What’s the source?
Under the right circumstances, a producer
could make more money with a flop than
he could with a hit-It’s simply a matter of creative accounting
Top Ten Signs Your Olympic Event Is Fixed
- Event judge by former Enron CEO Kenneth Lay
Top Ten Super Bowl Moments
-Drunk, desperate deposed Enron CEO Kenneth Lay
steals commemorative coin used in opening toss
Top Ten Features Of The New Elvis Theme Resort
-The opportunity to take part in the worst financial
scheme since Enron
Top Ten Things Overheard at Martha Stewart's
Thanksgiving Dinner
-Let's give thanks that we live in a country where
vast wealth still has a good shot at keeping you out
of prison"
-"A meal like that is worth a dozen cartons of
cigarettes"
Companies Under Investigation
Aldelphia
Arthur Andersen
AOL
Bristol Myers Squibb
Computer Associates International
Deloitte & Touche
Enron
Ernst & Young
Global Crossing
Investigation cont’d
Halliburton
Imclone
Kmart
KPMG
Peregrine
PricewaterhouseCoopers
Qwest
Tyco
Worldcom Inc.
Xerox
Why so many financial statement
frauds all of a sudden?
Good economy was masking many problems
Ethical ambiguity in corporate culture
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
Good Economy Masked Problems
With increasing stock prices, increasing profits
and increasing wealth for everyone, no one
worried about potential problems.
How to value a dot.com company:
–
–
–
–
Take their loss for the year
Multiply the result by negative 1 to make it positive
Multiply that number by at least 100
If stock price is less than the result…buy; if not,
buy anyway
People were making nonsensical investment
decisions
Corporate Ethics
Attendees at the April, 1998 Business Week Forum
of Chief Financial Officers:
– 67% of CFOs said they had fought off other
executives’ requests to “misrepresent corporate
results”
– 12% of CFOs admitted they had “yielded to the
requests” while 55% said they had “fought off
requests” to misrepresent corporate results
Honesty studies
– People are becoming less honest
– Less modeling and labeling
Ethical Problems
The Transformation of Andersen
Leonard Spacek and the DuPont
Compare to Waste Management
decision
Executive Incentives
Meeting Wall Street’s Expectations
– Stock prices are tied to meeting Wall Street’s earnings
forecasts
– Focus is on short-term (quarterly) 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
salary-based compensation (tied to stock price)
Bernie Ebbers (WorldCom)
– 1997 Compensation--$935,000 per year
– 1997 Stock options—1.2 million shares at $26 per
share—stock went to $64.50 ($46.2 million in profit)
– Performance is based on earnings & stock price
High Amounts of Debt & Leverage
During 2000, Enron’s derivates-related liabilities
increased from $1.8 billion to $10.5 billion
Enron hid billions in off-balance sheet (SPE) debt
Enron’s on-balance sheet debt was huge
WorldCom had nearly $100 billion in debt
– Not only did Bernie Ebbers borrow $100 billion for
WorldCom but he also racked up over $1.3 billion
in personal debt while CEO of WorldCom
Every company that committed financial
statement fraud had huge amounts of debt
186 public companies with $368 billion in debt filed for
bankruptcy in 2002—includes WorldCom, Conseco, Global
Crossing, United Airlines
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.
– 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 makes rules for every situation
Auditors—the CPAs
Failed to accept responsibility for fraud detection
(SEC, Supreme Court, public expects them to detect
fraud) If auditors aren’t the watchdogs, then who
is?
Became greedy--$500,000 per year per partner
compensation wasn’t enough; saw everyone else
getting rich (Andersen’s partners were jealous of
Accenture partner’s income)
Audit became a loss leader
– Easier to sell lucrative consulting services from the inside
– Became largest consulting firms in the U.S. very quickly
(Andersen Consulting grew to compete with Accenture)
A few auditors got too close to their clients
Entire industry, especially Arthur Andersen, was
punished for actions of a few
Accounting Regulation
Early 20th century economic growth also
gave rise to rise in business scandals
International Match debacle resulted in
mandatory audits for all companies with
listed securities.
