Unit 7: Financial Statement Unit 7: Financial Statement Fraud and the Enron Fraud and the Enron ScandalScandal

Professor Thomas Genovese

Financial Statement Financial Statement FraudsFrauds1. 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 1. Revenue Related Financial Statement FraudsFinancial Statement Frauds

By far, the most common accounts manipulated when perpetrating financial statement fraud are revenues and/or accounts receivable.

Revenue-Related Fraud Revenue-Related Fraud SchemesSchemesTwo reasons for the prevalence of

revenue-related 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 Revenue-Related Fraud SchemesSchemesCommon Revenue-related Fraud

Schemes:Related-party transactionsSham salesBill-and-hold salesSide agreementsConsignment salesChannel stuffingLapping or kiting

Revenue-Related Fraud Revenue-Related Fraud SchemesSchemesCommon Revenue-related Fraud

Schemes:Redating or refreshing

transactionsLiberal return policiesPartial shipment schemesImproper cutoffRound-tripping

Identifying Revenue-Related Identifying Revenue-Related FraudFraudWays to detect:1.Analytical symptoms2.Accounting or documentary

symptoms3.Lifestyle symptoms4.Control symptoms5.Behavioral and verbal symptoms6.Tips and complaints

2. Overstating Inventory2. Overstating InventoryThe second most common way to commit financial statement fraud.

Beginning Inventory OKPurchases OKGoods Available for sale OKEnding Inventory HighCost of Goods Sold LowIncome High

Inventory & Cost of Goods Inventory & Cost of Goods Sold FraudsSold Frauds

The Effect of Inventory Overstatement

Income StatementWhen 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 Is understated

Gross Margin Is overstated

Expenses Are not affected

Net Income Is overstated

Inventory & Cost of Goods Inventory & Cost of Goods Sold FraudsSold FraudsMost common inventory-related fraud schemes:

Double countingCapitalizingCutoff problemsOverestimating inventoryBill-and-hold salesConsigned inventory

3. 3. Understatement of Understatement of Liabilities Liabilities FraudFraudSchemes that understate liabilitiesUnderstating accounts payableUnderstating Accrued LiabilitiesRecognizing Unearned Revenue as

Earned RevenueUnder recording Future ObligationsNot Recording or Under recording

Various Types or Debt (Notes, Mortgages, etc.)

Omission of Contingent Liabilities

Understatement of Liabilities Understatement of Liabilities FraudFraudWays to detect understatement of liabilities

Abnormal analytical symptoms

Documentary symptoms

4. Asset Overstatement Frauds4. Asset Overstatement Frauds

Overstatement of current assets (e.g. marketable securities)

Overstating pension assetsCapitalizing as assets amounts that

should be expensedFailing to record

depreciation/amortization expenseOverstating assets through mergers

and acquisitionsOverstating inventory and receivables

(covered earlier)

Overstatement of Assets Overstatement of Assets FraudFraudSchemes that Overstate Assets

Overstatement of Assets Overstatement of Assets FraudFraudWays to detect overstatement of

assetsCompare changes and trends in

financial statement account balancesCompare changes and trends in

financial statement relationshipsCompare 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 Frauds4. Disclosure FraudsThree 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 Inadequate Disclosure FraudFraudWays to identify Disclosure FraudLook 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 Why so many financial statement frauds all of a statement frauds all of a sudden?sudden?Moral decay in societyExecutive incentivesWall Street expectations—rewards for

short-term behaviorNature of accounting rulesBehavior of CPA firms and lawyersGreed by investment banks,

commercial banks, and investorsEducation failures

Executive IncentivesExecutive IncentivesMeeting 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 IncentivesMarket 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.

Which firm would you invest in?

Firm A Firm B

Nature of Accounting Nature of Accounting RulesRulesIn the U.S., accounting standards are

“rules-based” 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 CPAsAuditors—the CPAsFailed 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 quicklyA few auditors got too close to their

clients

Enron’s HistoryEnron’s History 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)Enron’s History (cont’d) 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 MotivationThe Motivation Enron delivered smoothly growing earnings (but not cash

flows.) Wall Street took Enron on its word but probably did not understand its financial statements.

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.)

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.”

The Role of Stock OptionsThe Role of Stock OptionsEnron (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 Enron’s Corporate StrategyStrategy 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 Role of Enron’s Use of Special Purpose Entities (SPEs)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

quartersMany 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.

Role of Arthur AndersenRole of Arthur Andersen 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 FirmsRole of Law FirmsEnron’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 Role of Credit Rating AgenciesAgenciesThe 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 Events2001 - Notable EventsJeff Skilling left on August 14—gave no

reason for his departure.By mid-August , the stock price began to fallFormer CEO, Kenneth Lay, returned in

AugustOct. 16…announced $618 million loss but

not that it had written down equity by $1.2 billion

October…Moody’s downgraded Enron’s debtNov. 8…Told investors they were restating

earnings for the past 4 and ¾ yearsDec. 2…Filed bankruptcy

So Why Did Enron So Why Did Enron Happen?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 sourDeceptive reporting practices—lack of

transparency in reporting financial affairsUnduly aggressive earnings targets and

management bonuses based on meeting targets.

Excessive interest in maintaining stock prices.

Will there be another Will there be another Enron?Enron?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.)

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.)