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 accessing the reasonable of managements estimates.

Background

Waste Management, Inc.s Form 10-K filed with the securities and Exchange commission (SEC) on march 28,1997 described the company at the time as a keading international provider of waste management services. According to disclosures in the formn 10-K, the primary scource of its business involved providing solid waste management services consisting of collection, transfer, resource recovery, and disposal services for 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 business, and special event customers. In addition to solid Waste managements Services, the company provides 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 oncorporated in 1968. In 28 years of operations, the company had grown to be a keader 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 $184 billion. The companys stock, which traded arroud $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 dinancial statements revealed thar the company was feeling pressures from the effects of exchanges that were occurring in its markets and in the environmental industry. Although consolidated revenues were increasing, the 1996 consolidated statements of income showed decreasing net income, as summarized on the next page.

( Gambar 1)

According to managements 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 costumer 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 companys 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 companys total consolidated assets. Disposal sites included approximately 66,400 total acres, which had estimating remaining lives ranging from one to over 100 years based upon managements site plans and estimated annual volumes of waste. The vehicles and equipment included approximately 21,400 collection and transfer vehicles, 1,6 millions containers, and 25,100 stationary compactors. In addition, the form 10-K stated that company owned, operated or leased 16 trash-to-energy facilities, eight cogeneration and small power production facilities, two coal handling facilities, three biosolids driying, pelletizing and composting facilities, one wastewater plan 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 straight-line method as follows:

Buildings10 to 40 years

Vehicles and equipment3 to 20 years

Leasehold Improvements Over the live of the lease

Other information about the companys financial position as of December 31. 1996 is shown below in the consolidated Balance Sheet:

(Gambar 2)

FRAUD 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 anded December 31, 1996 and for three-moonth periods ended March 31, 1997 and June 20, 1997. The press release also disclosed managements 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 request by the SECs Division of Corporation Finance, the January 5 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 investements as well as a review of certain of its accounting methods and estimates. The company stated further it was continuing to carefully examine the companys 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 throught 1996, in addition to reporting its financial results for the year ended December 31, 1997. The press released noted that the 1997 fourth quarter result included a special charge and adjustment to expenses related to the companys 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 billions 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 millions.

The februarry press release further disclosed that certain items of expense were incorrectly reported in prior year financial statements. According to the release, the restatement principally related to the calculation of vehicle, equipment and container depreciation expense and capitalized interest cost related to landfills. The company admitted to the use of incorrect vehicle and container salvages values and usefull lives assumption. In responses, the company disclosed that it had implemented new, more conservative accounting policies and practices including those realted to landfill cost accounting and had adopted new fleet management strategy impacting vehicle and equipment depreciation and amortization. In particular, the company disclosed that it was 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 wheter currently unpermitted expansions to exisiting 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 & Poors lowered its rating on Waste Managementt, Inc. to BBB from A as news of the companys overstatement of earnings became public , waste managements shareholders lost more than $6 billion in the market value of their investments when the stock price plummeted by more than 33%. In Marcgh 1998, the SEC announced a formal investigation into the companys 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 Managements financial result between 1992 and 1997. According to Thomas C. Newkirk, associate director of the SECs Division of Enforcement, Our Complaint described 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.

The SECs complaint alleges that company management fraudulently manipulated the companys financial results to meet predetermined earnings targets. The companys revenues were not growing fast enough to meet those targets, so the defendants resorted to improperly eliminating and deferring current period expenses to inflate earnings. They employed a multitude of improper accountinf practices to achieve this objective. Among other things, the SEC noted that the defendants:

Avoided depreciation expenses on their garbage trucks by both assigning unsupported and inflated salvage values and extending their useful lives.

Assigned arbitrary salvages values to the other assets that previously had no salvage value.

Failed to record expenses for decreases in the value of landfills as they were filled with waste.

Refused to record expenses necessary to write off the costs of unsuccessfull and abandoned landfill developments projects.

Established inflated environtmental reserves (liabilities) in connection with acquisitions so that the excess reserves could be used to avoid recording unrelated operating expenses.

Improperly capitalized a variety of expenses, and

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 targeted earnings, and was the spokesperson who announced the companys phony numbers. During the year, Buntrock and other corporate officers monitored the companys actual result and compared them to the quarterly targeted set in budget. To reduce expenses and inflate earnings artificially, the officers use top-level adjustments to conform the companys actual results to the oredetermind earnings targets. The inflated earnings of one period became the floor for future manipulations. Yo 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 know as netting and geography to make reported result paper better than they actually were and to avoid public scrutiny. The netting activities allowed them to eliminate approximately $490 million current period accounting misstatements by offsetting them against unrelated one-time gains on the sale exchange of assets. The geography entries allowed them to move tens of millions of dollars between various line items on the companys 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 bulding the profitability of the companys core solid waste operations and at all times exercised overall control over the companys largest subsidiary. He ensured that required write-offs were not recorded and, in some instances, overruled accounting decision that would have 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, he defendants fraudulent conduct was driven by greed and desire to retain their corporate positions and status in business and social communities. Buntrock podes 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 benefits by donating inflated company stock to his college almamater to fund a building in his name. he was the primary beneficiary of the fraud and allegedly reaped more than $16,9 millions in ill-gotten gains from, among other things, performance based bonuses, retirement benefits, charitable giving, and selling company stock while the fraud was ongoing. Rooney allegedly reaped more than $9,2 million ill-gotten gains from, among other things, performance based bonuses, retirement benefits, charitable giving, 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 companys long-time auditor, Arthur Andersen, LLP, which had served as waste managements 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 Managements history as a public company had previously worked as an auditor at Andersen.

During the 1990s, approximately 14 former Andersen employees work for Waste Management, most often in key financial and accounting positions. During the period 1991 through 1997, Andersen billed Waste Management approcimately $7,5 million in audit fees and $11,8 millions 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 thew fraud, waste management executives capped Andersens audit fees and advised the Andersen engagement partner that the firm could earn additional fees through special work. Andersen nevertheless identified the companys improper accounting practices and quantified much of the impact of those practices on the companys financial statements. Andersen annually presented company management with what it called proposed adjusting journal entries (PAJEs) to correct errors that undertated expenses and overstated earnings in the companys financial statements.

Management consistently refused to make the adjustments called by the PAJEs, according to the SECs 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 companys 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 unrevaled. In mid-July 1997, a new CEO ordered a review of the companys accounting practices. That review ultimately led to the restatement of the companys financial statements for 1992 through the third quarted of 1997.

EPILOGUE

In addition to the fraudulent activities related to the 1992 through 1997 financial statements, waste managements 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 result for the companys 1999 second quarter. According to the SEC, in June 1999 management continued to reiterate projected result for quarter ended June 30,199, despite being aware of significant adverse trends in its business which made continued public support of its announced forecasts unreasonable. Apparently, waste managements information system failures made junes earnings forecast even more unreasonable since the company could not generate information from which reliable forecasts could be made.

The SECs order was triggered by a July 6, 1999 company announcement of revenue shortfalls versus its internal bufget of approcimately $250 million for the second quarter. This news sent the share prices falling. On july 7, 1999, share 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. 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 penalty of %7 million, the largest ever assessed against an accounting firm at the time. The SEC 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 companys annual financial statements conformed to generally accepeted accounting principles. According to Richard Walker, SEC Director of Enforcement, Arthur Andersen and its partners failed to stand up to the company management and thereby betrayed their ultimate allegiance to Waste Managements Shareholders and 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 allefations. 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 audits of Enron Corporation and the accounting firms ultimate demise.