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Hidden Financial RiskUnderstanding Off–Balance Sheet Accounting... Hidden Financial RiskUnderstanding Off–Balance Sheet Accounting J.. Edward Ketz is MBA Faculty Director and Associate P

Hidden Financial Risk

Understanding Off–Balance Sheet Accounting

Hidden Financial Risk

Understanding Off–Balance Sheet Accounting

J Edward Ketz

JOHN WILEY & SONS, INC

This book is printed on acid-free paper ∞

Copyright © 2003 by J Edward Ketz All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

Copyright 2002 SmartPros Ltd www.smartpros.com Reprinted with permission.

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Library of Congress Cataloging-in-Publication Data

1 Accounting—Case studies 2 Accounting firms—Corrupt

practices—Case studies 3 Business ethics—Case studies I Title.

HF5635 K43 2003

658.15 ′5—dc21

2003003952 Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

For Charity and Benjamin

About the Author

J Edward Ketz is MBA Faculty Director and Associate Professor of Accounting at the

Penn State Smeal College of Business He has been a member of the Penn State facultysince 1981 He holds a bachelor’s degree in political science, a master’s degree inaccountancy, and a Ph.D in business administration, all from Virginia Tech

The teaching and research interests of Dr Ketz focus on financial accounting,accounting information systems, and accounting ethics He has published numerousacademic and professional articles, and he has written seven books Also, he is coeditor

of Advances in Accounting Education.

Dr Ketz writes two columns about financial reporting issues Accounting Today

pub-lishes “Accounting Annotations,” while “Accounting Cycle: Wash, Rinse, and Spin”appears on SmartPros.com He has been cited in the popular and business press, includ-

ing The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today, and he has served as an accounting commentator on CNNfn.

PART I My Investments Went Ouch! 1

1 What? Another Accounting Scandal? 3

Notes

PART II Hiding Financial Risk 51

3 How to Hide Debt with the Equity Method 53

Equity Method versus Trading-Security

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30

Details about the Equity Method and Consolidation 58

4 How to Hide Debt with Lease Accounting 73

5 How to Hide Debt with Pension Accounting 103

6 How to Hide Debt with Special-Purpose Entities 125

Preliminary Corporate Responses

PART III Failures that Led to Deceptions 149

7 Failure of Managers and Directors 151

8 Failure of the Auditing Profession 173

Appendix Sutton’s Critique of Serving the Public Interest 195

PART IV Making Financial Reports Credible 251

11 Andersen Has the Solution—Really! 253

Preface

When I graduated with a doctorate in 1977, I researched and published articles on stream topics, particularly current value accounting and the interaction between earn-ings and cash flows After a while, it occurred to me that these are not the crucial issues

main-of financial accounting and reporting Ethics and honesty and fairness to financial ment users comprise the foundational issues of the profession If a business enterpriseadopted the best methods for accounting but did so with treachery and duplicity, itwould not help any capital market agent If I have to choose between the best account-ing methods and managerial integrity, I always prefer the latter

state-I started writing articles on such topics in the 1980s and published them in obscureacademic journals Then in January 1996 I began writing the “Spirit of Accounting” col-

umn for Accounting Today with my friend Paul Miller I needed a break in 2000, so I

quit the column; Paul Bahnson joined Paul Miller on it After a year’s respite, I found

myself writing “Accounting Annotations” for Accounting Today and “The Accounting

Cycle: Wash, Rinse, and Spin” for SmartPros.com

Then Enron disclosed problems in its third-quarter report of 2001 and soon declaredbankruptcy All of a sudden people were interested in accounting at levels I had neverexperienced previously During the first half of 2002 I had at least 500 interviews withthe media, and I discussed at length issues about Enron, Global Crossing, WorldCom,Tyco, Adelphia, and Arthur Andersen My main message was simple: The culture offinancial reporting that began around 1990 brought about this mess When managersengage in “earnings management,” what they really mean is that when they cannotmake profits legitimately, they will exaggerate and abuse accounting numbers until thereported numbers make them look good Aiding and abetting this process of “earningsmanagement” have been board directors who never asked serious questions, corporatelawyers who were eager to push the limits, stock brokers and investment bankers whodid not care how they made a buck, financial analysts who worried little that they served

as used-car salesmen for their investment banking firms, auditors who looked the otherway, an impotent Financial Accounting Standards Board, an overextended Securitiesand Exchange Commission, and members of Congress who would tolerate almost any-thing for sufficiently large campaign contributions

