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The Crisis of Confidence in Business

The Crisis of Confidence in Business W. Steve Albrecht, Associate Dean Marriott School of Management Brigham Young University Presentation at the University of Montana November, 2004 Let’s start with a story—who committed fraud in this case? Rich Man--three friends Lawyer Accountant

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The Crisis of Confidence in Business

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  1. The Crisis of Confidence in Business W. Steve Albrecht, Associate Dean Marriott School of Management Brigham Young University Presentation at the University of Montana November, 2004

  2. Let’s start with a story—who committed fraud in this case? • Rich Man--three friends • Lawyer • Accountant • Minister 1/1/02 Rich Friend 50,000 Fifty Thousand and no/100--------------- I M Smarter than U

  3. The Accountant’s Check Eternity My Rich Friend 50,000 Fifty Thousand Dollars and no/100-------------------------------------- I. M . Smarter Than U. Honor Commitment

  4. Crisis of Confidence • In recent years there has been a crisis of confidence in the business world • The market value of international stock exchanges plummeted in early 2000 • Terrorists acts such as “9/11” were a contributing factor • BUT unethical behavior destroyed more wealth than all terrorist acts combined!

  5. 391% 78% 9/11 5049 5000 4000 3000 2000 1114 1000 The NASDAQ “Bubble” 1996 1997 1998 1999 2000 2001 2002 2003 2004

  6. Other markets looked very similar Total market loss worldwide… $15 trillion

  7. Why the Crash—What Happened? Misstated financial statements: Quest, Enron, Global Crossing, HeathSouth, WorldCom, Xerox, Rite-Aid, Harris Scarfe, HIH, etc. Executive loans and corporate looting: John Rigas (Adelphia), Dennis Kozlowski Bernie Ebbers (WorldCom) Insider trading scandals: Martha Stewart, Sam Waksal, One.Tel, etc. IPO favoritism, incl. spinning and laddering: Bernie Ebbers, etc. Massive fraud by employees

  8. Why the Crash—What Happened? Excessive CEO retirement perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM (consulting contracts, use of corporate planes, executive apartments, maids, etc.) Exorbitant stock options for executives Loans for trading fees and other quid pro quo transactions: Citibank, Chase, etc. Bankruptcies and excessive debt Mutual Fund Frauds: Late trading and market timing to benefit insiders and favored customers

  9. Consequences of These Problems • Lost confidence in capital markets • Lawsuits—one company has over 3,000 • Going out of business/bankruptcies • Lost reputation and bad press • Longer and more expensive audits, special inquiries • Fines & investigations • Damaged employees & reputations • Lost retirement and pension funds • Directors with personal liability, forced resignations • Losses from fraud • Significant legislative activity

  10. Lost Reputation

  11. The Cost of Bad Press

  12. Largest Bankruptcy Filings

  13. How Costly is Financial Statement Fraud? • Financial statement fraud causes a decrease in the market value of a stock of approximately 500 to 1,000 times the amount of the fraud. $2 billion drop in stock value $7 million fraud

  14. Example: Martha Stewart • Martha Stewart gained ~$46,000 by using inside information • Martha Stewart Living Omnimedia shareholders lost ~$750,000,000 after Martha’s arrest and ensuing publicity!

  15. Fraud Against OrganizationsA Costly Business Problem • Large Fraud of $2.6 Billion over 9 years • Year 1 $600K • Year 3 $4 million • Year 5 $80 million • Year 7 $600 million • Year 9 $2.6 billion • In years 8 and 9, four of the world’s largest banks were involved and lost over $500 million Some of the organizations involved: Merrill Lynch, J.P. Morgan Chase, Union Bank of Switzerland, Credit Lyonnaise, Sumitomo, and others.

  16. Fraud Losses Reduce Net Income $ for $ If Profit Margin is 10%, Revenues Must Increase by 10 times Losses to Recover Affect on Net Income Losses……. $100 Million Revenue…...$1 Billion Fraud Robs Income Why Fraud Against Organizations is a Costly Business Problem Revenues $100 100% Expenses 90 90% Net Income $ 10 10% Fraud 1 Remaining $ 9 To restore the $1 of lost income, need $10 more dollars of revenue.

