Fraud & Bankruptcy

1. Fraud & Bankruptcy Dr. Clive Vlieland-Boddy

2. Defining Financial Statement Fraud • Falsification, alteration, or manipulation of financial records • Material intentional omissions or wrong statement of events, from which financial statements are prepared • Deliberate misapplication of accounting principles or policies • Intentional omissions or presentation of inadequate disclosures regarding accounting principles and policies and related financial amounts

3. Costs of Financial Statement Fraud • More than 50% of U.S. corporations are victims of fraud with losses of more than $500,000 • Enron lost about $70 billion in market capitalization to investors, employees, and pensioners • Enron, WorldCom, Quest, Global Crossing, and Tyco’s loss to shareholders was $460 billion

4. Costs of Financial Statement Fraud • Other fraud costs are • legal costs • increased insurance costs • loss of productivity • adverse impacts on employee morale • customers’ goodwill • suppliers’ trust • negative stock market reactions

5. Effects of Financial Statement Fraud • Undermines the reliability, quality, transparency, and integrity of the financial reporting process • Jeopardizes the integrity and objectivity of the auditing profession, especially auditors and auditing firms • Diminishes the confidence of the capital markets, as well as market participants, in the reliability of financial information • Makes the capital markets less efficient

6. Effects of Financial Statement Fraud • Adversely affects the nation’s economic growth and prosperity • Results in huge litigation costs • Destroys careers of individuals involved in financial statement fraud. • Causes bankruptcy or substantial economic losses by the company engaged in financial statement fraud

7. Effects of Financial Statement Fraud • Encourages regulatory intervention • Causes devastation in the normal operations and performance of alleged companies • Raises serious doubt about the efficacy of financial statement audits • Erodes public confidence and trust in the accounting and auditing profession

8. Who Commits Financial Statement Fraud • Senior management • Mid- and lower-level employees • Organized criminals

9. Why Do People Commit Financial Statement Fraud • To conceal true business performance • To preserve personal status/control • To maintain personal income/wealth

10. Why Senior Management Will Overstate Business Performance Corporate Pressure • To meet or exceed the earnings or revenue growth expectations of stock market analysts • To comply with loan covenants • To increase the amount of financing available from asset-based loans • To meet a lender’s criteria for granting/extending loan facilities • To meet corporate performance criteria set by the parent company

11. Why Senior Management Will Overstate Business Performance - Greed • To meet personal performance criteria • To trigger performance-related compensation or earn-out payments • To support the stock price in anticipation of a merger, acquisition, or sale of personal stockholding • To show a pattern of growth to support a planned securities offering or sale of the business

12. Why Senior Management Will Understate Business Performance • To move “surplus” profits to the next accounting period. • To take all possible write-offs in one “big bath” now so future earnings will be consistently higher. • To reduce expectations now so future growth will be better perceived and rewarded. • To preserve a trend of consistent growth, avoiding volatile results. • To reduce the value of an owner-managed business for purposes of a divorce ­settlement. • To reduce the value of a corporate unit whose management is planning a buyout

13. How Do People Commit Financial Statement Fraud • Playing the accounting system • Beating the accounting system • Going outside the accounting system

14. Methods of Financial Statement Fraud • Fictitious revenues • Timing differences • Improper asset valuations • Concealed liabilities and expenses • Improper disclosures

15. Financial Statement Schemes by Category

16. Fictitious Revenues • Recording of goods or services that did not occur • Fake or phantom customers • Legitimate customers • Sales with conditions • Pressures to boost revenues

17. Timing Differences • Recording revenue and/or expenses in improper periods • Shifts revenues or expenses between one period and the next, increasing or decreasing earnings as desired

18. Concealed Liabilities • Liability/expense omissions • Capitalized expenses • Failure to disclose warranty costs and liabilities

19. Improper Disclosures • Liability omissions • Subsequent events • Management fraud • Related-party transactions • Accounting changes

20. Improper Asset Valuation • Inventory valuation • Accounts receivable • Business combinations • Fixed assets

21. Detection of Fraudulent Financial Statement Schemes • SAS 99 – Consideration of Fraud in a Financial Statement Audit as well as ISA • “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