Writing short essays or talking a few minutes with a reporter necessarily involves apartial examination of some identifiable, circumscribed issue of financial accounting.This book allows me to address these concerns in a broader and more coherent fashion

I see three purposes of this book: (1) to lay out in some detail several specific problems

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in the financial reporting arena, (2) to describe how the system failed to correct any ofthese problems during 2001 and 2002, and (3) to suggest a course of action for improv-ing things The latter is critical if the stock market crash of 2001/2002 is not to be repli-cated Ironically, the thrust of my suggestions rests on the work of former partners inArthur Andersen.

When one says and writes the things I do, it is not surprising that some people object.During the spring of 2002 I received a number of e-mails from Arthur Andersen per-sonnel I wish to share two of them here, both sent to me on March 21, 2002 The firste-mail came from a lawyer/certified public accountant at Arthur Andersen

I am deeply disturbed at some of the public comments you are making to the media withrespect to Arthur Andersen and the Enron matter

To quote you as quoted in the Houston Chronicle: “Rightly or wrongly they are ing at Andersen in part for that justice because Andersen obviously had an audit failurehere in approving things that shouldn’t have been done.” What did we approve that should-

look-n’t have been approved [sic] How much do you know about what went on at Enron?

Where is your information coming from?

Because you are a professor of accounting, I would expect more rationale, reasoned,and knowledgeable statements from you I would refer you to AU 316, Consideration ofFraud in a Financial Statement Audit The statement clearly indicates that an auditor can-not obtain absolute assurance that a material misstatement will be detected Because of theconcealment aspects of fraudulent activity (i.e collusion and falsification of documents),even a properly planned and executed audit may not detect material misstatements result-ing from fraud Whether Arthur Andersen did or did not perform at the requisite level ofprofessional competency is yet to be determined We have admitted to making mistakes,but those mistakes are not the cause of the downfall of Enron and should not be the cause

of the downfall of my firm

You are doing my firm, the accounting profession, and the public a great disservice bydisseminating inaccurate information Audits are not designed to detect fraud Never have

been Auditors to [sic] not go into client offices and put a gun to the client’s head and

demand that they tell them about all of their fraudulent activities while searching throughthe secret drawer in the client’s desk for the second set of books Auditors perform a pro-fessional service that can be subverted by management fraud This is the point you should

be making

I would ask that you utilize your bully pulpit to strengthen the profession, not aid in itsdemise

The second e-mail also criticizes my comments It comes from an accounting alumnus

I am an Arthur Andersen audit partner and Penn State alumni I have read your name andrelated quotes throughout articles over the past several months and I have a few questionsfor you In an article I read today you are quoted as saying “I think the story of Enron hasresonated basically to the bone for so many Americans that they want justice done Rightly

or wrongly they are looking at Andersen in part for that justice because Andersen ously had an audit failure here in approving things that shouldn’t have been done.” I waswondering if I could get a copy of research/study or whatever you have to support yourstatement Please provide me with a list of these things that Andersen approved that cre-ated an audit failure This could really save everyone a lot of time and money Have you

obvi-P REFACE

ever worked outside of academia? Ever audited a public company? Ever worked in publicaccounting? Do you really know anything about Arthur Andersen? I guess I would not be

as troubled with your quote if it was the first one However, I have read these idiotic,unsupported opinions from you over the last several months I find it curious that you seem

to be the only accounting professor in the United States with any opinion what so ever.Could it be that other accounting professors feel that they just don’t have enough facts toreach these conclusions that are obvious to you? Or maybe other accounting professorsdon’t thirst for the limelight like you do What ever the answer is, I really don’t care I justwanted to let you know that I will not support Penn State financially in the future and Iwill implore all my fellow Penn State partners and other alumni to do the same while youare employed there I don’t believe a University should employ someone who would makesuch careless, unsupportable remarks Whatever happens to Andersen, my partners and Iwill survive and thrive and I will go out of my way to share my views like you seem to goout of you way to share yours

