1<br />Corporate Transgressions  and Financial Gimmickry<br />JimDavidson, CFE, CPA, CFS<br />Certified Corporate Director...
2<br />DEVASTATINGMillions  & Billions Lost<br />Deceptive practices, executive fraud, shaken confidence<br />Financial ma...
3<br />Financial, Business & Ethical<br />Scandals and high profile cases<br />Manipulations, tricks & red flags<br />Repe...
4<br />Scandals and Transgressions<br />Abhold<br />ADELPHIA<br />ANDERSEN<br />AOL<br />Baker Hughes<br />Bally<br />Baus...
5<br /> Scandals and Transgressions (Cont’d)<br />Credit Suisse First Boston<br />Duke Energy<br />Dynegy<br />Fleming Com...
6<br />Scandals and Transgressions (Cont’d)<br />HEALTHSOUTH<br />Homestore<br />Interpublic<br />JDS Uniphase<br />JP Mor...
7<br />Scandals and Transgressions (Cont’d)<br />Mirand<br />Nicor Energy<br />Nine West<br />Nortel<br />North Face/VF Co...
8<br />Scandals and Transgressions (Cont’d)<br />Squibb<br />Sybase<br />Symbol<br />3Com<br />TYCO<br />Vail Resorts<br /...
9<br />Why the Scandals?<br />Blamed high tech boom<br />Meeting quarterly earnings <br />Stock options, greed and short-t...
10<br />Why the Scandals? (Cont’d)<br />“Accounting fraud does tend to come in waves, and is discovered most often after a...
11<br />Why the Scandals? (Cont’d)<br />“Just a few”- rotten apple theory<br />Specific incentives – bonuses, excessive op...
12<br />Why the Scandals? (Cont’d)<br />Incentives: Greed, power, ego<br />Opportunity:<br />	–Weak governance <br />	– Co...
13<br />Why the Scandals?(Cont’d)<br />Rationalization:<br />– “Everyone’s doing it.” <br />“Wall Street expects it.”<br /...
14<br />Lessons of History<br />It’s the incentives - GREED!<br />Irrational exuberance -  booms & bubbles<br />Regulation...
15<br />TRUST BETRAYED<br />All fraud by those we trust!<br />CEO and/or CFO 80% of cases<br />Anonymous survey of CFO’s:<...
16<br />Recent Scandals<br />Greed — more widespread than previous?<br />Prominent industries  - energy, high tech,telecom...
EARNINGS MANAGEMENT<br />What is it? How is it accomplished?<br />How is detected?<br />
18<br />Earnings Management Defined<br />“Active manipulation of earnings toward predetermined target” {Mulford & Comisky}...
19<br />Gimmicks and Illusions:What? How? When?<br />“Big Bath” charges –write-offs, over reserves, 	“cushions” ensure hig...
20<br /> Earnings Management Tricks and Gimmicks<br />“Materiality&quot;– Intentionally recording errors within 	ceiling –...
21<br />	Other Tricks & Gimmicks<br />Earnings management - manipulation and outright fraud<br />Discretionarypolicies & e...
22<br />Other Tricks & Gimmicks<br />Related party loan guarantees, obligations, synthetic leases<br />Extreme tax avoidan...
23<br />Self-Dealing – Questionable and Unauthorized<br />Disguised executive compensation<br />“Evergreen” stock options<...
24<br />Earnings Management Environment<br />Overbearing CEO with substantial ego<br />Few independent directors<br />Inad...
25<br />DECEPTION– LIABILITIES<br />Special purpose entities<br />Off-books complex schemes and webs - nonconsolidated deb...
26<br />Aggressive Tax Shelters<br />Off-shore tax havens, shelter deals, questionable legal/tax accounting interpretation...
27<br />Questionable, Unauthorized Funds<br />Disguised executive compensation<br />“Evergreen” stock options<br />Undiscl...
28<br />Earnings Restatements<br />Previously rare, increasingly common<br />Highly suspect manipulation & deception<br />...
