Business Fraud

Business Fraud (The Enron Problem)W. Steve AlbrechtPh.D., CPA, CIA, CFEBrigham Young University

These Are Interesting TimesNumber and size of financial statement frauds are increasingNumber and size of frauds against organizations are increasingSome recent frauds include several peopleas many as 20 or 30 (seems to indicate moral decay)Many investors have lost confidence in credibility of financial statements and corporate reportsMore interest in fraud than ever beforenow a course on many college campuses

Example of a Fraud Where I TestifiedLarge Fraud of $2.6 Billion over 9 yearsYear 1$600KYear 3$4 millionYear 5$80 millionYear 7$600 millionYear 9$2.6 billionIn years 8 and 9, four of the worlds largest banks were involved and lost over $500 million

Why Fraud is a Costly Business ProblemFraud Losses Reduce Net Income $ for $If Profit Margin is 10%, Revenues Must Increase by 10 times Losses to Recover Affect on Net IncomeLosses. $1 MillionRevenue.$1 Billion Fraud Robs IncomeRevenues$100100%Expenses 90 90%Net Income$ 10 10%Fraud 1Remaining $ 9

To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.

Fraud Cost.Two Examples General Motors$436 Million FraudProfit Margin = 10%$4.36 Billion in Revenues NeededAt $20,000 per Car, 218,000 Cars

Bank$100 Million FraudProfit Margin = 10 %$1 Billion in Revenues NeededAt $100 per year per Checking Account, 10 Million New Accounts

Financial Statement FraudFinancial 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

Types of FraudFraudulent Financial StatementsEmployee FraudVendor FraudCustomer FraudInvestment ScamsBankruptcy FraudsMiscellaneous FraudsThe common element is deceit or trickery!

Recent Financial Statement FraudsEnronWorldComAdelphiaGlobal CrossingXeroxQwestMany others (Cendant, Lincoln Savings, ESM, Anicom, Waste Management, Sunbeam, etc.)

Current Executive Fraud-Related ProblemsMisstating 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.)

Largest Bankruptcy Filings (1980 to Present)from BankruptcyData.com

Why so many financial statement frauds all of a sudden?Good economy was masking many problemsMoral decay in societyExecutive incentivesWall Street expectationsrewards for short-term behaviorNature of accounting rulesBehavior of CPA firmsGreed by investment banks, commercial banks, and investorsEducator failures

Good economy was masking problemsWith 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 yearMultiply the result by negative 1 to make it positiveMultiply that number by at least 100If stock price is less than the resultbuy; if not, buy anyway

Executive IncentivesMeeting Wall Streets ExpectationsStock prices are tied to meeting Wall Streets earnings forecastsFocus is on short-term performance onlyCompanies are heavily punished for not meeting forecastsExecutives have been endowed with hundreds of millions of dollars worth of stock optionsfar exceeds compensation (tied to stock price)Performance is based on earnings & stock price

Incentives for F.S. FraudIncentives 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.

Nature of Accounting RulesIn 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 cant do thisbecause it isnt GAAPIt is impossible to make rules for every situation

Auditorsthe CPAsFailed 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 richAudit became a loss leaderEasier to sell lucrative consulting services from the insideBecame largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture)A few auditors got too close to their clientsEntire industry, especially Arthur Andersen, was punished for actions of a few

EducatorsNeed to teach Ethics moreNeed to teach students about fraudoffer a fraud courseNeed to teach students how to thinkWe have taught them how to copy, not thinkWe have asked them to memorize, not thinkWe have done what is easiest for us and easiest for our students

Financial Statement FraudsRevenue/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)

Revenue Related Financial Statement FraudsBy far, the most common accounts manipulated when perpetrating financial statement fraud are revenues and/or accounts receivable.

Accounts ReceivablexxxRevenuesxxx (Income Assets )

Revenue-Related Transactions and Frauds

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TransactionAccounts InvolvedFraud Schemes

1. Estimate all uncollectible accounts receivableBad debt expense, allowance for doubtful accounts1. Understate allowance for doubtful accounts, thus overstating receivables

2. Sell goods and/or services to customersAccounts receivable, revenues (e.g. sales revenue) (Note: cost of goods sold part of entryh is included in Chapter 5)2. Record fictitious sales (related parties, sham sales, sales with conditions, consignment sales, etc.)3. Recognize revenues too early (improper cutoff, percentage of completion, etc.)4. Overstate real sales (alter contracts, inflate amounts, etc.)

