Looking at Cooking the Financial

Books

Ron Weifenbach

Managerial Accounting

Abstract

This paper looks at the consequences of companies who misrepresent their

financial statements. The paper will outline what happens when and after fraud is

discovered in the representation of the financial statements of a publicly traded

company and how it affects managers, the company and the shareholders. The

paper will outline the consequences from the following perspectives; legal,

monetary and non monetary. This paper will out the Sarbanes-Oxley act titles and

summarize each as to what each requires. The paper summarizes the rise and fall of

two large publicly traded companies that were both held out at one time as model

corporations. The paper will discuss their beginnings and their financial

misrepresentations and practices that led to their demise.

 The concept of cooking the books has been around since the beginning of

financial record keeping. Incentives to misrepresent financials are sometimes too

great for CEO’s and managers to resist. The fraud begins like any other typical

situation. It begins with a small misrepresentation that then gives way to another

larger change. The perpetrator gets comfortable reaping the rewards from the

misrepresentations than the fraud becomes too much to manage and too large to

control. Fellow managers are then enlisted into getting involved and the fraud

grows; soon it has become so obvious to the outside world that red flags pop up on

every corner. Once the fraud has been identified the denial stage takes over;

managers and CEO’s scramble to cover the scandal. CEO’s and managers deny

any wrong doing or any misrepresentation of the financials. Soon the SEC and

DOJ get involved and typically start an investigation. The motives for top level

mangers and CEO’s involved are usually motivated by greed.

This paper takes as look at the fallout from the discovery of fraud in large

publicly traded corporations. This paper will review the aspects of financial

misrepresentation from a legal perspective and also from an image perspective.

The company will face different consequences than the manager who perpetrated

the fraud, this paper will review and discuss those ramifications. Shareholders will

always be the biggest financial losers. This paper will delve into the area of

shareholders losses and how they may be affected.

 The biggest question to be answered is “how do these companies cook their

books?” This paper will tell the tale of the rise and fall of two corporate giants

whom operated in different industries; from their beginning to their peaks and

ultimately their demise. World Com was number 2 in the telecom industry next to

ATT. Enron was a breed of its own a large conglomerate that reached into a few

different industries. From its beginning of a merger of two gas supply pipeline

companies to a multifaceted complex corporate profit machine built on a house of

cards. Thousands lost their jobs and their life savings when the house of cards

tumbled.

Top managers face different consequences when fraud is discovered in their

company. Greg Neihauss, Greg Roth and Philip Stratan found that the probability

of a CEO losing their job increases when a firm is subjected to securities class

action lawsuits. Sometimes the cost of changing a management team is outweighed

by the actual cost of doing so. This may give rise to suspensions. As the stakes rise

and the public involvement are more predominant the SEC and DOJ become more

involved. The SEC may launch investigations in securities and exchange breach of

rules and regulations. Once these levels of fraud have been uncovered the DOJ

prosecutes for any criminal activities. According to J. Karpaff, O. Lee and G.

Martin, between 1978 and 2002 federal regulations brought 585 enforcement

actions for financial misrepresentations by publically traded companies. Legal

penalties that individuals and firms paid can be substantial. According to Karpaff,

Lee, and Martin, individuals were assessed at $15.9 billion in fines and civil

penalties and 190 managers received jail sentences for financial reporting issues.

Spite these statistics legislators and others called for greater regulatory and

disclosure requirements. This gave rise to the defense for the Sarbanes-Oxley Act

that passed the House and Senate almost unanimously following the exposure of

WorldCom and Enron both of whom will be discussed in further detail in this

paper.

According to Karpaff, Lee, and Martin, from 1978 to 2002 $13.3 billion in

penalties were assessed against individuals involved in financial misrepresentation.

An additional $2.6 billion in settlements were levied against perpetrators of

financial fraud through share holder class action of derivative lawsuits.

Corporations pay the price for financial misrepresentation. Many companies

will face non-monetary penalties such as cease and desist where they are legally

bound to stop public trading temporarily or in some cases permanent injunctions

take place. From the outside these instructions seemed that the punishment did not

match the crime while in reality only a few companies have managed to make it

back as a publicly traded company. Corporations will suffer from credibility and

reputation losses once misrepresentation of financials is discovered. Creditors and

investors will be reluctant to do business with companies facing an uncertain

financial future as an ongoing concern. Board raters will down grade corporate

debt causing the cost of capital to rise. Suppliers will pull back in fear of receiving

payment for supplies delivered. Creditors may call in margins such as in the case

of World Com as will be discussed later in this paper. Monetary consequences will

continue to mount against companies against companies averaged $32.8 million

not including the $2.25 imposed on World com for overstating earnings.

