Business Fraud (The Enron Problem)

Business Fraud (The Enron Problem) W. Steve Albrecht Ph.D., CPA, CIA, CFE Brigham Young University

These Are Interesting Times • Number and size of financial statement frauds are increasing • Number and size of frauds against organizations are increasing • Some recent frauds include several people—as many as 20 or 30 (seems to indicate moral decay) • Many investors have lost confidence in credibility of financial statements and corporate reports • More interest in fraud than ever before—now a course on many college campuses

A recent fraud where I testified • 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

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……. $1 Million Revenue….$1 Billion Fraud Robs Income Why Fraud is a Costly Business Problem Revenues $100 100% Expenses 90 90% Net Income $ 10 10% Fraud 1 Remaining $ 9 To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.

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 Fraud Cost….Two Examples

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

1. Denmark 2. Finland 3. Sweden 4. New Zealand 5.Iceland 6. Canada 7. Singapore 8. Netherlands, Norway 16. Hong Kong 17. United States Austria 25. Japan 29. Taiwan 43. South Korea 52. China 81. Nigeria 84. Paraguay 85. Cameroon Fraud Internationally—Transparency Int’l

Fraudulent Financial Statements Employee Fraud Vendor Fraud Customer Fraud Investment Scams Bankruptcy Frauds Miscellaneous Frauds The common element is deceit or trickery! Types of Fraud

Recent Financial Statement Frauds • Enron • WorldCom • Adelphia • Global Crossing • Xerox • Qwest • Many others (Cendant, Lincoln Savings, ESM, Anicom, Waste Management, Sunbeam, etc.)

Current Executive Fraud-Related Problems • Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc. • Executive Loans and Corporate Looting: John Rigas (Adelphia), Denis Kozlowski (Tyco--$170 million) • Insider Trading: Martha Stewart, etc. • IPO Favoritism: John Ebbers ($11 million) • CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, Fleet Boston Financial, IBM (Consulting Contracts, Use of Corporate Planes, etc.)

Largest Bankruptcy Filings(1980 to Present)

Why so many financial statement frauds all of a sudden? • Good economy was masking many problems • Moral decay in society • Executive incentives • Wall Street expectations—rewards for short-term behavior • Nature of accounting rules • Behavior of CPA firms • Greed by investment banks, commercial banks, and investors • Educator failures "The Perfect Storm"

Good economy was masking problems… • With increasing stock prices, increasing profits and increasing wealth for everyone, no one worried about potential problems. • 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

Moral Decay • Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed: • 67% of CFOs said they had been asked by senior company executives to misrepresent corporate financial results • 12% of CFOs admitted they had actually misrepresented financial results…55% said they had fought off requests to “cook the books” • Honesty studies • 1961: 12% • 1986: 31% • 2002: ??? • Modeling & Labeling • More dishonest modeling (examples) • Less labeling (teaching & training)(10 hrs. per week less time)

Executive Incentives • Meeting Wall Street’s Expectations • Stock prices are tied to meeting Wall Street’s 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 options—far exceeds compensation (tied to stock price) • Performance is based on earnings & stock price

Firm A Firm B Which firm will have the higher stock price? Incentives for F.S. Fraud Incentives to commit financial statement fraud are very strong. Investors want decreased risk and high returns. Risk is reduced when variability of earnings is decreased. Rewards are increased when income continuously improves.

Complaint in Fraud Case—Expert Witness • Several hundred million in earnings overstatement • Complaint: “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 ___ to ___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.)”

Complaint in Fraud Case—Expert Witness • “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.”

