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Gary Giroux

Social Research: An International Quarterly, Volume 74, Number 4,

Winter 2008, pp. 1205-1238 (Article)

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DOI: 10.1353/sor.2008.0026

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Gary Giroux
What Went Wrong?
Accounting Fraud and
Lessons from the Recent
Scandals

In the public eye, Enron’s mission was nothing more than

the cover stoiy for a massive fraud.
—Bethany McLean and Peter Elkind

CORPORATE FRAUD, BANKRUPTCIES, AND VARIOUS ILLEGAL ACTS HAVE

always been part of the business environm ent. Every tim e fiascos erupt
there is a shock, but business history records dozens o f m ajor failures,
frauds, and other measures o f massive corruption each decade. The big
ones often h it during recessions or periods of other economic problems,
as expected. The high-risk firms are the m ost vulnerable to economic
shocks. The recent scandals are no exceptions. The m ost im portant
scandals are the focus of this paper and are summ arized in table 1.
Although th e problem s th a t exist are diverse, a few com m on
characteristics stand out. The first is the obvious backdrop o f corporate
greed. Presumably, senior executives expect to get away w ith it. They
also fit the financial-corporate culture described above. And earnings
m anipulation is part of (and usually central to) m ost o f the scandals.
Some of them used brazen and unsophisticated approaches (such as
WorldCom), while others used new, sophisticated devices to defraud
(like Enron). Determ ining th e existence of crim inal acts takes years.

social research Vol 75 : No 4 : W inter 2008 1205

Table 1. Twenty-First-Century Scandals
Company Year Description
Enron 2001 Declared bankruptcy on December 2, 2001
after restating earnings in the 3rd-quarter
10-Q, indicating major problems with spe­
cial-purpose entities. Investigations by the
SEC, Justice Department, and others; execu­
tives indicted and class-action lawsuits
filed.
Global 2002 Overstated revenue and earnings over net­
Crossing work capacity swaps and then declared
bankruptcy; investigated by SEC and FBI.
WorldCom 2002 Recorded improper expenses of $3.8 bil­
lion and then declared bankruptcy; under
investigation for accounting fraud and other
violations; the amount of improper expenses
uncovered approached $10 billion.
Tyco 2002 Conglomerate with questionable practices
on accounting for acquisitions and other
issues. Restated 1999-2001 financials based
on merger-related restructurings plus other
problems with reserves. CEO and CFO
indicted.
Qwest 2002 Subject to criminal investigation by Justice
Department and accounting practice probe
by the SEC, associated with “hollow
swaps.”
Adelphia 2002 Cable TV operation charged with over­
stating earnings; former CEO John Rigas
charged with looting the company, which
went bankrupt.
Imclone 2002 Insider trading charges against former CEO
for selling stock after FDA rejected a new
drug; alleged to have tipped off Martha
Stewart and other friends and
relatives.
Merrill Lynch, 2002 Major investment banks settled with the
Salomon, New York attorney general, SEC, and other
Smith Barney, regulators on deceptive stock analysis and
Credit Suisse, other brokerage-related practices, similar
Goldman to Merrill Lynch earlier. The total fine was
Sachs, J. P. a combined $2 billion approximately, plus
Morgan, and other sanctions and agreement to correct
others deceptive practices.

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Table 1, continued
HealthSouth 2003 Accused of accounting fraud involving $1.4
billion in earnings and $800 million in over­
stated assets. Former CFO and others plead­
ed guilty to fraud charges.
The Mutual 2003 The mutual funds have only limited SEC reg­
Funds Scandal ulation requirements and often poor corpo­
rate governance, yet have been considered
highly ethical. That changed when New York
Attorney General Eliot Spitzer sued them on
several counts. Some pundits consider the
mutual fund scandal as egregious as Enron.
Fannie Mae 2004 Fraudulent accounting practices totaling
$16 billion and extensive payouts to ousted
executives; earnings restated and executives
fired.
AIG 2005 Internal control weaknesses and poor corpo­
rate governance; CEO fired.
Stock Option 2006 Backdating options grant date to lower
Backdating stock price; dozens of companies investi­
gated by SEC.
Subprime 2007 Massive number of mortgage loans to sub­
Loans prime borrowers, often without documen­
tation. Mortgages then repackaged through
SPEs and sold as bonds. Huge losses taken
at major financial institutions and many
executives fired. An FBI investigation is
ongoing.

Two industries were particularly prom inent in the scandals: the

energy companies and telecom m unications. Deregulation allowed the
stodgy energy companies th a t carried out such basic operations as trans­
m itting natural gas to becom e high-tech energy traders using sophis­
ticated derivatives and structured-finance deals. The result was giant
profits for the lenders. Continued big profits m eant increasing risks
and more complex deals. For Enron and others it also m eant hiding the
losses in controversial and often fraudulent off-balance-sheet schemes.
The telecom m unications industry transform ed from m onopolist AT&T
in the 1970s to a group of dynamic and competitive high-tech giants,
all trying to integrate and dom inate w ith new telecom m unications

Accounting Fraud and Lessons from Recent Scandals 1207

m ethods. Overcapacity led to shady capacity-trading schemes booked
as revenues and, despite the deceptive accounting, big losses and bank­
ruptcies.
The various investm ent bank scandals are included because their
deceptive practices encouraged earnings m anagem ent and an environ­
m ent of fraud. The recent m ortgage-related scandals directly involve
investm ent banks. Investm ent banking deals, especially those th a t
were complicated and skirted the regulations, were veiy profitable. The
banks would seemingly do any deal and locate it anywhere in the world
for the right price. Rather th a n em phasizing financial and economic
reality, analysts and brokers were encouraged to push stocks of compa­
nies doing investment-banking business w ith the parent company, irre­
spective of the underlying perform ance potential.
Enron and W orldCom w ere the largest scandals in Am erican
history in term s of the size of the companies (based on m arket capi­
talization). Both represent fraud on a large scale, although entirely
different from one to the other. Enron used sophisticated fraud based
on complex financial instrum ents, while WorldCom used an unsophis­
ticated scheme o f capitalizing operating expenses for several billion
dollars. Many o f the other corporate scandals around 2002 also involved
relatively large companies. The shock of Enron led to congressional
hearings and, after the fall of WorldCom some six m onths later, real
financial reform w ith the passage of the Sarbanes-Oxley Act of 2002.

ENRON
Enron is the prem ier scandal, a “new economy” energy-trading company
th at seemed to succeed at everything it attem pted. At its height, which
occurred on August 23, 2000, Enron had a stock price over $90, which
gave it a m arket value of alm ost $70 billion. Revenues for 2000 were
over $100 billion, m aking it the seventh-largest American corporation
(based on revenues); stated assets were $65.5 billion; earnings were $1.3
billion (if a $287 m illion write-off is ignored). Stock returns for Enron
were large, 89 percent ju st for the year 2000 and 700 percent for the
decade. This performance resulted in huge com pensation payments to

