A Look Back at One of the Biggest Corporate Scandals in U.S.
History
FINA 503
DATE: 02/18/10
JOSE CINTRON,MBA
1
Enron & WorldCom will change the world
2WORLDCOM: In 1998, the telecommunications industry began to
slow down and WorldCom's stock was declining. CEO came under
increasing pressure from banks to cover margin calls on his
WorldCom. Beginning in 1999 and continuing through May 2002,
WorldCom used shady accounting methods to mask its declining
financial condition by falsely professing financial growth and
profitability to increase the price of WorldCom's stock.
3HOW THIS HAPPEN The fraud was accomplished in two main ways.
First, WorldCom's accounting department underreported 'line costs'
(expenses with other telecommunication companies) by capitalizing
these costs on the balance sheet rather than properly expensing
them. Second, the company inflated revenues with bogus accounting
entries from corporate unallocated revenue accounts.
4
Revenues xxx (no change)
COGS xxx (no change)
Computer expenses: xxx (Huge Decrease)
Fees companies phone networks: xxx (Huge Decrease)
NET INCOME xxx (Huge Increase)
How the Fraud took place
CFOs directions affected the income statement:5Overstating Asset
Frauds (WorldCom)Overstatement of current assets(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
HOW WAS DISCOVER The first discovery of illegal activity was by
WorldCom's own internal audit department who uncovered $3.8 b. of
the fraud in June 2002. The company's audit committee and board of
directors were notified of the fraud. The Securities and Exchange
Commission (SEC) launched an investigation. By the end of 2003, it
was estimated that the company's total assets had been inflated by
around $11 billion.
7
8Largest Bankruptcy Filings CompanyAssets (Billions)When Filed1.
WorldCom$103.9July 20022. Enron$63.4Dec. 20013. Conseco$61.4Dec.
20024. Texaco$35.9April 19875. Financial Corp of America$33.9Sept.
19886. Global Crossing$30.2Jan. 20027. PG&E$29.8April 20018.
UAL$25.2Dec. 20029. Adelphia$21.5June 200210. MCorp$20.2March
1989
9Z-score Analysis for WorldCom The Z-score formula for
predicting bankruptcy. Ratio Definition 1999 2000 2001X1 Working
capital/total assets (0.08) (0.08) (0.00)X2 Retained earnings/total
assets (0.01) 0.03 0.04X3 Earnings before interest and taxes/total
assets 0.08 0.08 0.02X4 Market value of equity/book value of total
liabilities 3.58 1.13 0.54X5 Sales/total assets 0.39 0.40 0.34 Z
Z-score 2.697 1.274 0.798Z > 2.99 -Safe 1.8 < Z < 2.99
-Grey Z < 1.80 -Distress
Z-scores for WorldCom based on its annual 10-K reports .We found
that the company indeed experienced a rapid deterioration in its
Z-score.
10 CONSOLIDATING BALANCE SHEET (10K SEC) (IN MILLIONS) AT
DECEMBER 31, 2000
WORLDCOM MCI GROUP ELIMINATIONS WORLDCOM Current
assets...................................... $ 9,068 $ 2,312
$(1,625) $ 9,755 Property and equipment,
net......................... 35,177 2,246 -- 37,423 Goodwill and
other intangibles...................... 36,685 9,909 -- 46,594
Other assets........................................ 4,963 168 --
5,131 Total assets...................................... $85,893
$14,635 $(1,625) $98,903
Current liabilities................................. $14,213 $
5,085 $(1,625) $17,673 Long-term
debt...................................... 11,696 6,000 -- 17,696
Noncurrent liabilities.............................. 3,648 1,087 --
4,735 Minority interests.................................. 2,592 --
-- 2,592 Company redeemable preferred securities...... 798 -- --
798 Shareholders' investment............................ 52,946
2,463 -- 55,409 Total liabilities and shareholders' investment....
$85,893 $14,635 $(1,625) $98,903 ======= ======= ======= =======$
9,755 / 17,673=(7,918) WORKING CAPITAL OR .55 CURRENT RATIOTHE
HIGHER THIS RATIO THE BETTER TO MEET THEIR CURRENT OBLIGATIONS.
