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Corporate Accounting Scandals


Sarbanes-Oxley and newfound corporate accountability. Newfound litigation grounds New Need for Insurance! ... New Grounds for Litigation ... – PowerPoint PPT presentation

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Title: Corporate Accounting Scandals

Corporate Accounting Scandals Insurance
Agenda for Today
  • The diminishing audit quality of the 1990s
  • The bubble burst
  • Enron, WorldCom, Global Crossing, Tyco, Adelphia,
  • Reform!!! Sarbanes-Oxley and newfound corporate
  • Newfound litigation grounds ? New Need for

Why so many financial statement frauds all of a
  • Good economy was masking many problems
  • Moral decay in society
  • Executive incentives
  • Wall Street expectationsrewards for short-term
  • Nature of accounting rules
  • Behavior of CPA firms
  • Greed by investment banks, commercial banks, and
  • Educator failures

"The Perfect Storm"
These Are Interesting Times
  • Number and size of financial statement frauds are
  • Number and size of frauds against organizations
    are increasing
  • Some recent frauds include several peopleas many
    as 20 or 30 (seems to indicate moral decay)
  • Many investors have lost confidence in
    credibility of financial statements and corporate
  • More interest in fraud than ever beforenow 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. 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.
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
  • 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 cant do thisbecause it
    isnt 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
  • 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 weve all heard of failed as
    a result of corruption and fraud
  • Enron
  • WorldCom
  • Global Crossing
  • Adelphi

Largest Bankruptcy Filings (1980 to
Present) from
  • 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.

  • 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
  • His background was in banking and asset and
    liability management.
  • His recommendation that Enron create a Gas
    Bankto buy and sell gas

Enrons History (contd)
  • 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 handsomelythe reward system
    was eat what you kill
  • Fastow was a Kellogg MBA hired by Skilling in
    1990Became 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

Enrons 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 managementBlockbuster 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
  • 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!

  • 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

  • Several Vacation Homes and luxury apartments in
  • 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

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

  • 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
  • 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 officers knowledge, the financial
    statements do not contain any material
    misstatements or omissions.
  • The financial statements fairly state the
    companys financial position and results from
    past operation.

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//

Directors Officers Insurance
New Demand for Directors and Officers insurance
  • Think of the lawsuits facing some of Enrons

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 Enron Paulo 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 Azurix John Mendelsohn-
    a director of Enron Jerome Meyer- a director of
    Enron Frank Savage- a director of Enron and a
    member of its Finance Committee John Urquhart- a
    director of Enron and was senior advisor to the
    Chairman in 1998 John Wakeham- a director of
    Enron Charls Walker- a director of Enron Herbert
    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 Directors and Officers insurance
  • Think of the liability for Arthur Andersens
    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
  • 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.

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

A Twist to Enrons DO Policies
  • Some of Enrons DL 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 wont totally disappear.
  • Watch for new developments in regulations.
  • SOX adjustments
  • More large DO claims.

  • Some material taken from the AICPA Website