Unit 7: Financial Statement Fraud
and the Enron Scandal
Professor Thomas Genovese
Financial Statement Frauds
1. Revenue/Accounts Receivable Frauds
(Global Crossing, Quest, ZZZZ Best)
2. Inventory/Cost of Goods Sold Frauds
(PharMor)
3. Understating Liability/Expense Frauds
(Enron)
4. Overstating Asset Frauds (WorldCom)
5. Inadequate
Disclosure/Misrepresentation (Bre-X
Minerals)
1. Revenue Related Financial
Statement Frauds
By far, the most common accounts
manipulated when perpetrating financial
statement fraud are revenues and/or
accounts receivable.
Revenue-Related Fraud Schemes
Two reasons for the prevalence of revenuerelated financial statement fraud:
1. The availability of acceptable alternatives
for recognizing revenue.
2. The ease of manipulating net income
using revenue and receivable accounts.
Revenue-Related Fraud Schemes
Common Revenue-related Fraud Schemes:
 Related-party transactions
 Sham sales
 Bill-and-hold sales
 Side agreements
 Consignment sales
 Channel stuffing
 Lapping or kiting
Revenue-Related Fraud Schemes
Common Revenue-related Fraud Schemes:
 Redating or refreshing transactions
 Liberal return policies
 Partial shipment schemes
 Improper cutoff
 Round-tripping
Identifying Revenue-Related Fraud
Ways to detect:
1. Analytical symptoms
2. Accounting or documentary symptoms
3. Lifestyle symptoms
4. Control symptoms
5. Behavioral and verbal symptoms
6. Tips and complaints
2. Overstating Inventory
The second most common way to
commit financial statement fraud.
Beginning Inventory
Purchases
Goods Available for sale
Ending Inventory
Cost of Goods Sold
Income
OK
OK
OK
High
Low
High
Inventory & Cost of Goods Sold
Frauds
The Effect of Inventory Overstatement
Income Statement
When inventory is overstated, then…
Gross Revenue (Sales)
Are not affected
Sales Returns
Are not affected
Sales Discounts
Are not affected
Net Revenues (Sales)
Are not affected
Cost of Goods Sold
Gross Margin
Expenses
Net Income
Is understated
Is overstated
Are not affected
Is overstated
Inventory & Cost of Goods Sold
Frauds
Most common inventory-related
fraud schemes:
 Double counting
 Capitalizing
 Cutoff problems
 Overestimating inventory
 Bill-and-hold sales
 Consigned inventory
3.
Understatement of Liabilities
Fraud
Schemes that understate liabilities
 Understating accounts payable
 Understating Accrued Liabilities
 Recognizing Unearned Revenue as Earned
Revenue
 Under recording Future Obligations
 Not Recording or Under recording Various
Types or Debt (Notes, Mortgages, etc.)
 Omission of Contingent Liabilities
Understatement of Liabilities Fraud
Ways to detect understatement of
liabilities
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Abnormal analytical symptoms
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Documentary symptoms
4. Asset Overstatement Frauds
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Overstatement of current assets (e.g.
marketable securities)
Overstating pension assets
Capitalizing as assets amounts that should be
expensed
Failing to record depreciation/amortization
expense
Overstating assets through mergers and
acquisitions
Overstating inventory and receivables (covered
earlier)
Overstatement of Assets Fraud
Schemes that Overstate Assets
Overstatement of Assets Fraud
Ways to detect overstatement of assets
 Compare changes and trends in financial
statement account balances
 Compare changes and trends in financial
statement relationships
 Compare financial statement balances with
nonfinancial information or things, such as
the assets they represent
 Compare financial statement balances and
policies with those used by other similar
companies
4. Disclosure Frauds
Three Categories of Disclosure Frauds:
1. Overall misrepresentations about the nature of the
company or its products, usually made through
news reports, interviews, annual reports, and
elsewhere
2. Misrepresentations in the management
discussions and other non-financial statement
sections of annual reports, 10-Ks, 10-Qs, and
other reports
3. Misrepresentations in the footnotes to the financial
statements
Inadequate Disclosure Fraud
Ways to identify Disclosure Fraud
 Look for inconsistencies between
disclosures and information in the
financial statements
 Inquire of management concerning
related-party transactions, contingent
liabilities, and contractual obligations
 Review a company’s files and records with
the SEC and other regulatory agencies
Why so many financial statement
frauds all of a sudden?
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Moral decay in society
Executive incentives
Wall Street expectations—rewards for shortterm behavior
Nature of accounting rules
Behavior of CPA firms and lawyers
Greed by investment banks, commercial banks,
and investors
Education failures
Executive Incentives

Meeting Wall Street’s Expectations
◦ Stock prices are tied to meeting Wall Street’s earnings
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 options—far
exceeds compensation (tied to stock price)
◦ Performance is based on earnings & stock price
Market Incentives
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.
Firm A
Which firm would you invest in?
Firm B
Nature of Accounting Rules

In the U.S., accounting standards are “rulesbased” 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.
Auditors—the CPAs
Failed to accept responsibility for fraud
detection (SEC, Supreme Court, and the public
expects them to detect fraud).
