Case 5-9 Weatherford International

Cast of Characters1 Weatherford International PLC is a multinational Irish public limited company based in Switzerland, with U.S. offices in Houston, Texas. Weatherford's shares are registered with the SEC and are listed on the NYSE. Weatherford files periodic reports, including Forms 10-K and 10-Q, with the Commission pursuant to Exchange Act Section 13(a) and related rules thereunder. James M. Hudgins, CPA, served as Weatherford's Director of Tax from January 1999 until mid-2000, when he became Vice President of Tax, and as an Officer from February 2009 until his resignation on March 31, 2012. Darryl S. Kitay, CPA, served as Weatherford's Tax Manager and Senior Manager from April 2004 until 2011, then as Weatherford's Tax Director through January 2013. Kitay reported to Hudgins from April 2004 until March 2012. Weatherford relieved Kitay of all supervisory responsibilities associated with Weatherford's income tax accounting in May 2012, after the filing of the Second Restatement of financial statements. Weatherford terminated Kitay's employment in July 2013. Ernst & Young LLP was Weatherford's external auditor from 2001 to March 2013. On March 7, 2013, Weatherford's audit committee decided not to re-appoint EY.

SEC Order Against EY On October 18, 2016, the SEC announced that EY agreed to pay more than $11.8 million to settle charges related to failed audits of Weatherford based on the auditors' failure to detect deceptive income tax accounting to inflate earnings. The EY penalty is in addition to the $140 million penalty already agreed to. The combined $152 million will be returned to investors who were harmed by the accounting fraud. The Commission also charged the EY partner who coordinated the audits, Craig Fronckiewicz, and a former tax partner who was part of the audit engagement team, Sarah Adams. Both agreed to suspensions to settle charges that they disregarded significant red flags during the audits and reviews. The SEC's order stated that, despite placing the Weatherford audits in a high-risk category, EY's audit team repeatedly failed to detect the company's fraud until it was more than four years ongoing. The audit team was aware of post-closing adjustments that Weatherford was making to significantly lower its year-end provision for income taxes each year, but it relied on Weatherford's unsubstantiated explanations instead of performing the required audit procedures to scrutinize the company's accounting. The SEC's order also found that EY did not take effective measures to minimize known recurring problems its audit teams experienced when auditing tax accounting.2 Facts of the Case Between 2007 and 2012, Weatherford, a large multinational provider of oil and natural gas equipment and services, issued false financial statements that inflated its earnings by over $900 million in violation of U.S. GAAP. Weatherford issued materially false and misleading statements about its net income, EPS, effective tax rate ("ETR"), and other key financial information. Weatherford did not have sufficient internal accounting controls to identify and properly account for its accounting of income taxes throughout the relevant period.

As a result, Weatherford was forced to restate its financial statements on three separate occasions over eighteen months. The first restatement was made public on March 1, 2011, when Weatherford announced that it would restate its financial results for 2007-2010 and that a material weakness existed in its ICFR for the accounting of income taxes. That restatement, filed on March 8, 2011, reduced previously reported net income by approximately $500 million (the "First Restatement"). $461 million of the First Restatement resulted from a four-year income tax accounting fraud orchestrated by Hudgins and Kitay. Hudgins and Kitay made numerous post-closing adjustments or "plugs" to fill gaps to meet ETRs that Weatherford previously disclosed to financial analysts and the public. This deceptive intercompany tax accounting improperly inflated Weatherford's earnings and materially understated its ETR and tax expense. The fraud created the misperception that the tax structure Weatherford designed to reduce its tax expense and ETR was far more successful than it actually was. From 2007 to 2010, Weatherford regularly promoted its favorable ETR to analysts and investors as one of its key competitive advantages, which it attributed to a superior international tax avoidance structure that Hudgins constructed at the urging of senior management. After announcing the First Restatement, Weatherford's stock price declined nearly 11% in one trading day ($2.38 per share), closing at $21.14 per share on March 2, 2011. The decline eliminated over $1.7 billion from Weatherford's market capitalization. Weatherford announced additional restatements in February 2012 and July 2012 (the "Second Restatement" and "Third Restatement," respectively). After the First Restatement, Weatherford attempted to remediate its material weakness in internal control over income tax accounting. Throughout its remediation efforts in 2011, Weatherford filed its Forms 10-Q on a timely basis and falsely reassured investors that it was performing additional reconciliations and post-closing procedures to ensure that its financial statements were fairly presented in conformity with GAAP. However, Weatherford, through Hudgins and Kitay, failed to review, assess, and quantify known income tax accounting issues that had a high risk of causing additional material misstatement as early as July 2011. When Weatherford filed its Second Restatement on March 15, 2012, Weatherford reported a $256 million drop in net income from 2007-2011 as a result of additional errors in its income tax accounting, and its material weakness in internal control over income tax accounting remained. At least $84 million of that drop in net income resulted from an income tax accounting GAAP violation Hudgins and Kitay knew about, but failed to assess and quantify, before Weatherford filed its third quarter financial statements. Four months after filing the Second Restatement, Weatherford announced that it was withdrawing reliance on all previous financial statements because it had discovered additional income tax errors that reduced prior period net income by $107 million. By the time Weatherford issued its Third Restatement on December 17, 2012, Weatherford had reduced net income from prior periods by an additional $186 million, largely driven by books, records, and internal accounting controls issues identified and corrected during Weatherford's remediation efforts in 2012.

