Business_Fraud-Erron .ppt

7/29/2019 Business_Fraud-Erron .ppt

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2003, 2005 by the AICPA

Business Fraud

(The Enron Problem)W. Steve Albrecht

Ph.D., CPA, CIA, CFEBrigham Young University


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This presentation is intended for use in higher education for instructional purposes only, and is not for application inpractice. Permission is granted to classroom instructors to photocopy this document for classroom teaching purposesonly. All other rights are reserved. Copyright 2003, 2005 by the American Institute of Certified Public Accountants,

Inc., New York, New York.


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These Are Interesting Times

Number and size of financial statement fraudsare increasingNumber and size of frauds against organizationsare increasing

Some recent frauds include several peopleasmany as 20 or 30 (seems to indicate moraldecay)Many investors have lost confidence in credibility

of financial statements and corporate reportsMore interest in fraud than ever beforenow acourse on many college campuses


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Example of a Fraud Where I Testified

Large Fraud of $2.6Billion over 9 years Year 1 $600K

Year 3 $4 million

Year 5 $80 million

Year 7 $600 million

Year 9 $2.6 billion

In years 8 and 9, four of

the worlds largest bankswere involved and lostover $500 million

0

500,000,000

1,000,000,000

1,500,000,000

2,000,000,000

2,500,000,000

3,000,000,000

Year 1 Year 3 Year 5 Year 7 Year 9


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Why Fraud is a Costly BusinessProblem

Fraud Losses ReduceNet Income $ for $

If Profit Margin is 10%,Revenues Must Increaseby 10 times Losses toRecover Affect on NetIncome Losses. $1 Million

Revenue.$1 Billion

Fraud Robs Income

Revenues $100 100%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 ofincome.


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Fraud Cost.Two Examples

General Motors

$436 Million Fraud

Profit Margin = 10%

$4.36 Billion inRevenues Needed

At $20,000 per Car,218,000 Cars

Bank

$100 Million Fraud

Profit Margin = 10 %

$1 Billion in RevenuesNeeded

At $100 per year perChecking Account,

10 Million NewAccounts


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Types of Fraud

Fraudulent FinancialStatements

Employee Fraud

Vendor Fraud

Customer Fraud

Investment Scams

Bankruptcy FraudsMiscellaneous Frauds

The common elementis deceit or trickery!


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Recent Financial StatementFrauds

Enron

WorldCom

Adelphia

Global Crossing

Xerox

Qwest

Many others (Cendant, Lincoln Savings, ESM,Anicom, Waste Management, Sunbeam, etc.)


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Current Executive Fraud-RelatedProblems

Misstating Financial Statements: Quest, Enron,Global Crossing, WorldCom, etc.Executive Loans and Corporate Looting: JohnRigas (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.)


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Largest Bankruptcy Filings(1980 to Present)

from BankruptcyData.com

Company Assets (Billions) When Filed

1. WorldCom $103.9 July 2002

2. Enron $63.4 Dec. 2001

3. Conseco $61.4 Dec. 2002

4. Texaco $35.9 April 1987

5. Financial Corp of America $33.9 Sept. 1988

6. Global Crossing $30.2 Jan. 2002

7. PG&E $29.8 April 2001

8. UAL $25.2 Dec. 2002

9. Adelphia $21.5 June 2002

10. MCorp $20.2 March 1989


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Why so many financial statementfrauds all of a sudden?

Good economy was masking many problemsMoral decay in societyExecutive incentives

Wall Street expectationsrewards for short-termbehaviorNature of accounting rulesBehavior of CPA firms

Greed by investment banks, commercial banks,and investorsEducator failures


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Good economy was maskingproblems

With increasing stock prices, increasing profitsand increasing wealth for everyone, no oneworried about potential problems.

How to value a dot.com company: Take their loss for the year

Multiply the result by negative 1 to make it positive

Multiply that number by at least 100

If stock price is less than the resultbuy; if not, buyanyway


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Executive Incentives

Meeting Wall Streets Expectations

Stock prices are tied to meeting Wall Streetsearnings forecasts

Focus is on short-term performance only Companies are heavily punished for not meeting

forecasts

Executives have been endowed with hundreds of

millions of dollars worth of stock optionsfar exceedscompensation (tied to stock price)

Performance is based on earnings & stock price


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Incentives for F.S. Fraud

Incentives to commit financial statement fraud are very

strong. Investors want decreased risk and high returns.

Risk is reduced when variability of earnings is decreased.

Rewards are increased when income continuously improves.

Which firm will have the higher stock price?

