When Does Unethical Behavior Turn Into Fraud

1
When Does Unethical Behavior Turn Into Fraud

• W. Steve Albrecht
• Brigham Young University

2
(No Transcript)
3
Disclaimer

• I am a trustee for the FAF and on a new committee
  to provide oversight to the FASB

FAF (Trustees)
FASB
GASB
GASAC
FASAC
The views I express are my own personal views and
do not represent the views of the FAF, FASB,
FASAC or any other accounting policy-making or
advisory group.
4
The Nature of Accounting

• There is no true earnings number for a company
  (Hicksian income--J. Hicks, 1939 Value and
  Capital)the amount that can be consumedpaid out
  in dividendsduring a period, while leaving the
  firm equally well off at the beginning and end of
  the period)
• Generally6 Accepted Accounting Principles (GAAP)
  have never tried to measure Hicksian Incomeit is
  impossible to measure accurately
• Almost every number on the financial statements
  requires either timing or estimate judgments or
  arbitrary allocations.
• Well intentioned people often disagree about the
  estimates and judgments.

5
Why There is No True Income

• In many ways, the accounting rule making process
  is one of preferences and often becomes political
  (e.g. preparers v. investors, etc.)
• Accounting is an art, not a science (there are no
  absolute truths)
• Accounting rules are set by the FASB as fairly as
  possible but often in ways that require
  cost/benefit and other compromises
• There are numerous measurement problems requiring
  estimates
• There are numerous timing problems requiring
  judgments

6
Examples of Compromises on FASB Statements

• FAS 133 on derivatives (to prevent unpredictable
  changes in earnings the FASB carved out
  exceptions for hedging deals, forward contracts
  or materials, insurance policies and other
  special cases (thus, the standard became 800
  pages)
• Expensing RD as incurred v. capitalize
• Allocation of depreciation over lives of assets
  (Cost/Benefit Tradeoffs)

7
How Companies Deal with this Uncertainty

• Some make conservative estimates
• Some make aggressive estimates
• Some make neutral estimates
• Some use ethical and unethical ways to manage
  earnings
• Some commit financial statement fraud

8
My Own Experience

• As a young college graduate working for a Big 4
  accounting firm I was assigned to help audit a
  group of health spas. It became obvious to me
  that many people who purchased spa memberships
  with great intentions to lose weight or get in
  shape soon quit going to the spas and quit making
  monthly payments. As a result, the companys
  uncollectible receivables were estimated to be
  about 45 of revenues. Reported income could
  have been significantly higher or lower just by
  changing this one estimate.

9
My Own Experience

• This uncertainty in income bothered me for
  several years and so, for my Ph.D. dissertation,
  I decided to use hindsight and measure what the
  real uncollectible receivables were for a similar
  company. The confidence intervals I built around
  their net income over time include zero income
  for 5 years in a row. As a result, I concluded
  that net income could really have been from a
  negative 5 million to a positive 30 million,
  depending on their uncollectible receivables and
  other estimates.

10
The financial reporting continuum

• Conservative Neutral
  
  Intentional
• Accounting Accounting
  Aggressive Accounting
  Fraud
• 
  
• Modify Operating Decisions Modify
  Accounting -Delay expenditures
  -early adoption of rules
  (e.g. marketing, RD, etc.)
  -Massage estimates
• 
  -Incent more revenues -Massage
  timing
• (e.g. special discounts)

Aggressive accounting is often referred to as
Earnings Management (EM), although you can manage
earnings up or down.
Companies send signals to investors through
their financial reporting. There is much academic
literature on signaling that shows that,
generally, more conservative signals are received
better than more aggressive signals.
11
The financial reporting continuum

• Conservative Neutral
  
  Intentional
• Accounting Accounting
  Aggressive Accounting
  Fraud
• 
  
• Modify Operating Decisions Modify
  Accounting
• 
  Earnings Management
• Where would you overlay the following vertical
  lines on the above continuum?

