Chapter 11 a:Financial statement fraud


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  • This is the first chapter of three chapters related to Management of fraud. Today in this chapter we will discuss a number of corporate management frauds that occurred in America in last decade. We will find that these kind of frauds are mostly done by company’s management to meet the internal and external expectations. More similar like Parmalat case (Italy) we did before the break.We will also discuss the element of these fraud.
  • This presentation will help in laying a foundation base for understanding the particular type of frauds. And help you all learn. Who does these fraud? Why they do it? How they do it?
  • Enron was a Houston-based natural gas pipeline company formed by merger in 1985. By late 2000, Enron had morphed into the 7th largest U.S. company, and the largest U.S. buyer/seller of natural gas and electricity. Enron was heavily involved in energy brokering, electronic energy trading, global commodity and options trading, etc.On October 16, 2001, was the first major public sign of trouble, Enron announces a huge third-quarter loss of $618 million. On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry into Enron’s accounting practices and detected the financial statement fraud. On December 2, 2001, Enron files for bankruptcy, which was the largest corporate bankruptcy in US.
  • SEC findings states that Enron used dubious accounting schemes and profits in the firm were overstated by 20% for 3 years• to reduce Enron’s tax payments;• to inflate Enron’s stock price and credit rating;• to hide losses in off-balance-sheet subsidiaries;• to engineer off-balance-sheet schemes to funnel money to themselves, friends, and family;Why will they fraudulently misrepresent Enron’s financial condition in public reports.
  • • to reduce Enron’s tax payments;• to inflate Enron’s stock price and credit rating;• to hide losses in off-balance-sheet subsidiaries;• to engineer off-balance-sheet schemes to funnel money to themselves, friends, and family;Why will they fraudulently misrepresent Enron’s financial condition in public reports.
  • Accounting discrepancies became public and investors lost billions of dollars. The stock price which was as high as $90 earlier in the year dropped to less than $1 in matter of days.
  • Management according to SEC was the fraud preprator. After found guilty and before his sentencing Lay died of heart disease.Skilling and Fastow were found guilty and served the prison termsAnderson was found guilty for destruction of evidence and lost the reputation as the independent auditor.
  • Few months later another fraud came to light which was again audited by Anderson. The firm was star performer in telecom industry. The company’s total assets were inflated by $11 billion. These assets were created by the executives out of the company’s expenses. Several people at world com were convicted of fraud including the CEO and CFO. Like Enron, worldcom filed bankruptcy soon after fraud came to light. Both these frauds had several similarities are two most well known frauds in the history of United States.
  • We can find and see that there is direct relationship between the financial statements and the capital markets.The stock markets and the bond markets are two key components of the capitalist economy.The efficiency and liquidity of these markets depends upon the ability of investors, lenders and regulators to raise the capital and assess the the performance of the business.The financial statements prepared by the organizations play a very significant role in keeping the capital markets efficient. They disclose:Where company has been?Where it is currently? AndWhere it is going?These statements provide a fair representation of the financial statement of the company and are based on GAAP principles.Unfortunately these statements are sometimes prepared in a way to intentionally misstate the financial position of organization.
  • During years 2000-2002 many corporate wrong doings were revealed which created the crisis of confidence in capital markets.The crisis led to $15 trillion decline in the market value of public stock companies. To have a more complete view I would move on to the next slide and give an overview of the notable abuses that occurred during the same time period.
  • These frauds involved 20 or more people helping to create fictitious financial results or we could say cooking the books.Bernie Ebbers the CEO of WorldCom was taking inappropriate loans from the company and in a way misusing the power. Its was something against the accounting ethics.Insider trading was used to earn personal profit from the trading of stock and Martha- Sam were convicted for using this practice. Techniques like spinning and laddering were used and IPO opportunity was given to those who arrange quid pro quo opportunities and to those who promise to buy more shares as the price increases.These companies were highly criticized for giving huge costly perks and benefits like expensive consulting contracts, corporate planes, executive apartments etc. to their CEOs.Because of abuses described here and similar problems 7 0f 10 bankruptcies in US history occurred in 2001-2002. Four of these seven involved financial statement fraud.There have been increasing rate of fraud against the organization by its employees. And some of the frauds were as high as 2-3 billion.Financial institutions were providing the loans to executives of companies like Enron and WorldCom for making million of dollars in transaction fees.(Citibank and JP Morgan)
  • This table here shows the 10 largest corporate bankruptcies in last decade. At present 3 of the top 10 bankruptcies were in year 2001 and 2002. Other four were Global crossing, Adelphia, United Airlines and Kmart were with lesser denominations of fraud but occurred in the same period.
  • Backdating is the method for providing executive compensation and was a very common practice in 2006, as investigated by SEC.This method is used by Top management when they use their power to buy shares at fixed price and change the effective dates on stock options deliberately. Let us now see how does it work.