29<br />ENRON<br />Largest bankruptcy 2001 <br /> 7th largest corporation - $1.2 billion equity reduction in quarter<br />...
30<br />Enron<br />Extreme use SPEs for blatant manipulation<br />Initial use to grow company, managing risk<br />More com...
31<br />Enron (Cont’d)<br />Gas trading to electricity, risk management, telecom,  and expanding internationally<br />Base...
32<br />Enron (Cont’d)<br />Energy trading: spot market purchases volatility drove demand for risk management and related ...
33<br />Enron (Cont’d)<br />Focused on meeting quarterly earnings<br />Initially cost savings, but increasingly more gimmi...
34<br />Enron(Cont’d)<br />CFO manipulated for own enrichment - independence problem<br />Questionable SPEs approved by at...
35<br />Enron(Cont’d)<br />Some operations major blunders<br />Dramatic increased risk but unwillingness to disclose losse...
36<br />WorldCom<br />Growth through mergers & acquisitions <br />$100+ billion assets (with half intangibles)<br />Debt t...
37<br />WorldCom(Cont’d)<br />WorldCom restated earnings<br />Andersen fired<br />CFO and CEO fired<br />WorldCom bankrupt...
38<br />Tyco<br />Conglomerate through acquisitions<br /> “Deal a Day Dennis” Kozlowski acquired 750 companies<br />Merger...
39<br />Tyco(Cont’d)<br />CIT $9.4 billion loss for 2002<br />Kozlowski indicted for evading taxes & “raiding” Tyco<br />O...
40<br />Adelphia<br />Fifth cable & communications<br />Restatements -  billions off-balance-sheet “co-borrowing agreement...
41<br />What do Enron, WorldCom, Tyco, Adelphia have in common?<br />Massive deception, manipulation, self-dealing<br />Gr...
42<br />What Happened at Andersen?<br />Long-time reputation for integrity and professionalism<br />“Aggressive auditing” ...
43<br />Governance Red Flags<br />CEO also board chairman<br />Executive ego and dominance <br />Permissive governance str...
44<br />Corporate Governance<br />Majority independent board members – fraud less likely<br />Board  and executive compens...
45<br />Corporate Governance<br />Board oversight and “tone at the top”<br />Independent directors fact and appearance<br ...
46<br />Legislative Reaction: SOX<br />Strengthened governance -- independent directors, mandatory committees <br />Indepe...
47<br />Legislative Reaction: SOX (Cont’d)<br />Established PCAOB<br />A new regulatory structure for  accounting firms<br...
48<br />Corporate Transgressions  and Financial Gimmickry<br />Jim Davidson, CFE, CPA, CFS<br />Certified Corporate Direct...
49<br />QUESTIONS?<br />
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  1. 1. 1<br />Corporate Transgressions and Financial Gimmickry<br />JimDavidson, CFE, CPA, CFS<br />Certified Corporate Director<br />
  2. 2. 2<br />DEVASTATINGMillions & Billions Lost<br />Deceptive practices, executive fraud, shaken confidence<br />Financial markets - billions evaporated<br />Recession – bankruptcies, savings, pensions, jobs lost, financial ruin <br />Reputations, careers destroyed, imprisonment<br />
  3. 3. 3<br />Financial, Business & Ethical<br />Scandals and high profile cases<br />Manipulations, tricks & red flags<br />Repercussions–legal, financial, reputation<br />Lessons learned<br />Corporate culture -- “Tone at the Top”<br />Management integrity<br />
  4. 4. 4<br />Scandals and Transgressions<br />Abhold<br />ADELPHIA<br />ANDERSEN<br />AOL<br />Baker Hughes<br />Bally<br />Bausch & Lomb<br />Bristol-Myers<br />CENDANT<br />Citibank<br />CMS Energy ($5.2 billion)<br />COMPUTER ASSOCIATES<br />
  5. 5. 5<br /> Scandals and Transgressions (Cont’d)<br />Credit Suisse First Boston<br />Duke Energy<br />Dynegy<br />Fleming Companies<br />EDS<br />El Paso<br />ENRON ($85 billion)<br />GATEWAY<br />Gaylord Entertainment<br />GLOBAL CROSSING ($9 billion)<br />Haliburton<br />J<br />