Ethical Questionable
Unethical Fraudulent
12
Conservative Accounting

• Choosing the more conservative option among
  allowable options when reporting discretion is
  exercised (e.g. shorter depreciable lives,
  earlier permitted recognition of expenses, later
  permitted recognition of revenues, etc.)

13
Neutral Accounting

• To be neutral, accounting information must report
  economic reality as faithfully as possible
  without coloring the image it communicates for
  the purpose of influencing behavior in some
  particular direction (FASB, Concept Release No.
  2, 1980)

14
Aggressive Accounting

• Choosing the more aggressive option among
  allowable options when reporting discretion is
  exercised (e.g. longer depreciable lives, later
  permitted recognition of expenses, earlier
  permitted recognition of revenues, etc.).
  Sometimes leads to inaccurate or unlawful
  accounting practices in order to make financial
  statements seem healthier than they are in
  reality (Often referred to as earnings
  management)

15
Financial Statement Fraud

• Intentional actions, misstatements, or omissions
  intended to hide or distort the real financial
  performance or financial condition of an entity
  to deceive the users of the financial statements.
  Also known as cooking the books and
  management fraud.

16
Earnings Management

• Preparing financial reports that reflect the
  decisions of management rather than the companys
  underlying financial performance
• With earnings management, preparers are often
  trying to get others to believe what they
  themselves do not believe (often involves self
  deception or paternalistic behaviorknowing what
  is best for others)

17
Most Common Ethics/Fraud Line Drawn by Companies

• Acceptable earnings management Optimizing
  financial performance through pro-active
  operational decision making coupled with the
  effective selection and application of acceptable
  alternatives available within the parameters of
  GAAP.
• Unacceptable earnings management Altering or
  ignoring reality so as to externally report,
  currently and/or in the future, financial
  performance consistent with or better than
  targets previously established by corporate
  management and/or stock analysts.

18
Questions You Should Ask Yourself

• Would I be comfortable with our financial
  reporting if
• Your mother were the major investor
• You were the major investor
• Your financial reporting was described on the
  front page of the local newspaper
• Your accounting was questioned by the SEC or
  PCAOB
• You worked for Institutional Shareholder Services
  (ISS)

19
How is Financial Statement Fraud Accomplished?

• Intentional misapplication of generally accepted
  accounting principles (GAAP).
• Intentional omission or misrepresentation of
  information about transactions or events
  (including inadequate or misleading disclosures).
• Recording fictitious transactions.
• Unreasonable estimates
• Timing manipulation of revenues, expenses,
  accruals, etc.

20
Why do companies end up in different places on
reporting continuum?

• GAAP allows flexibility in making accounting
  and/or operating changes
• Managers often try to convey certain messages and
  signals to investors (sometimes messages they
  believe and sometimes messages they dont believe)

21
3 Most Common Thresholds of Earnings
Management-F/S Fraud

• Report positive profits report earnings above
  zero
• Sustain recent performance make at least as much
  as last year
• Meet analysts expectation particularly their
  earnings forecasts
• Earnings falling just short of thresholds
  will be
• managed upward there were discontinuities
  in
• the earnings distributions that indicated
  EM. The
• future performance of firms just meeting
  thresholds
• was worse than those of control groups that
  were less
• suspect.

22
Positive/Zero Profits
23
Sustaining Recent Performance
24
Meeting Analysts Expectations
25
What Regulators Have Said About Earnings
Management

• Sept. 2, 1998Arthur LeavittThose who operate
  in the grey area between legitimacy and outright
  fraud are poisoining the F/R process (J. of A.,
  Dec. 98, p. 12)

26
Earnings Management-F/S Fraud

• Earnings management/aggressive accounting/F.S.
  fraud is the most important ethical issue facing
  the accounting profession, management and
  directors of organizations.