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Enron chairm an Kenneth Lay (a base salary of $1.3 million, $7 million
bonus, plus 782,000 stock options for the year; Lay also exercised 2.3
m illion options, for a gain o f $123 million). M anipulation was paying
off. The stock would trade for less th an $1 later in 2001, the debt would
be rated ju n k and the company declared bankruptcy December 2, 2001.
Despite the total collapse, m any of the executives would cash out their
options and be paid additional m illions, while thousands of Enron
employees were fired and lost all of their retirem ent funds invested in
Enron.
In term s of scandal, Enron had it all: gigantic executive compen­
sation incentive packages; m anagem ent dedicated to m eeting all
quarterly earnings forecasts to m aintain the com pensation—often by
accounting m anipulation; a rubber-stam ping board of directors; a chief
financial officer (CFO) enriching him self through related-party partner­
ships and hidden side agreements; an accommodating auditor in Arthur
Andersen, and an equally accom m odating law firm in Vinson and
Elkins; investm ent bankers who would structure virtually any financial
deal anywhere in the world for big fees, and whose financial analysts
always seemed to rate Enron a strong buy, no m atter the economic real­
ity; and a political system th a t often stacked the deck in favor of Enron,
thanks in part to large campaign contributions and massive lobbying.
People who raised doubts, both inside and outside the company, were
often fired. Otherwise, there seemed to be a com plete lack of ethical
standards by alm ost everyone involved. Enron can be considered a
microcosm of the entire scandal environm ent.
There have been m ore books and articles w ritten about Enron
than any other scandal, m any w ritten by insiders and joum alists follow­
ing Enron for years. Power Failure: The Inside Story of the Collapse of Enron
(2003) is coauthored by whistleblower hero Sherron Watkins (with jour­
nalist Mimi Swartz), an Enron vice president who attem pted to convince
CEO Kenneth Lay of the seriousness of the accounting m anipulations.
Kurt Eichenwald’s Conspiracy of Fools (2005) is the last of the significant
books and probably the best in detailing the Enron story. Other books
include The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall

Accounting Fraud and Lessons from Recent Scandals 1209

of Enron (2003) by Bethany McLean and Peter Elkind; Anatomy of Greed:
The Unshredded Truth From an Enron Insider (2002) by Brian Craver; and
Enron: The Rise and Fall (2003) by Loren Fox. Enron: What Happened and
What We Can Learn From It, by Bentson and Hartgraves (2002) was a seri­
ous academic attem pt to pu t the Enron scandal into perspective for the
future of financial accounting and auditing.

THE EARLY YEARS

Enron started as a big, stodgy gas tra n sm ission com pany w hen
InterN orth Inc. and Houston Natural Gas m erged in 1985. It had the
largest gas transm ission system in th e United States: a 38,000-mile
pipeline network. Kenneth Lay soon became CEO. The nam e Enron was
adopted in 1986. One result for the m erger was a load of debt, a continu­
ing problem w hen Enron executives w anted to expand rapidly—and
new ju n k bonds did not help the leverage ratios or investor confidence.
(Enron bounced around betw een low investm ent grade and ju n k bond
ratings.)
Enron’s first scandal was in 1987. The dubious response by Lay,
A rthur Andersen, and others suggests th e ir interest in profits over
ethics and willingness to hide bad news. The com pany had a small
energy-trading subsidiary in New York called Enron Oil. It was started
and ru n by Louis Borget. Although profitable (im portant for a slumping
Enron), it was fraudulent from the start. Part of the m anipulation was
moving profits from one period to the next, apparently based on orders
from Houston.
Enron’s auditor, A rthur Andersen, investigated and discovered
several unusual transactions and potentially fraudulent acts. They
reported to Enron’s audit comm ittee, b ut w ould not com m ent on the
illegality of the acts. If m aterial, Enron would have to disclose the im pro­
priety to the Securities and Exchange Commission (SEC) and restate
earnings. Rather th an face these sanctions (and possible bankruptcy),
Enron declared the problems im m aterial and did not disclose the bogus
transactions. Andersen w ent along w ith the decision. And, amazingly,
Borget stayed on. A crooked operation seemed to be okay if profitable.

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 Unfortunately for Enron, Borget was still a crook. Some of the
fraudulent acts benefited Enron, but Borget was interested in diverting
cash for him self and accomplices. There were two sets of books, one
real and one for the Houston office. There were sham transactions, kick­
backs from brokers, phony companies, and various offshore accounts.
Borget skimmed some $4 m illion from Enron. Borget speculated using
cash vastly beyond the lim it am ounts stated by Enron, and later bet
wrong on the price of oil. Trading losses approached $1 billion before
he confessed. Enron ended up taking an $85 m illion loss (after taxes) in
1987. Despite the earlier indications o f fraudulent activities, Lay denied
responsibility and blamed only the rogue traders for the loss.
The SEC and U.S. attorney’s office investigated Enron, b u t the
focus was on Borget and his cronies. Borget was sentenced to a year in
jail. The trading operation was shut down. Enron restated earnings in
1988, but survived despite this lack of honesty. However, it seems the
lesson th at Lay and others drew from the episode was the im portance of
cover-ups and obfuscation. The basic internal controls and governance
policies in place did not w ork but rem ained uncorrected.

GAS TRADING
U ntil th e 1980s, n atu ral gas was highly regulated and gas prices
controlled. Gas contracts w ere m ainly long term and relatively little
risk was present for buyers and sellers. Pipeline profits were fairly low
but dependable. That all changed w ith deregulation. W ith volatile gas
prices subject to m arket conditions and the potential for lower prices,
gas users moved from long-term contracts to the spot m arket (initially
30-day supply contracts). In this now unstable m arket, prices initially
fell, supply dropped, and prices rose again.
This was n ot a profitable environm ent for a pipeline company.
Lay’s business strategy shifted to the unregulated gas sales m arket,
w hich lent to Enron’s gas-trading business. Enron bought and sold stan­
dard am ounts o f gas and becam e a m arket maker, initially from the
standard spot m arket contracts. As th eir expertise increased, Enron
traders moved to offering longer-term contracts, for which they could

Accounting Fraud and Lessons from Recent Scandals 1211

charge a prem ium over spot prices. Enron would become the largest
gas trader in North America by the early 1990s.
Suppliers and users often w ant to hedge certain risks, such as
future rising or falling gas prices. As a m arket m aker, Enron could
provide forw ard contracts (at stated future prices) to m eet this risk.
As long as Enron had roughly an equal num ber of buyers and sellers,
both Enron and the custom ers could be fully hedged. The New York
Mercantile Exchange (NYMEX) would standardize these as gas futures
contracts. Enron would move into additional—and m ore complex—
derivatives, such as options and swaps. In a swap prices are exchanged,
usually fixed for variables (such as interest rates). Enron also started
swapping oil for natural gas (see Giroux, 2004, chap. 11, for a m ore
thorough discussion o f derivatives).
In the new world of deregulated gas, finding and selling natural
gas became risky and banks were reluctant to loan m oney to produc­
ers, at least the smaller ones called wildcatters. To solve this problem,
Enron form ed the Gas Bank in 1989, ru n by form er Kinsey consultant
Jeffrey Skilling. The idea was to provide a m ore stable m arket, w ith
Enron in the profitable middle. The producers contracted to sell their
expected future natural gas to Enron. Enron would give them the cash
up front, the equivalent of a bank loan. The producers would th en drill
for new gas and pay off Enron in gas rather th an cash. Simultaneously,
Enron would contract to sell the gas to users in the future at a set price.
Since the future prices were now known (to Enron), the company could
“len d ” m ore m oney to the producers. The result: relative stability.
The price and supply were now guaranteed, as was Enron’s expected
return.
Skilling had another innovative idea: trading these contracts.
His idea was to be an active trader ra th e r th a n an ow ner of these
resources—his “asset-light” strategy. Of course, Enron always owned
substantial pipeline and o th er heavy assets and the massive debt to
fund these expensive assets. But Skilling would continue to prom ote
th e asset-light strategy and seem ed to successfully convince analysts
and investors.

