The SEC:
Garbage In / Garbage Out

A Sighting from The Catbird Seat

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Garbage In / Garbage Out

A Critique of Fraudulent Financial Reporting: 1987-1997 (the COSO Report)
The SEC Accounting Regulatory Process (AAERs)
By
Abraham J. Briloff, Ph.D., CPA
Emanuel Saxe Distinguished Professor Emeritus
Bernard M. Baruch College
The City University of New York

According to traditional wisdom, the efficiency of a sanitation department should not be measured by the amount of garbage it picks up, but instead by what is left behind. This axiom came to mind regularly as I reviewed and reflected on " Fraudulent Financial Reporting: 1987-1997 An Analysis of U.S. Public Companies", a report commissioned by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Committee was comprised of the American Accounting Association, the American 'Institute of Certified Public Accountants, the Financial Executive Institute, the Institute of Management Accountants, and the Institute of Internal Auditors. This research was intended to update the work of the National Commission on Fraudulent Financial Reporting, which released its report in 1987.

A prefatory caveat: "garbage" is used here entirely as a metaphor; accordingly, it is not to be construed literally nor as a pejorative. The report was introduced with the following as the statement of the objective of the study:

Fraudulent financial reporting can have significant consequences for the organization and for public confidence in capital markets. Periodic high profile cases of fraudulent financial reporting raise concerns about the credibility of the U.S. financial reporting process and call into question the roles of auditors, regulators, and analyst in financial reporting. Thus, COSO commissioned this research project to provide COSO and others with information that can be used to guide future efforts to combat the problem of financial statement fraud and to provide a better understanding of financial statement fraud cases.

The research was undertaking by three academics, professors Mark S. Beasley, Joseph V. Carcello, and Dana R. Hermanson -- all of whom happened to be Ernst & Young alumni.

The research pursued by the research team involved their analysis of the Accounting and Auditing Enforcement Releases (AAERs) promulgated by the Securities and Exchange Commission over the eleven year span 1987-1997; thus, they took as their universe the 880 AAERs that were issued during that period. According to the study this universe was adopted because: "The AAERs, which contain summaries of enforcement actions by the SEC against public companies, represent one of the most comprehensive sources of alleged cases of financial statement fraud in the United States."...

Only if the professors were determined to be blind-sighted could they have failed to see that the companies thus profiled were not representative of the "high profile cases of fraudulent financial reporting. . ." alluded to in the opening gambit of their report. Only then would they have failed to recognize that the 99 corporations thus probed were not the grist for articles appearing with regrettably frequent regularity in the Wall Street Journal, Business Week, Forbes, Baryons, Fortune, the Accounting Today, et al.

Those 99 cases were not essentially representative of the crisis in confidence, the GAAP in credibility, which confront the accounting profession, especially our commitment to the independent audit of publicly owned corporations. They were not especially the stuff that for example led to the October 5, 1998 Business Week special issue devoted to as proclaimed by the cover "Who can you trust?", which then included feature articles captioned "Earning Hocus-Pocus" and "Where are the Accountants?"

Nor were these 99 corporations, and as will be pointed up presently, the AAERs generally, the basis for the strident impassioned addresses by the Chairman and the Chief Accountant of the Securities and Exchange Commission. The companies thus profiled were not in their minds when they inveighed against for example:

• Improper revenue recognition, both timing and amounts;

• Improper expense recognition, amount and classification; • Use and abuse of so-called "restructuring charges" created as an incident to a business combination or otherwise;

• So-called "cookie jar reserves", whereby some pluses are stashed away to be used at a later date to offset minuses;...

Especially important for this critique is the data complied by the research team as their table 16, "Types of auditors named in AAERs." Thus for their in-depth analysis of the auditors involved in the corporations identified by the AAERs 46 were audited by non-Big Eight/Six, and 10 were audited by the Big Eight/Six. According to the professors, of the 46 audited by non-Big Eight/Six firms 29 reflected actual involvement by the firms in the fraud and 17 were "substandard audit", of the 10 identified with the Big Eight/Six firms one represented an actual involvement and the other 9 "substandard audit." Once again I found that analysis incredible in light of the nature and auditor involvement in the catalog of cause-celebra which were spread on the pages of the business media and court dockets. In sum, the professors did an extraordinarily competent job in their arithmetic recycling of the garbage that was dumped into the SEC's AAER pit; however, they failed to realize that contrary to their presumption the Releases did not represent, "...one of the most comprehensive sources of alleged cases of financial statement fraud in the United States."