22. Auditing Standards • Obtaining information needed to identify risks of material misstatement due to fraud • Making inquiries of management about the risks of fraud and how they are addressed • Consider any unusual or unexpected relationships that have been identified in performing analytical procedures in planning the audit. • Consider whether one or more fraud risk factors exist. • Consider other information that may be helpful in the identification of risks of material misstatement due to fraud

23. Financial Statement Analysis • Vertical analysis • Analyzes the relationships between the items on an income statement, balance sheet, or statement of cash flows by expressing components as percentages • Horizontal analysis • Analyzes the percentage change in individual financial statement items • Ratio analysis • Measures the relationship between two different financial statement amounts

24. Deterrence of Financial Statement Fraud • Reduce pressures to commit financial statement fraud • Reduce the opportunity to commit financial statement fraud • Reduce rationalization of financial statement fraud

25. Reduce Pressures to Commit Financial Statement Fraud • Establish effective board oversight. • Avoid setting unachievable financial goals. • Avoid applying excessive pressure on employees to achieve goals. • Change goals if changed market conditions require it • Ensure compensation systems are fair and do not create too much incentive to commit fraud. • Discourage excessive external expectations of future corporate performance. • Remove operational obstacles blocking effective performance.

26. Reduce the Opportunity to Commit Financial Statement Fraud • Maintain accurate and complete internal accounting records. • Carefully monitor the business transactions. • Establish a physical security system to secure company assets. • Maintain accurate personnel records including background checks on new employees. • Encourage strong supervisory and leadership relationships within groups to ensure enforcement of accounting procedures. • Establish clear and uniform accounting procedures with no exception clauses. • Ensure good internal controls and ethical behaviour.

27. Reduce Rationalization of Financial Statement Fraud • Promote strong values, based on integrity, throughout the organization. • Have policies that clearly define prohibited behavior with respect to accounting and financial statement fraud. • Provide regular training to all employees communicating prohibited behavior.

28. Reduce Rationalization of Financial Statement Fraud • Have confidential advice and reporting mechanisms to communicate inappropriate behavior. • Have senior executives communicate to employees that integrity takes priority and that goals must never be achieved through fraud. • Ensure management practices what it preaches and sets an example by promoting honesty in the accounting area. • The consequences of violating the rules and the punishment of violators should be clearly communicated

29. Studies on Corporate Failures • Studies have shown that a majority of those corporate failures were traceable to the predominance of one individual or several working in concert in the board. • Invariably fraudulent practices were found. • Failure of checks and balances mechanism.

30. Each Party’s Responsibility • Directors - Issues of compliance & profitability • Directors - Issues of conformance & performance • Shareholders - Questions at AGM & EGM on company’s performance • Shareholders – Nomination of independent directors? • External auditors • Independence • Change of auditors • Who audits the auditors?

31. What Went Wrong? Spectacular corporate accounting scandals and failures include: • Parmalat - fraudulently offered US$100 million worth of unsecured notes to U.S. investors in 2003, at the same time inflated its assets by at least US$5 billion • HIH- deficiency of the group was estimated to be between A$3.6 billion and A$5.3 billion • OneTel – Murdoc’s Son’s failed business, resulted in a A$291 million loss in 2000)

32. What Went Wrong? • Enron - At the conclusion of the claims reconciliation process, the allowable claims against the company are expected to be approximately $63 billion, and the cash and equity assets available for ultimate distribution are expected to be around $12 billion • Tyco - The company had lost more than $9 billion in 2002, and was facing a staggering $11 billion of debt maturing in calendar year 2003

33. What Went Wrong? • WorldCom - WorldCom Inc. said it discovered another $3.3 billion in accounting irregularities on top of the $3.8 billion it announced in June 2002 • Perwaja Steel – Losses and debts totaling RM10 billion

34. Enron’s Values In their 1998 Annual Report, their values are spelt out as: • CommunicationWe have an obligation to communicate. Here, we take the time to talk with one another… and to listen. We believe that information is meant to move and that information moves people. • RespectWe treat others as we would like to be treated ourselves. We do not tolerate abusive or disrespectful treatment.

35. Enron’s Values • Integrity We work with customers and prospects openly, honestly and sincerely. When we say we will do something, we will do it; when we say we cannot do something, then we won’t do it. • Excellence We are satisfied with nothing less than the very best in everything we do. We will continue to raise the bar for everyone. The great fun here will be for all of us to discover just how good we can really be.