3. Accept returned goods from customersSales returns, accounts receivable5. Not record returned goods from customers6. Record returned goods after the end of the period

4. Write off receivables as uncollectibleAllowance for doubtful accounts, accounts receivable7. Not write off uncollectible receivables8. Write off uncollectible receivables in a later period

5. Collect cash after discount periodCash, accounts receivable9. Record bank transfers as cash received from customers10. Manipulate cash received from related parties

6. Collect cash within discount periodCash, sales discounts, accounts receivable11. Not recognize discounts given to customers

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1. Purchase inventoryInventory, accounts payable1. Under-record purchase2. Record purchases too late3. Not record purchases

2. Return merchandise to supplierAccounts payable, inventory4. Overstate returns5. Record returns in an earlier period (cutoff problem)

3. Pay vendor within discount periodAccounts payable, inventory, cash6. Overstate discounts7. Not reduce inventory cost

4. Pay vendor without discountAccounts payable, cashConsidered in another chapter

5. Inventory is sold; cost of goods sold is recognizedCost of goods sold, inventory8. Record at too low an amount9. Not record cost of goods sold nor reduce inventory

6. Inventory becomes obsoleteLoss on write-down of inventory, inventory10. Not write off or write down obsolete inventory

7. Inventory quantities are estimatedInventory shrinkage, inventory11. Over-estimate inventory (use incorrect ratios, etc.)

8. Inventory quantities are countedInventory shrinkage, inventory12. Over-count inventory (double counting, etc.)

9. Inventory cost is determinedInventory, cost of goods sold13. Incorrect costs are used14. Incorrect extensions are made15. Record fictitious inventory

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1. Purchase inventoryInventory, accounts payable1. Record payable in in subsequent period2. Don't record purchase3. Overstate purchase returns and purchase discounts4. Record payment made in later period as being paid in an earlier period5. Fraudulent recording of payment (e.g. kiting)

2. Incur payroll and other accrued liabilitiesPayroll tax expense, salary expense, various expenses, salaries payable, payroll taxes payable, various accrued liabilities6. Not accrue liabilities7. Record accruals in later period

3. Sell products purchasedAccounts receivable, sales revenue, unearned revenue8. Record unearned revenues as earned revenues

4. Service products sold, repay deposits or repurchase something in the future (future commitments)Warranty (service) expense, warranty or service liability9. Not record warranty (service) liabilities10. Under-record liabilities11. Record deposits as revenues12. Not record repurchase agreements & commitments

5. Borrow moneyCash, notes payable, mortgages payable, etc.13. Borrow from related parties14. Don't record liabilities15. Borrow against asset equities16. Writeoff liabilities as forgiven17. Claim liabilities as personal debt rather than debt of the equity

6. Incur contingent liabilitiesLoss from contingencies, losses payable18. Not record contingent liabilities19. Record contingent liabilities at too low an amount

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Improper capitalization of costs as assets that should be expensedVarious deferred charge and intangible asset accounts1. Inappropriately capitaalizing various kinds of start-up costs, marketing costs, salaries, research and development costs, and other such expenditures

Inflating assets through mergers, acquisitions and restructuringCan be any asset2. Using market values rather than book values to record assets3. Having the wrong entity be the "purchaser"4. Allocating costs among assets in inappropriate ways.

Overstating fixed assetsLand, buildings, equipment, leasehold improvements, and so forth5. Sham purchases and sales of assets with "straw buyers"6. Overstating asset costs with related parties7. Not recording depreciation8. Collusion with outside parties to overstate assets (e.g. allocating inventory costs to fixed assets)

Misstating cash and marketable securitiesCash, marketable securities, and other short-term assets9. Misstating marketable securities with the aid of related parties10. Misappropriation of cash resulting in misstated financial statements without management's knowledge

Overstating accounts receivable and/or inventory to hide thefts of cash by managementAccounts receivable, inventory11. Covering thefts of cash or other assets by overstating receivables and/or inventory

Overstating InventoryThe second most common way to commit financial statement fraud is to overstate inventory.Beginning InventoryOKPurchasesOKGoods Available for saleOKEnding InventoryHighCost of Goods SoldLowIncomeHigh

Inventory/Cost of Goods Sold Frauds

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1. Estimate all uncollectible accounts receivableBad debt expense, allowance for doubtful accounts1. Understate allowance for doubtful accounts, thus overstating receivables

2. Sell goods and/or services to customersAccounts receivable, revenues (e.g. sales revenue) (Note: cost of goods sold part of entryh is included in Chapter 5)2. Record fictitious sales (related parties, sham sales, sales with conditions, consignment sales, etc.)3. Recognize revenues too early (improper cutoff, percentage of completion, etc.)4. Overstate real sales (alter contracts, inflate amounts, etc.)

