Hidden Financial Risk: Understanding Off-Balance Sheet Accounting
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00 Ketz FM 5/21/03 9:58 AM Page i Hidden Financial Risk Understanding Off–Balance Sheet Accounting 00 Ketz FM 5/21/03 9:58 AM Page ii 00 Ketz FM 5/21/03 9:58 AM Page iii Hidden Financial Risk Understanding Off–Balance Sheet Accounting J. Edward Ketz JOHN WILEY & SONS, INC. 00 Ketz FM 5/21/03 9:58 AM Page iv This book is printed on acid-free paper. ∞ Copyright © 2003 by J. Edward Ketz. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada Copyright 2002 SmartPros Ltd. www.smartpros.com. Reprinted with permission. 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For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Ketz, J. Edward. Hidden financial risk : understanding off-balance sheet accounting / J. Edward Ketz. p. cm. Includes bibliographical references and index. ISBN 0-471-43376-4 (CLOTH) 1. Accounting—Case studies. 2. Accounting firms—Corrupt practices—Case studies. 3. Business ethics—Case studies. I. Title. HF5635 .K43 2003 658.15′5—dc21 2003003952 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 00 Ketz FM 5/21/03 9:58 AM Page v For Charity and Benjamin 00 Ketz FM 5/21/03 9:58 AM Page vi About the Author J. Edward Ketz is MBA Faculty Director and Associate Professor of Accounting at the Penn State Smeal College of Business. He has been a member of the Penn State faculty since 1981. He holds a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D. in business administration, all from Virginia Tech. The teaching and research interests of Dr. Ketz focus on financial accounting, accounting information systems, and accounting ethics. He has published numerous academic and professional articles, and he has written seven books. Also, he is coeditor of Advances in Accounting Education. Dr. Ketz writes two columns about financial reporting issues. Accounting Today pub- lishes “Accounting Annotations,” while “Accounting Cycle: Wash, Rinse, and Spin” appears on SmartPros.com. He has been cited in the popular and business press, includ- ing The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today, and he has served as an accounting commentator on CNNfn. vi 00 Ketz FM 5/21/03 9:58 AM Page vii Contents Preface xi PART I My Investments Went Ouch! 1 1 What? Another Accounting Scandal? 3 Accounting Prophets: “They Have No Profits” 4 A Rash of Bad Accounting 5 Debt? What Debt? 11 Summary and Conclusion 15 Notes 30 2 Balance Sheet Woes 33 Investment Risks 34 Some Ratios That Index Financial Risk 34 Financial Leverage and its Effects 36 Stock Prices and Financial Leverage 41 Bankruptcy Prediction Models 43 Bond Ratings Prediction Models 45 Cost of Lying 46 Summary and Conclusion 47 Notes 48 PART II Hiding Financial Risk 51 3 How to Hide Debt with the Equity Method 53 Brief Overview of Accounting for Investments 54 Equity Method versus Trading-Security and Available-for-Sale Methods 55 Boston Chicken 57 vii 00 Ketz FM 5/21/03 9:58 AM Page viii CONTENTS Details about the Equity Method and Consolidation 58 Hiding Debt with the Equity Method 63 Summary and Conclusion 70 Notes 71 4 How to Hide Debt with Lease Accounting 73 Present Value 74 Brief Overview of Lease Accounting 83 More Details about Lease Accounting 90 Adjusting Operating Leases into Capital Leases 91 Summary and Conclusion 101 Notes 101 5 How to Hide Debt with Pension Accounting 103 Definitions and Concepts Underlying Pension Plans 105 Brief Overview of Pension Accounting 111 Adjusting Pension Assets and Liabilities 117 Summary and Conclusion 122 Notes 123 6 How to Hide Debt with Special-Purpose Entities 125 Special-Purpose Entity Landscape 126 Securitizations 131 Synthetic Leases 137 Accounting for Special-Purpose Entities 141 Preliminary Corporate Responses about Special-Purpose Entity Accounting 142 Summary and Conclusion 143 Notes 144 PART III Failures that Led to Deceptions 149 7 Failure of Managers and Directors 151 Failure of Managers 152 Failure of Directors 155 Business Ethics: As Oxymoronic as Corporate Governance? 161 Culture 164 Summary and Conclusion 167 Notes 168 viii 00 Ketz FM 5/21/03 9:58 AM Page ix Contents 8 Failure of the Auditing Profession 173 Securities Laws and the Auditing Profession 174 Evolution of Underauditing 177 Changing Nature of the Big, Independent Auditor 180 Serving the Public Interest 185 Andersen Verdict 187 Young Model: A Reprise 188 Summary and Conclusion 190 Notes 191 Appendix Sutton’s Critique of Serving the Public Interest 195 9 Failure of Regulation 213 Failure of the Financial Accounting Standards Board 214 Failure of the Securities and Exchange Commission 219 Failure of Congress 223 Failure of the Courts 227 Summary and Conclusion 227 Notes 228 10 Failure of Investors 233 Failure of Financial Governance 234 More Accounting 235 Enron—A Reprise 238 Rules for Investing 242 Summary and Conclusion 247 Notes 247 PART IV Making Financial Reports Credible 251 11 Andersen Has the Solution—Really! 253 Arthur Andersen Forgets its Roots 255 Purpose of Financial Reporting 256 Socialization 262 Andersen’s Accounting Court 263 Summary and Conclusion 265 Notes 267 Bibliography 269 Index 291 ix 00 Ketz FM 5/21/03 9:58 AM Page x 00 Ketz FM 5/21/03 9:58 AM Page xi Preface When I graduated with a doctorate in 1977, I researched and published articles on main- stream topics, particularly current value accounting and the interaction between earn- ings and cash flows. After a while, it occurred to me that these are not the crucial issues of financial accounting and reporting. Ethics and honesty and fairness to financial state- ment users comprise the foundational issues of the profession. If a business enterprise adopted the best methods for accounting but did so with treachery and duplicity, it would not help any capital market agent. If I have to choose between the best account- ing methods and managerial integrity, I always prefer the latter. I started writing articles on such topics in the 1980s and published them in obscure academic journals. Then in January 1996 I began writing the “Spirit of Accounting” col- umn for Accounting Today with my friend Paul Miller. I needed a break in 2000, so I quit the column; Paul Bahnson joined Paul Miller on it. After a year’s respite, I found myself writing “Accounting Annotations” for Accounting Today and “The Accounting Cycle: Wash, Rinse, and Spin” for SmartPros.com. Then Enron disclosed problems in its third-quarter report of 2001 and soon declared bankruptcy. All of a sudden people were interested in accounting at levels I had never experienced previously. During the first half of 2002 I had at least 500 interviews with the media, and I discussed at length issues about Enron, Global Crossing, WorldCom, Tyco, Adelphia, and Arthur Andersen. My main message was simple: The culture of financial reporting that began around 1990 brought about this mess. When managers engage in “earnings management,” what they really mean is that when they cannot make profits legitimately, they will exaggerate and abuse accounting numbers until the reported numbers make them look good. Aiding and abetting this process of “earnings management” have been board directors who never asked serious questions, corporate lawyers who were eager to push the limits, stock brokers and investment bankers who did not care how they made a buck, financial analysts who worried little that they served as used-car salesmen for their investment banking firms, auditors who looked the other way, an impotent Financial Accounting Standards Board, an overextended Securities and Exchange Commission, and members of Congress who would tolerate almost any- thing for sufficiently large campaign contributions.