Care 1.5 Waste Management: The Definition of an Asset Synopsis In February 1998 Waste Management announced that it was restating the financial statements it had issued for the years 1993 through 1996. In its restatement, Waste Management said that it had materially overstated is reported pretax earnings by 51.43 billion. After the announcement, the company's stock dropped by more than 33 percent and shareholders lost over $6 bilion. The SEC brought charges against the company's founder, Dean Buntrock, and five other fornier top officers. The charges alleged that management had made repeated changes to depreciation-related estimates to reduce expenses and had entployed several improper accounting practices related to capitalization policies, also designed to reduce expenses. In its final judg. ment, the SEC permanently barred Buntrock and three other executives from acting as officers or directors of public companies and required pay ment from them of $30.8 million in penalties Capitalization of Landfill Costs and Other Expenses Under Generally Accepted Accounting Principles (GAAP), a cost can be capi- talized if it provides economic benefits to be used or consumed in future opera tions. A company is required to write off, as a current period expense, any deferred costs at the time the company learns that the underlying assets have been either impaired or abandoned. Any costs to repair or return property to its original condition are required to be expensed when incurred. Finally, interest SEC, Accounting and Auditing forcement ease No. 152 March 26, 2002 2 SEC, Accounting and Auditing Enforcement Release No. 229 August 29, 2005 22 Section One Proud Cases Violations of Accounting Principles can be capitalized as part of the cost of acquiring assets for the period of time that it takes to put the asset in the condition required for its intended use. How- ever, GAAP requires that the capitalization of interest must cease once the asset is substantially ready for its intended use. Capitalization of Landfill Permitting Costs Waste Management capitalized the costs related to obtaining the required permits to develop and expand its many landfills. It also capitalized interest on landfill construction costs, as well as costs related to systems development at its landfills. As part of its normal business operations, Waste Management allocated sub- stantial resources toward the development of new landfills and the expansion of existing landfills. A significant part of the landfill development and expan- sion costs related to the process of obtaining required permits from government authorities. Over the years, the company faced increasing difficulty in obtain- ing the required landfill permits, and had already invested significantly in many projects that had to be abandoned or were materially impaired when the required permits could not be obtained The company routinely capitalized the costs related to obtaining the required permits, so it could defer recording expenses related to those landfills until they were put into productive use. However, instead of writing off the costs related to impaired and/or abandoned landfill projects and disclosing the impact of such write-offs, management disclosed in its Form 10-K filed with the SEC only the risk of future write-offs related to such projects. The management team of Waste Management also allegedly transferred the costs of unsuccessful efforts to obtain permits to other sites that had received permits or sites for which the company was still seeking permits. In effect, it was commingling impaired or abandoned landfill project costs with the costs of a permitted site (a practice known as "basketing, which did not comply with GAAP). In addition to basketing, the company also allegedly transferred unamortized costs from landfill facilities that had closed earlier than expected to other facilities that were still in operation (a practice known as "bundling" which also did not comply with GAAP). Management never disclosed the use of bundling or basketing in its Form 10-Ks. In 1994, after its auditor Arthur Andersen discovered these practices, man- agement allegedly agreed to write off $40 million related to dead projects over a span of 10 years, and also promised to write off future impairments and aban- donments in a prompt manner. However, during 1994, 1995, 1996, and 1997, management effectively buried the write-offs related to abandoned and impaired projects by netting them against other gains, as opposed to identify ing the costs separately as it had promised Andersen Case 1.5 Waste Management: The Definition of an Aset 23 Capitalization of Interest on Landfill Construction Costs In accordance with GAAP, Waste Management was able to capitalize interest related to landfill development because of the relatively long time required to obtain permits, construct landfills, and prepare them to receive waste. How- ever, Waste Management utilized the "net book value (NBV) method," which essentially enabled it to avoid GAAP's requirement that interest