36. Corporate Governance Rating Corporate scandals have created a market for a new breed of independent third parties who provide/sell guidance on which companies deserve our trust, such as: • Standard & Poors • Institute for Corporate Law and Governance • Institutional Shareholder Services (ISS) ISS uses a Corporate Governance Quotient that measures global companies against 61 different governance criteria. ISS rated Parmalat bottom of the 69 Italian companies in its listings.

37. Enron, The Indictment: Richard Causey(Chief Accountant),Jeffrey Skilling(CEO),Kenneth Lay(Chairman) Amongst other things: • manipulating Enron's publicly reported financial results, making public statements and representations about Enron's financial performance and results that were false and misleading

38. Enron: Defendants' Profit as a Result of the Scheme • Enriched themselves through salary, bonuses, grants of stocks and stock options, other profits. • Skilling received approximately US$200 million from sale of Enron stock options, netting over US$89 million in profit and was paid more than US$14 million in salary and bonuses.

39. Enron: Defendants' Profit as a Result of the Scheme • Lay received US$300 million from sale of Enron stock options, netting over US$217 million profit and paid more than US$19 million in salary and bonuses • Causey received more than US$14 million from sale of Enron stock and options, netting over US$5 million profit and paid more than US$4 million in salary and bonuses.

40. WorldCom, The Indictment:Bernard Ebbers(CEO), Scott Sullivan(CFO) Amongst other things: • Fraudulent adjustment to WorldCom’s expenses and revenue. • False statements

41. WorldCom, The Indictment:Bernard Ebbers(CEO), Scott Sullivan(CFO) False Statements: “We are pleased with our industry-leading incremental revenue growth of US$1.1 billion this quarter. Commercial services revenues of US$6.4 billion are up 19% year over year.”

42. Tyco, The Indictment:Dennis Kozlowski(CEO),Mark Swartz(CFO) Amongst other things: • Compensation amounting to millions paid to executive officers, loans extended to executive officers which were later or given, related party transactions, certain executives utilizing Tyco's corporate resources to fund personal ventures and property acquisitions, to increase their own personal wealth.

43. Tyco, The Indictment:Dennis Kozlowski(CEO),Mark Swartz(CFO) • The first trial of Kozlowski and Swartz, who are accused of looting the company of $600 million, ended in a mis-trial in April 2004. • Prosecutors retrying the men say they'd like to begin proceedings in September 2004

44. Adelphia CommunicationsThe Indictment: John (CEO), Timothy (CFO), Michael Rigas (VP Operations), James Brown (VP Finance), Michael Mulcahey (Dir) Amongst other things: Routinely used Adelphia's corporate aircraft for their personal affairs, without reimbursement to Aldelphia, used approx US$252,157,176 in Adelphia funds to pay margin calls against loans to the Rigas family.

45. Adelphia Communications,The Indictment: John(CEO),Timothy(CFO),Michael Rigas(VP Operations),James Brown(VP Finance),Michael Mulcahey(Dir) These uses of Adelphia funds and assets for the benefit of the Rigas Family were not presented to or authorized by the Adelphia Board of Directors, were not disclosed to the Outside Directors, and were not disclosed to the public.

46. OneTel: The Collapse • Factors of collapse included poor management, trading while insolvent and other breaches of the Australian Corporations Act 2001. • Directors paid themselves large bonuses while the company was insolvent.

47. OneTel: Quotes from Brad Keeling(Director) “Sometimes you can be good at promoting something. It becomes very big and you still might be good at promoting but not good enough at managing ”

48. OneTel: Quotes from Brad Keeling (Director) “It probably happens a lot. Whether you're an engineer or a marketer, when things start to boom people feel they're invincible and that feeling of invincibility has to be countered. Everybody is fallible and you have to realise what your capabilities are.”

49. HIH - The Royal Commission Enquiry “ ‘Beware the ides of March.’ The soothsayer’s words have become synonymous with unheeded warnings since they were penned by Shakespeare some 400 years ago. Caesar’s response—`He is a dreamer; let us leave him: pass’—is less well known but equally apposite. These words sum up the life and times of HIH, and they resonated eerily throughout the inquiries I made.” The Hon Justice OwenCommissioner

50. HIH - The Royal Commission Enquiry • It is futile to attempt to offer a prescription for all companies • The governance of corporate entities comprehends the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled in corporations. • It includes the practices by which that exercise and control of authority is in fact effected.