Called to Account
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Called to Account

Financial Frauds that Shaped the Accounting Profession

Paul M. Clikeman

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eBook - ePub

Called to Account

Financial Frauds that Shaped the Accounting Profession

Paul M. Clikeman

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About This Book

Called to Account traces the evolution of the global public accounting profession through a series of scandals leading to voluntary or mandated reforms. Ever entertaining and educational, the book describes 16 of the most audacious accounting frauds of the last 80 years, and identifies the accounting standards and legislation adopted as a direct consequence of each scandal.

This third edition offers expanded coverage of the Global Financial Crisis and international auditing. While retaining favorite chapters exposing the schemes of "Crazy Eddie" Antar, "Chainsaw Al" Dunlap, and Barry "the Boy Wonder" Minkow, new chapters describe the accounting problems at Lehman Brothers, Colonial Bank, and Olympus. Students will learn that financial fraud is a global problem, and that accounting reform is heavily influenced by politics.

With discussion questions and a chart mapping each chapter to topics covered in popular auditing textbooks, Called to Account is the ideal companion for classes in auditing, fraud examination, advanced accounting, or professional responsibilities.

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1 Scandal and reform

Mistakes are the portals of discovery.
—James Joyce1
Public accountants faced a crisis in the spring of 2002. More than 300 earnings restatements in the United States during 2000 and 2001 revealed just how illusory profits reported during the 1990s had been. Enron’s bankruptcy in December 2001 shattered investors’ confidence, launching a 2,000-point decline in the Dow Jones Industrial Average. Soon after the Justice Department indicted Arthur Andersen for shredding 20 boxes of Enron-related documents, internal auditors uncovered an even more audacious accounting fraud at WorldCom. Certified public accountants, once held in high esteem, fell below politicians and journalists in public opinion polls.
By the end of 2002, American financial reporting had been dramatically transformed. Congress responded to the accounting scandals at Enron and WorldCom by passing the Public Company Accounting Reform and Investor Protection Act, better known as the Sarbanes–Oxley Act of 2002. The legislation limited the nonaudit services accountants could perform for their audit clients and established the Public Company Accounting Oversight Board (PCAOB) to regulate public accounting firms. The Auditing Standards Board (ASB) pushed through a new auditing standard requiring auditors to perform more procedures specifically designed to detect fraud. The Financial Accounting Standards Board (FASB) tightened accounting rules for special purpose entities, and the Securities and Exchange Commission (SEC) demanded more extensive disclosures of off-balance sheet financing.
Accountants in other countries experienced similar changes during the early 2000s as governments enacted accounting and auditing reforms in response to their own domestic accounting scandals. Japan strengthened its auditor independence rules in 2004, banning auditors from owning shares of their client’s stock. Canada adopted regulations in 2005 requiring corporate executives to certify their company’s internal controls. Australia’s CLERP 9 legislation mandated audit partner rotation after five years and a two-year “cooling-off” period before auditors may serve as officers or directors of former clients.

Scandal and reform

The Enron- and WorldCom-inspired accounting reforms of 2002 followed a familiar pattern. Seventy years earlier, Ivar Kreuger’s investment scam at Swedish Match Company inspired Congress to pass the U.S. Securities Acts of 1933 and 1934. These landmark bills required corporations to publish annual audited financial statements and established the Securities and Exchange Commission (SEC) to regulate financial reporting.
Between 1932 and 2002, the cycle of scandal and reform repeated itself many times. Auditors’ failure in 1938 to detect $19 million of fictitious assets at McKesson & Robbins prompted the American Institute of Accountants to issue the first authoritative standards specifying procedures for appointing auditors and conducting audits. The Equity Funding scandal of 1973 led auditors to develop new procedures for testing computerized accounting records. The savings and loan crisis of the 1980s resulted in new legislation requiring more thorough audits of financial institutions. Arthur Andersen’s audit failures at Sunbeam and Waste Management during the 1990s influenced the SEC to revise its auditor independence requirements. In fact, the history of public accounting can be described as a series of scandals followed by voluntary or mandated reforms.

