Business Fraud (The Enron Problem)

W. Steve Albrecht Ph.D., CPA, CIA, CFE Brigham Young University

2003, 2005 by the AICPA

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, 2005 by the American Institute of Certified Public Accountants, Inc., New York, New York.

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 peopleas 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 beforenow a course on many college campuses
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Example of a Fraud Where I Testified

Large Fraud of $2.6 Billion over 9 years
Year 1 Year 3 Year 5 Year 7 Year 9 $600K $4 million $80 million $600 million $2.6 billion
3,000,000,000 2,500,000,000 2,000,000,000 1,500,000,000 1,000,000,000 500,000,000 0 Year 1 Year 3 Year 5 Year 7 Year 9

In years 8 and 9, four of the worlds largest banks were involved and lost over $500 million

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Why Fraud is a Costly Business Problem

Fraud Losses Reduce Net Income $ for $ If Profit Margin is 10%, Revenues Must Increase by 10 times Losses to Recover Affect on Net Income
Losses. $1 Million Revenue.$1 Billion

Fraud Robs Income

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

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

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Fraud Cost.Two Examples

General Motors
$436 Million Fraud Profit Margin = 10% $4.36 Billion in Revenues Needed At $20,000 per Car, 218,000 Cars

Bank
$100 Million Fraud Profit Margin = 10 % $1 Billion in Revenues Needed At $100 per year per Checking Account, 10 Million New Accounts

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Financial Statement Fraud

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

$7 million fraud

$2 billion drop in stock value

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Types of Fraud
Fraudulent Financial Statements Employee Fraud Vendor Fraud Customer Fraud Investment Scams Bankruptcy Frauds Miscellaneous Frauds The common element is deceit or trickery!

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Recent Financial Statement Frauds

Enron WorldCom Adelphia Global Crossing Xerox Qwest Many others (Cendant, Lincoln Savings, ESM, Anicom, Waste Management, Sunbeam, etc.)

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Current Executive Fraud-Related Problems

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

(1980 to Present)

from BankruptcyData.com Company 1. WorldCom 2. Enron 3. Conseco 4. Texaco 5. Financial Corp of America Assets (Billions) $103.9 $63.4 $61.4 $35.9 $33.9 When Filed July 2002 Dec. 2001 Dec. 2002 April 1987 Sept. 1988

6. Global Crossing
7. PG&E 8. UAL 9. Adelphia 10. MCorp
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$30.2
$29.8 $25.2 $21.5 $20.2

Jan. 2002
April 2001 Dec. 2002 June 2002 March 1989

Why so many financial statement frauds all of a sudden?

Good economy was masking many problems Moral decay in society Executive incentives Wall Street expectationsrewards for short-term behavior Nature of accounting rules Behavior of CPA firms Greed by investment banks, commercial banks, and investors Educator failures
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Good economy was masking problems

With increasing stock prices, increasing profits and increasing wealth for everyone, no one worried about potential problems. How to value a dot.com company:
Take their loss for the year Multiply the result by negative 1 to make it positive Multiply that number by at least 100 If stock price is less than the resultbuy; if not, buy anyway

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Executive Incentives
Meeting Wall Streets Expectations
Stock prices are tied to meeting Wall Streets earnings forecasts Focus is on short-term performance only Companies are heavily punished for not meeting forecasts Executives have been endowed with hundreds of millions of dollars worth of stock optionsfar exceeds compensation (tied to stock price) Performance is based on earnings & stock price

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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.

Firm A

Firm B

Which firm will have the higher stock price?

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Nature of Accounting Rules

In the U.S., accounting standards are rulesbased 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 cant do thisbecause it isnt GAAP It is impossible to make rules for every situation
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Auditorsthe CPAs
Failed to accept responsibility for fraud detection (SEC, Supreme Court, public expects them to detect fraud) If auditors arent the watchdogs, then who is? Became greedy--$500,000 per year per partner compensation wasnt enough; saw everyone else getting rich Audit became a loss leader
Easier to sell lucrative consulting services from the inside Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture)

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

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Educators
Need to teach Ethics more Need to teach students about fraudoffer a fraud course Need to teach students how to think
We have taught them how to copy, not think We have asked them to memorize, not think We have done what is easiest for us and easiest for our students
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Financial Statement Frauds

Revenue/Accounts Receivable Frauds (Global Crossing, Quest, ZZZZ Best) Inventory/Cost of Goods Sold Frauds (PharMor) Understating Liability/Expense Frauds (Enron) Overstating Asset Frauds (WorldCom) Overall Misrepresentation (Bre-X Minerals)
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Revenue Related Financial Statement Frauds

