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Corporate Transgressions and

Financial Gimmickry

Jim Davidson, CFE, CPA, CFSCertified Corporate Director

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DEVASTATINGMillions & Billions Lost

• Deceptive practices, executive fraud, shaken confidence

• Financial markets - billions evaporated• Recession – bankruptcies, savings, pensions,

jobs lost, financial ruin • Reputations, careers destroyed, imprisonment

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Financial, Business & Ethical• Scandals and high profile cases• Manipulations, tricks & red flags• Repercussions–legal, financial, reputation• Lessons learned• Corporate culture -- “Tone at the Top”• Management integrity

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Scandals and Transgressions• Abhold• ADELPHIA• ANDERSEN• AOL• Baker Hughes• Bally• Bausch & Lomb• Bristol-Myers• CENDANT• Citibank• CMS Energy ($5.2 billion)

• COMPUTER ASSOCIATES

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Scandals and Transgressions (Cont’d) • Credit Suisse First Boston• Duke Energy• Dynegy• Fleming Companies• EDS• El Paso• ENRON ($85 billion)• GATEWAY• Gaylord Entertainment• GLOBAL CROSSING ($9 billion)• Haliburton

J

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Scandals and Transgressions (Cont’d)

• HEALTHSOUTH• Homestore• Interpublic• JDS Uniphase• JP Morgan Chase• Kimberly Clark• Kmart• LUCENT• Martha Stewart• Merck• Merrill Lynch• Microstrategy

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Scandals and Transgressions (Cont’d)• Mirand• Nicor Energy• Nine West• Nortel• North Face/VF Corp• Parmalat• Peregrine Systems• QUEST• Reliant Energy ($6 billion)• Rite-Aid• Royal Dutch/Shell• Solomon Smith Barney• SUNBEAM

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Scandals and Transgressions (Cont’d)

• Squibb• Sybase• Symbol• 3Com• TYCO• Vail Resorts• Veritas• Waste Management ($6 billion)• WORLDCOM ($11 billion)• XEROX ($6.5 billion)

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Why the Scandals?• Blamed high tech boom• Meeting quarterly earnings • Stock options, greed and short-term price

manipulation• Historically, same result - speculative bubbles

followed by crashes• Fiascos, corruption, business failures follow

economic booms

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Why the Scandals? (Cont’d)

“Accounting fraud does tend to come in waves, and is discovered most often after a market collapse, since no one is interested in investigating much when stock prices are high and everyone’s making big money.”

Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (Toffler)

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Why the Scandals? (Cont’d)

• “Just a few”- rotten apple theory • Specific incentives – bonuses, excessive

options• Institutional environment turns blind eye

to unethical or illegal acts• Culture allows egregious acts • “It pays to do it, it’s easy to do, and it’s

unlikely that you’ll be caught.” [Schilit]

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Why the Scandals? (Cont’d)

• Incentives: Greed, power, ego• Opportunity:

–Weak governance – Corporate culture

– Ineffective auditing – Lax regulation – Haphazard enforcement

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Why the Scandals? (Cont’d)

• Rationalization:

– “Everyone’s doing it.” –“Wall Street expects it.”–“Investment bankers engineered it.” –“Our attorneys blessed it.” –“Our auditors accepted it.”

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Lessons of History

• It’s the incentives - GREED!• Irrational exuberance - booms & bubbles• Regulations not fool-proof • Corporate culture• Ethics, particularly at the top is key

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TRUST BETRAYED

• All fraud by those we trust!• CEO and/or CFO 80% of cases• Anonymous survey of CFO’s:

–Two-thirds asked to participate–One-third admitted to doing so

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Recent Scandals

• Greed — more widespread than previous?• Prominent industries - energy, high tech,

telecommunications• Giant firms – largest bankruptcies in history• Earnings manipulation central

EARNINGS MANAGEMENT

What is it? How is it accomplished?

How is detected?

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Earnings Management Defined

• “Active manipulation of earnings toward predetermined target” {Mulford & Comisky}

• “Purposeful intervention in external financial reporting process with intent of obtaining private gain” {Shipper}

• “Intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading” {ACFE}

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Gimmicks and Illusions:What? How? When?

• “Big Bath” charges –write-offs, over reserves, “cushions” ensure higher future earnings

• “Merger Magic”– write-offs, misclassifications & disguised costs so no future “drag”

• “Cookie-Jar Reserves” – income smoothing– “good time” over accruals and reserves used in “bad times”

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Earnings Management Tricks and Gimmicks

• “Materiality"– Intentionally recording errors within ceiling – “too small to matter”

• Revenue recognition – Accelerated, premature before delivery and with contingencies–Consignment–Channel stuffing–Round-trips, swaps & barters to gross up sales–Bill and hold–Related party

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• Earnings management - manipulation and outright fraud

• Discretionary policies & estimates– capitalization, amortization, deferred expenses, inventory, judgments - bad debts, contingencies

• Liability deception – Off-books complex schemes & webs, special purpose entities

Other Tricks & Gimmicks

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Other Tricks & Gimmicks• Related party loan guarantees, obligations,

synthetic leases• Extreme tax avoidance (evasion ?), off-shore

havens, questionable legal/tax interpretations• Blatant misstatements–disguised transactions

and misclassifications- capitalized repair and maintenance

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Self-Dealing – Questionable and Unauthorized

• Disguised executive compensation• “Evergreen” stock options• Excessive perks & misused funds• Undisclosed related party transactions

and self-dealing – personal “piggy-bank”

