In Conclusion U.S. Securities & Exchange Commission Division of Enforcement The U.S. Securities and Exchange Commission, as a matter of policy, disclaims.

In Conclusion

U.S. Securities & Exchange Commission Division of Enforcement The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Views expressed herein are those of the presenter and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.

Today’s Topic Financial Reporting and Issuer Disclosure Financial Reporting and Issuer Disclosure Focus on Financial Fraud Focus on Financial Fraud

Financial Fraud is: “… Intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements…” “… Intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements…” “… it may entail gross and deliberate distortion of corporate records, … falsified transactions, … [or] the misapplication of accounting principles.” “… it may entail gross and deliberate distortion of corporate records, … falsified transactions, … [or] the misapplication of accounting principles.” Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987 Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987

Fraud is Different than Errors “Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors.” “Fraudulent financial reporting differs from other causes of materially misleading financial statements, such as unintentional errors.” Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987 Report of the National Commission on Fraudulent Financial Reporting; COSO, October 1987

Three Conditions are Usually Present: Management has an incentive or is under pressure Management has an incentive or is under pressure The opportunity exists for a fraud to be perpetrated The opportunity exists for a fraud to be perpetrated The fraudsters rationalize their fraudulent acts The fraudsters rationalize their fraudulent acts Statement on Auditing Standards 99, October 2002 Statement on Auditing Standards 99, October 2002

How Does it All Begin?

Answer: Starts with “making the numbers” Starts with “making the numbers” Then, “Managing the Numbers” Then, “Managing the Numbers” Ends with “making up the numbers” Ends with “making up the numbers”

Rationalization includes: “We need to make our projections…” “We need to make our projections…” “I’m getting pressure from the boss…” “I’m getting pressure from the boss…” “We need to meet Street expectations…” “We need to meet Street expectations…” “Our acquisition will fall through if we don’t…” “Our acquisition will fall through if we don’t…”

And, Let’s Not Forget the Popular “We’ll make it up next quarter…”

But, even a simple mistake can be turned into a financial fraud through “cover-up” efforts.

Annual Caseload by Fiscal Year

SEC Enforcement: FY 2002 598 total cases 598 total cases Largest categories: Largest categories:  Financial fraud and issuer reporting (27%)  Offering fraud (20%)  Broker-dealer (14%)  Insider trading (10%)  Market manipulation (7%)  Investment adviser/company (8%)

Financial Reporting and Issuer Disclosure: Actions Filed 163 actions filed in FY 2002 163 actions filed in FY 2002  Compared to:  112 in FY 2001  103 in FY 2000  94 in FY 1999  79 in FY 1998

Sources of Cases Other Agencies Other Agencies Self-Reporting Self-Reporting Auditor Reports Auditor Reports Informants Informants

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Complaint Center 500-800 complaints a week 500-800 complaints a week Many concern financial misconduct Many concern financial misconduct www.sec.gov www.sec.gov

Commission Top Priority October 17, 2001: “Financial fraud and reporting cases are our top priority” October 17, 2001: “Financial fraud and reporting cases are our top priority” FY 2002 – 216 New financial fraud and reporting investigations opened FY 2002 – 216 New financial fraud and reporting investigations opened 69% increase over FY 2001 69% increase over FY 2001

Resources 970 Staff Members 970 Staff Members 2500+ Open Investigations 2500+ Open Investigations Half of resources on financial fraud Half of resources on financial fraud

Common Fraud Schemes Premature revenue recognition Premature revenue recognition Excess reserves to smooth earnings Excess reserves to smooth earnings Improper capitalized costs Improper capitalized costs Changing estimates “to make the numbers” Changing estimates “to make the numbers” Top-Side Journal Entries Top-Side Journal Entries “Earnings Management” “Earnings Management”

Traditional Fraudulent Revenue Schemes Backdating of contracts Backdating of contracts Fictitious invoices Fictitious invoices Shipment of unfinished product Shipment of unfinished product Revenue after the fiscal period Revenue after the fiscal period Revenue recognized on products not shipped or not yet manufactured Hidden “side letters” giving customers rights to return product

New Types of Cases Looting Looting SPE’s SPE’s Related party transactions Related party transactions Undisclosed compensation Undisclosed compensation Misleading “Pro Forma” releases Misleading “Pro Forma” releases Round-tripping Round-tripping Accommodations Accommodations Channel stuffing Channel stuffing Acceleration of revenue in multiple-element arrangements Acceleration of revenue in multiple-element arrangements

Growth in Enforcement Investigations In 1998, we had 1733 investigations In 1998, we had 1733 investigations In 2002, we had 2402 investigations In 2002, we had 2402 investigations 39% increase in investigations 39% increase in investigations