Be that as it may the nicely scented garbage thus collected was then packaged most colorfully and provided with an appropriate cache and is being disseminated by the American Institute of Certified Public Accountants on behalf of the others in the COSO consortium.

To respond to the conclusions reflected by table 16 of the report I undertook an independent analysis of the 962 AAERs promulgated during the 1987-1998 span, hence, 82 AAERs in addition to those subjected to the study by the three professors so as also to include the releases promulgated during 1998.

My probe identified a total of over 131 Releases directed against the audit firms and members of the audit firms targeted by the releases. Of these 23 involved the Accounting Pentagon, of which only two, release no. 655 (March 1'S, 1995) and 994 (December 4, 1997), were directed against the firms per se: Ernst & Young in its audit of the Republic Bank Corporation, and KPMG in the matter of BayMark. That against Ernst & Young related to inappropriate financial dealings between the Bank and partners of the firm. That against KPMG stemed from the firm's aborted creation of an underwriting affiliate; that last has, in fact, been overwhelmed by an enormous factor by the recent billion-dollar liaison formed between the firm and Cisco Systems. The remaining releases involving the Accounting Oligopoly were directed as follows:

Other than Savin and Transmark I defy the reader to identify any of the high profile cases that were spread on the pages of our various business journals. Absent from the roster identified with the major accounting firms are such fiascoes as: Phar-Mor, Crazy Eddie, Colonial Realty, Jamaica Water and Power. I turn to release No. 582 promulgated on August 17, 1994 for special study; according to that release captioned in the Matter of Donald F. Withers:

Withers caused Coopers & Lybrand to issue audit reports containing unqualified opinions on Transmark's financial statements for the years ended 1985, 1987, 1988, and 1989 . . . Withers engaged in improper professional conduct by causing Coopers & Lybrand to misstate in these audit reports that Transmark's financial statements were presented in conformity with GAAP and that the audits had been concluded in accordance with GAAS. Specifically: (1) Withers failed to obtain sufficient competent evidential matter to afford a reasonable basis for Coopers & Lybrand's opinion on Transmark's financial statements: (2) Withers failed to exercise due professional care in the performance of the audit; and (3) Withers caused Coopers & Lybrand to issue unqualified opinions on Transmark's financial statements which stated that the audit was performed in accordance with GAAS, when Withers had failed to meet prescribed auditing standards."Withers caused?" Rubbish! By way of background, the fraud here involved was rooted in the financial statements of Guarantee Security Life Insurance ("GSL"), the principal subsidiary of Transmark. As it happened, I became intimately familiar with that GSL fiasco; my article describing the fraud, "Junkie Juggling Act" appeared in Baryons, April 6, 1992, and then on April 29 I testified before Senator Sam Nunn's Permanent Subcommittee on Investigation.

At the core of the fraud, were annual phantom transactions between GSL and Merrill Lynch, whereby, as of December 31 of each year, GSL appeared to have sold to Merrill Lynch the hundreds of millions of dollars of junk bonds in its portfolio, and concurrently appeared to have bought a corresponding amount of Treasury's. As of the first day of the new year, these phantom sales/purchases were reversed, the objective of all this fakery was to avoid a 20 percent mandatory security loss reserve which would have been required against the year end junk-bond portfolio; such a reserve would have rendered GSL insolvent. All this I asserted was unquestionably recognized by Withers.

There is no question but that Withers failed in his professional undertaking; in fact, in my view, he should consider himself lucky that the SEC proceedings ended with a "consent decree"; in various contexts I have stated that in an earlier day even lesser transgressions would have involved the alleged miscreants in criminal proceedings.

