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© 2003, 2005 by the AICPA Business Fraud (The Enron Problem) W. Steve Albrecht Ph.D., CPA, CIA, CFE Brigham Young University
This presentation is intended for use in higher education for instructional purposes only, and is not for application in practice. Permission is granted to classroom instructors to photocopy this document for classroom teaching purposes only. All other rights are reserved. Copyright © 2003, 2005 by the American Institute of Certified Public Accountants, Inc., New York, New York.
© 2003, 2005 by the AICPA These Are Interesting Times Number and size of financial statement frauds are increasing Number and size of frauds against organizations are increasing Some recent frauds include several people—as many as 20 or 30 (seems to indicate moral decay) Many investors have lost confidence in credibility of financial statements and corporate reports More interest in fraud than ever before—now a course on many college campuses
© 2003, 2005 by the AICPA Example of a Fraud Where I Testified Large Fraud of $2.6 Billion over 9 years –Year 1$600K –Year 3$4 million –Year 5$80 million –Year 7$600 million –Year 9$2.6 billion In years 8 and 9, four of the world’s largest banks were involved and lost over $500 million
© 2003, 2005 by the AICPA Why Fraud is a Costly Business Problem Fraud Losses Reduce Net Income $ for $ If Profit Margin is 10%, Revenues Must Increase by 10 times Losses to Recover Affect on Net Income –Losses……. $1 Million –Revenue….$1 Billion Fraud Robs Income Revenues$100100% Expenses 90 90% Net Income$ 10 10% Fraud 1 Remaining $ 9 To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.
© 2003, 2005 by the AICPA Fraud Cost….Two Examples General Motors –$436 Million Fraud –Profit Margin = 10% –$4.36 Billion in Revenues Needed –At $20,000 per Car, 218,000 Cars Bank –$100 Million Fraud –Profit Margin = 10 % –$1 Billion in Revenues Needed –At $100 per year per Checking Account, 10 Million New Accounts
© 2003, 2005 by the AICPA Financial Statement Fraud Financial statement fraud causes a decrease in market value of stock of approximately 500 to 1,000 times the amount of the fraud. $7 million fraud $2 billion drop in stock value
© 2003, 2005 by the AICPA Types of Fraud Fraudulent Financial Statements Employee Fraud Vendor Fraud Customer Fraud Investment Scams Bankruptcy Frauds Miscellaneous Frauds The common element is deceit or trickery!
© 2003, 2005 by the AICPA Recent Financial Statement Frauds EnronWorldComAdelphia Global Crossing XeroxQwest Many others (Cendant, Lincoln Savings, ESM, Anicom, Waste Management, Sunbeam, etc.)
© 2003, 2005 by the AICPA Current Executive Fraud-Related Problems Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc. Executive Loans and Corporate Looting: John Rigas (Adelphia), Dennis Kozlowski (Tyco--$170 million) Insider Trading: Martha Stewart, etc. IPO Favoritism: John Ebbers ($11 million) CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, Fleet Boston Financial, IBM (Consulting Contracts, Use of Corporate Planes, etc.) (Consulting Contracts, Use of Corporate Planes, etc.)