Growth in Financial Fraud Actions In 1998, we brought 79 financial fraud/reporting actions In 1998, we brought 79 financial fraud/reporting actions In 2002, we brought 163 financial fraud/reporting actions In 2002, we brought 163 financial fraud/reporting actions 106% growth in financial fraud actions 106% growth in financial fraud actions

Growth in Actions Involving Fortune 500 Companies In 1998, 4 of the 79 financial fraud actions (5%) involved Fortune 500 companies In 1998, 4 of the 79 financial fraud actions (5%) involved Fortune 500 companies In 2002, 29 of the 163 financial fraud actions (18%) involved Fortune 500 companies In 2002, 29 of the 163 financial fraud actions (18%) involved Fortune 500 companies 625% growth 625% growth

Actions Brought in the Last 12 Months Michael Kopper and Andrew Fastow (Enron) Michael Kopper and Andrew Fastow (Enron) WorldCom WorldCom RiteAid and its senior management RiteAid and its senior management Adelphia Communications and its senior management Adelphia Communications and its senior management Microsoft Microsoft Senior management of Waste Management Senior management of Waste Management Amazon.com Amazon.com Xerox Xerox

Still More PricewaterhouseCoopers PricewaterhouseCoopers Ernst & Young Ernst & Young Top officers of Tyco Top officers of Tyco Homestore.com officers Homestore.com officers Dynegy Dynegy KPMG KPMG HealthSouth HealthSouth

FINANCIAL REPORTING AND ISSUER DISCLOSURE: Themes and Trends

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities

Close Cooperation with Prosecutors Corporate Fraud Task Force Corporate Fraud Task Force US Attorneys want the cases US Attorneys want the cases State authorities want the cases State authorities want the cases Plenty of cases to go around Plenty of cases to go around

Criminal Cases –FY 2002 17 Federal districts brought criminal securities fraud cases 17 Federal districts brought criminal securities fraud cases More than 259 people and entities charged More than 259 people and entities charged

Enron Michael J. Kopper held various executive positions at Enron, most of the time reporting directly to Andrew Fastow, Enron’s CFO. Michael J. Kopper held various executive positions at Enron, most of the time reporting directly to Andrew Fastow, Enron’s CFO. In August 2002, the Commission filed a settled action against Kopper in which he agreed to disgorge and forfeit $12 million, to be permanently enjoined from violating the federal securities laws, and to be barred from acting as an officer or director of public companies. In August 2002, the Commission filed a settled action against Kopper in which he agreed to disgorge and forfeit $12 million, to be permanently enjoined from violating the federal securities laws, and to be barred from acting as an officer or director of public companies. On the same day, Kopper pleaded guilty to conspiracy to commit wire fraud and money laundering, agreed to forfeit $4 million (included in the $12 million above), and to cooperate with the government's continuing investigation. On the same day, Kopper pleaded guilty to conspiracy to commit wire fraud and money laundering, agreed to forfeit $4 million (included in the $12 million above), and to cooperate with the government's continuing investigation.

Enron Commission filed enforcement action against Andrew Fastow, former CFO of Enron, alleging violations of anti-fraud, periodic reporting, books and records, and internal controls provisions of federal securities laws. Commission filed enforcement action against Andrew Fastow, former CFO of Enron, alleging violations of anti-fraud, periodic reporting, books and records, and internal controls provisions of federal securities laws. Commission seeks disgorgement of all ill-gotten gains, including all compensation received subsequent to commencement of the alleged fraud, civil money penalties, a permanent bar from acting as a director or officer of a public company, and an injunction from future violations of the federal securities laws. Commission seeks disgorgement of all ill-gotten gains, including all compensation received subsequent to commencement of the alleged fraud, civil money penalties, a permanent bar from acting as a director or officer of a public company, and an injunction from future violations of the federal securities laws. Commission brought action in coordination with DOJ’s Enron Task Force, which filed a related criminal complaint against Fastow. Commission brought action in coordination with DOJ’s Enron Task Force, which filed a related criminal complaint against Fastow.

Enron Commission complaint alleges: Fastow involved with three transactions -- RADR, Chewco, and Southampton – that were part of an alleged scheme to hide his and Michael Kopper's interest in and control of certain entities in order to keep those entities off Enron's balance sheet. Fastow secretly nominated certain of the owners of these three entities, funded certain of their investments through undisclosed loans, collected undisclosed fees, and demanded and received under-the-table payments, including payments to himself and his family members disguised as yearly $10,000 non-taxable gifts. Purpose of scheme was self-enrichment and to mislead analysts, rating agencies, and others about Enron's true financial condition.