11
WorldCom Statement of Cash flowCash flows from operating
activities: 2000 2001 Net income Operating Activities $4,153 $1,501
Originally Reported Revised as of April 15, 2004 2000 2001 2002 N
Net loss $ -48,909 -15,597 -9,173
HOW ENDED On July 21, 2002, WorldCom filed for Chapter 11
bankruptcy protection, the largest such filing in United States
history. The company emerged from Chapter 11 bankruptcy in 2004
becoming MCI. On March 15, 2005 Bernard Ebbers (CEO) was found
guilty of all charges and convicted on fraud, conspiracy and filing
false documents with regulators. He was sentenced to 25 years in
prison.
I dont belief this happen to me .
13What do these dates have in common?December 2, 2001
July 19, 2002
August 31, 2002Enron declares bankruptcy
MCI WorldCom declares bankruptcy
Arthur Anderson agrees to stop auditing public companies
14How did this happen?Earnings pressureLack of mandated
disclosure of company reporting modelMinimal oversight into
corporate business practicesNo documented or enforced internal
controlsDependency on consulting fees Assumed good intent of their
clientInability to continuously monitor a companys internal
controlsUnable to identify violations of internal controls
Corporate Issues Audit Firm Issues
15How Did Congress Respond?Sarbanes Oxley Act
16Sarbanes Oxley ActSection 103: Your auditor (and therefore,
you should) maintain all audit related records, including
electronic ones, for seven years. Section 201: Firms that audit
your companys books can no longer provide you with IT related
services. Section 301: You must provide systems or procedures that
allow employees to communicate effectively with the audit
committee. Highlights
17Sarbanes Oxley ActSection 302: Your CEO and CFO must sign
statements verifying the completeness and accuracy of financial
reports. Sections 404 CEOs, CFOs and outside auditors must attest
to the effectiveness and accuracy of financial reports. Section
409: Companies must report material changes in their financial
conditions on a rapid and current basis. The act calls it real-time
disclosure but is unclear on what it means. Highlights
(continued)
18SarbanesOxley ActBehaviorConsequenceAny CEO or CFO who
recklessly violates his or her certification of the companys
financial statements.If willfully violates. Fine of up to
$1,000,000 and/or up to 10 years imprisonment.
Fine of up to $5 million and/or up to 20 years imprisonment. Any
person who corruptly alters, destroys, conceals, etc., any records
or documents with the intent of impairing the integrity of the
record or document or use in an official proceeding. Fine and/or up
to 20 years imprisonment. SarbanesOxley Law19Sarbanes - Oxley
Impact on Information Systems
20The 3 Cs of Sarbanes-OxleyThe jobs of the CEO, CFO & CIO
got tougher on July 30, 2002 -- the day the Sarbanes-Oxley Act was
signed. The legislation requires significant changes to financial
practices and corporate governance, and touches all corporate areas
-- including technology. For the first time ever, the CFO and CEO
can look a CIO in the eye and say, 'Guess what, you're on the hook
with us.'
CEOs, CFOs and CIOs
21System Control ExamplesFinancial Statement GenerationReport
parameter changes are documented Data that generates financial
statements is accurateInventory Item Creation Costing is accurately
assignedPurchasingApproved suppliers are usedApproval limits cannot
be easily manipulatedCustomer CreationDuplicate customersCredit
limits22Oversight of Financial Data ExamplesStandard Data Entry is
EnforcedAccurate reportingSegregation of Duties Separation of
functions to minimize risk of fraudAudit changes to sensitive
dataApproval processes for creation of financial dataOversight into
Financial ProcessesEnsure all month/year end activities are
completed
23Benefits of the New Oxley Act1. Increased confidence of
CEO/CFO in meeting requirements2. Improved coordination of Company
Management Team3. Improved and clarified Corporate Governance
process4. Systematized process for early identification of business
risks/ whistle blowing issues/incident management5. Systematized
approach to dealing with change (i.e., transactions, personnel,
accounting principles, internal controls and operating procedures)
6. Increased operational effectiveness
24The Enron ScandalThe Enron scandal was a corporate scandal
involving the American energy Enron Corporation, the world's
leading energy company and the accounting, auditing, and
consultancy firm Arthur Andersen.On October 16, 2001, in the first
major public sign of trouble, Enron announces a huge third-quarter
loss of $618 million.