capitalization cease once the asset became substantially ready for its intended use. Waste Management's auditor, Arthur Andersen, advised the company from its first use of the NBV method (in 1989) that this method did not conform to GAAP. Corporate Controller Thomas Hau admitted that the method was "techni- cally inconsistent with FAS Statement No. 34 (the controlling GAAP pro- nouncement] because it included interest (capitalization related to cells of landfills that were receiving waste." Yet the company wrote in the footnotes to its financial statements that "li]nterest has been capitalized on significant land- fills, trash-to-energy plants and other projects under development in accor- dance with FAS No. 34." Ultimately the company agreed to utilize a new method that conformed to GAAP, beginning January 1, 1994. Corporate Controller Thomas Hau and CFO James Koenig allegedly determined that the new GAAP method would result in an increased annual interest expense of about $25 million; therefore they chose to phase in the new method over three years, beginning in 1995. However, the com- pany was still utilizing the NBV method for interest capitalization as of 1997 Capitalization of Other Costs The company also chose to capitalize other costs, such as systems development costs, rather than record them as expenses in the periods in which they were incurred. In fact, it used excessive amortization periods (10- and 20-year peri- ods for the two largest systems) that did not recognize the impact of technolog- ical obsolescence on the useful lives of the underlying systems. The SEC found evidence that the company's auditor Arthur Andersen proposed several adjusting journal entries to write off the improperly deferred systems development costs. Andersen also repeatedly advised management to shorten the amortization periods. In 1994 management finally agreed to shorten the amortization periods and to write off financial statement mis statements resulting from improperly capitalized systems costs over a period of five years. During 1995 the company changed the amortization periods and wrote off improperly capitalized systems costs by netting them against other gains. Ibid 1. Identify SAS No. 99 risk factors implicated by the case. 2. Define the key principle or concept identified in the title. (e.g., what is the revenue recognition principle? What is the definition of "asset?" What is the expense recognition principle?) 3. Discuss the core accounting issues associated with the principle or concept. Care 1.5 Waste Management: The Definition of an Asset Synopsis In February 1998 Waste Management announced that it was restating the financial statements it had issued for the years 1993 through 1996. In its restatement, Waste Management said that it had materially overstated is reported pretax earnings by 51.43 billion. After the announcement, the company's stock dropped by more than 33 percent and shareholders lost over $6 bilion. The SEC brought charges against the company's founder, Dean Buntrock, and five other fornier top officers. The charges alleged that management had made repeated changes to depreciation-related estimates to reduce expenses and had entployed several improper accounting practices related to capitalization policies, also designed to reduce expenses. In its final judg. ment, the SEC permanently barred Buntrock and three other executives from acting as officers or directors of public companies and required pay ment from them of $30.8 million in penalties Capitalization of Landfill Costs and Other Expenses Under Generally Accepted Accounting Principles (GAAP), a cost can be capi- talized if it provides economic benefits to be used or consumed in future opera tions. A company is required to write off, as a current period expense, any deferred costs at the time the company learns that the underlying assets have been either impaired or abandoned. Any costs to repair or return property to its original condition are required to be expensed when incurred. Finally, interest SEC, Accounting and Auditing forcement ease No. 152 March 26, 2002 2 SEC, Accounting and Auditing Enforcement Release No. 229 August 29, 2005 22 Section One Proud Cases Violations of Accounting Principles can be capitalized as part of the cost of acquiring assets for the period of time that it takes to put the asset in the condition required for its intended use. How- ever, GAAP requires that the capitalization of interest must cease once the asset is substantially ready for its intended use. Capitalization of Landfill Permitting Costs Waste Management capitalized the costs related to obtaining the required permits to develop and expand its many landfills. It also capitalized interest on landfill construction costs, as well as costs related to systems development at its landfills. As part of its normal business operations, Waste Management allocated sub- stantial resources toward the development of new landfills and the expansion of existing landfills. A significant part of the landfill development and