Waste
management, Inc. Manipulating Accounting estimates
LEARNING
OBJECTIVES After completing and discussing this case you should be
able to [1] Recognize risk factors suggesting the presence of the
three conditions of fraud [2] Identify financial statement accounts
that are based on subjective management estimates [3] Recognize
inherent risks associated with accounting estimates [4] Describe
auditor responsibilities for assessing the reasonableness of
management’s estimatesBACKGROUND Waste Management, Inc.’s Form
10-K filed with the Securities and Exchange Commission (SEC) on March
28, 1997 described the company at that time as a leading
international provider of waste management services. According to
disclosures in the Form 10-K, the primary source of its business
involved providing solid waste management services consisting of
collection, transfer, resource recovery, and disposal services for
commercial, industrial, municipal, and residential customers, as well
as other waste management companies. As part of these services, the
company provided paper, glass, plastic, and metal recycling services
to commercial and industrial operations and curbside collection of
such materials from residences. The company also provided services
involving the removal of methane gas from sanitary landfill
facilities for use in electricity generation and provided Port-O-Let
portable sanitation services to municipalities, commercial
businesses, and special event customers. In addition to solid waste
management services, the company provided hazardous waste and other
chemical removal, treatment, storage, and disposal services.
According to information in the Form 10-K, the Oak Brook, Illinois
based company was incorporated in 1968. In 28 years of operations,
the company had grown to be a leader in waste management services.
For the year ended December 31, 1996, the company reported
consolidated revenues of $9.19 billion, net income of $192 million,
and total assets of $18.4 billion. The company’s stock, which
traded around $36 per share in 1996, was listed on the New York Stock
Exchange (NYSE), in addition to being listed on the Frankfurt,
London, Chicago, and Swiss stock exchanges. Despite being a leader in
the industry, the 1996 financial statements revealed that the company
was feeling pressures from the effects of changes that were occurring
in its markets and in the environmental industry. Although
consolidated revenues were increasing, the 1996 Consolidated
Statement of Income showed decreasing net income, as summarized on
the next page.
According
to management’s disclosures in the 1996 Form 10-K, Waste
Management, Inc. was encountering intense competition, primarily in
the pricing and rendering of services, from various sources in all
phases of its waste management and related operations. In the solid
waste collection phase, competition was being felt from national,
regional, and local collection companies. In addition, the company
was competing with municipalities and counties, which through the use
of tax revenues were able to provide such services at lower direct
charges to the customer than could Waste Management. Also, the
company faced competition from some large commercial and industrial
companies, which handled their own waste collection. In addition, the
company encountered intense competition in pricing and rendering of
services in its portable sanitation services business and its on-site
industrial cleaning services business. Management noted that the
pricing, quality, and reliability of services and the type of
equipment utilized were the primary methods of competition in the
industry. Over half of the company’s assets as of December 31, 1995
and 1996 involved property and equipment, consisting of land
(primarily disposal sites), buildings, vehicles and equipment, and
leasehold improvements, with land and vehicles and equipment
representing 20% and 27%, respectively, of the company’s total
consolidated assets. Disposal sites included approximately 66,400
total acres, which had estimated remaining lives ranging from one to
over 100 years based upon management’s site plans and estimated
annual volumes of waste. The vehicles and equipment included
approximately 21,400 collection and transfer vehicles, 1.6 million
containers, and 25,100 stationary compactors. In addition, the Form
10-K stated that the company owned, operated or leased 16
trash-to-energy facilities, eight cogeneration and small power
production facilities, two coal handling facilities, three biosolids
drying, pelletizing and composting facilities, one wastewater
treatment plant and various other manufacturing, office and warehouse
facilities. The accounting policies footnote in the 1996 financial
statements disclosed that the cost of property and equipment, less
estimated salvage value, was being depreciated over the estimated
useful lives on the straight-line method as follows:
Other
information about the company’s financial position as of December
31, 1996 is shown below in the Consolidated Balance Sheet:
FRUD
REVEALED Before the 1997 annual financial statements were released,
the company issued a press release on January 5, 1998 announcing that
it would file amended reports on Form 10-K and 10-Q for the year
ended December 31, 1996 and for the three-month periods ended March
31, 1997 and June 30, 1997. The press release also disclosed
management’s plans to revise certain previously reported financial
data and to issue revised financial statements for 1994 and 1995 to
reflect various revisions of various items of income and expense. The
revisions were prompted by a request by the SEC’s Division of
Corporation Finance. The January 5th press release noted that the
Waste Management board of directors and audit committee were engaged
in an extensive examination of its North American operations, assets,
and investments as well as a review of certain of its accounting
methods and estimates. The company stated further that it was
continuing to carefully examine the company’s accounting estimates
and methods in several areas, including the areas of vehicle and
equipment depreciation and landfill cost accounting. The company also
disclosed that it had named a new acting chief executive officer
(CEO) and an acting chief financial officer (CFO) to replace the
former CEO and CFO, both of whom resigned in 1997. On January 28,
1998, the company issued another press release reporting that the
company would restate prior period financial results including
earnings for 1992 through 1997 to reflect revisions in various items
of expense, including those in the areas of vehicle and equipment
depreciation and landfill cost accounting. The January 28, 1998 press
release also noted that the restatement would not affect revenues for
these periods. Finally, on February 24, 1998, the company publicly
reported restated earnings for 1992 through 1996, in addition to
reporting its financial results for the year ended December 31, 1997.
