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Introduction to the Company:
Tyco International Ltd. is a diversified manufacturing
and service company that caters to a vast number
of people through its five business segments.
The Fire and Security segment designs, manufactures,
installs, monitors and services electronic security
and fire protection systems. The Electronics segment
designs, manufactures and distributes electrical
and electronic components, and designs, manufactures,
installs, operates and maintains undersea fiber-optic
cable communications systems. The Healthcare segment
designs, manufactures and distributes medical
devices and supplies, imaging agents, pharmaceuticals
and adult incontinence and infant care products.
The Engineered Products and Services segment designs,
manufactures, distributes and services engineered
products and provides environmental and other
industrial consulting services. The Plastics and
Adhesives segment designs, manufactures and distributes
plastic products, adhesives and films (Tyco official
website).
Thesis:
Tyco International Ltd. blatantly misstated accounts,
concealed information from its auditors and exploited
company schemes while its auditors watched and
refrained from exercising required audit procedures
to reveal the malpractice, all the while becoming
a party to the fraud. With the recent spate of
corporate scandals, this one has again put a question
mark on business credibility.
Analysis:
The Accounting Fraud:
It was in January 2002 that questions rose about
the accuracy of Tyco's bookkeeping and accounting.
The stock value dropped by 19 percent as investors
became less than confident about the company’s
position. The Securities and Exchange Commission
began an investigation of Tyco's top executives
and inquiries into the accuracy of the company's
books began.
The Securities and Exchange Commission reported
a number of key findings, all confirming suspicions
of possible accounting malpractices that had been
carefully masked by company auditors. During the
time period between 1997 and 2001, Price Waterhouse
Coopers (PwC) LLP was responsible for Tyco’s
financial audits and Richard P. Scalzo was the
PwC engagement partner for these audits. When
these audits were being conducted, Scalzo gained
knowledge of certain events and practices that
warned him about the integrity of Tyco’s
senior management. The SEC found that at least
by the end of the audit for fiscal year ended
September 30, 1998, if not before, Scalzo knew
enough incriminating facts to have compelled him
to reevaluate the risk assessment of the Tyco
audits and to carry out additional audit procedures.
But Scalzo did not take the required steps in
these regards. Hence, PwC, on behalf of Scalzo,
disregarded the Generally Accepted Accounting
Standards openly and went against them. However,
at the end of all the fiscal years, from 1998
till 2001, the firm still released an audit report,
stating falsely on it that it had audited Tyco’s
financial reports “in accordance with auditing
standards generally accepted in the United States
of America” when this had in fact not been
done. Presented in the paragraphs below are some
facts about accounting malpractices at Tyco International
Ltd. and Scalzo’s knowledge of them (Tyco
details corporate wrongdoing; United States of
America before the Securities and Exchange Commission).
The SEC found in its investigation that the company’s
top executives, L. Dennis Kozlowski (Tyco's Chairman
of the Board, President, and Chief Executive Officer)
and Mark H. Swartz (Tyco's Chief Financial Officer
and an Executive Vice President) were using the
KELP (Tyco’s Key Employee Loan Program,
started in 1983, designed to encourage ownership
of Tyco common shares by executives and other
principal employees) for purposes of payment of
taxes on the vesting of restricted stock. The
audit for 1997 discovered that the KELP account
activity for Kozlowski was suspicious: Most of
the line items for the account said “WINE
CELLAR”, “NEW ENG WINE”, “BMW
REG/TAX”, “WALDORF”, “WALDORF
EXPEN” and such like – obviously not
the payment of taxes on the vesting of restricted
tax. Tyco’s senior management continued
to exploit the KELP as a “revolving line
of credit” and this continued for the years
following 1997 as well, up until 2001. Aside from
this, Kozlowski and Swartz used the KELP to borrow
more than $50 million and then exercised the stock
options available to them. This stock was later
sold back to the company, through an off-shore
subsidiary (United States of
America before the Securities and Exchange Commission).
By the 1999 audit, it was found by PwC’s
audit team that some of Tyco’s top officers
had been granted non-interest-bearing loans of
tens of millions of dollars. For example, Kozlowski
had $35.5 million, and that Swartz had $8 million,
of such loans. These were granted under Tyco’s
relocation loan program and were meant to be used
to facilitate Tyco employees in the purchase of
real estate, according to company requirements
that these employees relocate to offices in New
York City and Boca Raton, Florida. When the audit
team recommended that as due the firm’s
standard audit procedures, Tyco should disclose
the existence of such non-interest-bearing loans,
Swartz told Scalzo that such disclosure was not
necessary because the loans were immaterial to
Tyco's financial statements. He downright refused
to make the disclosure and this was another question
mark on the integrity and credibility of Tyco’s
executives (United States of America before the
Securities and Exchange Commission).
