Business Financial Crime: Financial Statement Fraud

1. Business Financial Crime: Financial Statement Fraud

2. Learning Outcomes: Appreciate financial statement fraud stemming from irregularities – not misappropriation of assets Understand main rationale for such fraud activity in the recent past, as well as the conditions necessary for such fraud to flourish Describe some of the main methods employed to distort reported results Appreciate some fraud warning signs

4. Enron (2002) • Admits that for over 3 years its net income was inflated by almost $600,000,000. • May have overstated assets by $24,000,000,000 according to company executives • Engaged in energy swaps to overstate revenues

5. Reliant Resources Inc. 2002 • Conducted fake transactions with four power companies, inflated revenue by 10% over 3-year period. • Dynegy also indicated that it conducted similar transactions.

6. WorldCom Inc., 2002 • Reports corrected income to reflect “Unspecified Net Loss” • Original expenses of $41.8 billion were corrected to be above $43.3 billion. • By August of 2002, found $7.1 billion in expenses and irregularities.

7. Xerox Corporation, 2002 • $6.5 billion recorded as equipment sales revenue in 1997 through 2000 should have been $5.1 billion in service, rental, and financing from 1997-2001.

8. IBM 2002 • Used a $290 million gain from sale of business 3 days prior to end of 4th Qtr of 2001 to help beat Wall Street’s profit forecast (Business Week, May 6, 2002) • This one-time, undisclosed gain was used to lower operating costs.

9. Gillette (2003), James Kilts, CEO • “I asked … why we made these big deals at the end of the quarter.” • “It’s you guys in Boston. You guys made us do it.” • The circle of doom: • Over-optimistic forecasts … high goals • Build inventory, overhead, new capital • Miss targets, cut prices, cut advertising, give incentives to distributors/retailers

10. The Issue – Perpetrated by Management • Different companies, different industries, different issues, different casts of characters • The major cases all have two things in common: • ALL INVOLVE MANAGEMENT OVERRIDE OF AN OTHERWISE EFFECTIVE SYSTEM OF INTERNAL CONTROL • THE BOARD OF DIRECTORS AND AUDIT COMMITTEES DID NOT DETECT THE OVERRIDE

11. What is Earnings Management? • Healy and Whalen (1999): “ Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”

12. Incentives for Earnings Management • Increase the firm's share price, particularly when the stock is about to be issued or used in a transaction. • Decrease the firm's share price prior to a management buyout. • Meet analyst or management earnings forecast. • Increase managers' compensation that is tied to earnings performance. • Avoid violating debt covenants. • Reduce taxes by shifting income to lower tax rate years.

14. Matching Earnings Estimates • compute sales and subtract expenses to calculate the profit… OR • … start with the profit that investors are expecting and manipulate sales and expenses to make sure the numbers come out right.

16. Restatements in the USA in 2004Post Sarbanes Oxley • 253 of the restatements were associated with the audited financial statements • 23% increase over 2003 • Revenue recognition & reserves and contingencies were the leading cause of restatements

17. Errors Involve: Mistakes in gathering and processing data Incorrect use of estimates Certain mistakes in applying accounting principles Irregularities Involve: Manipulating, altering or falsifying records Intentional omission of events, transactions or significant events Misapplication of accounting principles with intent to deceive Errors v Irregularities

19. The Trajectory of Fraud • Fraud starts out small • Increases in complexity and aggressiveness • Grows in magnitude and number of participants • No way out

21. The Slippery Slope • Utilize aggressive reserves • Delay/alter expense recognition • Manipulate revenue recognition • Make unsupportable entries • Exploit acquisition reserves • Fabricate additional revenues

22. Utilise Aggressive Reserves • Bad debt reserves • Returns & allowances • Inventory obsolescence • Change pension assumptions • Depreciation reserves • Special charges

25. The Slippery Slope • Utilize aggressive reserves • Delay/alter expense recognition • Manipulate revenue recognition • Make unsupportable entries • Exploit acquisition reserves • Fabricate additional revenues

26. Delay or Alter Expense Recognition • Fail to write down impaired assets • Investment income offsets expenses • Shift expenses to earlier periods • Research and Development in related companies • Capitalize operating expenses

29. The Slippery Slope • Utilize aggressive reserves • Delay/alter expense recognition • Manipulate revenue recognition • Make unsupportable entries • Exploit acquisition reserves • Fabricate additional revenues