Enron Commission complaint further alleges: Fastow participated in two additional transactions that were essentially sham sales - best described as secret asset-parking arrangements. Fastow and others backdated documents to avoid diminution in Enron's investment in the stock of a technology company. Specifically, Fastow and others created documents that purported to lock in the value of Enron's investment in that company back in August of 2000, when that company's stock was trading at its all-time high price. Throughout the period of his alleged fraudulent conduct, Fastow sold millions of dollars worth of Enron securities.

Adelphia Communications Commission filed charges against Adelphia, its founder (John J. Rigas), his three sons, and two other senior executives, alleging one of the most extensive financial frauds ever to take place at a public company. Commission filed charges against Adelphia, its founder (John J. Rigas), his three sons, and two other senior executives, alleging one of the most extensive financial frauds ever to take place at a public company. US Attorney for SDNY filed related criminal charges against several of the same defendants. US Attorney for SDNY filed related criminal charges against several of the same defendants. Commission’s investigation is continuing. Commission’s investigation is continuing.

Adelphia Communications SEC complaint alleges that Adelphia, at the direction of the individual defendants: SEC complaint alleges that Adelphia, at the direction of the individual defendants:  Fraudulently excluded billions of dollars in liabilities from its consolidated financial statements by hiding them on the books of off-balance sheet affiliates;  Falsified operations statistics and inflated earnings; and  Concealed rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds for Rigas Family stock purchases and the acquisition of luxury condominiums.

Adelphia Communications The Commission is seeking: The Commission is seeking:  Officer and Director bars  Disgorgement of all ill-gotten gains, including:  Compensation received during the fraud  Property unlawfully taken from Adelphia through undisclosed related-party transactions  Severance payments  Permanent anti-fraud injunctions  Civil penalties from each defendant, including Adelphia.  Penalty against company sought because Adelphia failed early on to cooperate with the Commission's investigation and actually allowed the fraud to continue until the Rigas family lost control over the company's conduct.

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability  Greater use of O&D bars  Disgorgement of compensation

Officer and Director Bars Officer and Director bars sought in all categories of cases :  FY 2002: 126  FY 2001: 51  FY 2000: 38

Rite Aid Former CEO, CFO, Vice Chairman charged with fraud in connection with wide-ranging accounting fraud scheme that enabled the company to overstate its income in every quarter from May 1997 to May 1999. Former CEO, CFO, Vice Chairman charged with fraud in connection with wide-ranging accounting fraud scheme that enabled the company to overstate its income in every quarter from May 1997 to May 1999.  Former CEO also charged with engaging in undisclosed related-party transactions and fabricating Board minutes to facilitate the fraud. Commission is seeking: Commission is seeking:  Fraud injunctions  Officer & Director bars  Disgorgement of bonuses  Civil penalties

Rite Aid Commission also brought settled cease and desist proceedings against the company for reporting and books-and-records violations, and against the former COO for fraud and causing the company’s violations. Commission also brought settled cease and desist proceedings against the company for reporting and books-and-records violations, and against the former COO for fraud and causing the company’s violations.  Rite Aid cooperated in the investigation, including declining to assert its attorney-client privilege and voluntarily providing Commission staff with full access to an internal investigation conducted by Rite Aid's counsel.  The value of this cooperation was considered in determining the appropriate resolution of this matter. Parallel criminal charges were filed against the three former officers and directors. Parallel criminal charges were filed against the three former officers and directors.

Disgorgement of Stock Options and Other Compensation FY 2002: Sought from 28 individuals FY 2002: Sought from 28 individuals FY 2001: Sought from 18 individuals FY 2001: Sought from 18 individuals  55% increase in FY 2002

Tyco International Commission alleged that 3 former top executives of Tyco -- L. Dennis Kozlowski, the former chief executive officer and chairman of Tyco's board of directors, Mark H. Swartz, the former chief financial officer and a director, and Mark A. Belnick, the former chief legal officer -- failed to disclose multi-million dollar low interest and interest- free loans they took from the company. Commission alleged that 3 former top executives of Tyco -- L. Dennis Kozlowski, the former chief executive officer and chairman of Tyco's board of directors, Mark H. Swartz, the former chief financial officer and a director, and Mark A. Belnick, the former chief legal officer -- failed to disclose multi-million dollar low interest and interest- free loans they took from the company.

Tyco International Commission’s complaint alleges: Commission’s complaint alleges:  Kozlowski and Swartz covertly caused the company to forgive tens of millions of dollars of those outstanding loans without disclosure to investors.  Kozlowski and Swartz engaged in other undisclosed related party transactions.  Belnick failed to disclose the receipt of more than $14 million of interest-free loans from the company.  Kozlowski, Swartz and Belnick sold their shares of Tyco stock valued at millions of dollars while their self-dealing remained undisclosed.

