© 2003 by the aicpa business fraud (the enron problem) w. steve albrecht ph.d., cpa, cia, cfe...

© 2003 by the AICPA© 2003 by the AICPA

Business Fraud Business Fraud (The Enron Problem)(The Enron Problem)

W. Steve AlbrechtW. Steve Albrecht

Ph.D., CPA, CIA, CFEPh.D., CPA, CIA, CFE

Brigham Young UniversityBrigham Young University

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 by the American Institute of Certified Public Accountants, Inc., New York, New York.


These Are Interesting TimesThese Are Interesting Times

Number and size of financial statement frauds Number and size of financial statement frauds are increasingare increasingNumber and size of frauds against organizations Number and size of frauds against organizations are increasingare increasingSome recent frauds include several people—as Some recent frauds include several people—as many as 20 or 30 (seems to indicate moral many as 20 or 30 (seems to indicate moral decay)decay)Many investors have lost confidence in credibility Many investors have lost confidence in credibility of financial statements and corporate reportsof financial statements and corporate reportsMore interest in fraud than ever before—now a More interest in fraud than ever before—now a course on many college campusescourse on many college campuses


A recent fraud where I testifiedA recent fraud where I testified

Large Fraud of $2.6 Large Fraud of $2.6 Billion over 9 yearsBillion over 9 years– Year 1Year 1 $600K$600K– Year 3Year 3 $4 million$4 million– Year 5Year 5 $80 million$80 million– Year 7Year 7 $600 million$600 million– Year 9Year 9 $2.6 billion$2.6 billion

In years 8 and 9, four of In years 8 and 9, four of the world’s largest banks the world’s largest banks were involved and lost were involved and lost over $500 millionover $500 million

0

500,000,000

1,000,000,000

1,500,000,000

2,000,000,000

2,500,000,000

3,000,000,000

Year 1 Year 3 Year 5 Year 7 Year 9


Why Fraud is a Costly Business Why Fraud is a Costly Business ProblemProblem

Fraud Losses Reduce Fraud Losses Reduce Net Income $ for $Net Income $ for $

If Profit Margin is 10%, If Profit Margin is 10%, Revenues Must Increase Revenues Must Increase by 10 times Losses to by 10 times Losses to Recover Affect on Net Recover Affect on Net IncomeIncome– Losses……. $1 MillionLosses……. $1 Million– Revenue….$1 Billion Revenue….$1 Billion

Fraud Robs IncomeFraud Robs Income

Revenues $100 100%Expenses 90 90%Net Income $ 10 10%Fraud 1Remaining $ 9

To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.


Fraud Cost….Two Examples Fraud Cost….Two Examples

General MotorsGeneral Motors– $436 Million Fraud$436 Million Fraud– Profit Margin = 10%Profit Margin = 10%– $4.36 Billion in $4.36 Billion in

Revenues NeededRevenues Needed– At $20,000 per Car, At $20,000 per Car,

218,000 Cars218,000 Cars

BankBank– $100 Million Fraud$100 Million Fraud– Profit Margin = 10 %Profit Margin = 10 %– $1 Billion in Revenues $1 Billion in Revenues

NeededNeeded– At $100 per year per At $100 per year per

Checking Account, Checking Account, 10 Million New 10 Million New Accounts Accounts


Financial Statement FraudFinancial Statement Fraud

Financial statement fraud causes a Financial statement fraud causes a decrease in market value of stock of decrease in market value of stock of approximately 500 to 1,000 times the approximately 500 to 1,000 times the amount of the fraud.amount of the fraud.

$7 million fraud $2 billion drop in stock value


Fraud Internationally—Fraud Internationally—Transparency Int’lTransparency Int’l

1. Denmark1. Denmark

2. Finland2. Finland

3. Sweden3. Sweden

4. New Zealand4. New Zealand

5.Iceland5.Iceland

6. Canada6. Canada

7. Singapore7. Singapore

8. Netherlands, Norway8. Netherlands, Norway

16.16. Hong Kong Hong Kong17. 17. United StatesUnited States

AustriaAustria25. Japan25. Japan29. Taiwan29. Taiwan43. South Korea43. South Korea52. China52. China81. Nigeria81. Nigeria84. Paraguay84. Paraguay85. Cameroon85. Cameroon


Types of FraudTypes of Fraud

Fraudulent Financial Fraudulent Financial StatementsStatements

Employee FraudEmployee Fraud

Vendor FraudVendor Fraud

Customer FraudCustomer Fraud

Investment ScamsInvestment Scams

Bankruptcy FraudsBankruptcy Frauds

Miscellaneous FraudsMiscellaneous Frauds

The common element The common element is deceit or trickery!is deceit or trickery!


