Professional Documents
Culture Documents
11 - Chapter 6 PDF
11 - Chapter 6 PDF
124
6.2 Selected Case Studies of Highly Publicised World Audit Failures
In this section we are going to investigate some high-profile accounting and audit
failures that have taken place during last ten years or so. The cases are presented
chronologically. We begin our investigation with the collapse of US energy company Enron,
which is possibly the most infamous and shocking event in accounting and business history.
We intend to conclude our study with the Satyam scandal in India.
6.2.1 The Enron Collapse (USA) (2001)
The collapse of US energy company Enron, which directly initiated the fall of its
auditor Arthur Andersen (AA)2, not only lead to the stock market crash but also brought the
accounting and auditing profession into great disrepute. Before its bankruptcy filing in
December 2001, Enron was widely regarded as one of the most innovative, fastest growing,
and best managed businesses in the United States. Enron Corporation based in Houston, Texas,
was created in 1985 by Kenneth Lay as a result of the merger of Houston Natural Gas and Inter
North. 1989 onwards Enron began trading in commodities, buying and selling wholesale
contracts in energy. In 2000, Enron’s position on the Fortune 5003 list of the US’s big
companies was at an enviable seven The turnover grew at a fast pace, growing from 40 billion
US dollar in 1999 to 101 billion US dollar in 2000, with most of the new income coming from
broking energy commodities (Satheesh Kumar, 2010). The company’s business was to sell
natural gas and electricity, deliver energy and other commodities such as bandwidth internet
connection, and provide risk management and financial services to the clients around the
world. Its natural gas pipeline business proved to be a grand success. The company then
introduced trading in derivative contracts based on prices of oil, gas, electricity and other
variables, and soon this derivative trading became its core business. The company’s earnings
soared and its share prices also sky rocketed. The reported annual revenues of the company
grew from about $10 billion in the early 1990s to $101 billion in 2000, ranking it seventh on
the Fortune 5003 Enron’s shares were then selling at $90 per unit, which placed company’s
market value at $700 billion. In just 15 years, Enron grew from nowhere to be one of
America’s largest companies, employing 21,000 staff in more than 40 countries. But the
fortune did not last long. The company’s success soon turned out to be an elaborate scam.
Trouble actually began in August 2001 when the Enron CEO resigned for undisclosed reasons.
The company reported its first quarterly loss in 4 years taking a charge against earnings of $1
billion for poorly performing businesses. The reported third quarter loss was $618 million. On
November 8, the company announced in a SEC filing that it was restating its earnings since
1997 - reducing them by $586 million. The news that the company had previously inflated its
profits produced a disastrous effect on the share price. As share price collapsed (Enron’s stock
125
was valued at $90 per share at the beginning of 2001 and it is worth almost nothing at the end
of the same year) bond rating agencies downgraded Enron’s debt to below-investment-grade,
or junk bond status. In December 2001, the company filed for bankruptcy protection in the
biggest case of bankruptcy in the US up to that point. The US Department of Justice, the SEC,
the market regulator and various congressional committees probed the wrongdoings of Enron.
The Enron collapse harmed not only its investors but also thousands of its workers who lost
their jobs and retirement packages. It is estimated that Enron demise caused a loss of about $80
billion in market capitalization to investors, including sophisticated financial institutions and
employees (Nguyen, 2008).
Fraudulent Accounting at Enron
Enron adopted fraudulent accounting practices and its audit firm AA, which was being
paid huge audit and non-audit fees, collaborated in that exercise. Enron used to adopt
questionable accounting and reporting practices over a long period of time. But its auditor AA,
failed to detect Enron’s frauds. Enron broke up after revelations of AA’s performance as
statutory auditor. The Powers Committee, appointed by the Enron’s Board to look into the
firm’s accounting in October 2001, observes: “The evidence available to us suggests that
Andersen did not fulfil its professional responsibilities in connection with its audits of Enron’s
financial statements, or its obligation to bring to the attention of Enron’s Board (or the Audit
and Compliance Committee) concerns about Enron’s internal contracts over the related-party
transactions”4. Benston et al. (2003) observe on Powers Report of 2002 and identified five
types of failures that are most noteworthy: first, Enron’s failure to account properly for and
disclose investments in special purpose entities (SPEs), Enron’s contingent liability for their
debt, and Enron’s dealings with them; second, Enron’s incorrect recognition of revenue that
increased its reported net income; third, restatements of merchant investments using fair-value
accounting based on unreliable information to overstate both assets and net income of
merchant investments; fourth, Enron’s incorrect accounting for its own stock that was issued to
and held by SPEs; and fifth, inadequate disclosure of and accounting for related-party
transactions, conflicts of interest, and their costs to stockholders.
Investigations have revealed that the company used to book projected profits
immediately after building an asset, such as a power plant, without waiting for their realization.
If the revenue from the asset was less than the projected amount, instead of taking the loss, the
company would then transfer these assets to an off-the-books firm, where the loss would go
unreported. The company also adopted “the mark-to-market” practice to hide losses and make
the company appear to be more profitable than it really was. In order to cope with the
mounting losses, the company often used special purpose entities (SPEs) in a creative way5. It
126
used SPEs to hide any assets that were losing money or business ventures that had gone
unprofitable. In this way it used to keep impaired assets off of the company's books. In return,
the company would issue to the investors of the SPE shares of Enron's common stock to
compensate them for the losses. Much of the revenue that Enron was reporting during these
years did not represent any actual money generated from operations. Instead, it came from
investors. A major part of the reported revenue was the product of accounting manipulations
orchestrated by the company’s Chief Finance Officer, Andrew Fastow. In fact, whatever
money that was paid out as dividend to shareholders came from the investors themselves and
not from profitable gas and energy trading transactions.