1212 social research

MARK-TO-MARKET
W hen Skilling started at Enron, he dem anded th at his division
use m ark-to-market accounting; in other words, long-term gas delivery
and other trading contracts would be valued at m arket or fair value
rather th an the m ore typical historical cost (where the income would
be spread over the life of th e contract and roughly m atch actual cash
flows). Accounting standards have m oved (som ewhat slowly) from
historical cost to m arket value for financial instrum ents (but generally
no t for physical assets). The current rules are based on the Financial
A ccounting Standards Board’s Statem ent No. 157 (2006). Mark-to-
m arket for gas contracts was a stretch at the tim e, b u t was approved
by Enron’s board of directors and th e SEC. Enron would expand the
use of mark-to-market and th e technique became a generator of huge
earnings and a m ajor m echanism for quarterly earnings m anipulation.
(The later subprim e m ortgage scandals also relied on mark-to-market
accounting for earnings manipulation.)
Mark-to-market is an appropriate technique for financial instru­
m ents where a well-developed m arket exists (such as the stock market)
and specific closing prices are obvious. Fair values are recorded on the
balance sheet and gains and losses imm ediately recognized, usually on
the income statem ent. Thus, profits are “front-loaded” (that is, reported
immediately). The essential logic is th a t it the actual trade contract
th at determ ines profitability, while actually fulfilling the contract (and
generating cash) becomes secondary.
At the end of every accounting period the financial instrum ents
are revalued to the new m arket value. Consequently, earnings vola­
tility is common. However, Enron was recording relatively long-term
contracts using mark-to-market. Reliable m arket values really did not
exist on gas prices one to te n years out. Pricing became an exercise in
“mark-to-model,” w ith m ath models predicting values. Because of this,
big gains could be recorded before any gas (or cash) changed hands.
Since trader incentives were based on the value o f the trades and not on
actual gas deliveries, predictions were optimistic. On a quarterly basis,
if Enron was desperate for additional incom e, these contracts could

Accounting Fraud and Lessons from Recent Scandals 1213

be recalculated on an even m ore optim istic basis. W hen incom e was
greater th an expected, large reserves (called cookie jar reserves) could
be set up for potential future trading losses (for m ore on revenue recog­
nition and the use of fair value, see Giroux, 2006, chaps. 8 and 14).
Actual cash flows depend on fulfilling th e long-term contracts,
w ith actual profit based prim arily on current gas prices. Based on mark-
to-m arket, incom e was tak en from trading and expected long-term
re tu rn and was independent o f actual cash flows. Thus, th e gain on
a 10-year contract to deliver a set am ount o f gas each m onth would
be booked im m ediately (and, at least theoretically, revalued quarterly),
b u t actual cash flows w ould be spread out over the 10-year delivery
period. Since Enron did n ot have a long-term operating perspective,
this was a strategy for disaster.
A basic technique to record cash as a “cash from operations”
item (suggesting th a t earnings are tied closely to cash performance)
rath er th an “cash from financing” (primarily borrowing) was the use
o f prepaym ents (prepays). Enron was loaning m oney to gas producers
through the Gas Bank and th en using m ark-to-m arket to record the
expected earnings; however, no cash was generated (cash would come
several years later w hen the gas was delivered). Enron would “contract”
w ith offshore entities to deliver natural gas in the future and be paid
cash (recorded as cash from operations). But these contracting entities
were actually set up by Chase M anhattan and other Enron bankers to
appear as legitimate sales w hen in fact they were disguised loans. These
prepays could am ount to billions of dollars and camouflaged the actual
negative cash flows w hen Enron was reporting large earnings (a signal
o f m anipulation to m ost analysts). They also did not report the obliga­
tion for cash received as a liability on the balance sheet.
It should be pointed out th a t Enron traders w ere experts at
gas prices and innovative a t developing new gas-related derivatives
instrum ents. Commodities trading (Enron expanded to electricity and
other commodities trading) became Enron’s m ost profitable business.
However, th at profitability was overstated using m ark-to-m arket and
included the obvious valuation problems. Various Enron groups also

1214 social research

speculated on com m odities prices, usually profitable b ut not always.
Enron was relatively successful at camouflaging th e losses associated
w ith volatility and wrong predictions.

STRUCTURED FIN A N C IN G AND SPECIAL PURPOSE

ENTITIES
Enron is particularly infam ous for its use o f structured financing, espe­
cially special purpose entities (SPEs). Structured financing and SPEs
have been an increasingly com m on set of financial arrangem ents used
predom inately by banking and o th er financing organizations and
would play a m ajor role in the later subprim e mortgage scandals. Banks
started moving m ortgage and loan receivables into SPEs beginning in
the 1980s and would th en “securitize” them for resale as bonded debt
instrum ents. The SPE places assets and corresponding liabilities in a
separate legal structure (perhaps a partnership). The SPE m ust have at
least one independent equity investor contributing assets of at least 3
percent of th e fair value of assets (this was raised to 10 percent after
Enron’s collapse). To be independent, the investor m ust be an outsider
and assume the risk of the transaction(s) involved. Independence would
become a m ajor flaw in Enron’s schemes.
The rationale of the SPE is to perform specific tasks and isolate
financial risks. All the technical details m ust be m et (for example, the
independent investor and the equity investm ent at risk) or the SPE m ust
be consolidated into th e financial statem ents o f the parent, Enron.
(Accounting procedures for SPEs are complex and are governed prim ar­
ily by Financial Accounting Standards Board (FASB) Statem ent 94 and
140 and FASB Interpretation 46R. See Giroux, 2006, chap. 12).
The basic idea of securitization is to convert assets (either finan­
cial or physical) to securities based on the future cash flows, sell these
to investors, and record cash. The liabilities are transferred to a sepa­
rate entity, cash is received (that m ay be recorded as cash from oper­
ations—w hich Enron needed to convince analysts th a t profits were
real), and the whole package priced at m arket value, usually for a nice
gain recorded on the income statem ent. W hen an active m arket exists,

Accounting Fraud and Lessons from Recent Scandals 1215

such as the stock m arket, pricing is straightforward (generally the most
recent closing price). W hen an active m arket does not exist, pricing is
usually based on m athem atical models, w hich can be m anipulated.
A big problem w ith Enron’s potential growth was its massive debt
load and ju n k bond rating (later raised to low investm ent grade and
back to ju n k status before the final collapse). To continue to grow, the
company turned more and m ore to SPEs. Skilling hired Andrew Fastow
as an SPE specialist, who combined various energy-related assets th at
were th en sold to institutional investors. Fastow created Enron’s first
SPE in 1991, called Cactus, to fund long-term contracts w ith oil and
gas producers. The Gas Bank required cash paym ent to producers, to
be later paid back in gas. Some $900 m illion of these contracts were
bundled together and sold as packages to General Electric and other
investors. Enron received th e investor cash equivalent to w hat was paid
to the producers (using borrow ed money) and moved the debt to the
SPE. Cash was generated and the debt moved off the balance sheet.
The basic purpose of Enron’s use o f SPEs and other structured
financing techniques was to “keep fresh debt off the books, camouflage
existing debt, book earnings, or create operating cash flow” (McLean
and Elkind, 2003: 155). U nder Fastow, they becam e bigger, m ore
complex, and m ore deceptive. Increasingly, the focus became m anipu­
lation rath er th an legitim ate financial purposes. As SPEs grew m ore
deceptive, independent investors became harder to locate and the struc­
ture th en emphasized w hat was the bare m inim um th at the auditors,
lawyers, and regulators w ould allow. The investm ents (plus a sizable
return) were often guaranteed by Enron, another violation o f the intent
of the SPE. Then Fastow and his employees became the so-called inde­
pendent investors, m aking a travesty of the concept o f independence
and economic reality.
In 1993, Enron form ed a 50-50 partnership (a jo int venture) w ith
California Public Employees’ Retirem ent System (CalPERS) to invest in
natural gas project called JEDI. The use of jo in t ventures requires the
equity m ethod (see Giroux, 2006, chap. 14), w hich effectively hides debt,
since the net am ount invested is recorded as a single line-item called