Securities Act of 1934 created SEC
The Securities and Exchange
Commission (www.sec.gov)
Independent, nonpartisan regulatory
agency
Chair and four additional commissioners
appointed by President to 5 year terms
(staggered)
Polices federal securities laws
Does not assess the quality of the
securities offered.
Insider Trading
Trading done by a person with access to
key non-public information.
Imclone - Sam Waksal
Sam’s friend Martha Stewart
SEC Open Case
6/6 Board member (also audit committee
member) receives co flash report predicting 2nd
qtr losses of $4M
6/11 – attends meeting where AA warns of a
potentially significant loss (>$4M)
6/22 – sells 212,140/317,152 shares for
$848,560
7/10 – deadline for filing SEC Form 4 (filed 8
mths later)
8/20 – co announces loss of over $23 M
12/31 – price continually drops to $1
PCAOB
Public Company Accounting Oversight Board
Created by SOX
Private sector organization subject to SEC
oversight
Responsible for all auditing, attestation, quality
control, ethics and independence standards
applicable to registered public accounting firms.
Became the authoritative body for auditing
standards, taking that responsibility away from
the AICPA and the profession.
Rise of Corporate Cops
Pat Gnazzo
Window Dressing?
Do they have too much power?
Let’s examine a few…
Tyco
WorldCom
Health South
Enron
Tyco - Operations
100 countries and revenues
in excess of $36 billion.
Four key businesses: Fire
and security, Electrical and
electronic components,
Healthcare, and Financial
services.
CEO Dennis Kozlowski and
former CFO Mark H. Swartz
were the main players in the
fraud
May 28, 2001
December 23, 2002
What happened?
Poster Boy of corporate excess and greed
Chisels NYC out of $1 million in Sales tax
due on fine art (he was worth $500 million
at the time)
Hit with 38 felony counts for pilfering $170
million directly from the company and for
pocketing an additional $430 million
through tainted sales of stock
Bending the numbers
Loading up on Goodwill
Purchasing Accounting Liabilities
Immaterial Acquisitions and Plenty of
Them!
Tax Tricks
Moved Offshore
Set Up a Finance Subsidiary
Set Up over 100 Subsidiaries
The Trial
“Coercive letter” to juror prompts the judge
to end the first 6-month trial
Dennis Kozlowski and Mark Swartz were
convicted last June on 22 of 23 counts of
grand larceny, conspiracy, securities fraud
and falsifying business records.
Sentenced to 8-25 years in state prison
World Com
Largest corporate fraud in US history
Bernard Ebbers, former CEO, convicted
on conspiracy, securities fraud and filing
false statements to regulators in an $11
billion accounting fraud (the biggest in
history).
Sentenced to 25 years in prison
Fraud led to the largest corporate
bankruptcy in history in 2002
The Trial
Prosecutors have secured guilty pleas
from five of his underlings, including his
former CFO Scott Sullivan
Under pressure to meet analysts’
expectations
Equity shareholders received $250 million
in stock when Enron emerged from
bankruptcy
The Fraud
http://www.aicpa.org/download/antifraud/121.ppt
HealthSouth
From 1996-2003 HealthSouth’s value was
inflated by more than $2.7 billion through an
accounting fraud at the company.
Fifteen former HealthSouth executives, including
5 of the comppany’s FOs, pleaded guilty to
criminal charges in connection with the fraud.
Scrushy was acquitted last June by a jury in
Birmingham of all 36 federal criminal charges
that he took part in the fraud.
HealthSouth
Judge ordered Scrushy to repay
HealthSouth more than $47.8 in bonuses
HealthSouth rejected demands from
Scrushy for more than $100 million in
severance pay and bonuses. He is suing.
Scrushy paid a writer $10,000 to produce
several favorable articles for an AL
newspaper that he reviewed before
publication during his fraud trail.
