Profit Manipulation & Fraud

1. Profit Manipulation & Fraud Dr. Clive Vlieland-Boddy

2. Profit Measurement

3. Content How to make 2+ 2 = 3 or 5! Balance with Corporate governance Top Management fraud Accounting fraud The case of Enron – an example 3

4. Top Management fraud Fraud committed by members of the boards Abuse of power Demage of the company and third parties A common case of Top Management fraud is  accounting fraud 4

5. Common Earnings Management • Smoothing earnings (moving profits between years) • Managing earnings upward (moving profits between years) • Taking a bath • Off balance sheet financing

6. Taking a Bath • What companies / CFO’s will do in bad years • Positioning to manage earnings in good years • Sometimes, they will “profit” from the bathwater and write all off in one year so as to clear the past problems in one hit. • Window Dressing

7. Earnings Management Acceptable “Earnings Management”:Being Cautious • “Optimizing financial performance through pro-active operational decision making coupled with the effective selection and application of acceptable alternative available within the parameters of IFRS” Unacceptable “Earnings Management” Being Greedy! • “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”

8. Accounting Fraud - Incorrect financial statement presentation • Unjustified classification • Merge items of a balance sheet which should be displayed separately (Netting Assets and Liabilities!) • False naming of balance sheet and income statement items • Unjustified balancing • Even though false balancing doesn‘t change the net profit, it displays the items in an incorrect way 8

9. Earnings Management • Common Revenue Manipulations: • Premature Recognition • Channel Stuffing • Backdated Contracts • Fictitious Transactions • Related Party Transactions

10. Accounting Fraud -Falsification of profits • Valuation fraud • overvaluation (defaulted extraordinary depreciation) • untervaluation (of provisions) • Defauted booking of an asset or a liability • Booking of a not existing asset or a liability 10

11. Accounting Fraud - Creative accounting or “Window dressing“ Managers try to present the company in a better shape than it is by: • Progressive balancing in bad times • Avoid booking of provisions • Valuation of inventory as high as possible • Linear depreciation 11

12. Accounting Fraud- Creative accounting as “window dressing“ Managers try to present the company in a worse shape than it is by: • Conservative balancing in good times • Booking of provisions for expenses • Valuation of inventory as low as possible. • Accellerated depreciation 12

13. Examples

14. Prepaid Expenses Objective: Inflate them How they do it: No future Economic value

15. Non Current Assets Objective: Inflate them How they do it: Don't own Inflate values Insider sales

16. How they do it: No future value No cash outlay Fail to amortize Intangible Non Current Assets Objective: Inflate them

17. Objective: Inflate it CashLikelihood of Fraud – How they do it: Cash journals Misclassification

18. Inflate them Inflate them Misclassify them Misclassify them How they do it: Fictitious receivables Insider receivables Understate allowance Accounts Receivable Trade Likelihood of Fraud – Objectives:

19. Objective: Decrease Reported Income Income Statement Revenues Expenses Income

20. Objective: Inflate it Quantities and prices Inventories – Basic Principles Ending inventories = Net income

21. Accounting Fraud

22. Top Management • The ability of top management to override controls significantly increases the likelihood of fraud

23. Accounting frauds in the USA Enron (Energy, 2001) Reliant Resources/CMS Energy/Dynegy (Energy, 2002) Worldcom (Telecommunications, 2002) Xerox (Office Technology, 2002) Tyco International (Conglomerate, 2002) Global Crossing (Fiber Glass Supplier, 2002) Merck (Pharmaceutical Industry, 2002) Adelphia Communications (Cabel Network, 2002) AOL Time Warner (Media, 2002) Computer Associates (Software, 2004) 23

24. Accounting frauds in Europe SAir Group (Airline, CH, 2001) Lernout & Hauspie (Speech Products, B, 2001) Ahold (Retailer, NE, 2003) Yline (Software & Internet Services, AUT, 2003) Parmalat (Food Industry, Italy, 2003) Adecco (Leasing personell, CH, 2004) ABB (Electro Technics, CH, 2004) 24