  17. General Motors $436 Million Fraud Profit Margin = 10% $4.36 Billion in Revenues Needed At $20,000 per Car, 218,000 Cars Bank $100 Million Fraud Profit Margin = 10 % $1 Billion in Revenues Needed At $100 per year per Checking Account, 10 Million New Accounts Why Fraud Against Organizations is a Costly Business Problem

  18. 1. Finland 2. Iceland 3. Denmark 3.New Zealand 5.Singapore 5. Sweden 7. Netherlands 8.Australia 8. Norway 8. Switzerland 11. Canada 18. United States 21. Japan 23. France 54. Brazil 56. Mexico 66. China 86. Russia 132. Nigeria 133. Bangladesh Fraud InternationallyTransparency International

  19. Why Did So Many Financial Statement Frauds Occur? • Good economy was masking many problems • Moral decay in society • Misplaced executive incentives • Unachievable Wall Street expectations—rewards for short-term behavior • Large amounts of debt and other leverage • Nature of accounting rules • Behavior of auditing firms • Greed by executives, investment banks, commercial banks, and investors • Educator failures "The Perfect Storm"

  20. 1. Good Economy Masked Problems • With increasing stock prices, increasing profits and increasing wealth for everyone, no one worried about potential problems. • People were making nonsensical investment decisions—“irrational exuberance” • How to value a dot.com company: • Take their loss for the year • Multiply the result by negative 1 to make it positive • Multiply that number by at least 100 • If stock price is less than the result…buy • If not, buy anyway!

  21. 2. Moral Decay • Attendees at the April, 1998 Business Week Forum of Chief Financial Officers: • 67% of CFOs said they had fought off other executives’ requests to “misrepresent corporate results” • 12% of CFOs admitted they had “yielded to the requests” while 55% said they had “fought off requests” to misrepresent corporate results • Honesty studies • People are becoming less honest • Less modeling and labeling of good ethical behavior

  22. Dishonesty Is Increasing 12% in 1961 31% in 1986 Retail Losses 30% customers 70% employees $400 billion annually $9 per employee per day (2002 Study) Organizations lose between 1% and 6% of revenues to fraud Insurance fraud in 2000 was $120 billion General Motors had $436 million fraud Large bank in recent year 6200 customer frauds 2100 employee frauds 3600 lawsuits Has There Really Been “Moral Decay”?Data from the U.S. We All Pay for Fraud!

  23. The Transformation of Arthur Andersen • Early days of Andersen • Leonard Spacek—epitome of ethics • DuPont lost to a competitor because Anderson would not agree with accounting method • Recent years • Waste Management case • Anderson turns a blind eye to abuses to keep account

  24. 3. Executive Incentives Meeting Wall Street’s Expectations • Stock prices are tied to Wall Street’s earnings forecasts • Focus is on short-term (quarterly) performance only • Price is heavily punished for not meeting forecasts • Compensation is based on earnings & stock price • Bonuses tied to stock price • Stock options—often far in excess of salary

  25. Example: Bernie Ebbers, WorldCom Million $

  26. Firm A Firm B 4. Wall Street’s Expectations • Investors want decreased risk and growing returns. • Risk is reduced when variability of earnings is decreased. • Rewards are increased when income continuously improves. Which firm will have the higher stock price?

  27. Actual Complaint in $2.8 Billion Financial Statement Fraud Case “The goal of this scheme was to ensure that (the company) always met Wall Street’s growing earnings expectations for the company. (The company’s) management knew that meeting or exceeding these estimates was a key factor for the stock price of all publicly traded companies and therefore set out to ensure that the company met Wall Street’s targets every quarter regardless of the company’s actual earnings. During the period 1998 to 1999 alone, management improperly inflated the company’s operating income by more than $500 million before taxes, which represents more than one-third of the total operating income reported by (the company.)”

  28. Actual Complaint in $2.8 Billion Financial Statement Fraud Case “The participants in the illegal scheme included virtually the entire senior management of (the company), including but not limited to its former chairman and chief executive officer, its former president, two former chief financial officers and various other senior accounting personnel. In total, there were over 20 individuals involved in the earnings overstatement schemes.”