Tyco’s management continued to use general
unallocated reserves to off-set unexpected expenses
throughout the fiscal years 1998-2001. Scalzo
was privy to this and witnessed Tyco’s accounting
practices going against accounting standards:
once, in 1999, the PwC team auditing Tyco’s
Flow Control division found that expenses of $10.6
million at the division’s Earth Tech subsidiary
had been wrongly charged against purchase accounting
accruals and had to be reversed, Tyco emerged
with additional post-period adjustments to counter
the impact of this unexpected charge. What Tyco
had done was that, in order to make up for the
purchase accounting reversals, it included items
that PwC had marked for inclusion on the fiscal
year 1999 SUD, but it booked these items selectively
and only as necessary to off-set the impact of
the unanticipated charges (United States of America
before the Securities and Exchange Commission).
In the period of one calendar year, there were
three occasions when the company’s practices
regarding executive bonuses were suspicious. Scalzo
was aware of all three. For example, in September
2000, Kozlowski decided to grant bonuses to fifty-one
Tyco officers, managers, and employees, as rewards
for their contributions to the gain from the TyCom
IPO. This would be in the form of cash, forgiveness
of relocation loans, and/or Tyco stock under Tyco's
restricted stock program. These bonuses totaled
$95,962,653, of which Kozlowski and Swartz received
$49,586,754. During the SEC investigation, it
was uncovered that
Tyco had classified $44,642,065 of the $95.9 million
as a TyCom offering expense, and the rest had
been charged against previous over-accruals of
general and administrative expense and against
an accrual for federal income taxes. This was
a blatant misstatement of accounts. Aside from
this, Tyco had also given PwC false information
during the audit of 2001 regarding $20 million
finder’s fee paid to Frank E. Walsh, Jr.,
then a Tyco outside Director, in connection with
Tyco's 2001 acquisition of The CIT Group, Inc.
All of this was strictly against accounting standards
and practices. (United States of America before
the Securities and Exchange Commission)
Possible Auditing Procedures:
The fraud was being detected but Scalzo was not
following the requirements of the GAAS. This was
how Tyco managed to successfully indulge in malpractice
for consecutive fiscal years. Scalzo did not adhere
to the requirements of GAAS when he conducted
the financial statement audits for fiscal years
1998, 1999, 2000, and 2001, under an assessment
of risk that was never marred or changed by facts
and events that he became privy to, such facts
and events which definitely questioned the integrity
of Tyco’s top brass.
For example, as per AU § 316.33, Scalzo did
not “modify the nature, timing, and extent
of other planned procedures” when he came
upon incriminating facts. He did not reevaluate
risk assessment when he came across certain conditions
such as refusal to disclose the existence of non-interest-bearing
loans or concealment of events like Frank E. Walsh,
Jr.’s finder’s fee as he should have
done according to AU § 316.25, .33. In the
course of these years, Scalzo never reassessed
the level of audit risk relating to executive
compensation or related party transactions. Non-disclosure
on financial statements was not dealt with the
seriousness and severity dictated by standard
audit procedures. For example, if Scalzo had reevaluate
audit risk in this regard and had taken additional
audit steps to disclose the loans or their authorization,
Tyco might not have continued to dodge the system.
Scalzo should have done more than just review
and consider the company’s financial statements
– he should have reviewed the PwC working
papers on the use of the loans, he should have
insisted on their prominent disclosure and he
should have well informed the audit committee
of the existence of these loans.
Audit risk should also have been reevaluated when
the issue arose about bonuses being granted in
connection with the TyCom IPO. When Scalzo was
told by Swartz, a principal beneficiary of the
bonuses that they were immaterial, he should have
reevaluated audit risk. He should also have insisted
that they be obviously disclosed in the financial
statements and he should have informed the audit
committee that Kozlowski and Swartz were recipients
of these bonuses. When Scalzo found that the Tyco
management had hid information about the Walsh
CIT finder’s fee and had in fact, misreported
facts, he should have reevaluated audit risk for
such transactions and taken additional audit steps
as per requirement of the GAAS.
Hence, Tyco was definitely indulging in fraudulent
activities but the very purpose of an audit is
to detect and expose such fraud. When Scalzo and
PwC failed to reveal the malpractice they knew
about and take the required audit steps to further
reach at the helm of affairs, they encouraged
Tyco to continue to deceive the system (United
States of America before the Securities and Exchange
Commission; Symonds & Brady, 2002).
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