Waste_management_case_study_examination.docx

Waste Management Case Study Examination of Fraud Southern New Hampshire University For: Professor Kari Day By: Christopher Broome Date: 06/08/2014

Waste Management Case Study: Examination of Fraud

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Abstract From 1992-1997, Waste Management was found to have materially misstated their financial statements. The misstatements were a product of top management’s deceit in order to earn bonuses based on the company’s performance. When confronted by their external auditors, they not only refused to make their corrections, but enticed them to help conceal the fraud. Overall, the fraud occurred due to an organization breakdown of control and balance. The only members of the organization who had the opportunity and ability to commit such a massive fraud, did so without any resistance. They proceeded as if they were above the law and that the only thing that mattered was taking as much as they could. This was a fraud that was apparent, could have been mitigated by the board of directors, could have been reported by the auditors, but no one was accountable for their responsibilities to the organization until it was too late.

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“The Company’s primary objective is to maximize stockholder value, while adhering to the laws of the jurisdictions within which it operates and observing the highest ethical standards.” The previous statement is the mission statement of Waste Management (“WM”). Waste Management is a waste disposal company that was founded on promoting the health and prosperity of those they served through a clean environment. Each mission statement harbors an underlying fiduciary responsibility of honesty and protection of their community members of all sorts. Instead of honoring such commitments, they let their greed guide their actions. Management was determined to expand the company and drive revenues at any cost, figuratively and literally. What this led to was increasingly risky and ill-advised practices, especially with their accounting, to meet goals to trigger big pay days and cover their tracks. A few individuals compromised the wellbeing of a company, its employees, its shareholders, and its customers. Their fraudulent actions and complete disregard for the standards they swore to uphold were clear, methodical, and a reckless endangerment for all associated. Establishing an executive compensation package is a complicated process. It requires handsome rewards for maximizing shareholder wealth, as stated in Waste Management’s mission statement. This is necessary to make the job attractive to the executives that immerse themselves in their jobs. The opportunity cost of use of time and amount of pay may dissuade candidates from leading companies if they do not feel their services are compensated appropriately. By offering a high base salary, the company could be in jeopardy of instituting a lame duck culture with a CEO that is not driven to succeed. By tying compensation to performance figures, the company risks an environment that is pressure packed and filled with executives that will do whatever it takes to meet their projections.

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The latter is the compensation plan that was implemented at WM. The incentive latent plan injected greed and deceit into the business when management struggled to meet its objectives. On March 26, 2002, the SEC completed an investigation of Waste Management and filed a complaint against the company. This came about due to fraudulent activity perpetrated by the executive management team. According to the NY Times, the officers accused were Dean Buntrock, founder and CEO, Philip Rooney, former president, James Koenig, CFO, Thomas Hau, CAO, Hebert Getz, general counsel, and Bruce Tobecksen, VP of Finance (Schroeder, 2001, p.1). It is a list of the only individuals who could have had the opportunity to commit such a massive fraud. With the adjustments coming after period numbers were in, the fraud would have surpassed most internal controls. These men were chosen for their business savvy, hard work, and integrity. Ultimately the founder fostered a culture that created crooks. In this case, the federal government filed a complaint against WM. It is not apparent as to whether they were unable to filed criminal charges against the officers or if they chose not. The Sarbanes Oxley Act of 2002 had been passed two months earlier. Amongst the items listed in the complaint was fraudulent record keeping and financial reporting, but the complaint was headlined by a violation of anti-fraud provision in the Securities Act of 1933. To paraphrase the act, “it is illegal to offer securities through interstate commerce by misstating related material information” (Congress, 2012, p.57). This provision is an easily enforceable piece of legislation that allows the federal government to impose civil liability on any public company that violates the act. The civil fines and penalties were imposed to penalize WM as a company for the wrongdoing of the officers. Because there was a civil complaint as opposed to criminal charges,