27
Reactions to EM/Fraud

• Denial
• Denial
• Denial
• Anger
• Rationalization
• Depression
• Acceptance

Denial
Acceptance
Depression
Anger
Rationalization
"There's No Way The Financials Could Be Mistated!
28
When Is It Fraud Warranty Expense Example

• Conservative Neutral Aggressive
  Intentional
• Accounting Accounting
  Accounting
  Fraud
• 2.80 2.65
  2.50 2.25
  1.25
  
• Facts Sell hair dryers for 30 provide
  warranty for 1 year. Average warranty cost over
  the past few years has been 2.70 with no
  specific pattern but has ranged from 2.50 to
  2.80. How much warranty expense do you record
  as an offset to the 30 per hair dryer of revenue?

Average between 2.50 and 2.80
Have there been significant quality improvements?
29
Reporting 1.25 as Warranty ExpenseError or Fraud

• Errors--Unintentional
• Mistakes in gathering or processing data
• Incorrect use of estimates
• Incorrect timing estimates
• Mistakes in applying accounting principles

• Fraud--Intentional
• Intentional violation of accounting standards
• Underreporting of expenses
• Overstating revenues so ratio changes
• Abusive estimates
• Timing manipulations

30
Anatomy of F/S Fraud

• Always starts out small
• Increases in complexity and aggressiveness
• Grows in magnitude and number of participants
• Affects each periods financial statements by
  increasing amounts
• Eventually, allows no way out

• Example of the slippery slope leading to fraud
• Utilized aggressive estimates
• Delayed/altered expense recognition
• Accelerated revenue recognition
• Exploited acquisition reserves
• Fabricated additional revenue
• Made unsupported topside journal entries
• 3 billion fraud I was an expert witness in

31
When is it fraud?

• In the final analysis, the question of whether
  something is F/S fraud, earnings management
  and/or aggressive accounting or even neutral or
  conservative accounting is one of judgment.

1st Judgment 2nd Judgment 3rd Judgment
4th Judgment Preparers Auditors
Regulators
Investors/Courts
Different judgments often result in
misstatements and lawsuits!
32
Judgments Are Often Not The Same

• Ive been an expert witness in 35 cases where
  potential F/S fraud was the issue. There were
  always questions and disagreements about
• Did the accounting constitute F/S fraud, earnings
  management, aggressive accounting, or acceptable
  accounting?
• Did the preparers intend to deceive
• Should the auditors have caught the deception
  
• Are the motivations for litigation justified?
• In the end, the courts decide whether or not the
  accounting constituted F/S fraud

33
How to Prove F/S Fraud

• Proving that F/S were fraudulently prepared means
  intent must be proven. You can only do that
• With sufficient repeated occurrences to infer
  intent (ridiculous estimates or judgments)
• With forged documents
• With admissions by co-conspirators
• Otherwise, it is always argued that the
  accounting involved errors not fraud

34
Why People Act UnethicallyAggressive Accounting,
EM, Fraud
Perceived Pressure
Compromise Triangle


Perceived Opportunity
Rationalization

The compromise triangle is the same
as the fraud triangle!
35
Why People Commit Fraud
Perceived Pressure
Fraud Triangle


Perceived Opportunity
Rationalization

The fraud triangle is one example of the
compromise trianglematter of degree!
36
Pressures to Report More Aggressively
Pressures to report aggressive earnings 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?
37
Pressures to Report More Aggressively

• Five years ago 30 of an executives compensation
  was based on stock prices. Today the equivalent
  figure is 46. The median figure for stock
  ownership by CEOs is four times their pay and for
  CFOs, it is twice their pay.
• Towers Perrin Study

38
Opportunities to Report More Aggressively

• Weak internal controls or overrides of internal
  controls
• Poor oversight by the board of directors,
  auditors, etc.
• Complex business organizations
• Concentration of power in one or two key people
• Lack of vigilance by auditors
• Etc.

