Why so many financial statement frauds all of a sudden?

1. Accounting Updates Southern Gas Association Accounting & Financial Executives Conference April 28, 2003Robert E. (Bob) JensenTrinity UniversitySan Antonio, TX 78212http://www.trinity.edu/rjensen/

2. Why so many financial statementfrauds all of a sudden? Systemic Problems of Accounting That Cannot or Will Not Be Solved: http://www.trinity.edu/rjensen/FraudConclusion.htm "The Perfect Storm" • Behavior of CPA Firms: http://www.trinity.edu/rjensen/fraud.htm Greed on Wall Street: Rotten to the Core http://www.trinity.edu/rjensen/fraud.htm#Cleland Washington DC Prostitutes: Representative Fernand St Germain (D-RhodeIsland) $32 Billion for 30 YearsSenator Phil Gramm (R-Texas) & Wife Wendy $400 billion and countinghttp://www.trinity.edu/rjensen/fraud.htm#WarningSigns

3. Why so many financial statement frauds all of a sudden? "The Perfect Storm" Good economy was masking many problems Moral decay in society Executive incentives Wall Street expectations—rewards for short-term behavior

4. Why so many financial statement frauds all of a sudden? Failure of Corporate Audit Committees "The Perfect Storm" Board of Directors Failures and Greed Financial Analyst Conflict of Interests and Greed: Rotten at the Core • Education Failures: Graduates of Greed Rather Than Professionalism

5. Good economy was masking problems…. With increasingstock prices, profits and wealth for everyone, no one worried about potential problems.

6. Detailed Rules Detailed Complicated Rules With Loop Holes Big Enough To Drive A Truck Through

7. Nature of Accounting Rules Allows companies and auditors to be extremely creative when not specifically prohibited by standards. “rules-based” vs. “principles based” rhetoricalnonsense

8. Loop Hole Examples Include: • SPEs and other types of off- balance sheet financing Revenue recognition approaches, Merger reserves • Pension accounting Other accounting schemes.

9. 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…”

10. Unaccountable Contracts Expect New Amendments in SFAS 149

11. GAAP CRITICISM Fosters Short-Term Earnings Manipulations Does Not Show Value Creation

12. Executive Incentives • Meeting Wall Street’s Expectations • Performance is based on earnings & stock price • Focus is on short-term (quarterly) performance only • Stock prices are tied to meeting Wall Street’s earnings forecasts • Moral Hazard: Employee Stock OptionsDid you ever hear the name Lou Pai? • Companies are heavily punished for not meeting forecasts

13. Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999. Princeton University

14. GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... " Stock Fell 13% With This Revelation Jack Welch, Former General Electric Chairman

15. Enron’s CEO of Enron Broadband Services, Ken Rice, had a $33,000 customized Hellcat motorcycle in his office just for a distinctive decoration. Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land.

16. Beat The Numbers

17. How To Play Numbers Game Aggressive Accounting Earnings Management Income Smoothing Fraudulent Financial Reporting Creative Accounting Practices

18. Rewards of The Game Share Price Effect Borrowing Cost Effect Bonus Plan Effect Political Cost Effect

19. How to value a dot.com company: • Take the reported pro forma 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 it anyway

20. Incentives for F.S. Fraud 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. Firm A Firm B Which firm will have the higher stock price?

21. 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 • 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 • Tradition of sending puppies out to yap at the receivables

22. In a separate case in late September, a judge's divorce ruling unsheathed guarded financial information about accounting firm Ernst & Young, which is a private partnership that does not file public financial reports. In divorce papers for Ernst & Young chief executive officer Richard S. Bobrow, a 45-page judge's opinion revealed how much the CEO was paid and put a dollar value on the company for the first time, giving competitors a rare peek into the firm's finances.

23. Annual Salary $ 3 Million $25 million in salary $US29 million in partnership earnings over the next decade. Pension worth $1 million a year for life and had access to a corporate jet owned by Ernst & Young and a New York apartment. $ 24 million to Janet Bobrow Jan Bobrow makes $ 10 an hour part-time at Central Church of the Nazarene in Lenexa, Kan.