1216 social research

“Investm ents” on the balance sheet. CalPERS invested $250 m illion
in cash, Enron an equivalent am ount in Enron stock. Therefore, the
value of JEDI would go up and down w ith Enron’s stock. JEDI acquired
a num ber of production companies (it also was allowed to loan money,
form partnerships, and c a n y out other investm ent techniques), which
provided added opportunities for Enron and was reasonably profitable.
Enron bought out CalPERS’ JEDI share in 1997 for $383 million,
a sizable profit over the original $250 m illion investm ent. To keep the
debt off-balance-sheet, Enron created an SPE called Chewco (set up as
a separate corporation). Enron’s banks would provide the 97 percent
debt; it was th e 3 percent equity in terest th a t was difficult to find.
Fastow w anted to be th e “independent investor,” a clear violation
rejected by Skilling and law firm Vinson and Elkins. Instead, Fastow’s
employee Michael Kopper became the investor (with some funding by
additional relatives and friends). This was allowed for some reason;
the explanation was th a t Kopper was not an officer o f Enron. This is
a related-party-transaction, at best a questionable practice. Most of
th e so-called 3 percent investm ent was actually borrow ed, an o th er
violation of the rules. It was later determ ined (in the Powers Report,
2002) th at Chewco was form ed improperly. The stage was set; Enron
was moving from aggressive to fraudulent accounting. It is likely th at
beginning w ith Chewco, Fastow and his crew were m aking side deals
for self-enrichm ent and hiding relevant details from the board and
auditors.

MEETING QUARTERLY EARNINGS TARGETS

Richard Kinder’s job as chief operating officer (until he left in 1996, and
Skilling after that) included m aking sure Enron m et its quarterly earn­
ings forecasts, initially through cost savings, th en m ore gimmicks. The
incentives were clear: the com pensation packages for Kinder, Skilling,
Lay and others were aim ed at earnings and stock price performance.
Kinder and Lay would receive options for hundred o f thousands o f
shares, but m ost would not vest for several years—unless the company
m et its earnings targets (typically 15 percent grow th a year). Missing

Accounting Fraud and Lessons from Recent Scandals 1217

these earnings targets, even by a few cents a share, would result in
greatly reduced executive compensation.
Enron had m any volatile operations and missing quarterly budget
targets or generating huge losses was n ot uncom m on. Instead of issu­
ing warnings to analyst, the rush was on to “find” additional earnings.
W hen shortfalls were small, deals were closed early to generate reve­
nues in the current quarter or the recording o f losses was delayed. For
big “loss recovery” periods, two interrelated schemes were used. The
first was to revalue physical assets using “fair value” models, based on
FASB Statem ent No. 125 (this standard, now superseded, was designed
to be used only for financial assets)—th at is, front-load profit streams
on m ajor project such as large power plants. The second was to use
SPEs in virtually any complex context to record earnings.
In the sum m er of 1996, Enron traders were speculating on gas
prices and lost $90 m illion instead of expected gains of a $100 million
or so. To make up for this loss, the investments in JEDI were revalued
using mark-to-market. This was an allowed accounting procedure only
if these investm ents were held for resale, w hich Enron th en claimed.
This worked so well th at m ark-to-m arket was extended even further,
eventually being used on about 35 percent o f Enron assets (according to
McLean and Elkind, 2003).
In 1998 Enron made a $10 million investm ent in a small Internet
com pany called Rhythms NetConnections. Rhythms NetCon n ections
w ent public through an initial public offering (IPO) in 1999 and th a t
day the stock increased to $69 a share. Enron recorded the entire $290
m illion gain. To lock in th a t gain, Fastow set up a complex set o f SPEs
and other relationships through a partnership called LJM. LJM would
prove to be fraudulent.
An example of a sham sale was the unloading of pow er plants
floating on barges off the coast of Nigeria. Since Enron could find no
real buyers in 1999 (and th e com pany needed m ore profit and cash
flow), a deal was reached w ith Merrill Lynch as a sale and (informal)
buyback. This was really a loan th at would allow Enron to book a gain
of $12 m illion and create operating cash flow of $28 million. Thanks to

1218 social research

the barge deal, Enron was able to m atch analysts’ expectations of $1.17
a share. The buyer next year was Fastow’s LJM2 (see below), providing
Merrill the expected profit of $775,000.
Long-term contracts could be reevaluated to m ake them appear
profitable and th en book th e newfound earnings in the current quarter.
Since mark-to-model was often used, the models could be reru n w ith
m ore optim istic assum ptions. And long-term contracts could be rene­
gotiated or restructured to book more profits.

M ANIPULATIO NS A N D FRAUD
Enron acquired o th er com panies to move into electric utilities,
finance, risk m anagem ent, and, toward the end, a telecom m unications
company. W hy is not easily explained; Enron had not any experience in
any of these areas. Based on economic reality, m ost o f these new enter­
prises were not successful. Enron expanded into Enron Development
to build pow er plants around the w orld and into Enron Broadband,
tim ing the entrance into telecom m unications ju st before the collapse
of th at industry. Some projects were m arginally profitable, other disas­
ters, but the same SPE manipulations were used to set up complex deals
so Enron could hide the losses and book nonexistent profits instead.
Trading profits increased w ith volatility and opportunities
expanded w h en California deregulated energy. Enron used every
trading trick to overcharge California buyers; giant electric utilities
California Edison and Pacific Gas and Electric declared bankruptcy in
2001. Enron traders developed specific strategies such as Fat Boy, Death
Star, Get Shorty, and Ricochet specifically to disrupt California power
and increase electricity prices. These trading practices were im proper
and some (based on later litigation) proved to be illegal.
Fastow was general partn er in LJM beginning in 1999 and later
LJM2. These were separate partnerships, each using SPEs. The idea was
to have a vehicle to quickly provide accounting benefits (that is, no real
econom ic benefits) in the form of increased profits, hiding losses, moving
debt off-balance-sheet, and showing operating cash flows. They also
enriched Fastow and his partners. The board of directors was required