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

Auditors—the CPAs • 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 • 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

Educators • Haven’t taught “ethics” enough (can’t make up own rules to meet own needs” • Need to teach students about fraud—need 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

Financial Statement Frauds • Revenue/Accounts Receivable Frauds (Global Crossing, Quest, ZZZZ Best) • Inventory/Cost of Goods Sold Frauds (PharMor) • Understating Liability/Expense Frauds (Enron) • Overstating Asset Frauds (WorldCom) • Overall Misrepresentation (Bre-X Minerals)

Revenue Related Financial Statement Frauds • By far, the most common accounts manipulated when perpetrating financial statement fraud are revenues and/or accounts receivable. • Accounts Receivable xxx Revenues xxx (Income Assets )

Revenue-Related Transactions and Frauds

Overstating Inventory • The second most common way to commit financial statement fraud is to overstate inventory. Beginning Inventory OK Purchases OK Goods Available for sale OK Ending Inventory High Cost of Goods Sold Low Income High

Inventory/Cost of Goods Sold Frauds

Understating Liability Frauds(3rd Most Common) • Not recording accounts payable • Not recording accrued liabilities • Recording unearned revenues as earned • Not recording warranty or service liabilities • Not recording loans or keep liabilities off the books • Not recording contingent liabilities

Asset Overstatement Frauds(4th Most Common) • Overstatement of Current Assets (e.g. Marketable Securities) • Overstating Pension Assets • Capitalizing as assets amounts that should be expensed • Failing to record depreciation/amortization expense • Overstating assets through mergers and acquisitions • Overstating inventory and receivables (covered earlier)

Disclosure Frauds Three Categories of Disclosure Frauds: • Overall misrepresentations about the nature of the company or its products, usually made through news reports, interviews, annual reports, and elsewhere • Misrepresentations in the management discussions and other non-financial statement sections of annual reports, 10-Ks, 10-Qs, and other reports • Misrepresentations in the footnotes to the financial statements

Detecting Financial Statement Fraud 1. Management & Board 2. Relationships With Others Detecting Financial Statement Fraud 3. Organization & Industry 4. Financial Results & Operating Characteristics

Enron Fraud • Compared to other financial statement frauds, Enron was a very complicated fraud. (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 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

Enron’s 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

Enron’s History • Created Energy derivative • Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it • Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits. • Skilling began hiring the “best and brightest” traders and rewarded them handsomely—they were allowed to “eat what they killed” • Fastow was a Kellogg MBA hired by Skilling in 1990—Became CFO in 1998 • Started Enron Online Trading in late 90s • Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

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 Sacks is a trading company. Its stock price was 20 times earnings while Enron’s 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.”

The Role of Stock Options Enron (and many other companies) avoided hundreds of millions of dollars in taxes by its use of stock options. Corporate executives received large quantities of stock options. When they exercised these options, the company claimed compensation expense on their tax returns. Accounting rules let them omit that same expense from the earnings statement. The options only needed to be disclosed in a footnote. Options allowed them to pay less taxes and report higher earnings while, at the same time, motivating them to manipulate earnings and stock price.

Enron’s Corporate Strategy • Was devoid of any boundary system • Enron’s core business was losing money—shifted its focus from bricks-and-mortar energy business to trading of derivatives (most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were) • During 2000, Enron’s derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billion • Enron’s top management gave its managers a blank order to “just do it” • Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.

Aggressive Nature of Enron • Because Enron believed it was leading a revolution, it 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.”

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

Notable Events • Jeff Skilling left in August—gave no reason for his departure. • By mid-August 2001, the stock price began falling • Former CEO, Kenneth Lay, came back in August • Oct. 16…announced $618 million loss but not that it had written down equity by $1.2 billion • October…Moody’s downgraded Enron’s debt • Nov. 8…Told investors they were restating earnings for the past 4 and ¾ years • Dec. 2…Filed bankruptcy

Executives Abandon Enron • Rebecca Mark-Jusbasche, formerly CEO of Azurix, Enron’s troubled water-services company left in August, 2000 • Joseph Sutton, Vice Chairman of Enron, left in November, 2000. • Jay Clifford Baxter, Vice Chairman of Enron committed suicide in May, 2001 • Thomas White, Jr., Vice Chairman, left in May, 2001. • Lou Pai, Chairman of Enron Accelerator, departed in May 2001. • Kenneth Rice, CEO of Enron’s Broadband services, departed in August 2001. • Jeffrey Skilling, Enron CEO, left on August 14, 2001

Enron’s revenues and income * Without LJM1, LJM2, Chewco and the “Four Raptors” partnerships. There were hundreds of partnerships—mainly used to hide debt.