  • Backdating led to million of dollars in the increased compensation for company executives at the expense of the shareholders, and also resulted in misstated financial statements. Companies using this practice also violated income tax rules because the difference in grant price and the market price should have been taxable income to company’s executives.
  • These are the 3 elements which come together to motivate fraud.The perceived pressure is very significant element for the financial statement fraud for example pressure of financial losses, failure to meet the earning expectations and inability to compete with competitors. Lastly, Pressure on executives to increase the stock price to boost the compensation for management. More the pressure more will be the probability of fraud occurrence.Fraud could only be committed if there is an opportunity to commit it. If the executives believe that they will be caught and punished will rarely commit fraud. On the other hand factors like inadequate internal controls, weak board of directors, and ability to hide fraud behind the complex structures will give an opportunity to commit fraud. (Remedy: Conduct Independent audit for final check) Finally, there will be a need to rationalize the actions as acceptable. For example: we need to protect our share holders and keep share prices high, It is for the good of the company, The problem is temporary and will offset by future positive results.This triangle provided us with insight if WHY these ethical compromises occurred.
  • During this period businesses appeared to be highly profitable which helped the fraud perpetrators to hide their actions for long time periods, and by the use of internet new inexperienced investors bought many shares in stock market, during this period many firms did not even correctly credit the reason behind the success which increased the pressure on the management.The general decay of the moral values in the society was the next contributing element. It was found that cheating at schools, lying for getting the job and dishonesty among the people was increasing.Executives of the companies were gifted with millions of dollars in stock option and kept the share price high even at the cost of accurate financial statements. CEO actually stopped managing the firms and started managing the stock price to earn profits like Ebbres in 1997 of $409 million.Wall street analysts targeted short term behavior of the firms. Companies were using comparisons with the stock price of similar firms. Stock based incentives increased the pressure to meet analysts expectations. Not to miss these estimates companies intend to make fraud.Each of the fraudulent companies had huge amount of the debts. This debt pressurize the executives to have more earnings to meet interest costs and other lender’s requirements.Unlike Australia and UK, the accounting practices in US are more rule based than principle based. Companies could find the loopholes in the rules and then it becomes hard for the auditors to prohibit their clients using such methods of accounting.Accounting firms used audits as the loss leaders and to establish relationships with the companies auditors started selling them consultancy services. Auditors lost their focus and became advisors.Greed in executives, investment banks and investors was increasing when each of this group was benefited from the strong economy and none of them wanted to accept bad news.Educators did not provide sufficient ethics training their students. By not forcing students to face realistic ethical dilemmas in the class. Graduated were then ill-equipped to deal with such dilemmas they face in business world. Accountants could not challenge the instructions of CFOs, Students were not taught about fraud etc.
  • Parmalat Italy case false documents of Bank of America were produced by the company to mislead the investors.Symptoms example:Missing document: Document may have actually been lostLedger may be out of balance: it could be unintentional accounting errorAnalytical relationship not making sense: it may be because of unrecognized changes in the economic factors…..
  • These enforcement releases are usually issued when financial statement fraud occurs at a company that has publically traded stocks. These studies have found approximately 300 such frauds.
  • In 1999 committee of sponsoring organization(COSO) released their research study. Random sample of 204 financial statement fraud was taken out of the sourced 300 frauds from SEC enforcement releases.
  • This is the very recent study of AAER released in May 2010 by COSO. Like the previous study this study also found that CEO, President, and CFO were the members of management associated with fraud. And in 18 of these cases SEC brought charges against auditing firms and individual auditors. 65% of these cases involved misstatement of financial data to boost the share price and hide their losses.1.The average Fraud increasing from $25 million in last 10 years to $400 million.3. 20% of these individuals were indicated in 2 years of SEC investigation.4. Improper revenue continued to be the most common fraud method.5. 60% of those changed did that during the fraud and remaining 40% before the fraud.Including the declines in the stock prices these companies incurred serious negative consequences like bankruptcy and delisting from stock exchange.
  • Chapter 11 a:Financial statement fraud

    1. 1. Financial Statement Fraud Chapter 11a By Ritika Sareen
    2. 2. Presentation Outline  Two well known Frauds: ◦ ENRON ◦ WorldCom  Using financial Statements for fraud  Brief introduction to Financial statement fraud.  Overview of fraud related practices  Fraud motivators and the elements  Nature and Statistical findings.
