ALZA CORPORATION: AN ILLUSTRATION OF FORM OVER SUBSTANCE Timothy L. McCoy Margaret A.

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A$!tract Before merging with Johnson & Johnson in 2001, ALZA Pharmaceuticals Corporation was on the cutting edge of both drug delivery systems and creative financial arrangements. This paper explains the creation of two spin-off corporations by ALZA for the purpose of funding research and development (R&D) activities to be carried out primarily by and for the benefit of ALZA. The agreements between ALZA and its two spin-offs are outlined, the financial statement impact for ALZA is examined, and the disclosures made regarding the arrangements are critiqued. Results show that existing GAAP was circumvented to enhance revenue and net income over a period of eight years. Finally, the paper discusses the potential efficacy of a principles-based accounting standard in preventing the overstatement and circumvention of GAAP and argues for the continuing need for detailed guidance in the standard-setting process.

Texas A&M University, Corpus Christi. Henderson State University.

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McCoy & Hoskins: or! over Su"stance

I. INTRO%UCTION A#$A %har!aceutica&s Corporation 'as incorporated under the &a's o( the State o( Ca&i(ornia on )une **, *+,-. .ts (ounder, A&e/andro $a((aroni, 'as a !e!"er o( the scienti(ic tea! that invented the "irth contro& pi&& . 0y the !id *+-12s the co!pany had deve&oped into a &eadin3 provider o( contro&&ed4 dosa3e dru3 de&ivery syste!s ran3in3 (ro! skin patches to &o'4 current e&ectric devices that ad!inister dru3s throu3h the skin. A#$A is responsi"&e (or such 'or&d4c&ass de&ivery syste!s as 5the patch6 (or 7icoder! C8, the &eadin3 s!okin3 cessation dru3. 9ther dru3s uti&i:in3 A#$A2s techno&o3y inc&ude %rocardia ;#, an ora& an3ina<hypertension treat!ent, and Suda(ed =>, an over4the4 counter a&&er3y !edication. %rior to the *++12s A#$A2s revenues consisted so&e&y o( roya&ties (ro! sa&es o( other co!panies2 products that used A#$A2s de&ivery syste!s. ?ar&y in the decade, A#$A devised a p&an to co!p&e!ent its a&ready existin3 dru3 de&ivery syste!s "y deve&opin3 its o'n dru3 products there"y "eco!in3 a (u&&y inte3rated phar!aceutica& co!pany. To acco!p&ish its o"/ective, A#$A conducted t'o @&A arran3e!ents throu3h spin4o(( corporations. These 'ere Therapeutic Aiscovery Corporation BTACC created in the ear&y *++12s and Crescendo %har!aceutica&s Corporation BCrescendoC created in the &ate *++12s. The following paragraphs explain the details of the TDC and Crescendo arrangements, illustrate and critique the methods used by ALZA to report the results of the two corporations, compare ALZAs accounting and reporting practices to GAAP applicable at the time of the arrangements, and illustrate how GAAP was circumvented to overstate ALZAs revenues throughout the 1990s. Then, subsequent new GAAP is reviewed, and the impact of its application on R&D arrangements such as ALZAs is summarized. Finally, the Security and Exchange Commissions (SECs) and Financial Accounting Standards
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$ina Moukhei"er, 5%uttin3 a Spin on @&A,6 or"es, Do&. *,E:E B e"ruary, *+++C, ***.

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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Boards (FASBs) efforts toward principles-based accounting are discussed briefly, and conclusions are drawn as to whether the present rules-based accounting standards contributed to the misleading presentation of financial results. II. REVIE& OF T E T%C AN% CRESCEN%O ARRAN'EMENTS The T%C Arra#geme#t .n &ate *++= and !id *++E, A#$A created TAC, a deve&op!ent4sta3e co!pany, "y payin3 F=G1 !i&&ion (or the ne' corporation2s co!!on stock. That stock consisted o( t'o c&asses, *11 shares o( C&ass 0 Co!!on Stock and approxi!ate&y H.H !i&&ion shares o( C&ass A Co!!on Stock. A#$A retained o'nership o( TAC2s C&ass 0 Co!!on Stock B'hich carried certain "&ockin3 ri3htsC and distri"uted a&& o( TAC2s C&ass A Co!!on Stock to A#$A shareho&ders as a specia& dividend o( units. ?ach unit consisted o( one share o( TAC C&ass A Co!!on Stock and one 'arrant to purchase one4ei3hth o( one share o( A#$A co!!on stock. The TAC C&ass A Co!!on Stock and the A#$A 'arrants 'ere &isted and traded independent&y on the 7ASAA8 stock !arket. TAC2s *++E or! *14I, (i&ed 'ith the S?C, stated that the va&ue o( the units 'as F>>.+ !i&&ion and that the va&ue o( TAC2s stock apart (ro! the units cou&d not "e ascertained. TAC2s or! *14I (urther stated that TAC 'as reJuired to use the entire F=G1 !i&&ion received (ro! A#$A, p&us any invest!ent inco!e earned thereon &ess or3ani:ation costs and ad!inistrative expenses, on the deve&op!ent o( TAC products. The products to "e considered (or deve&op!ent 'ou&d "e proposed "y A#$A, and A#$A 'ou&d provide the @&A activities. There(ore, the F=G1 !i&&ion 'ou&d (&o' "ack to A#$A as A#$A per(or!ed the @&A activities. A#$A !aintained the ri3ht to deter!ine 'hether to patent TAC products. .( A#$A chose not to patent, TAC 'as prohi"ited (ro! doin3 so. TAC2s *++E *14I