The press release noted that the 1997 fourth quarter results included
a special charge and adjustments to expenses related to the company’s
comprehensive examination of its operations and accounting practices.
The cumulative charge totaled $2.9 billion after-tax and $3.5 billion
pre-tax, which reduced stockholders’ equity to $1.3 billion as of
December 31, 1997. The restatement of the 1996 financial results
alone took the company from a previously reported net income of $192
million to a restated 1996 net loss of $39 million. The February
press release further disclosed that certain items of expense were
incorrectly reported in prior year financial statements. According to
the release, the restatements principally related to the calculation
of vehicle, equipment, and container depreciation expense and
capitalized interest costs related to landfills. The company admitted
to the use of incorrect vehicle and container salvage values and
useful lives assumptions. In response, the company disclosed that it
had implemented new, more conservative accounting policies and
practices including those related to landfill cost accounting and had
adopted a new fleet management strategy impacting vehicle and
equipment depreciation and amortization. In particular, the company
disclosed that it was adopting new policies that included shortening
the depreciable lives for certain categories of assets to reflect
their current anticipated useful lives and had eliminated salvage
values for trucks and waste containers. Additionally, the company
revealed that it had revised certain components of the landfill cost
accounting process by adopting more specific criteria to determine
whether currently unpermitted expansions to existing landfills should
be included in the estimated capacity of sites for depreciation
purposes. The financial community responded immediately to the news.
On February 25, 1998, Standard & Poor’s lowered its rating on
Waste Management, Inc. to “BBB” from “A-”. As news of the
company’s overstatements of earnings became public, Waste
Management’s shareholders lost more than $6 billion in the market
value of their investments when the stock price plummeted by more
than 33%. In March 1998, the SEC announced a formal investigation
into the company’s bookkeeping. SEC INVESTIGATION FINDINGS By March
2002, the SEC announced it had completed its investigation of the
accounting practices at Waste Management, Inc. and announced that it
had filed suit against the founder and five other top officers of the
company, charging them with perpetrating a massive financial fraud
lasting more than five years. The complaint filed in the U.S.
District Court in Chicago, charged that the defendants engaged in a
systematic scheme to falsify and misrepresent Waste Management’s
financial results between 1992 and 1997. According to Thomas C.
Newkirk, associate director of the SEC’s Division of Enforcement,
“Our complaint describes one of the most egregious accounting
frauds we have seen. For years, these defendants cooked the books,
enriched themselves, preserved their jobs, and duped unsuspecting
shareholders.”1 The SEC’s complaint alleges that company
management fraudulently manipulated the company’s fnancial results
to meet predetermined earnings targets. The company’s revenues were
not growing fast enough to meet those targets, so the defendants
resorted to improperly eliminating and deferring current period
expenses to infate earnings. They employed a multitude of improper
accounting practices to achieve this objective. Among other things,
the SEC noted that the defendants: ƒ Avoided depreciation expenses
on their garbage trucks by both assigning unsupported and inflated
salvage values and extending their useful lives, ƒ Assigned
arbitrary salvage values to other assets that previously had no
salvage value, ƒ Failed to record expenses for decreases in the
value of landfills as they were filled with waste, ƒ Refused to
record expenses necessary to write off the costs of unsuccessful and
abandoned landfill development projects, ƒ Established inflated
environmental reserves (liabilities) in connection with acquisitions
so that the excess reserves could be used to avoid recording
unrelated operating expenses, ƒ Improperly capitalized a variety of
expenses, and ƒ Failed to establish sufficient reserves
(liabilities) to pay for income taxes and other expenses. The SEC
alleged that the improper accounting practices were centralized at
corporate headquarters, with Dean L. Buntrock, founder, chairman, and
CEO as the driving force behind the fraud. Allegedly, Buntrock set
the earnings targets, fostered a culture of fraudulent accounting,
personally directed certain of the accounting changes to make the
targeted earnings, and was the spokesperson who announced the
company’s phony numbers. During the year, Buntrock and other
corporate officers monitored the company’s actual operating results
and compared them to the quarterly targets set in the budget. To
reduce expenses and inflate earnings artificially, the officers used
“top-level adjustments” to conform the company’s actual results
to the predetermined earnings targets. The inflated earnings of one
period became the floor for future manipulations. To sustain the
scheme, earnings fraudulently achieved in one period had to be
replaced in the next period. According to the SEC, the defendants
allegedly concealed their scheme by using accounting manipulations
known as “netting” and “geography” to make reported results
appear better than they actually were and to avoid public scrutiny.