By far, the most common accounts manipulated when perpetrating financial statement fraud are revenues and/or accounts receivable. Accounts Receivable Revenues (Income Assets )
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xxx

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Revenue-Related Transactions and Frauds

Transaction 1. Estimate all uncollectible accounts receivable 2. Sell goods and/or services to customers Accounts Involved Bad debt expense, allowance for doubtful accounts Accounts receivable, revenues (e.g. sales revenue) (Note: cost of goods sold part of entryh is included in Chapter 5) Sales returns, accounts receivable Fraud Schemes 1. Understate allowance for doubtful accounts, thus overstating receivables 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.) 5. Not record returned goods from customers 6. Record returned goods after the end of the period 7. Not write off uncollectible receivables 8. Write off uncollectible receivables in a later period 9. Record bank transfers as cash received from customers 10. Manipulate cash received from related parties 11. Not recognize discounts given to customers

3. Accept returned goods from customers 4. Write off receivables as uncollectible 5. Collect cash after discount period

Allowance for doubtful accounts, accounts receivable Cash, accounts receivable

6. Collect cash within Cash, sales discount period discounts, accounts receivable
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Overstating Inventory
The second most common way to commit financial statement fraud is to overstate inventory.
Beginning Inventory Purchases Goods Available for sale Ending Inventory Cost of Goods Sold Income
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OK OK OK High Low High

Inventory/Cost of Goods Sold Frauds

Transaction 1. Purchase inventory Accounts Involved Inventory, accounts payable Fraud Schem es 1. Under-record purchase 2. Record purchases too late 3. Not record purchases 2. Return merchandise to Accounts payable, 4. Overstate returns supplier inventory 5. Record returns in an earlier period (cutoff problem) 3. Pay vendor w ithin Accounts payable, 6. Overstate discounts discount period inventory, cash 7. Not reduce inventory cost 4. Pay vendor w ithout Accounts payable, cash Considered in another chapter discount 5. Inventory is sold; cost Cost of goods sold, 8. Record at too low an amount of goods sold is inventory 9. Not record cost of goods sold nor reduce recognized inventory 6. Inventory becomes Loss on w rite-dow n of 10. Not w rite off or w rite dow n obsolete inventory obsolete inventory, inventory 7. Inventory quantities Inventory shrinkage, 11. Over-estimate inventory (use incorrect ratios, are estimated inventory etc.) 8. Inventory quantities Inventory shrinkage, 12. Over-count inventory (double counting, etc.) are counted inventory 9. Inventory cost is Inventory, cost of goods 13. Incorrect costs are used determined sold 14. Incorrect extensions are made 15. Record fictitious inventory
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Understating Liability Frauds (3rd Most Common)

Not recording accounts payable Not recording accrued liabilities Recording unearned revenues as earned Not recording warranty or service liabilities Not recording loans or keep liabilities off the books Not recording contingent liabilities
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Asset Overstatement Frauds (4th Most Common)

Overstatement of current assets (e.g. marketable securities) Overstating pension assets Capitalizing as assets amounts that should be expensed Failing to record depreciation/amortization expense Overstating assets through mergers and acquisitions Overstating inventory and receivables (covered earlier)
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Disclosure Frauds
Three 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

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Detecting Financial Statement Fraud

1. Management & Board 2. Relationships With Others

Detecting Financial Statement Fraud

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

Enron Fraud
Compared to other financial statement frauds, Enron was very complicated. WorldCom, for example, was a $7 billion fraud that involved simply capitalizing expenses (line costs) that should have been expensed (Accounting 200 topic). Enron involved many complex transactions and accounting issues. What we are looking at here is an example of superbly complex financial reports. They didnt have to lie. All they had to do was to obfuscate it with sheer complexityalthough they probably lied too. Senator John Dingell
2003, 2005 by the AICPA

Enrons History
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
2003, 2005 by the AICPA

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 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
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The Motivation
Enron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didnt understand its financial statements. It was all about the price of the stock. Enron was a trading company and Wall Street normally doesnt reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enrons was 70 times earnings.) In its last 5 years, Enron reported 20 straight quarters of increasing income. Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings from a vaguer business known as wholesale energy operations and services.

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The Role of Stock Options

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

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

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Aggressive Nature of Enron

Because Enron believed it was leading a revolution, it pushed the rules. Employees attempted to crush not just outsiders but each other. Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.