Accounting Fraud and Lessons from Recent Scandals 1219

to waive its conflict-of-interest requirem ents. Andersen audit partner
David Duncan agreed to go along only if the board approved, which it
did. Fastow did not m ake it clear th at he would generate substantial
profits for him self or th a t m any of the schemes w ould skirt the law
(at best) and be subject to substantial future risk. At a m inim um , these
should have been disclosed as related-party-transactions and, in m any
cases, SPEs consolidated in th e Enron financial statements. The degree
to which the SPEs were m ishandled and Fastow was allowed to m anipu­
late them through the audit comm ittee, auditor A rthur Andersen, and
various law firms is quite remarkable.
The first LJM deal was th e Rhythms NetConnections hedge to lock
in the gain recorded in 1999. LJM set up a subsidiary called LJM Swap
Sub, which would sell a put option on Enron’s Rhythms NetConnections
stock (a put option requires th e seller, in this case Enron, to sell the
stock at a certain price if the buyer exercises the option). Enron would
transfer 3.4 m illion shares of its own stock to LJM to serve as a hedge.
This transaction had no economic substance, but was an accounting
artifact to benefit Enron (and Fastow). Astonishingly, nobody objected.
This transaction was, in fact, extrem ely complex and involved bank­
ers at Credit Suisse First Boston and Greenwich NatWest, a British
bank. The plan to unw ind this transaction was even m ore complex and
three bankers from NatWest became the first people indicted in the
Enron scandal for wire fraud. The buyer was a new partnership called
Southham pton Place, controlled by Michael Kopper. Fastow, Kopper,
and th e bankers greatly enriched them selves. Naturally, the details
were unknow n to the board or the auditors.
Flush from the profit from LJM, Fastow set up an even larger part­
nership w ith LJM2. W ithin LJM2 four new SPEs, called Raptor I-IV, were
formed. The prim ary asset was Enron stock. This was an accounting
artifact, set up to provide hedges against the decline in value of various
stocks and other assets, but th e real purpose was manipulation. Fastow
was the so-called independent investor and, in effect, negotiated w ith
him self betw een Enron and LJM2. Over 50 investor groups were found

1220 social research

to invest some $400 m illion in LJM2. According to McLean and Elkind
(2003), the LJM partnerships contributed alm ost $230 m illion in earn­
ings and m ore th an $2 billion in cash flow to Enron. For example, LJM2
invested $30 m illion in a Polish power plant, on w hich Enron booked a
$16 m illion gain for the December 1999 quarter. Because of problems,
no outside buyer could be found, so the investm ent was bought back
for $32 million using other subsidiaries.
An idea used in Raptor I was the total retu rn swap. Raptor was
required to pay Enron for any losses on its investments, but kept all the
gains. One investm ent was Avici systems, a m aker of netw orking equip­
m ent. W hen Avici w ent public, its share price hit over $160 a share on
August 3. The “hedge” in Raptor I for Avici was m ade in September,
b ut was backdated to August 3 to lock in the m axim um price. Enron
booked a $75 m illion gain. A m ajor problem w ith the Raptors was the
use o f Enron stock as the prim ary capital. Unfortunately, the price of
Enron stock started falling in 2000 and the result was th a t some o f the
Raptors were in trouble. Rather th an m ake the necessary charges to
earnings in 2000, the Raptors were restructured to cross-collateralize
them (meaning th a t the guarantees were provided by all the Raptors
for each other).
There w ere over 20 deals m ade through LJM2, all complex, all
deceptive, and all designed to provide accounting benefits to Enron
and m illions of dollars to Fastow and his accomplices. According to
Swartz and W atkins (2003: 310), Fastow “earned” $58.9 m illion from
LJM and LJM2.

PO LITICA L PRESSURE
As an S&P 500 company willing to bully anyone, Enron applied pressure
to the auditors, investm ent bankers and analysts, and politicians at the
federal and state levels. In m ost cases, the m ain reason for influence
was cash—the funds Enron was willing to spend on investm ent banking
deals, consulting contracts to the auditors, political contributions, and
so on. In fact, Enron really did not have th a t m uch real political clout

Accounting Fraud and Lessons from Recent Scandals 1221

(it needed the banking deals m ore than any of the banks did; the $52
m illion Andersen received in audit and consulting fees was a small part
o f total firm revenues), but was quite successful in persuading these
groups to step over the line. The lack of obvious ethical constraints on
any one’s part dem onstrates a m ajor facilitator for Enron’s fraud.
Hype also was im portant, especially to the financial analysts to
m aintain those “strong buy” ratings. Since m ost of the analysts worked
for the investm ent banks th a t received millions for Enron deals, this
was m uch easier (see Gasparino, 2005). In fact, m ost analysts seemed
to believe the hype th at Enron was a great company prim ed to make
billions and undervalued. Enron actually was good at energy trading
and Enron Online was a real Internet innovation. But the overall busi­
ness strategy m ade little sense, w ith Enron spending billions on a m ulti­
tude of poor investments, always hidden from public view.
Analysts who m aintained some independence and had negative
comm ents about Enron did it at their own peril. John Olson, an analyst
for Credit Suisse First Boston, covered Enron from the 1980s. He recom­
m ended “hold” (not sell, b u t not strong buy either) and was generally
less th an enthusiastic about Enron. Lay com plained to Credit Suisse
executives and Olson left Credit Suisse for Goldman Sachs, then Merrill
Lynch—w here Olson was fired after Merrill was left out of significant
Enron investm ent banking offerings. Apparently, this was punishm ent
for Olson’s ratings—flawed research according to Enron (Gasparino,
2005: 233).
Enron was a political contributor to both parties from the start.
The cash involved kept getting bigger and totaled some $6 million to
politicians and political parties. Lay and his wife also contributed almost
another $1 million. They were m ajor supporters of Texans Tom Delay
(Republican House whip) and Senator Phil Gram m . Lay developed many
direct political connections, especially w ith President George H. W. Bush
and Vice President Dick Cheney. Lay also chaired the 1992 Republican
Convention in Houston. Of course, he supported George W. Bush for
president (earning the nickname “Kenny Boy”). He was nam ed a Pioneer,

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the term used for people raising at least $100,000 for Bush. Lay was influ­
ential in determ ining certain political appointm ents, such as commis­
sioners at the Federal Energy Regulatory Commission (FERC) and Enron
executive Thomas W hite joined the Bush administration as secretary of
the Army. Lay also was influential in Cheney’s analysis of energy policy as
a m em ber of his task force. Former FERC commissioner Wendy Gramm
(wife of then-Senator Phil Gramm) was an Enron board member.
W hat did Enron get for its m oney and influence? Enron received
billions of dollars in loans and other benefits for a m ultitude of inter­
national projects. Between 1989 and 2001, 20 or so governm ent agen­
cies such as the Export-Import Bank and the World Bank loaned some
$7.2 billion for 38 Enron project around the world (McLean and Elkind,
2003). W hen a huge power plant being built in Dabhol, India ran into
political trouble, US Secretary of State Colin Powell talked to the Indian
foreign minister, as did ambassadors and other high officials support­
ing Enron.
W hen Enron was floundering in late 2001, Lay still had access to
top officials. He called Federal Reserve Board chairm an Alan Greenspan,
Treasury Secretary Paul O’Neill, and Com m erce Secretary Donald
Evans. O’Neill asked Undersecretary for Domestic Finance Peter Fisher
to follow up on Enron, but the federal governm ent ultim ately did not
respond. There are limits to access.