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McCoy & Hoskins: or! over Su"stance

stated that TAC o'ned no (aci&ities and &eased corporate o((ices (ro! A#$A. As the so&e ho&der o( TAC2s C&ass 0 Co!!on Stock, A#$A 'as entit&ed to vote separate&y as a c&ass to prevent any !er3er or &iJuidation o( TAC or the sa&e, &ease, exchan3e, trans(er or other disposition o( any su"stantia& asset o( TAC. .n addition, A#$A he&d options to purchase a&& o( TAC2s C&ass A Co!!on Stock at a price stipu&ated in TAC2s @estated Certi(icate o( .ncorporation. A#$A exercised this option in *++H 'hen TAC had exhausted !ost o( its (unds. The Cre!ce#(o Arra#geme#t The TAC arran3e!ent proved to "e very success(u& and, seekin3 to dup&icate that success, A#$A created Crescendo %har!aceutica&s Corporation, another deve&op!ent4sta3e co!pany, in !id *++H "y payin3 FE11 !i&&ion (or Crescendo2s co!!on stock. As 'ith TAC, Crescendo had t'o c&asses o( stock, *,111 shares o( C&ass 0 Co!!on stock and approxi!ate&y (ive !i&&ion shares o( C&ass A Co!!on Stock. A#$A !aintained o'nership o( the C&ass 0 stock and distri"uted the C&ass A Co!!on Stock to ho&ders o( A#$A2s co!!on stock and converti"&e de"entures. The Crescendo C&ass A Co!!on Stock 'as traded on the 7ASAA8 stock !arket separate&y (ro! the A#$A stock. Crescendo2s *++H or! *14I &isted the va&ue o( the C&ass A Co!!on Stock as approxi!ate&y FGH.H !i&&ion. Crescendo and A#$A entered into a nu!"er o( a3ree!ents, inc&udin3 a techno&o3y &icense a3ree!ent, a &icense option a3ree!ent, and a deve&op!ent a3ree!ent. Under the techno&o3y &icense a3ree!ent, Crescendo 'as 3ranted a 'or&d'ide &icense to use A#$A techno&o3y to deve&op Crescendo products. A#$A received a !onth&y one !i&&ion do&&ar techno&o3y (ee (ro! Crescendo (or three years. The &icense option a3ree!ent 3ranted A#$A the option to &icense each Crescendo product deve&oped under the deve&op!ent a3ree!ent. The deve&op!ent a3ree!ent stated that A#$A 'ou&d conduct product deve&op!ent and other

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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re&ated activities on "eha&( o( Crescendo. Accordin3 to the deve&op!ent a3ree!ent, 'ork p&ans and cost esti!ates 'ere provided "y A#$A and approved "y Crescendo. Crescendo 'as reJuired to spend the FE11 !i&&ion contri"uted "y A#$A Bp&us invest!ent earnin3s &ess Crescendo2s ad!inistrative costs and other (eesC on activities under the deve&op!ent a3ree!ent. The initia& products under the deve&op!ent a3ree!ent 'ere products started under the TAC co&&a"oration. Crescendo2s or! *14I (or (isca& year ended Aece!"er E*, *++H (i&ed 'ith the S?C revea&ed that Crescendo had one e!p&oyee, o'ned no (aci&ities, &eased corporate o((ices (ro! A#$A, received ad!inistrative services (ro! A#$A, and 'as dependent on A#$A (or its operatin3 and accountin3 syste!s. As in the TAC arran3e!ent, Crescendo2s @estated Certi(icate o( .ncorporation prohi"ited C&ass A stockho&ders (ro! takin3 or per!ittin3 any action that !i3ht i!pair A#$A2s ri3hts or increase Crescendo2s authori:ed capita&i:ation 'ithout A#$A2s per!ission. .n addition, Crescendo 'as prohi"ited (ro! &icensin3 its products to any co!pany other than A#$A. A#$A he&d an option to purchase a&& o( Crescendo2s C&ass A Co!!on Stock at a price stipu&ated in Crescendo2s @estated Certi(icate o( .ncorporation. A#$A2s accountin3 and reportin3 (or its arran3e!ents 'ith TAC and Crescendo invo&ved severa& areas o( KAA%. The (o&&o'in3 section revie's and eva&uates the !ethods used "y A#$A to record its invest!ent in TAC and Crescendo and its re&ated @&A activities. III. ALZA)S ACCOUNTIN' AN% REPORTIN' FOR T%C AN% CRESCEN%O ALZAs financial reports disclosed its relationship with TDC and Crescendo, the amounts invested in each, and revenue received from each. To record the contribution of $250 million to TDCs capital and the distribution of TDC stock to ALZA shareholders, ALZA reduced Retained Earnings by $36.6 million