  29. Meeting WS Projections Firm1st Qtr 2nd Qtr3rd Qtr Morgan Stanley $ 0.17 $0.23 Smith Barney 0.17 $0.21 0.23 Robertson Stephens 0.17 0.25 0.24 Cowen & Co. 0.18 0.21 Alex Brown 0.18 0.25 Paine Webber 0.21 0.28 Goldman Sachs 0.17 Furman Selz 0.17 0.21 0.23 Hambrecht & Quist 0.17 0.21 0.23 Actual Earnings $0.08 $0.13 $0.16 Fraud 0.09 0.09 0.07 Reported EPS 0.17 0.22 0.23 Fraud (Millions) $62 M $61M $71M Wall Street expectations were especially high for certain industries such as the telecom industry (e.g. Global Crossing, ATT, WorldCom, Quest)

  30. How People Got Involved • The CFO instructed the chief accountant to increase earnings by $105 million. The chief accountant was skeptical about the purpose of these instructions but he did not challenge them. The mechanics were left to the chief accountant to carry out. The chief accountant created a spreadsheet containing seven pages of improper journal entries, 105 in total, that he determined were necessary to carry out the CFO’s instructions. Over 20 people were involved in making or instructing to make similar entries.

  31. 5. High Amounts of Debt & Other Leverage • During 2000, Enron’s derivates-related liabilities increased from $1.8 B to $10.5 B • By 2001 Enron hid $25 B in off-balance sheet (SPE) debt while on-balance sheet debt was $13 B • WorldCom had nearly $100 B in debt • Not only did Bernie Ebbers borrow $100 billion for WorldCom but he also racked up over $1.3 billion in personal debt while CEO of WorldCom • Every company that committed financial statement fraud had huge amounts of debt In U.S. 186 public companies with $368 billion in debt filed for bankruptcy in 2002—includes WorldCom, Conseco, Global Crossing, United Airlines

  32. 6. Nature of Accounting Rules • In the U.S., accounting standards are “rules-based” instead of “principles based.” • Allows companies and auditors to be extremely creative when not specifically prohibited by standards. • Examples are SPEs and other types of off-balance sheet financing, revenue recognition approaches, merger reserves, pension accounting, and other accounting schemes. • When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…” • It is impossible to makes rules for every situation

  33. 7. Behavior of Auditing Firms • Failed to accept responsibility for fraud detection (SEC, Supreme Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is? • Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting rich (Andersen’s partners were jealous of Accenture partner’s income) • Audit became a loss leader • Easier to sell lucrative consulting services from the inside • Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture) • A few auditors got too close to their clients • Entire industry, especially Arthur Andersen, was punished for actions of a few

  34. 8. Greed by All Parties • Jeff Skilling, onetime CEO of Enron: “All that matters is money.” • One large investment bank issued $2 billion of Enron debt it internally considered “legal but sleazy.” It received huge fees for this issue. • Example: Jack Grubman, CitiBank, and the million dollar preschool

  35. 9. Educator Failures • Haven’t taught “ethics” enough in the classroom • Need to teach students about fraud—“Most students wouldn’t recognize a fraud if it hit them between the eyes!” • Need to teach students how to think—more analytical skills; less memorization • Need to teach ethicalcourage and ethicalleadership

  36. How did we teach? Professors Lecture Professionals find similar examples and copy (last year’s work papers Assign Problems at end of chapters Students can’t work problems What did we teach? We taught our students how to copy! Students graduate and get assignments (e.g. perform audit) Find similar examples in the chapters and copy Never really learn or think analytically

  37. Opportunity Pressure Fraud Triangle Rationalization The Fraud Triangle • Good economy masked problems • Lack of controls from board, auditors • Nature of accounting rules • Educator failures • Behavior of CPA firms • Executive incentives • Wall Street expectations—rewards for short-term behavior • Large amounts of debt and leverage • Greed by investment banks, commercial banks, investors and executives Moral Decay in Society

  38. Example of a Company Gone Wrong

  39. Enron: A Case of Complexity • WorldCom was a $9 billion fraud but a simple one • Capitalized expenses that should have been expensed • Enron involved many complex transactions and accounting issues • “What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexity—although they probably lied too.” Senator John Dingell

