On January 12, 1999, McKESSON CORPORATION, a large health care supply firm, paid $12 billion to acquire HBO & COMPANY, a leading producer of health care-related software. (Note: To avoid confusion, be aware that HBO & Company is not connected with HBO, the cable channel.) On April 22, 1999, the combined company, called McKESSON HBOC, announced that preliminary calculations indicated that income for that year ended March 31, 1999, was $237.1 million. A few days later, a staff auditor from DELOITTE & TOUCHE, performing a routine confirmation of accounts receivable, was surprised to hear from a customer that a $20 million sale reported by the HBO division had never taken place. It was soon learned that $42 million in sales reported by HBO should not have been recognized. When this information was announced to the financial press by McKesson HBOC in April 28, 1999, the company’s stock price dropped from $65 5/8 to $34 7/16 in one day; this 47.5% drop represented a market value loss of $8.8 billion.
Further investigation revealed that the accounting improprieties at McKesson HBOC were much more widespread that originally suspected. On May 25, 1999, the company revealed that further earnings restatements would be announced in the future. On July 14, 1999, when McKesson HBOC filed its 10-K with the SEC, it was revealed that net income for the year ended March 31, 1999, was not $237.1 million, as announced earlier, but was actually $84.9 million. The final amount of overstated revenue in the HBO division was $327 million, which was spread over the preceding three years.
The HBO revenue overstatements, which appear to have been the work of top managers of HBO (five of whom were fired by McKesson HBOC on June 21, 1999), were accomplished in the following ways.
· Side letters. Great pleasure was put on HBO salespeople in order for the company to meet its revenue targets. To get wavering customers to close deals, the sales people would promise that the customer could cancel the deal in the future if it was unable to obtain financing, if its boar of directors didn’t approve, or even if it just changed its mind. The terms of these conditional agreements were written up in letters that were kept in files separate from the sales “orders”.
· Backdating. In order to meet quarterly revenue targets, sales orders in the first couple of weeks of a new quarter were backdated so that they would boost reported revenue in the preceding quarter.
· Advanced recognition of future sales. At the time of an original software sale, HBO would sometimes recognize revenue for both that sale and for all future upgrades. Often, these expected future upgrades did not even exist at the time the revenue was recognized.
For accountants and auditors, the McKesson HBOC case stirs memories o the famous McKesson & Robbins fraud of 1937. For fiscal 1937, McKESSON & ROBBINS, the predecessor of McKesson HBOC, reported total assets of $87 million included $10 million in nonexistent inventory and $9 million in fictitious receivables. The fraud was perpetrated by the top managers of McKesson & Robbins and involved phony purchases from and sales to dummy Canadian companies, which were actually just empty offices staffed by secretaries who forwarded mail.
The well-published McKesson & Robbins fraud spurred the auditing profession to adopt two auditing standards that are still followed today.
1. The physical existence of inventory must be confirmed through direct observation. This simple procedure applied in the McKesson & Robbins case would have revealed that the reported purchases from the Canadian suppliers were phony.
2. The existence and accuracy of reported receivables must be independently confirmed by contacting a sample of the parties who allegedly owe the money. Sixty-two years after the original McKesson & Robbins scandal, this simple procedure, applied by a staff auditor at Deloitte & Touche, uncovered the modern-day McKesson HBOC fraud.
Sources: Elizabeth McDonald, “The Ghost of Scandal Past,” The Wall Street Journal, June 30, 1999, p. B1.
Ralph T. King, Jr., “McKesson Restates Income Again as Probe of Accounting Widens,” The Wall Street Journal, July 15, 1999, p. A1.
10-K Filing of McKesson HBOC for the year ended March 31, 1999.
Monday, June 25, 2007
Qualified Audit Opinions in China
The need for external independent auditors arises because potential creditors and investors are naturally suspicious of the financial reports prepared by company managers. Managers have incentives to favorably bias the reported numbers such as to make it easier to get loans, to attract investors, and to increase their own bonuses and job advancement opportunities .An independent auditor increases the reliance that external users can place on the management prepared financial statements.
Before the 1990s, there was no need for external auditors in China. When all companies in China were owned by the state and managed by central planners in Beijing, company financial statement were view as confidential government documents not available to outsiders. There was no need for independent external auditors because there were no external financial statement users. The economic reforms of the 1980s resulted in decentralization of the ownership of the Chinese state-owned enterprises (SOE).The demand for external audits of Chinese companies increased dramatically with the establishment of the Shanghai and Shenzhen Stock Exchanges, in 1990 and 1991,respectively.