The netting activities allowed them to eliminate approximately $490
million in current period accounting misstatements by offsetting them
against unrelated one-time gains on the sale or exchange of assets.
The geography entries allowed them to move tens of millions of
dollars between various line items on the company’s income
statement to make the financial statements appear as management
wanted. In addition to Buntrock, the SEC complaint named other Waste
Management officers as participants in the fraud. Phillip B. Rooney,
president and chief operating officer (COO), and James Koenig,
executive vice president CFO, were among the six officers named in
the complaint. According to the SEC, Rooney was in charge of building
the profitability of the company’s core solid waste operations and
at all times exercised overall control over the company’s largest
subsidiary. He ensured that required write-offs were not recorded
and, in some instances, overruled accounting decisions that would
have a negative impact on operations. Koenig was primarily
responsible for executing the scheme. He ordered the destruction of
damaging evidence, misled the audit committee and internal
accountants, and withheld information from the outside auditors.
According to the SEC staff, the defendants’ fraudulent conduct was
driven by greed and a desire to retain their corporate positions and
status in the business and social communities. Buntrock posed as a
successful entrepreneur. With charitable contributions made with the
fruits of the ill-gotten gains or money taken from the company,
Buntrock presented himself as a pillar of the community. According to
the SEC, just 10 days before certain of the accounting irregularities
first became public, he enriched himself with a tax benefit by
donating inflated company stock to his college alma mater to fund a
building in his name. He was the primary beneficiary of the fraud and
allegedly reaped more than $16.9 million in ill-gotten gains from,
among other things, performancebased bonuses, retirement benefits,
charitable giving, and selling company stock while the fraud was
ongoing. Rooney allegedly reaped more than $9.2 million in ill-gotten
gains from, among other © 201 things, performance-based bonuses,
retirement benefits, and selling company stock while the fraud was
ongoing. Koenig profited by more than $900,000 from his fraudulent
acts. According to the SEC, the defendants were allegedly aided in
their fraud by the company’s long-time auditor, Arthur Andersen,
LLP, which had served as Waste Management’s auditor since before
the company became a public company in 1971. Andersen regarded Waste
Management as a “crown jewel” client. Until 1997, every CFO and
chief accounting officer (CAO) in Waste Management’s history as a
public company had previously worked as an auditor at Andersen.
During the 1990s, approximately 14 former Andersen employees worked
for Waste Management, most often in key financial and accounting
positions. During the period 1991 through 1997, Andersen billed Waste
Management approximately $7.5 million in audit fees and $11.8 million
in other fees related to tax, attest work, regulatory issues, and
consulting services. A related entity, Andersen Consulting (now
Accenture) also billed Waste Management corporate headquarters
approximately $6 million in additional non-audit fees. The SEC
alleged that at the outset of the fraud, Waste Management executives
capped Andersen’s audit fees and advised the Andersen engagement
partner that the firm could earn additional fees through “special
work.” Andersen nevertheless identified the company’s improper
accounting practices and quantified much of the impact of those
practices on the company’s financial statements. Andersen annually
presented company management with what it called Proposed Adjusting
Journal Entries (PAJEs) to correct errors that understated expenses
and overstated earnings in the company’s financial statements.
Management consistently refused to make the adjustments called for by
the PAJEs, according to the SEC’s complaint. Instead, the
defendants secretly entered into an agreement with Andersen to write
off the accumulated errors over periods up to ten years and to change
the underlying accounting practices in future periods. The signed,
four-page agreement, known as the Summary of Action Steps, identified
improper accounting practices that went to the core of the company’s
operations and prescribed 32 “must do” steps for the company to
follow to change those practices. The Action Steps thus constituted
an agreement between the company and its outside auditor to cover up
past frauds by committing additional frauds in the future, according
to the SEC complaint. As time progressed, the defendants did not
comply with the Action Steps agreement. Writing off the errors and
changing the underlying accounting practices as prescribed in the
agreement would have prevented the company from meeting earnings
targets, and the defendants from enriching themselves. The fraud
scheme eventually unraveled. In mid-July 1997, a new CEO ordered a
review of the company’s accounting practices. That review
ultimately led to the restatement of the company’s financial
statements for 1992 through the third quarter of 1997. EPILOGUE In
addition to the fraudulent activities related to the 1992 through
1997 financial statements, Waste Management’s fraudulent activities
continued. In July 1999 the SEC issued a cease and desist order
alleging that management violated U.S. securities laws when they
publicly projected results for the company’s 1999 second quarter.