39
Rationalizations to Report More Aggressively

• Well only do it once.
• Well get over this problem.
• Were doing it for the greater goodsaving our
  people, saving our company.
• We intend to make it right
• Everyone cooks the books a little
• The government (Wall Street) gave us no choice.
• Our share price will fall

40
Financial Statement Soft Spots
41
Examples of Estimates in F/S

• Depreciation (lives, salvage values, etc.)
• Bad Debts/Collectibility of receivables
• Impairment of Asset Values
• Warranty Expenses
• Pension liabilities

• Revenue recognition
• of completion
• Bundled sales
• Precious metal reserves
• Reserves

42
Most common examples of EM-F/S Fraud

• Revenue massaging (50 of all cases)
• Inventory Frauds
• Understating Expenses/Liabilities
• Overstating Assets
• Acquisition/Divestiture Frauds
• Disclosure Frauds

43
Common Revenue F/S Frauds (50)

• Recognizing revenue prematurely
• Channel stuffing
• Improper cutoff
• Skewed fair value allocations within multiple
  element arrangements
• L-T Construction contract manipulation
• Bill hold transactions
• Accounting for non-reoccurring gains as operating
  revenue
• Failure to eliminate intercompany sales
• Manipulated contra-revenue allowances
• Etc.

• Recognizing consignment sales and other
  contingencies as revenue
• Recognizing sales with guarantees or right of
  return as revenue
• Side agreements
• Recording fictitious sales
• Recording sales to related parties at amounts gt
  market value
• Recording revenue from exchanges of similar
  non-monetary assets
• Recording borrowed funds as revenue
• Sell-in revenue manipulation
• Backdating contracts
• Etc.

Receivables Revenues
(Results in increased revenue, GM, income
assets)
44
Managed Earnings

• I figured out how we can double our quarterly
  sales. From now on, each quarter will last six
  months.

3 months just isnt long enough--what can we do?
45
Revenue-Related Frauds

• Drug Testing Company (SRO)

100 per visit 10 visits per patient 1,000 per
patient 100 patients 100,000 contract
Billing Milestone
500
Visit (100)
1,000 Patient Finished
5
10
Patient Visits
46
Slippery Slope of Fraud
Conservative
Aggressive
Fraud
Patient is First Billing
Each Patient
Change contract finished milestone (5
visits) Visit
terms (white-out) (10 visits)
This companys slippery slope happened as
follows --First recognized revenue when patient
was finished (high drop-out rate and not
paid unless patient finishes) --Next
recognized revenue at first billing milestone
(after 5 visits) --Next recognized revenue
when each visit took place --Finally, used
white-out to change the numbers in the contracts
(multiplied them by a factor of 4)
Last stage is definitely fraud, 2nd and 3rd
stages may be fraud!
47
Misleading Investors Creditors

• Lincoln Savings Loan
• Misled regulators and investors about the company
  and its transactions
• Profitability of the company
• Nature of transactions
• Buyers of property
• Financial position

48
Sale to RA Homes
RA Homes
September 30 Continental Ranch 1300 Acres
Lincoln Savings Loan
September 30 5 million down 20 million Note
September 25, 3 million loan
November 12 2 million Loan
FAS 66 Question
49
West Continental Mortgage
West Continental Mortgage
Lincoln Savings Loan
March 31 Hidden Valley Ranch
March 31 3.5 million down 10.5 million note
March 30 3.5 Million Note
March 31 3.5 Million Note
March 30 30 million Loan
E.C. Garcia Company
May 1 25 million Loan
June 30 34 Million Overpayment
50
ESM Fraud
1,308 Billion Receivable 944 Million
Payable
ESM Group
Fictitious receivable from related entity
Receivable From Outsiders 1.149
Billion
ESM Government
1.513 Billion
Payable to Outsiders
Homestate Savings
51
ESM Footnote to Financial Statements
Note D The company entered into repurchase and
resale agreements with customers whereby specific
securities are sold or purchased for short
durations of time. These agreements cover
securities, the rights to which are usually
acquired through similar purchase/ resale
agreements. The company has agreements with an
affiliated company for securities purchased under
agreements to resell amounting to approximately
1,308,199,000 and securities sold under
agreements to repurchase amounting to
approximately 944,356,000 at December 31, Year
4. Accrued interest receivable from and payable
to the affiliated company at year and were
6,932,000 and 16,454,000 respectively.
52
Inventory/Cost of Goods Sold Financial Statement
Fraud
1. Understating purchases or recording in later
periods 2. Not recording purchases 3. Overstating
purchase returns 4. Overstating discounts 5.
Recording too low an amount as cost of goods
sold 6. Over-counting, over-estimating or
over-stating inventory 7. Not writing off
obsolete inventory 8. Recording fictitious
inventory
53
Inventory Fraud