RESTATEMENTS AN D COLLAPSE
O ther com panies gained expertise in energy trading, driving down
E nron’s profitability and pushing it to assum e greater risks and to
venture into trading areas it had no expertise in. The end result was
obvious. Losses, side deals gone bad, and other shady practices caught
up w ith Enron. Complex fraudulent transactions using SPEs, however,
hid the problems for quite a while.
The tech bubble b u rst in the spring o f 2000; tech and telecoms
stocks tumbled. Enron was trying to m ake itself into both a tech/tele­
com com pany w ith Enron Broadband and an Interest company w ith

Accounting Fraud and Lessons from Recent Scandals 1223

Enron Online. Even if Enron Broadband and other ventures had been
hugely successful (which th ey were not), Enron could hardly have
m aintained its prem ium stock price. The stock price peaked at $90 in
August 2000, then dropped sporadically. Enron executives were bailing
out of their options, including Lay and Skilling. Hedge fund managers
such as Jim Chanos investigated Enron’s reporting and took a dim view
o f the mysterious disclosers and difficulty o f figuring out how Enron
m ade money. All of Enron’s shenanigans could be camouflaged, but not
completely hidden. Chanos and other hedge funds started selling short.
Some big institutions started selling their Enron shares.
The Raptor SPEs w ere funded w ith Enron stock and, therefore
“w ith no skin” (that is, no hard assets), could not be kept off the balance
sheet (even w ith accom m odating attorneys, auditors, and board
members). The Raptors were underw ater some $700 million. The deci­
sion was made to term inate the Raptors and take the loss. At the same
tim e, chaos reigned at several Enron businesses, from Enron Broadband
to the Dabhol power plant. At the same tim e, Lay was publicly proclaim­
ing th at Enron was doing great.
Enron reported big third-quarter 2001 losses. A ndersen also
discovered an accounting error on closing the Raptors w hen a decrease
in equity was recorded as a write-down in notes receivable. The third-
quarter report also included a $1.2 billion write-down in equity to correct
this error. Enron’s earnings release reported: “Recurring third-quarter
earnings of $0.43 per diluted share; reports nonrecurring charges of
$1.01 billion after tax; reaffirms recurring earnings estim ate of $1.80
for 2001 and $2.15 for 2002.” No m ention was made of the billion-dollar
write-down of equity. In other words, Enron was still being deceptive.
The stock dropped to $33 a share.
Fastow was soon fired, b ut the company did not realize the extent
of the damage to its credibility—essential to its stock price and borrow­
ing capacity from the banks. The news grew worse. The SEC announced
it was conducting a form al investigation of Enron. The bond rating-
agencies were scrutinizing Enron closely. The auditors reevaluated the

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SPEs. Chewco did n ot have enough equity to be a separate SPE and other
problem s w ere discovered w ith LJM. A ndersen w anted the company
to restate it earnings by $1.2 billion from 1997-2000, w hich it did on
November 8, 2001.
W ith a com plete lack o f credibility, Enron had no ban k or
other com m ercial credit. It could n ot roll over its com m ercial paper
(very short-term unsecured loans). Banks were unw illing to lend any
additional m oney beyond w h at was required in outstanding letters
of credit and traders w ere unw illing to trade w ith Enron except for
cash. (Most trading transactions are on credit, since the parties usually
have superlative credit; the potential for default is called counterparty
risk (see Giroux, 2003, chaps. 11-12). In desperation, Enron tried to
be acquired by gas com petitor Dynegy. W ith new revelations of prob­
lems, Dynegy backed out. Enron’s bond rating, w hich had eventually
reached m inim um investm ent grade at BBB-, was downgraded to ju n k
status. W ith no chance of a bailout and no last-m inute shenanigans
possible, Enron declared bankruptcy on December 2, 2001. Just prior
to failure, Enron gave $55 m illion in bonuses to key executives while
firing 4,500 employees.
The investigations began. The C alifornia Public U tilities
Commission started one in December 2001. The SEC filed a subpoena
against Fastow. The US D epartm ent o f Justice began an investigation
early in 2002. Enron employees and others started filing suits to reclaim
losses. House and Senate com m ittees started hearings and issued
subpoenas to m any Enron executives. The Justice D epartm ent indicted
A rthur Andersen for obstruction of justice.
Over several years, over 30 Enron executives and em ployees
were indicted by the Justice D epartm ent. Fastow was indicted on 78
crim inal counts for defrauding Enron. He agreed to a 10-year prison
sentence, one of the few crooks to get serious jail tim e. Both Skilling
and Lay w ere indicted in 2004, convicted, and sentenced to long jail
term s. Several o th er have also pled guilty, including Kopper and
Fastow’s wife, Lea.

Accounting Fraud and Lessons from Recent Scandals 1225

 The Enron story is a useful microcosm of all th at could go wrong
w ith high-tech business and th e m otivations for th e stock m arket
bubble of the late 1990s. This includes executive greed, ruthlessness,
a lack o f ethical standards, accom m odating auditors, law firms, and
investm ent bankers, lack o f proper regulatory oversight, substantial
political contributions used to acquire influence in W ashington, and
a derelict board o f directors. The stodgy gas transm ission com pany
rem ade itself as a high-tech conglom erate and, despite obvious high
leverage and extrem e financial risks, was able to mislead investors on
its true value for years.

OTHER MAJOR SCANDALS

The Enron scandal came after the m arket collapse in 2000 and during
th e developing recession. As th e largest bankruptcy, it resulted in
headlines, in stan t m edia analysis, and congressional hearings. The
call for im m ediate congressional reform (the original Sarbanes-Oxley)
was starting to dim inish w hen new scandals erupted, beginning w ith
WorldCom, w hich replaced Enron as the largest bankruptcy ever. Real
reform was inevitable.

WorldCom
By the middle of 2002, the financial and political worlds stopped hyper­
ventilating about Enron and business as usual was returning. Then
came the announced bankruptcy of WorldCom on July 22, 2002 after
the discovery of alm ost $4 billion in accounting irregularities in June
(later to rise to $11 billion), replacing Enron as the largest failure in
American history. WorldCom listed assets of $107 billion (and a m arket
value th at peaked at $115 billion in 1999), compared w ith Enron’s $63
billion. Business as usual was no longer possible. Serious reform resur­
faced, including Sarbanes-Oxley in a slightly watered-down version of
the original bill. Former WorldCom chief financial officer (CFO) Scott
Sullivan was charged in th e m ultibillion dollar accounting fraud;

1226 social research

form er controller David Myers and three others pleaded guilty to secu­
rities fraud.
Bernard Ebbers and others started Long Distance Discount
Service in 1983. The name was changed to WorldCom in 1995. Growth
came m ainly through over 70 mergers, w ith the big one the $42 billion
acquisition of telecom giant MCI in 1998—m uch larger than WorldCom
at the time. Ebbers was a m aster at using the board of directors to his
advantage. As described by Haddad:

T hrough th e 1990s, th e then-nine-m em ber board was

composed of insiders and execs from acquired companies.
[The board] collected plenty of perks—from use of a corpo­
rate je t to financial support from Ebbers—in their pet proj­
ects. And they piled up loads of WorldCom stock—as m any
as 10,000 stock options per year. [T]he board O.K.’d mega
loans to Ebbers. They backed him through the stupendous
expansion of WorldCom—to the brink of its collapse (2002:
138).

At first glance WorldCom looked solid, based on the 2001 10-K.

Total assets w ere $104 billion and stockholders’ equity $58 billion,
resulting in a debt-to-equity ratio o f 79.3 percent. Not bad for a tele­
com. However, almost $51 billion of the assets were goodwill and other
intangibles, while cash totaled less th an $1.5 billion. This indicates the
significance o f acquisitions, b u t who knows to w hat extent the goodwill
represents real assets or ju st overpaying for the acquired companies. In
bankruptcy, goodwill is not a real asset and the $30 billion in long-term
debt was huge. According to the 10-K, earnings were off for 2001, w ith
n et income of $1.5 billion compared w ith $4.1 billion the previous year.
Revenues were down and operating expenses up. Net income for the
first quarter o f 2002 was a less than stellar $172 m illion, down from
$610 for the same quarter in 2001. But even this lousy performance was
not correct.

