Earnings Management & Different Scandals

Financial Statements AnalysisInstructor: Jibran Sheikh

Jibransheikh@comsats.edu.pk

Why the Scandals

• Accounting fraud does tend to come in waves, and is discovered most often after a market collapse, since no one is interested in investigating much when stock prices are high and everyone’s making big money.

Barbara Toffler

Enron

• Fortune Magazine selected Enron as "America's most innovative company" for six straight years from 1996 to 2001.

• Stogy gas transmission company started with massive debt

• Formed a gas trading company, expanded into electricity, risk mgt. & telecom; expanded internationally

• Based on economic reality, many of these were failures

• Based on earnings magic, all were successful

Enron 2

• Gas trading: deregulated & volatile, need for spot market purchases & related derivatives, volatility increased trading profits

• Problem of massive & potential junk bond ratings

• Use of special purpose entities (SPEs) to reduce perception of too much debt

Enron 3

• Importance of meeting quarterly earnings, initially through cost savings, then increasingly more gimmicks

• Scheme 1: revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front-loading profits

• Scheme 2: using SPEs in virtually any complex context to record earnings

Enron 4

• SPEs were mishandled• CFO Andy Fastow manipulated these for his

own enrichment + independence problem• Particularly shady SPEs approved by auditor

Arthur Andersen, attorneys, & board of directors; accommodated by investment banks & no obvious oversight by SEC

Enron 5

• Some operations were successful, others were major blunders; the net effect was to dramatically increase financial risk, & Enron’s unwillingness to disclose real losses as they occurred

• Mid-2001: stock price dropped, executives bailed out of stock options, bond ratings back to junk status

• Enron restated earnings in 3rd quarter 2001• With no credibility, Enron declared bankruptcy in

December 2001, the biggest bankruptcy until …

WorldCom

• Bernie Ebbers started long-distance telecom company in 1983 (name changed to WorldCom in 1995)

• Growth through merger strategy (note earnings magic of business combinations)

• WorldCom “looked” solid, with total assets of $104 billion & debt-to-equity of 79.3%, but half the assets were goodwill & other intangibles

• In 2002 internal audit found operating expenses capitalized

WorldCom 2

• New auditor KPMG reviewed the books, old auditor Arthur Andersen was fired; Ebbers resigned in April

• In June 2002 WorldCom announced $3.8 billion in accounting errors, mainly by capitalizing “line costs” (fees to other telecom companies for network access rights—these are operating expenses)

WorldCom 3

• WorldCom restated earnings, CFO was fired• Actual capitalization misstatements totaled

over $11 billion• WorldCom filed for bankruptcy in July 2002,

replacing Enron as the largest bankruptcy in US history

Tyco

• Starting as a research lab, Tyco became a conglomerate through acquisitions

• CEO “Deal a Day Dennis” Kozlowski acquired 750 companies, using the earnings magic of combination accounting

• Acquisition of CIT Group a particular fiasco, resulting in big losses (& extra financial reporting that showed many of Tyco’s manipulation shenanigans

Tyco 2

• Big loss on sale of CIT & total $9.4 billion loss for 2002

• Kozlowski indicted for evading taxes & “raiding” Tyco• Tyco did not go bankrupt• Despite obvious manipulation & deception on a vast

scale, it’s not clear that the company actually engaged in criminal acts (court cases pending)

Adelphia

• John Regas transformed a cable franchise into a communications empire

• Restated earnings in 2002, including billion in off-balance-sheet “co-borrowing agreements”

• Filed for bankruptcy in June 2002• Regas & others charged with financial fraud

What do Enron, WorldCom & Tyco Have in Common

• Deception on a massive scale—manipulation at the highest levels of the companies

• Growth through acquisitions plus related Business combination accounting abuse

• Importance of meeting quarterly earnings targets at all costs—related enrichment of senior executives

• Accommodating auditors, attorneys & boards of directors

• All three restated earnings

What Happened at Arthur Andersen?

• One of original Big 8, founded in 1913, stressing integrity & consistency

• Especially since the 1980s, AA had a history of “aggressive auditing,” clients became too valuable to defy (Toffler)

• Associated with many of the big scandals: Sunbeam, Waste Management, Enron, WorldCom & Global Crossing

• Found guilty of obstruction of justice in Enron case

Some closing commentsRevsine (1991) “Research evidence is consistent with the notion that managers use latitude in existing financial reporting to benefit themselves”.Tweedie “I find it frightening some people are just lifting the numbers and using them as sancrosant ... some of them would be better off driving buses -it would be safer for a lot of us”

AUSTIN MITCHELL: “CREATIVE ACCOUNTING COULD BE BETTER CALLED MANIPULATIVE ACCOUNTING BECAUSE IT HAS MORE IN COMMON WITH THE MASSAGE PARLOUR THAN THE CREATIVITY OF THE LITERARY SALON”.