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and reduced Paid-in-Capital by $213.4 million. Therefore, earned equity and contributed equity were reduced. When Crescendo was formed, however, the accounting was somewhat different. ALZA reduced Retained Earnings by $49.1 million and reduced current earnings with a one-time charge labeled Contribution to Crescendo for $247 million. This resulted in a reduction of earned equity and a significant charge to ALZAs 1997 net income. Since the investment in Crescendo was $300 million, there must have been a charge to another account for the remaining $3.9 million. The financial statements do not specifically disclose the account charged, but the income statement does reveal an $8 million distribution to debenture holders. Since some of the Crescendo stock was distributed to debenture holders, the remaining $3.9 million needed to make the entry balance may have been included in that amount. As A#$A provided @&A activities (irst (or TAC then (or Crescendo, A#$A recorded in(&o's (ro! the t'o co!panies as @&A revenue. .n addition, A#$A recorded @&A ?xpense (or its costs o( those @&A activities. The notes to A#$A2s *++, (inancia& state!ents c&ai!ed that, "ecause A#$A2s @&A revenues represented rei!"urse!ent o( A#$A2s @&A costs, those activities did not contri"ute si3ni(icant&y to operatin3 resu&ts . urther!ore, the Mana3e!ent Aiscussion and Ana&ysis o( the *++, (inancia& report stated that: .( A#$A 'ere to exercise its purchase option Lo( TACM, A#$A 'ou&d need to (und any continuin3 deve&op!ent expenses (or TAC products. .( A#$A 'ere to choose not to exercise the %urchase 9ption, "ut to &icense so!e or a&& o( the products, A#$A 'ou&d need to (und the additiona& product deve&op!ent activities necessary to co!p&ete the &icensed products. .( A#$A 'ere to use its o'n (unds to cover these expenses, the
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Securities and ?xchan3e Co!!ission, A#$A %har!aceutica&s Corporation, S?C or!s *14I, *++H, at 7ote *.

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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product deve&op!ent activities 'ou&d resu&t in research and deve&op!ent expenses 'ithout the correspondin3 research and deve&op!ent revenues previous&y provided "y TAC .
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This paper contends, ho'ever, that A#$A2s disc&osures 'ere not entire&y truth(u& (or t'o reasons. irst, TAC2s Band Crescendo2sC (unds 'ere not separate (ro! A#$A N indeed A#$A provided those (unds 'hen the invest!ent 'as !ade in the t'o spin o((s. Second, recordin3 "oth revenue and expense did not re(&ect econo!ic rea&ity. @ather, the e((ect 'as to overstate "oth revenue and inco!e. .n other 'ords, 'ithout the TAC and Crescendo arran3e!ents, A#$A2s (inancia& state!ents 'ou&d have sho'n on&y @&A expense, 'hich 'ou&d have reduced net inco!e. 0y recordin3 @&A revenue (ro! TAC and Crescendo, ho'ever, A#$A 'as a"&e to avoid reducin3 inco!e "y the a!ount o( @&A expense. This conc&usion is supported in Ta"&e *. TABLE 1 Effect of ALZA Spin-offs on Net R&D Expense and Net Income Panel A Net R&D Expense Calculated From Items Reported in ALZA Financial Statements (in millions)
1993 Total R&D Expense *Total R&D Revenue 1994 1995 1996 $141.6 131.2 1997 $156.8 135.0 1998 $182.8 124.4 1999 2000 Total $53.1 $76.1 $103.4 46.8 68.7 104.0 $183.6 $190.8 $1,088.2 120.8 100.1 831.0 $257.2

Net R&D Expense $ 6.3 $ 7.4 $ (.6) $ 10.4 $ 21.8 $ 58.4 $ 62.8 $ 90.7 *Total R&D Revenue includes the following amounts from TDC and Crescendo: TDC & Crescendo Revenue $ 4.9 $31.6 $ 70.1 $100.7 $ 97.5 $ 95.0 $ 90.5 $68.3

$558.6

Securities and ?xchan3e Co!!ission, A#$A %har!aceutica&s Corporation, S?C or!s *14I, *++H, at Mana3e!ent Aiscussion and Ana&ysis.