In response to this demand for the independent certification of the financial statements of publicly traded companies, in 1995 the Chinese government adopted a more rigorous set of auditing standards to be followed by Chinese CPA firms. Before these standards were enacted, qualified public auditors were rare and were not publicly announced. The first publicly announced audit qualification under the new standards was published in the Shanghai Securities Journal on February 15,1996. (Note: In China ,all listed companies are required to print their annual report and auditor’s opinion in one of seven designated newspapers.)On this date ,YANZHONG ENTERPRISES, a Shanghai-based conglomerate, revealed that its auditor, DA HUA CPA, had qualified the audit report for the 1995 financial statements .The reason for the qualification was that YANZHONG had misclassified investment gains and interest income as part of operating income and refused to revise the presentation. The reaction to this audit qualification was rapid and negative-The DA HUA CPA firm received many phone calls asking whether Yanzhong was on the verge of bankruptcy. Overall, for the ninety-six Chinese audit qualifications announced in 1996, 1997, 1998, the average loss in company market value was 2% in the three days surrounding the qualifications announcements
Source:Charles J.P.Chen,Xijia Su,and Ronald Zhao,”An Emerging Market’s Reaction to Initial Modified Audit Opinions:Evidence from the Shanghai Stock Exchange,” Contemporary Accounting Research,October 2000
Before the 1990s, there was no need for external auditors in China. When all companies in China were owned by the state and managed by central planners in Beijing, company financial statement were view as confidential government documents not available to outsiders. There was no need for independent external auditors because there were no external financial statement users. The economic reforms of the 1980s resulted in decentralization of the ownership of the Chinese state-owned enterprises (SOE).The demand for external audits of Chinese companies increased dramatically with the establishment of the Shanghai and Shenzhen Stock Exchanges, in 1990 and 1991,respectively.
In response to this demand for the independent certification of the financial statements of publicly traded companies, in 1995 the Chinese government adopted a more rigorous set of auditing standards to be followed by Chinese CPA firms. Before these standards were enacted, qualified public auditors were rare and were not publicly announced. The first publicly announced audit qualification under the new standards was published in the Shanghai Securities Journal on February 15,1996. (Note: In China ,all listed companies are required to print their annual report and auditor’s opinion in one of seven designated newspapers.)On this date ,YANZHONG ENTERPRISES, a Shanghai-based conglomerate, revealed that its auditor, DA HUA CPA, had qualified the audit report for the 1995 financial statements .The reason for the qualification was that YANZHONG had misclassified investment gains and interest income as part of operating income and refused to revise the presentation. The reaction to this audit qualification was rapid and negative-The DA HUA CPA firm received many phone calls asking whether Yanzhong was on the verge of bankruptcy. Overall, for the ninety-six Chinese audit qualifications announced in 1996, 1997, 1998, the average loss in company market value was 2% in the three days surrounding the qualifications announcements
Source:Charles J.P.Chen,Xijia Su,and Ronald Zhao,”An Emerging Market’s Reaction to Initial Modified Audit Opinions:Evidence from the Shanghai Stock Exchange,” Contemporary Accounting Research,October 2000
Arthur Andersen and the Enron Case
The firm ARTHUR ANDERSEN audited the financial statements of Enron (and gave it an unqualified opinion) for each year of its existence, from 1985 through 2000. In the wake of the Enron scandal, investors, regulators, and the public desired answers to three questions with respect to Arthur Andersen and Enron:
- Did Arthur Andersen's audit team know about Enron's controversial accounting issues, particularly the special-purpose entities (SPEs)?
- Did Arthur Andersen employees help Enron set up these SPEs?
- Why did employees of Arthur Andersen shred Enron-related documents?
Did Arthur Andersen Know?
Yes. For example, on February 5, 2001, partners of Arthur Andersen met to discuss Enron. The partners were concerned about the Enron SPEs, particularly the active involvement of Enron's CFO in the SPEs. The partners agreed that their concerns should be shared with Enron's board of directors. A board meeting was held the next week (on February 12), with representatives of Andersen in attendance, but the minutes do not indicate that they shared any of the SPE concerns. In fairness to Andersen, notwithstanding its shocked protestations to the contrary, many parties outside Enron had known of these SPEs for years. In particular, a number of Wall Street investment firms were investors in the SPEs (along with Enron's CFO) and thus had inside information about how the SPEs were structured. These investment firms included GE CAPITAL, J.P. MORGAN CAPITAL, MERRILL LYNCH, and MORGAN STANLEY.
Did Arthur Andersen Help?
Yes. The following comes from an internal Enron investigation conducted in early 2002: “From 1997 to 2001, Enron paid Andersen $5.7 million in connection with work performed specifically on the LJM and Chewco transactions.” The LJM and Chewco transactions were the most prominent of the SPEs involved in the Enron accounting scandal. Again, out of fairness to Arthur Andersen, it should be noted that advisory work on difficult accounting issues is a service that all accounting forms have been providing to their clients for years. This is a valuable service because it allows all U.S. companies to take advantage of the technical expertise developed by the large audit firms.
Why Did Andersen Shred?