Tax Strategy

A key component of Weatherford's tax strategy was to develop a superior international tax avoidance structure that reduced Weatherford's ETR and tax expense (and increased EPS and cash flow) while providing a competitive advantage over U.S.-based peer companies. In 2002, Weatherford changed its place of incorporation from the U.S. to Bermuda, a 0% tax jurisdiction, through a process known as inversion.

Weatherford further refined its international tax structure from 2003 through 2006 by implementing a series of hybrid instruments to facilitate the movement of revenue from higher tax rate jurisdictions (i.e., Canada and U.S.) to lower tax rate jurisdictions (i.e., Hungary and Luxembourg). Hybrid instruments are often used in international tax planning to achieve deductions in one, typically high tax rate, jurisdiction and shift income to another, typically low tax rate, jurisdiction. Hybrid instruments are structured to incorporate features of both debt and equity, such that the instrument typically qualifies as debt in one jurisdiction and equity in another. Payments on debt may be deducted in computing taxable income while the yields are accrued but not necessarily paid and, therefore, not calculated as taxable income. As a result, these international tax avoidance strategies reduced Weatherford's ETR from 36.3% in 2001 to 25.9% by the end of 2006.

Weatherford senior management and Hudgins understood that Weatherford's tax structure and resulting ETR added significant value and was material to analysts and investors alike. Wall Street analysts closely followed Weatherford's ETR and its effect on earnings. Each percentage point in Weatherford's ETR translated into $0.02 to $0.03 in EPS. Weatherford's senior management knew its tax department was perpetually understaffed and overworked during the years leading up to the First Restatement. Hudgins led a tax staff that was roughly the same size as when he was hired, and Hudgins pressed his employees to work long hours to make Weatherford's tax structure extremely competitive. Weatherford and Hudgins quickly gained a reputation with the company's external auditor as a challenging and demanding client known for taking aggressive accounting positions, particularly in the area of income tax accounting. Although Weatherford reduced its ETR by nearly 10% from 2001 to the end of 2006, its CFO remarked that Weatherford's ETR remained somewhat above that of other inverted peer companies in his response to an analyst's question during the year-end earnings call on January 30, 2007. Soon thereafter, Weatherford started reporting ETR results that created a false perception that its international tax structure was outperforming similarly-situated competitors by a significant margin. For example, in 2008 and 2009, fueled by its deceptive income tax accounting practices, Weatherford reported pre-restatement ETRs of 17.1% and 6.5%. In connection with fiscal years 2007 through 2010, Hudgins and Kitay engaged in fraudulent practices relating to income tax accounting that violated GAAP and made Weatherford's financial statements materially false and misleading. During each of those years, Weatherford repeatedly and publicly disclosed ETR estimates and recorded tax expenses that Hudgins and Kitay knew, or were reckless in not knowing, were fabricated. Each year, Hudgins and Kitay made or authorized unsupported post-closing adjustments to accounting data that intentionally lowered Weatherford's actual ETR and tax expense. To do so, they reversed accounting data that had been correctly input into Weatherford's consolidated tax provision from the company's accounting system, and did not notify Weatherford's accounting department why they had made such adjustments. Hudgins and Kitay performed no work to support the adjustments, which were merely a "plug" to arrive at the lower estimated ETR and tax expense amounts. Without disclosing how they arrived at their numbers, they provided these amounts for inclusion in Weatherford's consolidated financial statements, which senior management shared with analysts and investors repeatedly during earnings calls and public financial statements. This conduct went undetected for over four fiscal years. Kitay identified the existence of the adjustments to EY each year, but, when questioned about them, Kitay made misleading and inconsistent responses to the auditors and failed to disclose the true reason for the adjustments. Kitay sometimes asked Hudgins to review his responses before providing them to EY. The errors were finally discovered in February 2011. By that time, a "phantom income tax receivable" had increased to such dramatically disproportionate heights, over $460 million, that it defied even the unsupported explanations of Hudgins and Kitay. Shortly thereafter, Weatherford released the First Restatement in March 2011.