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Enrons Arrogance
Enrons banner in lobby: Changed from The Worlds Leading Energy Company to THE WORLDS LEADING COMPANY

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2001 - Notable Events

Jeff Skilling left on August 14gave no reason for his departure. By mid-August , the stock price began to fall Former CEO, Kenneth Lay, returned in August Oct. 16announced $618 million loss but not that it had written down equity by $1.2 billion OctoberMoodys downgraded Enrons debt Nov. 8Told investors they were restating earnings for the past 4 and years Dec. 2Filed bankruptcy
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Executives Abandon Enron

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

Year 1997 Revenues $20.2 B Income $105 M Income (Restated)* $9 M

1998
1999

$31.2 B
$40.1 B

$703 M
$893 M

$590 M
$643 M

2000

$100.1 B

$979 M

$827 M

* Without LJM1, LJM2, Chewco and the Four Raptors partnerships. There were hundreds of partnershipsmainly used to hide debt.
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Value at Risk (VAR) Methodology

Some warning signs disclosed by Frank Portnoy before January 24, 2002 Senate Hearings Enron captured 95% confidence intervals for one-day holding periodsdidnt disclose worst case scenarios Relied on professional judgment of experienced business and risk managers to assess worst case scenarios Investors didnt know how much risk Enron was taking Enron had over 5,000 weather derivatives deals valued at over $4.5 billioncouldnt be valued without professional judgment From the 2000 annual report In 2000, the value at risk model utilized for equity trading market risk was refined to more closely correlate with the valuation methodologies used for merchant activities. Given the failure of the risk and valuation models at a sophisticated hedge funds such as Long-Term Capital Managementthat employed rocket Scientists and Nobel laureates to design sophisticated computer models, Enrons statement that it would refine its own models should have raised concerns
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Special Purpose Entities (SPEs)

(Enrons principal method of financial statement fraud involved the use of SPEs)

Originally had a good business purpose Help finance large international projects (e.g. gas pipeline in Central Asia) Investors wanted risk and reward exposure limited to the pipeline, not overall risks and rewards of the associated company Pipeline to be self-supported, independent entity with no fear company would take over SPE limited by its charter to those permitted activities only Really a joint venture between sponsoring company and a group of outside investors Cash flows from the SPE operations are used to pay investors
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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 quarters Many SPE transactions were timed (or illegally backdated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations
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Accounting License to Cheat

Major issue is whether SPEs should be consolidated* SPEs are only valuable if unconsolidated. 1977--Synthetic lease rules (Off-balance sheet financing) (Allowed even though owned more than 50%) 1984EITF 84-15 Grantor Trust Consolidations (Permitted non-consolidation if owned more than 50%) 1990EITF 90-15 (The 3% rule) Allowed corporations such as Enron to not consolidate if outsiders contributed even 3% of the capital (the other 97% could come from the company.) 90-15 was a license to create imaginary profits and hide genuine losses. FAS 57 requires disclosure of these types of relationships. 3% rule was formalized with FAS 125 and FAS 140, issued in September 2000.
*Usually entities must be consolidated if company owns 50% or more
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Mark-to-Market Accounting
Accounting and reporting standards for marketable securities, derivatives and financial contracts are found in FAS 115 and FAS 133. Changes in market values are reported in the income statement for certain financial assets and in shareholders equity (component of Accumulated Other Comprehensive Income) for others Gains often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and prices provides opportunities for management to create and manage earnings Enron often recognized revenue at the time contracts (even private) were signed based on net present value of all future estimated revenues and costs. Profits really tracked price of oil futuresalmost perfectly correlated

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The Chewco SPE

Accounted for 80% of SPE restatement or $400 million In 1993, Enron and the California Public Employees Retirement System (CalPERS) formed a 50/50 partnershipJoint Energy Development Investments Limited (JEDI) In 1997, Enron bought out CalPERS interest in JEDI Half of the $11.4 million that bought the 3% involved cash collateral provided by Enron meaning only 1 and percent was owned by outsiders
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LJM1 SPE
Responsible for 20% of SPE restatement or $100 million Should have been consolidatedan error in judgment by Andersen (per Andersen) After Andersens initial review in 1999, Enron created a subsidiary within LJM1, referred to as Swap Sub. As a result, the 3% rule for residual equity was no longer met. Andersen was reviewing this transaction again at the time problems were made public involved complex issues concerning the valuation of various assets and liabilities.
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Enrons Disclosures
SEC Regulation S-K requires description of related-party transactions that exceed $60K and for which an executive has a material interest Related Party Transactions footnote included in Forms 10-Q and 10-K beginning with second quarter of 1999 through 2nd quarter of 2001 From 2000 annual report Enron entered into transactions with limited partnerships whose general partners managing partner is a senior official of Enron. (Fastow)
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Enrons FootnotesDisclosures of Enron Partnership

