owed the company, without disclosure to investors as required by the federal securities laws. (SEC 2002) Kozlowski and Swartz engaged in numerous highly profitable related party transactions with Tyco and awarded themselves lavish perquisites without disclosing either the transactions or perquisites to Tyco shareholders. (US District Court 2002)Messrs. Kozlowski and Swartz ... treated Tyco as their private bank, taking out hundreds of millions of dollars of loans in compensation without ever telling investors, said Stephen M. Cutler, the SECs Director of Enforcement. (SEC 2002)

But Not What He Told ThemAt the same time that Kozlowski and Swartz engaged in their massive covert fradulant use of corporate funds, Kozlowski regularly assured investors that at Tyco nothing was hidden behind the scenes, that Tycos disclosures were exceptional and that Tycos management prided itself on having sharp focus with creating shareholder value. Similarly, Swartz regularly assured investors that Tycos disclosure practice remains second to none. (US District Court 2002)KELP and Relocation LoansMost of Kozlowskis and Swartzs improper Tyco loans were taken through abuse of Tycos Key Employee Corporate Loan Program (the KELP). A disclosure description of the plan as filed with the SEC, explicitly described its narrow purpose (US District Court 2002): [U]nder the Program, loan proceeds may be used for the payment of federal income taxes due upon the vesting of Company common stock from time to time under the 1983 Restricted Stock Ownership Plans for Key Employees, and to refinance other existing outstanding loans for such purpose.Kozlowski and Swartz bestowed upon themselves hundreds of millions of dollars in KELP loans which they used for purposes not legitimately authorized by the KELP. From 1997 to 2002, Kozlowski took an aggregate of approximately $270 million charged as KELP loans even though he only used $29 million of that to cover taxes from the vesting of his Tyco stock. The rest was used for impermissible and unauthorized purposes. For example, with his KELP loans, Kozlowski amassed millions of dollars in fine art, yachts, and estate jewelry, as well as an apartment on Park Avenue and a palatial estate in Nantucket. He also used the KELP to fund his personal investments and business ventures. (US District Court 2002)Kozlowski and Swartz also abused Tycos relocation loan program to enrich themselves. When Tyco moved its corporate offices from New Hampshire to New York City, an interest-free loan program was established. It was designed to assist Tyco employees who were required to relocate from New Hampshire to New York. Kozlowski used approximately $21 million of relocation loans for various other purposes, including the purchase of prestigious properties in New Hampshire, Nantucket and Connecticut. Kozlowski even used approximately $7 million of Tycos funds to purchase a Park Avenue apartment for his wife from whom he had been separated for many years and whom he subsequently divorced. (US District Court 2002)Kozlowski and Swartz did not stop there. Instead, they oversaw and authorized transactions by which tens of millions of dollars of their KELP loans and relocation loans were forgiven and written off Tycos books. They also directed the acceleration of the vesting of Tyco common stock for their benefit. (US District Court 2002)They Deserve BonusesIn December 2000, Kozlowski and Swartz engineered another program whereby Tyco paid them bonuses comprised of cash, Tyco common stock, and_or forgiveness of relocation loans. From that program, Kozlowski received 148,000 shares of Tyco common stock, a cash bonus of $700,000, and $16 million in relocation loan forgiveness. Swartz received 74,000 shares of Tyco common stock, a cash bonus of $350,000, and $8 million in relocation loan forgiveness. None of these payments were disclosed as part of Kozlowskis and Swartzs executive compensation in Tycos annual reports. (US District Court 2002)The AuditorIn 2003, the SEC sued Richard P. Scalzo, CPA, the PricewaterhouseCoopers LLP (PwC) audit engagement partner for Tyco from 1997 through 2001. (SEC 2003a) The SEC alleged that Scalzo received multiple and repeated facts regarding the lack of integrity of Tycos senior management, but he did not take appropriate audit steps in the face of this information. The SEC maintained that those facts were sufficient to obligate Scalzo to reevaluate the risk assessment of the Tyco audits and to perform additional audit procedures, including further audit testing of certain items (most notably, certain executive benefits, executive compensation, and related party transactions). He did not perform these procedures. (SEC 2003a)

Red Flags and Post Period AdjustmentsIn the September 30, 1997 audit, factual red flags appeared in the audit working papers. The working papers contained 26 pages of reports prepared by the company, listing the activity in the various KELP accounts of Tyco employees. Three of those 26 pages listed the KELP account activity for L. Dennis Kozlowski. Most of the line items for the Kozlowski account also include a brief description, and 18 carry descriptions that are immediately recognizable as not being for the payment of taxes on the vesting of restricted stock. For example, one item reads WINE CELLAR, another reads NEW ENG WINE, another BMW REG_TAX, another ANGIE KOZLOWS, and 13 read either WALDORF, WALDORF RENT, WALDORF EXPEN, WALDORF RENT A, or WALDORF RENT S. (SEC 2003b)In the September 30, 1998 audit, the audit team noticed a series of transactions in which three Tyco executive exercised Tyco stock options, by borrowing from the KELP, and then sold the shares back to the company the next business day through an offshore Tyco subsidiary. Tyco then wrote a check to the executives, representing a net settlement of the transactions. After consulting with PwC national partners, the PwC audit team came to the conclusion that Tyco should include a compensation charge of approximately $40 million. (SEC 2003b)Faced with the reality of having to book an unanticipated $40 million compensation charge, Tyco suddenly arrived at $40 million in additional, contemporaneous, post-period adjustments which had the effect of negating the impact of the $40 million charge. The $40 million in credits raise significant issues $7.8 million resulted from Tyco reversing a previous fourth quarter charge for restricted stock expense for certain executives no longer required. The rationale advanced for that reversal was that the executives had decided to forego the corresponding bonuses in the fourth quarter.The companys treatment for certain executive bonuses provided evidence of problems. For example, Tyco made an initial public offering (IPO) of its previously wholly-owned subsidiary, TyCom Ltd. Because of the IPOs success, Kozlowski decided to grant $96 million in bonuses to Tyco officers and employees. Tyco accounted for the bonuses as: (1) a TyCom offering expense, (2) a credit for previous over-accruals of general and administrative expense, and (3) a contra-accrual for federal income taxes. None of it was booked as compensation expense.Discussion Questions What tests should an auditor perform to find evidence concerning misstatement of executive compensation expense? Are public statements by the CEO to investors considered a disclosure that requires the attention of the auditor? If the Sarbanes-Oxley Act, Section 402 Enhanced Conflict Provisions was in effect in 2001, would that have made a difference to the disclosure requirements?