Waste Management Case Study: Examination of Fraud

the officers ordinarily would have escaped the brunt of the punishment. To ensure the fraudster did not benefit even after civil penalties the fraudsters were also punished with a “disgorgement of ill-gotten gains. According to Investopedia, disgorgement is to pay back ill-gotten gains (Disgorgement, 2013, p.1). The gains that are to be repaid via disgorgement are purely what were taken as part of any wrongdoing. They are separate from any punitive damage handed down in the civil court. Disgorgement would not have been limited to the fraudsters. Anyone who profits from illegal activity regardless of whether they were involved may be required to forfeit such gains, including those making obviously favorable trading decisions on the open market. It is not unlike the fruit of the poisonous tree where one cannot gain from illegal procedures. Those involved received their punishment and retribution was served, but like any fraud, it may have been detected earlier. The fraud that was perpetrated was a blatant violation and departure from general accepted accounting principles (GAAP). Their desire was to meet earnings protections so their goal was to expand their profit by pushing down or foregoing expenses. Listed in the complaint were accusations that WM would extend the useful life of depreciable assets and adjust their salvage value. Under U.S GAAP, companies are allowed to use multiple methods for depreciating assets. The salvage value is the amount an asset will be worth on the books once it is fully depreciated. Waste Management would extend the useful life of assets to avoid depreciation expenses. They would also inflate the salvage value of their assets. This would minimize the capital gain on the disposition of the asset. By lowering their capital gains, they minimize their income tax expense. A second form of earnings manipulation WM enacted was improper capitalization of expenses. Expenses can be classified as either revenue or capital. An expense is classified as

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Waste Management Case Study: Examination of Fraud

capital if it extends the useful life of an asset. An expense is revenue in nature when it is used to facilitate operations. Waste Management would frequently capitalize assets that did not fit those parameters. By doing so, they would defer expenses paid on the books. These capitalized items would be depreciated over a false useful life and incrementally affect the income statement as opposed to suddenly, as it should have been. Additionally, the other way this practice affects their financial statements is by overstating their assets and inflating their balance sheet. The company appeared to be in a much stronger position with fraudulent profits rolling into retained earnings, false assets, and no increase in liabilities. The underlying accounting violation the company was guilty of is the expense recognition principle. According to Kieso, expenses should be recorded in the period they are incurred (when assets are “used up” or liabilities are incurred) (2011, p.74). By avoiding the recognition of expenses and pushing them to future periods, they materially misstated their financial statements. The tactics listed above would skew any analytical measurements an outside evaluator would try to perform. The fraud activities were buried deep in their financial statements. Their actions were departures from several pieces of the two major fundamental qualities of the hierarchy of accounting, relevance and faithful representation. Without those aspects ingrained into the culture of accounting, the financial statements can never be reporting properly. As a public company, WM was required to have their books audited. As one of the biggest corporations in the U.S, they required the services of one of the Big Five, Arthur Andersen. Arthur Andersen consistently found the errors in WM’s accounting practices and would propose adjustments to fix them. Waste Management’s officers declined to make those adjustments. Instead they offered Arthur Andersen the opportunity to perform “special work” to

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earn additional fees outside of the scope of their agreement. Ultimately, WM bribed Arthur Andersen to issue unqualified opinions in their audit report and to write off the accounting errors over time to conceal the fraud. It was at this stage where the company began to commit illegal acts outside of their accounting fraud. It is curious to question as to why the officers, especially Buntrock, the founder and CEO would want to defraud their shareholders and risk their livelihood. It is not as if they were not handsomely paid before the fraud. As the public would come to find out, money does make the world go round, but self-preservation is a strong motivator as well. It was the CEO, Dean Buntrock that set the earnings goals for the company. As stated in the introduction of this paper, tying officer compensation to earnings can be a strong, but risky motivator. Although it is the CEO’s manage the direction of the company, the CEO answers to the board of directors, who in turn answer to the shareholders. When the company struggles, especially when they fall short of earnings protections, it endangers the CEO and their officer team. It is natural to want to prevent that. That does not mean that the officers should have taken a by any means necessary approach. The officers perpetrated this fraud to protect their jobs and sustained it to undeservedly enrich their lives. In the end, Waste Management would have to correct all the accounting misstatements they recorded over the years. As stated in the SEC’s complaint, “when the company filed its restated financial statements in February 1998, the company acknowledged that it had misstated its pre-tax earnings by approximately $1.7 billion. At the time, the restatement was the largest in corporate history” (Waste, 2002, p.1). This restatement would cause the stock price to tumble.