Subsequent investigations have revealed several circumstances that made it possible for
Enron to succeed in deceiving the public. There was connivance with external auditors and
banks. The SEC exempted Enron from investment laws and Enron took its full advantage. The
issue which has particularly shocked many is the unholy nexus between Enron and its external
auditor Arthur Andersen. Andersen has been Enron auditor for over a long duration (about 20
years). It provided both external and internal audit services for several years. And that enabled
it to generate a very large amount of fee from the company. In 2000, Arthur Andersen earned
$25 million in audit fees and $27 million in consulting fees, which accounted for roughly 21%
of the audit fees of public clients for Arthur Andersen's Houston office. Such was the nexus
between the two parties that Andersen even opened a permanent office space in Enron’s
buildings. Andersen knew it clearly that there were serious problems with Enron’s financial
statements, but it overlooked those problems and signed the statements off. On June 15 2002,
Arthur Andersen was charged with and found guilty of obstruction of justice for shredding the
thousands of documents related to its audit of Enron and deleting e-mails and company files
that tied the firm to its audit of Enron. The firm was effectively put out of business. Since the
US SEC does not allow convicted felons to audit public companies, the firm agreed to
surrender its CPA license and its right to practice before the SEC on August 31 2002,
effectively putting the firm out of business, and 28000 employees in the US and 85,000
employees worldwide lost their jobs. The damage to the firm’s name has been so great that it is
difficult for it to return as a viable business even on a limited scale. There were over 100 civil
suits pending against the firm related to its audits of Enron and other companies. The firm sold
most of its American operations to KPMG, D&T, E&Y, and GT. Enron is not an isolated case.
There have been many other audit failure cases involving AA. Examples include WorldCom,
Waste Management, the Baptist Foundation of Arizona, and Sunbeam. However, Enron is the
worst case of corporate obstruction that has ever been seen. As a consequence of the Enron
scandal, several new regulations and legislations have been enacted to bring about greater
127
transparency in corporate financial reporting. This has happened not only in the United States
but also in many other countries throughout the world.
128
his duties as a director in good faith and in the interests of the company. Former HIH’s chief
executive Ray Williams was also sentenced to imprisonment.
Problems with HIH Audit
HIH’s auditor was Arthur Andersen (AA), the auditor of Enron and many others.
Investigations have revealed that Andersen had compromised its independence in several
different respects. It came to be established that there was a close relationship and unholy
nexus between HIH executives and its auditor, Andersen. Three former partners of Andersen
sat on the board of HIH. Moreover, HIH paid Andersen huge amounts towards non-audit
services. This was a reason why the auditors elected to remain silent about the company’s
fraudulent accounting practices (HIH Royal Commission Report, 2003, Section 21.4.7). The
audit report for the financial year ending June 2000 was an unqualified one. It reported that the
accounts gave a true and fair view of the company’s financial performance, complied with
accounting standards and corporate regulations and other professional reporting requirements
(Armstrong and Fransis, 2008, p.9). In that year company reported an operating surplus of
$939 million. But four months later a different picture emerged. Losses of about $800 million
forced HIH into liquidation. The liquidator sued Andersen alleging that the auditors breached
their contract with HIH and produced misleading or deceptive reports. It was alleged that
Andersen: (a) failed to detect the under provisioning of claims; (b) incorrectly assessed
reinsurance contracts; (c) failed to detect the overvaluing of intangible assets; and (d) failed to
retain a position of impartiality and independence. It was discovered later that Andersen had
changed the way it conducted HIH audits in 1999. Traditional audits were conducted with the
examination of the paper trails to ensure the accounts reflected what revenue had come in and
what expenses had been paid out. But the new approach used the “business audit process”
which focused more on reviewing client risk-management systems. A limited number of
transactions were reviewed as part of a process of working out whether systems within the
company were working properly. This was done in an attempt to make audits more profitable
by reducing the staff time spent testing larger sample transactions. Although auditors’ role was
severely criticized in the Commission Report, they were not implicated in any criminal action.
129
production capacities of YGX. They put their one year investigation findings in the article
‘Trap of YGX”, appeared on the website of “Caijing” on August 2 and 5 2001 respectively.
They asserted that the YGX’s profits were probably fabricated. On August 3 2001 the Chinese
regulator, CSRC started a formal investigation into YGX financial chicanery. The shares of
YGX were suspended from trading from August 3 2001 through September 7 2001. The stock
prices of YGX dropped continually and reached the lowest at the closing price of Rmb
2.33(US$0.28) on January' 22 2002. On September 6 2001, after the formal investigations, the
CSRC announced that YGX falsified and over-reported profits of Rmb 745 million (US $90
million) during 1999-2000 by fabricating accounting documents including purchase and sales
contracts, export documents, tax invoices, tax rebate slips and bank notes.
