BA 427 – Assurance and Attestation Services Lecture 14 Tales of Fraud that Keep Auditors Awake at Night

Aggressive Accounting  “One-time” charges  Restatements  Off-balance sheet transactions  “Pro forma” earnings releases

Revenues Cost of Sales Gross Profit General & Admin : Restructuring & asset impairment : Net Income $16,210 7,729 8,481 5,049 : 1,605 : $17 $16,949 8,018 8,931 5,280 : 220 : $1,146 $16,641 8,063 8,578 4,989 : 538 : $(1,515) $13,687 7,325 6,362 3,711 : 340 : $557

Revenues Cost of Sales Gross Profit General & Admin Restructuring & asset impairment Net Income $16,244 8,326 7,918 4,410 : 358 : $1,288 $14,713 7,979 6,734 3,912 : 1,290 : $5

Revenues Cost of Sales Gross Profit : General & Admin Restructuring & asset impairment : Net Income $13,234 8,670 4,564 : 2, : $76 $12,835 8,225 4,610 : 2, : $770 $13,317 9,033 4,284 : 2, : $265

Restatements

Waste Management: exaggerated earnings by 1.4 billion from 1992 to 1997

Off-balance Sheet Transactions 3% rule for the Special Purpose Entities Also, mark to market accounting

Pro Forma earnings releases First quarter of 2001: Pro Forma “Operating Loss”:$ 49 million GAAP loss:$234 million

Pro Forma earnings releases Third quarter of 1999: Pro Forma net income: $14 million GAAP loss before one-time charges: $ 3 million GAAP loss after one-time charges: $67 million

Pro Forma earnings releases Third quarter of 2001: Pro Forma loss #1 $0.27 per share Pro forma loss #2:$0.68 per share GAAP loss: $1.08 per share

Lecture 14 – Tales of Fraud  Accounting irregularities Fraudulent financial reporting: the intentional misstatement of financial statements.  Who gains and who loses when this occurs? Misappropriation of assets (theft)

Lecture 14 – Tales of Fraud  Prologue McKesson & Robbins

Lecture 14 – Tales of Fraud  McKesson & Robbins McKesson was a drug company Listed on the NYSE By the time the fraud was discovered, the balance sheet contained $19 million of fictitious assets, including $10 million of fictitious inventories. Fictitious assets accounted for 25% of total assets on the balance sheet.

Lecture 14 – Tales of Fraud  McKesson & Robbins The principle shareholder and CEO of the company, Philip Musica (alias F.D. Coster) had been convicted of fraud twice before. Musica committed suicide. In 1939, the AICPA membership voted that henceforth, receivables must be confirmed, and inventory must be observed, whenever these accounts are material.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  The Savings and Loan crisis Over 1,000 (mostly small) savings and loan institutions failed in the 1980s. Reasons included deregulation, rising interest rates, and regional real estate busts. The S & L crisis gave rise to 4,000 lawsuits against accountants and their firms, seeking an estimated $15 billion. The largest settlement was for over $400 million. Malpractice insurance rates rose after the crisis, and accounting firms became more risk averse.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis The best known audit failure of the S & L crisis was Lincoln Savings and Loan.  Lincoln S & L chief Charles Keating was convicted of fraud, racketeering and conspiracy, and spent four years in jail.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  MiniScribe Manufacturer of computer disk storage devices. Founded in 1980, bankrupt in : Lost a key sales contract with IBM. In the late ’80s, tone at the top was all wrong.  The Chief of MiniScribe, Q. T. Wiles, was abrasive and demanding.  Wiles would be convicted of securities fraud.

Lecture 14 – Tales of Fraud  MiniScribe Sales personnel were encouraged to meet numbers in any way they could.  Defective inventory recorded as first quality.  Goods were shipped that had never been ordered The allegation that made MiniScribe famous: bricks shipped to bogus customer warehouses. Coopers & Lybrand was sued, settled in 1992 probably for about $40 million.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Barings Bank A 200-year-old British Bank that helped finance the Louisiana Purchase. Barings collapsed on February 26, 1995  Brought down by a single mid-level trader and by an earthquake in Japan.  The single most spectacular business failure that ever occurred as the result of fraud without collusion by senior management.  The most spectacular repercussion of internal control weaknesses.