3. Accept returned goods from customersSales returns, accounts receivable5. Not record returned goods from customers6. Record returned goods after the end of the period

4. Write off receivables as uncollectibleAllowance for doubtful accounts, accounts receivable7. Not write off uncollectible receivables8. Write off uncollectible receivables in a later period

5. Collect cash after discount periodCash, accounts receivable9. Record bank transfers as cash received from customers10. Manipulate cash received from related parties

6. Collect cash within discount periodCash, sales discounts, accounts receivable11. Not recognize discounts given to customers

ch 5 p. 5


1. Purchase inventoryInventory, accounts payable1. Under-record purchase2. Record purchases too late3. Not record purchases

2. Return merchandise to supplierAccounts payable, inventory4. Overstate returns5. Record returns in an earlier period (cutoff problem)

3. Pay vendor within discount periodAccounts payable, inventory, cash6. Overstate discounts7. Not reduce inventory cost

4. Pay vendor without discountAccounts payable, cashConsidered in another chapter

5. Inventory is sold; cost of goods sold is recognizedCost of goods sold, inventory8. Record at too low an amount9. Not record cost of goods sold nor reduce inventory

6. Inventory becomes obsoleteLoss on write-down of inventory, inventory10. Not write off or write down obsolete inventory

7. Inventory quantities are estimatedInventory shrinkage, inventory11. Over-estimate inventory (use incorrect ratios, etc.)

8. Inventory quantities are countedInventory shrinkage, inventory12. Over-count inventory (double counting, etc.)

9. Inventory cost is determinedInventory, cost of goods sold13. Incorrect costs are used14. Incorrect extensions are made15. Record fictitious inventory

ch 6 p.6


1. Purchase inventoryInventory, accounts payable1. Record payable in in subsequent period2. Don't record purchase3. Overstate purchase returns and purchase discounts4. Record payment made in later period as being paid in an earlier period5. Fraudulent recording of payment (e.g. kiting)

2. Incur payroll and other accrued liabilitiesPayroll tax expense, salary expense, various expenses, salaries payable, payroll taxes payable, various accrued liabilities6. Not accrue liabilities7. Record accruals in later period

3. Sell products purchasedAccounts receivable, sales revenue, unearned revenue8. Record unearned revenues as earned revenues

4. Service products sold, repay deposits or repurchase something in the future (future commitments)Warranty (service) expense, warranty or service liability9. Not record warranty (service) liabilities10. Under-record liabilities11. Record deposits as revenues12. Not record repurchase agreements & commitments

5. Borrow moneyCash, notes payable, mortgages payable, etc.13. Borrow from related parties14. Don't record liabilities15. Borrow against asset equities16. Writeoff liabilities as forgiven17. Claim liabilities as personal debt rather than debt of the equity

6. Incur contingent liabilitiesLoss from contingencies, losses payable18. Not record contingent liabilities19. Record contingent liabilities at too low an amount

ch 7 p. 13


Improper capitalization of costs as assets that should be expensedVarious deferred charge and intangible asset accounts1. Inappropriately capitaalizing various kinds of start-up costs, marketing costs, salaries, research and development costs, and other such expenditures

Inflating assets through mergers, acquisitions and restructuringCan be any asset2. Using market values rather than book values to record assets3. Having the wrong entity be the "purchaser"4. Allocating costs among assets in inappropriate ways.