Public Relations
Scrushy son-in-law acquired a cable TV
station in B’ham while on trial and
broadcasted a daily update along with
“Viewpoint” program with wife
Son-in-law acquired another TV station in
Montgomery weeks before Scrushy was to
appear before Federal court on charges of
bribing a former governor of AL.
What’s to come?
Civil case filed by SEC is set for trial in
April 2007.
Bribery trial is scheduled later this year.
Enron
So many players……
Enron Fraud
Compared to other financial statement frauds,
Enron was a very complicated fraud.
“What we are looking at here is an example of
superbly complex financial reports. They didn’t
have to lie. All they had to do was to obfuscate
it with sheer complexity—although they probably
lied too.”
Senator John Dingell
Enron’s History
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.
Kenneth Lay, CEO, hired McKinsey & Company
to assist in developing business strategy. They
assigned a young consultant named Jeffrey
Skilling.
Feb. 2001-- Fortune magazine names Enron
“The Most Innovative Company in America” -company was worth $60 billion
Dec. 2001 – Enron files the biggest bankruptcy
in U.S. history (now exceeded by WorldCom)
Role Players
Enron
Kenneth Lay –
Founding and last CEO
Jeff Skilling –
CEO from 2/2001 to 8/2001
Andrew Fastow –
CFO
Michael Kopper –
Assistant to Fastow
Andersen
David Duncan –
Audit Partner
Michael Odom –
Risk Mgt Partner
Nancy Temple –
Firm Attorney
Enron’s Strategy
Created Energy derivative
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.
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 Corporate Strategy
Enron’s core business was losing money—
shifted its focus from bricks-and-mortar
energy business to trading of derivatives
(most derivatives profits were more
imagined than real with many employees
lying and misstating systematically 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 Changing Business
Producer
Utility
2Wholesale
Industrial User
4”Extras”
3Retail
1Transportation
and Distribution
Total Revenues
Transportation
and Distribution
Wholesale
Services
Retail Energy
Services
1998
$1,849B
$27,725B
$1,072B
1999
$2,032B
$36,287B
$1,807B
2000
$2,955B
$94,906B
$4,615B
Enron’s Changing Business
Enron Operating Income: 1996-2000
2000
Transportation
and
Distribution
Wholesale
Services
Years
1500
1000
500
0
1996 1997 1998 1999 2000
Operating Income
The Motivation
Enron delivered smoothly growing earnings (but
not cash flows.)
It was all about the price of the stock.
In its last 5 years, Enron reported 20 straight
quarters of increasing income.
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.”
Aggressive Nature of Enron
Because Enron believed it was leading a
revolution, it pushed the rules.
Employees attempted to crush not just
outsiders but each other.
Enron took more risk than others—”it swung for the fences.”
Enron’s Arrogance
Enron’s banner in lobby: Changed from
“The World’s Leading Energy Company” to
“THE WORLD’S LEADING COMPANY”
“Older, stodgier companies will topple over
from their own weight…”
Skilling
Conference of Utility Executives in 2000:
“We’re going to eat your lunch”….Jeff
Skilling
“Value at Risk (VAR)” Methodology
Investors didn’t know how much risk Enron was
taking
Enron had over 5,000 weather derivatives deals
valued at over $4.5 billion—couldn’t be valued
without professional judgment
In 2000 annual report “In 2000, the value at risk
model utilized for equity trading market risk was
refined to more closely correlate with the
valuation methodologies used for merchant
activities.”
Enron’s statement that it would “refine” its own
models should have raised concerns
Special Purpose Entities (SPEs)
(Enron’s principal method of financial statement fraud involved the use of SPEs
(Special Purpose Entities))
Originally had a good business purpose
Investors wanted risk and reward exposure
limited to the pipeline, not overall risks and
rewards of the associated company
SPE limited by its charter to those permitted
activities only
Really a joint venture between sponsoring
company and a group of outside investors
Cash flows from the SPE operations are used to
pay investors
Enron’s Use of Special Purpose
Entities (SPEs)
To hide bad investments and poor-performing
assets
Earnings
Quick execution of related-party transactions at
desired prices.