Firm A Firm B


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Nature of Accounting Rules

In the U.S., accounting standards are rules-based instead of principles based. Allows companies and auditors to be extremely

creative when not specifically prohibited by standards.

Examples are SPEs and other types of off-balancesheet financing, revenue recognition approaches,merger reserves, pension accounting, and otheraccounting schemes.

When the client pushes, without specific rules inevery situation, there is no room for the auditors tosay, You cant do thisbecause it isnt GAAP

It is impossible to make rules for every situation


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Auditorsthe CPAs

Failed to accept responsibility for fraud detection (SEC,Supreme Court, public expects them to detect fraud) Ifauditors arent the watchdogs, then who is?Became greedy--$500,000 per year per partnercompensation wasnt enough; saw everyone else gettingrichAudit became a loss leader Easier to sell lucrative consulting services from the inside Became largest consulting firms in the U.S. very quickly

(Andersen Consulting grew to compete with Accenture)

A few auditors got too close to their clientsEntire industry, especially Arthur Andersen, waspunished for actions of a few


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Educators

Need to teach Ethics more

Need to teach students about fraudoffera fraud course

Need to teach students how to think

We have taught them how to copy, not think

We have asked them to memorize, not think

We have done what is easiest for us andeasiest for our students


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Financial Statement Frauds

Revenue/Accounts Receivable Frauds(Global Crossing, Quest, ZZZZ Best)

Inventory/Cost of Goods Sold Frauds(PharMor)

Understating Liability/Expense Frauds(Enron)

Overstating Asset Frauds (WorldCom)

Overall Misrepresentation (Bre-X Minerals)


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Revenue Related FinancialStatement Frauds

By far, the most common accountsmanipulated when perpetrating financialstatement fraud are revenues and/or

accounts receivable.

Accounts Receivable xxx

Revenues xxx

(Income Assets )


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Transaction Accounts Involved Fraud Schemes

1. Estimate all

uncollectibleaccounts receivable

Bad debt expense,

allowance fordoubtful accounts

1. Understate allowance for doubtful

accounts, thus overstating receivables

2. Sell goods and/or

services to

customers

Accounts 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

customers

Sales returns,

accounts receivable

5. Not record returned goods from

customers

6. Record returned goods after the end of

the period

4. Write off

receivables as

uncollectible

Allowance for

doubtful accounts,

accounts receivable

7. Not write off uncollectible receivables

8. Write off uncollectible receivables in a

later period

5. Collect cash after

discount period

Cash, accounts

receivable

9. Record bank transfers as cash received

from customers

10. Manipulate cash received from related

parties

6. Collect cash within

discount period

Cash, sales

discounts, accounts

receivable

11. Not recognize discounts given to

customers

Revenue-Related Transactions and Frauds


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Overstating Inventory

The second most common way to commitfinancial statement fraud is to overstateinventory.

Beginning Inventory OKPurchases OK

Goods Available for sale OK

Ending Inventory High

Cost of Goods Sold Low

Income High


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Transaction Accounts Involved Fraud Schemes

1. Purchase inventory Inventory, accounts

payable

1. Under-record purchase

2. Record purchases too late

3. Not record purchases2. Return merchandise to

supplier

Accounts payable,

inventory

4. Overstate returns

5. Record returns in an earlier period (cutoff

problem)

3. Pay vendor w ithin

discount period

Accounts payable,

inventory, cash

6. Overstate discounts

7. Not reduce inventory cost

4. Pay vendor w ithout

discount

Accounts payable, cash Considered in another chapter

5. Inventory is sold; cost

of goods sold is

recognized

Cost of goods sold,

inventory

8. Record at too low an amount

9. Not record cost of goods sold nor reduce

inventory

6. Inventory becomes

obsolete

Loss on w rite-dow n of

inventory, inventory

10. Not w rite off or w rite down obsolete inventory

7. Inventory quantities

are estimated

Inventory shrinkage,

inventory

11. Over-estimate inventory (use incorrect ratios,

etc.)