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Some of the officers sold their shares in WM before the restatement in an attempt to avoid massive losses. Before government intervention, it was the shareholders that absorbed the brunt of the loss. Eventually, the day of reckoning had to come for the fraudsters and the company. Three years after the SEC filed its complaint, they settled with four of the originally listed charged men, including Buntrock, Rooney, Hau, and Getz. According to the SEC, “the Judgments also require payment of over $30 million in total, comprised of $16.4 million in disgorgement, $10.4 million prejudgment interest, and $4 million in civil penalties” (SEC,2005, p.1). This ruling ensured that not only would the fraudsters not profit from their actions, but be severely penalized in addition to what they stole. The former CFO, Koenig, chose to take the charges to civil litigation and lost. He was ordered to pay more than four million dollars in 2008. Finally, the Wall Street Journal reported that Waste Management and Arthur Andersen settled a class action law suit filed by the shareholders for $229 million for damages caused by the fraud. This settlement was separate from the $457 million agreement Waste Management came to for accounting failures in 1998 during a merger. Investors/creditors were not given fair presentation for analyzing the financial statements. A troubling item in their financial statements would have been their continual uses of one-time expense write offs. Waste Management was able to separately state expense items that they said were not reoccurring and therefore should not be used in the valuation of the business. Doing this would make the company look more favorable and achieve earnings goals. These write-offs should have been disclosed.

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Investors could have and should have questioned these repeated abuses to get a better understanding as to why these were not related to the ongoing operations. Arthur Andersen was able to uncover the fraud. Although it is not their responsibility to detect fraud, they should help implement internal controls are instituted to prevent fraud. They chose to facilitate the illegal activities. Should another auditor have engaged WM, they would have been exposed to several red flags. These red flags would include lack of debt or equity financing to correspond with supposed capital assets, earnings consistently meeting predetermined targets, and an excessive amount of obsolete fixed assets. Many accounting software’s allow for tracing of adjustments in their system. The auditors could have in revealed the top level adjustments that improperly wrote off millions in expenses each period. When it comes to prevention, the culture at the top should have been addressed. The board of directors should not have allowed a compensation package intertwined with earnings. It entices a culture of fraud. Additionally, an anonymous tip line could have been instituted for employees that were exposed to the fraud, but were not committing the fraud. With the fraud occurring at the highest level, it is that environment that needs to be fixed. Their actions were a clear violation of their mission statement. The officers let their greed get in the way of operating the company in good faith. The failures were not the officers alone. The auditors and board of directors also failed in their duties. The wellbeing of the shareholders and lenders were never considered. It is the responsibility of the board to institute provisions to keep management in check so they shareholders are protected. Instead their lack of action allowed the founder and CEO to do whatever it took to keep his job and make massive amounts of money. It is the shareholder proceeds that allowed the company to operate, yet the negligence of the board and fraudulent acts of management that hurt those they work for.

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References Congress, U. (2012, April 5). The Securities Act of 1933. . Retrieved May 29, 2014, from https://www.sec.gov/about/laws/sa33.pdf Disgorgement." Investopedia. Forbes Magazine. 22 Nov. 2013 Retrieved . Judge Enters Final Judgment Against Former CFO of Waste Management, Inc. Following Jury Verdict in SEC's Favor. (2008, January 3). Press Release: ; 2008-2; Jan. 3, 2008. Retrieved May 20, 2014, from http://www.sec.gov/news/press/2008/2008-2.htm Kieso, D., & Warfield, W. (2011). Intermediate accounting (Fourteenth ed.). USA: John Wiley & Sons. SEC. (2005, August 29). Dean L. Buntrock, Phillip B. Rooney, James E. Koenig, Thomas C. Hau, Herbert A. Getz, and Bruce D. Tobecksen: Lit. Rel. 19351 / August 29, 2005. Dean L. Buntrock, Phillip B. Rooney, James E. Koenig, Thomas C. Hau, Herbert A. Getz, and Bruce D. Tobecksen: Lit. Rel. 19351 / August 29, 2005. Retrieved May 20, 2014, from http://www.sec.gov/litigation/litreleases/lr19351.htm Schroeder, M. 2001. SEC Fines Arthur Andersen $7 Million In Relation to Waste Management Audits. New York Times. Retrieved from http://online.wsj.com/news/articles/SB992971291203974783 Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud. (2002, March 26). Waste Management Founder, Five Others Sued for Massive Fraud. Retrieved May 18, 2014, from http://www.sec.gov/news/headlines/wastemgmt6.htm

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