With the accounting scandal around the Munich-based media company EM.TV in the years 1998-2000, the auditors’ profession caught unprecedented attention in Germany. As the society had just “discovered” stock markets for the broader masses, the burst of the dot-com bubble and especially EM.TV’s crash served as a painful warning signal that also in the equity markets, higher returns are not risk-free. Quickly after the full extent of EM.TV’s scandal became visible and clear, the investor community filed a lawsuit against the management, and also prepared to sue PricewaterhouseCoopers, which audited the financial statements.
This paper attempts to shine light on the EM.TV story, focusing on the role of the auditors. While definitely playing a central role, it will be shown that auditing in this particular case rather helped to dismantle the problematic issues and to reveal a more realistic assessment of the company’s financial health. I will first give a brief overview of the discussed company as well as the special stock market environment it operated in. Secondly, I will summarize the major accounting malpractices that, consequently, have made this issue so relevant for the topic of auditing. The main part will then analyze the auditing and accountability issues, in this case implemented by PriceWaterhouseCoopers (PwC), by outlining their approach and methodology, and the subsequent actions taken. This will then be drawn further to discuss and conclude with general effects on the auditing market, especially in Germany.
II. Background: EM.TV and the German “Neuer Markt” (New Market)
EM.TV, a Munich-based media company, went public in October 1997. Within two-and-a-half years, investors who bought the very first shares were rewarded with a skyrocketing stock price going up by 31125% (Bloomberg). With this, EM.TV, intimately related to its CEO and founder Thomas Haffa, was the most celebrated star of the German start-up index “Neuer Markt”. This segment of Deutsche Börse was established following the example of the American Nasdaq, giving alleged growth prospect companies access to equity capital markets. Hand in hand with the upcoming dot-com bubble, this market niche developed into the hottest stock market of the time - and EM.TV was upfront. Haffa made it on the cover of the magazine Businessweek as the “Cartoon King” (1999) with a firm whose main business was the sales of TV programming and of merchandising licenses. For accelerated expansion, EM.TV entered into an M&A acquisition spree, with more than 25 acquisitions or partnerships within two years (EM.TV annual report 1999). Praised by analysts and admired by EM.TV investors, CEO Thomas Haffa was omnipresent in the high society, organizing parties, giving interviews, closing new deals. EM.TV broke all records. In August 1999, EM.TV’s market capitalization surpassed Lufthansa’s value and was worth more than the three largest media corporations in Germany combined (Spiegel, 2000). In March 2000 Haffa invested ca. €1.8bn for licenses related to Formula 1 (EM.TV annual reports 2000 and 2001). At the same time however, EM.TV reported negative Free Cash Flows for 1999, while having a positive EBITDA (EM.TV annual report 1999). One of the first publicized odd features of the company. Over the year 2000, the stock market starting cooling down and also EM.TV shares fell from its all- time high. Furthermore, over the summer pressure increased on the management to correct central business figures. Suddenly it turned out that ca. €179 mn. of revenues were overstated, and goodwill write-offs to an unknown extent were pending (Focus Money, 2002). What had happened to the related accounting entries?
III. Brief Overview of Accounting Malpractices
Being a media company, the value of licenses and TV rights were critical for the business of EM.TV. The firm quickly built up a significant stock of those intangible assets, which it then sold to TV broadcasters and other media companies. What mattered in this context is the way EM.TV amortized those licenses over time. Contrary to sector- typical accelerated amortization techniques, EM.TV applied a straight-line depreciation. The useful life hereby was indicated with 20 years in 1998 and 1999, before being even extended further to 30 years in 2000 (EM.TV annual reports). As reasoning for this, in its annual report 1999 (p.88), EM.TV states that “These depreciation methods were applied because film and merchandising rights in the area of children’s entertainment are particularly longlived.” Whereas indeed Mickey Mouse and Donald Duck have a long-lasting value for the rights’ owner, it is more than questionable if EM.TV’s “Teenage Mutant Hero Turtles” and other entertainment series could qualify for similar treatment. With regards to auditors, this was definitely an account which involved a high level of subjectivity, but PwC accepted this accounting policy.
Secondly, EM.TV had created an inscrutable structure of holdings and acquisitions, which had quadrupled its asset value regarding goodwill. The then existing accounting principles required an amortization of goodwill. EM.TV made use of this, and first amortized goodwill within five years as indicated in the 1998 report. In a swift change, the 2000 annual report comments that goodwill can be amortized over a twenty year period. This accounting method allowed EM.TV to keep a large goodwill figure in their books, artificially inflating the balance sheet while avoiding write-down losses in the Profit-and-Loss Statement. However, some major accounting entries did not pass the auditors’ approval. Two investments, which EM.TV sold again shortly after the purchase could not be recorded as “extraordinary gains”, but had to be offset against the initial purchase price - the €179 mn. loss in stated revenues, which were described before (Focus Money, 2002). EM.TV subsequently had to announce a profit warning of EBITDA being cut down by 60%, which caused the stock price to plummet (Focus Money, 2001).