© 2003, 2005 by the AICPA Largest Bankruptcy Filings (1980 to Present) from BankruptcyData.com Company Assets (Billions) When Filed 1. WorldCom $103.9 July 2002 2. Enron $63.4 Dec. 2001 3. Conseco $61.4 Dec. 2002 4. Texaco $35.9 April 1987 5. Financial Corp of America $33.9 Sept. 1988 6. Global Crossing $30.2 Jan. 2002 7. PG&E $29.8 April 2001 8. UAL $25.2 Dec. 2002 9. Adelphia $21.5 June 2002 10. MCorp $20.2 March 1989
© 2003, 2005 by the AICPA Why so many financial statement frauds all of a sudden? Good economy was masking many problems Moral decay in society Executive incentives Wall Street expectations—rewards for short-term behavior Nature of accounting rules Behavior of CPA firms Greed by investment banks, commercial banks, and investors Educator failures
© 2003, 2005 by the AICPA Good economy was masking problems… With increasing stock prices, increasing profits and increasing wealth for everyone, no one worried about potential problems. How to value a dot.com company: –Take their loss for the year –Multiply the result by negative 1 to make it positive –Multiply that number by at least 100 –If stock price is less than the result…buy; if not, buy anyway
© 2003, 2005 by the AICPA Executive Incentives Meeting Wall Street’s Expectations –Stock prices are tied to meeting Wall Street’s earnings forecasts –Focus is on short-term performance only –Companies are heavily punished for not meeting forecasts –Executives have been endowed with hundreds of millions of dollars worth of stock options—far exceeds compensation (tied to stock price) –Performance is based on earnings & stock price
© 2003, 2005 by the AICPA Incentives for F.S. Fraud Incentives to commit financial statement fraud are very strong. Investors want decreased risk and high returns. Risk is reduced when variability of earnings is decreased. Rewards are increased when income continuously improves. Which firm will have the higher stock price? Firm AFirm B
© 2003, 2005 by the AICPA Nature of Accounting Rules In the U.S., accounting standards are “rules- based” instead of “principles based.” –Allows companies and auditors to be extremely creative when not specifically prohibited by standards. –Examples are SPEs and other types of off-balance sheet financing, revenue recognition approaches, merger reserves, pension accounting, and other accounting schemes. –When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…” –It is impossible to make rules for every situation
© 2003, 2005 by the AICPA Auditors—the CPAs Failed to accept responsibility for fraud detection (SEC, Supreme Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is? Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting rich Audit became a loss leader –Easier to sell lucrative consulting services from the inside –Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture) A few auditors got too close to their clients Entire industry, especially Arthur Andersen, was punished for actions of a few
© 2003, 2005 by the AICPA Educators Need to teach Ethics more Need to teach students about fraud—offer a “fraud” course Need to teach students how to think –We have taught them how to copy, not think –We have asked them to memorize, not think –We have done what is easiest for us and easiest for our students
© 2003, 2005 by the AICPA Financial Statement Frauds Revenue/Accounts Receivable Frauds (Global Crossing, Quest, ZZZZ Best) Inventory/Cost of Goods Sold Frauds (PharMor) Understating Liability/Expense Frauds (Enron) Overstating Asset Frauds (WorldCom) Overall Misrepresentation (Bre-X Minerals)
© 2003, 2005 by the AICPA Revenue Related Financial Statement Frauds By far, the most common accounts manipulated when perpetrating financial statement fraud are revenues and/or accounts receivable. Accounts Receivablexxx Revenuesxxx (Income Assets ) (Income Assets )
© 2003, 2005 by the AICPA Revenue-Related Transactions and Frauds
© 2003, 2005 by the AICPA Overstating Inventory The second most common way to commit financial statement fraud is to overstate inventory. Beginning InventoryOK PurchasesOK Goods Available for saleOK Ending InventoryHigh Cost of Goods SoldLow IncomeHigh
© 2003, 2005 by the AICPA Inventory/Cost of Goods Sold Frauds
© 2003, 2005 by the AICPA Understating Liability Frauds (3 rd Most Common) Not recording accounts payable Not recording accrued liabilities Recording unearned revenues as earned Not recording warranty or service liabilities Not recording loans or keep liabilities off the books Not recording contingent liabilities
© 2003, 2005 by the AICPA Asset Overstatement Frauds (4 th Most Common) Overstatement of current assets (e.g. marketable securities) Overstating pension assets Capitalizing as assets amounts that should be expensed Failing to record depreciation/amortization expense Overstating assets through mergers and acquisitions Overstating inventory and receivables (covered earlier)
© 2003, 2005 by the AICPA Disclosure Frauds Three Categories of Disclosure Frauds: 1.Overall misrepresentations about the nature of the company or its products, usually made through news reports, interviews, annual reports, and elsewhere 2.Misrepresentations in the management discussions and other non-financial statement sections of annual reports, 10-Ks, 10-Qs, and other reports 3.Misrepresentations in the footnotes to the financial statements
© 2003, 2005 by the AICPA Detecting Financial Statement Fraud Detecting Financial Statement Fraud 1. Management & Board 2. Relationships With Others 3. Organization & Industry 4. Financial Results & Operating Characteristics
© 2003, 2005 by the AICPA Enron Fraud Compared to other financial statement frauds, Enron was very complicated. WorldCom, for example, was a $7 billion fraud that involved simply capitalizing expenses (line costs) that should have been expensed (Accounting 200 topic). Enron involved many complex transactions and accounting issues. “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity—although they probably lied too.” “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity—although they probably lied too.” Senator John Dingell
© 2003, 2005 by the AICPA Enron’s History In 1985 after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. Enron incurred massive debt and no longer had exclusive rights to its pipelines. Needed new and innovative business strategy Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a young consultant named Jeffrey Skilling. His background was in banking and asset and liability management. His recommendation: that Enron create a “Gas Bank”— to buy and sell gas
© 2003, 2005 by the AICPA Enron’s History (cont’d) Created Energy derivative Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits. Skilling hired the “best and brightest” traders and rewarded them handsomely—the reward system was eat what you kill Fastow was a Kellogg MBA hired by Skilling in 1990— Became CFO in 1998 Started Enron Online Trading in late 90s Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition
© 2003, 2005 by the AICPA The Motivation Enron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didn’t understand its financial statements. It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.) In its last 5 years, Enron reported 20 straight quarters of increasing income. Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings from a vaguer business known as “wholesale energy operations and services.”
