The Accounting Onion

SEC Settlement with Auditors of WorldCom: Too Little, Too Late?

Coming on the heels of accusations that the SEC is trending toward less vigorous enforcement against financial reporting violations, the SEC published here and here its settlements with the two Arthur Andersen partners that planned and supervised the 2001 audit of WorldCom.  Six years later, the settlements amount to little more than slaps on the wrist:  both auditors were suspended from practicing before the SEC for at least three years, no monetary penalties were assessed, and no admissions of guilt were obtained.  (By the way, one of the auditors has let his CPA license lapse, and the other is still licensed as a CPA in Mississippi.)

I have three questions for the SEC.  First, why were these individuals allowed to settle without admitting or denying guilt in what appears to have been an open-and-shut case?  Second, why were no monetary penalties assessed?  Third, why did it take six years, with only this so-called "settlement" to show for all this time and, presumably, effort?

I'll leave any kind of thorough treatment of the last two questions for future ruminations (feel free to do it without me!), and will focus henceforth on my dissatisfaction with a settlement that does not require auditors to admit to the public that they made inexcusable mistakes -- in what was apparently a slam-dunk case. 

Background

Most readers will recall that the WorldCom accounting fraud was astonishing for both the magnitude of the errors in the financial statements, and the simplicity of the accounting.  We're not talkin' 'bout complex financial arrangements, arcane consolidation, pension, stock option or revenue recognition rules; we're talkin' the third week of Accounting 101.  We're talkin' about capitalizing telephone line access fees ("line costs") that should have been expensed.  Over a number of quarters, $3 billion in payments that should have been reported as expenses on the income statement were parked in property and equipment (P&E) accounts on the balance sheet.  The "top-side" accounting entries to effectuate the fraudulent misstatements circumvented internal controls and were made by accountants with the highest authority in the company.   

The $3 billion capitalization of line costs was the first of the WorldCom accounting frauds to come to light, but it paled in comparison to the additional $8 billion of accounting misstatements that were subsequently discovered.  As Cynthia Cooper, the whistle blower on the first $3 billion wrote in her recent book (I reviewed it here):

"...[top management at WorldCom] had a process called 'close the gap,' whereby they would compare quarterly revenue to Wall Street expectations, analyze potential items they could record to make up the difference, and book revenue items that had not been booked in the past."

Given the magnitude of the misstatements, it doesn't seem possible that they could have occurred in the absence of a broken audit.  The two Andersen partners on the WorldCom account were charged with violating the SEC's own rules of professional conduct as they apply to accountants* who practice before the Commission: Rule 102(e). That also should have kept things relatively simple, as the case would be made before an administrative law judge; no interaction with the courts or other government agencies would have been required.  I'm not a lawyer, but I think that the threshold standard of proof in such a case would have been the same as civil litigation, "preponderance of evidence."

Also, the SEC reached only for the low-hanging fruit when bringing their charges against the two audit partners, both of whom had been involved with WorldCom for a number of years.  Basically, in addition to intentional, knowing or reckless conduct, the most difficult to prove, there are two other ways that an accountant can violate Rule 102(e):

1. A single instance of highly unreasonable conduct that results in a violation of professional standards in circumstances in which the accountant should know that heightened scrutiny is warranted, or;
2. Repeated instances of (merely) unreasonable conduct, each resulting in a violation of professional standards that indicate a lack of competence.