Companies will face class action lawsuits in numbers that exceed regulatory

agency fines. According to Karpaff, Lee and Martin, the mean suit will end up in

settlement of $9.2 million not counting the $2.8 billion suit against Cendant

Corporation involving 12 years of systemic accounting manipulation.

This combination of monetary and non monetary penalties gives rise to the

perfect storm. Fraud, discovering of cooked books, fines, penalties, injunctions

sanctions, loss of reputation, loss of credibility, rising credit costs, mounting losses

creates the beginning of the end for most companies.

The consequences to managers and firms directly correlate to the biggest

loser of all the shareholders. The investors whom had made decisions based upon

the financial information provided by the company’s financial books. The perfect

storm leaves the shareholder with huge financial losses or stocks that are not even

worth the paper they are printed on. According to Karpaff, Lee, and Martin the

following devaluing of shares takes place:

  Upon announcement of financial misrepresentations the stock

plummets 25%

 The initial announcement of a federal enforcement action is associated

with an average decline in the target firm’s stock value equal 13%

 Law suits amount to a 5% decrease

 The restatement of the financials of the misrepresentation is typically

29%

 The results imply that 66% of the losses incurred are due to the

concerns of future earnings.

They go further to put it in to dollars, for each dollar that was misrepresented

there will be 17¢ in legal penalties and $2.28 in lost reputation.

The disclosure of fraud in the telecom giant World Com and the Enron

scandal spurred on the passing of the Sarbanes-Qxley Act. The act was named for

Senator Paul Sarbanes and Representative Michael Oxley they were the main

contributors. The act introduced sweeping financial reporting and corporate

governance reform. Compliance to the act was set out in a series of 11 titles. The

act does not apply to privately held companies. The titles are listed and

summarized below:
I. Public Company Accounting oversight Board creating a board that

provides oversight of public accounting firms that provide auditors services.

It also creates a regulatory and oversight board for auditors.

II. Auditor Independence

Established standards for external auditors to limit conflict of interests.

III. Corporate Responsibility

Define that senior executives must take individual responsibilities for the

accuracy and completeness of corporate financial reports.

IV. Enhanced Financial Disclosures

Describes enhanced reporting requirements for financial transactions

including off balance sheet transactions, proforma figures and stock

transactions of corporate officers. It lays out internal control requirements,

mandates audits and reports on the such. Requires reports on material

changes.

V. Analyst Conflicts of Interest

Defines the codes of conflict for securities analysts and requires disclosure

of knowable conflicts of interest.

VI. Commission Resources and Authority

Defines authority of SEC to censor or bar securities professionals from

practice and defines the conditions for these consequences.

VII. Studies and Reports

Requires SEC and controller general to perform various studies and report

the findings. Some such studies are:

 Effects of consolidation of public accounting firms

 The role of credit reporting tendencies in the operation of securities

markets

 Securities violations and enforcement actions

 Whether banks assisted Enron, Global Crossing and others to

manipulate financial conditions

VIII. Corporate and Criminal Fraud Accountability

Defines specific criminal penalties for manipulation, destruction or alteration

of financial records or other interference with investigations while providing

certain protections for whistle-blowers

IX. White Collar Crime Penalty Enhancement

Increases in the penalties for white collar crimes and conspiracies.

X. Corporate Tax Returns

The chief executive officer should sign the corporate tax return.

XI. Corporate Fraud Accountability

Identifies corporate fraud and records tampering as criminal offenses and

joins those offenses to specific penalties. It also revises sentencing and

 strengthens penalties. It also enables the SEC to temporarily freeze

transactions or payments that have been deemed large or unusual.

The concept of the Sarbanes-Oxley Act was to protect those who relied upon

financial records. Today the jury is still out as to whether the costs to implement

the act actually substantiate the enactment of its titles. There are those who will

argue for its provisions and those who will argue against. One thing is clear as long

as greed exists so will the opportunistic crooks that will capitalize on the

opportunities to bring home the bacon whatever the costs maybe. The Sarbenes-

Oxly Act will be recognized as tool to the following discussions of World Com

and Enron should act as reminders.

