Auditors are in the spotlight as the number of stock-option scandals expands. It seems the manipulation of option prices was more common than previously believed. It brings to light another fear that the Big Four accounting firms misinterpreted accounting rules, overlooked any warning signs or approved the accounting practices allowing manipulation, according to the San Jose Mercury News.
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One issue seems to be that companies issued options at discounted prices, not necessarily illegal, without disclosing these grants to the Internal Revenue Service (IRS), investors or regulators. Another issue seems to be that companies repeatedly backdated options to dates more advantageous to the grantees, which saw paper profits sooner than others.
Damon Silvers, associate general counsel for the AFL-CIO, told the San Jose Mercury News, “This appears to be a fairly significant failure of the audit firms. The question is, ‘What test did you use?’ If the answer is, ‘We had no test,’ then it’s a question of diligence.” Silvers added, if the accounting firms knew of the abuses, “then clearly it was an audit failure.”
Some 50 companies have disclosed that the Securities and Exchange Commission or Department of Justice is investigating them for option abuses. Of these companies, 19 are based in California’s Silicon Valley. The San Jose Mercury News reports that about another two-dozen companies have announced they are conducting internal reviews or have been implicated by investment watchdogs, shareholder lawsuits or Wall Street analysts.
Remedies to ensure these abuses will be found in future audits have raised concerns. The Public Company Accounting Oversight Board (PCAOB) has been called on by investors and audit experts to notify auditors on how to find and prevent any future abuses. The San Jose Mercury News reports that at least two large auditing firms, PricewaterhouseCoopers and Ernst & Young, believe it is too early to be making recommendations.
“You have to understand that the auditor is looking at evidence prepared by management. The auditor is placing trust that management and the general counsel haven’t lied to them. We’re not at those meetings. We don’t know whether or not the option was actually granted a month ago or two months ago,” Chuck Landes told the San Jose Mercury News. Landes is the American Institute of Certified Public Accountants’ (AICPA) vice president for professional standards.
This has been a long fought battle. Back in 1993, it was proposed that companies record stock options on their balance sheets in order to close this accounting loophole. PBS.org reports that a Merrill Lynch study found that expensing stock options would have cut profits of leading tech companies by an average of 60 percent. The accounting industry resisted this change and in 1994, Sen. Joseph Lieberman (D-Conn.) lead an successful effort in Congress to condemn the proposal, resulting in a 88-to-9 vote.
Jim Leisenring, FASB’s vice president between 1988 and 2000, said, “It wasn’t an accounting debate. We switched from talking about, ‘Have we accurately measured the option?’ or, ‘Have we expensed the option on the proper date?’ to things like, ‘Western civilization will not exist without stock options,’ or, ‘There won’t be jobs anymore for people without stock options.’ … People tried to take the argument away from the accounting to be just plainly a political argument,” according to CFO.com.
Accounting battles can be won though. Robert Blakely took the CFO position at the newly rechristenened MCI Inc. in April 2003. If there ever was a challenge, Blakely had one—and succeeded. He and his army of accountants had the job of settling some $35 billion in outstanding debt, in addition to the restatement of financial results for years 2000, 2001 and 2002. The restatement ended up taking over a year and half to complete, according to CFO.com.
Creditor groups were given the opportunity to exchange their bonds for shares in the newly reorganized company, too. Ninety percent of them believed in the leadership of the new company, according to CFO.com. New corporate-governance policies were adopted and their internal controls were overhauled, as well as new directors being named. It was found that the fraud involved less than 50 employees and some $11 billion of fraud was buried in their books.
A February 2004 deadline was set by the bankruptcy judge and required a 60-day extention to complete. Between 500 and 600 employees were weeding through accounting entries, in addition to 200 to 300 staffers from the company’s auditor, KPMG. CFO.com reports that more accounting assistance was necessary and the company turned to Deloitte & Touche that provided another 600 accounting professionals for their massive effort. About 1,500 were working on the restatement at the peak of the audit effort in late 2003.
Billing systems were reexamined first and revenue was rerun to provide a proper baseline. The cash applications were rerun and then the income statements were rebuilt. Former CEO Ebbers’ $70 billion worth of acquisitions were reassessed in this process and overvalued by a total of $5.8 billion, according to CFO.com. The final effort resulted in a set of clean books and $5 billion in debt.