The SEC wisely chose the second of these two.  All they wanted, and needed, to address was conduct in violation of the equivalent of the third week of Accounting 101, plus the third or fourth week of Auditing 101. At the risk of being tedious, but to educate my readers who are taking Auditing 101 and to make the point that the SEC must have had a slam-dunk case, here is but a sample of the SEC's allegations:

• Andersen discovered fraud of a similar nature a year earlier, and affecting the same PP&E accounts.  There were other strong indicators that fraud might occur, like the financial straits of the CEO, a history of aggressive accounting, and industry factors.  Consequently, the engagement team classified overall audit risk as "maximum."  However, substantive tests of PP&E , one of the most significant balance sheet categories, were not expanded.
• The auditor's did not design or implement procedures to review top-side entries, evidently relying on management's representation that there were no significant top-side entries--even though fraud via top-side entries took place just one year earlier. 
• Additions to the PP&E accounts were only examined through the third quarter of 2001, and not as of the end of the fiscal year.  $841 million of the fraudulent charges to PP&E occurred in the fourth quarter.
• A reconciliation of beginning and ending PP&E balances was not done.  If the auditors had done so, they would have discovered that the $3 billion in fraudulent charges to PP&E were made in circumvention of normal approval processes.
• The expense accounts that were reduced by the top side entries were not reconciled to the financial statements and general ledger.  "Had they done so, the auditors would have discovered that the line cost expenses they were testing were significantly larger than the line cost expenses reflected in WorldCom's financial statements and general ledger."

Back to the Question

Let's be generous, and presume that those who pull the levers at the SEC subjugate their personal interests for the public interest.  Indeed, one could argue that there have been many cases where the SEC obtained the same monetary fines and sanctions -- or maybe even more -- in a settled action than it could have gotten in court.  One of the reasons this may be the case is that many defendants have an economic disincentive to admit guilt in an SEC action.  That's because (once again, I'm not a lawyer) one who admits guilt to the government may not deny it in a private action -- where the money penalties could be much bigger. 

So, in many instances, it may actually serve the public interest to give defendants the option of settlement with the SEC without an admission of guilt; but, my point is that it is certainly not always the case.  Now, ceasing to presume motives as pure as the driven snow, the SEC counts scalps, and a settlement containing an agreement to be sanctioned, however meaningless, counts as a scalp to be hung up before Congress and the world.  Fewer settlements mean more trials, and more trials mean fewer scalps. Even considering the predisposition for scalps of any color, this case took six years just to get settled! And, how many defendants are coerced into settling without admitting or denying guilt just so the SEC can have their scalp, even though the accused parties truly feel they did nothing wrong, but need to get the matter put behind them? 

Focusing specifically on the case of the WorldCom auditors, I can't possibly see how the public interest was served by settling without a fine, and without an admission of guilt.  If there was ever a case where the SEC could have sent an unequivocal message by making its case in court, this one was it. Can anyone say that more was gained by settling? Given the magnitude of the numbers, timing and other circumstances, can anyone say that the public does not rightfully want to know whether and how WorldCom's auditors violated the basic standards of their profession? 

And, not only is there a message opportunity, the public deserves more justice and closure.  Will private litigation against these auditors take place?  I doubt it, because their pockets probably aren't deep enough to fund the private attorneys.  Therefore, the argument of a defendant loathe to settle because of exposure to private litigation goes poof. Will the AICPA or state accountancy boards discipline these auditors?  It's been six years, and so far not a peep from them either -- just one more reason we need the PCAOB.

For the SEC, it shouldn't be about the money they collect in fines, or the number of years of sanctions they obtain from settlement, or even (and this is, I admit, controversial) about the sheer number of cases they bring.  It should be about deterrence: the message sent by a case that will contribute to greater trust in the capital markets by reducing the risk of fraud.  The reality, though, is that it is very convenient and self-serving to measure and report monetary fines,** volume of cases and years barred from practicing before the Commission.  The flip side of this reality is that one cannot possibly measure how many frauds did not occur because of the threat of vigorous and consequential law enforcement. Ergo, the focus of bureaucrats on scalps; in the case of the 2001 WorldCom audit that misplaced focus results in giving unduly short shrift to deterrence.   

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*Note to students: the SEC rules of professional conduct apply to all accountants at public companies -- not just their auditors.

**Well, maybe you can't always measure the effectiveness of the SEC by the fines they mete out. See Jonathan Weil's commentary in bloomberg.com on how he believes SEC Chair Cox inflated the numbers he reported in recent congressional testimony.