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McCoy & Hoskins: or! over Su"stance

Pa#e* B

Revised Net R&D Expense After Eliminating R&D Revenue Received from TDC and Crescendo (in millions)
1993 Total R&D Expense Outside R&D Revenue Revised Net R&D Expense $11.2 $39.0 $69.5 $111.1 $119.3 $153.4 $153.3 $159.0 $815.8 41.9 37.1 33.9 30.5 37.5 29.4 30.3 31.8 272.4 1994 1995 1996 $141.6 1997 $156.8 1998 $182.8 1999 2000 Total $53.1 $76.1 $103.4 $183.6 $190.8 $1,088.2

Panel C
ALZA Net I#come a! Re+orte( ,. Net I#come A-ter E*imi#ati#g R.% Re,e#/e -rom T%C a#( Cre!ce#(o

(in millions)
1993 Net Income As Reported Less: TDC & Crescendo Plus: Crescendo One-Time Charge Revised Net Income 1994 1995 1996 1997 1998 $108.3 1999 2000 Total $430.1 $45.7 $58.1 $72.4 $92.4 $(261.1) $91.0 $223.3

4.9 ____

31.6 ____

70.1 ____ $2.3

100.7 _____

97.5 247.0

95.0 _____ $13.3

90.5

68.3

558.6 247.0 $118.5

_____ _____ $0.5 $155.0

$40.8 $26.5

$(8.3) $(111.6)

%ane& A o( Ta"&e * sho's the a!ounts o( A#$A2s tota& @&A expense and tota& product deve&op!ent revenue B@&A revenueC as those resu&ts 'ere presented in the conso&idated (inancia& state!ents su"!itted as part o( A#$A2s or! *14I reJuired "y the S?C. As sho'n, the #et @&A expense reported on the (ace o( the inco!e state!ent (or the ei3ht4year period tota&s F=GH.= !i&&ion. 7ote that %ane& A a&so disc&oses the a!ount o( @&A revenue (ro! TAC and Crescendo. These a!ounts 'ere disc&osed in the notes to the (inancia& state!ents. The pro"&e! 'ith the nu!"ers presented in A#$A2s conso&idated (inancia& state!ents is that @&A revenue inc&udes the interco!pany revenue received (ro! TAC and Crescendo. %ane&

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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0 o( Ta"&e * sho's 'hat A#$A2s net @&A expense 'ou&d have "een i( the interco!pany revenue had "een exc&uded. The @&A revenue sho'n in %ane& 0 inc&udes on&y revenue received (ro! outside parties. .t is co!puted "y su"tractin3 the @&A revenue received (ro! TAC and Crescendo (ro! tota& @&A revenue. As sho'n, 'hen the interco!pany @&A revenue is exc&uded, net @&A expense tota&s F-*G.- !i&&ion over the ei3ht4year period. %ane& C o( Ta"&e * sho's the a!ount o( net inco!e a(ter re!ovin3 the @&A revenue (ro! TAC and Crescendo. irst, A#$A2s net inco!e as reported (or each o( the ei3ht years *++E throu3h =111 is sho'n. Then, the interco!pany revenue is su"tracted to sho' the actua& net inco!e (or those years. 7otice that the one4ti!e char3e a3ainst A#$A2s net inco!e in the year Crescendo 'as (or!ed has "een added "ack to *++H 'hen co!putin3 revised net inco!e. ?&i!inatin3 interco!pany revenue si3ni(icant&y reduced A#$A2s net inco!e in the years a((ected. .n (act, rather than cu!u&ative earnin3s o( F>E1.* !i&&ion over the ei3ht years, the co!pany actua&&y had cu!u&ative earnin3s o( F**-.G !i&&ion. Table 1 shows that the TDC and Crescendo arrangements effectively allowed ALZA to avoid recognizing the full impact of R&D expense on net income. In addition, ALZA overstated total revenue by $558.6 million, the amount received from TDC and Crescendo. Net income was overstated by a total of $311.6 million (Reported Net Income of $430.million minus Revised Net Income of $118.5 million) over a period of eight years. ALZAs accounting for its R&D arrangements allowed the company to take funds off its balance sheet, place them in controlled investment vehicles, and then bring them back into the company recognizing them as revenues to offset current R&D expenses. Since the S?C a&&o'ed the TAC dividend to "e char3ed to paid4in capita& and retained earnin3s, the arran3e!ent essentia&&y turned cash into retained earnin3s "y overstatin3 inco!e (or *++E throu3h *++H. The e((ect o( @&A expense (or certain pro/ects 'as erased (ro! earnin3s. 7ot on&y did A#$A2s "otto! &ine re!ain

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intact Bas opposed to decreasin3 (or the @&A expenseC, its top &ine actua&&y i!proved "ecause o( its o'n cash (&o'in3 "ack as revenue. The S?C reJuired the Crescendo a3ree!ent to "e recorded as a one4ti!e char3e to inco!e . There(ore, A#$A 'as (orced to record a &ar3e earnin3s reduction in the year o( Crescendo2s creation, "ut that reduction 'as recovered throu3h overstated earnin3s (ro! *++H4=111. To the extent ana&ysts tend to disre3ard one4ti!e char3esO the *++H char3e !ay not have "een a severe pena&ty (or A#$A. C&ay!an su33ests that co!panies 'ith in(reJuent one4ti!e char3es are not necessari&y pena&i:ed in the !arket and, dependin3 on the nature o( the char3e, !ay outper(or! the "road index.
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IV. COMPARISON OF ALZA)S ACCOUNTIN' TO T EN0 E1ISTIN' 'AAP ALZA may have used the TDC and Crescendo arrangements to overstate income, but did the company violate GAAP in effect during the time the two companies operated? According to SFAS No. 2 all R&D costs must be charged to expense when incurred because of the difficulty of identifying and valuing future economic benefit received from R&D expenditures. Technically, ALZA did record and report R&D expense. SFAS No. 68 requires that a liability must be recorded if an enterprise is obligated to repay funds provided by another party of an R&D contract regardless of the outcome of the R&D . In ALZAs case,
6 7

