1. Accounting Updates Southern Gas Association Accounting & Financial Executives Conference April 28, 2003 Robert E. (Bob) Jensen Trinity University San Antonio, TX 78212 http://www.trinity.edu/rjensen /

3. Why are the fees of large accounting firms so huge? “Chatper 1: The Andersen Way,” by Barbara Ley toffler, Page 1 Robert stared at him, disgusted. “We don’t do anything for $50,000.” The manager looked as if he might melt into a puddle of shame. After giving me a pleading glance, he slunk out of the partner’s office, knowing that when he returned he had better have a generously padded price for his piece of the project.

4. Why Does Accounting Fraud Begin? The main reason is that white collar crime pays even if you get caught and spend a year or two in Club Fed! Only idiots rob $150 from a gas station. Smart hoodlums get stock options for $250 million, cook the books, and exercise the options before the stock price plunges.

5. What is the history & culture? Pipe Dreams: Greed, Ego, and the Death of Enron by Robert Bryce (The Perseus Books Group ISBN 1-58648-138-x, 2002) Final Accounting: Ambition, Greed and the Fall of Arthur Andersen by Barbara Ley Toffler (Broadway Books, ISBN 0-7679-1382-5, 2003) Power Failure: The Inside Story of the Collapse of Enron by Mimi Swartz and Sherron Watkins (Doubleday, ISBN 0-385- 507887-9) http://www.trinity.edu/rjensen/fraud.htm#References

6. How Does Accounting Fraud Begin?

7. Answer: Cookin’ The Books Starts with “making the numbers” Then, “Managing the Numbers” Ends with “making up the numbers”

8. Rationalization includes: “We need to make our projections…” “I’m getting pressure from the boss…” “We need to meet Street expectations…” “Our acquisition will fall through if we don’t…”

10. But, even a simple mistake can be turned into a financial fraud through “cover-up” efforts.

11. Annual Caseload by Fiscal Year

12. SEC Enforcement: FY 2002 598 total cases Largest categories: –Financial fraud and issuer reporting (27%) –Offering fraud (20%) –Broker-dealer (14%) –Insider trading (10%) –Market manipulation (7%) –Investment adviser/company (8%)

13. Financial Reporting and Issuer Disclosure: Actions Filed 163 actions filed in FY 2002 – Compared to: 112 in FY 2001 103 in FY 2000 94 in FY 1999 79 in FY 1998

14. Why so many financial statement frauds all of a sudden? Systemic Problems of Accounting That Cannot or Will Not Be Solved: http://www.trinity.edu/rjensen/FraudConclusion.htm http://www.trinity.edu/rjensen/FraudConclusion.htm Behavior of CPA Firms: http://www.trinity.edu/rjensen/fraud.htm http://www.trinity.edu/rjensen/fraud.htm Greed on Wall Street: Rotten to the Core http://www.trinity.edu/rjensen/fraud.htm#Cleland http://www.trinity.edu/rjensen/fraud.htm#Cleland Washington DC Prostitutes: Representative Fernand St Germain (D-Rhode Island) $32 Billion for 30 Years Senator Phil Gramm (R-Texas) & Wife Wendy $400 billion and counting http://www.trinity.edu/rjensen/fraud.htm#WarningSigns http://www.trinity.edu/rjensen/fraud.htm#WarningSigns

15. Why so many financial statement frauds all of a sudden? Good economy was masking many problems Moral decay in society Executive incentives Wall Street expectations—rewards for short-term behavior

16. Why so many financial statement frauds all of a sudden? Failure of Corporate Audit Committees Board of Directors Failures and Greed Financial Analyst Conflict of Interests and Greed: Rotten at the Core Education Failures: Graduates of Greed Rather Than Professionalism

17. Good economy was masking problems …. With increasing stock prices, profits and wealth for everyone, no one worried about potential problems.