Last but not least, EM.TV applied an aggressive revenue recognition policy - too aggressive for the auditors’ taste. s PwC did no longer accept the practice of booking the revenues from multi-year licenses sold upfront, it had to re- state accounted revenues, for instance from its stake in the Formula 1 business (Spiegel, 2000). Eventually, the auditor took over the valuation of that investment so that one analyst commented “We don’t know how the auditors will finally value the stake of EM.TV in the Formula 1” (Spiegel, 2001). Indeed, this process delayed the publication date of the annual statements for 2000 significantly. The magazine Forbes (2001) noted: “The company's accountant, PricewaterhouseCoopers, was still trying to figure out big goodwill writedowns. Simply put, the company was plainly guessing its earnings figures.” ll in all, EM.TV’s accounting practices included plenty of questionable techniques. After having assented to those practices over some time, it looked like PwC applied the emergency brake to bring the accounting standards back on track. The following section will further analyze the role, behavior, and motives of the auditor in this issue.
IV. Analysis of the auditing and accountability issues
The annual reports 1998 and 1999, both signed by the same persons on behalf of the auditor PwC, indicate a standard unqualified statement as “Our audit *͙+ has not led to any reservations.” (annual report 1999, p.109).On the other hand, in retrospect we may well identify both error and fraudulent financial reporting practices by EM.TV, meaning unintentional as well as intentional misstatements as pointed out in the previous section. How and why did the auditor eventually object?
While it is not possible to give a fully exhaustive answer to this, a key report on the German “Neuer Markt”, issued by PwC itself, is likely to have played a crucial role in increased precautions. In July 2000, one internal study yielded that a significant number of the listed start-up firms, especially internet-related companies, will run into bankruptcy in the near future. s one PwC partner noted: “The air is getting thin.” (Spiegel, 2000). Generally, the auditing firm warned investors regarding overly aggressive sales and profit forecasts by some of the listed firms. This directly affected one of the auditor’s key considerations when evaluating the financial statements of EM.TV, namely their independent expectations of the estimates given by the client’s management. Management assertions appeared to be questionable especially regarding the presentation of assets, especially acquired media licenses, as well as regarding valuation issues, related to media rights and the value for goodwill.
It is likely that the EM.TV auditors felt that previous supporting data gathered were not sufficient and also further key risk assessment elements now appeared in a different light: management incentive around EM.TV was massive, given the stock price development and huge performance expectations. lso, opportunities for “cooking the books” were plentiful, as the firm had no internal auditor or control (in fact, Haffa’s own brother Florian served as CFO of the company). And finally, management attitudes were not coined by confidence-building behavior: CEO Thomas Haffa preferred to organize large VIP-parties and enjoy the glamour world than to emphasize a trust relationship with the auditor. In fact however, he was even well aware of the accounting techniques, but preferred not to make them a subject of discussion. For instance, when he was once directly asked about the justification for the revenue recognition of EM.TV, he menaced that person with a lawsuit (Gürtler, 2001, p. 65). All this implied an existing “fraud triangle” so that PwC’s audit risk model had to be re-adjusted. The Inherent Risk was imminent, with several red flag events hinting at misstatements, and the Control Risk did nothing to improve the situation, as internal control mechanisms were basically non-existent.
We have seen how EM.TV’s auditor most probably sensed that its auditing practices had to be amended. For the Acceptable Audit Risk (AAR) to remain constant, while Inherent Risk and Control Risk were significant, the Planned Detection Risk (PDR) had to be reduced by performing more substantive testing. Hence, PwC, in the fall of 2000, performed a thorough review of the accounting practices and estimates, and also examined the transactions registered. After the first re-statements had led to the resigning of Florian Haffa as CFO, a new, external chief financial officer, together with auditors, identified the first accounting malpractices as described above, which led to the profit warning (Handelsblatt, 2000). After this disastrous announcement, the auditor increased its level of investigation even further and even consulted external valuation experts, as especially the stake in the Formula 1 business posed significant accounting problems. This delayed the publication of the annual report 2000 by several weeks, which, however, even EM.TV by then preferred over the danger of releasing misstatements (Shortnews, 2001).
In retrospective, PwC had decided on the right procedure, since the misstatements in the accounts clearly fell in the category of materiality. The re-statements, published in the final figures, had resulted in a stunning loss for EM.TV in the year 2000, higher in absolute numbers than the total amount of revenues it had generated since its founding in 1989 (Gürtler,2001,p.206). While the stock market reaction over that period was dramatic, one might also argue that the role of the auditor saved EM.TV from running into severe financial distress, which would have harmed investors even more. Interestingly, PwC in the end gave again an unqualified statement for the year 2000 (annual report,p.117).
Yet, the events surrounding EM.TV had wider repercussions. In the face of this accounting scandal, German legislation was amended in the area of auditing regulation. Auditors were now subject to external quality controls, and shortly after, a regulation on transparency and publication specified objectives and extent of auditing work and report (Deloitte, 2011). This illustrates the relevance of the EM.TV case for the audit profession in Germany, which in the end perceived this story as a big warning signal regarding financial misstatement and the role of auditors.
- Quote paper
- Anonymous, 2011, Accounting Scandal at EM.TV 1998 - 2000: The Role of the Auditors, Munich, GRIN Verlag, https://www.grin.com/document/176312