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#.). Se&&ers, 5A&:a Ae&ivers: ?rnest Mario takes the Co!pany to a 7e' #eve&,6 %har!aceutica& ?xecutive, B7ove!"er, =111C, >>4G,, at >H. G Miche&&e C&ay!an, 59ne4Ti!e Char3es: 7ever Havin3 to Say Pou2re Sorry,6 inancia& Ana&ysts )ourna&, Do&. G*:G B a&&, *++GC, GH4,1, at ,1.
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inancia& Accountin3 Standards 0oard, Accountin3 (or @esearch and Aeve&op!ent Arran3e!ents, State!ent o( inancia& Accountin3 Standards 7o. = B7or'a&k, CT: AS0, *+H>C, at para3raph *= and >+. H inancia& Accountin3 Standards 0oard, @esearch and Aeve&op!ent Arran3e!ents, State!ent o( inancia& Accountin3 Standards 7o.,- B7or'a&k,

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the parties obligated to repay funds were TDC and Crescendo, not ALZA. Therefore, ALZAs accounting for R&D expense was in accordance with SFAS No. 2 and SFAS No. 68. Shou&d A#$A have inc&uded TAC2s and Crescendo2s operatin3 resu&ts in its conso&idated (inancia& state!entsQ The ans'er to that Juestion rests on 'hether A#$A contro&&ed TAC and Crescendo. Accordin3 to Accountin3 @esearch 0u&&etin BA@0C 7o. G*, the purpose o( conso&idated (inancia& state!ents is to present the resu&ts o( operations and the (inancia& position o( a parent and su"sidiary as i( they 'ere one entity . A@0 7o. G* states that, usua&&y, contro&&in3 interest is evidenced 'hen one co!pany o'ns a !a/ority votin3 interest in the other . The 0u&&etin states, ho'ever, that conso&idated (inancia& state!ents shou&d "e presented 'hen one co!pany directly or indirectly Le!phasis addedM o'ns a (inancia& contro&&in3 interest in the other . Rhi&e it is true that votin3 interests 'ere he&d "y o'ners o( C&ass A Co!!on Stock, it is a&so true that A#$A contro&&ed the operations o( TAC and Crescendo. A#$A se&ected the pro/ects (or research and deve&op!ent, !aintained the ri3ht to patent resu&tin3 products, and prohi"ited TAC and Crescendo (ro! patentin3 re/ected products. A#$A shared e!p&oyees 'ith TAC and Crescendo. 0oth co!panies o'ned no (aci&ities, &eased corporate o((ices (ro! A#$A, received ad!inistrative services (ro! A#$A, and 'ere dependent on A#$A (or their operatin3 and accountin3 syste!s. TAC and Crescendo 'ere prohi"ited (ro! &icensin3 their products to any co!pany other than A#$A. ina&&y, as so&e o'ner o( C&ass 0 Co!!on Stock, A#$A cou&d "&ock any action that !i3ht i!pair A#$A2s ri3hts or increase TAC2s or Crescendo2s authori:ed capita&i:ation 'ithout A#$A2s per!ission. ina&&y,
+ *1

CT: AS0, *+-=C, at para3raph G. - A!erican .nstitute o( Certi(ied %u"&ic Accountants BA.C%AC Co!!ittee on Accountin3 %ractices, Conso&idated inancia& State!ents, Accountin3 @esearch 0u&&etin 7o.G* B7e' Pork: A.C%A, *+G+C, at para3raph *. + A@0 7o.G*, at para3raph =. *1 A@0 7o.G*, at para3raph *.

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McCoy & Hoskins: or! over Su"stance