Recent Financial Statement Recent Financial Statement FraudsFrauds

EnronEnron

WorldComWorldCom

AdelphiaAdelphia

Global CrossingGlobal Crossing

XeroxXerox

QwestQwest

Many others (Cendant, Lincoln Savings, ESM, Many others (Cendant, Lincoln Savings, ESM, Anicom, Waste Management, Sunbeam, etc.)Anicom, Waste Management, Sunbeam, etc.)


Current Executive Fraud-Related Current Executive Fraud-Related ProblemsProblems

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

(Consulting Contracts, Use of Corporate Planes, (Consulting Contracts, Use of Corporate Planes, etc.)etc.)


Largest Bankruptcy FilingsLargest Bankruptcy Filings

(1980 to Present)(1980 to Present)

CompanyCompany Assets (Billions)Assets (Billions) When FiledWhen Filed

1. WorldCom1. WorldCom $101.9$101.9 July, 2002July, 2002

2. Enron2. Enron $63.4$63.4 Dec., 2001Dec., 2001

3. Texaco3. Texaco $35.9$35.9 April, 1987April, 1987

4. Financial Corp of America4. Financial Corp of America $33.9$33.9 Sept., 1988Sept., 1988

5. Global Crossing5. Global Crossing $25.5$25.5 Jan., 2002Jan., 2002

6. Adelphia6. Adelphia $24.4$24.4 June, 2002June, 2002

7. PG&E7. PG&E $21.5$21.5 April, 2001April, 2001

8. MCorp8. MCorp $20.2$20.2 March, 1989March, 1989

9. Kmart9. Kmart $17.0$17.0 Jan., 2002Jan., 2002

10. NTL10. NTL $16.8$16.8 May, 2002May, 2002


Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Good economy was masking many problemsGood economy was masking many problemsMoral decay in societyMoral decay in societyExecutive incentivesExecutive incentivesWall Street expectations—rewards for short-term Wall Street expectations—rewards for short-term behaviorbehaviorNature of accounting rulesNature of accounting rulesBehavior of CPA firmsBehavior of CPA firmsGreed by investment banks, commercial banks, Greed by investment banks, commercial banks, and investorsand investorsEducator failuresEducator failures


Good economy was masking Good economy was masking problems…problems…

With increasing stock prices, increasing profits With increasing stock prices, increasing profits and increasing wealth for everyone, no one and increasing wealth for everyone, no one worried about potential problems.worried about potential problems.

How to value a dot.com company:How to value a dot.com company:– Take their loss for the yearTake their loss for the year– Multiply the result by negative 1 to make it positiveMultiply the result by negative 1 to make it positive– Multiply that number by at least 100Multiply that number by at least 100– If stock price is less than the result…buy; if not, buy If stock price is less than the result…buy; if not, buy

anywayanyway


Moral DecayMoral DecayAttendees at the April, 1998 Business Week Forum of Chief Financial Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed:Officers revealed:– 67% of CFOs said they had been asked by senior company 67% of CFOs said they had been asked by senior company

executives to misrepresent corporate financial resultsexecutives to misrepresent corporate financial results– 12% of CFOs admitted they had actually misrepresented financial 12% of CFOs admitted they had actually misrepresented financial

results…55% said they had fought off requests to “cook the books”results…55% said they had fought off requests to “cook the books”

Honesty studiesHonesty studies– 1961: 12%1961: 12%– 1986: 31%1986: 31%– 2002: ???2002: ???

Modeling & LabelingModeling & Labeling– More dishonest modeling (examples)More dishonest modeling (examples)– Less labeling (teaching & training)(10 hrs. per week less time)Less labeling (teaching & training)(10 hrs. per week less time)


Executive IncentivesExecutive Incentives

Meeting Wall Street’s ExpectationsMeeting Wall Street’s Expectations– Stock prices are tied to meeting Wall Street’s Stock prices are tied to meeting Wall Street’s

earnings forecastsearnings forecasts– Focus is on short-term performance onlyFocus is on short-term performance only– Companies are heavily punished for not meeting Companies are heavily punished for not meeting

forecastsforecasts– Executives have been endowed with hundreds of Executives have been endowed with hundreds of

millions of dollars worth of stock options—far exceeds millions of dollars worth of stock options—far exceeds compensation (tied to stock price)compensation (tied to stock price)

– Performance is based on earnings & stock pricePerformance is based on earnings & stock price


Incentives for F.S. FraudIncentives 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.

Which firm will have the higher stock price?