But now going back to "Withers caused"--what nonsense! How could Withers cause Coopers & Lybrand to do anything Coopers & Lybrand was not inclined to do? Remember, C&L is infinitely larger and greater than Withers. Nor did he keep his agonizing concern regarding the issues confronting him secret from his colleagues. They were aware of what was troubling him and, to the extend they had any concern they might well have put enough red flags into the file so as to prevent any "rogue partner" from doing anything inconsistent with C&L's standards. Further, where was the "second partner review" required before C&L subscribed to the reports? As I testified before the Senate Committee (note 1):

Here there is absolutely no question ...that the Coopers & Lybrand people saw and realized that those yearend transactions were fake and flaky. But probably even more grievously, C&L's highest authority on the issues at hand, John Baily, Chairman of the Insurance Industry group at Coopers and Lybrand and at that time Chairman of the American Institute of Certified Public Accountants Insurance Companies Committee, testified before Senator Nunn's Committee that the procedures implemented by Withers were entirely consistent with what that expert believed to be appropriate, thus (note 2):

When we look at statutory accounting-and one of the key terms that I haven't really heard this morning is accounting practices prescribed or permitted. And I would underline the permitted, because in much of statutory accounting today it's what's permitted. What we have the regulators allowed-because of different circumstances, because of their own judgements in working with companies?

When the accountants, when the auditors, when the insurance companies, and yes, even the state, look at what is statutory, they sort through and it's interspersed among laws, regulations, which are in more detail or less detail in some States ...and on. And one of the thing that's part of that framework is what's allowed in examination and what do other companies do in the State. And that's a key, because each State has some differences.

The accountant's opinion itself is based on what's prescribed or permitted. And yes, the regulators have permitted some things because they've tried to work with the companies. It might be inferred from his testimony that if a company or its auditors could, somehow, somewhere come up with a particular accounting practice, it could be applied even if it produces patently false and misleading financial statements. Without in anyway, or to any degree, condoning Withers' conduct I believe that he was proceeding with what he believed to be the "tone at the top" at C&L. And I lament that "tone" especially at C&L. Thus, from my testimony before the Committee (note 3) (ellipses omitted):

. . . principal area of presentation has to do with my commentary regarding the role and the responsibility of the ostensibly independent auditors in this particular sorry saga, namely the firm of Coopers and Lybrand, a firm that I have 'know and respected in many different ways over the past half century of practice, having known their traditional leaders of the firm over the years, it's a very great, fine, responsible firm.Now where is it that I maintain the distinguished firm of Coopers and Lybrand failed so grievously? I maintain that they have desecrated their professional covenant with society. There is a covenant which gives us this professional stature which provides so much of our material and psychic benefits.

Where is it that I say Coopers and Lybrand particularly should not have been in this particular context? I refer to a phrase or a statement by one of their founders, Robert Montgomery. The firm, at one time, was known as Lybrand, Ross Brothers & Montgomery, some 60-some-odd years ago. Colonel Montgomery said it is the auditor's responsibility to fight the figures and find the facts and to assemble the figure and to set them forth truthfully so that all who run can read.

In sum: note how Withers was "left out there hanging, high and dry," while C&L goes unscathed, at least insofar, as the SEC's published bans are concerned. By correspondence with Professor Mark Beasley (note 4) I was informed that the Release against Withers was, in fact, included in table 16, categorized as "substandard audit" rather than "apparent involvement." Given the circumstances involved in this fraud, I challenged the professors to rationalize their judgment call that this was merely "substandard audit" rather than "apparent involvement." There were other AAERs involving high profile accounting fraud cases including:

Despite their "high profile," in none of these cases did the SEC proceed against the audit firms, i.e., those which I identified parenthetically above. Thus, the SEC appears to be oblivious of such critical questions as: "Where were the auditors? " "Where should they have been?" This despite the fact that the auditors in the Lincoln S&L fiasco were, for example, sharply criticized by U.S. District Judge Stanley Sporkin, and were required to pay hundreds of millions of dollars to settle various matters in the litigation.... Also in the action involving JWP U.S. District Judge, William C. Commer, observed (note 5):

