After the scandals at Enron and WorldCom, a lot of people and investors are asking: Are there a lot more companies out there with serious accounting problems?
The answer is yes, and the reason is pretty simple. The large number of corporations who have switched auditors in the wake of the Enron scandal has created a climate in which new auditors are correcting the mistakes of their predecessors - mistakes that might have gone unnoticed otherwise.
On July 31, FBI Special Agent Paul J. Higgins swore out a complaint against Scott Sullivan and David Myers of WorldCom. The complaint charges Sullivan and Myers with securities fraud.
When one auditing firm takes over a client from another auditing firm, it gets one free whack, one chance to clean up mistakes in accounting methods and estimates. In the first year, the new firm can blame poor estimates and accounting on the guy it took over from because the mistakes aren't its own. The new auditors know where to look for the mistakes because they might have clients with similar problems.
But once the auditing firm is on the job for a year, if mistakes become public, they look bad; they can't blame them on the guy who did the audit last year because they did the audit last year. After an auditor has blessed the books and accepted the accounting methods, if one of the accounting methods turns out to be wrong, the auditors have an incentive to work with the company to correct the problem gradually. Over several years, the big problem can be made smaller, so the correction of the problem is more likely to escape notice. No one looks bad, everybody is happy, and - in a few years - the books are correct.
Usually very few big companies change auditing firms in any one year. This year, with Arthur Andersen going away after the Enron mess, there is an unprecedented number of firms switching auditing firms. Put another way, there is a huge number of firms exposing themselves to one free whack. Rather than smoothing out the problems over several years, big corrections are being made now.
The WorldCom case is a good example of accounting estimates and methods gone wrong.
KPMG took over WorldCom from Arthur Andersen. KPMG told WorldCom's internal auditors to check the capital accounts - the best place to park expenses you don't want to recognize.
KPMG's one free whack at WorldCom uncovered a huge problem that WorldCom was on the verge of fixing over the next several years. Had WorldCom been allowed to smooth it out, and had its sales in future years increased, the company might have been able to hide the problem.
Most long-distance phone companies pay local phone companies a fee for the use of connections to customer homes. Usually this is a on a per-minute basis; the more minutes the long-distance company's customers talk to the customers of a local phone company, the higher the fee. WorldCom called these fees "line costs." Historically, according to the indictment, WorldCom paid to local phone companies about 42 cents of every dollar it charged its customers.
But when WorldCom was growing, it got a great idea. It decided to pay a fixed fee to local phone companies rather than a per-minute charge for minutes actually used. The local phone companies knew that WorldCom was growing rapidly, so they wanted a fixed fee that was higher in the current year than what WorldCom would have paid on a per-minute basis. WorldCom figured that in later years, as its business grew, it would be paying less per minute than it was now.
This idea is similar to a variable-rate mortgage on your home versus a fixed-rate mortgage. With a variable-rate mortgage, as mortgage rates go up or down, your rate follows. With a fixed-rate mortgage, the bank can never raise the rate, even if interest rates go up. In the first case, you take the risk of rising interest rates. In the second case, the bank takes that risk (and the customer takes the risk of falling rates). Because the bank is taking the risk of higher interest rates, the bank will charge you a higher rate for a fixed-rate mortgage.
So WorldCom paid a higher fixed fee for line costs than it was paying on a per-minute basis, figuring that as its business grew, it would end up paying less per minute because local companies could not charge more even though it would be using more time.
This is where the indictment says Sullivan and Myers got creative. They figured that 42 cents per dollar is what the line costs should be. Let's say that on a fixed-fee basis, they were paying about 50 cents per dollar. But based on the past growth of WorldCom's business, in five years the company might be paying, say, 30 cents or less per dollar. Therefore, rather than expensing the 50 cents per dollar, they took eight cents of every dollar and changed it from an expense to an asset. They re-named some line costs "other assets," "transmission equipment," "communications equipment," "furniture," and "construction in progress." This re-naming of some line costs lowered the total to 42 cents per dollar, and because that was the historical norm, no outsider noticed anything.
According to the indictment, the re-naming involved billions of dollars. There were $629 million of other assets that weren't there. There was $1.7 billion of transmission equipment that wasn't there. There was $717 million in communications equipment that wasn't there. There was $85 million in furniture that wasn't there. There was $702 million in construction in progress that wasn't there.
If WorldCom's call volume had increased, it could have reversed these entries, and the scheme might never have come to light. The problem is that WorldCom's volume never went up.
Sullivan and Myers were now caught with massive nonexistent assets on their books. Then Enron collapsed. Then Arthur Andersen collapsed. Then Arthur Andersen couldn't continue as WorldCom's auditor. Then KPMG got WorldCom as a client. Then KPMG took its free whack. That is when the $3.8-billion ball got knocked out of the park.