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Earnings Management Environment

• Overbearing CEO with substantial ego• Few independent directors• Inadequate board committee structure• Excess executive compensation and perks• Poor control structure and culture – “tone

at the top”

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DECEPTION– LIABILITIES

• Special purpose entities• Off-books complex schemes and webs

- nonconsolidated debt• Related party loan guarantees,

contractual obligations, synthetic leases

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Aggressive Tax Shelters• Off-shore tax havens, shelter deals,

questionable legal/tax accounting interpretations

• Complex series of loans, extreme tax avoidance and possible evasion

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Questionable, Unauthorized Funds

• Disguised executive compensation• “Evergreen” stock options• Undisclosed related party transactions/self-

dealing• Inadequate, ineffective corporate

governance

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Earnings Restatements• Previously rare, increasingly common• Highly suspect manipulation & deception• Over 900 restatements 1999-mid-2003 (GAO)

• Nearly 1,000 recent restatements • Predominantly revenue recognition• 20% of 2001 SEC enforcements

accounting related, increasing in 2002 - 2004

• Market reaction: Significant stock price declines

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ENRON• Largest bankruptcy 2001 • 7th largest corporation - $1.2 billion equity

reduction in quarter• Manipulation and deception -- special

purpose entities• Congressional hearings, revolutionary

changes -- regulatory, governance, scrutiny

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Enron

• Extreme use SPEs for blatant manipulation• Initial use to grow company, managing risk• More complex SPEs to record future

services as current income using “mark-to-market”

• Extensive conflicts of interest & related-party transactions

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Enron (Cont’d)

• Gas trading to electricity, risk management, telecom, and expanding internationally

• Based on economic-based assessments, many ventures were failures

• Based on manipulations and deception, all were successful

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Enron (Cont’d)

• Energy trading: spot market purchases volatility drove demand for risk management and related derivatives

• Massive debt and potential junk bond ratings

• Used special purpose entities to reduce perception of too much debt

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Enron (Cont’d)

• Focused on meeting quarterly earnings• Initially cost savings, but increasingly more

gimmicks• Scheme 1: Revalue physical assets using

“fair value” models (SFAS 125, designed for financial assets)—front-loading profits

• Scheme 2: Complex and mishandledSPEs to record earnings

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Enron (Cont’d)

• CFO manipulated for own enrichment - independence problem

• Questionable SPEs approved by attorneys, auditor/Andersen and board

• Accommodated by investment banks and no apparent SEC oversight

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Enron (Cont’d)• Some operations major blunders• Dramatic increased risk but unwillingness

to disclose losses• Stock price dropped, executives bailed out

of stock, ratings to junk• Restatements in 2001and subsequent

bankruptcy • Largest ever bankruptcy until …

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WorldCom

• Growth through mergers & acquisitions • $100+ billion assets (with half intangibles)• Debt to equity of 79.3%• $11 billion + capitalized operating

expenses

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WorldCom (Cont’d)

• WorldCom restated earnings• Andersen fired• CFO and CEO fired• WorldCom bankruptcy 2002• Replaced Enron as largest bankruptcy in

US history,

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Tyco

• Conglomerate through acquisitions• “Deal a Day Dennis” Kozlowski

acquired 750 companies• Merger magic • CIT acquisition fiasco showed Tyco’s

shenanigans

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Tyco (Cont’d)

• CIT $9.4 billion loss for 2002• Kozlowski indicted for evading taxes

& “raiding” Tyco• Obvious manipulation & deception • Not clear criminal acts

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Adelphia

• Fifth cable & communications• Restatements - billions off-balance-

sheet “co-borrowing agreements”• Rigas family fraud and significant self-

dealing• Bankruptcy 2002

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What do Enron, WorldCom, Tyco, Adelphia have in common?

• Massive deception, manipulation, self-dealing• Growth through acquisitions• Acquisition accounting abuse• Targeted earnings focused • Enrichment of senior executives• Accommodating auditors & boards of

directors • Restated financials

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What Happened at Andersen?• Long-time reputation for integrity and

professionalism• “Aggressive auditing” beginning in ‘80s• Clients too valuable to defy (Toffler)• Major client scandals: Sunbeam, Global

Crossing, Waste Management, Enron, WorldCom & Guilty of obstruction of justice

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Governance Red Flags• CEO also board chairman• Executive ego and dominance • Permissive governance structure -

manipulation more likely• Lax board committees - audit,

compensation, nominating and governance

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Corporate Governance• Majority independent board members –

fraud less likely• Board and executive compensation —

performance based • Conservative accounting • Transparent reporting – full and

understandable

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Corporate Governance• Board oversight and “tone at the top”• Independent directors fact and appearance• Competent & vigilant – not asleep at wheel• Audit committee focus – audit, expertise,

SEC investigations & past restatements• Compensation committee oversight,

executive compensation, insider trading• Investment banking relationships

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Legislative Reaction: SOX• Strengthened governance -- independent

directors, mandatory committees • Independent audit committee members and

“financial expert”• Internal control attestation• CEO and CFO certifications• Tougher penalties

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Legislative Reaction: SOX (Cont’d)

• Established PCAOB• A new regulatory structure for

accounting firms• Tighter corporate controls• New disclosure requirements• New record retention requirements

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Corporate Transgressions and

Financial Gimmickry

Jim Davidson, CFE, CPA, CFSCertified Corporate Director

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QUESTIONS?