Overstating fixed assetsLand, buildings, equipment, leasehold improvements, and so forth5. Sham purchases and sales of assets with "straw buyers"6. Overstating asset costs with related parties7. Not recording depreciation8. Collusion with outside parties to overstate assets (e.g. allocating inventory costs to fixed assets)

Misstating cash and marketable securitiesCash, marketable securities, and other short-term assets9. Misstating marketable securities with the aid of related parties10. Misappropriation of cash resulting in misstated financial statements without management's knowledge

Overstating accounts receivable and/or inventory to hide thefts of cash by managementAccounts receivable, inventory11. Covering thefts of cash or other assets by overstating receivables and/or inventory

Understating Liability Frauds(3rd Most Common)Not recording accounts payableNot recording accrued liabilitiesRecording unearned revenues as earnedNot recording warranty or service liabilitiesNot recording loans or keep liabilities off the booksNot recording contingent liabilities

Asset Overstatement Frauds(4th Most Common)Overstatement of current assets (e.g. marketable securities)Overstating pension assetsCapitalizing as assets amounts that should be expensedFailing to record depreciation/amortization expenseOverstating assets through mergers and acquisitionsOverstating inventory and receivables (covered earlier)

Disclosure FraudsThree Categories of Disclosure Frauds:Overall misrepresentations about the nature of the company or its products, usually made through news reports, interviews, annual reports, and elsewhere

Misrepresentations in the management discussions and other non-financial statement sections of annual reports, 10-Ks, 10-Qs, and other reports

Misrepresentations in the footnotes to the financial statements

Detecting Financial Statement FraudDetecting Financial Statement Fraud1. Management & Board 2. Relationships With Others3. Organization & Industry4. Financial Results & Operating Characteristics

Enron FraudCompared 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 didnt have to lie. All they had to do was to obfuscate it with sheer complexityalthough they probably lied too.Senator John Dingell

Enrons HistoryIn 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 strategyKenneth 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 Bankto buy and sell gas

Enrons History (contd)Created Energy derivativeLay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run itEnron 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 handsomelythe reward system was eat what you killFastow was a Kellogg MBA hired by Skilling in 1990Became CFO in 1998Started Enron Online Trading in late 90sCreated Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

The MotivationEnron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didnt understand its financial statements.

It was all about the price of the stock. Enron was a trading company and Wall Street normally doesnt reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enrons 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.

The Role of Stock OptionsEnron (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.

Enrons Corporate StrategyWas devoid of any boundary systemEnrons core business was losing moneyshifted 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, Enrons derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billionEnrons top management gave its managers a blank order to just do itDeals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.

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.

Enrons Arrogance

Enrons banner in lobby: Changed from The Worlds Leading Energy Company to THE WORLDS LEADING COMPANY

2001 - Notable EventsJeff Skilling left on August 14gave no reason for his departure.By mid-August , the stock price began to fallFormer CEO, Kenneth Lay, returned in AugustOct. 16announced $618 million loss but not that it had written down equity by $1.2 billionOctoberMoodys downgraded Enrons debtNov. 8Told investors they were restating earnings for the past 4 and yearsDec. 2Filed bankruptcy

Executives Abandon EnronRebecca Mark-Jusbasche, formerly CEO of Azurix, Enrons troubled water-services company left in August, 2000Joseph Sutton, Vice Chairman of Enron, left in November, 2000.Jay Clifford Baxter, Vice Chairman of Enron committed suicide in May, 2001Thomas White, Jr., Vice Chairman, left in May, 2001.Lou Pai, Chairman of Enron Accelerator, departed in May 2001.Kenneth Rice, CEO of Enrons Broadband services, departed in August 2001.Jeffrey Skilling, Enron CEO, left on August 14, 2001

Enrons revenues and income * Without LJM1, LJM2, Chewco and the Four Raptors partnerships. There were hundreds of partnershipsmainly used to hide debt.

Value at Risk (VAR) MethodologySome warning signs disclosed by Frank Portnoy before January 24, 2002 Senate Hearings

Enron captured 95% confidence intervals for one-day holding periodsdidnt disclose worst case scenariosRelied on professional judgment of experienced business and risk managers to assess worst case scenariosInvestors didnt know how much risk Enron was takingEnron had over 5,000 weather derivatives deals valued at over $4.5 billioncouldnt be valued without professional judgmentFrom 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 Managementthat employed rocket Scientists and Nobel laureates to design sophisticated computer models, Enrons statement that it would refine its own models should have raised concerns

Special Purpose Entities (SPEs) (Enrons principal method of financial statement fraud involved the use of SPEs)

Originally had a good business purposeHelp 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 companyPipeline to be self-supported, independent entity with no fear company would take overSPE limited by its charter to those permitted activities onlyReally a joint venture between sponsoring company and a group of outside investorsCash flows from the SPE operations are used to pay investors