Firm A Firm B


Complaint in Fraud Case—Expert Complaint in Fraud Case—Expert WitnessWitness

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


Complaint in Fraud Case—Complaint in Fraud Case—Expert WitnessExpert Witness

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


Nature of Accounting RulesNature of Accounting Rules

In the U.S., accounting standards are “rules-In the U.S., accounting standards are “rules-based” instead of “principles based.”based” instead of “principles based.”– Allows companies and auditors to be extremely Allows companies and auditors to be extremely

creative when not specifically prohibited by standards.creative when not specifically prohibited by standards.– Examples are SPEs and other types of off-balance Examples are SPEs and other types of off-balance

sheet financing, revenue recognition approaches, sheet financing, revenue recognition approaches, merger reserves, pension accounting, and other merger reserves, pension accounting, and other accounting schemes.accounting schemes.

– When the client pushes, without specific rules in every When the client pushes, without specific rules in every situation, there is no room for the auditors to say, situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…”“You can’t do this…because it isn’t GAAP…”

– It is impossible to makes rules for every situationIt is impossible to makes rules for every situation


Auditors—the CPAsAuditors—the CPAs

Failed to accept responsibility for fraud detection (SEC, Failed to accept responsibility for fraud detection (SEC, Supreme Court, public expects them to detect fraud) If Supreme Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is?auditors aren’t the watchdogs, then who is?Became greedy--$500,000 per year per partner Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting compensation wasn’t enough; saw everyone else getting richrichAudit became a loss leaderAudit became a loss leader– Easier to sell lucrative consulting services from the insideEasier to sell lucrative consulting services from the inside– Became largest consulting firms in the U.S. very quickly Became largest consulting firms in the U.S. very quickly

(Andersen Consulting grew to compete with Accenture)(Andersen Consulting grew to compete with Accenture)

A few auditors got too close to their clientsA few auditors got too close to their clientsEntire industry, especially Arthur Andersen, was Entire industry, especially Arthur Andersen, was punished for actions of a fewpunished for actions of a few


EducatorsEducators

Haven’t taught “ethics” enough (can’t Haven’t taught “ethics” enough (can’t make up own rules to meet own needs”make up own rules to meet own needs”Need to teach students about fraud—need Need to teach students about fraud—need a “fraud” coursea “fraud” courseNeed to teach students how to thinkNeed to teach students how to think– We have taught them how to copy, not thinkWe have taught them how to copy, not think– We have asked them to memorize, not thinkWe have asked them to memorize, not think– We have done what is easiest for us and We have done what is easiest for us and

easiest for our studentseasiest for our students


Financial Statement FraudsFinancial Statement Frauds

Revenue/Accounts Receivable Frauds Revenue/Accounts Receivable Frauds (Global Crossing, Quest, ZZZZ Best)(Global Crossing, Quest, ZZZZ Best)

Inventory/Cost of Goods Sold Frauds Inventory/Cost of Goods Sold Frauds (PharMor)(PharMor)

Understating Liability/Expense Frauds Understating Liability/Expense Frauds (Enron)(Enron)

Overstating Asset Frauds (WorldCom)Overstating Asset Frauds (WorldCom)

Overall Misrepresentation (Bre-X Minerals)Overall Misrepresentation (Bre-X Minerals)


Revenue Related Financial Revenue Related Financial Statement FraudsStatement Frauds

By far, the most common accounts By far, the most common accounts manipulated when perpetrating financial manipulated when perpetrating financial statement fraud are revenues and/or statement fraud are revenues and/or accounts receivable.accounts receivable.

Accounts ReceivableAccounts Receivable xxxxxx

RevenuesRevenues xxxxxx

(Income Assets )(Income Assets )


Transaction Accounts Involved Fraud Schemes

1. Estimate all uncollectible accounts receivable

Bad debt expense, allowance for doubtful accounts

1. Understate allowance for doubtful accounts, thus overstating receivables

2. Sell goods and/or services to customers

Accounts receivable, revenues (e.g. sales revenue) (Note: cost of goods sold part of entryh is included in Chapter 5)

2. Record fictitious sales (related parties, sham sales, sales with conditions, consignment sales, etc.)3. Recognize revenues too early (improper cutoff, percentage of completion, etc.)4. Overstate real sales (alter contracts, inflate amounts, etc.)