  40. Enron’s History • Born from merger of two pipeline companies in 1985. • 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—consultant Jeffrey Skilling. • Background in banking and asset and liability management. • Recommendation: create a “Gas Bank”—buy and sell natural gas • Feb. 2001-- Fortune magazine names Enron “The Most Innovative Company in America”--company worth $60B • Dec. 2001 – Enron files the biggest bankruptcy in U.S. history (now exceeded by WorldCom)

  41. Enron Kenneth Lay – Founding and last CEO Jeff Skilling – CEO from 2/2001 to 8/2001 Andrew Fastow – CFO Michael Kopper – Assistant to Fastow Andersen David Duncan – Audit Partner Michael Odom – Risk Mgt Partner Nancy Temple – Firm Attorney

  42. Producer Utility Industrial User 4”Extras” 2Wholesale 3Retail 1Transportation and Distribution Enron’s Changing Business

  43. Aggressive Nature of Enron • Enron believed it was leading a revolution • Pushed the rules • Employees attempted to crush not just outsiders but each other. “Enron was built to maximize value by maximizing the individual parts. • Enron traders were afraid to go to the bathroom because the guy sitting next to them might use information off their screen to trade against them.” Enron took more risk than others— ”it swung for the fences.”

  44. The Motivation • Enron delivered smoothly growing earnings (but not cash flows) • Wall Street took Enron on its word but didn’t understand its financial statements • It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. • Goldman Sachs, a trading company, had P/E of 20 • Enron’s P/E was 70 times earnings • In its last 5 years, Enron reported 20 straight quarters of increasing income

  45. Enron’s Arrogance “Those whom the Gods would destroy they first make proud.” Enron’s banner in lobby: Changed from “The World’s Leading Energy Company” to “THE WORLD’S LEADING COMPANY” “Older, stodgier companies will topple over from their own weight…” Skilling Conference of Utility Executives in 2000: “We’re going to eat your lunch”….Jeff Skilling

  46. Special Purpose Entities (SPEs)Enron’s principal method of financial statement fraud • Originally had a good business purpose • The SPE is really a joint venture between sponsoring company and a group of outside investors • To help finance large international projects (e.g. a gas pipeline in Central Asia) • Investors want risk and reward exposure limited to the pipeline, not the overall risks and rewards of the associated company • Pipeline is to be a self-supported, independent entity with no fear that the company will take over • Outsiders must own >3% to qualify for off balance sheet

  47. Hide Everything Bad Bring in Everything Good Manipulating numbers between entities Off-Balance Sheet SPE Enron Going back and forth: Debt, cash flows, earnings, Related party-transactions, investments, etc.

  48. Enron’s Use of Special Purpose Entities (SPEs) • To hide bad investments and poor-performing assets (Rhythms NetConnections). Declines in value of assets would not be recognized by Enron (Mark to Market.) • Earnings management—Blockbuster Video deal--$111 million gain (Bravehart, LJM1 and Chewco) • Quick execution of related-party transactions at desired prices. (LJM1 and LJM2) • To report over $1 billion of false income • To hide debt (Borrowed money and not put on financial statements of Enron) • To manipulate cash flows, especially in 4th quarters • Many SPE transactions were timed (or illegally back-dated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations

  49. LJM1 SPE One Enron Example (the “Rhythms” transaction): • Enron held Internet stock in company called Rhythms NetConnections • Stock was restricted (couldn’t be sold for a certain period of time) • Enron didn’t want exposure to risk of a price drop • The solution was simple! Find someone else who believes the Rhythms stock price would rise and was willing to sell a contract (a put option) to buy the stock in the future at a set price (a hedge!) • The problem was that Enron couldn’t find anyone willing to “do the deal” • Another simple solution! Start a company (a Special Purpose Entity or SPE) to take the other side of the transaction (Enron called it LJM1) • Where did the financing come from? • 97% from bank loan  Guaranteed with Enron stock • 3% from entity other than Enron Andrew Fastow and others! • Enron gave $168 million in Enron shares to LJM1 (LJM1’s primary asset) • LJM1 gave Enron a note for $64 million and a put option valued at $104 million • When everything “settled out,” Fastow received $15 million for his $1 million investment • Enron got to “hedge” (i.e., not report) a $103 million market loss on its stock investment

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