Accounting Hoax at Yinguangxia
The largest Chinese audit firm, Zhongtianqin CPA Firm (ZTQ), the auditor of YZX and
its subsidiary in Tianjin was substantially responsible for the misrepresentations and
fabrication. ZTQ had been the auditor of YGX since the latter was listed until the scandal
occurred. ZTQ was created through the merger between ZT and TQ in July 2000, took the
form of a limited liability company in China. Before disaffiliated in 1998 from the
government, ZT was named Shenzhen Zhonghua CPA Firm and TQ named Shekou Zhonghua
CPA Firm. ZTQ was regarded as the most successful domestic CPA Firm in Shenzhen (Jin
2002) and the biggest auditor nationwide in 2000 in terms of total assets of its clients. But ZTQ
broke the laws and issued unreliable audit reports. On September 7 2001, the Ministry of
Finance (MOF) of China disclosed that it planned to revoke the operating license of ZTQ and
the qualifications of two partners who were responsible for audit negligence. The formal
notification was sent out on February 8 2002, but ZTQ was already disbanded on September 7
2001. On May 14 2002, YGX received an administrative punishment notification by the
CSRC. YGX was fined Rmb 600,000 (US $72,289) according to the securities laws. This
notification stated that YGX fabricated profits of Rmb771 million (US $93 million) during
1998-2001. On December 20 2002, six persons (four managers in YGX and two partners in
ZTQ) were directly responsible for the severely misleading financial statements, were
sentenced according to Article 161 of the Chinese Criminal Laws. On September 16 2003,
these six persons were imprisoned for two to three years and fined for amounts ranging from
Rmb 30,000 (US $3,614) to Rmbl00,00(US $12,048) (Sami and Ye, 2005). In China, Article
63 of Securities Law of China of 1999 entitles investing community to recover their financial
damages from companies, organisations and persons who are responsible for the losses. They
are also entitled to sue company’s auditors for indemnifications against investment losses due
130
to audit failure. Article 42 of CPA Law requires CPA firms shall be liable for indemnifications
for violation of CPA Law of China and causing damages to their clients or related persons.
131
Adelphia collapse harmed not only its investors but also thousands of its workers and
employees who lost their jobs and retirement benefits. The founder of Adelphia was forced to
resign as CEO in 2002 after being indicted for several reasons. On July 24 2002, the US SEC
filed fraud charges against Adelphia Communications Corp; its founder John J. Rigas; his three
sons, Timothy J. Rigas, Michael J. Rigas, and James P. Rigas; and two senior executives of
Adelphia, James R. Brown, and Michael C. Mulcahey. In its complaint, the SEC charged that
Adelphia: (a) fraudulently excluded billions of dollars in liabilities from its consolidated
financial statements by hiding them on the books of off-balance sheet affiliates; (b) falsified
operations statistics and inflated earnings to meet Wall Street’s expectations; and (c) concealed
rampant self-dealing by the Rigas Family. In addition, the SEC charged that the company used
undisclosed corporate funds for Rigas Family stock purchases and the acquisition of luxury
condominiums in New York and elsewhere. On July 24 2002, John Michael, and Timothy
Rigas were arrested and charged with conspiracy to commit securities fraud, wire fraud, and
bank fraud6. The Rigases were convicted and they are in a federal prison in Butner, North
Carolina. The majority of Adelphia’s revenue generating assets were officially acquired by
Time Warner Inc. and Comcast Corp. on July 31 2006, LFC, an internet-based real estate
marketing firm, auctioned off the remaining Adelphia real estate assets7.
Accounting Dodge at Adelphia
Investigations soon revealed that the accounting system of Adelphia was a nightmare.
In addition to overstating the number of subscribers and earnings, the accounting system
exhibited an almost complete lack of internal controls. “Regas doctored financial records and
created sham transactions” including overstating the number of cable subscriber” (Hofmeister
and Hamilton, 2002). Carusso (2002) observes that the line of separation between corporate
funds and family funds was simply non-existent. Adelphia leased cars and even contracted for
landscaping and snow plowing through Rigass-controlled firms. After essentially treading
water for the first part of 2001, the second half of 2001 and early 2002 had been a very bad
period for investing people of Adelphia. The company’s stock had fallen from $47 in August
2001 to about $22 on March 27 2002 when the company released their financial statements of
2001. Adelphia shares tumbled 99% since mid-March 2002. The Rigases were convicted of
securities fraud and bank fraud, as well as conspiring to commit securities fraud, bank fraud,
falsify books and records and make false statements to the SEC. They concealed $2.3 billion in
liabilities to make investors think they were doing better than they actually were. The
Pennsylvania case, laid out in a 2005 indictment, charges the two men John Rigas and Timothy
Rigas with conspiring to defraud the US of more than $300 million in tax revenue by diverting
$1.9 billion from Adelphia for use by Rigas family members. It charged that John Rigas
132
evaded $51 million in income taxes for 1998 to 2000 and that Timothy Rigas evaded $85
million. Deloitte & Touche, the statutory auditor of Adelphia failed to discharge their
professional duties with due care. The audit firm was sued for professional negligence and
fraud and paid $50million to settle claims. In 2007, John Rigas and his sons were indicted for
looting Adelphia’s coffers by using the funds of company for their own purposes.
133
emerged from Chapter 11 bankruptcy in 2004 with about $5.7 billion in debt and $6 billion in
cash9. On February 14, 2005, Verizon Communications agreed to acquire MCI for $7.6 billion.
Accounting Manoeuvre at WorldCom
Beginning modestly in mid-year 1999 and continuing at an accelerated pace through
May 2002, WorldCom, under the direction of Ebbers (former CEO), Scott Sullivan (CFO) and
others used deceitful accounting policies and methods to cloak its declining earnings by a false
portrait of WorldCom’s financial growth and profitability. WorldCom’s accountants moved
around what appeared to be normal operating expenses into long-term capital assets, thereby
over-inflating company’s revenue. They did this to make themselves look better than what they
really were. The fraudulent accounting practice was exercised in order to raise company’s
stock prices. By the end of 2003, it was estimated that the company's total assets had been
inflated by around $11 billion. The company’s fraud was accomplished primarily in two ways.
