BA 427 – Assurance and
Attestation Services
Lecture 14
Tales of Fraud that Keep Auditors
Awake at Night
Aggressive Accounting
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“One-time” charges
Restatements
Off-balance sheet transactions
“Pro forma” earnings releases
1991
Revenues
Cost of Sales
Gross Profit
General & Admin
:
Restructuring &
asset impairment
:
Net Income
1992
1993
1994
$16,210
7,729
8,481
5,049
:
$16,949
8,018
8,931
5,280
:
$16,641
8,063
8,578
4,989
:
$13,687
7,325
6,362
3,711
:
1,605
:
$17
220
:
$1,146
538
:
$(1,515)
340
:
$557
1996
Revenues
Cost of Sales
Gross Profit
General & Admin
Restructuring &
asset impairment
Net Income
1997
$16,244
8,326
7,918
4,410
:
$14,713
7,979
6,734
3,912
:
358
:
$1,288
1,290
:
$5
2001
Revenues
Cost of Sales
Gross Profit
:
General & Admin
Restructuring &
asset impairment
:
Net Income
2002
2003
$13,234
8,670
4,564
:
2,627
$12,835
8,225
4,610
:
2,530
$13,317
9,033
4,284
:
2,648
659
:
$76
98
:
$770
484
:
$265
Restatements
250
200
150
# of
restatements
100
50
0
1995 1996 1997 1998 1999
Restatements
Waste Management: exaggerated earnings
by 1.4 billion from 1992 to 1997
Off-balance Sheet Transactions
3% rule for the
Special Purpose
Entities
Also, mark to
market accounting
Pro Forma earnings releases
First quarter of 2001:
Pro Forma “Operating Loss”:
$ 49 million
GAAP loss:
$234 million
Pro Forma earnings releases
Third quarter of 1999:
Pro Forma net income:
$14 million
GAAP loss before one-time charges: $ 3 million
GAAP loss after one-time charges:
$67 million
Pro Forma earnings releases
Third quarter of 2001:
Pro Forma loss #1
$0.27 per share
Pro forma loss #2: $0.68 per share
GAAP loss:
$1.08 per share
Lecture 14 – Tales of Fraud

Accounting irregularities

Fraudulent financial reporting: the
intentional misstatement of financial
statements.

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Who gains and who loses when this
occurs?
Misappropriation of assets (theft)
Lecture 14 – Tales of Fraud

Prologue

McKesson & Robbins
Lecture 14 – Tales of Fraud
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McKesson & Robbins
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McKesson was a drug company
Listed on the NYSE
By the time the fraud was discovered, the
balance sheet contained $19 million of
fictitious assets, including $10 million of
fictitious inventories.
Fictitious assets accounted for 25% of
total assets on the balance sheet.
Lecture 14 – Tales of Fraud

McKesson & Robbins
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The principle shareholder and CEO of the
company, Philip Musica (alias F.D. Coster)
had been convicted of fraud twice before.
Musica committed suicide.
In 1939, the AICPA membership voted
that henceforth, receivables must be
confirmed, and inventory must be
observed, whenever these accounts are
material.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

The Savings and Loan crisis

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Over 1,000 (mostly small) savings and loan
institutions failed in the 1980s.
Reasons included deregulation, rising interest
rates, and regional real estate busts.
The S & L crisis gave rise to 4,000 lawsuits
against accountants and their firms, seeking an
estimated $15 billion.
The largest settlement was for over $400 million.
Malpractice insurance rates rose after the crisis,
and accounting firms became more risk averse.
Lecture 14 – Tales of Fraud

The Savings and Loan crisis

The best known audit failure of the S & L
crisis was Lincoln Savings and Loan.

Lincoln S & L chief Charles Keating was
convicted of fraud, racketeering and
conspiracy, and spent four years in jail.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

MiniScribe

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Manufacturer of computer disk storage
devices.
Founded in 1980, bankrupt in 1990.
1985: Lost a key sales contract with IBM.
In the late ’80s, tone at the top was all
wrong.

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The Chief of MiniScribe, Q. T. Wiles, was
abrasive and demanding.
Wiles would be convicted of securities fraud.
Lecture 14 – Tales of Fraud

MiniScribe
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Sales personnel were encouraged to meet
numbers in any way they could.

