Question: Waste Management, Inc.’s Form 10-K

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 NewYork 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 pressure 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 in the Consolidated Balance Sheet that follows.



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 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 financial 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 inflate earnings.They employed a multitude of improper accounting 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 salvage values to 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 unsuccessful and abandoned landfill development projects,  Established inflated environmental 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 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, performance-based 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 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 forWaste 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. TheWall Street Journal subsequently reported that the company eventually 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. REQUIRED [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? PROFESSIONAL JUDGMENT QUESTIONS It is recommended that you read the Professional Judgment Introduction found at the beginning of the book prior to responding to the following questions. [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 statements?