Birth of a profession

British corporations began publishing audited financial statements in the 1840s. But sixty years later, many American business executives still resisted disclosing their profit margins and financial position to the public. Even as late as 1932, neither the U.S. government nor the American stock exchanges required industrial corporations to distribute audited financial statements to their shareholders.
During the 1920s, a Swedish financier and playboy named Ivar Kreuger raised more than $250 million from American investors by promising to pay dividends as high as 20 percent per year. News of Kreuger’s suicide in March 1932 was followed closely by the revelation that $115 million of investors’ money could not be located. Senators George Norris of Nebraska and Huey Long of Louisiana demanded federal legislation to protect investors from “scoundrels who peddle blue-sky securities.”2
President Franklin Delano Roosevelt responded to investors’ concerns by signing the Securities Act of 1933. The 1933 Act required corporations to publish a registration statement containing audited financial statements before selling securities to the public. One year later, Congress passed the Securities Exchange Act of 1934, which required public corporations to file an annual report containing audited financial statements. The 1934 Act also established the Securities and Exchange Commission (SEC) to administer and enforce federal securities laws in the United States.
Although the Securities Acts of 1933 and 1934 required public companies to open their books to auditors, audit procedures of the time provided little protection against fraud. Auditors in the early 1930s were not required to physically examine their clients’ assets or communicate with the clients’ purported customers. A twice-convicted fraudster named Philip Musica exploited these loopholes to commit a multi-million-dollar fraud at McKesson & Robbins. With the help of his three brothers, Musica forged sales invoices, shipping documents, and inventory records to inflate McKesson’s profits and assets.
The discovery of the McKesson & Robbins fraud in 1938 sparked extensive debate about the adequacy of auditors’ testing procedures. The SEC interviewed 46 witnesses trying to determine whether McKesson’s auditors had complied with generally accepted auditing standards and whether those auditing standards were adequate to ensure the reliability and accuracy of financial statements. Within six months of the McKesson & Robbins scandal, the Institute of Public Accountants published its first Statement on Auditing Procedure requiring auditors to observe their clients’ physical inventory counts and confirm receivables via direct communication with debtors.

Generally accepted accounting principles

The Securities Exchange Act of 1934 granted the SEC authority to write financial accounting standards for public companies. Uncomfortable with this responsibility, the early SEC commissioners delegated the task of writing detailed accounting rules to the Committee on Accounting Procedure and its successor, the Accounting Principles Board (APB).
National Student Marketing Corporation (NSMC) used a controversial accounting technique called “pooling-of-interests” to increase its revenues from $723,000 in 1967 to $68 million in 1969. A subsequent SEC investigation concluded that NSMC had overstated its revenues and improperly recognized profit on the sale of two subsidiaries.
When the APB tried to abolish pooling-of-interests accounting in 1969, angry financial managers and investment bankers bombarded the Board with hundreds of protest letters. IT&T threatened to sue the APB to block the proposed rule change. Representatives from three of the Big Eight accounting firms questioned the APB’s ability to write accounting standards. The AICPA was forced to replace the APB with a smaller Financial Accounting Standards Board (FASB) and grant voting rights to representatives from industry and the investment community.
Within weeks of the FASB’s establishment in 1973, an accounting scandal at Equity Funding Corporation of America (EFCA) threatened the new board’s existence. Whistleblower Ron Secrist revealed that EFCA employees had programmed the company’s computers to generate 64,000 phony life insurance policies. Ten young women were employed for the sole purpose of forging policy applications, doctors’ reports, and other documents to fill fictitious policyholder files. Twenty EFCA employees and two auditors were indicted for participating in the EFCA fraud.
Representative John Moss (D, California) and Senator Lee Metcalf (D, Montana) held a series of hearings in 1977 and 1978 to evaluate current procedures for writing accounting standards and performing audits. Several witnesses recommended abolishing the FASB and letting Congress, the SEC, or the General Accounting Office write accounting and auditing standards. Other witnesses complained that the SEC had no procedures for checking the quality of independent auditors’ work. Federal legislation was averted only after accountants adopted significant reforms. Accounting firms auditing public companies agreed to undergo a peer review every three years to determine their compliance with generally accepted auditing standards. And the firms promised to assign a concurring partner to each SEC client and rotate the engagement partner every five years.