8. Inventory quantities

are counted

Inventory shrinkage,

inventory

12. Over-count inventory (double counting, etc.)

9. Inventory cost is

determined

Inventory, cost of goods

sold

13. Incorrect costs are used

14. Incorrect extensions are made

15. Record fictitious inventory

Inventory/Cost of Goods Sold Frauds


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Understating Liability Frauds(3rd Most Common)

Not recording accounts payable

Not recording accrued liabilities

Recording unearned revenues as earnedNot recording warranty or service liabilities

Not recording loans or keep liabilities off

the booksNot recording contingent liabilities


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Asset Overstatement Frauds(4th Most Common)

Overstatement of current assets (e.g.marketable securities)Overstating pension assetsCapitalizing as assets amounts that should beexpensedFailing to record depreciation/amortizationexpenseOverstating assets through mergers and

acquisitionsOverstating inventory and receivables (coveredearlier)


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Disclosure Frauds

Three Categories of Disclosure Frauds:1. Overall misrepresentations about the nature of the

company or its products, usually made through newsreports, interviews, annual reports, and elsewhere

2. Misrepresentations in the management discussionsand other non-financial statement sections of annualreports, 10-Ks, 10-Qs, and other reports

3. Misrepresentations in the footnotes to the financialstatements


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Detecting Financial StatementFraud

Detecting Financial

Statement Fraud

1. Management & Board 2. Relationships

With Others

3. Organization & Industry 4. Financial Results &

Operating Characteristics


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Enron Fraud

Compared to other financial statement frauds, Enron wasvery complicated. WorldCom, for example, was a $7billion fraud that involved simply capitalizing expenses(line costs) that should have been expensed (Accounting

200 topic). Enron involved many complex transactionsand accounting issues.

What we are looking at here is an example ofsuperbly complex financial reports. They didnt have

to lie. All they had to do was to obfuscate it withsheer complexityalthough they probably lied too.

Senator John Dingell


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Enrons History

In 1985 after federal deregulation of natural gaspipelines, Enron was born from the merger of HoustonNatural Gas and InterNorth, a Nebraska pipelinecompany.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 assistin developing business strategy. They assigned a youngconsultant named Jeffrey Skilling.

His background was in banking and asset and liabilitymanagement.His recommendation: that Enron create a Gas Bankto buy and sell gas


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Enrons History (contd)Created Energy derivative

Lay created a new division in 1990 called Enron FinanceCorp. and hired Skilling to run itEnron soon had more contracts than any of its competitorsand, with market dominance, could predict future priceswith great accuracy, thereby guaranteeing superior profits.

Skilling hired the best and brightest traders and rewardedthem handsomelythe reward system waseat what youkillFastow was a Kellogg MBA hired by Skilling in 1990Became CFO in 1998

Started Enron Online Trading in late 90sCreated Performance Review Committee (PRC) thatbecame known as the harshest employee ranking systemin the country---based on earnings generated, creatingfierce internal competition


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The Motivation

Enron delivered smoothly growing earnings (but not cash flows.) WallStreet took Enron on its word but didnt understand its financialstatements.

It was all about the price of the stock. Enron was a trading companyand Wall Street normally doesnt reward volatile earnings of trading

companies. (Goldman Sacks is a trading company. Its stock pricewas 20 times earnings while Enrons was 70 times earnings.)

In its last 5 years, Enron reported 20 straight quarters of increasingincome.

Enron, that had once made its money from hard assets like pipelines,generated more than 80% of its earnings from a vaguer businessknown as wholesale energy operations and services.


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The Role of Stock Options

Enron (and many other companies) avoidedhundreds of millions of dollars in taxes by its useof stock options. Corporate executives receivedlarge quantities of stock options. When they

exercised these options, the company claimedcompensation expense on their tax returns.Accounting rules let them omit that sameexpense from the earnings statement. Theoptions only needed to be disclosed in a

footnote. Options allowed them to pay lesstaxes and report higher earnings while, at thesame time, motivating them to manipulateearnings and stock price.


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Enrons Corporate Strategy

Was devoid of any boundary systemEnrons core business was losing moneyshifted its focus frombricks-and-mortar energy business to trading of derivatives (mostderivatives profits were more imagined than real with manyemployees lying and misstating systematically their profits andlosses in order to make their trading businesses appear less volatile

than they were)During 2000, Enrons derivatives-related assets increased from $2.2billion 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 justdo it

Deals in unrelated areas such as weather derivatives, waterservices, metals trading, broadband supply and power plant were alljustified.


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Aggressive Nature of Enron

Because Enron believed it was leading arevolution, it pushed the rules. Employeesattempted to crush not just outsiders but

each other. Competition was fierce amongEnron traders, to the extent that they wereafraid to go to the bathroom and leave their

computer screen unattended and availablefor perusal by other traders.


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Enrons Arrogance

Enrons banner in lobby: Changed fromThe Worlds Leading Energy Company toTHE WORLDS LEADING COMPANY


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2001 - Notable Events

Jeff Skilling left on August 14gave no reasonfor his departure.