• PharMor significantly overstated the value of its
  inventory by moving inventory back and forth
  between stores so that it could be included in
  the inventory count more than once.
• Comptronix Corp. made false entries to increase
  its inventory and decrease its cost of sales.
• Laribee Wire Manufacturing Co., which was plagued
  by huge debt, recorded inventory that didnt
  exist and bloated the recorded values of
  inventory that did exist. Shipments between
  plants were recorded as inventory at both plants.
  
• Many companies overvalue obsolete inventories.
  Others create phantom items in the warehouse to
  augment the assets needed as loan collateral.
  Still others count inventory that they pretend
  they have ordered but that will never arrive.

54
Common expense manipulations

• Rainy day reserves
• Inappropriate accruals
• Capitalize when should expense
• Excessively lengthy tangible/intangible asset
  lives
• Unsupportable alterations to asset lives
• Inappropriate Depreciation/Amortization methods
• Unrecognized probable loss contingencies
• Unrecognized asset impairments
• Inappropriate restructuring charges
• Inappropriate nettings/offsets
• Managed allowances
• Not record expenses
• Timing
• Estimates

55
Collusive Loan Fraud

• Case of limited real estate partnerships
• Took out loans on equity in properties
• In far-a-way state
• Bank president was crooked
• Auditors sent confirmations when found liens
• Bank president manipulated loan payoff dates
• Auditors didnt catch fraud

56
Collusive Fraud
Liens on Property
Partnership
Bank
Borrows Money

Sends Confirmation
Audits Bank
Auditor

Removed Liens, Then Re-instated them
57
(No Transcript)
58
(No Transcript)
59
The WorldCom Fraud
60
How the Fraud Took Place

• Operating Expenses to Assets?
• Mr. Sullivans directions affected the income
  statement
• Revenues xxx (no change)
• COGS xxx (no
  change)
• Operating Expenses
• Fees paid to lease other
• companies phone networks xxx (Huge
  Decrease)
• Computer expenses xxx (Huge
  Decrease)
• NET INCOME xxx (Huge
  Increase)

Removed From Income Statement
Removed From Income Statement
61
How the Fraud Took Place

• Operating Expenses to Assets?
• -Mr. Sullivans directions affected the balance
  sheet
• Assets
• Computer assets xxx (Huge
  Increase)
• Leasing assets xxx (Huge
  Increase)
• Liabilities xxx (no
  change)
• Stockholders Equity
• Retained Earnings xxx (Huge
  Increase)

Added to Balance Sheet
Added to Balance Sheet
HAPPY INVESTORS
62
How the Fraud took place?

• Operating Expenses into Assets?
• WorldComs journal entry for 500 million in
  computer expenses
• Computer Assets 500 million
• Expenses/Cash
  500 million

The documents supporting the expenses were never
found!
63
Under-recording depreciation--Fraud at Waste
Management
64
How Was the Fraud Perpetrated?

• Refused to record expenses necessary to write off
  the costs of unsuccessful and abandoned landfill
  development projects 
• Established inflated environmental reserves
  (liabilities) in connection with acquisitions so
  that the excess reserves could be used to avoid
  recording unrelated operating expenses 
• Improperly capitalized a variety of expenses 
• Failed to establish sufficient reserves
  (liabilities) to pay for income taxes and other
  expenses
• Avoided depreciation expenses on their garbage
  trucks by both assigning unsupported and inflated
  salvage values and extending their useful lives
• Assigned arbitrary salvage values to other assets
  that previously had no salvage value
• Failed to record expenses for decreases in the
  value of landfills as they were filled with waste

65
How Large Was the Fraud?

• In 1998, Waste Management restated its 1992-1997
  earnings by 1.7 billion.

