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Lucent Technologies: A Study in Fraud and Earnings Management

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.

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Outline
Background of Lucent Timeline of events Perpetration of fraud Opportunities

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Company Background
Was spun off from AT&T on September 30, 1996 At the time, largest IPO Nations most widely held stock in Dec. 1999 Maintained reputation as a growth company
CEO pushed 20% sales growth

Sold software and hardware to phone companies and network operators


Software to detect cell phone fraud

Accused of aggressive accounting long before restatement


Pension fund accounting Acquisition accounting

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Timeline Selected events Pre-Restatement


Jul. 20, 2000 - Warns 4Q will miss Oct. 11, 2000 - 4Q estimate revised downward again Oct. 2000 - CEO fired, 1Q 01 warning, board learns of reporting problems and informs SEC Nov. 2000 - Internal investigation conducted Dec. 2000 - Paul ONeill resigns from audit committee to become Treasury Secretary, Dec. 2000 - Lawsuit filed against Lucent claiming Nina Aversano was fired for disputing unrealistic sales targets

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TimelineRestatement
Dec. 21, 2000 - Restates 4Q revenue
- $679 million restatement Restatement result of internal investigation, not SEC Lucent claimed that $125 million represented improper recognition, while the rest represented subsequent agreements with vendors

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TimelinePost Restatement
Jan. 24, 2001 - Reports sales have fallen 28% and restructuring charge announced Feb 8, 2001 - SEC investigation formalized Nov. 1, 2002 - WSJ article
Reports SEC investigation far broader than Lucent disclosed - Investigating earnings manipulations as far back as 1996 and role of audit committee - Looking into managements earnings projections - Examining potential overstatement of restructuring charge Lucent claims SEC investigation is almost complete

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Recap
Revenue recognition Restructuring charges Pension fund accounting Acquisition accounting

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Revenue
What the restatement consisted of:
$452 millionEquipment shipped to distributors but never sold (channel stuffing) $199 millionCredits offered to customers $28 millionPartial shipment of equipment

Documentary red flags:


The $125 million of improper revenue was attributable to false documents

Analytical red flags:


Fiscal 1999 revenue grew 20%, while receivables grew 49% Bad debt reserves decreased while accounts receivable and sales grew

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Restructuring Charge
$2.6 billion right before AT&T spin-off The issueUsing cookie-jar reserves to meet expectations by reversing the charge when needed From 1996 to 1999, Lucent reversed $540 million (28%) The resultLucent met expectations in three quarters that it otherwise would not have Similar to Xerox except for better disclosure

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Audit Committee
Paul Allaire - Former chairman and CEO of Xerox Franklin Thomas - Lucent director and Alcoa board member Betsy Atkins - Cofounder of Ascent Communication (a Lucent Acquisition) Paul ONeill - Alcoa CEO Donald Perkins - Committee chairman until Feb. 1999

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See Any Possible Red Flags?


Significant insider influence
All but Allaire are insiders

Potential ethical implications


Xerox

Peculiar timing of turnover


Why did Perkins leave

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Who Cooked Whos Books?


Fred Moldfoski posted earnings releases on Yahoo Finance on March 22-23, 2000
The fraudulent releases were designed to look like official Lucent releases The releases stated that Lucent would miss expectations The impact: Lucents stock opened at $62.125 and traded as low as $60.375

The ironyfrom what we know now, it is possible that Lucent had indeed missed expectations

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Charges included:
December 2000 - breach of contract suit filed by Nina Aversano May 17, 2004 - SEC against Lucent and 10 individuals changing them with fraud and violation of GAAP during reporting for fiscal 2000
$511 million revenue prematurely recognized; $637 million should not have been recognized [total $1.148 billion] $91 million pre-tax income prematurely recognized; $379 million should not have been recognized [total $470 million (16%)]

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Settlements included:
Lawsuit filed by Nina Aversano details undisclosed Shareholder lawsuits totaling $568 million Without admission or denial of charges, Lucent settled with SEC. As SEC believes Lucent did not fully cooperate, a $25 million civil fine was imposed.

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