30. Manipulate Revenue Recognition • Channel stuffing • A deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public. • Side Agreements • Quid pro quo • Long term contracts accelerated

32. The Slippery Slope • Utilize aggressive reserves • Delay/alter expense recognition • Manipulate revenue recognition • Make unsupportable entries • Exploit acquisition reserves • Fabricate additional revenues

33. Creative Accounting • No relationship to underlying transaction • Book nonexistent inventory • Fail to eliminate inter-company sales • Abusing structured finance transactions

35. Abusing Structured Finance Transactions THE PROBLEM • The gap between reported operating income and operating cash flows is substantial. • The Company needs to raise substantial amounts of cash, but is reluctant to issue additional equity. • Issuing additional debt will likely negatively impact the opinions of rating agencies. • A substantial portion of The Company’s business is dependent upon the strength of its credit rating.

36. Solution? – A “prepaid” transaction $300M+ paid to SPE by Bank for forward contract $300M paid to Enron by SPE for forward contract SPE Forward contract to deliver 390,000 barrels of oil over 46 months – March 99 to Dec 02 Forward contract to deliver 390,000 barrels of oil over 46 months – March 99 to Dec 02 Bank Enron Bank pays Enron a floating price on the oil Enron makes 46 monthly payments of £7.5m to bank totalling £345m

37. Accounting and Reporting Issues • The substance of the transaction (a loan) was ignored – it was accounted for based upon its form. • Because of its characterization as “trading" activity: • The balance sheet reported this obligation as a type of liability as opposed to debt. • Additionally, reported as cash flow from operations as opposed to financing cash flows.

38. Specifics of Transaction As a result of the “Financial Engineering”… • Total debt is materially understated. • Several key measures are favorably impacted, including (1) funds flow interest coverage, (2) funds flow to total debt, and (3) debt to equity. • Cash flow from operations is materially overstated, lessening the overall gap with operating income. • Financing cash flows are materially understated. • Enron’s credit rating remains unchanged.

39. The Slippery Slope • Utilize aggressive reserves • Delay/alter expense recognition • Manipulate revenue recognition • Make unsupportable entries • Exploit acquisition reserves • Fabricate additional revenues

40. Exploit Acquisitions Reserves • Release questionable reserves into income • Establish sham reserves • Undervalue the Target’s acquired assets

41. Establish Sham Reserves • Purchaser acquires in-progress contracts with estimated profit margin of 18% • Further analysis reveals: • Future Contract Revenues £25,350,000 • Future Contract Expenses £23,875,000 • Contract Profit £1,475,000 • Estimated Return 5.82%

42. Establish Sham Reserves – The Big Bath Effect Establish £30,000,000 reserve associated with future terminations Establish £16,000,000 reserve associated with future plant closings ? Establish £4,000,000 reserve associated with environmental remediation

43. Establish Sham Reserves • As £4,000,000 in future contract expenses get paid… • Cost of Goods Sold £4,000,000 CR P&L • Acquisition Reserve £4,000,000 DR B/S Overstates Gross Profit, Operating Income and Cash Flow From Operations

44. Undervalue Acquired Assets • XYZ PLC purchases a target for £250,000,000 in consideration • Allocates the purchase as follows: £110,000,000 to hard assets £40,000,000 to inventory Undervalued by 20m £20,000,000 to IP £80,000,000 to goodwill Overvalued by £20m

45. Undervalue Acquired Assets Undervaluing inventory artificially lowers the “Materials” component of Cost of Sales Overstates Gross Profit, Operating Income and Cash Flow From Operations

46. The Slippery Slope • Utilize aggressive reserves • Delay/alter expense recognition • Manipulate revenue recognition • Make unsupportable entries • Exploit acquisition reserves • Fabricate additional revenues

47. Fabricate Additional Revenues • Create phony sales invoices • Merger hold backs • Treat borrowings as operating revenue • Operating income overstated • Falls through to profit • Liabilities understated • Favourable impact on operating cash flow and financing cash flows

48. Potential Warning Signs • Balance Sheet – Trade debtors/Accounts receivable grows substantially faster than sales Aggressive revenue recognition

49. Potential Warning Signs • Balance Sheet – Growth in Trade Creditors/Accounts Payable substantially exceeds revenue growth Failing to pay current expenses – will require larger cash outlays in future periods (Bonus may be tied to CFFO)

50. Potential Warning Signs • Income Statement –Majority of net income comes from onetime gains Core business may be deteriorating