Corporate Accounting
Scandals & Insurance
Agenda for Today
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The diminishing audit quality of the 1990s
The bubble burst
Enron, WorldCom, Global Crossing, Tyco,
Adelphia, etc…
Reform!!! Sarbanes-Oxley and newfound
corporate accountability
Newfound litigation grounds  New Need for
Insurance!!!
Why so many financial statement
frauds all of a sudden?
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Good economy was masking many problems
Moral decay in society
Executive incentives
Wall Street expectations—rewards for short-term
behavior
Nature of accounting rules
Behavior of CPA firms
Greed by investment banks, commercial banks, and
investors
Educator failures
These Are Interesting Times
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Number and size of financial statement frauds are
increasing
Number and size of frauds against organizations are
increasing
Some recent frauds include several people—as
many as 20 or 30 (seems to indicate moral decay)
Many investors have lost confidence in credibility of
financial statements and corporate reports
More interest in fraud than ever before—now a
course on many college campuses
Why Was There Earnings
Management?
What is Earnings Management?
Basically, it is manipulating the financial
statements of a company to misrepresent the
true financial health of the company.
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.
Firm A
Firm B
Which firm will have the higher stock price?
Nature of Accounting Rules
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In the U.S., accounting standards are “rules-based”
instead of “principles based.”
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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
can’t do this…because it isn’t GAAP…”
It is impossible to make rules for every situation
Why Was There Earnings
Management?
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Reasons are probably wide and varied.
Complex problem.
Earnings management almost became the
norm in corporate America.
Corporations needed to manage their
earnings to remain competitive with other
companies.
Why Was There Earnings
Management?
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Audit quality was insufficient.
Competition for business was driving the
price of audits down. Not much of a premium
paid for having accurate audits.
Accounting firms focusing more on profitable
services like consulting.
Why Was There Earnings
Management?
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Financial service firms offered consulting
services in addition to audits.
Consulting is Advisory services to help senior
management improve the effectiveness of
corporate strategy, process, or operations by
assessing business needs and reviewing
business functions, plans and directions.
Why Was There Earnings
Management?
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Possible conflict of interest with accounting
firms providing both audit services and
consulting services.
Audit partners becoming more “friendly” with
upper management. After all, they want to
keep business!
Audit partners compensated more on
bringing in business than on their technical
skills.
The Scandals
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The culmination of the aforementioned
accounting problems was the bubble burst of
the late 1990s and the early 2000s.
Some companies that we’ve all heard of
failed as a result of corruption and fraud:
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Enron
WorldCom
Global Crossing
Adelphi
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
Enron
Enron
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Using Special Purpose Entities as a haven
for debt, synthetic profit.
Enron created several hundred of these
special purpose entities.
Auditors failed to stop the misstatements.
Investors lost nearly $60 Billion in the
collapse of the 5th largest corporation in the
US.
Enron
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In 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 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—the reward system was eat what you kill
Fastow was a Kellogg MBA hired by Skilling in 1990—
Became CFO in 1998
Started Enron Online Trading in late 90s
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
Enron’s Use of Special Purpose
Entities (SPEs)
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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 management—Blockbuster 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 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
What did Arthur Andersen Do?
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Andersen employees ordered tons of Enron
paperwork to be shredded before the
investigation of the fraud began.
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Rumor: U of I Arthur Andersen interns during
2001 claim to have shredded a ton of documents!
Enron
WorldCom
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Capitalized their line costs.
Line costs should have been expenses,
however, the false capitalization overstated
WorldCom's assets by billions of dollars.
Global Crossing
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Management had “unrealistic” revenue
targets.
Tried everything they could to meet the
targets.
“Swapped” fiber optic capacity to boost
revenue.
Revenue restatement of $19 million,
overstated assets by $1.2 billion
Adelphi
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Several Vacation Homes and luxury
apartments in Manhattan
Several private jets
Construction of a world-class 18-hole golf
course
Majority ownership of the Buffalo Sabres
$700,000 membership in an exclusive golf
club
Reaction
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Investor backlash
Billions lost in the frauds of 2001, 2002.