66
Common Acquisition/Divestiture Accounting
Manipulations

• Skewed fair value allocations
• Ignored/understated short-lived amortizing
  intangibles
• Excessively lengthy depreciation/amortization
  periods
• Establishing general contingency reserves
• Unsupported/ignored in-process RD
• Inappropriate adjustments to acquiree allowances
• Speculative pro-forma synergies
• Ignored/understated directly attributable
  expenses
• Ignored/understated overhead expense allocations

67
Complaint in Fraud CaseExpert Witness

• Several hundred million in earnings overstatement
• Complaint The goal of this scheme was to
  ensure that (the company) always met Wall
  Streets growing earnings expectations for the
  company. (The companys) management knew that
  meeting or exceeding these estimates was a key
  factor for the stock price of all publicly traded
  companies and therefore set out to ensure that
  the company met Wall Streets targets every
  quarter regardless of the companys actual
  earnings. During the period ___ to ___alone,
  management improperly inflated the companys
  operating income by more than 500 million before
  taxes, which represents more than one-third of
  the total operating income reported by (the
  company.)

68
Complaint in Fraud CaseExpert Witness

• The participants in the illegal scheme included
  virtually the entire senior management of (the
  company), including but not limited to its former
  chairman and chief executive officer, its former
  president, two former chief financial officers
  and various other senior accounting personnel.
  In total, there were over 20 individuals (all
  were business majors) involved in the earnings
  overstatement schemes.

69
Disclosure Frauds

• Undisclosed off balance-sheet entities,
  related-party transactions and derivatives
  manipulations
• 2. 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

70
Enron

• Kenneth Lay
• Founding and last CEO
• Jeff Skilling
• CEO from 2/2001 to 8/2001
• Andrew Fastow
• CFO
• Michael Kopper
• Assistant to Fastow

71
Enrons Corporate Strategy

• Enrons core business was losing moneyshifted
  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)
• Enrons top management gave its managers a blank
  order to just do it
• Deals in unrelated areas such as weather
  derivatives, water services, metals trading,
  broadband supply and power plant were all
  justified.

72
The Motivation

• Enron delivered smoothly growing earnings. Wall
  Street took Enron on its word but didnt
  understand its financial statements.
• It was all about the price of the stock. Enron
  was a trading company and Wall Street normally
  doesnt reward volatile earnings of trading
  companies.
• 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.

73
Special Purpose Entities (SPEs) (Enrons
principal method of financial statement fraud
involved the use of SPEs (Special Purpose
Entitiesnow called Variable Interest Entities
(VIEs)))

• SPEs originally had a good business purpose (To
  help finance large international projects--e.g. a
  gas pipeline in Central Asia)
• Investors wanted risk and reward exposure limited
  to the pipeline, not the overall risks and
  rewards of the associated company
• Pipeline was to be a self-supported, independent
  entity with no fear that the company would take
  over
• SPE was limited by its charter to those permitted
  activities only
• The SPE was really a joint venture between
  sponsoring company (Enron) and a group of outside
  investors
• The cash flows from the SPE operations were used
  to pay investors

74
Enrons Use of Special Purpose Entities (SPEs)

• 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 and 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

75
LJM1 SPE

• One Enron Example (the Rhythms transaction)
• Enron held Internet stock in company called
  Rhythms NetConnections
• Stock was restricted (couldnt be sold for a
  certain period of time)
• Enron didnt want exposure to risk of a price
  drop
• The solution was simple! Find someone else who
  believed the Rhythms stock price would rise and
  was willing to sell a contract (a put option) to
  buy the stock in the future at a set price (a
  hedge!)
• The problem was that Enron couldnt find anyone
  willing 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!