18. Detailed Complicated Rules With Loop Holes Big Enough To Drive A Truck Through Rules Detailed

19. Nature of Accounting Rules Allows companies and auditors to be extremely creative when not specifically prohibited by standards. “rules-based” vs. “principles based” rhetorical nonsense

20. Loop Hole Examples Include: SPEs and other types of off- balance sheet financing Pension accounting Merger reserves Other accounting schemes. Revenue recognition approaches,

21. When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…”

22. Unaccountable Contracts Expect New Amendments in SFAS 149

23. What’s going on at the FASB Spring 2003 Prepared for the Southern Gas Association Executive Conference on April 28, 2002. Robert E. Jensen, Trinity University, San Antonio, TX 78212

24. Topics Selected for Discussion Key Documents Effective 2002/2003 – Statements 143, 146, 147 and 148 – FINs 45 and 46 Next Documents to be Issued – Statements 149 and 150 Projects on the Agenda Other Items – FASB Staff Positions (FSPs) – Improving Standards (Principle-based Standards) – Convergence

25. Who is the FASB? Private-sector standard setter that provides guidance for accounting and financial reporting by public and non- public entities. Not an Oversight Body — no enforcement power. Formed in 1973 and recognized by the SEC and the AICPA as the creator of GAAP. – Public Companies – Private Companies – Not-for-Profit Entities

26. FASB’s Mission To establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. Accounting standards are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent and understandable financial information. Good financial and business reporting reduces the uncertainty premium charged by investors and lenders.

27. Impact of Sarbanes-Oxley FASB expects to be Recognized as Private Sector Accounting Standard Setting Body. FAF selects members of FASB (unlike PCAOB). FASB is separate from the PCAOB and neither reports to the other. Public companies will be billed for the cost to operate the FASB and the PCAOB. SEC to Report to Congress on Principle-Based Standards and Off-Balance Sheet Entities.

28. Certain Documents Effective 2002/2003 Statement 143, Accounting for Asset Retirement Obligations Statement 146, Accounting for Costs Associated with Exit or Disposal Activities Statement 147, Acquisition of Certain Financial Institutions Statement 148, Accounting for Stock-Based Compensation – Transition and Disclosure FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees FIN 46, Consolidation of Variable Interest Entities

29. Statement 143, Accounting for Asset Retirement Obligations Reason issued – to recognize a disposal liability when it is incurred that previously was not recognized until later. Issued June 01; Effective – fiscal year beginning after 6-15-02. Initial application results in recognition of: – a liability (initially at fair value) – higher cost and accumulated depreciation amounts – cumulative effect of accounting change.

30. Statement 146, Accounting for Costs Associated with Exit or Disposal Activities Reason issued – to replace Issue 94-3 and to recognize liabilities when they have been incurred and not before. Issued June 02; Effective for activities initiated after 12-31-02. Specific guidance for: – One-time Termination Benefits (usually a stay- bonus) – Contract Termination Costs (lease termination) – Other associated costs. Extensive disclosure requirements.

31. Statement 147, Acquisition of Certain Financial Institutions Reason issued – to remove all but mutual combinations from Statement 72 and FIN 9 and put certain customer- relationship intangibles into the scope of Statement 144 (impairment of long-lived assets). Issued October 02; Effective October 1, 2002. The Statement 72 intangible asset is treated as goodwill under Statement 142. Branch acquisitions are discussed.

32. Statement 148, Accounting for Stock-Based Compensation – Transition and Disclosure Reason issued – to provide additional transition alternatives for switching from the intrinsic method to the fair value method for stock-based employee compensation and to improve disclosures. Issued December 02; Alternatives and annual disclosures are effective for fiscal years ending after 12-15-02; interim disclosures are effective for interim periods beginning after 12-15-02.

33. FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees Reason issued – to improve disclosures with respect to information about guarantees, the identification of what is a guarantee and to improve accounting by requiring recognition of a liability when incurred. Issued November 02; Disclosure requirements effective for interim or annual periods ending after 12-15-02; recognition effective for guarantees issued or modified after 12-31-02. Guarantees are initially recognized at their fair value. Discussion of subsequent accounting and what in the debit is provided.

34. FIN 46, Consolidation of Variable Interest Entities Reason issued – to identify entities where applying the majority of voting interest approach is not effective (VIEs) and providing an approach to use for those entities. Issued January 03; Effective for new VIEs upon issuance and for existing VIEs at the beginning of the first interim or annual period beginning after 6-15-03. For nonpublic entities it is effective for existing VIEs at the end of the annual period beginning after 6-15-03. VIEs do not have sufficient equity investment at risk to permit the entity to finance its activities without additional financial support or the holders of the equity investment lack any one of the the 3 characteristics of a controlling financial interest.