Accounting Fraud and Lessons from Recent Scandals 1227

 Early in 2002, an in te rn a l au d it found o p eratin g expenses
charged as capital expenditures, double counting o f revenues and
undisclosed debt. New auditor KPMG reviewed th e books; old audi­
to r A rthur A ndersen was fired. Ebbers resigned in April. On June 25,
2002, W orldCom announced $3.8 billion in accounting errors ($3.1
billion for 2001 and $800 m illion for first q uarter 2002), m ainly by
capitalizing “line costs,” w hich are fees to other telecom companies
for netw ork access rights. These are operating expenses. W ith the
required restatem ents, n et losses were now reported for both 2001
and first quarter 2002. CFO Scott Sullivan was fired on the same day.
Further review found over $10 billion in operating expenses th a t
were fraudulently capitalized. WorldCom filed for bankruptcy in July
2002.
CFO Sullivan pleaded guilty o f securities fraud and agreed to
cooperate w ith prosecutors. Ebbers was indicted on securities fraud and
m aking false statem ents to the SEC and convicted. WorldCom emerged
from bankruptcy in 2004 as MCI, w ith debt reduced to less th a n $6
billion and about th at m uch cash. Debtors ultim ately received about
35 cents on the dollar in new bonds and stock; the original stockhold­
ers received nothing. MCI agreed to pay the SEC some $750 m illion to
repay investors wiped out by the scandal.

Tyco
Tyco started as a research lab in 1960, only to be transform ed into a
conglom erate through acquisitions. Dennis Kozlowski becam e presi­
dent and chief operating officer (COO) in 1989, then CEO in 1992. He
earned his “Deal-a-Day Dennis” nicknam e w ith 750 acquisitions, w ith
up to 200 in some years. Earnings magic based on business combina­
tion accounting gave the im pression of substantial grow th and rising
earnings. Revenues rose alm ost 50 percent a year from 1997 to 2001.
W ith the $6 billion acquisition of ADT Security Services, the acquisi­
tion was structured as a reverse takeover so th at Tyco could use ADT’s
Bermuda registration to shelter foreign earnings. The SEC started an

1228 social research

investigation into Tyco’s acquisition accounting in 1999, but did not
charge Tyco w ith wrongdoing.
Tyco’s acquisition of CIT Group, the biggest independent comm er­
cial financial com pany in th e United States, for $9.2 billion in 2001
was a disaster. Deceptive techniques used by Tyco became public w ith
this acquisition (CIT continued to issue financial statem ents after the
acquisition to continue to m aintain a high credit rating). Apparently,
Tyco specialized in “spring loading,” notifying the acquired company to
modify accounting policies before the acquisition and m aking various
write-offs and adjustments, w ith the intent of improving the perceived
perform ance o f th e parent im m ediately after the acquisition. Before
the acquisition date, CIT disposed o f $5 billion in poorly perform ing
loans, made downward adjustm ents o f $221.6 m illion, increased the
credit-loss provisions, and took a $54 m illion charge to acquisition
costs (apparently “pushed dow n” from Tyco). Revenues for CIT were
extremely low ju st before the deal and dramatically increased after the
deal. The result, according to Symonds (2002), was a net loss reported
by CIT just before the acquisition date.
After the acquisition, CIT reported n et income of $71.2 million.
That increased Tyco’s earnings for the Septem ber 2001 quarter, but
luck ran out. Tyco Capital (CIT’s new name) had extrem e problem s
w ith credit, since it was now tied to Tyco. Ultimately, this new busi­
ness segment was sold. Tyco recorded this as a discontinued operation
(recording an after-tax loss o f $6.3 billion). For the year ended September
30, 2002, Tyco had a total n e t loss o f $9.4 billion. The com pany had
goodwill and other intangibles of nearly $33 billion, liabilities o f alm ost
$42 billion, and equity of less than $25 billion.
In 2002, Dennis Kozlowski was charged w ith evading $1 m illion
in New York sales tax on paintings he bought (apparently using nonin­
terest loans from Tyco). He resigned in June. In Septem ber 2002, he
and form er Tyco CFO Mark Swartz were charged w ith 38 felonies th at
ranged from “enterprise corruption and grand larceny” for raiding Tyco
of some $600 million. A m istrial was declared in May 2004 and a retrial

Accounting Fraud and Lessons from Recent Scandals 1229

scheduled for 2005. W hat s not clear is if lyco actually engaged in
crim inal acts. There is no doubt they were m anipulative and deceptive,
but illegality can be hard to prove. Unlike m ost of the scandal-plagued
companies, Tyco did no go bankrupt.

Adelphia
John Rigas tu rn e d a local cable franchise into a com m unications
empire, including high-speed Internet, cable, and long-distance phone
service. In May 2002, Adelphia announced the earnings restatem ent for
2000 and 2001, including billions of dollars in off-balance-sheet liabili­
ties associated w ith “co-borrowing agreements.” The company filed for
bankruptcy in June 2002, following an SEC suit charging Adelphia and
several executives w ith extensive financial fraud: “Adelphia, at the direc­
tion of the individual defendants: (1) fraudulently excluded billions of
dollars of liabilities from its consolidated financial statem ents by hiding
them in off-balance-sheet affiliates: (2) falsified operation statistics and
inflated Adelphia’s earnings to m eet Wall Street expectations; and (3)
concealed ram pant self-dealing by the Rigas family” (GAO, 2002:122).
Aldelphia also created sham transactions and false docum ents
indicating th at debts were repaid, rather th an shifted to affiliates. Self-
dealing by the Rigas family included using Adelphia funds to purchase
stock for the Rigas family, tim ber rights, construct a golf club, pay off
m argin loans o f various family m embers, and purchase several condo­
miniums.
The financial statem ents of Adelphia indicated a company w ith
problem s. The last 10-K filed (for the fiscal year ended December 31,
2000) showed a n et loss of $548 million, w ith losses also in 1998 and
1999. The last 10-Q. (for th e Septem ber 2001 quarter) also showed
continuing losses. Of $21.5 billion in total assets, $14.1 billion were
intangibles (primarily goodwill). Liabilities totaled $16.3, while equity
was only $4.2 billion. And th a t is after they cooked the books!
Adelphia indicates th e im portance o f corporate governance.
Included on Adelphia’s nine-m em ber board of directors were five Rigas

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family members: John as chairm an and CEO, three sons, and a son-in-
law. Son Timothy also was CFO and son Michael was an executive vice
president. Rigas, two sons, and two form er Adelphia executives were
indicted on crim inal charges for conspiracy, bank fraud, and securities
fraud. John Rigas and son Timothy were convicted o f conspiracy and
fraud in 2004.