3. Accept returned goods from customers

Sales returns, accounts receivable

5. Not record returned goods from customers6. Record returned goods after the end of the period

4. Write off receivables as uncollectible

Allowance for doubtful accounts, accounts receivable

7. Not write off uncollectible receivables8. Write off uncollectible receivables in a later period

5. Collect cash after discount period

Cash, accounts receivable

9. Record bank transfers as cash received from customers10. Manipulate cash received from related parties

6. Collect cash within discount period

Cash, sales discounts, accounts receivable

11. Not recognize discounts given to customers

Revenue-Related Transactions and Frauds


Overstating InventoryOverstating Inventory

The second most common way to commit The second most common way to commit financial statement fraud is to overstate financial statement fraud is to overstate inventory.inventory.Beginning InventoryBeginning Inventory OKOKPurchasesPurchases OKOKGoods Available for saleGoods Available for sale OKOKEnding InventoryEnding Inventory HighHighCost of Goods SoldCost of Goods Sold LowLowIncomeIncome HighHigh


Transaction Accounts Involved Fraud Schemes

1. Purchase inventory Inventory, accounts payable

1. Under-record purchase2. Record purchases too late3. Not record purchases

2. Return merchandise to supplier

Accounts payable, inventory

4. Overstate returns5. Record returns in an earlier period (cutoff problem)

3. Pay vendor w ithin discount period

Accounts payable, inventory, cash

6. Overstate discounts7. Not reduce inventory cost

4. Pay vendor w ithout discount

Accounts payable, cash Considered in another chapter

5. Inventory is sold; cost of goods sold is recognized

Cost of goods sold, inventory

8. Record at too low an amount9. Not record cost of goods sold nor reduce inventory

6. Inventory becomes obsolete

Loss on w rite-dow n of inventory, inventory

10. Not w rite off or w rite dow n obsolete inventory

7. Inventory quantities are estimated

Inventory shrinkage, inventory

11. Over-estimate inventory (use incorrect ratios, etc.)

8. Inventory quantities are counted

Inventory shrinkage, inventory

12. Over-count inventory (double counting, etc.)

9. Inventory cost is determined

Inventory, cost of goods sold

13. Incorrect costs are used14. Incorrect extensions are made15. Record f ictitious inventory

Inventory/Cost of Goods Sold Frauds


Understating Liability FraudsUnderstating Liability Frauds(3(3rdrd Most Common) Most Common)

Not recording accounts payableNot recording accounts payable

Not recording accrued liabilitiesNot recording accrued liabilities

Recording unearned revenues as earnedRecording unearned revenues as earned

Not recording warranty or service liabilitiesNot recording warranty or service liabilities

Not recording loans or keep liabilities off Not recording loans or keep liabilities off the booksthe books

Not recording contingent liabilitiesNot recording contingent liabilities


Asset Overstatement FraudsAsset Overstatement Frauds(4(4thth Most Common) Most Common)

Overstatement of Current Assets (e.g. Overstatement of Current Assets (e.g. Marketable Securities)Marketable Securities)Overstating Pension AssetsOverstating Pension AssetsCapitalizing as assets amounts that should be Capitalizing as assets amounts that should be expensedexpensedFailing to record depreciation/amortization Failing to record depreciation/amortization expenseexpenseOverstating assets through mergers and Overstating assets through mergers and acquisitionsacquisitionsOverstating inventory and receivables (covered Overstating inventory and receivables (covered earlier)earlier)


Disclosure FraudsDisclosure FraudsThree 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


Detecting Financial Statement Detecting Financial Statement FraudFraud

Detecting Financial Statement Fraud

1. Management & Board 2. Relationships With Others

3. Organization & Industry 4. Financial Results & Operating Characteristics


Enron FraudEnron Fraud

Compared to other financial statement frauds, Enron Compared to other financial statement frauds, Enron was a very complicated fraud. (WorldCom, for example, was a very complicated fraud. (WorldCom, for example, was a $7 billion fraud that involved simply capitalizing was a $7 billion fraud that involved simply capitalizing expenses (line costs) that should have been expensed expenses (line costs) that should have been expensed (Accounting 200 topic.) Enron involved many complex (Accounting 200 topic.) Enron involved many complex transactions and accounting issues. transactions and accounting issues.

““What we are looking at here is an example of superbly What we are looking at here is an example of superbly complex financial reports. They didn’t have to lie. All complex financial reports. They didn’t have to lie. All they had to do was to obfuscate it with sheer complexitythey had to do was to obfuscate it with sheer complexity—although they probably lied too.”—although they probably lied too.”

Senator John Dingell Senator John Dingell


Enron’s HistoryEnron’s History

In 1985 after federal deregulation of natural gas In 1985 after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline Natural Gas and InterNorth, a Nebraska pipeline company.company.Enron incurred massive debt and no longer had Enron incurred massive debt and no longer had exclusive rights to its pipelines.exclusive rights to its pipelines.Needed new and innovative business strategyNeeded new and innovative business strategyKenneth Lay, CEO, hired McKinsey & Company to assist Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a young in developing business strategy. They assigned a young consultant named Jeffrey Skilling.consultant named Jeffrey Skilling.His background was in banking and asset and liability His background was in banking and asset and liability management.management.His recommendation: that Enron create a “Gas Bank”—His recommendation: that Enron create a “Gas Bank”—to buy and sell gasto buy and sell gas


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


The MotivationThe MotivationEnron delivered smoothly growing earnings (but not cash flows.) Enron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didn’t understand its financial Wall Street took Enron on its word but didn’t understand its financial statements.statements.