In this case, E&Y's deficiency was not in the planning or execution of its annual audits. They were sufficiently thorough and effective to uncover virtually of the violations of GAAP which were ultimately correct in the restatements or which have been asserted by plaintiff's expert, Dr. Linvingstone. Instead E&Y's failure lay in the seeming spinelessness of John LaBarca and the other E&Y accountants in their dealings with JWP, and particularly with its CFO, Ernest Grendi. When they met to discuss E&Y's annual Summary of Audits Differences, Grendi almost invariably succeeded in either persuading or bullying them to agree that JWP's books required no adjustment. Part of the problem was undoubtedly the close personal relationship between Grendi and LaBarca. Grendi had been a partner of LaBarca in E&Y's predecessor firm and they continued to be good friends, regularly jogging together in preparation for the New York City Marathon.

For whatever reason, the record suggests that, in their confrontations with Grendi, LaBarca and his associates exhibited a level of tolerance and timidity inappropriate for an independent auditor. The "watch dog" behaved more like a lap dog. Obviously, an audit becomes a pointless exercise if the auditor, after discovering substantial errors in a publicly owned company's financial statements, supinely acquiesces in the client's refusal to correct the errors and certifies the statements anyway. And then there are those high profile accounting fraud situations where the SEC appears to have been completely oblivious of their accounting and auditing ramifications including:

Despite the extensive published commentaries on these high profile cases the auditors escaped the obloquy from the SEC at least insofar as AAERs are concerned. Farmer's Cooperative of Arkansas & Oklahoma is especially noteworthy. After a jury determination that Arthur Young was liable for $6.2 million of civil damages, the firm was constrained to defend itself before the US Supreme Court on a complaint alleging that it was also liable for additional damages under the Racketeer Influenced and Corrupt Organization Act ("RICO"). The firm prevailed by a 7 to 2 decision on the grounds that the auditors involvement did not meet "the conduct or participate" threshold test of the Act (note 6). Nonetheless, the Accounting Establishment was sufficiently "shook up" by this litigation so as to lobby successfully for a provision in Private Securities Litigation Act of 1995 so as to explicitly put independent auditors beyond the reach of RICO. Also evidencing the SEC's benign neglect in proceedings against audit firms we have a commentary by Melvyn Weiss, a leading securities class-action plaintiff's attorney (note 7):

Recently, my firm and I acted as a lead counsel in most of the Drexel Burnham Lambent and Michael Milken cases. Those included, among others, lawsuits brought on behalf of the people who are alleged to have been defrauded in such cases as the Lincoln Savings & Loan case in Phoenix (the Keating case), the Columbia Savings & Loan case in Los Angeles, the Integrated Resources case in New York, and the Executive Life cases in Los Angeles. These were among the financial institutions that regularly traded junk bonds issued by Drexel. We referred to such institutions as part of a "daisy chain" created by Milken to buy Drexel-underwriten junk bonds and to create an illusion of liquidity in that market. One accounting firm audited six of the major daisy chain entities. Those entities did not mark their junk bonds to market. They carried them at cost despite the low credit ratings of the bond issuers. Then, of course, when Drexel went under and could not continue to support the market, most of the bonds collapsed in price, many of the issuers failed, and the buyers of the bonds, including the savings and loans and insurance companies in the daisy chain, went under and society lost billions.

There are many more cases in which my firm and others like us have represented defrauded investors. Cascade, ZZZZ Best, BCCI, Coated sales, VMS and Crazy Eddie are some names that may be familiar. At times -- such as the recent situation involving Phar-Mor, a pharmaceutical firm that was cooking books - my firm will be retained to bring suit against the auditor son behalf of the company itself, usually after new management has been brought in or a bankruptcy trustee has taken over. The cases I just referred to represent symptoms of an epidemic of blown audits. In this environment and with such a history of consistent audit failures, it is fascinating to me that the Big Six accounting firms have formed a coalition to complain about being sued too often.