Results for 2007

The following summarizes the accounting and tax maneuvers for 2007. We limit the discussion to 2007 for the sake of brevity. Throughout the first three quarters of 2007, Weatherford recorded ETR and tax expense pursuant to FIN 18, "Accounting for Income Taxes in Interim Periods." FIN 18 prescribes an estimated annualized ETR approach for computing the tax provisions for the first three quarters of the year, which is based on a company's best estimate of current year ordinary income. GAAP, however, does not allow companies to use FIN 18 to calculate their year-end tax provisions. To comply with GAAP, Weatherford was required to record ETR and tax expense at year end pursuant to FAS 109, "Accounting for Income Taxes." FAS 109 establishes standards on how companies should account for and report the effects of income taxes, including the calculation of the year-end consolidated tax provision. Tax department personnel reviewed that information, after which the tax provisions for legal entities were finalized and then combined on a region-by-region basis. The region-based tax provisions were then consolidated to arrive at a single tax provision from which current and deferred assets and liabilities, associated tax expense (or benefit), and ETR were calculated and recorded. Shortly before Weatherford was scheduled to release its year-end financial results for 2007, however, Hudgins and Kitay discovered the year-end ETR and tax expense that had been calculated pursuant to FAS 109 far exceeded the ETR estimates and tax expense disseminated publicly to analysts and investors during the first three quarters of 2007 based on their ETR estimates. Faced with a deadline for reporting earnings, Hudgins and Kitay falsified the year-end consolidated tax provision by making an unsubstantiated manual $439.7 million post-closing "plug" adjustment to two different Weatherford Luxembourg entities. To do so, they intentionally reversed accounting data that had been correctly input to Weatherford's consolidated tax provision via the company's accounting system.3 The resulting plug adjustment, which Hudgins and Kitay then improperly applied a 35% tax rate to, allowed Weatherford to reduce its tax expense by $153.9 million for the year and to lower its ETR in line with previous ETR estimates publicly disclosed during quarterly calls with analysts. Hudgins and Kitay took no steps to determine the necessity and accuracy of the plug adjustment, either before or after it was made. They performed no work at any time to determine whether plugging the gap was appropriate under GAAP and made no attempt to substantiate the difference between the their publicly disclosed ETR estimates and tax expenses with the FAS 109 actual results that they were witnessing. Both Hudgins and Kitay knew, or were reckless in not knowing, that they should have reviewed and substantiated the actual tax numbers after the close process, but they never did. Hudgins and Kitay made no attempt to alert Weatherford's accounting department, internal auditor, or senior management of the significant issues related to its FAS 109 actual ETR results. Nor did they notify EY of any discrepancy. During 2007 and throughout the relevant period, Hudgins signed representation letters relied upon by Weatherford senior management and EY indicating, without exception, that the ICFR for the accounting of income taxes were effective and that the income tax accounting was completed in accordance with GAAP. These statements were false.