First, underreporting “line costs” (interconnection expenses with other telecommunication
companies), by capitalizing the same on the company’s balance sheet rather than properly
expensing them; and second, inflating revenues with fake accounting entries from "corporate
unallocated revenue accounts". WorldCom’s accountant at the time were AA, the same people
that looked after Enron’s books of accounts as well as other companies hit by accounting"'
scams including Global Crossing, Tyco, Adelphia and others. But AA accused Mr. Sullivan of
withholding information from them. WorldCom’s new accountant KPMG asked to scour the
books of accounts back to 199910. Evidence shows that the accounting fraud was discovered as
early as June 2001, when several former employees gave statements alleging instances of
hiding bad debt, understating costs, and backdating contracts. WorldCom's BoD did not
investigate these allegations. In June 2001 a shareholder lawsuit was filed against WorldCom.
The US SEC launched an investigation into the WorldCom matters in March 2002. By the end
of 2003, it was estimated that the company's total assets had been inflated by around $11
billion. On July 21 2002, WorldCom filed for Chapter 11 bankruptcy protection in the largest
such filing in US history at the time. The SEC investigation discovered WorldCom fraudulent
practices and filed a civil fraud lawsuit against WorldCom. At the same time federal charges
were filed by the SEC against several executives of the company. The SEC’s investigation into
the WorldCom’s accounting frauds turned up several key players. The executives and
employees who were implicated in the WorldCom chicanery process included: Bernard Ebbers
(former CEO), Scott Sullivan (former CFO), David Myers (former controller), Buford Yates
Jr. (former director of general accounting), Betty Vinson (former director of managemem
reporting), and Troy Normand (director of legal entity accounting). Ebbers suspected an
accounting fraud. Sullivan was indicted on charges of securities fraud, conspiracy, and false
134
statements to the SEC. David Myers was charged with securities fraud, conspiracy, and false
statements to the SEC. Buford Yates Jr., pleaded guilty to charges of securities fraud and
conspiracy. Betty Vinson, pleaded guilty to charges of conspiracy to commit securities fraud;
and Troy Normand, pleaded guilty to securities fraud and conspiracy charges. WorldCom is
currently settling the civil fraud lawsuit with the SEC11. On March 15 2005, Bernard Ebbers
was found guilty of all charges and convicted of fraud, conspiracy and filing false documents
with regulators—all related to the $11 billion accounting scandal at the telecommunications
company he founded. He was sentenced to 25 years in prison. Other former WorldCom
officials charged with criminal penalties in relation to the company's financial misstatements
include Scott Sullivan, David Myers, Buford Yates, and Betty Vinson and Troy Normand. At
the time of sentencing, Ebbers was 63 years old. On September 26, 2006, Ebbers turned up to
the Federal Bureau of Prisons prison at Oakdale, Louisiana, the Oakdale Federal Corrections
Institution to begin serving his sentence12.
135
fraud committed by the company ranged from simple to very sophisticated. It was the practice
of the company to set up shell companies for generating fake profits for it and its subsidiaries.
Investigations have revealed that the company’s finance director was involved in a “cut and
paste” forgery, in which a document with Bank of America letterhead was scanned and then
added to a document verifying a deposit account with that bank account holding over $4.98
billion. The document was then passed through a fax machine several times in order to appear
authentic. Auditors did not confirm the forged documents with outside third parties such as
banks and other creditors. Investigations have further revealed that the company, in addition to
adopting the “cut and paste” forgery, also adopted several traditional methods of dressing the
financial numbers. One such method related to selling credit-linked notes to itself, placing a
bet on its own credit worthiness in order to conjure up an asset out of thin air. Another method
involved using derivatives and other complex financial instruments to shore up its balance
sheet. Grant Thornton International (GT) was Parmalat’s auditor from 1990-99. In 1999,
Parmalat had to change its auditor under Italian law. It appointed Deloitte Touche Tohmatsu
(D&T) as its new auditor. However, GT continued to audit Parmalat’s offshore entities. It was
later known that GT’s accountants were fully aware of the shell games being played by
Parmalat’s executives. But they did not uncover the fraud. Instead, they actively participated in
the formulation of fraud schemes involving the setting up of fictitious companies and
structuring fake transactions with the objective of siphoning off company assets. It was D&T
auditor who raised the questions about Parmalat’s accounts. But this they did almost 3 years
after they became the auditors. It has, however, to be admitted that the fraud would not have
been detected had there been no change of auditors. GT International, the global organization
that ties all firms with the GT name together as an amalgam of independent entities, severed
ties with its Italian firm saying it had lost confidence in it. Tanzi, the Parmalat CEO, and five
other company executives were arrested for charges of financial fraud and money laundering.
The charges were established and Tanzi was sentenced to 10 years in prison.
136
closed on February 8 2010. Although Xerox is a global brand, it maintains a joint venture with
Fuji Xerox (Japan), Xerox India (formerly Modi Xerox) etc.15. In April 11 2002, the US SEC
filed a complaint against the company in which it was alleged that the company had deceived
the public between 1997 and 2000 by employing several accounting maneouvers or creative
accounting of various types. It was charged that the company’s accounting practices did not
only violated GAAP, but also was intentionally designed to fool the stock market into
believing that the company was working wonders. The SEC further alleged that the company’s
senior management was fully aware of the accounting actions that were being taken in order to
manipulate profits and assets. In response to the SEC’s complaint, Xerox agreed to pay a $10
million penalty and to restate its financial results for the years 1997 through 2000. On June 5
2003, six Xerox senior executives accused of securities fraud settled their issues with the SEC.