25. One Small Clue A former Scotland Yard scientist tried to create the world’s biggest fraud by authenticating $2.5 trillion worth of fake U.S. Treasury bonds. When two men tried to pass off $25 million worth of the bonds in Toronto in 2001, a Mountie noticed the bonds bore the word “dollar” rather “dollars.” Police later raided a London bank vault and discovered that the bonds had been printed with an ink jet printer that had not been invented when the bonds were allegedly produced. Zip codes were used even though they were not introduced until 1963.

26. Financial Reporting Fraud • Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared. • Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information. • Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

27. Activities to Boost Earnings • Recording revenue before it is earned. • Creating fictitious revenue. • Boosting profits with nonrecurring transactions. • Shifting current expenses to a later period. • Failing to record or disclose liabilities. • Shifting current income to a later period. • Shifting future expenses to an earlier period.

28. Four Factors Contributing to Business Fraud • Motive • Opportunity • Lack of integrity (or rationalization) • Capacity—the person must have the necessary traits, abilities, or positional authority to commit the crime

29. Components of Internal Controls • Control environment • Risk assessment • Control activities or control procedures • Information and communication systems support • Monitoring

30. Enron A real fraud

31. Foundation of Enron Corp. 1985: after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth In the process of the merger, Enron incurred massive debt In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow 31

32. The rise of Enron – The gas bank • Revolutionary solution to Enron's credit, cash and profit woes: a "gas bank" in which Enron • would buy gas from a network of suppliers and sell it to a network of consumers, • contractually guaranteeing both the supply and the price, • charging fees for the transactions and assuming the associated risk. 32

33. The rise of Enron – EOL Enron applied the „gas bank-concept“ to • the market for electric energy (1996) • other tradeable „commodities“ like coal, paper, steel, water, weather (1997) • 1999: Enron created EOL – an electronic commodities trading Web site, handling $335 bn in online commodity trades in 2000 33

34. The rise of Enron & The energy derivative • Enron created both a new product and a new paradigm for the industry  the energy derivative • Enron Finance Corp. • dominated the market for natural gas contracts • could predict future prices with great accuracy • thereby guaranteeing superior profits 34

35. External conditions and requirements Enron started to face various difficulties: • No appropriate accounting rules for such innovative products or concepts • Increasing requirements on debt ratio by rating agencies such as S&Ps Moody‘s • Increasing profit expectations of shareholders 35

36. Mark-to-market accounting outstanding derivative contracts on balance sheets at the end of a particular quarter  adjustment to fair market value, booking unrealized gains or losses to the income statement of the period. no quoted prices upon which to base valuations for long-term futures contracts in commodities such as gas 36

37. Credit ratings • To satisfy credit rating agencies, Enron had to make sure, its ROA and equity ratio is within an acceptabel range  reducing hard assets  earning increasing paper profits  using special purpose entities (SPV‘s or SPEs) 37

38. The structure of SPV / SPEs  sellshardassets  contributes hard assets and debt  borrows the bank credits without showing it up on the balance sheet Enron SPVs  in exchange for debt guarantees  booksprofits  gives credit to SPVs Bank 38

39. The subjects of fraud Market manipulation Sales and profit manipulation „Asset light“-strategy and minimizing of capital SPVs – Off-Balance-Sheet-Treatment of risks and liabilities Lack of an internal control system Lack of trancparency of Enron‘s disclosures Misbehaviour of auditors, banks and rating agencies 39

40. Aftermath of the Enron case • Critisism on the accounting profession • Adequacy of the U.S. discloser practices • Integrity of the independent audit process • Loss of confidence in financial markets  To restore the investor‘s confidence in financial reporting, SEC called for a new financial reporting system 40

41. Bye for now! Please ensure you Prepare for next session I’m ready forsome leisure time.