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Nature of accounting rules Behavior of CPA firms Greed by investment banks, commercial banks, and investors
Bad Lawyer Advice?
Education Failures
Corporate Accounting Ability Regulation
With increasing stock prices, profits and wealth for everyone, no one worried about potential problems.
or Not Go Round
FASB
Examples are: SPEs and other types of offbalance sheet financing Revenue recognition approaches,
Merger reserves
Pension accounting Other accounting schemes.
When the client pushes, without specific rules in every situation, there is no room for the auditors to say, You cant do thisbecause it isnt
GAAP
DA FASB
Example
GAAP CRITICISM
Fosters Earning Game Does Not Show Value Creation
Executive Incentives
Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999.
Princeton University
GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... "
How To Play
Numbers Game
Aggressive Accounting
Earnings Management
Income Smoothing Fraudulent Financial Reporting Creative Accounting Practices
Buy it anyway
Firm A
Firm B
Auditorsthe CPAs
Failed to accept responsibility for fraud detection (SEC, Supreme Court, public expects them to detect fraud) If auditors arent the watchdogs, then who is?
Became greedy--$500,000 per year per partner compensation wasnt enough; saw everyone else getting rich
A few auditors got too close to their clients Entire industry, especially Arthur Andersen, was punished for actions of a few
In a separate case in late September, a judge's divorce ruling unsheathed guarded financial information about accounting firm Ernst & Young, which is a private partnership that does not file public financial reports. In divorce papers for Ernst & Young chief executive officer Richard S. Bobrow, a 45-page judge's opinion revealed how much the CEO was paid and put a dollar value on the company for the first time, giving competitors a rare peek into the firm's finances.
Annual Salary $ 3 Million $25 million in salary $US29 million in partnership earnings over the next decade. Pension worth $1 million a year for life and had access to a corporate jet owned by Ernst & Young and a New York apartment.
Moral Decay
Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed: 67% of CFOs said they had been asked by senior company executives to misrepresent corporate financial results 12% of CFOs admitted they had actually misrepresented financial results55% said they had fought off requests to cook the books
Honesty studies
1961: 12%
1986: 31% 2002: ???
resigned after revealing he lied about his academic credentials. The fundamental picture
Executives at Vetrias, storage management software maker, found that CEOs claim to have earned an MBA from Stanford Business School was false.
$7 million fraud
IPO Favoritism: Bernie Ebbers ($11 million) CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM (Consulting Contracts, Use of Corporate Planes, Executive Apartments with meals,
Fraud Internationally
1. Denmark 2. Finland 3. Sweden 4. New Zealand 5. Canada 6. Netherlands 7. Norway 8. Australia 13 Germany 14. United Kingdom 16. U.S.A. 36. Brazil 40. Philippines 47. Mexico 49. Russia 52. Nigeria
Company 1. WorldCom 2. Enron 3. Texaco 4. Financial Corp of America 6. Adelphia 7. PG&E 8. MCorp 9. Kmart 10. NTL
When Filed July, 2002 Dec., 2001 April, 1987 Sept., 1988 Jan., 2002 June, 2002 April, 2001 March, 1989 Jan., 2002 May, 2002
THE BEGINNING Enron began as a pipeline company in Houston in 1985. It profited by promising to deliver so many cubic feet of gas to a particular utility or business on a particular day at a market price.
Deregulation of electrical power markets, a change due in part to lobbying from senior Enron officials:
Chairman Kenneth L. Lay,expanded Enron into an energy broker, trading electricity and other commodities
RISING POWER Enron became a giant middleman that worked like a hybrid of traditional exchanges. But instead of simply bringing buyers and sellers together, Enron entered the contract with the seller and signed a contract with the buyer, making money on the difference between the selling price and the buying price. Enron kept its books closed, making it the only party that knew both prices.
Over time, Enron began to design increasingly varied and complex contracts. Contract to insure against: 1.a rise or fall in interest rates,
THE UNRAVELING As its services became more complex and its stock soared, Enron created a constellation of partnerships that allowed managers to shift debt off the books. Chewco Whitewing
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
LJM1 SPE
Responsible for 20% of SPE restatement or $100 million Should have been consolidatedan error in judgment by Andersen (per Andersen) After Andersens 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 publicinvolved complex issues concerning the valuation of various assets and liabilities.