The Savings & Loan crisis

The savings and loan crisis of the 1980s was the biggest financial debacle since the Great Depression of the 1930s. Dishonest savings and loan operators squandered billions of dollars on junk bonds and unsuccessful business ventures while manipulating their accounting records to hide their losses. The U.S. federal government spent nearly $500 billion during the late 1980s and early 1990s to close more than 700 failed financial institutions.
The savings and loan crisis originated with the volatile interest rates of the 1970s. Interest rate fluctuations caused sharp changes in the prices of investment securities. Managers at ESM Government Securities began buying and selling millions of dollars of treasury bonds, gambling that they could predict when interest rates would rise and fall. When ESM’s luck turned bad, CEO Alan Novick concealed $300 million of losses by recording fictitious transactions with an affiliated company. ESM’s bankruptcy in March 1985 led to the near collapse of the Ohio savings and loan system. After Cincinnati-based Home State Savings & Loan lost $145 million on deposit at ESM, Ohio Governor Richard Celeste closed the state’s 70 privately-insured thrifts until emergency legislation could be passed to shore up the state’s insurance fund. The most shocking aspect of the ESM story was that the company’s auditor, Jose Gomez, learned of the fraud in 1979 but allowed it to continue for five years while accepting $200,000 of “loans” from ESM executives. Gomez was sentenced to 12 years in prison for his role in covering up the ESM fraud.
Lincoln Savings & Loan’s bankruptcy cost U.S. taxpayers $2.3 billion. Charles H. Keating Jr. purchased Lincoln Savings & Loan (LS&L) in 1983 for $51 million. During the next six years, Keating and his family withdrew $34 million from Lincoln while investing more than $2 billion of the thrift’s assets in junk bonds, undeveloped land, and unsecured loans. When government regulators tried to seize LS&L in 1987, five U.S. senators—recipients of hundreds of thousands of dollars of Keating campaign contributions—intervened on Keating’s behalf. LS&L’s auditors did little to constrain Keating’s reckless investment practices. Arthur Young partner Jack Atchison accepted a $930,000-per-year position with LS&L’s parent company shortly after permitting the thrift to report $80 million of profits on dubious land sales.
The House and Senate Banking Committees held hearings in early 1989 to investigate why so many savings and loans needed intervention. During the hearings, several government regulators accused the nation’s auditors of abetting their clients’ crimes. A representative from the Office of Thrift Supervision testified that the deficient 1986 and 1987 audits of Lincoln Savings & Loan were “proof positive that any thrift in America could obtain a clean audit opinion despite being grossly insolvent.”3 A General Accounting Office (GAO) representative cited multiple examples of auditors failing to identify or report clients’ internal control problems. Representative Henry Gonzalez, chairman of the House Banking Committee, concluded at the end of the hearings that public accountants had been “derelict in their duty to sound alarms about impending disasters in the [thrift] industry.”4
Congress tightened regulation of savings and loans through the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA). FIRREA doubled the minimum net worth requirements of savings and loans and restricted the amounts they could invest in risky assets. Two years later, Congress addressed a similar crisis in the nation’s banking system. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) raised banks’ minimum capital requirements, prescribed standards for loan documentation, and prohibited “excessive” executive compensation.
Two other provisions of the FDICIA significantly altered the accounting profession. The FDICIA required auditors to examine and report on each bank’s internal accounting controls. Eleven years later, the Sarbanes–Oxley Act of 2002 extended the FDICIA’s internal control reporting and auditing requirements to all public companies over a certain size. Furthermore, the FDICIA required banks to disclose the fair market values of their monetary assets and liabilities. Since 1991, the FASB has moved slowly but steadily away from historical cost accounting toward mark-to-market accounting.

Auditors and fraud

Investors have always believed that the auditor’s primarily job is to prevent and detect corporate fraud. But throughout the twentieth century, American auditors tried to disclaim responsibility for their clients’ deceitful accounting practices. Verification of Financial Statements, published by the American Institute of Accountants in 1929, warned that the recommended auditing procedures would “not necessarily disclose defalcations nor every understatement of assets concealed in the records by operating transactions or by manipulation of accounts.”5 The 1957 edition of Robert Montgomery’s influential Auditing Theory and Practice text described fraud detection as a “responsibility not assumed.”6
A series of well-publicized accounting frauds during the 1970s and 1980s forced auditors to accept more responsibility for detecting and reporting corporate wrongdoing. Two of the most audacious frauds occurred at ZZZZ Best and Crazy Eddie, Inc. ZZZZ Best was founded in 1982 by a 16-year-old high school student named Barry Minkow. Within five years, ZZZZ Best had a market capitalization of $200 million. When ZZZZ Best collapsed in 1987, investigators learned that most of the company’s purported revenues were fictitious. Minkow, who was barely out of his teens, was sentenced to 25 years in prison. Eddie Antar, the founder of Crazy Eddie’s Ultra Linear Sound Experience, realized more than $60 million from sales of Crazy Eddie stock while recording false sales and altering inventory records to inflate the company’s stock price. After the Crazy Eddie fraud was discovered, Antar fled the country and eluded police for more than two years while living off money stashed in secret bank accounts. Antar was eventually captured in Israel and sentenced to seven years in prison.
In 1988, the Auditing Standards Board issued nine new auditing standards designed to reduce the incidence of fraudulent financial reporting. SAS No. 53 required auditors to design their audits to “provide rea...

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