Phantom Income Tax Receivable

The inappropriate plug adjustments and the resulting improper tax benefits recorded from 2007 through 2010 created a $461 million debit balance to Weatherford's current income tax payable, which Respondents reclassified as an income tax receivable for reporting purposes. This improper accounting should have raised red flags long before the First Restatement. Hudgins and Kitay made misleading statements about the true reasons for the growing tax debit balance, claiming falsely that they had made either sizeable prepayments or overpayments to foreign tax jurisdictions that they would be working to recover. For example, during the fourth quarter of 2009, Weatherford reclassified the large debit balance within the Current Income Tax Payable account to a Prepaid Other account. In response to EY inquiries about the large "Prepaid Other" debit balance, Kitay responded, "We do not believe it would be appropriate to classify these balances as receivables until such time as a claim for refund has been filed." By 2010, Hudgins was aware of the phantom receivable and told others at Weatherford that he was working to recover all overpaid amounts, although he knew there were no such overpaid amounts. In performing its audit of Weatherford's financial statements, EY and Weatherford identified a number of additional income tax accounting errors that increased Weatherford's tax expense by tens of millions of dollars, including: (1) failure to timely accrue foreign taxes; (2) uncertain tax position accruals that were not reflected in Weatherford's consolidated tax provisions; (3) entries to prematurely reverse liabilities related to uncertain tax positions (some of which were improperly classified as current taxes payable); and (4) understatements of income tax expense related to deferred tax liability.

Material Weakness in ICFR

On or about February 15, 2011, after consideration of the errors and issues discovered and after consultation with EY, Weatherford's internal audit group concluded that there was a material weakness in internal control surrounding accounting for income taxes due to inadequate staffing and technical expertise, ineffective review and approval practices, inadequate processes to effectively reconcile income tax accounts, and inadequate controls over the preparation of Weatherford's quarterly tax provision. After the identification of the material weakness, EY expanded the audit procedures for all income tax accounts, including a reconciliation of Weatherford's current taxes payable (and receivable) accounts. On or about February 20, 2011, a review of Weatherford's income tax receivable balance uncovered the phantom $461 million receivable which, in turn, led to the First Restatement. At no time prior to this process did Hudgins or Kitay inform anyone of the true reason they made the post-closing adjustments. On March 1, 2011, Weatherford filed a Form 8-K with the Commission in which it made public for the first time that it would be restating its financial results for 2007-2010 and that a material weakness existed in its ICFR for the accounting of income taxes. Weatherford's stock price dropped nearly 11% to $21.14 on the news.

"Restated Financial Statements On March 8, 2011, Weatherford filed its First Restatement in which it restated its previously reported financial results for the years ended December 31, 2007, 2008, 2009, and the first three quarters of 2010. According to Weatherford, the First Restatement was necessary to correct "errors in [the Company's] accounting for income taxes." The following table depicts the impact the Restatement had on Weatherford's reported net income for the periods covered by the First Restatement.

Year Ended Reported Net Income (in millions) Restated Net Income (in millions) % Change

2007 $1,070.6 $ 940.6 13.8%

2008 $1,393.2 $1,246.5 11.3%

2009 $ 253.8 $ 170.1 42.6%

Q1 - Q3 2010 $ 78.3 $ (21.6) 462.0%

Violations

SEC Securities Act provisions prohibit any person/corporation from:

-Obtaining money or property in the offer or sale of securities by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; -Engaging in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser in the offer or sale of securities; -Failing to make and keep books, records and accounts which, in reasonable detail, accurately and fairly reflect their transactions and dispositions of their assets; -Devising and maintaining a system of internal accounting controls that doesn't sufficiently provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP.

Weatherford agreed to report to the SEC during a two-year term its compliance with Commission regulations and GAAP regarding its accounting for income taxes, financial reporting, and the status of any remediation, implementation, auditing, and testing of its internal accounting controls and compliance measures. Hudgins and Katay were denied the privilege of appearing and practicing before the Commission as an accountant for five years after which they could apply for reinstatement. Financial penalties included: $140 million, as to Weatherford; for Hudgins, disgorgement of $169,728, prejudgment interest of $39,339, and a civil money penalty in the amount of $125,000, for a total of $334,067 to the SEC; and for Kitay, a civil money penalty in the amount of $30,000 to the SEC.

Questions

1-Explain how pressures and incentives drove the actions taken by Hudgins and Kitay to commit financial statement fraud. 2-Describe the problems in the audit of Weatherford International by Ernst & Young. Are any of these issues reflective of a violation of the rules of conduct in the AICPA Code? Explain. 3-Describe the deficiencies in the internal accounting systems, ICFR, and corporate governance at Weatherford. Were there any violations of the rules of conduct in the AICPA Code by Hudgins or Kitay? Explain. 4-Explain how Weatherford and Hudgins used aggressive accounting positions in the area of income tax accounting.