LJM2 SPE
Raptors I-IV Established by Enron CFO to provide a quick buyer for Enron assets By December 2000, $1.5 billion in hedged investments, $500 million Enron gain Financial reward to Enron CFOat least $15 million Enron Financial Statement ImpactHedged $1 billion in losses over 5 quarters; reported earnings of $1.5 billion.
Insufficient Disclosure.
2000 Proxy Statement During 2000, certain Enron subsidiariesentered into a number of transactions with LJM2 Co-InvestmentAndrew S. Fastow, Executive Vice President and Chief Financial Officer of Enron, is the managing member of LJM2s general partner. Paragraph outlining the transactions These transactions occurred in the ordinary course of Enrons business and were negotiated on an arms length basis with senior officers of Enron other than Mr. Fastow. Management believes that the terms of the transactions were reasonable and no less favorable than the terms of similar arrangements with unrelated third parties.
The partnerships were used for unbundling and reassembling the various components of a contract. We strip out price risk, we strip out interest rate risk, he said. Whats left may not be something that we want. The obvious question is Why would anyone want whatever was left?
Role of Andersen
Was paid $52 million in 2000, the majority of which was for non-audit related consulting services.
Failed to spot many of Enrons losses
Did both external and internal audits CFOs and controllers were former Andersen executives Accused of document destruction was criminally indicted Went out of business One Partner I had $4 million in my retirement account and lost it all. Some partners who transferred to other firms now have two equity loans and no retirement savings.
Did they know? 2/5/01: Andersen partners meet to discuss Enrons accounting, related parties, fees, etc. Issue: For a significant amount of time, according to notes of the meeting, the Andersen accountants debated a critical point: What should they do about two SPEs, LJM1 and LJM2, that had been set up 18 months earlier by Fastow? Resolution: They drew up a "to do" list: Recommend a special committee of the Board to review LJM deals. Review the SPE accounting tests. 2/12/01: The Big Meeting: Andersen partners meet with Enron board's audit and compliance committee. All Enron executives were excused from the room. And then..no evidence of any discussion Interesting side note: From 1997 to 2001, Enron paid Andersen $5.7 million in connection with work performed specifically on the LJM and Chewco transactions.
Anderson Shredding
The Document Destruction Chronology
October 12 Nancy Temple sends Document retention policy email to Michael Odom. October 17 SEC asks Enron for information about its accounting. October 23 David Duncan calls urgent meeting, organizes effort to shred and dispose. The topics of discussion, according to a typed agenda, included: "SEC probe/shareholder lawsuits" and "soft and hard copy file review." November 8 Andersen receives subpoena from SEC. November 9 Duncans assistant sends email to secretaries: no more shredding.
Email message about Document Policy: To: Michael C. Odom Date: 10/12/2001 10:53 a.m. From: Nancy A. Temple Subject: Document retention policy MikeIt might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions. Nancy
Some partnerships' losses would have to be paid for out of Enron stock or cash in 2003, bringing the debts back home. There are indications that Enron executives and its accounting firm, Arthur Andersen, had warnings of problems nearly a year ago. According to a Feb. Andersen considered dropping Enron as a client. In August, Enron Vice President Sherron Watkins wrote an anonymous memo to former Chairman Kenneth L. Lay, detailing reasons she thought Enron "might implode in a wave of accounting scandals."
On Oct. 16, Enron announced a $638 million loss for the third quarter, and Wall Street reduced the value of stockholders' equity by $1.2 billion. Enron announced Nov. 8 that it had overstated earnings over the past four years by $586 million and that it was responsible for up to $3 billion
in obligations to partnerships. A $23 billion merger offer from rival Dynegy was dropped Nov. 28 after lenders downgraded Enron's debt to junk-bond status.
various
THE INVESTIGATION Dozens of lawsuits have been filed against the company by an array of pension funds. Dozens more are directed at former Chairman Kenneth L. Lay, former CEO Jeffrey Skilling and former Chief Financial Officer Andrew Fastow.
Kenneth L. Lay, former Enron Chairman and CEO (resigned Jan. 23, 2002)
Lay and Enron poured millions of dollars into both political parties, cultivating access and using the entree to lobby Congress, the White House and regulatory agencies for action that was critical to the energy company's spectacular growth. In addition to being one of the single largest financial backers of President George W. Bush's political career, Lay is also one of the president's
friends.