They agreed to pay $22 million in penalties, disgorgement, and interest16.
Accounting Trap at Xerox
According to SEC’s charge, the adoption of irregular accounting practices enabled the
company to increase its pretax earnings by $405 million in 1997, $655 million in 1998, and
$511 million in 1999. It was later discovered that several parties, including the then senior
Xerox management, the Board of Directors and external auditor KPMG, were involved in
some dirty financial number games. Xerox utilized creative accounting techniques to
misrepresent its assets and liabilities, and manipulate its profits. This enabled the senior
members of the company’s management team to enrich themselves to the tune of millions at
shareholders’ expense (Mills, 2003, pp. 21-30). The company’s accounting manipulations took
two basic forms17. The first was the so-called “cookie jar” method, which involved improperly
storing revenue off the balance sheet and then releasing the stored funds at strategic times in
order to boost lagging earnings for a particular quarter. The second method adopted by the
company was the acceleration of revenue from short-term equipment rentals, which were
improperly classified as long-term leases. The difference was significant because according to
the US GAAP the entire value of a long-term lease can be included as revenue in the first year
of the agreement. The value of a rental, on the other hand, is spread out over the duration of the
contract. It is this second type of manipulation which accounted for the major part of the
company’s earnings. On January 29 2003, the SEC filed a complaint against Xerox’s auditors
KPMG. KPMG questioned the legitimacy of the company's accounting practices. But the
company management demanded that a new partner be assigned to its audit. In order to keep
the relationship with Xerox that had lasted nearly 40 years, and to protect the $82 million in
audit and non-audit fees KPMG would collect from Xerox between 1997 and 2000, KPMG
complied with management's request. In April 2005 the audit firm settled with the SEC by
137
paying a $22.48 million fine. However, as part of the settlement, KPMG neither admitted nor
denied wrongdoing. Xerox settled the matter by paying a penalty of $10 million—the biggest
fine the SEC has ever levied for accounting fraud. Xerox has not collapsed. It has gradually
been able to recover from catastrophe. The executives that had participated in the financial
number games have been ousted.
138
Each of these auditors worked on the annual audits of that company for more than 15 years. It
was ascertained that the three ChuoAoyama auditors had not only been aware of Kanebo true
financial condition but had also recommended additional methods for concealing the
company’s poor financial health (Knapp. 2011). In May 2006, the Financial Services Agency
of Japan ordered ChuoAoyama PwC to halt auditing services for listed companies and those
capitalized at ¥500 million (US$4.56 million) or more. This affected more than 2300 client
companies. Though the suspension was for a temporary period, the audit firm could not restore
its business. The firm was eventually liquidated. The three ex-accountants from ChuoAoyama
PwC, Kuniaki Sato were sentenced to 18 months in prison; Kazutoshi Kanada and Seiichiro
Tokumi received one year in jail.
6.2.9 The Lehman Brothers Tumbledown (USA) (2008)
Lehman Brothers Inc. was founded in 1850. Lehman Brothers built a global recognition
and respectability doing business in investment banking, equity and fixed-income sales and
trading (especially US Treasury securities), market research, investment management, private
equity, and private banking. Lehman Brothers actively participated in the global capital
markets, headquarters in New York and regional headquarters in London and Tokyo. On
September 15 2008, the Lehman Brothers filed for Chapter 11 bankruptcy protection following
the massive exodus or mass departure of most of its clients, drastic losses in its stock, and
devaluation of its assets by several notable credit rating agencies. The filing marked the largest
bankruptcy in US history. Before declaring its bankruptcy, Lehman was the fourth largest
investment bank in the USA, behind Goldman Sachs, Morgan Stanley, and Merrill Lynch.
Lehman's bankruptcy was the largest failure of an investment bank since Drexel Burnham
Lambert collapsed amid fraud allegations 18 years ago20. Immediately following the
bankruptcy filing of Lehman Brothers, an already distressed financial market began a period of
extreme volatility, during which the Dow experienced its largest one day point loss, largest
intra-day range (more than 1,000 points) and largest daily point gain. The fall of Lehman also
had a severe effect on small private investors such as bond holders and holders of so-called
Minibonds. Subsequently, Nomura Holdings announced that it would acquire Lehman
Brothers’ franchise in the Asia-Pacific region, including Japan, Hong Kong and Australia, as
well as Lehman Brothers' investment banking businesses in Europe and the Middle East. The
deal became effective on October 13, 2008.
Financial Chicanery at Lehman Brothers
Lehman Brothers’ bankruptcy occurred as a result of a series of unprecedented adverse
events in the financial markets. Lehman executives regularly used cosmetic accounting
gimmicks at the end of each quarter to make its finances appear less shaky than they really
139
were. At the centre of the Lehman Brothers’ controversy was a technique called “Repo 105”,
under which Lehman Brothers was able to move billions of dollar off its balance sheet in the
second quarter of 2008 alone. Repo 105 is essentially a type of secured loan and is booked that
way in the accounts, leading to an increase both in assets and liabilities . The US bankruptcy
court appointed Anton R. Valukas to investigate what led to Lehman Brother’s collapse and
determine whether creditors could bring claims against Lehman’s estate or former officers.
Valukas and his Chicago based law firm, Jenner & Block, LLP, have produced a 2209 pages
report regarding the bankruptcy of Lehman Brothers. The report states that Lehman employed
“balance sheet manipulation” by utilizing an accounting practice known as “Repo 105”.