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Defective inventory recorded as first quality.
Goods were shipped that had never been
ordered
The allegation that made MiniScribe
famous: bricks shipped to bogus
customer warehouses.
Coopers & Lybrand was sued, settled in
1992 probably for about $40 million.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

Barings Bank
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A 200-year-old British Bank that helped
finance the Louisiana Purchase.
Barings collapsed on February 26, 1995
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Brought down by a single mid-level trader
and by an earthquake in Japan.
The single most spectacular business failure
that ever occurred as the result of fraud
without collusion by senior management.
The most spectacular repercussion of internal
control weaknesses.
Lecture 14 – Tales of Fraud
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Barings Bank
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A 28-year-old trader named Nick Leeson
earned millions of dollars for Barings by
speculating in Asian currency markets.
When Leeson’s luck reversed, he was able
to hide trading losses in a secret account.
Eventually, Leeson lost $1.4 billion for the
bank.
A lack of segregation of duties contributed
to Leeson’s ability to hide losses.
Lecture 14 – Tales of Fraud

Barings Bank
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Nick Leeson initially fled to Malaysia, made
his way to Germany, where he was
extradited to Great Britain.
Leeson was convicted of fraud
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He served several years in jail
He contracted colon cancer and
was released from jail
His wife divorced him
The movie Rogue Trader is
based on Leeson
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

Cendant
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HFS Inc and CUC International merged in
1997 to form Cendant.
Fraud by CUC surfaced in 1998. Revenues
had been inflated by $500 million over
three years.
At the time, it was the largest accounting
fraud in the nation’s history.
Cendant lost $14 billion in market value
following the public disclosure of the fraud.
Lecture 14 – Tales of Fraud
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Cendant
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An investigation of the fraud commissioned
by Cendant’s law firm revealed numerous
and pervasive instances in which CUC
officials inflated earnings from 1995 to
1997.
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17 of 22 operating units inflated earnings.
The report of the investigation accused
Cendant’s top management of “grave
negligence at best” and “willful ignorance at
worst.”
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

Sunbeam
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
In 1998, under Albert Dunlap (a.k.a.
Chainsaw Al), Sunbeam managed earnings
by recording sales without the related sales
returns, and sales for goods not yet
shipped.
The SEC alleged that $60 million of $186
million in income was fraudulent.
Lecture 14 – Tales of Fraud

Sunbeam
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An SEC lawsuit alleged securities fraud by
Dunlap, four senior managers, and a partner
at Arthur Andersen, all of whom settled the
charges without admitting or denying guilt.
At the time of the restatement, shareholders
lost $1.2 billion in stock value.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

Waste Management, Inc.
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In the late ’90s, the company inflated
earnings by $1.7 billion, in part by changing
depreciation schedules on PP&E.
The accounting scandal caused its stock
price per share to decline from $56 to $13.
The company settled a shareholder classaction lawsuit for $457 million.
Lecture 14 – Tales of Fraud

Waste Management, Inc.
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Arthur Andersen allegedly settled a malpractice
claim by the company for about $20 million.
The SEC accused A.A. of "knowingly or recklessly"
issuing false and misleading audit reports for Waste
Management for the years 1993 though 1996.
A.A. paid a $7 million civil fine imposed by the SEC.
Three Andersen partners, without admitting or
denying wrongdoing, agreed to an anti-fraud
injunction, a civil penalty, and a bar from appearing
or practicing in front of the SEC as an accountant,
with the possibility of reinstatement.
Lecture 14 – Tales of Fraud
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Waste Management, Inc.

According to SEC Director of Enforcement
Richard Walker:
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Arthur Andersen and its partners failed to stand
up to company management and thereby
betrayed their ultimate allegiance to Waste
Management’s shareholders and the investing
public. Given the positions held by these
partners and the duration and gravity of the
misconduct, the firm itself must be held
responsible for the false and misleading audit
reports.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud
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Tyco International
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Rumors of accounting irregularities surfaced in
1999.
In addition to the fraud allegations, there was
misappropriation of assets by senior management.
Former CEO Dennis Kozlowski and the former CFO
were accused of the theft of $600 million. They
contended that the Board had authorized it as
compensation.
In 2005, both men were sentenced to jail terms
ranging from 8 to 25 years.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

ImClone Systems
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Insider trading charges by senior
management.
On December 28, 2001, the company
announced that its drug Erbitux had failed to
receive F.D.A. approval. The company’s
founder, his daughter, his father, and his
friend Martha Stewart, sold over $10 million
in shares on December 27th and 28th.
Stewart served prison time for obstruction
of justice, and company founder Sam
Waksal is serving 7 years in prison.
Lecture 14 – Tales of Fraud
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ImClone Systems

A Congressional hearing revealed “a culture
of corruption” at ImClone dating back to
1986.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

WorldCom (MCI)
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From about 1999 until 2002, the company
inflated assets by about $11 billion.
In June 2002, the company’s internal audit
department uncovered $3.8 billion of the
fraud, related to the capitalization of
expenses.
The company had also inflated revenues
with bogus accounting entries.
Lecture 14 – Tales of Fraud
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WorldCom (MCI)
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KPMG had already replaced AA as the
company’s auditors. AA withdrew its 2001
audit opinion.
In 2005, Bernie Ebbers, former CEO, was
sentenced to 25 years in prison.
Numerous WorldCom accounting managers
had submitted guilty pleas by the time of
Ebbers’ trial.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