  6. 6. 6<br />Scandals and Transgressions (Cont’d)<br />HEALTHSOUTH<br />Homestore<br />Interpublic<br />JDS Uniphase<br />JP Morgan Chase<br />Kimberly Clark<br />Kmart<br />LUCENT<br />Martha Stewart<br />Merck<br />Merrill Lynch<br />Microstrategy<br />
  7. 7. 7<br />Scandals and Transgressions (Cont’d)<br />Mirand<br />Nicor Energy<br />Nine West<br />Nortel<br />North Face/VF Corp<br />Parmalat<br />Peregrine Systems<br />QUEST<br />Reliant Energy ($6 billion)<br />Rite-Aid<br />Royal Dutch/Shell<br />Solomon Smith Barney<br />SUNBEAM<br />
  8. 8. 8<br />Scandals and Transgressions (Cont’d)<br />Squibb<br />Sybase<br />Symbol<br />3Com<br />TYCO<br />Vail Resorts<br />Veritas<br />Waste Management ($6 billion)<br />WORLDCOM ($11 billion)<br />XEROX ($6.5 billion)<br />
  9. 9. 9<br />Why the Scandals?<br />Blamed high tech boom<br />Meeting quarterly earnings <br />Stock options, greed and short-term price manipulation<br />Historically, same result - speculative bubbles followed by crashes<br />Fiascos, corruption, business failures follow economic booms<br />
  10. 10. 10<br />Why the Scandals? (Cont’d)<br />“Accounting fraud does tend to come in waves, and is discovered most often after a market collapse, since no one is interested in investigating much when stock prices are high and everyone’s making big money.”<br />Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (Toffler)<br />
  11. 11. 11<br />Why the Scandals? (Cont’d)<br />“Just a few”- rotten apple theory<br />Specific incentives – bonuses, excessive options<br />Institutional environment turns blind eye to unethical or illegal acts<br />Culture allows egregious acts<br />“It pays to do it, it’s easy to do, and it’s unlikely that you’ll be caught.” [Schilit]<br />
  12. 12. 12<br />Why the Scandals? (Cont’d)<br />Incentives: Greed, power, ego<br />Opportunity:<br /> –Weak governance <br /> – Corporate culture<br /> – Ineffective auditing<br /> – Lax regulation<br /> – Haphazard enforcement<br />
  13. 13. 13<br />Why the Scandals?(Cont’d)<br />Rationalization:<br />– “Everyone’s doing it.” <br />“Wall Street expects it.”<br />“Investment bankers engineered it.” <br />“Our attorneys blessed it.” <br />“Our auditors accepted it.”<br />
  14. 14. 14<br />Lessons of History<br />It’s the incentives - GREED!<br />Irrational exuberance - booms & bubbles<br />Regulations not fool-proof<br />Corporate culture<br />Ethics, particularly at the top is key<br />
  15. 15. 15<br />TRUST BETRAYED<br />All fraud by those we trust!<br />CEO and/or CFO 80% of cases<br />Anonymous survey of CFO’s:<br />Two-thirds asked to participate<br />One-third admitted to doing so<br />
  16. 16. 16<br />Recent Scandals<br />Greed — more widespread than previous?<br />Prominent industries - energy, high tech,telecommunications<br />Giant firms – largest bankruptcies in history<br />Earnings manipulation central<br />
  17. 17. EARNINGS MANAGEMENT<br />What is it? How is it accomplished?<br />How is detected?<br />
  18. 18. 18<br />Earnings Management Defined<br />“Active manipulation of earnings toward predetermined target” {Mulford & Comisky}<br />“Purposeful intervention in external financial reporting process with intent of obtaining private gain” {Shipper}<br /> “Intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading” {ACFE}<br />
  19. 19. 19<br />Gimmicks and Illusions:What? How? When?<br />“Big Bath” charges –write-offs, over reserves, “cushions” ensure higher future earnings<br />“Merger Magic”– write-offs, misclassifications & disguised costs so no future “drag”<br />“Cookie-Jar Reserves” – income smoothing– “good time” over accruals and reserves used in “bad times” <br />