More on the CAQ Survey

I thought I had beaten flat the CAQ's survey of audit committee members in my last post.  Lo and behold, here is one more nasty tidbit brought to my attention that merits sunlight.

Among the organizations that with whom CAQ partnered for the recruitment of survey takers was the National Association of Corporate Directors (NACD).  NACD must know who among its members are on audit committees; nevertheless, it blithely sent CAQ's survey out as a mass mailing to all of its 17,500 members.  As you may well have anticipated, there were no controls to ensure that the survey would be responded to by audit committee members only.

OK, so maybe not all respondents were actually members of audit committees -- big deal. But, what if respondents weren't even members of a corporate board?  According to the NACD website:

"NACD accepts both individual and full board membership. Associate membership is available to professional services organizations -- such as legal practices, audit firms and compensation consultants -- who provide essential board guidance and advisory services." [italics supplied]

Recalling that CAQ based their statistics on the responses of only 253 volunteers, how many of these volunteers weren't even board members?   What if 50 of the respondents were actually audit partners?  My point is that they survey methodology was so loosey-goosey, we have no way of knowing. 

Gatekeepers Hoodwinking Gatekeepers

As Bejamin Disraeli said, "There are three kinds of lies: lies, damned lies, and statistics."  Perhaps statistics is the most insidious of the trio because they can be the most beguiling.  The CAQ sits at the same point on the Disraeli scale as any other lobbying organizations who conciously produce data that they intend to be mistaken for information.  But, there should be an important difference: the CAQ is controlled by audit firms who, according to the "P" in "CPA", purport to be ethically bound to protect the public interest.  When journalists are hoodwinked by CAQ into reporting on mere data as if it were information, then CPAs have failed to live up to the ethical standards of those who fund it.

Journalists also function in a large sense as gatekeepers for misleading information.  How ironic is it that CAQ, an organization funded and controlled by audit firms, was so facile in its manipulation of other gatekeepers?

Low Quality Stats from Center for Audit Quality

Much ado has been made lately of the insubstantial contribution business school professors have made to practice through research.  Accounting research of the last forty years, being no exception, was blasted in a commentary in the Chronicle for Higher Education for not addressing questions relevant to accounting professionals.  The authors, academic accountants themselves, blame universities for not providing more robust incentive systems to encourage a broader range of topics and methodologies. 

I want to add another reason:  practitioner organizations barely give lip service to academic research, because their members actually don't want to know what academics have to say.  That's because the truth can be so darn inconvenient (apologies to A. G.).  Just recently, the Financial Accounting Foundation says it doesn't believe it is necessary anymore to have academic representation on the FASB (see earlier post); and now a new report by the Center for Audit Quality (CAQ) presents the results of their "commissioned" survey of audit committee members.  "Research," by any standard academic, it ain't.

I have two problems with the survey.  First, the survey methods are so crude, that if an academic had tried to present this work to peers as serious research, either his sanity or intelligence would be called into question.  Second, the presentation of the "key findings," such as they are, have been skewed to fit the public relations agenda of the accounting profession:  post-Enron rehabilitation of auditors' reputations, and entrenchment of the revenue-producing aspects of SOX.  Other than these two criticisms, the report is just fine.

Let's start with the methodology:

Non-random sample -- CAQ states, without explanation, that it was "not feasible from a cost or time standpoint" to take a random sample.  How ironic is it that an organization sponsored by auditors would forgo random sampling, the indispensable basis of so many auditing standards, procedures and concepts?  CAQ blithely asks us to assume this is a minor detail:

"With a pure probability sample of this size, one could say with ninety-five percent confidence that the overall results would have a sampling error of +/- 6.2 percentage points.  As this survey is not a pure probability sample, theoretically no sampling error can be calculated."