 Became greedy--$500,000 per year per partner
compensation wasn’t enough.
 Audit became a loss leader
◦ Easier to sell lucrative consulting services
from the inside
◦ Became largest consulting firms in the U.S.
very quickly
 A few auditors got too close to their clients
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Enron’s History
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In 1985 after federal deregulation of natural gas
pipelines, Enron was born from the merger of Houston
Natural Gas and Inter North, a Nebraska pipeline
company.
Enron incurred massive debt and no longer had
exclusive rights to its pipelines.
Needed new and innovative business strategy.
Kenneth 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
Bank”—to buy and sell gas.
Enron’s History (cont’d)
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Created Energy derivative.
Lay created a new division in 1990 called Enron Finance
Corp. and hired Skilling to run it.
Enron 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 handsomely—so long as they produced.
Fastow was a Kellogg MBA hired by Skilling in 1990—
Became CFO in 1998
Created 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 Motivation
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Enron delivered smoothly growing earnings (but not cash flows.) Wall
Street took Enron on its word but probably did not understand its
financial statements.
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It was all about the price of the stock. Enron was a trading company
and Wall Street normally does not reward volatile earnings of trading
companies. (For example, Goldman Sacks is a trading company. Its
stock price was 20 times earnings while Enron’s was at one time 70
times earnings.)
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In its last 5 years, Enron reported 20 straight quarters of increasing
income.
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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 Options
Enron (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.
Enron’s Corporate Strategy
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Enron’s core business was losing money It shifted its focus from
bricks-and-mortar energy business to trading of derivatives (most
derivatives profits were more imagined than real. Employees
systematically lied and misstated their profits and losses in order to
make their trading businesses appear less volatile than they were).
During 2000, Enron’s derivatives-related assets increased from $2.2
billion to $12 billion and derivates-related liabilities increased from
$1.8 billion to $10.5 billion
Enron’s top management gave its managers a blank order to “just
do it”.
Thus, its business had no natural boundaries. Deals in unrelated
areas such as weather derivatives, water services, metals trading,
broadband supply and power plant were all justified.
Role of Enron’s Use of Special Purpose
Entities (SPEs)
To hide bad investments and poor-performing assets
(Rhythms Net Connections). Declines in value of assets
would not be recognized by Enron (Mark to Market).
 To “manage” earnings—(LJM1 and Chewco)
 To quickly execute related-party transactions at desired
prices. (LJM1 and LJM2)
 To report over $1 billion of false income.
 To hide debt (Borrowed money was not put on financial
statements of Enron)
 To manipulate cash flows, especially in 4th quarters
 Many 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.
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Role of Arthur Andersen
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Was paid $52 million in 2000, the majority for non-audit related
consulting services.
Failed to spot many of Enron’s losses.
Should have assessed Enron management’s internal controls on
derivatives trading.
Expressed approval of internal controls during 1998 through 2000
Kept a whole floor of auditors assigned at Enron year around.
Enron was Andersen’s second largest client
Provided both external and internal audits
CFOs and controllers were former Andersen executives
Accused of document destruction—was criminally indicted.
Went out of business.
Role of Law Firms
Enron’s outside law firm was paid
substantial fees and had previously
employed Enron’s general counsel
 Failed to correct or disclose problems
related to derivatives and special purpose
entities
 Helped draft the legal documentation for
the SPEs.
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Role of Credit Rating Agencies
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The three major credit rating agencies—Moody’s,
Standard & Poor’s and Fitch/IBCA—received substantial
fees from Enron.
Just weeks prior to Enron’s bankruptcy filing—after
most of the negative news was out and Enron’s stock
was trading for $3 per share—all three agencies still
gave investment grade ratings to Enron’s debt.
Being rated as “investment grade” was necessary to
make SPEs work
2001 - Notable Events
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Jeff Skilling left on August 14—gave no reason
for his departure.
By mid-August , the stock price began to fall
Former CEO, Kenneth Lay, returned in August
Oct. 16…announced $618 million loss but not
that it had written down equity by $1.2 billion
October…Moody’s downgraded Enron’s debt
Nov. 8…Told investors they were restating
earnings for the past 4 and ¾ years
Dec. 2…Filed bankruptcy
So Why Did Enron Happen?
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Individual and collective greed—company, its employees,
analysts, auditors, bankers, rating agencies and
investors—didn’t want to believe the company looked
too good to be true
Atmosphere of market euphoria and corporate
arrogance.
High risk deals that went sour
Deceptive reporting practices—lack of transparency in
reporting financial affairs
Unduly aggressive earnings targets and management
bonuses based on meeting targets.
Excessive interest in maintaining stock prices.
Will there be another Enron?
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Yes
◦ Trending increases in the number of financial
statement frauds:
 1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)
◦ Incentives still there (e.g., Stock Options, etc.)
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No
◦ Sarbanes-Oxley Bill contains many key provisions
 Executive “sign off”
 Requirement to have internal controls
 Rules for accountants (mandatory audit partner rotation;
Oversight Board, limitations on services, etc.)