  20. 20. 20<br /> Earnings Management Tricks and Gimmicks<br />“Materiality&quot;– Intentionally recording errors within ceiling – “too small to matter”<br />Revenue recognition – Accelerated, premature before delivery and with contingencies<br />Consignment<br />Channel stuffing<br />Round-trips, swaps & barters to gross up sales<br />Bill and hold<br />Related party <br />
  21. 21. 21<br /> Other Tricks & Gimmicks<br />Earnings management - manipulation and outright fraud<br />Discretionarypolicies & estimates– capitalization, amortization, deferred expenses, inventory, judgments - bad debts, contingencies<br />Liability deception – Off-books complex schemes & webs, special purpose entities<br />
  22. 22. 22<br />Other Tricks & Gimmicks<br />Related party loan guarantees, obligations, synthetic leases<br />Extreme tax avoidance (evasion ?), off-shore havens, questionable legal/tax interpretations<br />Blatant misstatements–disguised transactions and misclassifications- capitalized repair and maintenance<br />
  23. 23. 23<br />Self-Dealing – Questionable and Unauthorized<br />Disguised executive compensation<br />“Evergreen” stock options<br />Excessive perks & misused funds<br />Undisclosed related party transactions and self-dealing – personal “piggy-bank”<br />
  24. 24. 24<br />Earnings Management Environment<br />Overbearing CEO with substantial ego<br />Few independent directors<br />Inadequate board committee structure<br />Excess executive compensation and perks<br />Poor control structure and culture – “tone at the top”<br />
  25. 25. 25<br />DECEPTION– LIABILITIES<br />Special purpose entities<br />Off-books complex schemes and webs - nonconsolidated debt<br />Related party loan guarantees, contractual obligations, synthetic leases<br />
  26. 26. 26<br />Aggressive Tax Shelters<br />Off-shore tax havens, shelter deals, questionable legal/tax accounting interpretations<br />Complex series of loans, extreme tax avoidance and possible evasion<br />
  27. 27. 27<br />Questionable, Unauthorized Funds<br />Disguised executive compensation<br />“Evergreen” stock options<br />Undisclosed related party transactions/self-dealing<br />Inadequate, ineffective corporate governance<br />
  28. 28. 28<br />Earnings Restatements<br />Previously rare, increasingly common<br />Highly suspect manipulation & deception<br />Over 900 restatements 1999-mid-2003 (GAO)<br />Nearly 1,000 recent restatements <br />Predominantly revenue recognition<br />20% of 2001 SEC enforcements accounting related, increasing in 2002 - 2004<br />Market reaction: Significant stock price declines<br />
  29. 29. 29<br />ENRON<br />Largest bankruptcy 2001 <br /> 7th largest corporation - $1.2 billion equity reduction in quarter<br />Manipulation and deception -- special purpose entities<br />Congressional hearings, revolutionary changes -- regulatory, governance, scrutiny<br />
  30. 30. 30<br />Enron<br />Extreme use SPEs for blatant manipulation<br />Initial use to grow company, managing risk<br />More complex SPEs to record future services as current income using “mark-to-market”<br />Extensive conflicts of interest & related-party transactions<br />
  31. 31. 31<br />Enron (Cont’d)<br />Gas trading to electricity, risk management, telecom, and expanding internationally<br />Based on economic-based assessments, many ventures were failures<br />Based on manipulations and deception, all were successful<br />
  32. 32. 32<br />Enron (Cont’d)<br />Energy trading: spot market purchases volatility drove demand for risk management and related derivatives<br />Massive debt and potential junk bond ratings<br />Used special purpose entities to reduce perception of too much debt<br />
  33. 33. 33<br />Enron (Cont’d)<br />Focused on meeting quarterly earnings<br />Initially cost savings, but increasingly more gimmicks<br />Scheme 1: Revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front-loading profits<br />Scheme 2: Complex and mishandled SPEs to record earnings<br />