By mid-August , the stock price began to fall

Former CEO, Kenneth Lay, returned in AugustOct. 16announced $618 million loss but notthat it had written down equity by $1.2 billion

OctoberMoodys downgraded Enrons debt

Nov. 8Told investors they were restatingearnings for the past 4 and years

Dec. 2Filed bankruptcy


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Executives Abandon Enron

Rebecca Mark-Jusbasche, formerly CEO of Azurix,Enrons troubled water-services company left in August,2000Joseph Sutton, Vice Chairman of Enron, left inNovember, 2000.

Jay Clifford Baxter, Vice Chairman of Enron committedsuicide in May, 2001Thomas White, Jr., Vice Chairman, left in May, 2001.Lou Pai, Chairman of Enron Accelerator, departed inMay 2001.Kenneth Rice, CEO of Enrons Broadband services,departed in August 2001.Jeffrey Skilling, Enron CEO, left on August 14, 2001


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Enrons revenues and income

Year Revenues Income Income(Restated)*

1997 $20.2 B $105 M $9 M

1998 $31.2 B $703 M $590 M

1999 $40.1 B $893 M $643 M

2000 $100.1 B $979 M $827 M

* Without LJM1, LJM2, Chewco and the Four Raptors partnerships. Therewere hundreds of partnershipsmainly used to hide debt.


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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 holdingperiodsdidnt disclose worst case scenariosRelied on professional judgment of experienced business and riskmanagers to assess worst case scenarios

Investors didnt know how much risk Enron was takingEnron had over 5,000 weather derivatives deals valued at over $4.5billioncouldnt be valued without professional judgmentFrom the 2000 annual report In 2000, the value at risk modelutilized for equity trading market risk was refined to more closelycorrelate with the valuation methodologies used for merchantactivities.

Given the failure of the risk and valuation models at a sophisticatedhedge funds such as Long-Term Capital Managementthatemployed rocket Scientists and Nobel laureates to designsophisticated computer models, Enrons statement that it wouldrefine its own models should have raised concerns


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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. gaspipeline in Central Asia)Investors wanted risk and reward exposure limited to thepipeline, not overall risks and rewards of the associatedcompanyPipeline to be self-supported, independent entity with nofear company would take overSPE limited by its charter to those permitted activitiesonlyReally a joint venture between sponsoring company anda group of outside investorsCash flows from the SPE operations are used to payinvestors


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Enrons Use of Special PurposeEntities (SPEs)

To hide bad investments and poor-performing assets(Rhythms NetConnections). Declines in value of assetswould not be recognized by Enron (Mark to Market).Earnings managementBlockbuster Video deal--$111million gain (Bravehart, LJM1 and Chewco)

Quick execution of related-party transactions at desiredprices. (LJM1 and LJM2)To report over $1 billion of false incomeTo hide debt (Borrowed money was not put on financialstatements 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 bebooked just in time and in amounts needed, to meetinvestor expectations


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Accounting License to Cheat

Major issue is whether SPEs should be consolidated*SPEs are only valuable if unconsolidated.1977--Synthetic lease rules (Off-balance sheetfinancing) (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 corporationssuch as Enron to not consolidate if outsiderscontributed even 3% of the capital (the other 97% couldcome from the company.) 90-15 was a license to create

imaginary profits and hide genuine losses. FAS 57requires 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


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Mark-to-Market Accounting

Accounting and reporting standards for marketable securities,derivatives and financial contracts are found in FAS 115 and FAS133.Changes in market values are reported in the income statement forcertain financial assets and in shareholders equity (component ofAccumulated Other Comprehensive Income) for others

Gains often determined by proprietary formulas depending on manyassumptions about interest rate, customers, costs and pricesprovides opportunities for management to create and manageearningsEnron 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


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The Chewco SPE

Accounted for 80% of SPE restatement or $400millionIn 1993, Enron and the California PublicEmployees Retirement System (CalPERS)

formed a 50/50 partnershipJoint EnergyDevelopment Investments Limited (JEDI)In 1997, Enron bought out CalPERS interest inJEDI

Half of the $11.4 million that bought the 3%involved cash collateral provided by Enronmeaning only 1 and percent was owned byoutsiders


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LJM1 SPE

Responsible for 20% of SPE restatement or$100 millionShould have been consolidatedan error in

judgment by Andersen (per Andersen)

After Andersens initial review in 1999, Enroncreated a subsidiary within LJM1, referred to asSwap Sub. As a result, the 3% rule for residualequity was no longer met.