Valukas, refers repeatedly to “Repo 105,” a name for a set of accounting tactics originated by
Lehman that temporarily shuffled about $50 billion off the firm’s balance sheet for the two
fiscal quarters before it collapsed. Essentially, directly before a reporting period, Lehman
would enter into an arrangement to sell and then repurchase financial assets. These would
normally be classified as “transactions”. Lehman’s use of Repo 105, hidden from the firm’s
board but not its auditors Ernst & Young (E&Y), helped the investment bank look less
indebted than it really was. So, Ernst & Young helped Lehman Brothers conceal its
deteriorating financial condition before Lehman’s historic collapse. Lehman never publicly
disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the
considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material
impact these transactions had on the firm’s publicly reported net leverage ratio. According to
former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10K and
10Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its
Repo 105 practice. Valukas found that Repo 105 was not disclosed to several agencies -
government regulators, rating agencies, investors, even to Lehman’s board of directors.
Lehman apparently did not act alone. Valukas report discovered that Lehman’s auditor, E&Y
was made aware of Repo 105 and did not challenge the use of this questionable accounting.
The report by Valukas found that while Lehman’s directors should have exercised greater
caution, they did not cross the line into “gross negligence.” He concludes that Lehman’s
directors did not breach their duty to monitor Lehman’s risks. The Repo 105 transactions were
done in accordance with an internal accounting policy, supported by legal opinions and
approved by E&Y. At no time did Lehman’s senior financial officers, legal counsel or E &Y
raise any concerns about the use of Repo 105 with Mr. Fuld, who throughout his career
faithfully and diligently worked in the interests of Lehman and its stakeholders. The Wall
Street Journal observes that in May 2008, a Lehman Senior Vice President, Matthew Le, wrote
a letter to management alleging accounting improprieties. In the course of investigating the
140
allegations, E & Y was advised by Lee on June 12 2008 that Lehman used $50 billion of Repo
105 transactions to temporarily move assets off balance sheet quarter end. On June 13 2008, E
&Y met with the audit committee of Lehman but did not advise it about Lee’s assertions. E
&Y took virtually no action to investigate the Repo 105 allegations. They took no steps to
question the non-disclosure by Lehman of its use of $50billion of temporary, off balance sheet
transactions. Further, colourable claims exists that E &Y did not meet professional standards
both in investigating Lee’s allegations and in connection with its audit and review of Lehman’s
financial statements22. The regulatory action could be seen to implicate both Lehman’s auditors
E&Y, and the former CEO, Richard S. Fuld, Jr, This could potentially lead to E&Y being
found guilty of malign influence and financial malpractice and Richard Fuld facing time in
prison.
141
Raju, and the former CFO Vadlamani Srinivas. The Satyam forgery threatened to weaken
investors’ confidence in India at a time when the country's economy was already reeling from
the world financial crisis and recession. An editorial in the London-based Financial Times said
that the Satyam fraud would not only damage India's software and outsourcing industry; it had
raised “disturbing questions about the risks of doing business in India—and even the
sustainability of the country's much-vaunted growth miracle.” Subsequently the company was
taken over by Tech Mahindra and has been renamed as Mahindra Satyam. Mahindra Group is
one of the top 10 industrial firms in India with offices in 32 countries and has more than 75000
employees.
Financial Trickery at Satyam
Satyam tumbled down is the biggest audit failure in India of recent times. Stayam’s
statutory auditor, Price Waterhouse Coopers (PwC), failed to detect (a) inflated billing to
customers; (b) non-existent cash and bank balances of $ I billion; (c) overstated debtors $ 100
million; (d) operating margin shown high at 24% in quarter two (Sept 2008) as against 3% real
profit margin. Further, such manipulation was done in earlier years (6 years $ 1.2 billion) 24.
Several factors that contribute to Satyam’s failure include: PwC could not carry out audit
procedure strictly, professional judgments were erroneous, and audit report of PwC with a
qualified opinion was subsidized by management’s representation. Satyam's auditor PwC’s
fees jumped from Rs. 92 lakh (as stated in the consolidated balance sheet data) in 2004-05
fiscal year to Rs. 1.69 crore the next year. But it was in the financial year 2006-07 when PwC's
auditing fees shot phenomenally to Rs. 4.21 crore. It saw a marginal high in the last fiscal with
its fee for the year 2007-08 stated as Rs. 4.31 crore. The hike in auditing fees has not been as
significant in other IT majors in India namely, Wipro and Infosys that too have crossed the
crore marks but the jump has not been as sharp. After Satyam collapsed overseas agencies like
the US SEC said that Indian affiliate of PwC routinely failed to follow the most basic audit
procedures. PwC India violated its most fundamental duty as a public watchdog by failing to
comply with certain most elementary auditing standards and procedures in conducting the
Satyam audits, said Robert Khuzami, the SEC’s director of enforcement. The SEC penalized
the firm for its failed audits of Satyam that falsely reported more than $1 billion in profits. It is
mentioned that PwC accelerated its Asia expansion in 2002 when it took over offices and staff
from Arthur Andersen, which was auditor for Enron and once one of the “Big-Five” global
accounting firms25. The SEC and the PCAOB fined the affiliate, PwC India, $7.5 million in
what was described as the largest American penalty ever against a foreign accounting firm.