A#$A he&d an option to purchase a&& o( TAC2s and Crescendo2s C&ass A Co!!on Stock. The conc&usion !ust "e dra'n that, even thou3h A#$A did not technica&&y possess votin3 contro& o( TAC and Crescendo, it c&ear&y contro&&ed TAC and Crescendo. Co!"inin3 the resu&ts o( TAC and Crescendo 'ou&d have e&i!inated the interco!pany revenue and the overstate!ent o( net inco!e. V. 'AAP SUBSE2UENT TO T%C AN% CRESCEN%O FORMATION Aurin3 the &ast year o( Crescendo2s existence the AS02s ?!er3in3 .ssues Task orce co!p&eted discussion on EITF 99-16: Accounting for Transactions with Elements of Research and Develo ment Arrangements! The .ssue prescri"es the accountin3 (or arran3e!ents such as those A#$A !ade 'ith TAC and Crescendo. The .ssue speci(ica&&y addresses transactions 'here a sponsor Bsuch as A#$AC capita&i:es a ne' co!pany 'ith cash and techno&o3y ri3hts in exchan3e (or C&ass A and C&ass 0 stock. The C&ass A stock is distri"uted to the sponsor2s shareho&ders su"/ect to a purchase option, 'hi&e the C&ass 0 stock is retained 'hich carries no votin3 ri3hts "ut does carry certain "&ockin3 ri3hts. The sponsor su"seJuent&y per(or!s research and deve&op!ent activities (or the ne' co!pany. The Task orce conc&uded that the sponsor shou&d treat the cash paid (or the ne' co!pany C&ass A stock as restricted cash. The distri"ution o( the ne' co!pany C&ass A stock shou&d "e treated as a dividend to co!!on stockho&ders o( the sponsor "ased on the (air va&ue o( the stock at the ti!e o( distri"ution. The ne' co!pany C&ass A Co!!on Stock shou&d "e presented on the sponsor2s "a&ance sheet in a si!i&ar !anner as !inority interest . Had ?.T ++4*, "een in e((ect at the ti!e o( the (or!ation o( TAC and Crescendo, A#$A 'ou&d have de"ited restricted cash (or F=G1
**

**

inancia& Accountin3 Standards 0oard, ?.T ++4*,, Accountin3 (or Transactions 'ith ?&e!ents o( @esearch and Aeve&op!ent Arran3e!ents B7or'a&k, CT: AS0, *+++C, at para3raph G.

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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!i&&ion and FE11 !i&&ion respective&y. At the sa!e ti!e, the co!pany 'ou&d have de"ited dividends and credited an account si!i&ar to !inority interests in the a!ount o( each stockSs (air !arket va&ue BF>>.+ !i&&ion (or TAC and FGH.H !i&&ion (or CrescendoC. ?.T ++4*, reJuires that, as @&A activities are per(or!ed "y the sponsor, @&A expense is reco3ni:ed. @ather than reco3ni:in3 revenue (ro! the ne' co!pany, ho'ever, the sponsor credits restricted cash. .( this ?.T had "een in e((ect, there(ore, A#$A 'ou&d not have credited @&A revenue, and the overstate!ent o( revenue and inco!e 'ou&d have "een avoided. The Task orce noted that the accountin3 prescri"ed has essentia&&y the sa!e e((ect as reJuirin3 conso&idation o( the ne' co!pany "y the sponsor. There(ore, had ?.T ++4*, "een in e((ect durin3 the years o( TAC2s and Crescendo2s existence, operatin3 resu&ts 'ou&d have "een the sa!e as those presented in %ane& C o( Ta"&e *. VI. RULES0BASE% V. PRINCIPLES0BASE% ACCOUNTIN' STAN%AR%S The resu&ts o( such (inancia& 'ran3&in3s as A#$A2s are evidenced "y the ever4increasin3 vo&u!e o( AS0 State!ents and .nterpretations. 0ecause o( the 3ro'in3 tendency to e!phasi:e (or! over su"stance 'hen reportin3 (inancia& re&ationships, the S?C and the AS0 have recent&y "e3un a drive to'ard a princip&es4"ased approach to U.S. Standard Settin3. .n (act, Section *1- o( the Sar"anes49x&ey Act o( =11= reJuires the S?C to study the adoption o( a princip&es4"ased syste! inc&udin3 the extent to 'hich the U.S. syste! is current&y princip&es4"ased, the ti!e reJuired to chan3e to such a syste!, its (easi"i&ity, and an econo!ic ana&ysis o( its i!p&e!entation. A princip&es4"ased approach 'ou&d provide standards 'ith an appropriate &eve& o( speci(icity 'here (e', i( any, exceptions are inc&uded . %ercenta3e
*=

*=

Securities and ?xchan3e Co!!ission, Study %ursuant to Section *1-BdC o( the Sar"anes49x&ey Act o( =11= on the Adoption "y the United States inancia&

>>

McCoy & Hoskins: or! over Su"stance

tests, or 5"ri3ht4&ines,6 'ou&d "e avoided since they a&&o' (inancia& en3ineers to achieve technica& co!p&iance 'ith standards 'hi&e evadin3 their intent. Accordin3 to the AS0, the princip&es4 "ased approach 'ou&d "e si!i&ar to that used to deve&op .nternationa& Accountin3 Standards and in other countries, such as the United Iin3do! . Schipper ar3ues that current U.S. KAA% is a&ready "ased on a set o( princip&es ste!!in3 (ro! the AS02s Conceptua& ra!e'ork . 0ecause these standards contain detai&, exp&anations, and prescriptions, ho'ever, they &ead so!e to "e&ieve they are ru&es "ased. The a!ount o( detai&, co!p&exity, and ru&es to inc&ude in a particu&ar standard are the standard4setter2s di&e!!a: Havin3 provided a princip&e that c&ear&y states the intent o( a standard, ho' !uch additiona& exp&anation shou&d "e providedQ Ho' !any ter!s shou&d "e de(ined, and at 'hat &eve& o( detai&Q Ho' !uch prescriptive exp&anation a"out ho' to app&y the standard, such as nu!erica& exa!p&es shou&d "e inc&udedQ
*E *> *G