This is a tale of two companies, a rise and fall of WorldCom and Enron. This

paper has chosen these companies to illustrate how corporate fraud is perpetrated

and what the consequences are once the misrepresentations are discovered.

Bernie Ebbers was the visionary CEO of a small telecom long distance

phone service provider. Ebbers through a period of 15 years, a process of over 60

mergers and acquisitions of companies created a giant telecom business. After

consuming MCI in 1998 World Com became number 2 in the telecom industry

next to ATT. The acquisition of MCI would be the telecom giant’s last; the MCI

acquisitions almost immediately was proven a bad decision. MCI sales prior to the

acquisition were slipping and continued after the merger. During the year of 1999
World Com was held out as the company to be. Bernie Ebbers was a hugely

successful flamboyant businessman. Ebbers leveraged World Com Stock to

finance other business interests such as yachting and a stake in the timber business.

Life was good at World Com; stock prices hit $64 a stake. Income from operations

was in the billions. World Com had enjoyed unprecedented growth orchestrated by

Ebbers. Profit margins for World Com outpaced all others in the industry. Sales

though declining in the industry remained ahead of all of its competitors.

WorldCom market share increased faster than its competitors. WorldCom’s ability

to control expenses was second to none. World Com was held out as a model

corporation; yes life was good at World Com; too good to be true!

Things in the telecom industry started to unravel around 1998. As mentioned

earlier right from the beginning of the MCI acquisition the industry had started its

decline. The stock and the company had reached its pinnacle in 1999. Almost

immediately after its high, WorldCom stock begins to slide. Bankers who had

given loans based on WorldCom stock began to call in margins. Ebbers began to

feel the heat from the decline in the business and pressure to pay up on debt.

WorldCom posed a merger with sprint. The merger failed citing concerns of

reduced competition. At this point the wheels began to fall off. WorldCom stock

plummeted to $15 a share. Between the years of 2000 and 2002 World Com loaned

their CEO Ebbers $400 million.

 As the stock prices continued to plummet World Com management hatched

a scheme to make the company appear to be more profitable to keep stock prices

from the continued free fall. In 2002 an internal auditor uncovered the scam. The

scam consisted of under estimating expenses and overstating revenues. The scam

of underestimating expenses was perpetrated by capitalizing phone line expenses.

WorldCom did not own its own phone lines they had to buy line time from other

companies. Instead of directly expensing the cost of those lines relative to the

income the expenses were capitalized significantly reducing expenses for the

period. World Com also created artificial revenue accounts to show income

streams for the period that really did not exist. After the fraud was uncovered it

was apparent that world Com had greatly overstated EBITDA.

The SEC launched an investigation into World Com’s financial reporting. In

July of 2002 WorldCom filed chapter 11 bankruptcy. World Com stock dropped to

20 cents a share. Over 17,000 people lost their jobs and WorldCom was over $35

billion dollars in debt. Fraud had accounted for over $79.5 billion in

misrepresentations. Several of WorldCom’s top executives faced criminal charges.

CEO Ebbers received 25 years in prison and CFO Sullivan received 5 years in

prison. The independent auditor, Arthur Anderson agreed to pay $65 million in

fines. Insurance companies agreed to pay $36 million in claims. The company paid

fines of $750 million. The biggest loser were the shareholders, they lost value of
over $80 billion. World Com emerged from bankruptcy and immediately shed the

WorldCom name and changed their name to MCI. The federal government later

awarded MCI with a no bid contract to rebuild the wireless infrastructure in Iraq.

MCI was later purchased by Verizon Inc.

This paper will now look at another corporate giant which had fallen victim

to perpetrated misrepresentation of financial statements. From humble beginnings,

the product of a merger between two gas pipeline companies, Enron is born. In the

year of 1985 two gas line companies Houston Natural Gas and Internorth merge

and create what will be known as Enron. The 1990s seem to be the birth period of

creative and entrepreneurial spirits. As deregulation gives way to companies

abilities to venture into new market segments companies like Enron take advantage

of their business expertise. Enron launches its profitable venture. The measurement

capitalizes on their position in the supply of gas and their pipeline leverage.