To report over $1 billion of false income
To hide debt
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
LJM1 SPE
One Enron Example (the “Rhythms” transaction):
Enron held Internet stock in company called
Rhythms NetConnections
Stock was restricted
Enron didn’t want exposure to risk of a price drop
The solution was simple! A hedge
No one to do the deal
Another simple solution! Start a company (a Special
Purpose Entity or SPE) to take the other side of the
transaction (Enron called it LJM1)
Where did the financing come from?
– 97% from bank loan  Guaranteed with Enron
stock
– 3% from entity other than Enron Andrew
Fastow and others!
Where did the financing come from?
– 97% from bank loan  Guaranteed with Enron
stock
– 3% from entity other than Enron Andrew
Fastow and others!
Enron gave $168 million in Enron shares to LJM1
(LJM1’s primary asset)
LJM1 gave Enron a note for $64 million and a put
option valued at $104 million
When everything “settled out,” Fastow received $15
million for his $1 million investment
Enron got to “hedge” (i.e., not report) a $103 million
market loss on its stock investment
Fastow’s Explanation of
Partnerships (SPEs)
The partnerships were used for
“unbundling and reassembling” the various
components of a contract. “We strip out
price risk, we strip out interest rate risk,”
he said. “What’s left may not be
something that we want.”
The obvious question is “Why would
anyone want whatever was left?”
The Unwinding of Enron--Notable
Events
Jeff Skilling left in August—gave no reason for his
departure.
By mid-August 2001, the stock price began falling
Former CEO, Kenneth Lay, came back 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
Clue #1: Warnings about Enron
In early 2001, Jim Chanos, who runs Kynikos
Associates, a highly regarded firm specializing in
short selling said publicly that “no one could
explain how Enron actually made money.” He
noted that Enron had completed transactions
with related parties that “were run by a senior
officer of Enron” and assumed it was a conflict of
interest. (Enron wouldn’t answer questions
about LJM and other partnerships.)
Clue #2: Fortune Article…March 5,
2001
“To skeptics, the lack of clarity raises a red flag about
Enron’s pricey stock…the inability to get behind the
numbers combined with ever higher expectations for the
company may increase the chance of a nasty surprise.
Enron is an earnings-at-risk story…”
“At the least, these sorts of hard-to-predict earnings are
usually assigned a lower multiple...In 1999 its cash flow
from operations fell from $1.6 billion the previous year to
$1.2 billion. In the first nine months of 2000, the
company generated just $100 million in cash. (In fact,
cash flow would have been negative if not for the $410
million in tax breaks it received from employees’
exercising their options.”
Clue # 3: Executives Abandon
Enron
Rebecca Mark-Jusbasche, formerly CEO of Azurix,
Enron’s troubled water-services company left in August,
2000
Joseph Sutton, Vice Chairman of Enron, left in
November, 2000.
Jay Clifford Baxter, Vice Chairman of Enron committed
suicide in May, 2001
Thomas White, Jr., Vice Chairman, left in May, 2001.
Lou Pai, Chairman of Enron Accelerator, departed in
May 2001.
Kenneth Rice, CEO of Enron’s Broadband services,
departed in August 2001.
Jeffrey Skilling, Enron CEO, left on August 14, 2001
Clue #4: Enron’s Cash Flows
Enron’s cash flows bore little relationship to
earnings (a lot due to mark to market.) On
balance sheet debt climbed from $3.5 billion in
1996 to $13 billion in 2001.
Key Ratio
Net Income (from Operations*) – Cash Flow (from Operations**)
Net Income (from Operations)
Would expect to be about zero or slightly negative over time
*From the Income Statement
**From the Statement of Cash Flows
Enron’s Cash Flow Ratio
4
3
2
1998
1999
2000
2001
1
0
-1
-2
3
6
9
months months months
Year
Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000,
1st two quarters in 2001.