These accusations inspired me to write this book While this text responds to thequestions and allegations just listed in depth, I wish to provide a summary response atthis stage If Arthur Andersen is so innocent in the Enron case, how do you explainBoston Chicken, Waste Management, Sunbeam, Arizona Baptist Foundation, GlobalCrossing, and WorldCom? It expands one’s credulity past the breaking point to thinkthat Arthur Andersen could be the victim with respect to all of these failures

With respect to the first e-mail written by the Arthur Andersen lawyer/CPA, I havethree additional points First, to the best of my knowledge, I have not disseminated inac-curate information I have responded with the facts that I had at the time, coupled with

my analysis If I have disseminated inaccurate information, show me my specific takes instead of merely asserting that I have made errors It seems to me, given what wenow know, that I was right in what I said and wrote Second, you are correct in alleg-ing that auditors often claim that audits are not designed to detect fraud What you areforgetting is that the investment community thinks differently To their collective mind,

mis-if you are not checking on the accuracy and completeness of the disclosures and fying that managers are not lying to us, what is the point? If you do not check thesethings, we are wasting our money on your audits Third, it was not my intent to aid inthe demise of Arthur Andersen My goal was and remains to talk about the culture offinancial reporting and seek for improvements It appears to me that Arthur Andersenundid itself Your firm screwed up the audits at Boston Chicken, Waste Management,Sunbeam, Arizona Baptist Foundation, Global Crossing, as well as at Enron andWorldCom Your firm committed these audit failures, not I

veri-To the gentleman who wrote the second e-mail, I have four further points First, Ihave been writing about accounting ethics for 20 years While you may be unaware of

my work, it is out there in the public domain and you can read and critique it as youchoose But please do not accuse me of doing no research just because you are too lazy

to determine what my previous work has been Second, I admit that I have never audited

a company, although I have studied and researched the nexus between financial ing and stock investments for 30 years My expertise in financial accounting and report-ing is foundation enough to enable me to make comments about shoddy audits Third,

report-I do not understand why other accounting professors have not responded to the events

Preface

xiii

of the past two years Perhaps they are timid and shy; perhaps they are too busy doingtheir research in financial economics; perhaps they do not wish to work with the media;

or perhaps they or their departments have received money from your firm, which causedthem to be afraid to speak out Last, I think it unfortunate that you will not support PennState because of what I have said Your commentary shows that you do not understandthe university system, nor do you approve of my First Amendment right to free speech

My statements are my own; I do not speak for the university Fortunately, the tenure tem allows me to make unpopular testimonials even when university officials do notagree with my remarks Business contributions to universities benefit society becausethey foster research and teaching efforts and because the money can support the educa-tion of students who otherwise would not get the chance to attend Lack of donationswill hurt poor and needy potential students, not me

sys-From this tête-à-tête between two (former) partners at Arthur Andersen and me, thereader should see what is at stake Do we preserve the status quo, claiming that thereare only a few rotten apples, and hope things improve? Or do we acknowledge that aninfectious problem exists when managers lust to “manage earnings” while directors,lawyers, auditors, stock brokers, and members of Congress do not have the fortitude tostop them?

In my judgment, a serious problem exists in the world of financial reporting; indeed,the problem is so deep-seated that only a fundamental change in the system will restorecredibility to financial reports In this book I shall explore how managers hide corpo-rate liabilities and why the economic system has not responded appropriately to repairthe underlying causes of the problems I conclude with a chapter on how to improve thesystem and exhort readers to work toward this goal

I wish to thank John DeRemegis at John Wiley & Sons for encouraging me to writethis book and for sufficient prodding to finish it I appreciate the help of Penn StateMBA students Hsiuwen (“Wendy”) Lin and Puntawat Sirisuksakulchai, CMA andCFM, who conducted some of the financial analyses and assisted with library and otherresearch activities I also thank Judy Howarth, who edited the book

P REFACE