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Financial Statement Fraud - Enron.aicpa
Financial Statement Fraud - Enron.aicpa
This presentation is intended for use in higher education for instructional purposes only, and is not for
application in practice. Permission is granted to classroom instructors to photocopy this document for
classroom teaching purposes only. All other rights are reserved. Copyright 2003, 2005 by the
American Institute of Certified Public Accountants, Inc., New York, New York.
Year 1
Year 3
Year 5
Year 7
Year 9
$600K
$4 million
$80 million
$600 million
$2.6 billion
$100
90
$ 10
1
$ 9
100%
90%
10%
Bank
$7 million fraud
$2 billion drop in
stock value
Types of Fraud
Fraudulent Financial
Statements
Employee Fraud
Vendor Fraud
Customer Fraud
Investment Scams
Bankruptcy Frauds
Miscellaneous Frauds
2003, 2005 by the
AICPA
from BankruptcyData.com
Company
Assets (Billions)
When Filed
1. WorldCom
$103.9
July 2002
2. Enron
$63.4
Dec. 2001
3. Conseco
$61.4
Dec. 2002
4. Texaco
$35.9
April 1987
$33.9
Sept. 1988
6. Global Crossing
$30.2
Jan. 2002
7. PG&E
$29.8
April 2001
8. UAL
$25.2
Dec. 2002
9. Adelphia
$21.5
June 2002
10. MCorp
$20.2
March 1989
Executive Incentives
Meeting Wall Streets Expectations
Stock prices are tied to meeting Wall Streets earnings
forecasts
Focus is on short-term performance only
Companies are heavily punished for not meeting
forecasts
Executives have been endowed with hundreds of
millions of dollars worth of stock optionsfar exceeds
compensation (tied to stock price)
Performance is based on earnings & stock price
2003, 2005 by the
AICPA
Firm B
Auditorsthe CPAs
Failed to accept responsibility for fraud detection (SEC,
Supreme Court, public expects them to detect fraud) If
auditors arent the watchdogs, then who is?
Became greedy--$500,000 per year per partner
compensation wasnt enough; saw everyone else getting
rich
Audit became a loss leader
Easier to sell lucrative consulting services from the inside
Became largest consulting firms in the U.S. very quickly
(Andersen Consulting grew to compete with Accenture)
Educators
Need to teach Ethics more
Need to teach students about fraudoffer
a fraud course
Need to teach students how to think
We have taught them how to copy, not think
We have asked them to memorize, not think
We have done what is easiest for us and
easiest for our students
2003, 2005 by the
AICPA
xxx
xxx
Accounts Involved
Fraud Schemes
1. Estimate all
uncollectible
accounts receivable
2. Sell goods and/or
services to
customers
3. Accept returned
goods from
customers
Sales returns,
accounts receivable
4. Write off
receivables as
uncollectible
Allowance for
doubtful accounts,
accounts receivable
Cash, accounts
receivable
Overstating Inventory
The second most common way to commit
financial statement fraud is to overstate
inventory.
Beginning Inventory
Purchases
Goods Available for sale
Ending Inventory
Cost of Goods Sold
Income
2003, 2005 by the
AICPA
OK
OK
OK
High
Low
High
Disclosure Frauds
Three Categories of Disclosure Frauds:
1. Overall misrepresentations about the nature of the
company or its products, usually made through news
reports, interviews, annual reports, and elsewhere
2. Misrepresentations in the management discussions
and other non-financial statement sections of annual
reports, 10-Ks, 10-Qs, and other reports
3. Misrepresentations in the footnotes to the financial
statements
2003, 2005 by the
AICPA
2. Relationships
With Others
Detecting Financial
Statement Fraud
3. Organization & Industry
2003, 2005 by the
AICPA
Enron Fraud
Compared to other financial statement frauds, Enron was
very complicated. WorldCom, for example, was a $7
billion fraud that involved simply capitalizing expenses
(line costs) that should have been expensed (Accounting
200 topic). Enron involved many complex transactions
and accounting issues.
What we are looking at here is an example of
superbly complex financial reports. They didnt have
to lie. All they had to do was to obfuscate it with
sheer complexityalthough they probably lied too.
Senator John Dingell
2003, 2005 by the
AICPA
Enrons History
In 1985 after federal deregulation of natural gas pipelines,
Enron was born from the merger of Houston Natural Gas
and InterNorth, a Nebraska pipeline company.