25The Enron ScandalOn October 22, 2001, the Securities and
Exchange Commission (SEC) begins an inquiry into Enrons accounting
practices.
On December 2, 2001, Enron files for bankruptcy, the largest
bankruptcy in US history up to that time
26 ConsequencesThousands of employees lost their jobs and even
their life savings in 401(k) plans tied to the energy company's
stock. Disastrous falling down on the whole stock market during the
following months, especially in the financial service
industry.Arthur Andersen, which at the time was one of the five
largest accounting firms in the world, was dissolved.
27 How this happenThe company used shortcomings of Rule-Based US
GAAP , special purpose entities, and poor financial reporting to
hide billions in debt from failed deals and projects. Enron's audit
committee failed to follow up on high-risk accounting issues
Andersen was pressured by the company to ignore accounting
practices.
28 How this happen.Continued 1993-2001: Enron senior management
used. Complex and foggy accounting schemesto reduce Enrons tax
payments;to inflate Enrons income and profits;to inflate Enrons
stock price and credit rating;to hide losses in off-balance-sheet
subsidiaries;to engineer off-balance-sheet schemes to direct money
to themselves, friends, and family;to fraudulently misrepresent
Enrons financial condition in public reports.
29 Example of one scheme Enrons creation of over 3000 (!)
partnerships started about 1993 when it teamed with Calpers (Calif.
Public Retirement System) to create JEDI (Joint Energy Development
Investments) fund. Why partnerships? According to GAAP , as long as
Enron could find another partner to take at least a 3% stake, Enron
was not required to report the partnerships financial condition in
its own financial statements.
30 Example of one scheme Continued Enron used partnerships to
hide bad bets it made on speculative assets by selling these assets
to the partnerships in return for IOUs backed by Enron stock as
collateral! (over $1 billion by 2002) In November 1997, Calpers
wanted to cash out of JEDI. To keep JEDI afloat, Enron needed a new
3% partner. It created another partnership Chewco to buy out
Calpers stake in JEDI.
31 Example of one scheme Continued Chewco needs $383 million to
give Calpers It gets.. $240 million loan from Barclays bank
guaranteed by Enron $132 million credit from JEDI (whose only asset
is Enron stock)Chewco still must get 3% from some outside source to
avoid inclusion in Enrons books
32 Example of one scheme Continued Chewco Capital Structure:
Outside 3%$115,000 from M. Kopper (worked at the time for
Enron)$11.4 million loans from Big River and Little River (two new
companies formed expressly by Enron for this purpose who get a loan
from Barclays Bank)
Example of one scheme ContinuedBarclays Bank begins to doubt the
strength of the new companies Big River and Little River. It
requires a cash reserve to be deposited (as security) for the $11.4
million dollar loans.This cash reserve is paid by JEDI, whose net
worth by this time consists solely of Enron stock, putting Enron in
the at-risk position for this amount
Profit to Enron from all this?
$10 million in guarantee fee + fee based on loan balance to
JEDI. A total of $25.7 million revenues from this source. Increase
in price of Enron stock held by JEDI. Enron recognized $126 million
in the first quarter of 2000 from this.But everything began to fall
apart when Enrons share price started to drop in Fall 2000.
Generally Accepted Accounting Principles prior to 2002.Auditing
companies often consult for the companies they audit (conflict of
interest).Audit company partners often later accept jobs from their
client companies.Companies often retain the same auditing company
for long periods of time.Auditing companies have been allowed to
police themselves.Appointment of auditor company is in theory by
shareholders but in practice by senior management
36REFERENCESWorldCom Scandal-Retrieved-February15, 2010
from:http://www.associatedcontent.com/article/162656/worldcomWorldCom
finds accounting errors-February15, 2010
from:http://www.networkworld.com/news/2002/0626wcom.html
http://secfilings.com/searchresultswide.aspx?TabIndex=2&FilingID=317601&type=html&companyid=11628&ppu=%2fdefault.aspx%3fticker%3d%26amp%3bname%3dWORLDCOM%26amp%337