24. Moral Decay • Attendees at the April, 1998 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 results…55% said they had fought off requests to “cook the books” • Honesty studies • 1961: 12% • 1986: 31% • 2002: ???

25. How Much Stanford MBA Worth? • $500,000 dollars • $ 10 Million dollars • $ 100 Million dollars • $ 1 billion dollars

26. The market lopped a cool $1 billion off Veritas' (VRTS) market cap yesterday when its CFO resigned after revealing he lied about his academic credentials. The fundamental picturehasn't changed—unless the CFO's duplicity extended to the books.

27. Executives at Vetrias, storage management software maker, found that CEO’s claim to have earned an MBA from Stanford Business School was false.

28. Financial Statement Fraud Will Destroy Your Shareholder Value

29. 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

30. These Are Interesting Times • Number and size of financial statement frauds are increasing • Number and size of frauds against organizations are increasing • Some recent frauds involve several people—as many as 20 or 30 (seems to indicate moral decay) • Many investors have lost confidence in credibility of financial statements and corporate reports • More interest in fraud than ever before—now a course on many college campuses—from 3 or 4 to over 50 college campuses

31. Current Executive Fraud-Related Problems • Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc. • Executive Loans and Corporate Looting: John Rigas (Adelphia), Dennis Kozlowski (Tyco--$170 million—the $15,000 umbrella stand) IPO Favoritism: Bernie Ebbers ($11 million) • CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM(Consulting Contracts, Use of Corporate Planes, Executive Apartments with meals, maids, etc.)

32. Current Executive Fraud-Related Problems • Exorbitant Stock Options for Executives

33. Complaint in Fraud Case • Several hundred million in earnings overstatement • Complaint: “The goal of this scheme was to ensure that (the company) always met Wall Street’s growing earnings expectations for the company. (The company’s) 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 Street’s targets every quarter regardless of the company’s actual earnings. During the period ___ to ___alone, management improperly inflated the company’s operating income by more than $500 million before taxes, which represents more than one-third of the total operating income reported by (the company.)”

34. Complaint in Fraud Case • “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 involved in the earnings overstatement schemes.”

35. 1. Denmark 2. Finland 3. Sweden 4. New Zealand 5. Canada 6. Netherlands 7. Norway 8. Australia 13 Germany 14. United Kingdom 16. U.S.A. 36. Brazil 40. Philippines 47. Mexico 49. Russia 52. Nigeria Fraud Internationally

36. Largest Bankruptcy Filings(1980 to Present)

37. Recent Financial Statement Frauds • Enron • WorldCom • Adelphia • Global Crossing • Xerox • Qwest • Many others

38. Enron’s Use of Special 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 (Market 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

39. Special Purpose Entities & Off-Balance Sheet Financing What is the business purpose? To transfer risks and losses to someone else One Enron Example (the “Rhythms” transaction): • Enron holds Internet stock in company called Rhythms NetConnections • Stock is restricted (can’t be sold for a certain period of time • Enron doesn’t want exposure to risk of a price drop • The solution is simple! Find someone else who believes the Rhythms stock price will rise and is willing to sell a contract (a put option) to buy the stock in the future at a set price (a hedge!) • The problem is that Enron can’t 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 does the financing come from? • 97% from bank loan  Guaranteed with Enron stock • 3% from entity other than Enron Andrew Fastow and others! Now “Do the Deal” • Enron gives $168 million in Enron shares to LJM1 (LJM1’s primary asset) • LJM1 gives Enron a note for $64 million and a put option valued at $104 million • When everything “settles out,” Fastow receives $15 million for his $1 million investment • Enron gets to “hedge” (i.e., not report) a $103 million market loss on its stock investment

40. LJM1 SPE • Responsible for 20% of SPE restatement or $100 million • Should have been consolidated—an error in judgment by Andersen (per Andersen) • After Andersen’s initial review in 1999, Enron created a subsidiary within LJM1, referred to as Swap Sub. As a result, the 3% rule for residual equity was no longer met. • Andersen was reviewing this transaction again at the time problems were made public—involved complex issues concerning the valuation of various assets and liabilities.