Tyco International Commission is seeking disgorgement of all ill-gotten gains, payment of civil money penalties, enjoining the defendants from future violations of the federal securities laws, and officer and director bars. Commission is seeking disgorgement of all ill-gotten gains, payment of civil money penalties, enjoining the defendants from future violations of the federal securities laws, and officer and director bars.  Disgorgement sought from Kozlowski and Swartz includes all compensation they received subsequent to their fraudulent acts and omissions, including salary, bonuses, stock options and grants, and any advances that have not been repaid.  Commission seeks disgorgement by all 3 defendants of all loans not properly repaid to Tyco as well as losses avoided from sales of Tyco securities subsequent to their fraudulent acts and omissions.

Disgorgement of Stock Options and Other Compensation Waste Management (Buntrock): Injunctive action charging founder, Buntrock, and five other former top officers with fraud in systematic scheme to misrepresent financial results. Company acknowledged that it had misstated its pre-tax earnings by $1.7 billion over a five- year period. Waste Management (Buntrock): Injunctive action charging founder, Buntrock, and five other former top officers with fraud in systematic scheme to misrepresent financial results. Company acknowledged that it had misstated its pre-tax earnings by $1.7 billion over a five- year period.  Commission is seeking O&D bars, disgorgement of options, bonuses, performance-based compensation and proceeds from stock sales, and civil penalties.

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Cooperate and coordinate with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations

“Real Time” Enforcement Take actions to stop fraud and other investor harm expeditiously; Take actions to stop fraud and other investor harm expeditiously;  Trading suspensions  TROs and orders freezing assets Bring cases in pieces (e.g., issuer, then officers, then auditors) Bring cases in pieces (e.g., issuer, then officers, then auditors)

WorldCom 6/25/02 Co. admits it capitalized $3.8 billion of expenses to meet estimates during last five quarters 6/25/02 Co. admits it capitalized $3.8 billion of expenses to meet estimates during last five quarters 2001 reported earnings of $2.3 billion 2001 reported earnings of $2.3 billion Actually lost $662 million Actually lost $662 million SEC files case in less than 24 hours SEC files case in less than 24 hours

WorldCom Within 48 hours, Commission obtained a court order preventing destruction of documents, prohibiting extraordinary payments to current and former officers, directors and other employees, and appointing a corporate monitor. Within 48 hours, Commission obtained a court order preventing destruction of documents, prohibiting extraordinary payments to current and former officers, directors and other employees, and appointing a corporate monitor.

WorldCom Nov. 26, 2002–partial settlement Nov. 26, 2002–partial settlement Full injunctive relief Full injunctive relief Extensive review of governance and internal controls Extensive review of governance and internal controls Employee training Employee training Penalty reserved Penalty reserved

WorldCom SEC has charged four WorldCom employees and officers SEC has charged four WorldCom employees and officers Criminal charges also filed Criminal charges also filed Restatement to exceed $9 billion Restatement to exceed $9 billion Commission’s investigation is continuing, along with investigation of U.S. Attorney’s Office for S.D.N.Y. Commission’s investigation is continuing, along with investigation of U.S. Attorney’s Office for S.D.N.Y.

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations 4. Hold companies accountable for non- cooperation

Xerox Commission alleged undisclosed accounting actions that accelerated revenue recognition of equipment by over $3 billion and increased pre-tax earnings by $1.5 billion over a four-year period. Commission alleged undisclosed accounting actions that accelerated revenue recognition of equipment by over $3 billion and increased pre-tax earnings by $1.5 billion over a four-year period. Company settled to a fraud injunction and other relief. Company settled to a fraud injunction and other relief. The Commission’s investigation is continuing. The Commission’s investigation is continuing.

Xerox Goal: show growth in the face of competitive challenges Goal: show growth in the face of competitive challenges Commission alleged scheme was orchestrated by senior management Commission alleged scheme was orchestrated by senior management Accelerated recognition of revenue into current periods at the expense of future Accelerated recognition of revenue into current periods at the expense of future 1997-2000 accelerated revenue by over $3 billion and increased earnings by $1.5 billion 1997-2000 accelerated revenue by over $3 billion and increased earnings by $1.5 billion One-offs One-offs Cushion reserves Cushion reserves

Xerox Settled for $10 million penalty, restatement and special review of accounting controls Settled for $10 million penalty, restatement and special review of accounting controls Penalty reflects, in part, sanction for lack of “full” cooperation in the investigation Penalty reflects, in part, sanction for lack of “full” cooperation in the investigation

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations 4. Hold companies accountable for non- cooperation – but credit meaningful cooperation.