Greed
Fastow was removed as Enron's CFO on Oct. 24, 2001 as the SEC began a probe into conflicts of interest in two partnerships he created and managed. Those partnerships earned him around $30 million in management fees from the deals in addition to his Enron salary.
In early October, Fastow was charged with securities, wire and mail fraud, money laundering and conspiring to inflate Enron's profit
Kopper and his domestic partner, William D. Dodson, reaped $10.5 million based on a $125,000 investment in a partnership called Chewco, according to an investigative report issued by Enron's board of directors. In August 2002, Kopper pleaded guilty to financial wrongdoing and agreed to surrender $12 million in the first criminal case against a company official.
Jeffrey Skilling, former Enron Chief Executive Officer (resigned Aug. 14, 2001)
Senior Enron executives criticized former CEO Skilling about possible conflicts of interest in two partnerships he created with former Chief Financial Officer Andrew Fastow. Jeffrey McMahon, then Enron's treasurer, was "highly vexed" about the conflicts, "complained mightily" and suggested a list of remedies.
Baxter was one of 29 former and current Enron executives and board members named as defendants in a federal lawsuit, after he sold 577,436 shares of Enron for $35.2 million before Enron's collapse.
He was found shot to death in a car Jan. 15, 2002, in an apparent suicide.
Watkins is the internal whistleblower who in August of 2001, more than two months before Enron disclosed it had overstated its profits and understated its debts, warned Kenneth L. Lay that the company might "implode in a wave of accounting scandals." Shortly after Enron Chief Executive Officer Jeffrey Skilling suddenly resigned. Watkins described "a veil of secrecy" around partnerships involving the energytrading company's former chief financial officer, Andrew Fastow
Arthur Andersen The job of Arthur Andersen, one of the nation's largest accounting firms, was to make sure investors could rely on Enron's financial statements. But Andersen also was a major business partner-soliciting and selling millions in consulting services to Enron. Andersen was also responsible for some of Enron's internal bookkeeping, and some Andersen executives ended up taking jobs at Enron.
Led by then-chief executive Joseph F. Berardino, Arthur Andersen took its case public, saying it would take "all appropriate steps" to defend its integrity. Berardino also suggested that the company might stop selling consulting services to firms it audits. Barardino has since resigned from the firm.
Employees Thousands of Enron employees, many with similar skills, were left unemployed. Enron encouraged employees to invest in the company, matched their 401(k) contributions with company stock, and briefly froze the plan in late October, barring employee sales, before the stock's final plunge. Thousands of employees and retirees have next to nothing in their accounts.
Banks One of Enron's biggest lenders, J.P. Morgan Chase, announced losses of $456 million as of Jan. 2002 related to Enron's demise. Citigroup recorded $228 million as of Jan. 2002 in Enron-related losses. But banks and regulators said the overall impact would be minimal, because no one bank is overinvested in Enron.
THE IMPACT
Investors Enron's stock lost nearly all its value, dropping from almost $34 on Oct. 16, 2001. Billions of dollars in stock value were erased. The stock has been delisted from the New York Stock Exchange.
THE IMPACT
Politicians
Several prominent politicians from both parties returned Enron contribution money to the company or contributing it to charity. Others have been asked about their relationships with Enron.
THE IMPACT
Arthur Andersen Its reputation was badly damaged. Divisions of the business have been sold to other companies. There is also the possibility of staggering liability claims.
THE IMPACT
SEC files suit against KPMG and partners over Xerox Accounting
They have been charged with allowing Xerox to report false financial results between 1997 and 2000, rather than risk losing a key audit client. Office equipment maker Xerox last June was forced to restate more than US 6 Billion in revenues over 5 years after regulators accused it of using accounting tricks to prop up its earnings.
Response
Specifically, KPMG offered a detailed description of events as they unfolded in the Xerox case and argued that it did the "right thing" by refusing to sign off on the company's 2000 financial statements in the face of what it called "strong client resistance."
FBI Agent Coleen Rowley, who called the bureau on the carpet for ignoring evidence hinting at the September 11 terrorist attacks.
Former Enron vice president Sherron Watkins, whose memos warning company chairman Ken Lay about accounting irregularities failed to stop Enron's collapse.
Cynthia Cooper, a WorldCom vice president who told the company's board of directors about nearly $4 billion in accounting irregularities.