Report Footnote 10QQ1 2000 Footnote 7 10QQ2 2000 Footnote 8 10QQ3 2000 Footnote 10 Filed with the SEC 5/15/2000 8/14/2000 11/14/2000

10QQ1 2001 Footnote 8

10QQ2 2001 Footnote 8 10QQ3 2001 Footnote 4
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5/15/2001
8/14/2001 11/19/2001

The Famous Misleading Earnings Release on October 16, 2001

Headline: Enron Reports Recurring Third Quarter Earnings of $0.43 per diluted share Projected recurring earnings for 2002 of $2.15 If you dug deep, you learned that Enron actually lost $618 million or $0.84 per sharethey had mislabeled $1.01 billion of expenses and losses as non-recurring. Shockingly, there was no balance sheet or cash flow information with the release There was no mention of a $1.2 billion charge against shareholders equity, including what was described as a $1 billion correction to an accounting error. (This was learned a couple of days later.)
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Didnt Anyone See Enrons Problems?

Enron grew to be the 7th largest Fortune 100 company while media hype and the stock market euphoria reigned But in late 2000 negative reports began to originate from some skeptics

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The Skeptics
Jonathan Weil, Energy traders cite gains, but some math is missing, The Wall Street Journal (Texas ed.) 9/20/2000 Feb. 2001 analyst report from John S. Herold, Inc. by Lou Gagliardi and John Parry Bethany McLean, Is Enron overpriced? Fortune, 3/5/2001
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Enrons Cash Flows

Enrons cash flows bore little relationship to earnings (a lot due to mark to market.) On the balance sheet, debt climbed from $3.5 billion in 1996 to $13 billion in 2001. Key Ratio
Net Income (from Operations*) Cash Flow (from Operations**)

Net Income (from Operations) Would expect to be about zero over time
*From the Income Statement **From the Statement of Cash Flows
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Enrons Cash Flow Ratio

4 3 2 1 0 -1 -2 3 6 9 months months months Year 1998 1999 2000 2001

Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000, 1st two quarters in 2001.
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Role of Andersen
Was paid $52 million in 2000, the majority for non-audit related consulting services. Failed to spot many of Enrons losses Should have assessed Enron managements internal controls on derivatives tradingexpressed approval of internal controls during 1998 through 2000 Kept a whole floor of auditors assigned at Enron year around Enron was Andersens second largest client Provided both external and internal audits CFOs and controllers were former Andersen executives Accused of document destructionwas criminally indicted Went out of business 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 equity loans and no retirement savings.

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Role of Investment & Commercial Banks

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

Enrons outside law firm was paid substantial fees and had previously employed Enrons general counsel Failed to correct or disclose problems related to derivatives and special purpose entities Helped draft the legal documentation for the SPEs
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Role of Credit Rating Agencies

The three major credit rating agenciesMoodys, Standard & Poors and Fitch/IBCAreceived substantial fees from Enron Just weeks prior to Enrons bankruptcy filingafter most of the negative news was out and Enrons stock was trading for $3 per shareall three agencies still gave investment grade ratings to Enrons debt. These firms enjoy protection from outside competition and liability under U.S. securities laws. Being rated as investment grade was necessary to make SPEs work

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So Why Did Enron Happen?

Individual and collective greedcompany, its employees, analysts, auditors, bankers, rating agencies and investorsdidnt want to believe the company looked too good to be true Atmosphere of market euphoria and corporate arrogance High risk deals that went sour Deceptive reporting practiceslack of transparency in reporting financial affairs Unduly aggressive earnings targets and management bonuses based on meeting targets Excessive interest in maintaining stock prices

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Will there be another Enron?

Yes
Recent years have seen an increase in the number of financial statement frauds
1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)

Incentives still there (Stock Options, etc.)

No
Sarbanes-Oxley Bill contains many key provisions
Executive sign off Requirement to have internal controls Rules for accountants (mandatory audit partner rotation; Oversight Board, limitations on services, etc.)

Accountants are being much more careful

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