  34. 34. 34<br />Enron(Cont’d)<br />CFO manipulated for own enrichment - independence problem<br />Questionable SPEs approved by attorneys, auditor/Andersen and board<br />Accommodated by investment banks and no apparent SEC oversight<br />
  35. 35. 35<br />Enron(Cont’d)<br />Some operations major blunders<br />Dramatic increased risk but unwillingness to disclose losses<br />Stock price dropped, executives bailed out of stock, ratings to junk<br />Restatements in 2001and subsequent bankruptcy <br /> Largest ever bankruptcy until …<br />
  36. 36. 36<br />WorldCom<br />Growth through mergers & acquisitions <br />$100+ billion assets (with half intangibles)<br />Debt to equity of 79.3%<br />$11 billion + capitalized operating expenses<br />
  37. 37. 37<br />WorldCom(Cont’d)<br />WorldCom restated earnings<br />Andersen fired<br />CFO and CEO fired<br />WorldCom bankruptcy 2002<br />Replaced Enron as largest bankruptcy in US history, <br />
  38. 38. 38<br />Tyco<br />Conglomerate through acquisitions<br /> “Deal a Day Dennis” Kozlowski acquired 750 companies<br />Merger magic <br />CIT acquisition fiasco showed Tyco’s shenanigans <br />
  39. 39. 39<br />Tyco(Cont’d)<br />CIT $9.4 billion loss for 2002<br />Kozlowski indicted for evading taxes & “raiding” Tyco<br />Obvious manipulation & deception <br />Not clear criminal acts<br />
  40. 40. 40<br />Adelphia<br />Fifth cable & communications<br />Restatements - billions off-balance-sheet “co-borrowing agreements”<br />Rigas family fraud and significant self-dealing<br />Bankruptcy 2002<br />
  41. 41. 41<br />What do Enron, WorldCom, Tyco, Adelphia have in common?<br />Massive deception, manipulation, self-dealing<br />Growth through acquisitions<br />Acquisition accounting abuse<br />Targeted earnings focused <br />Enrichment of senior executives<br />Accommodating auditors & boards of directors <br />Restated financials<br />
  42. 42. 42<br />What Happened at Andersen?<br />Long-time reputation for integrity and professionalism<br />“Aggressive auditing” beginning in ‘80s<br />Clients too valuable to defy (Toffler)<br />Major client scandals: Sunbeam, Global Crossing, Waste Management, Enron, WorldCom & Guilty of obstruction of justice<br />
  43. 43. 43<br />Governance Red Flags<br />CEO also board chairman<br />Executive ego and dominance <br />Permissive governance structure - manipulation more likely<br />Lax board committees - audit, compensation, nominating and governance<br />
  44. 44. 44<br />Corporate Governance<br />Majority independent board members – fraud less likely<br />Board and executive compensation —performance based <br />Conservative accounting <br />Transparent reporting – full and understandable<br />
  45. 45. 45<br />Corporate Governance<br />Board oversight and “tone at the top”<br />Independent directors fact and appearance<br />Competent & vigilant – not asleep at wheel<br />Audit committee focus – audit, expertise, SEC investigations & past restatements<br />Compensation committee oversight, executive compensation, insider trading<br />Investment banking relationships<br />
  46. 46. 46<br />Legislative Reaction: SOX<br />Strengthened governance -- independent directors, mandatory committees <br />Independent audit committee members and “financial expert”<br />Internal control attestation<br />CEO and CFO certifications<br />Tougher penalties<br />
  47. 47. 47<br />Legislative Reaction: SOX (Cont’d)<br />Established PCAOB<br />A new regulatory structure for accounting firms<br />Tighter corporate controls<br />New disclosure requirements<br />New record retention requirements<br />
  48. 48. 48<br />Corporate Transgressions and Financial Gimmickry<br />Jim Davidson, CFE, CPA, CFS<br />Certified Corporate Director<br />
  49. 49. 49<br />QUESTIONS?<br />
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