Parmalat
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An Italian dairy and food corporation;
Europe’s largest dairy.
The company declared bankruptcy in late
2003, after accounting fraud was
discovered.
Numerous shell companies were set up to
generate fake profits.
Lecture 14 – Tales of Fraud

Parmalat
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Founder Calisto Tanzi was charged with
financial fraud and money laundering. He
diverted at least $600 million from the
company to other family-owned businesses.
Grant Thornton had been the company’s
auditors while the fraud was committed.
Lecture 14 – Tales of Fraud
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The Savings and Loan crisis
MiniScribe
Barings Bank
Cendant
Sunbeam
Waste Management, Inc.
Tyco International
ImClone Systems
WorldCom
Parmalat
Enron
Lecture 14 – Tales of Fraud

Enron
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
Founded in 1985 by Kenneth Lay
Stock price rose
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311% from 1990 to 1998 (comparable to the
S&P 500
56% in 1999
87% in 2000
At December 31, 2000
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Market to Book was about 6
Market value to earnings was about 70
Lecture 14 – Tales of Fraud

Enron, events of 2001
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August 14: Jeff Skilling resigns
Mid-to-late August: Sheri Watkins writes her
now-famous anonymous letter to Ken Lay
October 12: An Arthur Andersen lawyer
contacts the Houston office regarding the
firm’s document retention policy, prompting
the shredding of documents.
October 16: Enron announces nonrecurring
charges of $1 billion
Lecture 14 – Tales of Fraud

Enron, events of 2001
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October 22: The SEC opens an investigation
into potential conflicts of interest.
November 8: Enron restates F/S for prior
four years, for a cumulative charge of $600
million.
November 28: Enron’s debt is downgraded
by credit agencies to junk bond status.
December 2: Enron files for bankruptcy.
Lecture 14 – Tales of Fraud

Enron
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Initially a natural gas pipeline company.
Then became a trader in natural gas, taking
advantage of the recent deregulation of the
natural gas market.
Diversified into trading and making markets
for electricity, coal, steel, paper and pulp,
water and broadband fiber optic cable.
Diversified into international energy
projects.
Lecture 14 – Tales of Fraud

Enron

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
The company became expert in managing
trading business risks.
The trading business adopted mark-tomarket accounting, recognizing the present
value of the estimated stream of future
profits on long-term contracts.
For example, in 2000 Enron recognized
profits in excess of $100 million on a deal
with Blockbuster to stream video, despite
serious questions about the feasibility of the
technology and the market demand.
Lecture 14 – Tales of Fraud

Enron



The company used hundreds of SPEs
(Special Purpose Entities) to fund or manage
risks associated with specific assets.
By following technical accounting rules of
SPEs, Enron was able to keep these entities
out of their consolidated F/S.
However, the Chewco did not satisfy these
accounting rules, and Enron restated its F/S
in October 2001 to correct this.
Lecture 14 – Tales of Fraud

Enron



There was footnote disclosure about the
SPEs, but it was terse.
Several key employees, including CFO
Andrew Fastow, were partners in the SPEs.
In some instances, the SPEs were showing
Enron stock as an important asset.
Lecture 14 – Tales of Fraud

Enron, Corporate Governance

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
Heavy use of stock options for senior
managers.
The audit committee had 6 members, all
seemingly well qualified. However, their
pattern was to hold a few short meetings
each year.
Arthur Andersen: Enron accounted for about
27% of all public company audit fees for the
Houston office.
Lecture 14 – Tales of Fraud

Enron, Corporate Governance

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
Hence, AA may have compromised its
independence.
Alternatively, the engagement team may
have lacked the expertise to evaluate
complex financial transactions that clearly
were intended to achieve financial reporting
objectives, not business objectives.
Andersen’s Houston office was permitted to
overrule AA’s Practice Partner in Chicago.
Lecture 14 – Tales of Fraud

Enron


From October 19 (when AA learned that
Enron was being investigated by the SEC)
through November 8, 2001 (when the SEC
served AA a subpoena), Arthur Andersen
personnel shredded extensive amounts of
physical documentation and deleted
computer files related to Enron.
The government charged AA with
destruction of documents related to the
audit.
Lecture 14 – Tales of Fraud

Enron



AA was ultimately convicted of one count of
obstruction of justice, related to the
alteration of a memo.
As a result of this conviction, AA was no
longer able to audit public companies.
The conviction was subsequently
overturned.
Arthur Andersen

Three strikes and you’re out!
 Sunbeam
 Waste Management
 Enron
Eulogy for Arthur Andersen
“Civilization has brought to man the realization
that there is only one lasting achievement
toward which all men may contribute. It is to
raise the standard of integrity by which men
deal with one another, and at the same time
earn their own livelihood.”
Leonard Spacek
Chairman of the Board
Arthur Andersen & Co.
December 1, 1963