According to the SEC, in June 1999 management continued to reiterate
projected results for the quarter ended June 30, 1999, despite being
aware of significant adverse trends in its business which made
continued public support of its announced forecasts unreasonable.
Apparently, Waste Management’s information system failures made
June’s earnings forecast even more unreasonable since the company
could not generate information from which reliable forecasts could be
made. The SEC’s order was triggered by a July 6, 1999 company
announcement of revenue shortfalls versus its internal budget of
approximately $250 million for the second quarter. This news sent the
share prices falling. On July 7, 1999, share prices went from $53.56
to $33.94 per share, and by August 4, 1999, share prices were down to
$22.25 per share. The Wall Street Journal subsequently reported that
the company evidentially settled a class action suit related to these
1999 charges for $457 million.2 Despite these negative events, the
company continues to operate. As for Arthur Andersen, the SEC
eventually settled charges with Andersen and four of its partners
related to the 1992 through 1996 audited financial statements.
Andersen agreed to pay a penalty of $7 million, the largest ever
assessed against an accounting firm at that time. The SEC’s
complaint against Andersen said that the firm knew Waste Management
was exaggerating its profits throughout the early and mid-1990s, and
repeatedly pleaded with the company to make changes. Each year
Andersen gave in, certifying the company’s annual financial
statements conformed to generally accepted accounting principles.
According to Richard Walker, SEC Director of Enforcement, “Arthur
Andersen and its partners failed to stand up to company management
and thereby betrayed their ultimate allegiance to Waste Management’s
shareholders and the investing public. Given the positions held by
these partners and the duration and gravity of the misconduct, the
firm itself must be held responsible for the false and misleading
audit reports.” The SEC filed a civil fraud complaint against three
Andersen partners who were involved in the audit, all of whom settled
without admitting or denying the allegations. The three partners
agreed to pay fines of $30,000 to $50,000 each and agreed to be
banned from auditing public companies for up to five years. A fourth
partner was barred from auditing for one year. These charges against
Andersen related to the Waste Management fraud and other high profile
frauds, including the fraud at Sunbeam Corporation, provided a
significant backdrop for all the allegations against Andersen in 2001
and 2002 for its role in the audits of Enron Corporation and the
accounting firm’s ultimate demise.
[1]
Review Waste Management’s Consolidated Balance Sheet as of December
31, 1996. Identify accounts whose balances were likely based on
significant management estimation techniques. Describe the reasons
why estimates were required for each of the accounts identified.
[2]
Describe why accounts involving significant management estimation are
generally viewed as inherently risky.
[3]
Review professional auditing standards to describe the auditor’s
responsibilities for examining management-generated estimates. Also,
describe the techniques commonly used by auditors to evaluate the
reasonableness of management’s estimates.
[4]
The Waste Management fraud primarily centered on inappropriate
estimates of salvage values and useful lives for property and
equipment. Describe techniques Andersen auditors could have used to
assess the reasonableness of those estimates used to create Waste
Management’s financial statements. [5] Three conditions are often
present when fraud exists. First, management or employees have an
incentive or are under pressure, which provides them a reason to
commit the fraud act. Second, circumstances exist – for example,
absent or ineffective internal controls or the ability for management
to override controls – that provide an opportunity for the fraud to
be perpetrated. Third, those involved are able to rationalize the
fraud as being consistent with their personal code of ethics. Some
individuals possess an attitude, character, or set of ethical values
that allows them to knowingly commit a fraudulent act. Using
hindsight, identify factors present at Waste Management that are
indicative of each of the three fraud conditions: incentives,
opportunities, and attitudes.
[6]
Several of the Waste Management accounting personnel were formerly
employed by the company’s auditor, Arthur Andersen. What are the
risks associated with allowing former auditors to work for a client
in key accounting positions? Research Section 206 of the
Sarbanes−Oxley Act of 2002 and provide a brief summary of the
restrictions related to the ability of a public company to hire
accounting personnel who were formerly employed by the company’s
audit firm.
[7]
Discuss possible reasons why the Andersen partners allegedly allowed
Waste Management executives to avoid recording the identified
accounting errors. How could accounting firms ensure that auditors do
not succumb to similar pressures on other audit engagements?
[8]
What is meant by the term professional judgment?
[9]
What kind of professional judgments did the auditors of Waste
Management have to make in regards to the examination of the
accounting for property, plant, and equipment?
[10]What
are some examples of judgment traps and tendencies that likely
affected the auditor’s judgment when auditing Waste
Management’s financial statem
The post Manipulating Accounting estimates appeared first on My Assignment Online.