Satyam is now under new management and continues in business. It agreed to pay a $10
million fine to settle a related SEC case regarding the fraud. The Satyam case is currently
142
being probed by the SFIO of India, in association with Central Bureau of Investigation (CBI)
and Enforcement Directorate (ED). The CBI alleged that prime accused of Satyam scam
Ramalinga Raju along with nine others had hatched a criminal conspiracy to cheat investors of
over Rs 14,000 crore (September 10 2010, The Times of India). The SEBI refused to stay
proceedings against PwC partners S Gopalakrishan and Srinivas Talluri for their alleged
involvement in the Satyam frauds and asked them to appear before it on February 5 2012. The
ICAI has constituted the Disciplinary Committee (Satyam Bench) under the CA Act to
investigate the Satyam frauds. In December 2011, the Committee.barred Lovelock & Lewes
auditors from practice for life and imposed a penalty of Rs 5 lakh each for their alleged role in
the Satyam scam. The Committee found negligence in duties and inadequate due diligence by
Srinivas Talluri and Vadlamani Srinivas while they conducted their duties at Satyam. The
ICAI Code of Conduct was also not followed. (Jan 5 2012, The Economic Times).
The following table provides a summary of the audit failure cases referred to above.
Table 6.1: Summarized View of the Audit Failure Case Analysis
Company Nature of accounting When the Compan Remarks
(Country) irregularities/fraud perpetrated Scandal y auditor
erupted and
went public
Enron Manipulated accounts to keep 2001 Arthur Attributed as the biggest
(USA) reported income and cash flow up, Andersen audit failure in the world.
asset values inflated, and liabilities Enron had to declare
off the balance sheet. The CFO bankruptcy in 2001 and the
was indicted on 78 counts of fraud, audit firm was dissolved.
money laundering, and conspiracy.
HIM Substantial losses were kept 2001 Arthur The independence of
Insurance off the books. Andersen auditor was compromised
(Australia in several different
) respects.
Yinguang Falsified and over-reported profits 2001 Zhongtia On May 14 2002, YGX
xia(YGX) of Rmb 745 million (90 million nqin received administrative
(China) US dollar) during 1999-2000 by (ZTQ) punishment notification by
fabricating accounting documents. the CSRC. ZTQ broke the
laws and issued severely
unreliable audit reports.
ZTQ was disbanded on
September 7 2001.
Adelphia Doctored financial records and 2002 Deloitte The audit firm was sued
(USA) created sham transactions to inflate & for professional
earnings and hide debts. It falsified Touche negligence and fraud; paid
operations statistics and inflated $50million to settle claims.
earnings to meet Wall Street's
expectations, and concealed
rampant self-dealing by the Rigas
family.
143
World Committed accounting 2002 Arthur The auditor has been
Com improprieties of unprecedented Andersen blamed for not being able
(USA) magnitude through improper to detect the accounting
booking of profits and improper improprieties; the
capitalization of expenses. company is under
WorldCom’s accountant did this bankruptcy protection.
work to make themselves look
better than what they really were i
to help raising their stock prices. i
Parmalat Numerous shell companies were 2003 Grant The company was declared
(Italy) set up to generate fake profits for Thornton bankrupt in late 2003 and
the company and created assets out (principal Grant Thornton expelled
of thin air—the manipulations took auditor) the Italian operation from
place over a period of 15 years. its global network.
Xerox Inflated profits through premature 2003 KPMG The auditor questioned the
(USA) recognition of revenues. legitimacy of accounting
policies but ultimately
yielded to protect it huge
NAS fees.
Kanebo The company had been in negative 2005 ChuoAoy The auditor received a
(Japan) net worth for nine years but had ama business suspension order
disguised its troubles by declaring (PwC) from the FSA.
as much as $2 billion in
nonexistent profits.
Lehman The company had used 2008 Ernst & The company became
Brothers complicated transactions that Young bankrupt and it was the
(USA) enabled it to remove liabilities largest bankruptcy in
from its balance sheet and hide the American history, which
true level of its debts. brought the global
economy to its knees; the
auditor has been accused
of helping the company
disguise its financial
condition.
Satyam Manipulated accounts over a 2009 Price The audit partners for the
(India) number of years by recording non Water- company were imprisoned
existent assets; the company had house for alleged audit
Rs. 50.4bn of fictitious cash on its (Indian misconduct. The CBI and
balance sheet on 30 September Division the ICAI have found
2008. of PwC) Satyam auditors of prima
facie guilty in the case.
6.3 Summary
The accountancy profession has received consistently infamous press in recent years.
Auditor independence is one of the contributing factors in several high profile corporate
scandals in the early 21st century. Financial trickeries are intentional acts by unscrupulous
management of the company by applying creative accounting practices. Statutory audits are
necessary safeguards against wrongdoings, misjudgement, negligence and fraudulent
accounting practices adopted by management. But everything depends on the auditor’s
professional competence, thoroughness of the audit and finally the probity and independence
of auditor. In this chapter we have investigated a series of highly publicised cases of audit
failures of the recent past. The recent audit failures have tarnished the credibility of the
accounting profession. It has cast doubt over the overall value of external auditing and the role
144
of such auditors. Our investigation reveals that in many cases the auditors not only failed to
detect circumstances that were detectable but also assisted management in the formulation of
schemes for manipulation of financial numbers in the company’s books of accounts and
financial statements. In many cases auditors violated the auditing standards. In some cases the
quality control failures throughout audit firm have been comprehended. In the audit procedure,
the professional accountants were short of sufficient caution and professional scepticism, and
were credulous of explanation of management of companies. The auditors, in many cases,
performed their “watch-dog” functions like a “lap-dog”. Although audit needs a great deal of
professional discernment which needs work experience, some disgusting audit failures resulted
from lack of it. While partners with high level of experience and high income were busy in
expanding consulting services, young chaps with little experience and lower income were in
front-line of audit.