Setting aside that calculation of a sampling error is not "theoretically" possible (read simply as "not possible in any way, shape or form"), +/- 6.2 percentage points is actually a pretty large number that can affect one's reading of the results.  Maybe that's why it is not mentioned again in the report.

Sample size -- Let's agree that the population of interest, audit committee members of public companies, number very approximately 10,000.  Only 253 of them volunteered in response to invitations to participate.  Given the low participation level, it is highly likely for non-respondents to have significantly different opinions than the self-selected volunteers.  If anything was done to test that proposition (yes, academics routinely apply techniques for doing so), CAQ did not report it.

Sample demographics -- CAQ gathered very little information about the respondents.  We know virtually nothing about their financial or accounting expertise.  For example, how many are "designated financial experts"?  How many are former auditors? 

We do know, however, that 44% took their first position on an audit committee post SOX.  As some of the key survey questions ask their opinions about the pre- and post- SOX environment, their opinions may be different, or even less reliable, than the respondents with longer tenure on audit committees.

Wording of the questions -- Let's say you joined your first audit committee in 2007.  How would you respond to this key question:

"Based on your experience as an audit committee member [italics supplied], how would you rate the overall quality of audits of publicly traded companies being conducted today?

First, I don't know if a respondent could reliably separate their audit committee member experience from their prior experience.  Second, given the variability in length of tenure of audit committee members -- some pre-SOX, and other not -- it appears as if two populations are being combined into one. 

The next survey question is:

"And over the past several years, would you say that the overall quality of audits of publicly traded companies has...?" 

Assuming that the "based on your experience" language carries forward, how is the newbie audit committee member supposed to answer that?  Dunno.  Remember, these folks are 44% of the respondents!

Integrity and Objectivity Red Flag -- Neither the organization that purportedly conducted the survey was disclosed in the survey report, nor the scope of their responsibilities.  Imagine an audit report not identifying the auditor; this is not much different.  Was the contractor a well-respected company that didn't want to be associated with the end product?  Was it an organization with other ties to CAQ?  Just asking.    

Now, on to the reported "key findings"

Current state of audit quality -- The audit committee now appoints the auditor and reviews their work much more closely than in the pre-SOX era.  What board member would be willing to admit, even anonymously, that their choice of auditor was a mistake?  So, it's not surprising that CAQ finds that 95% of respondents rate their auditors' work as "good" or better.  As a "key finding", it's a big fizzle. 

The other side of the coin is more provocative: a client paying top dollar for audit services should not be satisfied with work that was only "good" or "fair." That's how 22% of respondents saw it.  Moreover, 17% said that the situation had not changed or worsened since the passage of SOX. 

Risk of fraudulent financial statements -- CAQ blithely reports that 87% of respondents believe the risk of releasing financial statements that are materially inaccurate due to fraud is not very high.  That's a good thing?  I don't think so, especially when you consider that these are audited financial statements!  Has SOX affected the potential for fraudulent misstatements?  The CAQ would like you to think so, because auditors sure have made a lot of money out of ICFR audits.  Yet, unstated is the fact that 40% of respondents do not believe that the risk of fraudulent misstatement has decreased with SOX. 

Complexity of financial statements -- CAQ would like you to believe that audit committee members think that financial statements are too complicated.  But, the questions don't even begin to address the nature of the complexity, or the sophistication of the respondents as regards financial statements.  And if you still doubt that a self-serving agenda is driving the report, here's the smoking cannon: buried in the back pages (question 17C) is the undiscussed finding that respondents clearly do not feel that GAAP is too complex.  Yet financial statements are too complicated.  Figure that one out!

If you are one of those who believe that the CAQ was created by the powers that be to function as shill for audit firms, then this survey report could be your Exhibit A.  It is also Exhibit A for my point that practitioners with self-serving agendas have good reason to be threatened by the contribution of academics.  But, if truth is the goal, then the participation of academics, trained and paid to apply discipline and rigor to a question, is an asset.