• Enron gave 168 million in Enron shares to LJM1
  (LJM1s 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

76
The Cost of Financial Statement Fraud
77
Some warning signs of financial statement fraud

• A/R or other assets increase substantially faster
  than sales
• Growth in A/P substantially greater than revenue
  growth
• Majority of income from one-time gains
• Operating expenses decline sharply relative to
  sales
• Financing terms change
• Cash flow from operations materially lags net
  income
• Cash flows come primarily from asset sales,
  borrowings or equity offerings
• Change in accounting principles, estimates or
  classifications
• Non-consolidation of related entity
• New, elaborate footnotes

78
Considerations

• In determining if something is financial
  statement fraud, ask the following questions
• Is the EM material to the F/S
• Is the EM intentional
• Will the EM change user decisions
• Is the spirit or letter of the law being
  followed
• What is the motivation for the EM?
• Is there transparency or secrecy?

79
Financial Statement Fraud Statistics

• Attendees at a Business Week Forum of Chief
  Financial Officers revealed
• 67 of CFOs said they had been asked by senior
  company executives to misrepresent corporate
  financial results
• 12 of CFOs admitted they had actually
  misrepresented financial results55 said they
  had fought off requests to cook the books

80
How frequent is fraud/EM

• Another Conference of CFOs
• 78 had been asked to cast financial results in
  better light through using GAAP1/2 complied
• 45 reported they had been asked by management to
  alter their companys financial results38
  complied
• Another study
• 55 had been asked to manipulate financial
  statements .17 complied

81
Financial Statement Fraud Statistics

• The average financial statement fraud lasted 23.7
  months.
• The CEO was most often named as the perpetrator,
  being named in 72 of the cases. The CFO was
  named in nearly 70 percent of
• the cases.
• In 55 of the fraud cases, the last report prior
  to the fraud was an unqualified audit opinion, in
  24 of the cases the last audit opinion contained
  going concern, litigation, or other
  uncertainties, in 17 of the cases the opinion
  had modifications or qualifications due to change
  in accounting principle or change in auditor, and
  in 4 of the cases there were qualifications such
  as a scope limitation.

82
Financial Statement Fraud Statistics (Contd)

• Of the fraudulent companies, 78 were listed on
  the NASDAQ or other over-the-counter markets, 15
  traded on the NYSE, and 7 traded on the American
  Stock Exchange.
• Severe consequences were usually associated with
  companies that issued fraudulent financial
  statements. Thirty-six percent of the companies
  either filed for Chapter 11 bankruptcy, were
  described as defunct in the AAERs, or were
  taken over by a state or federal regulator after
  the fraud occurred.
• Many companies committing the fraud were
  experiencing net losses or were in close to
  break-even positions in periods before the fraud.

83
How rare is fraud?

• In a recent year, there were 25 cases of
  financial statement fraud reported
• In that same, there were 8,873 audits of public
  companies
• 25/8,873 0.003 of all audits

84
Frequency of Earnings Management

• One study estimates that operating profits of SP
  500 stocks have been inflated by at least 10 per
  year for 20 years through a mix of one-time
  write-offs, estimates, timing, and operating
  decisions
• GE had 100 consecutive quarters of increased
  earnings from continuing operations (through
  2000) resulting in highest capitalization590
  billion
• Walmart had 99 consecutive quarters of increased
  earnings from continuing operations (through
  1996)
• GE has long been know as a really aggressive
  practitioner of earnings management (Martin
  Stanley-Credit Swiss)
• No company, no matter how good, has 100 straight
  quarters of increased earnings without some
  management

85
Financial statement restatements
86
Financial Statement Fraud

• Financial statement fraud causes a decrease in
  market value of stock of approximately 500 to
  1,000 times the amount of the fraud.

2 billion drop in stock value
7 million fraud
87
Research Results

• Manipulating income with operating decisions was
  more ethically acceptable than manipulation by
  accounting methods
• Accountants with more years of experience were
  more tolerant of operating decision manipulation
  than younger accountants and both types of
  management were less problematic than for
  accountants with less responsibility

88
(No Transcript)
89
A concluding experience
Do not swim Dangerous Undercurrents