© 2003, 2005 by the AICPA The Role of Stock Options Enron (and many other companies) avoided hundreds of millions of dollars in taxes by its use of stock options. Corporate executives received large quantities of stock options. When they exercised these options, the company claimed compensation expense on their tax returns. Accounting rules let them omit that same expense from the earnings statement. The options only needed to be disclosed in a footnote. Options allowed them to pay less taxes and report higher earnings while, at the same time, motivating them to manipulate earnings and stock price.
© 2003, 2005 by the AICPA Enron’s Corporate Strategy Was devoid of any boundary system Enron’s core business was losing money—shifted its focus from bricks-and-mortar energy business to trading of derivatives (most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were) During 2000, Enron’s derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billion Enron’s top management gave its managers a blank order to “just do it” Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.
© 2003, 2005 by the AICPA Aggressive Nature of Enron Because Enron believed it was leading a revolution, it pushed the rules. Employees attempted to crush not just outsiders but each other. Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders. Because Enron believed it was leading a revolution, it pushed the rules. Employees attempted to crush not just outsiders but each other. Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.
© 2003, 2005 by the AICPA Enron’s Arrogance Enron’s banner in lobby: Changed from “The World’s Leading Energy Company” to “THE WORLD’S LEADING COMPANY”
© 2003, 2005 by the AICPA 2001 - Notable Events Jeff Skilling left on August 14—gave no reason for his departure. By mid-August, the stock price began to fall Former CEO, Kenneth Lay, returned in August Oct. 16…announced $618 million loss but not that it had written down equity by $1.2 billion October…Moody’s downgraded Enron’s debt Nov. 8…Told investors they were restating earnings for the past 4 and ¾ years Dec. 2…Filed bankruptcy
© 2003, 2005 by the AICPA Executives Abandon Enron Rebecca Mark-Jusbasche, formerly CEO of Azurix, Enron’s troubled water-services company left in August, 2000 Joseph Sutton, Vice Chairman of Enron, left in November, 2000. Jay Clifford Baxter, Vice Chairman of Enron committed suicide in May, 2001 Thomas White, Jr., Vice Chairman, left in May, 2001. Lou Pai, Chairman of Enron Accelerator, departed in May 2001. Kenneth Rice, CEO of Enron’s Broadband services, departed in August 2001. Jeffrey Skilling, Enron CEO, left on August 14, 2001
© 2003, 2005 by the AICPA Enron’s revenues and income YearRevenuesIncome Income (Restated)* 1997 $20.2 B $105 M $9 M 1998 $31.2 B $703 M $590 M 1999 $40.1 B $893 M $643 M 2000 $100.1 B $979 M $827 M * Without LJM1, LJM2, Chewco and the “Four Raptors” partnerships. There were hundreds of partnerships—mainly used to hide debt.