Those 'ho advocate a princip&es4"ased approach "e&ieve it 'i&& resu&t in !ore transparent (inancia& state!ents that 'ou&d !ore c&ose&y convey the econo!ic su"stance o( transactions and events . 0ut, is it possi"&e that a princip&es4"ased approach 'i&& achieve that 3oa&Q Can standards "e deve&oped that 'i&& e&i!inate
*,

@eportin3 Syste! o( a %rincip&es40ased Accountin3 Syste!, Bhttp:<<'''.sec.3ov<ne's<studies<princip&es"asedstand.ht!, =11EC, at Section ..C. *E inancia& Accountin3 Standards 0oard, %rincip&es40ased Approach to U.S. Standard Settin3, %roposa& o( the inancia& Accountin3 Standards 0oard B7or'a&k, CT: AS0, =11=C, *4=E, at *1. *> Iatherine Shipper, 5%rincip&es40ased Accountin3 Standards,6 Accountin3 Hori:ons, Do&. *H:* BMarch, =11EC, ,*4H=, at ,=. *G Shipper at ,E.
*,

inancia& Accountin3 Standards 0oard =11= at +4*1.

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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the need (or detai&ed and co!p&ex accountin3 ru&esQ Sir Aavid T'eedie, Chair!an o( the .nternationa& Accountin3 Standards 0oard, 'ho exp&ained his support (or such an approach "e(ore the U.S. Senate Co!!ittee on 0ankin3, Housin3, and ur"an A((airs stated: Re (avour an approach that reJuires the co!pany and its auditor to take a step "ack and consider 'hether the accountin3 su33ested is consistent 'ith the under&yin3 princip&eT 9ur approach reJuires "oth co!panies and their auditors to exercise pro(essiona& /ud3!ent in the pu"&ic interest. 9ur approach reJuires a stron3 co!!it!ent (ro! preparers to (inancia& state!ents that provide a (aith(u& representation o( a&& transactions and a stron3 co!!it!ent (ro! auditors to resist c&ient pressures. It will not work without those commitments Le!phasis addedM.
*H

The AS0 reiterated Sir T'eedie2s opinion a"out the need o( co!!it!ents on the part o( a&& parties invo&ved in the (inancia& reportin3 process. The 0oard stated: T i( adopted, a princip&es4"ased approach to standard settin3 'ou&d reJuire chan3es in the processes and "ehaviors o( a&& participants in the U.S. inancia& accountin3 and reportin3 process, not /ust the AS0 and other standard4settin3 "odies. Thus, in order for that approach to work, all participants must be equally committed to making those changes.
18

.s it a rea&istic expectation that (inancia& state!ent preparers and auditors 'i&& !ake these co!!it!entsQ @ecent history sho's count&ess exa!p&es 'here co!p&icated transactions
*H *-

inancia& Accountin3 Standards 0oard =11= at >. inancia& Accountin3 Standards 0oard =11= at G.

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McCoy & Hoskins: or! over Su"stance

are concocted to achieve an accountin3 o"/ective. Then, accountin3 (ir!s audit the (inancia& state!ents that contain the!. The distri"utions o( the TAC and Crescendo shares to the A#$A stockho&ders, so!e o( the !ost creative dividends ever devised, provide a per(ect exa!p&e o( this point. The TAC creation and distri"ution o( shares 'as the "rainchi&d o( Merri&&4#ynch. The arran3e!ent even had a na!eUA@@9R, 'hich stands (or asset and risk redep&oy!ent 'ith options and 'arrants. or its e((orts in structurin3 the TAC transaction, Merri&&4#ynch earned a tidy F=.G !i&&ion . .s it &ike&y that accountin3 and invest!ent (ir!s 'i&& co!!it the!se&ves to the &o(ty idea& o( representationa& (aith(u&ness at the cost o( !i&&ions o( do&&ars o( revenueQ Consider that the S?C "&essed the accountin3 (or the TAC transaction, and the auditors 3ave "oth TAC and A#$A c&ean audit opinions.
*+

VII. CONCLUSIONS The creation o( TAC and Crescendo did not chan3e A#$A2s (unda!enta& @&A activities. The @&A cou&d have "een conducted "y A#$A 'ith or 'ithout the t'o spun o(( entities. Rhy then 'ere the t'o entities createdQ The pri!ary reasons (or o((4"a&ance sheet (inancin3 are to !ake the (inancia& state!ents !ore attractive and to !ana3e inco!e tax positions . The (inancia& co!!unity is divided on 'hether o((4"a&ance sheet arran3e!ents !is&ead (inancia& state!ent users. Many creditors prepare ad/ust!ents (or co!!on o((4"a&ance sheet arran3e!ents such as &easin3. Ho'ever, the TAC and Crescendo arran3e!ents are !uch !ore sophisticated and certain&y !uch &ess transparent. The TAC and Crescendo arran3e!ents si3ni(icant&y enhanced A#$A2s revenues and net inco!e. .n addition, A#$A received a tax
=1

*+ =1

A&&an S&oan, 5Kuaranteed Ae&ivery,6 Money, BApri&, *++EC, H. @ichard Ka!"&e, 5Shre'd Band ?thica&C Tactics in 9((40a&ance4Sheet inancin3,6 Contro&&er Ma3a:ine, B9cto"er *++HC, E14E>, at E1.