Lecture 14 – Tales of Fraud  Barings Bank A 28-year-old trader named Nick Leeson earned millions of dollars for Barings by speculating in Asian currency markets. When Leeson’s luck reversed, he was able to hide trading losses in a secret account. Eventually, Leeson lost $1.4 billion for the bank. A lack of segregation of duties contributed to Leeson’s ability to hide losses.

Lecture 14 – Tales of Fraud  Barings Bank Nick Leeson initially fled to Malaysia, made his way to Germany, where he was extradited to Great Britain. Leeson was convicted of fraud  He served several years in jail  He contracted colon cancer and was released from jail  His wife divorced him  The movie Rogue Trader is based on Leeson

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Cendant HFS Inc and CUC International merged in 1997 to form Cendant. Fraud by CUC surfaced in Revenues had been inflated by $500 million over three years. At the time, it was the largest accounting fraud in the nation’s history. Cendant lost $14 billion in market value following the public disclosure of the fraud.

Lecture 14 – Tales of Fraud  Cendant An investigation of the fraud commissioned by Cendant’s law firm revealed numerous and pervasive instances in which CUC officials inflated earnings from 1995 to  17 of 22 operating units inflated earnings.  The report of the investigation accused Cendant’s top management of “grave negligence at best” and “willful ignorance at worst.”

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Sunbeam In 1998, under Albert Dunlap (a.k.a. Chainsaw Al), Sunbeam managed earnings by recording sales without the related sales returns, and sales for goods not yet shipped. The SEC alleged that $60 million of $186 million in income was fraudulent.

Lecture 14 – Tales of Fraud  Sunbeam An SEC lawsuit alleged securities fraud by Dunlap, four senior managers, and a partner at Arthur Andersen, all of whom settled the charges without admitting or denying guilt. At the time of the restatement, shareholders lost $1.2 billion in stock value.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Waste Management, Inc. In the late ’90s, the company inflated earnings by $1.7 billion, in part by changing depreciation schedules on PP&E. The accounting scandal caused its stock price per share to decline from $56 to $13. The company settled a shareholder class- action lawsuit for $457 million.

Lecture 14 – Tales of Fraud  Waste Management, Inc. Arthur Andersen allegedly settled a malpractice claim by the company for about $20 million. The SEC accused A.A. of "knowingly or recklessly" issuing false and misleading audit reports for Waste Management for the years 1993 though A.A. paid a $7 million civil fine imposed by the SEC. Three Andersen partners, without admitting or denying wrongdoing, agreed to an anti-fraud injunction, a civil penalty, and a bar from appearing or practicing in front of the SEC as an accountant, with the possibility of reinstatement.

Lecture 14 – Tales of Fraud  Waste Management, Inc. According to SEC Director of Enforcement Richard Walker:  Arthur Andersen and its partners failed to stand up to company management and thereby betrayed their ultimate allegiance to Waste Management’s shareholders and the investing public. Given the positions held by these partners and the duration and gravity of the misconduct, the firm itself must be held responsible for the false and misleading audit reports.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Tyco International Rumors of accounting irregularities surfaced in In addition to the fraud allegations, there was misappropriation of assets by senior management. Former CEO Dennis Kozlowski and the former CFO were accused of the theft of $600 million. They contended that the Board had authorized it as compensation. In 2005, both men were sentenced to jail terms ranging from 8 to 25 years.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  ImClone Systems Insider trading charges by senior management. On December 28, 2001, the company announced that its drug Erbitux had failed to receive F.D.A. approval. The company’s founder, his daughter, his father, and his friend Martha Stewart, sold over $10 million in shares on December 27 th and 28 th. Stewart served prison time for obstruction of justice, and company founder Sam Waksal is serving 7 years in prison.

Lecture 14 – Tales of Fraud  ImClone Systems A Congressional hearing revealed “a culture of corruption” at ImClone dating back to 1986.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  WorldCom (MCI) From about 1999 until 2002, the company inflated assets by about $11 billion. In June 2002, the company’s internal audit department uncovered $3.8 billion of the fraud, related to the capitalization of expenses. The company had also inflated revenues with bogus accounting entries.

Lecture 14 – Tales of Fraud  WorldCom (MCI) KPMG had already replaced AA as the company’s auditors. AA withdrew its 2001 audit opinion. In 2005, Bernie Ebbers, former CEO, was sentenced to 25 years in prison. Numerous WorldCom accounting managers had submitted guilty pleas by the time of Ebbers’ trial.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Parmalat An Italian dairy and food corporation; Europe’s largest dairy. The company declared bankruptcy in late 2003, after accounting fraud was discovered. Numerous shell companies were set up to generate fake profits.