© 2003, 2005 by the AICPA “Value at Risk (VAR)” Methodology Some warning signs disclosed by Frank Portnoy before January 24, 2002 Senate Hearings Enron captured 95% confidence intervals for one-day holding periods—didn’t disclose worst case scenarios Relied on “professional judgment of experienced business and risk managers” to assess worst case scenarios Investors didn’t know how much risk Enron was taking Enron had over 5,000 weather derivatives deals valued at over $4.5 billion—couldn’t be valued without professional judgment From the 2000 annual report “In 2000, the value at risk model utilized for equity trading market risk was refined to more closely correlate with the valuation methodologies used for merchant activities.” Given the failure of the risk and valuation models at a sophisticated hedge funds such as Long-Term Capital Management—that employed “rocket Scientists” and Nobel laureates to design sophisticated computer models, Enron’s statement that it would “refine” its own models should have raised concerns
© 2003, 2005 by the AICPA Special Purpose Entities (SPEs) (Enron’s principal method of financial statement fraud involved the use of SPEs) Originally had a good business purpose Help finance large international projects (e.g. gas pipeline in Central Asia) Investors wanted risk and reward exposure limited to the pipeline, not overall risks and rewards of the associated company Pipeline to be self-supported, independent entity with no fear company would take over SPE limited by its charter to those permitted activities only Really a joint venture between sponsoring company and a group of outside investors Cash flows from the SPE operations are used to pay investors
© 2003, 2005 by the AICPA Enron’s Use of Special Purpose Entities (SPEs) To hide bad investments and poor-performing assets (Rhythms NetConnections). Declines in value of assets would not be recognized by Enron (Mark to Market). Earnings management—Blockbuster Video deal--$111 million gain (Bravehart, LJM1 and Chewco) Quick execution of related-party transactions at desired prices. (LJM1 and LJM2) To report over $1 billion of false income To hide debt (Borrowed money was not put on financial statements of Enron) To manipulate cash flows, especially in 4 th quarters Many SPE transactions were timed (or illegally back- dated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations
© 2003, 2005 by the AICPA Accounting License to Cheat Major issue is whether SPEs should be consolidated*— SPEs are only valuable if unconsolidated. 1977--”Synthetic lease” rules (Off-balance sheet financing) (Allowed even though owned more than 50%) 1984—”EITF 84-15” Grantor Trust Consolidations (Permitted non-consolidation if owned more than 50%) 1990—”EITF 90-15” (The 3% rule) Allowed corporations such as Enron to “not consolidate” if outsiders contributed even 3% of the capital (the other 97% could come from the company.) 90-15 was a license to create imaginary profits and hide genuine losses. FAS 57 requires disclosure of these types of relationships. 3% rule was formalized with FAS 125 and FAS 140, issued in September 2000. *Usually entities must be consolidated if company owns 50% or more
© 2003, 2005 by the AICPA Mark-to-Market Accounting Accounting and reporting standards for marketable securities, derivatives and financial contracts are found in FAS 115 and FAS 133. Changes in market values are reported in the income statement for certain financial assets and in shareholders’ equity (component of Accumulated Other Comprehensive Income) for others Gains often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and prices— provides opportunities for management to create and manage earnings Enron often recognized revenue at the time contracts (even private) were signed based on net present value of all future estimated revenues and costs. Profits really tracked price of oil futures—almost perfectly correlated
© 2003, 2005 by the AICPA The Chewco SPE Accounted for 80% of SPE restatement or $400 million In 1993, Enron and the California Public Employees Retirement System (CalPERS) formed a 50/50 partnership—Joint Energy Development Investments Limited (JEDI) In 1997, Enron bought out CalPERS’ interest in JEDI Half of the $11.4 million that bought the 3% involved cash collateral provided by Enron— meaning only 1 and ½ percent was owned by outsiders
© 2003, 2005 by the AICPA LJM1 SPE Responsible for 20% of SPE restatement or $100 million Should have been consolidated—an error in judgment by Andersen (per Andersen) After Andersen’s initial review in 1999, Enron created a subsidiary within LJM1, referred to as Swap Sub. As a result, the 3% rule for residual equity was no longer met. Andersen was reviewing this transaction again at the time problems were made public— involved complex issues concerning the valuation of various assets and liabilities.
© 2003, 2005 by the AICPA Enron’s Disclosures SEC Regulation S-K requires description of related-party transactions that exceed $60K and for which an executive has a material interest “Related Party Transactions” footnote included in Forms 10-Q and 10-K beginning with second quarter of 1999 through 2 nd quarter of 2001 From 2000 annual report “…Enron entered into transactions with limited partnerships whose general partner’s managing partner is a senior official of Enron.” (Fastow)
© 2003, 2005 by the AICPA Enron’s Footnotes—Disclosures of Enron Partnership ReportFootnote Filed with the SEC 10Q—Q1 2000 Footnote 7 5/15/2000 10Q—Q2 2000 Footnote 8 8/14/2000 10Q—Q3 2000 Footnote 10 11/14/2000 10Q—Q1 2001 Footnote 8 5/15/2001 10Q—Q2 2001 Footnote 8 8/14/2001 10Q—Q3 2001 Footnote 4 11/19/2001
© 2003, 2005 by the AICPA The Famous “Misleading Earnings Release” on October 16, 2001 Headline: “Enron Reports Recurring Third Quarter Earnings of $0.43 per diluted share…” Projected recurring earnings for 2002 of $2.15 If you dug deep, you learned that Enron actually lost $618 million or $0.84 per share—they had mislabeled $1.01 billion of expenses and losses as non-recurring. Shockingly, there was no balance sheet or cash flow information with the release There was no mention of a $1.2 billion charge against shareholder’s equity, including what was described as a $1 billion correction to an accounting error. (This was learned a couple of days later.)