Who gets whacked next? Follow the former Arthur Andersen clients.
Mike LoGuidice is a forensic accountant and the Reader's art critic.
On July 31, FBI Special Agent Paul J. Higgins swore out a complaint against Scott Sullivan and David Myers of WorldCom. The complaint charges Sullivan and Myers with securities fraud.
When one auditing firm takes over a client from another auditing firm, it gets one free whack, one chance to clean up mistakes in accounting methods and estimates. In the first year, the new firm can blame poor estimates and accounting on the guy it took over from because the mistakes aren't its own. The new auditors know where to look for the mistakes because they might have clients with similar problems.
But once the auditing firm is on the job for a year, if mistakes become public, they look bad; they can't blame them on the guy who did the audit last year because they did the audit last year. After an auditor has blessed the books and accepted the accounting methods, if one of the accounting methods turns out to be wrong, the auditors have an incentive to work with the company to correct the problem gradually. Over several years, the big problem can be made smaller, so the correction of the problem is more likely to escape notice. No one looks bad, everybody is happy, and - in a few years - the books are correct.
Usually very few big companies change auditing firms in any one year. This year, with Arthur Andersen going away after the Enron mess, there is an unprecedented number of firms switching auditing firms. Put another way, there is a huge number of firms exposing themselves to one free whack. Rather than smoothing out the problems over several years, big corrections are being made now.
The WorldCom case is a good example of accounting estimates and methods gone wrong.
KPMG took over WorldCom from Arthur Andersen. KPMG told WorldCom's internal auditors to check the capital accounts - the best place to park expenses you don't want to recognize.
KPMG's one free whack at WorldCom uncovered a huge problem that WorldCom was on the verge of fixing over the next several years. Had WorldCom been allowed to smooth it out, and had its sales in future years increased, the company might have been able to hide the problem.
Most long-distance phone companies pay local phone companies a fee for the use of connections to customer homes. Usually this is a on a per-minute basis; the more minutes the long-distance company's customers talk to the customers of a local phone company, the higher the fee. WorldCom called these fees "line costs." Historically, according to the indictment, WorldCom paid to local phone companies about 42 cents of every dollar it charged its customers.
But when WorldCom was growing, it got a great idea. It decided to pay a fixed fee to local phone companies rather than a per-minute charge for minutes actually used. The local phone companies knew that WorldCom was growing rapidly, so they wanted a fixed fee that was higher in the current year than what WorldCom would have paid on a per-minute basis. WorldCom figured that in later years, as its business grew, it would be paying less per minute than it was now.
This idea is similar to a variable-rate mortgage on your home versus a fixed-rate mortgage. With a variable-rate mortgage, as mortgage rates go up or down, your rate follows. With a fixed-rate mortgage, the bank can never raise the rate, even if interest rates go up. In the first case, you take the risk of rising interest rates. In the second case, the bank takes that risk (and the customer takes the risk of falling rates). Because the bank is taking the risk of higher interest rates, the bank will charge you a higher rate for a fixed-rate mortgage.
So WorldCom paid a higher fixed fee for line costs than it was paying on a per-minute basis, figuring that as its business grew, it would end up paying less per minute because local companies could not charge more even though it would be using more time.
This is where the indictment says Sullivan and Myers got creative. They figured that 42 cents per dollar is what the line costs should be. Let's say that on a fixed-fee basis, they were paying about 50 cents per dollar. But based on the past growth of WorldCom's business, in five years the company might be paying, say, 30 cents or less per dollar. Therefore, rather than expensing the 50 cents per dollar, they took eight cents of every dollar and changed it from an expense to an asset. They re-named some line costs "other assets," "transmission equipment," "communications equipment," "furniture," and "construction in progress." This re-naming of some line costs lowered the total to 42 cents per dollar, and because that was the historical norm, no outsider noticed anything.
According to the indictment, the re-naming involved billions of dollars. There were $629 million of other assets that weren't there. There was $1.7 billion of transmission equipment that wasn't there. There was $717 million in communications equipment that wasn't there. There was $85 million in furniture that wasn't there. There was $702 million in construction in progress that wasn't there.
If WorldCom's call volume had increased, it could have reversed these entries, and the scheme might never have come to light. The problem is that WorldCom's volume never went up.
Sullivan and Myers were now caught with massive nonexistent assets on their books. Then Enron collapsed. Then Arthur Andersen collapsed. Then Arthur Andersen couldn't continue as WorldCom's auditor. Then KPMG got WorldCom as a client. Then KPMG took its free whack. That is when the $3.8-billion ball got knocked out of the park.
Who gets whacked next? Follow the former Arthur Andersen clients.
Mike LoGuidice is a forensic accountant and the Reader's art critic.