)ourna& o( Accountin3, ?thics & %u"&ic %o&icy Do&u!e ,, 7o. * B=11,C

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"ene(it "y she&terin3 roya&ty inco!e on its tax return "y usin3 TAC &osses . A#$A2s arran3e!ents 'ith TAC and Crescendo represent accountin3 at its "est and 'orst. Tactica&&y, there is o"vious creative 3enius in circu!ventin3 the intent o( a standard 'hi&e (o&&o'in3 the &etter o( its ru&es. @eceivin3 approva& (or the structure, as 'e&& as the creative accountin3 (or the arran3e!ents (ro! the S?C, the chie( 3overn!ent accountin3 'atchdo3, !ay a&so "e c&assi(ied as "ri&&iant. .t is true that A#$A did disc&ose its dea&in3s 'ith TAC and Crescendo in detai& in its notes to the (inancia& state!entsO ho'ever, A#$A repeated&y stated in its *1Is (i&ed 'ith the S?C throu3hout the years a((ected "y the co&&a"orations that the transactions had no si3ni(icant i!pact on operatin3 resu&ts. This paper has sho'n that these c&ai!s 'ere !is&eadin3 since revenues and net inco!e 'ere overstated as A#$A2s invest!ent (&o'ed "ack into the co!pany as revenue. This assertion is (urther supported "y the conc&usions dra'n in ?.T ++4*, that e&i!inated recordin3 the pay!ents received "y the sponsor as revenue. .( ?.T ++4*, had "een in e((ect durin3 the TAC and Crescendo arran3e!ents, its app&ication 'ou&d have !ore c&ose&y captured econo!ic rea&ity "y e((ective&y reJuirin3 conso&idation o( the entities, thus revea&in3 A#$A2s true @&A revenue, expense and inco!e. The va&ue added "y accountants and auditors has t'o (acets. 9ne va&ue is to society "y capturin3 econo!ic rea&ity in (inancia& state!ents and providin3 an independent attestation to their (airness in order to aid in the s!ooth operation o( the capita& !arkets. The other va&ue is to those 'ho intend to deceive and o"(uscate rea&ity. Accountants can certain&y aid in the &atter purpose as evidenced "y the TAC and Crescendo transactions. The o"vious intent o( the care(u&&y structured transactions 'as to skirt the esta"&ished 5ru&es6 re&ated to conso&idation o( direct&y contro&&ed entities 'hi&e turnin3 a "&ind eye to the not4so4'e&& de(ined concept o( conso&idation o( indirect&y contro&&ed entities.
=*

=*

Moukhei"er at ***.

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McCoy & Hoskins: or! over Su"stance

These transactions 'ere conceived "y invest!ent "ankers, "ut they 'ere put into e((ect "y accountants and accepted "y auditors. A princip&es4"ased approach to accountin3 standards !ay 'e&& "e in order. Speci(ica&&y re&ated to the conso&idation issue addressed in this paper, the AAA inancia& Accountin3 Standards Co!!ittee supports a princip&es4"ased conso&idation standard 'ith e((ective econo!ic contro& as the "asis (or conso&idation. Ho'ever there 'i&& sti&& "e a need (or ru&es and 3uide&ines to app&y such princip&es in order to aid those 'ho seek to co!p&y 'ith the princip&es and to prevent others (ro! circu!ventin3 the princip&es. Re have sho'n ho' TAC and Crescendo (&ourished under a ru&es4 "ased !enta&ity even thou3h the c&ear intent o( existin3 KAA% under A@0 7o. G* durin3 TAC and Crescendo2s existence 'as that entities direct&y or indirect&y contro&&ed shou&d "e conso&idated. 9n the other hand, had a strict&y princip&es4"ased syste! "een in e((ect, those 'ho intended to o"(uscate cou&d have c&ai!ed that, in their /ud3!ent, conso&idation 'as not necessary. .n other 'ords, i( standards 'ith c&ear state!ents o( intent and de(ined reJuire!ents can "e circu!vented "y those intent on doin3 so, ho' !uch easier 'i&& it "e to circu!vent standards 'ithout de(ined reJuire!entsQ Hence the need (or ru&es and 3uide&ines in app&yin3 the princip&es o( conso&idation re!ains.
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==

A!erican Accountin3 Association BAAAC inancia& Accountin3 Standards Co!!ittee, 5Co!!ents on AS02s %roposa&s on Conso&idatin3 Specia&4%urpose ?ntities and @e&ated Standard Settin3 .ssues,6 Accountin3 Hori:ons, Do&. *H:= B)une, =11EC, *,*4*HE, at *,=.