expan- sion costs related to the process of obtaining required permits from government authorities. Over the years, the company faced increasing difficulty in obtain- ing the required landfill permits, and had already invested significantly in many projects that had to be abandoned or were materially impaired when the required permits could not be obtained The company routinely capitalized the costs related to obtaining the required permits, so it could defer recording expenses related to those landfills until they were put into productive use. However, instead of writing off the costs related to impaired and/or abandoned landfill projects and disclosing the impact of such write-offs, management disclosed in its Form 10-K filed with the SEC only the risk of future write-offs related to such projects. The management team of Waste Management also allegedly transferred the costs of unsuccessful efforts to obtain permits to other sites that had received permits or sites for which the company was still seeking permits. In effect, it was commingling impaired or abandoned landfill project costs with the costs of a permitted site (a practice known as "basketing, which did not comply with GAAP). In addition to basketing, the company also allegedly transferred unamortized costs from landfill facilities that had closed earlier than expected to other facilities that were still in operation (a practice known as "bundling" which also did not comply with GAAP). Management never disclosed the use of bundling or basketing in its Form 10-Ks. In 1994, after its auditor Arthur Andersen discovered these practices, man- agement allegedly agreed to write off $40 million related to dead projects over a span of 10 years, and also promised to write off future impairments and aban- donments in a prompt manner. However, during 1994, 1995, 1996, and 1997, management effectively buried the write-offs related to abandoned and impaired projects by netting them against other gains, as opposed to identify ing the costs separately as it had promised Andersen Case 1.5 Waste Management: The Definition of an Aset 23 Capitalization of Interest on Landfill Construction Costs In accordance with GAAP, Waste Management was able to capitalize interest related to landfill development because of the relatively long time required to obtain permits, construct landfills, and prepare them to receive waste. How- ever, Waste Management utilized the "net book value (NBV) method," which essentially enabled it to avoid GAAP's requirement that interest capitalization cease once the asset became substantially ready for its intended use. Waste Management's auditor, Arthur Andersen, advised the company from its first use of the NBV method (in 1989) that this method did not conform to GAAP. Corporate Controller Thomas Hau admitted that the method was "techni- cally inconsistent with FAS Statement No. 34 (the controlling GAAP pro- nouncement] because it included interest (capitalization related to cells of landfills that were receiving waste." Yet the company wrote in the footnotes to its financial statements that "li]nterest has been capitalized on significant land- fills, trash-to-energy plants and other projects under development in accor- dance with FAS No. 34." Ultimately the company agreed to utilize a new method that conformed to GAAP, beginning January 1, 1994. Corporate Controller Thomas Hau and CFO James Koenig allegedly determined that the new GAAP method would result in an increased annual interest expense of about $25 million; therefore they chose to phase in the new method over three years, beginning in 1995. However, the com- pany was still utilizing the NBV method for interest capitalization as of 1997 Capitalization of Other Costs The company also chose to capitalize other costs, such as systems development costs, rather than record them as expenses in the periods in which they were incurred. In fact, it used excessive amortization periods (10- and 20-year peri- ods for the two largest systems) that did not recognize the impact of technolog- ical obsolescence on the useful lives of the underlying systems. The SEC found evidence that the company's auditor Arthur Andersen proposed several adjusting journal entries to write off the improperly deferred systems development costs. Andersen also repeatedly advised management to shorten the amortization periods. In 1994 management finally agreed to shorten the amortization periods and to write off financial statement mis statements resulting from improperly capitalized systems costs over a period of five years. During 1995 the company changed the amortization periods and wrote off improperly capitalized systems costs by netting them against other gains. Ibid 1. Identify SAS No. 99 risk factors implicated by the case. 2. Define the key principle or concept identified in the title. (e.g., what is the revenue recognition principle? What is the definition of "asset?" What is the expense recognition principle?) 3. Discuss the core accounting issues associated with the principle or concept