REGULATIONS AN D THE IMPACT ON LATER SCANDALS

The Sarbanes-Oxley Act was passed in 2002 basically to elim inate future
scandals. Funding was substantially increased for SEC review and
enforcem ent and rules im proved at stock exchanges, audit firms (includ­
ing a new federal audit regulator, th e Public Company Accounting
Oversight Board), accounting standards, and so on. Expanded regula­
tions, improved funding for oversight bodies, expanded auditor respon­
sibilities, and chastised com panies m eant scandals were expected to
stop. Unfortunately, the incentive structure of high executive compen­
sation tied to earnings and stock price performance did not change.
C orporate scandals continued, alth o u g h at a slow er pace:
HealthSouth in 2003; a m ajor m utual funds scandal in 2003-2004; AIG
corporate governance and internal control weaknesses in 2005; deriva­
tive deceptiveness at sem i-governm ent m ortgage buyers Fannie Mae
and Freddie Mac in 2005-2006; m ajor stock options deceptiveness at
dozens of companies discovered in 2006; and the m ajor subprim e m ort­
gage loan crisis in 2007. An insider trading investigation was started,
bu t did not develop into a scandal; investm ent bankers and others w ith
insider knowledge have the ability to enrich themselves w ith this infor­
m ation. This is a gray area for illegal acts.
H ealthSouth operates o u tp atien t surgical centers. The SEC,
related to deals w ith MedCenterDirect and Source Medical, charged the
company and senior executives w ith accounting fraud. The stock was
downgraded by S&P to a CCC rating, and the New York Stock Exchange
suspended trading following an SEC order to halt trading. CEO and
founder Richard Scrushy and several o ther senior executives were

Accounting Fraud and Lessons from Recent Scandals 1231

fired, as was auditor Ernst and Young. Scrushy was later indicted by
the federal governm ent on 85 counts, including m oney laundering and
m ail fraud. The m utual funds scandal involved m arket-tim ing issues,
essentially allowing individuals and groups to trade after hours, w hen
new inform ation was available at end-of-session prices.
Fannie Mae used fraudulent accounting practices reported to total
$16 billion. Fannie paid a $400 m illion penalty in 2006 for financial
statem ent m isstatem ents from 1998 to 2004. A basic problem is politi­
cal connections to Congress, w ith Fannie (and Freddie Mac) supplying
campaign contributions (both directly and from housing industry bene­
ficiaries) and jobs for politicians staying in W ashington. In 2006 Fannie
Mae restated earnings through 2004. Its total retained earnings were
cut $6.3 billion, the net of some dozen accounting rules violations (the
usual reasons: income smoothing and maximizing executive bonuses).

Stock Option Scandals

Stock options, as described above, were a m ajor factor in the earlier
scandals, because executives w ith large options packages (the ability
to buy shares of the com pany stock as a set price) could m ake millions
as stock prices w e n t up. Beginning in 2006 com panies are now
required to expense options, w hich should m ake this alm ost a nonis­
sue. Stock option issues do not w ant to go away. The latest scandals
are backdating and spring-loading—how companies can give options
to executives th a t illegally give th em additional gains. Backdating
sets the grant date to an earlier day w ith a lower stock price. Spring-
loading is w hen companies give options ju st before good news, w hich
is expected to boost the stock price. The Wail Street Journal reported
th a t m any com panies were handing out m illions o f options to execu­
tives right after 9/11 stock price drops: 511 execs a t 186 companies,
including about 90 big com panies th a t usually did n ot grant options
in Septem ber. By th e end o f 2006 some 130 com panies w ere u n d er
investigations by the SEC and other federal authorities for backdating
and other option m anipulations.

1232 social research

 A new w rinkle is exercise backdating: to backdate w hen the
options are exercised—this tim e to a low stock price. The idea is the
executives will hold the options for at least one year (note th a t m ost
options are exercised and im m ediately sold). They are th en eligible for
capital gains treatm ent and a m uch lower tax rate. That is, the tax on
the ordinary gain (exercise price m inus option grant, or strike, price)
is m inim ized and the capital gains portion maximized. The tax angle
m eans that in addition to the SEC, the Internal Revenue Service is inter­
ested (as is the Justice D epartm ent in cases of fraud).

Subprime Mortgage Loan Scandal

The subprime loan area is related to the housing crisis o f 2007, associ­
ated w ith huge drops in dem and and price in key housing m arkets.
Subprime loans are m ade to low-credit borrow ers at higher interest
rates, often w ith little or no down payment. W hen housing prices drop,
the mortgagees soon have negative equity and are likely to ju st walk
away from the house. The mortgage holder is stuck w ith the loan and
th e property. The m ortgages are packaged as structured debt (often
called collateralized debt obligations or CDOs) and sold through special
purpose entities (made infam ous from the Enron scandal). The losses
on these CDOs are the prim ary cause of the large bank write-offs. These
losses are continuing, getting larger, and dragging down stock prices
especially for financials.
As of mid-2008, financial write-downs of mortgage-backed securi­
ties are expected to total over $200 billion. As of April 2008, UBS had
the dubious lead, with write-downs of $38.3 billion, followed by Merrill
Lynch at $25.1 billion, Citigroup at $21.7 billion, AIG at $17.2 billion, and
Morgan Stanley, $13.1 billion. Many other banks also had multi-billion-
dollar write-offs. Bank m anagers and others were arrested and charged
w ith securities fraud in June 2008 and the FBI announced that some 300
real estate executives were charged with mortgage fraud (Hays, 2008).
The subprim e loan scandal is prim arily an investm ent banking
scandal rather th an an accounting scandal. The subprim e loan scandal

Accounting Fraud and Lessons from Recent Scandals 1233

seems a special case of a unique bubble, exacerbated by low interest
rates and new structured financing instrum ents w here controls were
n o t well developed. The evidence of fraud suggests th a t it occurred
m ainly at relatively low levels associated prim arily w ith mortgage orig­
ination. The m ajor problem is th at the large banks and other institu­
tional players badly misjudged the risks involved and actually increased
risky behavior as an obvious housing bubble developed. At the corpo­
rate level, this suggests incom petence rather than fraudulent intent.

CONCLUSIONS
This paper described the m ajor twenty-first-centuxy business scandals,
w ith particular focus on Enron. Enron was a case of sophisticated fraud
over an extended period, specifically to m anipulate quarterly earn­
ings to m aintain the vast com pensation of key executives. WorldCom
was a big company w ith a case of simple fraud (capitalizing operating
expenses), w ith the same result: bankruptcy. Combined w ith other
corporate scandals, the result was the Sarbanes-Oxley Act of 2002 to
im prove regulation and oversight, a quick and broad-based federal
response to these problems.
The early twenty-first century has proved th at the business cycle
still exists and corporate scandals are not a thing o f the past. Greed
and hubris are recurring them es in these as in earlier scandals. There
are obvious differences. Considerable oversight and regulations exist—
they ju st were not effective w hen not adequately enforced. Somewhat
unusual were the scandals at really big companies and the fraudulent
schemes coming from the executive offices. Most frauds are at smaller
companies and at lower levels in big companies.
The incentives were somewhat different. Two interrelated prob­
lems are relatively new: executive com pensation and m eeting analysts’
forecasts. It has always been the money, but the com pensation levels
beginning in the 1990s becam e huge and driven especially by stock
options. To make th a t work, quarterly earnings targets had to be met.
The result was higher stock prices. As stock prices peaked in the 1990s,

1234 social research

the tem ptations for fraud increased. Apparently, too m any executives
m aking millions of dollars in base pay and bonuses could not pass up
additional m illions in options even though fraud was required. The
basic problem today is th e executive com pensation structure essen­
tially rem ains the same; the result is senior m anagem ent still has incen­
tives to cheat. On the other hand, the executives are m ore likely to get
caught.
Will the business fraud problems subside? I am modestly hope­
ful. There seem to be fewer accounting-related scandals, suggesting the
post-Sarbanes-Oxley oversight and regulatory environm ent is w ork­
ing reasonably well. (This assumes th a t th e subprim e loan debacle is
a special case and n ot representative of accounting fraud.) New regula­
tions will likely be put into place (starting w ith investm ent banking
and mortgages) to reduce the occurrence of future fraud. Most execu­
tives and other players are reasonably honest, but it does not take th at
m any ethically challenged players to create the next scandal. As long as
the oversight authorities continue due diligence and adequate regula­
tory funding continues, accounting scandals should be fewer and less
severe.

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