Enron incurred massive debt and no longer had exclusive
rights to its pipelines.
Needed new and innovative business strategy
Kenneth Lay, CEO, hired McKinsey & Company to assist
in developing business strategy. They assigned a young
consultant named Jeffrey Skilling.
His background was in banking and asset and liability
management.
His recommendation: that Enron create a Gas Bank
to buy and sell gas
2003, 2005 by the
AICPA
The Motivation
Enron delivered smoothly growing earnings (but not cash flows.) Wall
Street took Enron on its word but didnt understand its financial
statements.
It was all about the price of the stock. Enron was a trading company
and Wall Street normally doesnt reward volatile earnings of trading
companies. (Goldman Sacks is a trading company. Its stock price
was 20 times earnings while Enrons was 70 times earnings.)
In its last 5 years, Enron reported 20 straight quarters of increasing
income.
Enron, that had once made its money from hard assets like pipelines,
generated more than 80% of its earnings from a vaguer business
known as wholesale energy operations and services.
2003, 2005 by the
AICPA
Enrons Arrogance
Enrons banner in lobby: Changed from
The Worlds Leading Energy Company to
THE WORLDS LEADING COMPANY
Revenues
Income
1997
$20.2 B
$105 M
Income
(Restated)*
$9 M
1998
$31.2 B
$703 M
$590 M
1999
$40.1 B
$893 M
$643 M
2000
$100.1 B
$979 M
$827 M
* Without LJM1, LJM2, Chewco and the Four Raptors partnerships. There
were hundreds of partnershipsmainly used to hide debt.
2003, 2005 by the
AICPA
(Enrons principal method of financial statement fraud involved the use of SPEs)
Mark-to-Market Accounting
Accounting and reporting standards for marketable securities,
derivatives and financial contracts are found in FAS 115 and FAS
133.
Changes in market values are reported in the income statement for
certain financial assets and in shareholders equity (component of
Accumulated Other Comprehensive Income) for others
Gains often determined by proprietary formulas depending on many
assumptions about interest rate, customers, costs and prices
provides opportunities for management to create and manage
earnings
Enron often recognized revenue at the time contracts (even private)
were signed based on net present value of all future estimated
revenues and costs.
Profits really tracked price of oil futuresalmost perfectly correlated
LJM1 SPE
Responsible for 20% of SPE restatement or
$100 million
Should have been consolidatedan error in
judgment by Andersen (per Andersen)
After Andersens initial review in 1999, Enron
created a subsidiary within LJM1, referred to as
Swap Sub. As a result, the 3% rule for residual
equity was no longer met.
Andersen was reviewing this transaction again at
the time problems were made publicinvolved
complex issues concerning the valuation of
various assets and liabilities.
2003, 2005 by the
AICPA
Enrons Disclosures
SEC Regulation S-K requires description of
related-party transactions that exceed $60K and
for which an executive has a material interest
Related Party Transactions footnote included in
Forms 10-Q and 10-K beginning with second
quarter of 1999 through 2nd quarter of 2001
From 2000 annual report Enron entered into
transactions with limited partnerships whose
general partners managing partner is a senior
official of Enron. (Fastow)
2003, 2005 by the
AICPA
Enrons FootnotesDisclosures of
Enron Partnership
Report
8/14/2000
11/14/2000
5/15/2001
8/14/2001
11/19/2001
Footnote
The Skeptics
Jonathan Weil, Energy traders cite gains,
but some math is missing, The Wall
Street Journal (Texas ed.) 9/20/2000
Feb. 2001 analyst report from John S.
Herold, Inc. by Lou Gagliardi and John
Parry
Bethany McLean, Is Enron overpriced?
Fortune, 3/5/2001
2003, 2005 by the
AICPA
Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000,
1st two quarters in 2001.
2003, 2005 by the
AICPA
Role of Andersen
Was paid $52 million in 2000, the majority for non-audit related
consulting services.
Failed to spot many of Enrons losses
Should have assessed Enron managements internal controls on
derivatives tradingexpressed approval of internal controls during
1998 through 2000
Kept a whole floor of auditors assigned at Enron year around
Enron was Andersens second largest client
Provided both external and internal audits
CFOs and controllers were former Andersen executives
Accused of document destructionwas criminally indicted
Went out of business
My partner friend I had $4 million in my retirement account and I lost
it all. Some partners who transferred to other firms now have two
equity loans and no retirement savings.
2003, 2005 by the
AICPA
No