It was all about the price of the stock. Enron was a trading company 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 and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.)was 20 times earnings while Enron’s was 70 times earnings.)

In its last 5 years, Enron reported 20 straight quarters of increasing In its last 5 years, Enron reported 20 straight quarters of increasing income.income.

Enron, that had once made its money from hard assets like pipelines, Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings from a vaguer business generated more than 80% of its earnings from a vaguer business known as “wholesale energy operations and services.” known as “wholesale energy operations and services.”


The Role of Stock OptionsThe Role of Stock Options

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


Enron’s Corporate StrategyEnron’s Corporate Strategy

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


Aggressive Nature of EnronAggressive Nature of Enron

Because Enron believed it was leading a Because Enron believed it was leading a revolution, it pushed the rules. Employees revolution, it pushed the rules. Employees attempted to crush not just outsiders but attempted to crush not just outsiders but each other. “Enron was built to maximize each other. “Enron was built to maximize value by maximizing the individual parts. value by maximizing the individual parts. “Enron traders were afraid to go to the “Enron traders were afraid to go to the bathroom because the guy sitting next to bathroom because the guy sitting next to them might use information off their screen them might use information off their screen to trade against them.”to trade against them.”

Enron took more risk than others—”it swung for the fences.”


Enron’s ArroganceEnron’s Arrogance

““Those whom the Gods would destroy they first make Those whom the Gods would destroy they first make proud.”proud.”

Enron’s banner in lobby: Changed from “The World’s Enron’s banner in lobby: Changed from “The World’s Leading Energy Company” to “THE WORLD’S LEADING Leading Energy Company” to “THE WORLD’S LEADING COMPANY”COMPANY”

““Older, stodgier companies will topple over from their own Older, stodgier companies will topple over from their own weight…” Skillingweight…” Skilling

Conference of Utility Executives in 2000: “We’re going to Conference of Utility Executives in 2000: “We’re going to eat your lunch”….Jeff Skillingeat your lunch”….Jeff Skilling


Notable EventsNotable Events

Jeff Skilling left in August—gave no reason for his Jeff Skilling left in August—gave no reason for his departure.departure.By mid-August 2001, the stock price began fallingBy mid-August 2001, the stock price began fallingFormer CEO, Kenneth Lay, came back in AugustFormer CEO, Kenneth Lay, came back in AugustOct. 16…announced $618 million loss but not that it had Oct. 16…announced $618 million loss but not that it had written down equity by $1.2 billionwritten down equity by $1.2 billionOctober…Moody’s downgraded Enron’s debtOctober…Moody’s downgraded Enron’s debtNov. 8…Told investors they were restating earnings for Nov. 8…Told investors they were restating earnings for the past 4 and ¾ yearsthe past 4 and ¾ yearsDec. 2…Filed bankruptcyDec. 2…Filed bankruptcy


Executives Abandon EnronExecutives Abandon Enron

Rebecca Mark-Jusbasche, formerly CEO of Azurix, Rebecca Mark-Jusbasche, formerly CEO of Azurix, Enron’s troubled water-services company left in August, Enron’s troubled water-services company left in August, 20002000Joseph Sutton, Vice Chairman of Enron, left in Joseph Sutton, Vice Chairman of Enron, left in November, 2000.November, 2000.Jay Clifford Baxter, Vice Chairman of Enron committed Jay Clifford Baxter, Vice Chairman of Enron committed suicide in May, 2001suicide in May, 2001Thomas White, Jr., Vice Chairman, left in May, 2001.Thomas White, Jr., Vice Chairman, left in May, 2001.Lou Pai, Chairman of Enron Accelerator, departed in Lou Pai, Chairman of Enron Accelerator, departed in May 2001.May 2001.Kenneth Rice, CEO of Enron’s Broadband services, Kenneth Rice, CEO of Enron’s Broadband services, departed in August 2001.departed in August 2001.Jeffrey Skilling, Enron CEO, left on August 14, 2001Jeffrey Skilling, Enron CEO, left on August 14, 2001


Enron’s revenues and incomeEnron’s revenues and income

YearYear RevenuesRevenues IncomeIncome Income Income (Restated)*(Restated)*

19971997 $20.2 B$20.2 B $105 M$105 M $9 M$9 M

19981998 $31.2 B$31.2 B $703 M$703 M $590 M$590 M

19991999 $40.1 B$40.1 B $893 M$893 M $643 M$643 M

20002000 $100.1 B$100.1 B $979 M$979 M $827 M$827 M

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


““Value at Risk (VAR)” MethodologyValue at Risk (VAR)” Methodology

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


Special Purpose Entities (SPEs) Special Purpose Entities (SPEs) (Enron’s principal method of financial statement fraud involved the use of SPEs (Enron’s principal method of financial statement fraud involved the use of SPEs