Kenneth Lay was the founder of Enron Corporation. Enron had over 37,000 miles

of pipeline used for transporting natural gas. During the early years long term

contracts were written through the supply lines creating stable pricing levels and

stable profit levels. Along came deregulation and Enron’s ability to grow profits

grew significantly. To add diversity Enron pursued to extend their gas pipeline

business model into energy trading.

 To further quench its appetite for growth Enron went international,

managing construction projects and managing energy plants. According to P.

Healy K Palepu by “2001 Enron had become a conglomerate that owned and

operated gas pipelines, electricity plants, pulp and paper plants, broadband assets

and water plants internationally and traded extensively in financial markets for the

same products and services.” By 1998 their stock had risen 311% even with the

markets. In 1999 stock rose 56% about 36% better than market. In 2000 stock rose

87% while the market experienced a 10% decline. Enron’s capitalization is at 70

times earnings at about $60 billion. Revenues were in the billions; Enron employed

over 20,000 employees and was one of the world’s largest leading electricity and

natural gas companies. Fortune magazine crowned Enron “America’s most

innovative company.” Enron is on top of the world. Enron Corporation had grown

to biblical proportions.

Their financial statements and business models were stretching the limits of

accounting standards. Enron took full advantage of this couples and multifaceted

business structure. Two of their business practices became problematic for Enron.

The first was creation of shell corporations made to keep liabilities off the books of

Enron Corporation. There are fundamental rules that govern special purpose

entities. One the independent third party must have at least 3 % of equity at risk

and a controlling financial interest in the entity. Next a practice referred to as

mark-to-market; Enron had several long term contracts that would yield profits as

they matured. Mark-to-market would allow the future revenues of a long term

contract be realized today based upon a calculation that would show a net

realizable value based upon hypothetical performance measures. These accounting

practices were acceptable and widely used. The problem was when the envelope

was pushed and misrepresented. Some examples from Enron cited from P. Healy

and K. Palepu, Journal of Economic Perspectives Paper, reads as follows:

In July 2000 Enron signed a 20 year agreement with Block Buster video to

introduce entertainment on demand to multiple U.S. cities by year-end.

Enron would store the entertainment on demand and encode and stream

entertainment over its global broadband network. Pilot projects in Portland,

Seattle and Salt Lake City were created to stream movies to a few dozen

apartments from servers set up in the basement. Based on these pilot

projections, Enron went ahead recognized estimated profits of more than

$110 million from the Blockbuster deal even though there were serious

questions about technical liability and market demand.

In another scam Enron had recognized revenue through mark-to-market on a

contract with Eli Lili to supply electricity to Indiana. The contract with Eli Lilly

was for $4.3 billion over 15 years. Enron recognized revenues of over $500

million. Indiana had not even de-regulated electricity. According to P. Healy and
G.Palepu, in 1999 Enron used a special interest entity to buy out Chewco from one

of their partners. The cost for the buyout was $383 million. Enron structured the

deal as to not consolidate therefore not showing the debt of Chewco on their books.

The announcements of accounting irregularities had plummeted Enron stock.

Enron was coming apart at the seams. Write downs of over one billion dollars due

to underperforming business entities; combined with mark-to-market performance

issues, shell company restatements of $612 million reduction in earnings and an

increase of $628 million in restated liabilities lead to Enron’s demise. In an effort

to stop the bleeding Enron attempts a merger with the small company Dynergy.

The merger is called off. Enron’s debt is downgraded to junk and Enron stock

plummets to zero. In December 2001 Enron files for chapter 11 bankruptcy.

Thousands of employees lost their jobs and their life savings. Top executives face

criminal charges. Lay the founder and once one of Houston’s most respected

power brokers and philanthropists dies and his conviction is vacated. Jeff Skilling

the executive who took Enron away from pipelines and into more glamorous

ventures was convicted on fraud charges.

This paper has identified cooking of the books, what it entails, and what

gave rise to the Sarbanes-Oxley Act. The paper went through the rise and fall of

two corporate role models. It has become apparent that history will repeat itself. As

long as greed is around so will be fraud and corruption. There will be different
scams with different players. It would seem to the writer of this paper to give the

advice of proceeding with caution, trust but verify, and when it seems to be to be

true, it probably is.

The End
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