Homestore Commission filed charges against John Giesecke Jr., Homestore's former chief operating officer; Joseph J. Shew, its former chief financial officer; and John DeSimone, its former vice president of transactions, for fraudulently inflating Homestore’s revenues by causing the company to overstate its advertising revenues by $46 million (64%) for the first three quarters of 2001. Commission filed charges against John Giesecke Jr., Homestore's former chief operating officer; Joseph J. Shew, its former chief financial officer; and John DeSimone, its former vice president of transactions, for fraudulently inflating Homestore’s revenues by causing the company to overstate its advertising revenues by $46 million (64%) for the first three quarters of 2001.

Homestore Commission announced that it would not bring enforcement action against Homestore because of its swift, extensive and extraordinary cooperation. Commission announced that it would not bring enforcement action against Homestore because of its swift, extensive and extraordinary cooperation. Cooperation included reporting discovery of possible misconduct to the Commission immediately upon the audit committee's learning of it, conducting thorough and independent internal investigation, sharing results of that investigation with the government, terminating responsible wrongdoers, and implementing remedial actions designed to prevent the recurrence of fraudulent conduct. Cooperation included reporting discovery of possible misconduct to the Commission immediately upon the audit committee's learning of it, conducting thorough and independent internal investigation, sharing results of that investigation with the government, terminating responsible wrongdoers, and implementing remedial actions designed to prevent the recurrence of fraudulent conduct.

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations 4. Hold companies accountable for non- cooperation 5. Conduct of gatekeepers scrutinized

Frank E. Walsh, Jr. (Tyco) Commission filed a settled civil action alleging that Frank E. Walsh Jr., a former Tyco director, violated the federal securities laws by signing a Tyco registration statement that he knew contained material misrepresentations. Commission filed a settled civil action alleging that Frank E. Walsh Jr., a former Tyco director, violated the federal securities laws by signing a Tyco registration statement that he knew contained material misrepresentations. According to the complaint, the registration statement filed in connection with Tyco's acquisition of The CIT Group Inc. incorporated and attached an Agreement and Plan of Merger stating that no one other that Lehman Brothers and Goldman, Sachs was entitled to an investment banking or finder's fee for representing Tyco in the transaction. According to the complaint, the registration statement filed in connection with Tyco's acquisition of The CIT Group Inc. incorporated and attached an Agreement and Plan of Merger stating that no one other that Lehman Brothers and Goldman, Sachs was entitled to an investment banking or finder's fee for representing Tyco in the transaction. At the time that he signed the registration statement, Walsh knew that he had been promised a $ 20 million finder's fee for having arranged a meeting of the companies' CEO's to discuss a possible merger. At the time that he signed the registration statement, Walsh knew that he had been promised a $ 20 million finder's fee for having arranged a meeting of the companies' CEO's to discuss a possible merger.

James A. Fitzhenry Fitzhenry was a Senior Vice President, General Counsel and Secretary for FLIR Systems, Inc Fitzhenry was a Senior Vice President, General Counsel and Secretary for FLIR Systems, Inc Commission found that in connection with FLIR’s 1998 year-end audit, Fitzhenry signed management representation letters to FLIR’s auditors that he understood contained material misrepresentations regarding $4.1 million in sales. Commission found that in connection with FLIR’s 1998 year-end audit, Fitzhenry signed management representation letters to FLIR’s auditors that he understood contained material misrepresentations regarding $4.1 million in sales. In settlement, Fitzhenry agreed to: In settlement, Fitzhenry agreed to:  Cease and desist from violating the lying-to-the- auditors rule of the Exchange Act, and  5-year prohibition on appearing or practicing before the Commission under Rule 102(e).

KPMG LLP Commission sued KPMG LLP and four KPMG partners – including the head of the firm’s department of professional practice – in connection with the audits of Xerox Corp. from 1997 through 2000. Commission sued KPMG LLP and four KPMG partners – including the head of the firm’s department of professional practice – in connection with the audits of Xerox Corp. from 1997 through 2000.  The Commission's complaint alleges that the defendants' fraudulent conduct allowed Xerox to inflate equipment revenues by approximately $3 billion and inflate pre-tax earnings by approximately $1.2 billion in the company's financial results for the relevant years. Commission’s action charges the firm and four partners with fraud, and seeks injunctions, disgorgement of all fees and civil money penalties. Commission’s action charges the firm and four partners with fraud, and seeks injunctions, disgorgement of all fees and civil money penalties.