35. FIN 46, Consolidation of Variable Interest Entities (cont’d.) An enterprise that has variable interests that will : – absorb a majority of the VIE’s variability in its expected losses (tie breaker), – receive a majority of the variability in its expected residual return, or – both is the VIE’s Primary Beneficiary and must consolidate.

36. Next Documents to be Issued SFAS 149, Amendments to Statement 133 – Incorporates various DIG issues into the Statement. – Clarifies the definition of a derivative (paragraph 66). – Effective 6-30-03.

37. Next Documents to be Issued (cont’d.) SFAS 150, Liability and Equity Instruments – The following instruments that have been treated as equity will be treated as liabilities: (1)Instruments that are mandatorily redeemable on a fixed or determinable date or upon an event certain to occur. (2)Obligations to repurchase an issuer’s equity shares (forward purchase contract or written puts) that must be physically or net cash settled.

38. Next Documents to be Issued (cont’d.) (3)Obligations that the issuer must or could settle by issuing a variable number of its equity shares when the obligation’s monetary value is fixed or varies on something other than equity values (accounts payable or accrued expense) or the variation is not in the same direction as equity values (written puts with net share settlement. –For public companies SFAS 150 probably will be effective for annual or interim periods beginning after 6-15-03. For nonpublic companies mandatorily redeemable instrument probably will be effective for annual periods beginning after 12-15-03.

39. Projects on the FASB’s Agenda Stock-Based Compensation Pension Disclosures Disclosures about Fair Value of Financial Instruments Liabilities and Equity (Phase II) Financial Performance Reporting Revenue Recognition Short-term International Convergence Purchase Method Procedures Combinations of Not-for-Profit Organizations Combinations of Mutuals Consolidation What can a QSPE do with respect to Reissuance of BI What does “legally released from being the primary obligator” mean?

40. Selected Projects Share-Based Compensation – working with IASB; goal is to get the same approach and have it effective as of 1-1-04. Pension Disclosures – will focus on information about plan assets and the population of persons to receive pension payments. Also, some quarterly information and where the expense is recorded in the I/S. Liabilities and Equity (Phase II) – how to treat instruments with both liability and equity elements; try to get convergence.

41. FASB Staff Positions (FSPs) New way to provide guidance on applying GAAP. Provides for due process and access. Look for FSPs website and get notice of posting from the e-mail Action Alert.

42. Improving Standards Document on Principles-Based Standards issued fall 2002; Roundtables held and comment letters received. Shifting focus to “how to improve standards” by addressing issues raised by our constituents. SEC doing a study. Changing relationship of FASB with EITF and AcSEC.

43. Convergence Working with the IASB on the following joint projects and parallel projects. – Revenue Recognition – Purchase Method Procedures – Stock-Based Compensation – Reporting Financial Performance. Both the FASB and IASB have a short-term convergence project to focus on matters not otherwise covered in a major project. All FASB projects and EITF issues consider convergence.

44. GAAP CRITICISM Fosters Short-Term Earnings Manipulations Does Not Show Value Creation

45. Executive Incentives Meeting Wall Street’s ExpectationsMeeting Wall Street’s Expectations Performance is based on earnings & stock price –Focus is on short-term (quarterly) performance only –Stock prices are tied to meeting Wall Street’s earnings forecasts Companies are heavily punished for not meeting forecasts –Moral Hazard: Employee Stock Options Did you ever hear the name Lou Pai?

46. Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999. Princeton University

47. GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... " Jack Welch, Former General Electric Chairman Stock Fell 13% With This Revelation

48. Enron’s CEO of Enron Broadband Services, Ken Rice, had a $33,000 customized Hellcat motorcycle in his office just for a distinctive decoration. Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land. Mostly he flew to his 77,000 acre ranch in Colorado.

49. Rebecca Mark, who’s bonuses ranged in the $40 million range at Enron, had a $6 million private jet budget that often flew her to her “tres chic vacation home in Taos.” according to Robert Bryce, p. 262. Jeff Skilling’s secretary, Rebecca Carter, got a Salary of $600,000 per year plus other perks, including the perky Jeff Skilling according to Schwartz and Watkins.

50. Beat The Numbers

51. How To Play Numbers Game Aggressive Accounting Earnings Management Income Smoothing Fraudulent Financial Reporting Creative Accounting Practices

52. Rewards of The Game Share Price Effect Borrowing Cost Effect Bonus Plan Effect Political Cost Effect