(Special Purpose Entities))(Special Purpose Entities))

Originally had a good business purposeOriginally had a good business purposeHelp finance large international projects (e.g. gas Help finance large international projects (e.g. gas pipeline in Central Asia)pipeline in Central Asia)Investors wanted risk and reward exposure limited to the Investors wanted risk and reward exposure limited to the pipeline, not overall risks and rewards of the associated pipeline, not overall risks and rewards of the associated companycompanyPipeline to be self-supported, independent entity with no Pipeline to be self-supported, independent entity with no fear company would take overfear company would take overSPE limited by its charter to those permitted activities SPE limited by its charter to those permitted activities onlyonlyReally a joint venture between sponsoring company and Really a joint venture between sponsoring company and a group of outside investorsa group of outside investorsCash flows from the SPE operations are used to pay Cash flows from the SPE operations are used to pay investorsinvestors


Enron’s Use of Special Purpose Enron’s Use of Special Purpose Entities (SPEs)Entities (SPEs)

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


Accounting License to CheatAccounting License to Cheat

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

*Usually entities must be consolidated if company owns 50% or more


Mark-to-Market AccountingMark-to-Market Accounting

Marketable securities, derivatives and financial contracts are Marketable securities, derivatives and financial contracts are required to be reported on the balance sheet at their current market required to be reported on the balance sheet at their current market values (rather than original cost) (Implemented with FAS 115 in values (rather than original cost) (Implemented with FAS 115 in 1993 (securities with readily determinable market values) and FAS 1993 (securities with readily determinable market values) and FAS 133 (for derivatives, even those with no traded market values) 133 (for derivatives, even those with no traded market values) Changes in market values are reported in the income statement for Changes in market values are reported in the income statement for certain financial assets and in shareholders’ equity (component of certain financial assets and in shareholders’ equity (component of Accumulated Other Comprehensive Income) for othersAccumulated Other Comprehensive Income) for othersGains often determined by proprietary formulas depending on many Gains often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and prices—assumptions about interest rate, customers, costs and prices—provides opportunities for management to create and manage provides opportunities for management to create and manage earningsearningsEnron often recognized revenue at the time (even private) contracts Enron often recognized revenue at the time (even private) contracts were signed based on net present value of all future estimated were signed based on net present value of all future estimated revenues and costs. revenues and costs. Profits really tracked price of oil futures—almost perfectly correlatedProfits really tracked price of oil futures—almost perfectly correlated


The Chewco SPEThe Chewco SPE

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


LJM1 SPELJM1 SPE

Responsible for 20% of SPE restatement or Responsible for 20% of SPE restatement or $100 million$100 millionShould have been consolidated—an error in Should have been consolidated—an error in judgment by Andersen (per Andersen)judgment by Andersen (per Andersen)After Andersen’s initial review in 1999, Enron After Andersen’s initial review in 1999, Enron created a subsidiary within LJM1, referred to as created a subsidiary within LJM1, referred to as Swap Sub. As a result, the 3% rule for residual Swap Sub. As a result, the 3% rule for residual equity was no longer met. equity was no longer met. Andersen was reviewing this transaction again Andersen was reviewing this transaction again at the time problems were made public—at the time problems were made public—involved complex issues concerning the involved complex issues concerning the valuation of various assets and liabilities.valuation of various assets and liabilities.


Fastow’s Explanation of Fastow’s Explanation of Partnerships (SPEs)Partnerships (SPEs)

The partnerships were used for The partnerships were used for “unbundling and reassembling” the various “unbundling and reassembling” the various components of a contract. “We strip out components of a contract. “We strip out price risk, we strip out interest rate risk,” price risk, we strip out interest rate risk,” he said. “What’s left may not be he said. “What’s left may not be something that we want.”something that we want.”

The obvious question is “Why would The obvious question is “Why would anyone want whatever was left?”anyone want whatever was left?”