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations 4. Hold companies accountable for non- cooperation 5. Conduct of gatekeepers scrutinized 6. Compliance with GAAP not always enough

Edison Schools Only three months after initiating inquiry, Commission instituted settled cease-and-desist proceeding against Edison Schools. Only three months after initiating inquiry, Commission instituted settled cease-and-desist proceeding against Edison Schools. Commission found that Edison, despite technical compliance with GAAP, inaccurately described aspects of its business in its SEC filings, in violation of the securities laws. Commission found that Edison, despite technical compliance with GAAP, inaccurately described aspects of its business in its SEC filings, in violation of the securities laws.  Specifically, Edison failed to disclose that a substantial portion of its reported revenues consist of payments that never reach Edison. Funds are instead expended by school districts to cover costs of operating schools managed by Edison.

Edison Schools In settling the action, Edison agreed to: In settling the action, Edison agreed to:  Cease and desist from committing violations  Add to its management a Director of Internal Audit to report to the Audit Committee  Create an Internal Audit Department appropriate for the company's size and business. Principle: If a company makes filings with the Commission that mischaracterize its business, or omit significant information, technical compliance with GAAP will not insulate it from enforcement action. Principle: If a company makes filings with the Commission that mischaracterize its business, or omit significant information, technical compliance with GAAP will not insulate it from enforcement action.

PNC Financial Services Accounting or alchemy Accounting or alchemy

SPEs: PNC Financial Services Get weak loans and investments off books Get weak loans and investments off books Avoid recognizing further losses Avoid recognizing further losses Keep possibility of gain Keep possibility of gain Use SPE’s Use SPE’s

PNC Financial Services Insurance company puts in 3% of equity for all common stock Insurance company puts in 3% of equity for all common stock Looks like IC controls business Looks like IC controls business PNC gets preferred for weak loans PNC gets preferred for weak loans SPE buys 30 year zero bond Treasury = preferred after 30 years SPE buys 30 year zero bond Treasury = preferred after 30 years

PNC Financial Services Not GAAP Not GAAP IC did not really put in 3% IC did not really put in 3% PNC really has the risk and rewards PNC really has the risk and rewards Fed and SEC blow whistle Fed and SEC blow whistle EPS – before restatement $1.91 EPS – before restatement $1.91 Restated: $1.38 Restated: $1.38 SEC charges fraud SEC charges fraud

PNC Financial Services GAAP is not alchemy GAAP is not alchemy Even if GAAP, must evaluate material accuracy and completeness of presentation of financial statements Even if GAAP, must evaluate material accuracy and completeness of presentation of financial statements Must disclose risks Must disclose risks

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations 4. Hold companies accountable for non- cooperation 5. Conduct of gatekeepers scrutinized 6. Compliance with GAAP not always enough 7. Facilitating another company’s reporting violations may create liability

Accommodations: Ashford -- Amazon Resolve dispute Resolve dispute Amazon will pay $600,000 to Ashford Amazon will pay $600,000 to Ashford Ashford will credit Amazon with providing 11,500 customers Ashford will credit Amazon with providing 11,500 customers Ashford asks Amazon to split the deal into two letters, one referring to 3000 customers and another for the balance Ashford asks Amazon to split the deal into two letters, one referring to 3000 customers and another for the balance

Ashford -- Amazon Ashford charged with fraud Ashford charged with fraud Amazon charged with being a cause of Ashford’s reporting violation because Amazon knew or should have known that the reason Ashford wanted to split the deal was to allow Ashford to improperly defer expenses Amazon charged with being a cause of Ashford’s reporting violation because Amazon knew or should have known that the reason Ashford wanted to split the deal was to allow Ashford to improperly defer expenses Moral – do not be an accomplice Moral – do not be an accomplice

Financial Reporting & Issuer Disclosure: Themes and Trends 1. Coordination with criminal authorities 2. Emphasis on personal accountability 3. Effort to speed up our investigations 4. Hold companies accountable for non-cooperation 5. Conduct of gatekeepers scrutinized 6. Compliance with GAAP not always enough 7. Facilitating another company’s reporting violations may create liability 8. Auditor independence remains a critical element of sound financial reporting

Ernst & Young and Moret Ernst & Young Accountants Moret affiliate has business arrangement with Baan Moret affiliate has business arrangement with Baan Moret audits Baan Moret audits Baan Moret relies on US E&Y which also had business arrangement with Baan Moret relies on US E&Y which also had business arrangement with Baan

Ernst & Young and Moret Ernst & Young Accountants E&Y case involved joint business arrangement between E&Y and audit client PeopleSoft. E&Y case involved joint business arrangement between E&Y and audit client PeopleSoft.