“Value at Risk (VAR)” Methodology • Enron captured 95% confidence intervals for one-day holding periods—didn’t disclose worst case scenarios • Relied on “professional judgment of experienced business and risk managers” to assess worst case scenarios • Investors didn’t know how much risk Enron was taking • Enron had over 5,000 weather derivatives deals valued at over $4.5 billion—couldn’t be valued without professional judgment • In 2000 annual report “In 2000, the value at risk model utilized for equity trading market risk was refined to more closely correlate with the valuation methodologies used for merchant activities.” • Given the failure of the risk and valuation models at a sophisticated hedge funds such as Long-Term Capital Management—that employed “rocket Scientists” and Nobel laureates to design sophisticated computer models, Enron’s statement that it would “refine” its own models should have raised concerns

Special Purpose Entities (SPEs) (Enron’s principal method of financial statement fraud involved the use of SPEs (Special Purpose Entities)) • Originally had a good business purpose • Help finance large international projects (e.g. gas pipeline in Central Asia) • Investors wanted risk and reward exposure limited to the pipeline, not overall risks and rewards of the associated company • Pipeline to be self-supported, independent entity with no fear company would take over • SPE limited by its charter to those permitted activities only • Really a joint venture between sponsoring company and a group of outside investors • Cash flows from the SPE operations are used to pay investors

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

Accounting License to Cheat • Major issue is whether SPEs should be consolidated*—SPEs are only valuable if unconsolidated. • 1977--”Synthetic lease” rules (Off-balance sheet financing) (Allowed even though owned more than 50%) • 1984—”EITF 84-15” Grantor Trust Consolidations (Permitted non-consolidation if owned more than 50%) • 1990—”EITF 90-15” (The 3% rule) Allowed corporations such as Enron to “not consolidate” if outsiders contributed even 3% of the capital (the other 97% could come from the company.) 90-15 was a license to create imaginary profits and hide genuine losses. FAS 57 requires disclosure of these types of relationships. • 3% rule was formalized with FAS 125 and FAS 140, issued in September 2000. *Usually entities must be consolidated if company owns 50% or more

Mark-to-Market Accounting • Marketable securities, derivatives and financial contracts are required to be reported on the balance sheet at their current market values (rather than original cost) (Implemented with FAS 115 in 1993 (securities with readily determinable market values) and FAS 133 (for derivatives, even those with no traded market values) • 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 (even private) contracts were signed based on net present value of all future estimated revenues and costs. • Profits really tracked price of oil futures—almost perfectly correlated

The Chewco SPE • Accounted for 80% of SPE restatement or $400 million • In 1993, Enron and the California Public Employees Retirement System (Calpers) formed a 50/50 partnership—Joint Energy Development Investments Limited (JEDI) • In 1997, Enron bought out Calpers’ interest in JEDI • Half of the $11.4 million that bought the 3% involved cash collateral provided by Enron—meaning only 1 and ½ percent was owned by outsiders

LJM1 SPE • Responsible for 20% of SPE restatement or $100 million • Should have been consolidated—an error in judgment by Andersen (per Andersen) • After Andersen’s 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 public—involved complex issues concerning the valuation of various assets and liabilities.

Fastow’s Explanation of Partnerships (SPEs) • The partnerships were used for “unbundling and reassembling” the various components of a contract. “We strip out price risk, we strip out interest rate risk,” he said. “What’s left may not be something that we want.” • The obvious question is “Why would anyone want whatever was left?”

Business Fraud (The Enron Problem)