$10 Billion
Expenses
Treated As Assets
The founder and former head of Adelphia, and two of his sons have been charged with looting the nation's No. 6 cable company to pay for luxury condos, a golf course and to cover personal investment losses.
Martha Stewart
A close friend of Sam Waksal, has repeatedly denied any wrongdoing in selling nearly 4,000 ImClone shares on Dec. 27, a day before federal regulators said they would not consider the drugmaker's application for its new cancer drug. ImClone's shares plummeted after the news came out.
--Dennis Kozlowski, the CEO until he was indicted and resigned in June, borrowed more than $40 million from the company, and the loans were later forgiven, reports the Wall Street Journal. The SEC rules governing disclosure of CEO pay are quite clear on those matters, and there is simply no way to avoid disclosing the forgiveness of such loans. Yet Tyco never did. The company neither confirms nor denies any of this, declining to comment pending the completion of an internal investigation.
Sample Frauds
Large Fraud of $2.6 Billion over 9 years
Year 1 Year 3 Year 5 Year 7 Year 9 $600K $4 million $80 million $600 million $2.6 billion
3,000,000,000 2,500,000,000 2,000,000,000 1,500,000,000 1,000,000,000 500,000,000 0 Year 1 Year 3 Year 5 Year 7 Year 9
In years 8 and 9, four of the worlds largest banks were involved and lost over $500 million
Some of the organizations involved: Merrill Lynch, Chase, J.P. Morgan, Union Bank of Switzerland, Credit Lynnaise, Sumitomo, and others.
Why Fraud is a Costly Business Problem that must be addressed by corporate executives
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
$100 90 $ 10 1 $ 9
To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.
Bank
$100 Million Fraud Profit Margin = 10 % $1 Billion in Revenues Needed At $100 per year per Checking Account, 10 Million New Accounts
Educators
Havent taught ethics enough (cant make up own rules to meet own needs Need to teach students about fraudneed a fraud course Need to teach students how to think
Educators
We have done what is easiest for us and easiest for our students
Students are provided with information needed to produce the desired behaviorhigh scores on content-based examinations.
Professors assign homework problems similar to examples used in class, examples in textbooks, and problems on examinations.
Educational Focus
Why do educators spend so much time focusing on content when content memorization has such a short useful life and when skills are transferable across positions and last so much longer? Is it because this type of teaching is easier to teach and much easier to assess?
Some Thoughts
Doing whats easiestour train monkey or operant conditioning approach to teaching has led to:
Inhibiting their ability to assess risks and think analytically Rule-based standards that allow firms to basically do whatever they wantyou cant legislate everything An ethical and public relations nightmare for accountants and the accounting profession
Types of Fraud
Fraudulent Financial Statements Employee Fraud Vendor Fraud Customer Fraud Investment Scams Bankruptcy Frauds Miscellaneous Frauds The common element is deceit!
Corporate Accountability
Sarbanes Bill
Whistleblower Protection Prohibits Disciplining or Discriminating against employees who provide information regarding securities law violations
Requires Attorneys to Report Material Violations of Securities or Breaches of Fiduciary Duty to the Companys CEO or Chief Legal Officer or if necessary to the Board of Directors
Auditor Independence
& Rotation
Rotation of Audit/Review Partners every 5 years Prohibits Some Non Audit Services
8K
Disclosures
Expanded 8 K Disclosures
Accelerated 8 K Reporting 2 Days
Accounting Issues
New Issuer Fees SEC Adopt Principles-based Accounting System Unlawful to Fraudulently Influence Auditors New Rules for Financial Experts on Audit Committee New Management Assessment of Internal Control
NYSE
Enhanced Disclosures
Material Off-Balance Sheet Transactions
Reconciliation of Pro Form F/S
Expenses
Management Transactions
Loans
8K
The SEC Sets New Ground Rules on Selective Disclosure & Insider Trading
Forfeiture of Bonuses, and Stock Incentives For Majority of Restatements Due Directors Must Be Independent to Misconduct
Dynamic Duo
Once The Camel Stick Its Head In the Tent, We Will Have Problems
The Sarbanes-Oxley Act apparently did not go far enough to suit California lawmakers. Under a law that took effect this month, public companies based in California or doing business there have to give the state extra layers of detail on insider activity.
Spirit of Transparency
Culture of Accountability
People of Integrity