US government determined to deter frauds of
this magnitude in the future.
Sarbanes-Oxley
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Created in 2002 in the wake of the previously
mentioned accounting scandals.
Created accountability among corporate
executives.
SOX 2002
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Section 302 pertains to liability.
CEO/CFO must sign off on financial statements- can
be held criminally liable if financials are false.
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Material Accuracy- The amount listed in the financials has
to be an accurate reflection of where the company is at.
Fair presentation of financial information
Disclose controls- so material information about a company
gets presented to top management.
Internal Accounting controls- provide assurance that the
financials conform to GAAP.
SOX 2002 Section 302
Contin…
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Based on the officer’s knowledge, the
financial statements do not contain any
material misstatements or omissions.
The financial statements fairly state the
company’s financial position and results from
past operation.
Accountability!!!!
New Grounds for Litigation
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In 2002, the U.S. Congress passed the Sarbanes
Oxley Act, which has had a major impact on the
liability of directors and officers. Although this
legislation protects shareholders and is expected to
improve corporate governance, it also bears the risk
of increasing the number of litigations. This act
establishes new fines and penalties for the
corporate board for securities fraud violation
involving accounting irregularities and financial
fraud.
http://www.aon.com/risk_management/d_and_o.jsp
Directors & Officers Insurance
New Demand for Director’s
and Officer’s insurance
Think of the lawsuits facing some of Enron’s
officers
Others Paying Out From Enron
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DIRECTORS:
*Robert Belfer- a director of Enron
*Norman Blake- a director of Enron
*Ronnie Chan- a director of Enron
*John Duncan- a director of Enron
Paulo Ferraz-Pereira- a director of Enron
*Joe Foy- a director of Enron
*Wendy Gramm- a director of Enron
*Robert Jaedicke- a director of Enron
*Charles LeMaistre- a director of Enron
*Rebecca Mark-Jusbasche- Chairman and CEO of Enron International and later Vice
Chairman, and CEO of Azurix
John Mendelsohn- a director of Enron
Jerome Meyer- a director of Enron
Frank Savage- a director of Enron and a member of its Finance Committee
John Urquhart- a director of Enron and was senior advisor to the Chairman in 1998
John Wakeham- a director of Enron
Charls Walker- a director of Enron
Herbert Winokur- a director of Enron
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Class action suits in the Hundreds of millions of dollars range. Part
of which was paid out of pocket due to directors not carrying
adequate Directors and Officers Insurance.
New Demand for Director’s
and Officer’s insurance
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Think of the liability for Arthur Andersen’s
partners on the Enron account!!
Implications of Liability
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As a company officer, you are responsible for
not only your actions, but those of your
subordinates as well.
Most technical information within a company
gets passed up through the hierarchal layers
for the company from bottom to top.
Professional Liability
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Most CGL policies exclude professional
liability loss exposures.
Legal fees for defending professional
liabilities cases can be very costly.
Other Effects of Enron on DOL
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Approximately 50% of all Directors and Officers
Liability claims are tied to Employment Practices
Liability claims. Employees that were once silent
about workplace harassment and discrimination are
now speaking out and taking action against their
employers.
Plant closings, layoffs, and mergers and acquisitions
are commonplace events that are providing fertile
ground for multi-million dollar class action claims.
The case of Enron in late 2001, coupled with an
already large downturn in the economy, has further
affected the pricing for Directors and Officers liability.
D&O Insurance
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The cost for Director's and Officer's
Insurance has gone up dramatically, and the
exclusions for coverage have increased.
A Twist to Enron’s D&O
Policies
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Some of Enron’s D&L claims were not paid
because since the claims resulted from
misrepresentation, the insurance companies
refused to pay the claim!
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Self insurance retention
The Future?
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These scandals might be reduced by new
laws, but they won’t totally disappear.
Watch for new developments in regulations.
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SOX adjustments
More large D&O claims.
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Some material taken from the AICPA Website