The overall conclusion is that in many cases of audit failures auditors were morally
dishonest and the frauds that occurred were affected with assistance and connivances of
auditors. Auditors lack their professional standards and code of ethics. Auditor independence
was sparse. Auditors were very often directed under management pressure to commit fraud due
to economic dependency on the client. The income from NAS was far higher than audit
income, which in many cases impaired auditor independence. Auditors were reported to have
charged more audit fees in comparison to other competing audit firms to issue unqualified
audit reports for the scam tainted companies. The findings of the selected case studies are
consistent with the findings of many leading cases on auditor’s negligence and liabilities
including Mckesson and Robbins Incorporated (1940)(USA) case, where auditor failure to
discover the gross overstatement of assets and the earnings is attributable to the manner in
which the audit was done; Pacific Acceptance Corporation Ltd. vs. Forsyth and Others (1971)
(Australia), where action was brought against auditors for negligence arising out of their
failure to discover fraudulent features in loans secured by registered mortgages; Escott vs.
BarCris Construction Corporation (1968)(USA), where action was brought against auditors,
directors and others for false statements of material facts in the registration statement regarding
debenture; United States vs. Simon (1969)(USA), where action was brought against a CPA firm
for certifying misleading financial statements. Other related leading audit cases are: Re. The
London and General Bank Ltd. (1895); Re. the Kinston Cotton Mills Co Ltd. (1896); The Irish
Woollen Co. Ltd. vs. Tyson and Others (1900); The Lee Estate Building and Investment Society
Ltd. vs. Shepherd (1887); and London and Oil Storage Co. Ltd. vs. Seear, Hasluck & Co.
(1904).
145
Endnotes
1. David Ehrenstein opines that the term “creative accounting” was first used in 1968 in the film.
Source: Ahttp://chaumurky.net/criterion/indepth- 184.html, cited in http://en.wikipedia.org/wiki/Creative
accounting.
2. AA LLP, based in Chicago, was once one of the “Big Five” accounting firms providing auditing, tax
and consulting services to large corporations was founded in 1913. It was founded by Arthur Andersen and
Clarence DeLany as Andersen, DeLany & Co. The firm changed its name to Arthur Andersen & Co. (AA)
in 1918. AA audited major corporations in the US in the early 1960s. AA had been alleged to have been
involved in the fraudulent accounting and auditing of Sunbeam Products, Waste Management, Baptist
Foundation, WorldCom, and Enron.
3. Source: The Enron Collapse: An Overview of Financial Issues, CRS Report for Congress, RS21135,
February 4 2002.
4. Andrew Comford: Internationally Agreed Principles For Corporate Governance And The Enron
Case, UNCTAD, G-24 Discussion Paer Series No. 30, New York, June 2004, p.30. Source:
http://www.unctad.org.en/docs/ gdsmdpb g2420046_en.pdf.
5. A detailed account of how Enron manipulated its accounts is contained in Fusaro and Miller (2002).
6. Source: Associated Press 2002, Chronology, Williams, F. 2002; The (Olean)Times Herald 26, July
2002; Adelphia Press Communications Releases.).
7. Source website: A http://www.lfc.com/695H2.
8. Source website: http://money.cnn.com/2002/07/19/news/worldcom_bankruptcy/) (accessed on
14/1/2012).
9. Source website: http://en.wikipedia.org/wiki/WorldComXaccessed on 24/6/2011).
10. Source website: http://www/guardian.co.uk/business./2002/aug/09/corpcratefraud .wo...) (accessed
on 14.1.2012).
11. Source website: http://www.lawyershop.com/practice-areas/criminal-law/white-coollar....
12. Source website: http://en.wikipedia.org/wiki/WorldCom.
13. Source website: http://www.allbusiness.com/accounting-reporting/fraud/1081567-l.html).
14. Source website: Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Parmalat.
15.Source website: Xerox Wikipedia, the free encyclopedia,
http://en.wikipedia.0rg/wiki/Xer0x#Alleged _accounting_ irregularities) (accessed on 24/6/2011).
16.. Source website: Xerox Wikipedia, the free encyclopedia,
http://en.wikipedia.0rg/wiki/Xerox#Alleged _accounting_ irregularities.
17. Detailed particulars concerning Xerox can be had from: About Xerox. (2007). [Online] Retrieved
April 16 2007 from Xerox Corporation database on the Website:
http://www.xerox.com/go/xrx/pbrtal/STServlet?
projectID=ST_About_Xerox&pageID=Landing&Xcntry=USA&Xlang=en_US.
18. Report: Business and Financial, 15 April 2005.
19. Source website: PWC Japan Unit Suspended Over Kanebo Fraud (available at: http://57slang.
wordpress.com/2006/08/15pwc-japa- unit-suspend...
20. Source website: A a b Andrew Ross Sorkin (2008-09-15).”In Frantic Day, Wall Street Banks Teeter”
(http://www.nytimes.com/2008/09/ 15/business/l 51ehman.html?hp).
21. A repo (buy back) is a transaction in which two parties agree to sell and purchase the same security.
Repo is a collateralised short-term borrowing and lending through sale/purchase operations in debt
instruments. It is a temporary sale of debt, involving full transfer of ownership of the securities, that is, the
assignment of voting and financial rights. (Khan, 2007, p.10.9).
22. Source website: http://www.huffing tonpost.com/2010/03/12/lehman-bankruptcy-rep....
23. Source website: http://www.msnbc.msn. Com/id/28539007/.
24. Source: Prateek Kumar Patel, “Satyam Audit failure - an enlightenment”, May 21 2011, available at
website.
25. Source website: http://in.reutersd.com/artcle/innovatiionNews/idINTRE507FD20090108.
146