Lecture 14 – Tales of Fraud  Parmalat Founder Calisto Tanzi was charged with financial fraud and money laundering. He diverted at least $600 million from the company to other family-owned businesses. Grant Thornton had been the company’s auditors while the fraud was committed.

Lecture 14 – Tales of Fraud  The Savings and Loan crisis  MiniScribe  Barings Bank  Cendant  Sunbeam  Waste Management, Inc.  Tyco International  ImClone Systems  WorldCom  Parmalat  Enron

Lecture 14 – Tales of Fraud  Enron Founded in 1985 by Kenneth Lay Stock price rose  311% from 1990 to 1998 (comparable to the S&P 500  56% in 1999  87% in 2000 At December 31, 2000  Market to Book was about 6  Market value to earnings was about 70

Lecture 14 – Tales of Fraud  Enron, events of 2001 August 14: Jeff Skilling resigns Mid-to-late August: Sheri Watkins writes her now-famous anonymous letter to Ken Lay October 12: An Arthur Andersen lawyer contacts the Houston office regarding the firm’s document retention policy, prompting the shredding of documents. October 16: Enron announces nonrecurring charges of $1 billion

Lecture 14 – Tales of Fraud  Enron, events of 2001 October 22: The SEC opens an investigation into potential conflicts of interest. November 8: Enron restates F/S for prior four years, for a cumulative charge of $600 million. November 28: Enron’s debt is downgraded by credit agencies to junk bond status. December 2: Enron files for bankruptcy.

Lecture 14 – Tales of Fraud  Enron Initially a natural gas pipeline company. Then became a trader in natural gas, taking advantage of the recent deregulation of the natural gas market. Diversified into trading and making markets for electricity, coal, steel, paper and pulp, water and broadband fiber optic cable. Diversified into international energy projects.

Lecture 14 – Tales of Fraud  Enron The company became expert in managing trading business risks. The trading business adopted mark-to- market accounting, recognizing the present value of the estimated stream of future profits on long-term contracts. For example, in 2000 Enron recognized profits in excess of $100 million on a deal with Blockbuster to stream video, despite serious questions about the feasibility of the technology and the market demand.

Lecture 14 – Tales of Fraud  Enron The company used hundreds of SPEs (Special Purpose Entities) to fund or manage risks associated with specific assets. By following technical accounting rules of SPEs, Enron was able to keep these entities out of their consolidated F/S. However, the Chewco did not satisfy these accounting rules, and Enron restated its F/S in October 2001 to correct this.

Lecture 14 – Tales of Fraud  Enron There was footnote disclosure about the SPEs, but it was terse. Several key employees, including CFO Andrew Fastow, were partners in the SPEs. In some instances, the SPEs were showing Enron stock as an important asset.

Lecture 14 – Tales of Fraud  Enron, Corporate Governance Heavy use of stock options for senior managers. The audit committee had 6 members, all seemingly well qualified. However, their pattern was to hold a few short meetings each year. Arthur Andersen: Enron accounted for about 27% of all public company audit fees for the Houston office.

Lecture 14 – Tales of Fraud  Enron, Corporate Governance Hence, AA may have compromised its independence. Alternatively, the engagement team may have lacked the expertise to evaluate complex financial transactions that clearly were intended to achieve financial reporting objectives, not business objectives. Andersen’s Houston office was permitted to overrule AA’s Practice Partner in Chicago.

Lecture 14 – Tales of Fraud  Enron From October 19 (when AA learned that Enron was being investigated by the SEC) through November 8, 2001 (when the SEC served AA a subpoena), Arthur Andersen personnel shredded extensive amounts of physical documentation and deleted computer files related to Enron. The government charged AA with destruction of documents related to the audit.

Lecture 14 – Tales of Fraud  Enron AA was ultimately convicted of one count of obstruction of justice, related to the alteration of a memo. As a result of this conviction, AA was no longer able to audit public companies. The conviction was subsequently overturned.

Arthur Andersen  Three strikes and you’re out! Sunbeam Waste Management Enron

Eulogy for Arthur Andersen “Civilization has brought to man the realization that there is only one lasting achievement toward which all men may contribute. It is to raise the standard of integrity by which men deal with one another, and at the same time earn their own livelihood.” Leonard Spacek Chairman of the Board Arthur Andersen & Co. December 1, 1963