Enron’s DisclosuresEnron’s Disclosures

SEC Regulation S-K requires description of SEC Regulation S-K requires description of related-party transactions that exceed $60K and related-party transactions that exceed $60K and an executive has a material interestan executive has a material interest

Included a footnote “Related Party Transactions” Included a footnote “Related Party Transactions” to financial statements in Forms 10-Q and 10-K to financial statements in Forms 10-Q and 10-K beginning with second quarter of 1999 through beginning with second quarter of 1999 through 22ndnd quarter of 2001 quarter of 2001

““A senior officer of Enron is managing member A senior officer of Enron is managing member of LJM’s general partner.” (Fastow)of LJM’s general partner.” (Fastow)


Enron’s Footnotes—Disclosures of Enron’s Footnotes—Disclosures of Enron PartnershipEnron Partnership

ReportReport FootnoteFootnote Filed with the Filed with the SECSEC

10Q—Q1 200010Q—Q1 2000 Footnote 7Footnote 7 5/15/20005/15/2000







The Famous “Misleading Earnings The Famous “Misleading Earnings Release” on October 16, 2001Release” on October 16, 2001

Heading: Enron Reports Recurring Third Quarter Heading: Enron Reports Recurring Third Quarter Earnings of $0.43 per diluted shares.Earnings of $0.43 per diluted shares.Projected recurring earnings for Projected recurring earnings for 20022002 of $2.15 of $2.15 If you dug deep, you learned that Enron actually lost If you dug deep, you learned that Enron actually lost $618 million or $0.84 per share—they had mislabeled $618 million or $0.84 per share—they had mislabeled $1.01 billion of expenses and losses as non-recurring.$1.01 billion of expenses and losses as non-recurring.Shockingly, there was no balance sheet or cash flow Shockingly, there was no balance sheet or cash flow information with the releaseinformation with the releaseThere was no mention of a $1.2 billion charge against There was no mention of a $1.2 billion charge against shareholder’s equity, including what was described as a shareholder’s equity, including what was described as a $1 billion correction to an accounting error. (This was $1 billion correction to an accounting error. (This was learned a couple of days later.)learned a couple of days later.)


Who Discovered Enron’s Who Discovered Enron’s Problems?Problems?

In early 2001, Jim Chanos, who runs Kynikos In early 2001, Jim Chanos, who runs Kynikos Associates, a highly regarded firm specializing in Associates, a highly regarded firm specializing in short selling said publicly that “no one could short selling said publicly that “no one could explain how Enron actually made money.” He explain how Enron actually made money.” He noted that Enron had completed transactions noted that Enron had completed transactions with related parties that “were run by a senior with related parties that “were run by a senior officer of Enron” and assumed it was a conflict of officer of Enron” and assumed it was a conflict of interest. (Enron wouldn’t answer questions interest. (Enron wouldn’t answer questions about LJM and other partnerships.)about LJM and other partnerships.)


Fortune Article…March 5, 2001Fortune Article…March 5, 2001

““To skeptics, the lack of clarity raises a red flag about To skeptics, the lack of clarity raises a red flag about Enron’s pricey stock…the inability to get behind the Enron’s pricey stock…the inability to get behind the numbers combined with ever higher expectations for the numbers combined with ever higher expectations for the company may increase the chance of a nasty surprise. company may increase the chance of a nasty surprise. Enron is an earnings-at-risk story…”Enron is an earnings-at-risk story…”““At the least, these sorts of hard-to-predict earnings are At the least, these sorts of hard-to-predict earnings are usually assigned a lower multiple...In 1999 its cash flow usually assigned a lower multiple...In 1999 its cash flow from operations fell from $1.6 billion the previous year to from operations fell from $1.6 billion the previous year to $1.2 billion. In the first nine months of 2000, the $1.2 billion. In the first nine months of 2000, the company generated just $100 million in cash. (In fact, company generated just $100 million in cash. (In fact, cash flow would have been negative if not for the $410 cash flow would have been negative if not for the $410 million in tax breaks it received from employees’ million in tax breaks it received from employees’ exercising their options.”exercising their options.”


Enron’s Cash Flows Enron’s Cash Flows

Enron’s cash flows bore little relationship to Enron’s cash flows bore little relationship to earnings (a lot due to mark to market.) On earnings (a lot due to mark to market.) On balance sheet debt climbed from $3.5 billion in balance sheet debt climbed from $3.5 billion in 1996 to $13 billion in 2001.1996 to $13 billion in 2001.

Key RatioKey Ratio

Net Income (from Operations*) – Cash Flow (from Operations**)Net Income (from Operations*) – Cash Flow (from Operations**) Net Income (from Operations)Net Income (from Operations)

Would expect to be about zero over timeWould expect to be about zero over time

*From the Income Statement**From the Statement of Cash Flows


Enron’s Cash Flow RatioEnron’s Cash Flow Ratio

-2

-1

0

1

2

3

4

3months

6months

9months

Year

1998

1999

2000

2001

Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000, 1st two quarters in 2001.