Enrons 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 managementBlockbuster 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 incomeTo hide debt (Borrowed money was not put on financial statements of Enron)To manipulate cash flows, especially in 4th quartersMany 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

Accounting License to CheatMajor 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%)1984EITF 84-15 Grantor Trust Consolidations (Permitted non-consolidation if owned more than 50%)1990EITF 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

Mark-to-Market AccountingAccounting 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 othersGains often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and pricesprovides opportunities for management to create and manage earningsEnron 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 futuresalmost perfectly correlated

The Chewco SPEAccounted for 80% of SPE restatement or $400 millionIn 1993, Enron and the California Public Employees Retirement System (CalPERS) formed a 50/50 partnershipJoint Energy Development Investments Limited (JEDI)In 1997, Enron bought out CalPERS interest in JEDIHalf of the $11.4 million that bought the 3% involved cash collateral provided by Enronmeaning only 1 and percent was owned by outsiders

LJM1 SPEResponsible for 20% of SPE restatement or $100 millionShould 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.

Enrons DisclosuresSEC 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 2nd quarter of 2001From 2000 annual report Enron entered into transactions with limited partnerships whose general partners managing partner is a senior official of Enron. (Fastow)

Enrons FootnotesDisclosures of Enron Partnership

The Famous Misleading Earnings Release on October 16, 2001Headline: Enron Reports Recurring Third Quarter Earnings of $0.43 per diluted shareProjected recurring earnings for 2002 of $2.15 If you dug deep, you learned that Enron actually lost $618 million or $0.84 per sharethey had mislabeled $1.01 billion of expenses and losses as non-recurring.Shockingly, there was no balance sheet or cash flow information with the releaseThere was no mention of a $1.2 billion charge against shareholders equity, including what was described as a $1 billion correction to an accounting error. (This was learned a couple of days later.)

Didnt Anyone See Enrons Problems?Enron grew to be the 7th largest Fortune 100 company while media hype and the stock market euphoria reignedBut in late 2000 negative reports began to originate from some skeptics

The SkepticsJonathan Weil, Energy traders cite gains, but some math is missing, The Wall Street Journal (Texas ed.) 9/20/2000Feb. 2001 analyst report from John S. Herold, Inc. by Lou Gagliardi and John ParryBethany McLean, Is Enron overpriced? Fortune, 3/5/2001

Enrons Cash Flows Enrons 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

Enrons Cash Flow RatioNegative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000, 1st two quarters in 2001.

Role of AndersenWas paid $52 million in 2000, the majority for non-audit related consulting services.Failed to spot many of Enrons lossesShould have assessed Enron managements internal controls on derivatives tradingexpressed approval of internal controls during 1998 through 2000Kept a whole floor of auditors assigned at Enron year aroundEnron was Andersens second largest clientProvided both external and internal auditsCFOs and controllers were former Andersen executivesAccused of document destructionwas criminally indictedWent out of businessMy 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.

Role of Investment & Commercial BanksEnron 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

Role of Law FirmsEnrons outside law firm was paid substantial fees and had previously employed Enrons general counselFailed to correct or disclose problems related to derivatives and special purpose entitiesHelped draft the legal documentation for the SPEs

Role of Credit Rating AgenciesThe three major credit rating agenciesMoodys, Standard & Poors and Fitch/IBCAreceived substantial fees from EnronJust weeks prior to Enrons bankruptcy filingafter most of the negative news was out and Enrons stock was trading for $3 per shareall three agencies still gave investment grade ratings to Enrons 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

So Why Did Enron Happen?Individual and collective greedcompany, its employees, analysts, auditors, bankers, rating agencies and investorsdidnt want to believe the company looked too good to be trueAtmosphere of market euphoria and corporate arroganceHigh risk deals that went sourDeceptive reporting practiceslack of transparency in reporting financial affairsUnduly aggressive earnings targets and management bonuses based on meeting targetsExcessive interest in maintaining stock prices

Will there be another Enron?YesRecent years have seen an increase in the number of financial statement frauds1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)Incentives still there (Stock Options, etc.) NoSarbanes-Oxley Bill contains many key provisionsExecutive sign offRequirement to have internal controlsRules for accountants (mandatory audit partner rotation; Oversight Board, limitations on services, etc.)Accountants are being much more careful

Documents

Business Fraud