To round out this analysis, the accompanying Appendix provides a roster of the 141 AAERs directed against CPAs or CPA firms other than the Big Eight/Six Five, for their alleged involvements in auditing irregularities. A "quick and dirty" scanning of that list discloses but a scant few which might be dubbed "high profile," e.g., ZZZZ Best, Towers Financial, Bevill, Bresler & Schulman, Chambers Development. A corresponding scanning discloses handful firms, which might be recognized as "high profile firms" e.g., KMG Main Hurdman, Frederic S. Todman, Fox & Company, Grant Thornton, Leventhol & Horwath.

In sum, putting it all together, the AAER archives could not conceivably be presumed to be the "...one of the most comprehensive sources of alleged cases of financial statement fraud in the United States."

Turning to 1999: On January 14, 1999, the SEC promulgated AAER No. 1098 in the Matter of PricewaterhouseCoopers LLP. This release did not involve any accounting irregularities, per se; instead, the firm was targeted because during 1996 through 1998 members and retirement plans of Coopers & Lybrand were investing in the securities of the firm's audit clients. What penance was imposed on PwC? From the release,

"PwC is hereby censured. PwC undertakes that it will take measures which it determines will be designed to provide reasonable assurance that it will comply with GAAS and Rule 2-O 1(b) of Regulation S-X requiring that public accounting firms be independent, in fact and appearance, of their audit clients. . ."There then followed a nexus of prophylactic procedures to undertaken by the firm, concluding with:

PwC further undertakes, pursuant to agreement with the Commission and not pursuant to Rule 102(e), to establish within 30 days a fund of $2.5 million to be used within 12 months, in a manner not unacceptable to the Commission staff, for programs) to further awareness and education throughout the profession relating to the independence requirements for public accounting firms."That monetary penalty works out to about $800 per PWC partner pretax -- just about enough to buy some vintage champagne to toast to third millennium.

Then, too, in AAER No. 1140 (June 30, 1999) the SEC found the senior management at W.R. Grace with their hands in a "cookie jar." Thus, some time in 1991 a significant subsidiary of Grace, National Medicare Care, Inc. ("NMC"), was confronted with an embarrassment of riches, i.e., earnings in excess of the amounts required to satisfy the expectations of Wall Street. Accordingly, it created the cookie jar loaded with so-called "excess reserves" -- cookies that were then fed into lean years. As the SEC saw it these practices induced "materially false filings" by smoothing the earnings of NMC "to bring the reported earnings of the Health Care Group in line with Grace's target earnings."

What was the penalty that was "to fit the crime"? "To establish within 30 days a fund of 1 million to be used within 12 months ... for programs) to further awareness and education relating to financial statements and generally accepted accounting principles." By my sights that was a cheap price to pay for absolution.

But then concurrently the SEC promulgated AAERs No. 1141 and No. 1142 involving Eugene Gaugham, CPA and Thomas Scanlon, CPA, respectively -both partners of Price Waterhouse. According to the SEC both partners were aware of the creation of the cookie jar and the reason for its creation; nonetheless, they capitulated to Grace's management rationalizing their acquiescence on the basis of "materiality".

What penalty was exacted from Messrs. Gaugham and Scanlon? The respondents were ordered "...to cease and desist from causing any violation and any further violation of Sections

13(a) and 13(b) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder." Who is not required to correspondingly "cease and desist"?

But of transcendent import in this context note how the firm PricewaterhouseCoopers is permitted to go scot-free. For shame!

Was there ever "a golden age" when things were different at the SEC? From the vantage point of the end of the millennium it might appear that there was such a time during the Nixon-Ford Administration, when Stanley Sporkin was the Director of the SEC Enforcement Division and John C. "Sandy" Burton was the Commission's Chief Accountant. Thus on July 2, 1975 the SEC promulgated Accounting Series Release ("ASR") 1 No. 173 directed against Peat Marwick Mitchell for that firm's sins of omission and commission in: National Student Marketing, Republic National Life Insurance Co., Penn Central, Stirling Homex and Talley. Industries. What sanctions were imposed on PMM? According to the release:

1. A review of PMM's audit practices will be conducted by a committee composed of persons agreed upon by PMM and the SEC. Follow-up reviews are to be carried on in the two succeeding years.