© 2003, 2005 by the AICPA Didn’t Anyone See Enron’s Problems? Enron grew to be the 7 th largest Fortune 100 company while media hype and the stock market euphoria reigned But in late 2000 negative reports began to originate from some skeptics
© 2003, 2005 by the AICPA The Skeptics Jonathan Weil, “Energy traders cite gains, but some math is missing,” The Wall Street Journal (Texas ed.) 9/20/2000 Feb. 2001 analyst report from John S. Herold, Inc. by Lou Gagliardi and John Parry Bethany McLean, “Is Enron overpriced?” Fortune, 3/5/2001
© 2003, 2005 by the AICPA Enron’s Cash Flows Enron’s cash flows bore little relationship to earnings (a lot due to mark to market.) On the balance sheet, debt climbed from $3.5 billion in 1996 to $13 billion in 2001. Key Ratio Net Income (from Operations*) – Cash Flow (from Operations**) Net Income (from Operations) Would expect to be about zero over time *From the Income Statement **From the Statement of Cash Flows
© 2003, 2005 by the AICPA Enron’s Cash Flow Ratio Negative Cash Flows: 1 st three quarters in 1999, 1 st three quarters in 2000, 1 st two quarters in 2001.
© 2003, 2005 by the AICPA Role of Andersen Was paid $52 million in 2000, the majority for non-audit related consulting services. Failed to spot many of Enron’s losses Should have assessed Enron management’s internal controls on derivatives trading—expressed approval of internal controls during 1998 through 2000 Kept a whole floor of auditors assigned at Enron year around Enron was Andersen’s second largest client Provided both external and internal audits CFOs and controllers were former Andersen executives Accused of document destruction—was criminally indicted Went out of business My partner friend “I had $4 million in my retirement account and I lost it all.” Some partners who transferred to other firms now have two equity loans and no retirement savings.
© 2003, 2005 by the AICPA Role of Investment & Commercial Banks Enron paid several hundred million in fees, including fees for derivatives transactions. None of these firms alerted investors about derivatives problems at Enron. In October, 2001, 16 of 17 security analysts covering Enron still rated it a “strong buy” or “buy.” Example: One investment advisor purchased 7,583,900 shares of Enron for a state retirement fund, much of it in September and October, 2001
© 2003, 2005 by the AICPA Role of Law Firms Enron’s outside law firm was paid substantial fees and had previously employed Enron’s general counsel Failed to correct or disclose problems related to derivatives and special purpose entities Helped draft the legal documentation for the SPEs
© 2003, 2005 by the AICPA Role of Credit Rating Agencies The three major credit rating agencies—Moody’s, Standard & Poor’s and Fitch/IBCA—received substantial fees from Enron Just weeks prior to Enron’s bankruptcy filing—after most of the negative news was out and Enron’s stock was trading for $3 per share—all three agencies still gave investment grade ratings to Enron’s debt. These firms enjoy protection from outside competition and liability under U.S. securities laws. Being rated as “investment grade” was necessary to make SPEs work
© 2003, 2005 by the AICPA So Why Did Enron Happen? Individual and collective greed—company, its employees, analysts, auditors, bankers, rating agencies and investors—didn’t want to believe the company looked too good to be true Atmosphere of market euphoria and corporate arrogance High risk deals that went sour Deceptive reporting practices—lack of transparency in reporting financial affairs Unduly aggressive earnings targets and management bonuses based on meeting targets Excessive interest in maintaining stock prices
© 2003, 2005 by the AICPA Will there be another Enron? Yes –Recent years have seen an increase in the number of financial statement frauds 1977-87 (300); 1987-1997 (300); 1997-2002 (over 300) –Incentives still there (Stock Options, etc.) No –Sarbanes-Oxley Bill contains many key provisions Executive “sign off” Requirement to have internal controls Rules for accountants (mandatory audit partner rotation; Oversight Board, limitations on services, etc.) –Accountants are being much more careful
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