The shredding was in compliance with Andersen’s existing document policy, which allowed and even encouraged the disposal of all peripheral documents not forming part of the formal audit workpapers. This policy was consistent with the practice o the other large audit firms, reflecting the impossibility of keeping every draft memo, email message, and to-do list generated as part of a complex audit. Andersen’s document policy also stated that, when Andersen was served a subpoena with respect to a certain audit engagement, no further documents or files could be disposed of. In the case of Enron, this two-faceted document policy was followed to the letter by Arthur Andersen—the shredding began in earnest on October 23, 2001, apparently in response to news of an SED investigation of Enron’s accounting practices, and the shredding stopped on November 9, one day after Andersen received a subpoena for its Enron-related documents. In retrospect, the document shredding undertaken by Andersen employees was $10 billion mistake. Without the sleazy image of cover-up conveyed by the news that Andersen employees had shredded at least 50 trunks and boxes of documents. Andersen would probably have escaped the Enron debacle with just a harsh reprimand from the SEC and, probably, a large settlement payment (around $1 billion) to Enron shareholders. Instead, the document shredding led to Andersen’s indictment on obstruction of justice charges, and the subsequent loss on credibility caused a rapid exodus of Andersen’s clients, blasting the prospects of a venerable accounting partnership that had previously had an aggregate value to the partners almost surely in excess of $10 billion.
Sources: Memo from Michael D. Jones to David B. Duncan and Thomas H. Bauer; subject: Enron retention meeting, February 6, 2001.
William C. Powers, Jr., Raymond S. Troubh, and Herbert S. Winokur, Jr., “Report of Investigation by the Special Investigate Committee of the Board of Directors of Enron Corp.,” February 1, 2002.
Email message from Nancy A. Temple to Michael C. Odom; subject: Document retention policy, October 12, 2001.
- Did Arthur Andersen's audit team know about Enron's controversial accounting issues, particularly the special-purpose entities (SPEs)?
- Did Arthur Andersen employees help Enron set up these SPEs?
- Why did employees of Arthur Andersen shred Enron-related documents?
Did Arthur Andersen Know?
Yes. For example, on February 5, 2001, partners of Arthur Andersen met to discuss Enron. The partners were concerned about the Enron SPEs, particularly the active involvement of Enron's CFO in the SPEs. The partners agreed that their concerns should be shared with Enron's board of directors. A board meeting was held the next week (on February 12), with representatives of Andersen in attendance, but the minutes do not indicate that they shared any of the SPE concerns. In fairness to Andersen, notwithstanding its shocked protestations to the contrary, many parties outside Enron had known of these SPEs for years. In particular, a number of Wall Street investment firms were investors in the SPEs (along with Enron's CFO) and thus had inside information about how the SPEs were structured. These investment firms included GE CAPITAL, J.P. MORGAN CAPITAL, MERRILL LYNCH, and MORGAN STANLEY.
Did Arthur Andersen Help?
Yes. The following comes from an internal Enron investigation conducted in early 2002: “From 1997 to 2001, Enron paid Andersen $5.7 million in connection with work performed specifically on the LJM and Chewco transactions.” The LJM and Chewco transactions were the most prominent of the SPEs involved in the Enron accounting scandal. Again, out of fairness to Arthur Andersen, it should be noted that advisory work on difficult accounting issues is a service that all accounting forms have been providing to their clients for years. This is a valuable service because it allows all U.S. companies to take advantage of the technical expertise developed by the large audit firms.
Why Did Andersen Shred?
The shredding was in compliance with Andersen’s existing document policy, which allowed and even encouraged the disposal of all peripheral documents not forming part of the formal audit workpapers. This policy was consistent with the practice o the other large audit firms, reflecting the impossibility of keeping every draft memo, email message, and to-do list generated as part of a complex audit. Andersen’s document policy also stated that, when Andersen was served a subpoena with respect to a certain audit engagement, no further documents or files could be disposed of. In the case of Enron, this two-faceted document policy was followed to the letter by Arthur Andersen—the shredding began in earnest on October 23, 2001, apparently in response to news of an SED investigation of Enron’s accounting practices, and the shredding stopped on November 9, one day after Andersen received a subpoena for its Enron-related documents. In retrospect, the document shredding undertaken by Andersen employees was $10 billion mistake. Without the sleazy image of cover-up conveyed by the news that Andersen employees had shredded at least 50 trunks and boxes of documents. Andersen would probably have escaped the Enron debacle with just a harsh reprimand from the SEC and, probably, a large settlement payment (around $1 billion) to Enron shareholders. Instead, the document shredding led to Andersen’s indictment on obstruction of justice charges, and the subsequent loss on credibility caused a rapid exodus of Andersen’s clients, blasting the prospects of a venerable accounting partnership that had previously had an aggregate value to the partners almost surely in excess of $10 billion.
Sources: Memo from Michael D. Jones to David B. Duncan and Thomas H. Bauer; subject: Enron retention meeting, February 6, 2001.
William C. Powers, Jr., Raymond S. Troubh, and Herbert S. Winokur, Jr., “Report of Investigation by the Special Investigate Committee of the Board of Directors of Enron Corp.,” February 1, 2002.
Email message from Nancy A. Temple to Michael C. Odom; subject: Document retention policy, October 12, 2001.
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