Corporate Accounting Scandals & Insurance

Agenda for Today

The diminishing audit quality of the 1990s The bubble burst Enron, WorldCom, Global Crossing, Tyco,

Adelphia, etc… Reform!!! Sarbanes-Oxley and newfound

corporate accountability Newfound litigation grounds New Need for

Insurance!!!

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

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

Why Was There Earnings Management?

What is Earnings Management?

Basically, it is manipulating the financial statements of a company to misrepresent the true financial health of the company.

Incentives for F.S. FraudIncentives 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

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 make rules for every situation

Why Was There Earnings Management?

Reasons are probably wide and varied. Complex problem. Earnings management almost became the

norm in corporate America. Corporations needed to manage their

earnings to remain competitive with other companies.

Why Was There Earnings Management?

Audit quality was insufficient. Competition for business was driving the

price of audits down. Not much of a premium paid for having accurate audits.

Accounting firms focusing more on profitable services like consulting.

Why Was There Earnings Management?

Financial service firms offered consulting services in addition to audits.

Consulting is Advisory services to help senior management improve the effectiveness of corporate strategy, process, or operations by assessing business needs and reviewing business functions, plans and directions.

Why Was There Earnings Management?

Possible conflict of interest with accounting firms providing both audit services and consulting services.

Audit partners becoming more “friendly” with upper management. After all, they want to keep business!

Audit partners compensated more on bringing in business than on their technical skills.

The Scandals

The culmination of the aforementioned accounting problems was the bubble burst of the late 1990s and the early 2000s.

Some companies that we’ve all heard of failed as a result of corruption and fraud: Enron WorldCom Global Crossing Adelphi

Largest Bankruptcy Filings

(1980 to Present)

from BankruptcyData.com

Company Assets (Billions) When Filed

1. WorldCom $103.9 July 2002

2. Enron $63.4 Dec. 2001

3. Conseco $61.4 Dec. 2002

4. Texaco $35.9 April 1987

5. Financial Corp of America $33.9 Sept. 1988

6. Global Crossing $30.2 Jan. 2002

7. PG&E $29.8 April 2001

8. UAL $25.2 Dec. 2002

9. Adelphia $21.5 June 2002

10. MCorp $20.2 March 1989

Enron

Enron

Using Special Purpose Entities as a haven for debt, synthetic profit.

Enron created several hundred of these special purpose entities.

Auditors failed to stop the misstatements. Investors lost nearly $60 Billion in the

collapse of the 5th largest corporation in the US.

Enron 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 (cont’d) 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 hired the “best and brightest” traders and rewarded them handsomely—the reward system was eat what you kill

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

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 was 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

What did Arthur Andersen Do?

Andersen employees ordered tons of Enron paperwork to be shredded before the investigation of the fraud began. Rumor: U of I Arthur Andersen interns during

2001 claim to have shredded a ton of documents!

Enron

WorldCom

Capitalized their line costs. Line costs should have been expenses,

however, the false capitalization overstated WorldCom's assets by billions of dollars.

Global Crossing

Management had “unrealistic” revenue targets.

Tried everything they could to meet the targets.

“Swapped” fiber optic capacity to boost revenue.

Revenue restatement of $19 million, overstated assets by $1.2 billion

Adelphi

Several Vacation Homes and luxury apartments in Manhattan

Several private jets Construction of a world-class 18-hole golf

course Majority ownership of the Buffalo Sabres $700,000 membership in an exclusive golf

club

Reaction

Investor backlash Billions lost in the frauds of 2001, 2002. US government determined to deter frauds of

this magnitude in the future.

Sarbanes-Oxley

Created in 2002 in the wake of the previously mentioned accounting scandals.

Created accountability among corporate executives.

SOX 2002

Section 302 pertains to liability. CEO/CFO must sign off on financial statements- can

be held criminally liable if financials are false. Material Accuracy- The amount listed in the financials has

to be an accurate reflection of where the company is at. Fair presentation of financial information Disclose controls- so material information about a company

gets presented to top management. Internal Accounting controls- provide assurance that the

financials conform to GAAP.

SOX 2002 Section 302 Contin…

Based on the officer’s knowledge, the financial statements do not contain any material misstatements or omissions.

The financial statements fairly state the company’s financial position and results from past operation.

Accountability!!!!

New Grounds for Litigation

In 2002, the U.S. Congress passed the Sarbanes Oxley Act, which has had a major impact on the liability of directors and officers. Although this legislation protects shareholders and is expected to improve corporate governance, it also bears the risk of increasing the number of litigations. This act establishes new fines and penalties for the corporate board for securities fraud violation involving accounting irregularities and financial fraud. http://www.aon.com/risk_management/d_and_o.jsp

Directors & Officers Insurance

New Demand for Director’s and Officer’s insurance

Think of the lawsuits facing some of Enron’s officers

Others Paying Out From Enron DIRECTORS:

*Robert Belfer- a director of Enron*Norman Blake- a director of Enron*Ronnie Chan- a director of Enron*John Duncan- a director of EnronPaulo Ferraz-Pereira- a director of Enron*Joe Foy- a director of Enron*Wendy Gramm- a director of Enron*Robert Jaedicke- a director of Enron*Charles LeMaistre- a director of Enron*Rebecca Mark-Jusbasche- Chairman and CEO of Enron International and later Vice Chairman, and CEO of AzurixJohn Mendelsohn- a director of EnronJerome Meyer- a director of EnronFrank Savage- a director of Enron and a member of its Finance CommitteeJohn Urquhart- a director of Enron and was senior advisor to the Chairman in 1998John Wakeham- a director of EnronCharls Walker- a director of EnronHerbert Winokur- a director of Enron

Class action suits in the Hundreds of millions of dollars range. Part of which was paid out of pocket due to directors not carrying adequate Directors and Officers Insurance.

New Demand for Director’s and Officer’s insurance

Think of the liability for Arthur Andersen’s partners on the Enron account!!

Implications of Liability

As a company officer, you are responsible for not only your actions, but those of your subordinates as well.

Most technical information within a company gets passed up through the hierarchal layers for the company from bottom to top.

Professional Liability

Most CGL policies exclude professional liability loss exposures.

Legal fees for defending professional liabilities cases can be very costly.

Other Effects of Enron on DOL Approximately 50% of all Directors and Officers

Liability claims are tied to Employment Practices Liability claims. Employees that were once silent about workplace harassment and discrimination are now speaking out and taking action against their employers.

Plant closings, layoffs, and mergers and acquisitions are commonplace events that are providing fertile ground for multi-million dollar class action claims.

The case of Enron in late 2001, coupled with an already large downturn in the economy, has further affected the pricing for Directors and Officers liability.

D&O Insurance

The cost for Director's and Officer's Insurance has gone up dramatically, and the exclusions for coverage have increased.

A Twist to Enron’s D&O Policies

Some of Enron’s D&L claims were not paid because since the claims resulted from misrepresentation, the insurance companies refused to pay the claim! Self insurance retention

The Future?

These scandals might be reduced by new laws, but they won’t totally disappear.

Watch for new developments in regulations. SOX adjustments

More large D&O claims.

Some material taken from the AICPA Website