41. The Chewco SPE • Accounted for 80% of SPE restatement or $400 million—hid losses • In 1993, Enron and the California Public Employees Retirement System (Calpers) formed a 50/50 partnership—Joint Energy Development Investments Limited (JEDI) • In 1997, Enron bought out Calpers’ interest in JEDI • Chewco Financing • $240 million loan from Barclays, guaranteed by Enron • $132 million loan from JEDI • $11.4 million loan from Barclays; called Equity • $0.1 million from Enron employee • Financial reward to Enron employee • $2 million management fee over 3 years (remained full-time Enron employee) • $10 million liquidation ($125K investment)

42. LJM2 SPERaptors I-IV • Established by Enron CFO to provide a quick buyer for Enron assets • By December 2000, $1.5 billion in “hedged” investments, $500 million Enron “gain” • Financial reward to Enron CFO—at least $15 million • Enron Financial Statement Impact—Hedged $1 billion in losses over 5 quarters; reported earnings of $1.5 billion.

43. Insufficient Disclosure……. • 2000 Proxy Statement “During 2000, certain Enron subsidiaries…entered into a number of transactions with LJM2 Co-Investment…Andrew S. Fastow, Executive Vice President and Chief Financial Officer of Enron, is the managing member of LJM2’s general partner.” • Paragraph outlining the transactions • “These transactions occurred in the ordinary course of Enron’s business and were negotiated on an arm’s length basis with senior officers of Enron other than Mr. Fastow. Management believes that the terms of the transactions were reasonable and no less favorable than the terms of similar arrangements with unrelated third parties.”

44. 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?”

45. Role of Andersen • Was paid $52 million in 2000, the majority of which was for non-audit related consulting services. Failed to spot many of Enron’s losses Kept a whole floor of auditors assigned at Enron year around • Enron was Andersen’s second largest client

46. Did both external and internal audits • CFOs and controllers were former Andersen executives • Accused of document destruction—was criminally indicted • Went out of business • One Partner “I had $4 million in my retirement account and lost it all.” Some partners who transferred to other firms now have two equity loans and no retirement savings.

47. Enron’s Audit Committee Auditor (Arthur Andersen) Enron’s Executives Where was Anderson? Did they know? • 2/5/01: Andersen partners meet to discuss Enron’s accounting, related parties, fees, etc. • Issue: For a significant amount of time, according to notes of the meeting, the Andersen accountants debated a critical point: What should they do about two SPEs, LJM1 and LJM2, that had been set up 18 months earlier by Fastow? • Resolution: They drew up a "to do" list: • Recommend a special committee of the Board to review LJM deals. • Review the SPE accounting tests. • 2/12/01:The Big Meeting: Andersen partners meet with Enron board's audit and compliance committee. • All Enron executives were excused from the room. • And then………..no evidence of any discussion • Interesting side note: From 1997 to 2001, Enron paid Andersen $5.7 million in connection with work performed specifically on the LJM and Chewco transactions.

48. Anderson Shredding The Document Destruction Chronology • October 12 – Nancy Temple sends “Document retention policy” email to Michael Odom. • October 17 – SEC asks Enron for information about its accounting. • October 23 – David Duncan calls urgent meeting, organizes effort to shred and dispose. • The topics of discussion, according to a typed agenda, included: • "SEC probe/shareholder lawsuits" and • "soft and hard copy file review." • November 8 – Andersen receives subpoena from SEC. • November 9 – Duncan’s assistant sends email to secretaries: “no more 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 Mike- It 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

49. The Cost of “Bad Press”

50. Some partnerships' losses would have to be paid for out of Enron stock or cash in 2003, bringing the debts back home. There are indications that Enron executives and its accounting firm, Arthur Andersen, had warnings of problems nearly a year ago. According to a Feb. Andersen considered dropping Enron as a client. In August, Enron Vice President Sherron Watkins wrote an anonymous memo to former Chairman Kenneth L. Lay, detailing reasons she thought Enron "might implode in a wave of accounting scandals."