PricewaterhouseCoopers and PricewaterhouseCoopers Securities Settled enforcement action against PricewaterhouseCoopers (PwC) and its broker-dealer affiliate, PricewaterhouseCoopers Securities (PwCS), for violations of the auditor independence rules. Settled enforcement action against PricewaterhouseCoopers (PwC) and its broker-dealer affiliate, PricewaterhouseCoopers Securities (PwCS), for violations of the auditor independence rules. The auditor independence violations arise from: The auditor independence violations arise from:  PwC's use of prohibited contingent fee arrangements with 14 different audit clients for which PwCS provided investment banking services, and  PwC's participation with two other audit clients, Pinnacle Holdings Inc. and Avon Products Inc., in the improper accounting of costs that included PwC's own consulting fees

PWC and PWCS PWC contingent fee arrangement with 14 audit clients for which PWCS provided investment banking services PWC contingent fee arrangement with 14 audit clients for which PWCS provided investment banking services For two clients, Pinnacle and Avon, PWC was also a cause of company’s GAAP violations For two clients, Pinnacle and Avon, PWC was also a cause of company’s GAAP violations

PWC and PWCS Remedies $5 million civil penalty $5 million civil penalty C&D from violating the auditor independence rules C&D from violating the auditor independence rules Censured for engaging in improper professional conduct. Censured for engaging in improper professional conduct.

Section 10A -- Solucorp Company recognizes licensing revenue before final deal Company recognizes licensing revenue before final deal Auditor finds backdated licensing agreement Auditor finds backdated licensing agreement Auditor fails to determine whether act illegal and fails to inform audit committee Auditor fails to determine whether act illegal and fails to inform audit committee

Andersen --Enron October 17, 2001 Enron announces problems October 17, 2001 Enron announces problems Andersen destroys documents Andersen destroys documents Andersen indicted Andersen indicted Clients flee Clients flee Engagement partner pleads guilty Engagement partner pleads guilty Firm convicted Firm convicted

Andersen – WMI The Underlying Fraud From 1992 to 1996, Waste Management overstates earnings by $1.43 billion and understates taxes by $178 million From 1992 to 1996, Waste Management overstates earnings by $1.43 billion and understates taxes by $178 million

Andersen Enjoined  Andersen and 3 partners enjoined from future fraud  Andersen fined $7 million  3 partners fined $30,000 to $50,000 each

102(e) Sanctions  Andersen and 4 partners charged with improper professional conduct  Andersen censured  4 partners barred

SEC Action First fraud injunction against a Big 5 firm in 20 years First fraud injunction against a Big 5 firm in 20 years Record penalty against a Big 5 firm of $7 million Record penalty against a Big 5 firm of $7 million First case against Big 5 firm Practice Director in 20 years First case against Big 5 firm Practice Director in 20 years

Andersen Indicted Two months later Two months later SEC begins Enron inquiry SEC begins Enron inquiry In October, Enron problems surface In October, Enron problems surface Andersen starts destroying Enron documents Andersen starts destroying Enron documents

Special Study Pursuant to Sarbanes-Oxley Act Section 704 summarizes financial reporting enforcement actions over the past five years Section 704 summarizes financial reporting enforcement actions over the past five years Available on SEC website – www.Sec.Gov Available on SEC website – www.Sec.Gov

What Preventive Measures can Management Take?

Preventive Measures for Mgmt. First: First: Full disclosure with your auditors Full disclosure with your auditors  Don’t wait for auditors to find problems  Vet novel or complex issues with national office technical experts

Preventive Measures Keep audit committee informed at all times Keep audit committee informed at all times  Discuss significant accounting policies, judgments and estimates

Preventive Measures Open discussions with Corp. Fin./OCA Open discussions with Corp. Fin./OCA  Pre-clearance program for novel and unusual accounting questions  See SECPS Practice Alert No. 2002-1

Preventive Measures And, last but not least And, last but not least Assess the “tone at the top” Assess the “tone at the top”  Aka – the “pressure from the top” Take a “fresh” look at your code of ethics Take a “fresh” look at your code of ethics  Ensure it is up-to-date and covers all lines of businesses  Reminder: S-O to require disclosure of any change to or waiver of code

Earnings Releases Perhaps the better approach is to issue earnings in close proximity to the filing of the financial statements Perhaps the better approach is to issue earnings in close proximity to the filing of the financial statements  Accelerated filers  Caution: Pro forma earnings

Pro Formas: Trump Hotels SEC’s first pro forma financial reporting case. SEC’s first pro forma financial reporting case. Commission found that Trump Hotels & Casino Resorts violated Section 10(b) and Rule 10b-5. Commission found that Trump Hotels & Casino Resorts violated Section 10(b) and Rule 10b-5. Company was ordered to cease and desist from violating those provisions. Company was ordered to cease and desist from violating those provisions.