Role of AndersenRole of Andersen

Was paid $52 million in 2000, the majority of which was for non-audit Was paid $52 million in 2000, the majority of which was for non-audit related consulting services.related consulting services.Failed to spot many of Enron’s lossesFailed to spot many of Enron’s lossesShould have assessed Enron management’s internal controls on Should have assessed Enron management’s internal controls on derivates trading—expressed approval of internal controls during 1998 derivates trading—expressed approval of internal controls during 1998 through 2000through 2000Kept a whole floor of auditors assigned at Enron year aroundKept a whole floor of auditors assigned at Enron year aroundEnron was Andersen’s second largest clientEnron was Andersen’s second largest clientDid both external and internal auditsDid both external and internal auditsCFOs and controllers were former Andersen executivesCFOs and controllers were former Andersen executivesAccused of document destruction—was criminally indictedAccused of document destruction—was criminally indictedWent out of businessWent out of businessMy partner friend “I had $4 million in my retirement account and I lost 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 it all.” Some partners who transferred to other firms now have two equity loans and no retirement savings.equity loans and no retirement savings.


Role of Investment & Commercial Role of Investment & Commercial BanksBanks

Enron paid several hundred million in fees, Enron paid several hundred million in fees, including fees for derivatives transactions.including fees for derivatives transactions.None of these firms alerted investors about None of these firms alerted investors about derivatives problems at Enron.derivatives problems at Enron.In October, 2001, 16 of 17 security analysts In October, 2001, 16 of 17 security analysts covering Enron still rated it a “strong buy” or covering Enron still rated it a “strong buy” or “buy.”“buy.”Example: One investment advisor purchased Example: One investment advisor purchased 7,583,900 shares of Enron for a state retirement 7,583,900 shares of Enron for a state retirement fund, much of it in September and October, 2001fund, much of it in September and October, 2001


Role of Law FirmsRole of Law Firms

Enron’s outside law firm was paid Enron’s outside law firm was paid substantial fees and had previously substantial fees and had previously employed Enron’s general counselemployed Enron’s general counsel

Failed to correct or disclose problems Failed to correct or disclose problems related to derivatives and special purpose related to derivatives and special purpose entitiesentities

Helped draft the legal documentation for Helped draft the legal documentation for the SPEsthe SPEs


Role of Credit Rating AgenciesRole of Credit Rating Agencies

The three major credit rating agencies—Moody’s, The three major credit rating agencies—Moody’s, Standard & Poor’s and Fitch/IBCA—received substantial Standard & Poor’s and Fitch/IBCA—received substantial fees from Enronfees from EnronJust weeks prior to Enron’s bankruptcy filing—after most Just weeks prior to Enron’s bankruptcy filing—after most of the negative news was out and Enron’s stock was of the negative news was out and Enron’s stock was trading for $3 per share—all three agencies still gave trading for $3 per share—all three agencies still gave investment grade ratings to Enron’s debt.investment grade ratings to Enron’s debt.These firms enjoy protection from outside competition These firms enjoy protection from outside competition and liability under U.S. securities laws.and liability under U.S. securities laws.Being rated as “investment grade” was necessary to Being rated as “investment grade” was necessary to make SPEs workmake SPEs work


So Why Did Enron Happen?So Why Did Enron Happen?

Individual and collective greed—company, its Individual and collective greed—company, its employees, analysts, auditors, bankers, rating agencies employees, analysts, auditors, bankers, rating agencies and investors—didn’t want to believe the company and investors—didn’t want to believe the company looked too good to be truelooked too good to be trueAtmosphere of market euphoria and corporate arroganceAtmosphere of market euphoria and corporate arroganceHigh risk deals that went sourHigh risk deals that went sourDeceptive reporting practices—lack of transparency in Deceptive reporting practices—lack of transparency in reporting financial affairsreporting financial affairsUnduly aggressive earnings targets and management Unduly aggressive earnings targets and management bonuses based on meeting targetsbonuses based on meeting targetsExcessive interest in maintaining stock pricesExcessive interest in maintaining stock prices


Will there be another Enron?Will there be another Enron?

YesYes– The executives of many companies failed to “sign off” The executives of many companies failed to “sign off”

on their financial statementson their financial statements– Recently, there have been many more financial Recently, there have been many more financial

statement frauds than ever beforestatement frauds than ever before1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)

– Incentives still there (Stock Options, etc.) Incentives still there (Stock Options, etc.)

NoNo– Sarbanes-Oxley Bill contains many key provisionsSarbanes-Oxley Bill contains many key provisions

Executive “sign off”Executive “sign off”Requirement to have internal controlsRequirement to have internal controlsRules for accountants (mandatory rotation; Oversight Board, Rules for accountants (mandatory rotation; Oversight Board, limitations on services, etc.)limitations on services, etc.)

– Accountants are being much more carefulAccountants are being much more careful

© 2003 by the aicpa business fraud (the enron problem) w. steve albrecht ph.d., cpa, cia, cfe...

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