    3. 3. Enron (US) - Timeline  Year 2000 ◦ Revenue- $101 Billion ◦ Employees- 21000 ◦ Countries of operation- 40  December, 2001 ◦ Financial statement fraud detected ◦ Enron filed bankruptcy
    4. 4. Investigation findings  Complex accounting schemes- Revenues Overstated Income Overstated Assets Overstated Profits Overstated Basic rules of accounting and ethics was violated
    5. 5. Share prices ( Oct- Dec 2001)
    6. 6. SEC Charges  Former CEO- Skilling  Current CEO- Ken Lay  CFO- Andy Fastow  Auditors- Arthur Anderson
    7. 7. Another Massive FRAUD: WorldCom  Star performer- Telecom Industry  Fraud more massive than Enron  Financial statement Fraud  Filed bankruptcy  CEO, CFO – convicted to fraud  Auditor - Arthur Anderson
    8. 8. Direct Relationship Financial Statements Capital Markets •Stock Markets & Bond Markets •Efficiency: based on investors and regulators •Significant role of financial statements •Fair representation •Based on GAAP Unfortunately, sometimes misstates
    9. 9. Introduction  Financial statement frauds ◦ Intentionally misstating position. ◦ Manipulating accounting records.  Resulting to: ◦ Huge losses to Investors. ◦ Lack of trust in markets. ◦ Lack of trust in accounting system. ◦ Embarrassments for people associated with fraud.
    10. 10. Capital Markets- Crisis  $15 Trillion Decline  America Experienced Severe Crisis.  Years 2000-2002
    11. 11. Overview- Fraud Related practices Misstated financial statements Qwest, Enron, World Com, Xerox etc. Executive loan and corporate looting Bernie Ebbers (WorldCom) Insider trading scandals ImClone stock- Martha and Sam IPO favoritism WorldCom & Enron Excessive CEO retirement perks Ford, PepsiCo, IBM, and GE Bankruptcies and excessive debt 7 largest bankruptcies in US till(2001-02) Massive frauds by employees $2-$3 billion Loans for trading fees Enron & WorldCom Excessive compensation for executives Bernie Ebbers (WorldCom)
    12. 12. Bankruptcy Storm Company Date Assets(in billions) Lehman Brothers 2008 $639 Washington Mutual 2008 $327 WorldCom 2002 $103 General Motors 2009 $91 CIT 2009 $71 Enron 2001 $65 Conseco 2003 $61 Chrysler 2009 $39 Thornburg 2009 $36 Pacific Gas and Electric 2001 $36
    13. 13. Yet another practice- BACKDATING Receiving stock grants at the lowest price of the year Selling the stock at the higher price Difference in price will be management profit.
    14. 14. BACKDATING - Continued
    15. 15. Fraud Motivators Perceived Pressure Perceived Opportunity Rationalization The Fraud Triangle
    16. 16. Elements of Perfect Storm Booming Economic Conditions Moral Decay Executive Incentives Unachievable expectations- Wall Street Enormous Debt Nature of US accounting rule Lack of auditor’s Independence Greed Educator Failures
    17. 17. Nature - Financial statement fraud Concealed using the falsified documents Suppressed by agreement between management and employees Rarely detected and difficult to prove Symptoms of fraud does not always indicate existence of fraud Thus investigators must exercise extreme care
    18. 18. Review Financial statements are the backbone of _____. These frauds usually involves ____ management which is motivated to keep the company stock price_____. Financial statement fraud is usually crafted to conceal it internally from _____. _____ is very common practice for executive compensation.
    19. 19. Review- Answers Financial statements are the backbone of Capitalism. These frauds usually involves Top management which is motivated to keep the company stock price High. Financial statement fraud is usually crafted to conceal it internally from Auditors. Backdating is very common practice for executive compensation.
    20. 20. Statistics SOURCE SEC’s Accounting and auditing enforcement releases. (AAERs) National Commission on Fraudulent Financial reporting The Tradeway Commission Report Committee of sponsoring organizations (COSO)
    21. 21. Sample Revealed Facts (1987- 1997) Average fraud last for 2 years Overstating assets and understating expenses is most common practice of fraud CEO was the fraud perpetrator in 72% cases Severe consequences: Bankrupt or taken over by state No independent directors or audit committee Directors dominated by insiders and grey directors Experiencing net losses or close to break-even point prior to fraud
    22. 22. Findings Reported (1998- 2007) 18% more frauds were investigated by SEC Median assets of the companies increased from $16million to $100 million CEO and CFO were named in over 89% of cases. 60% of the cases accounted for improper revenue recognition. 26% of the firms changed auditors around the time of fraud. Press coverage and government investigation led to decrease in stock price.
    23. 23. References Ellison, C. (2008, 05 08). [Web log message]. Retrieved from http://enron- not-the-fun-way/ Eric S. (2010, 10 20). 10 largest bankruptcies in history. Retrieved from largest-bankruptcies-in-history Albrecht, W. S., Albrecht, C. O., Albrecht, C. C., & Zimbelman, M. F. (2012). Fraud examination. (4 ed., Vol. e, pp. 357-366). United states of america: South western