Andersen was reviewing this transaction againat the time problems were made publicinvolved complex issues concerning thevaluation of various assets and liabilities.


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Enrons Disclosures

SEC Regulation S-K requires description ofrelated-party transactions that exceed $60K andfor which an executive has a material interest

Related Party Transactions footnote includedin Forms 10-Q and 10-K beginning with secondquarter of 1999 through 2nd quarter of 2001From 2000 annual report Enron entered into

transactions with limited partnerships whosegeneral partners managing partner is a seniorofficial of Enron. (Fastow)

E F t t Di l f


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Enrons FootnotesDisclosures ofEnron Partnership

Report Footnote Filed with theSEC

10QQ1 2000 Footnote 7 5/15/2000

10QQ2 2000 Footnote 8 8/14/2000

10QQ3 2000 Footnote 10 11/14/2000

10QQ1 2001 Footnote 8 5/15/200110QQ2 2001 Footnote 8 8/14/2001

10QQ3 2001 Footnote 4 11/19/2001

Th F Mi l di E i


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The Famous Misleading EarningsRelease on October 16, 2001

Headline: Enron Reports Recurring Third QuarterEarnings of $0.43 per diluted share

Projected recurring earnings for 2002 of $2.15

If you dug deep, you learned that Enron actually lost

$618 million or $0.84 per sharethey had mislabeled$1.01 billion of expenses and losses as non-recurring.

Shockingly, there was no balance sheet or cash flowinformation with the release

There was no mention of a $1.2 billion charge againstshareholders equity, including what was described as a$1 billion correction to an accounting error. (This waslearned a couple of days later.)

Did t A S E


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Didnt Anyone See EnronsProblems?

Enron grew to be the 7th largest Fortune100 company while media hype and thestock market euphoria reigned

But in late 2000 negative reports began tooriginate from some skeptics


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The Skeptics

Jonathan Weil, Energy traders cite gains,but some math is missing, The WallStreet Journal (Texas ed.) 9/20/2000

Feb. 2001 analyst report from John S.Herold, Inc. by Lou Gagliardi and JohnParry

Bethany McLean, Is Enron overpriced?Fortune, 3/5/2001


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Enrons Cash Flows

Enrons cash flows bore little relationship toearnings (a lot due to mark to market.) On thebalance 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


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Enrons Cash Flow Ratio

-2

-1

0

1

2

3

4

3months

6months

9months

Year

1998

1999

2000

2001

Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000,1st two quarters in 2001.


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Role of Andersen

Was paid $52 million in 2000, the majority for non-audit relatedconsulting services.Failed to spot many of Enrons lossesShould have assessed Enron managements internal controls onderivatives tradingexpressed approval of internal controls during1998 through 2000

Kept 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 indicted

Went out of businessMy partner friend I had $4 million in my retirement account and I lost itall. Some partners who transferred to other firms now have twoequity loans and no retirement savings.

R l f I t t & C i l


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Role of Investment & CommercialBanks

Enron paid several hundred million in fees,including fees for derivatives transactions.

None of these firms alerted investors aboutderivatives problems at Enron.

In October, 2001, 16 of 17 security analystscovering Enron still rated it a strong buy orbuy.

Example: One investment advisor purchased7,583,900 shares of Enron for a state retirementfund, much of it in September and October, 2001


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Role of Law Firms

Enrons outside law firm was paidsubstantial fees and had previouslyemployed Enrons general counsel

Failed to correct or disclose problemsrelated to derivatives and special purposeentities

Helped draft the legal documentation forthe SPEs


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Role of Credit Rating Agencies

The three major credit rating agenciesMoodys,Standard & Poors and Fitch/IBCAreceived substantialfees from Enron

Just weeks prior to Enrons bankruptcy filingafter most

of the negative news was out and Enrons stock wastrading for $3 per shareall three agencies still gaveinvestment grade ratings to Enrons debt.

These firms enjoy protection from outside competitionand liability under U.S. securities laws.

Being rated as investment grade was necessary tomake SPEs work


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So Why Did Enron Happen?

Individual and collective greedcompany, itsemployees, analysts, auditors, bankers, rating agenciesand investorsdidnt want to believe the companylooked too good to be true

Atmosphere of market euphoria and corporate arroganceHigh risk deals that went sour

Deceptive reporting practiceslack of transparency inreporting financial affairs

Unduly aggressive earnings targets and managementbonuses based on meeting targets

Excessive interest in maintaining stock prices


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Will there be another Enron?

Yes Recent 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.)No Sarbanes-Oxley Bill contains many key provisions

Executive 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-Erron .ppt