Statement of Cash Flows
1996
1995
1994
Net Income
584
520
453
Net Cash Provided by
*Used in) Operating
Activities
1040
(15)
460
Enron’s Earnings Picture
(in millions)
1996
1995
1994
Total Rev
13,289
9,189
8,987
Operating Rev
690
618
716
Net Income
584
520
453
AR relative to the ADA
(in millions)
1996
1995
Trade Receivables (net of
allowance for doubtful accts
of $6 and $12)
1,841
1,116
Role of Andersen
Was paid $52 million in 2000, the majority of
which was for non-audit related consulting
services.
Enron was Andersen’s second largest client
Did both external and internal audits
CFOs and controllers were former Andersen
executives
Andersen Shredding
Email message about Document Policy:
To: Michael C. Odom
Date: 10/12/2001 10:53 a.m.
From: Nancy A. Temple
Subject: Document retention policy
MikeIt might be useful to consider reminding the engagement
team of our documentation and retention policy. It will be
helpful to make sure that we have complied with the policy.
Let me know if you have any questions.
Nancy
The Cost of “Bad Press”
Role of Investment & Commercial
Banks
Companies like JP Morgan Chase made millions in loan
interest and fees but hundreds of millions in investment
banking business
Enron paid several hundred million in fees, including
fees for derivatives transactions.
None of these firms alerted investors about derivatives
problems at Enron.
In October, 2001, 16 of 17 security analysts covering
Enron still rated it a “strong buy” or “buy.”
Example: .One investment advisor purchased 7,583,900
shares of Enron for the a state retirement fund, much of
it in September and October, 2001
Where was Wall Street?
1. Few analysts did their homework.
2. Some Wall Street companies cashed in
(million$!) on LJM2 (names like Goldman
Sachs, Merrill Lynch, etc.
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
Role of Credit Rating Agencies
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.
These firms enjoy protection from outside
competition and liability under U.S. securities laws.
Being rated as “investment grade” was necessary to
make SPEs work
So Why Did Enron Happen?
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
See NYTimes 2/5/06 Enron’s Many Strands
Current Status
Fraud and conspiracy trial of Lay and
Skilling is reaching its halfway mark.
Richard Causey – pleaded guilty and will
serve 7 years
Andrew Fastow pleaded guilty and will
serve 10 years.
Lea Fastow completed a yearlong
sentence on tax charge.
Sarbanes Oxley
The Most Significant Financial Legislation
in 70 years
Good policy or a politically-driven
overreaction to the scandals that gave rise
to it?
1974 The Foreign Corrupt Practices Act in
response to revelations about bribery of
foreign government officials
Four Themes
Gatekeepers
Protecting the Integrity of the Investigative
Process
Personal Accountability and Greater
Deterrence at the Top
Enhanced Financial Disclosures
The Gatekeepers
Auditors – established PCOAB
Lawyers – reporting duties
Analysts – conflict of interest rules
Independent Directors – particularly Audit
Committee
Protecting the Integrity of the
Investigative Process
Requires auditors maintain their
workpapers for 5 years
Expressly probihits the destruction,
alteration or concealment of documents
Penalty of up to 20 years in prison
PCAOB wants auditors to be whistle
blowers
Personal Accountability and
Greater Deterrence at the Top
Requires public company CEOs and
CFOs to certify that the financial
statements their companies issue are
accurate.
Impose greater sanctions on corporate
officials who break the law
Lowered the standard the SEC must meet
in seeking officer and director bars
Enhanced Financial Disclosures
Section 404 – requires management’s
assessment of internal control over
financial reporting, along with the related
report of the independent auditor.
PWC saw an increase in audit fees
averaging 134% thanks to Section 404
Average cost of $5.8 billion
Will there be another Enron?
No, nothing has really changed!
Yes, Sarbanes Oxley will be an
effective deterrent