2. For the six-month period of May through October 1975, PMM is prohibited from accepting new engagements (with some exceptions) calling for SEC filings.3. PMM consents to the entry of orders of injunction in the four civil actions previously instituted by the Commission (i.e., NSM, Penn Central, Talley, and Republic National). Thus, PMM may not repeat its naughty deeds.

4. PMM will review and improve its operating practices.1 The predecessor series to the AAER....

By present standards that judgement would appear to be nothing short of draconian... nonetheless, when commenting on ASR No. 173 in my The Truth About Corporate Accounting (Harper and Row, 1981) I observed:

If it had been John Jones who had perpetrated but a scintilla of what that firm had done, would he even be permitted to affix his signature to another set of financial statements for filing with the SEC? Would he even be permitted to retain his right to call himself a certified public accountant-much less presuming to be prestigious? Could he (or anyone associated with his firm) aspire, much less succeed, to the chairmanship of the entire American Institute of CPA's and the chairmanship of the giant-firm section (SEC-Practice Section) of the AICPA? [I was there referring Walter Hanson, who was then a managing partner at PMM.] Ironically, as this article is being "put to bed" (at the advent of Y2K) the Chairman of the AICPA happens to be a member of KPMG's (nee the ASR's PMM hierarchy)...

But then back in 1975 no one could possibly have conceived that the head of the American Institute of Certified Public Accountants would permit his firm to sell out its birthright as professionals for a mere billion dollars. To my mind the conduct of KPMG and other major firms, which are correspondingly oriented, are perpetrating acts most discreditable to accountancy as a profession....

This has been a double-barreled critique. The first was directed against the COSO study, especially because the research team had followed the "red herring," i.e., that the AAERs "...represent one of the most comprehensive sources of alleged cases of financial statement fraud in the United States." The second was against the SEC for having created that "painted kipper."

But let us not be too harsh on the SEC; the Commission and its staff are undoubtedly doing the best they can with the limited resources made available to them for their herculean undertakings. This SEC condition is undoubtedly motivated by antigovernment obsession which presently prevails in our nation, and which is especially aggressive in our Congress. For example, from the New York Times article captioned "House Cuts Could Force S.E.C. layoffs" of August 3, 1999:

At a time when record numbers of Americans are investing their money and their trust in the stock and bond markets, a house panel has recommended a budget for the nation's top securities regulator next year that would require it to cut its workforce by 10 percent.Also from the lead article on page one of the Wall Street Journal on October 11, 1999 captioned "As Huge Changes Roil the Market, Some Ask: Where is the SEC?" (ellipsis omitted):

The nation's top market regulator is faced with a growing list of urgent issues to resolve: Devise a way to integrate new electronic exchanges with traditional stock markets; protect Internet investors from hucksters; ensure that the privatization of the biggest stock markets doesn't hinder regulatory oversight.

No one argues that the task is easy. The agency has been hampered by turnover of key staffers departing to more lucrative careers on Wall Street. The SEC has had a hard time getting the funds it says it needs from Congress. And the markets are transforming so quickly that even the most sophisticated financial powerhouses are bewildered by the pace of change - as evidenced by their investments in numerous, often competing, trading systems.

Meanwhile, the SEC is beset by a unionizing drive, led by workers disgruntled by low pay and soaring workloads. And attrition is way up.

But with the future of the markets at stake, Congress has signaled that it is determined to go its own way: Both the House and Senate are planning new legislation this year aimed at paring securities regulation. And in the Senate, the SEC faces a powerful adversary in Sen. Phil Gramm, who is now chairman of the Senate Banking Committee, which oversees the SEC.

Alas, Chairman Levitt and his cohorts are destined to continue with their speech making full of sound and fury, signifying a great, great deal-only to have their fragrance wasted on aired air of the prevailing politicized pragmatism....

http://aux.zicklin.baruch.cuny.edu/critical/Garbage.htm

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