Trump Hotel – Pro Forma Financial data that is not GAAP Financial data that is not GAAP 3Q ’99 Company trumpets results: “better than estimates;” result of improved operations 3Q ’99 Company trumpets results: “better than estimates;” result of improved operations Disclose not counting $83 mil. one time expense Disclose not counting $83 mil. one time expense

Trump Hotel Do not disclose $17 million one time gain is included Do not disclose $17 million one time gain is included Stock up 7.8% Stock up 7.8% Would not exceed estimates and would show revenue decline if excluded one time gain Would not exceed estimates and would show revenue decline if excluded one time gain Truth comes out: stock drops 6% Truth comes out: stock drops 6% Settled 10(b), 10b-5 C&D Settled 10(b), 10b-5 C&D

21(a) REPORT ON COOPERATION: The “Seaboard Report”

21(a) Report on Cooperation Framework for evaluating a proposed defendant’s cooperation Framework for evaluating a proposed defendant’s cooperation The carrot: Credit for extraordinary cooperation The carrot: Credit for extraordinary cooperation The stick: Harsher remedies for lack of “full cooperation” The stick: Harsher remedies for lack of “full cooperation” No promises -- Not an amnesty program No promises -- Not an amnesty program

21(a) Report on Cooperation Wider range of outcomes Wider range of outcomes Finer distinctions between wrongdoers Finer distinctions between wrongdoers Seaboard – No action against company Seaboard – No action against company Xerox -- $10 million penalty Xerox -- $10 million penalty Dynegy -- $3 million penalty Dynegy -- $3 million penalty

Four Principles Self-policing Self-policing Self-reporting Self-reporting Remediation Remediation Cooperation Cooperation

The Meaning of Cooperation Self-policing prior to discovery of misconduct Self-policing prior to discovery of misconduct  Effective compliance procedures  Appropriate “tone at the top” Self-reporting misconduct upon discovery Self-reporting misconduct upon discovery  Thorough review of nature, extent, origins & consequences  Disclosure to public and regulators

The Meaning of Cooperation Remediation Remediation  Dismissing or appropriately disciplining wrongdoers  Internal controls and procedures to prevent recurrence  Compensating those adversely affected Cooperation with law enforcement authorities Cooperation with law enforcement authorities

The Meaning of Cooperation: Internal Investigation Independent counsel Independent counsel Forensic auditors Forensic auditors Share results with staff Share results with staff Waive work product, privileges Waive work product, privileges Secure cooperation Secure cooperation

Independent Accountants Every case raises the question: Every case raises the question:

Let’s Get Back to the Basics

Back to the Basics… Know your audit client Know your audit client  Understand the key reports used by management  Understand the budget process  Understand the source of growth Know your client’s industry Know your client’s industry

Back to the Basics… Don’t over rely on management’s representations Don’t over rely on management’s representations Don’t get too comfortable with the client Don’t get too comfortable with the client Don’t engage in “Conversational Auditing” Don’t engage in “Conversational Auditing”

Back to the Basics… “Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence.” “Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence.” Statement on Auditing Standards 99, October 2002 Statement on Auditing Standards 99, October 2002

Professional Skepticism Should be displayed by all members of the team throughout the audit and review engagements Should be displayed by all members of the team throughout the audit and review engagements

Back to the Basics… Vary the audit testing performed Vary the audit testing performed Prepare a detailed audit program Prepare a detailed audit program Understand the client’s closing process Understand the client’s closing process Don’t forget the general ledger Don’t forget the general ledger

The Closing Process Follow-up on all questionable items during the final analytical review Follow-up on all questionable items during the final analytical review Examine all consolidating financial statements Examine all consolidating financial statements  Including, all post closing and top-side entries

Back to the Basics… Open dialogue with audit committee Open dialogue with audit committee  Both proposed and passed audit adjustments as a result of audit and the reviews  Troubles encountered during audit or reviews Ongoing dialogue with “financial experts” on committee may be necessary Ongoing dialogue with “financial experts” on committee may be necessary

Back to the Basics… Issues encountered during the audit --- Issues encountered during the audit ---  Deal with the issue at hand  Don’t try to “paper over” the problem  Management letter comment is not enough  Don’t make the client’s problem your own

In Conclusion U.S. Securities & Exchange Commission Division of Enforcement The U.S. Securities and Exchange Commission, as a matter of policy, disclaims.

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In Conclusion U.S. Securities & Exchange Commission Division of Enforcement The U.S. Securities and Exchange Commission, as a matter of policy, disclaims.

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