1. 1 Corporate Transgressions and Financial Gimmickry JimDavidson, CFE, CPA, CFS Certified Corporate Director

2. 2 DEVASTATINGMillions & Billions Lost Deceptive practices, executive fraud, shaken confidence Financial markets - billions evaporated Recession – bankruptcies, savings, pensions, jobs lost, financial ruin Reputations, careers destroyed, imprisonment

3. 3 Financial, Business & Ethical Scandals and high profile cases Manipulations, tricks & red flags Repercussions–legal, financial, reputation Lessons learned Corporate culture -- “Tone at the Top” Management integrity

4. 4 Scandals and Transgressions Abhold ADELPHIA ANDERSEN AOL Baker Hughes Bally Bausch & Lomb Bristol-Myers CENDANT Citibank CMS Energy ($5.2 billion) COMPUTER ASSOCIATES

5. 5 Scandals and Transgressions (Cont’d) Credit Suisse First Boston Duke Energy Dynegy Fleming Companies EDS El Paso ENRON ($85 billion) GATEWAY Gaylord Entertainment GLOBAL CROSSING ($9 billion) Haliburton J

6. 6 Scandals and Transgressions (Cont’d) HEALTHSOUTH Homestore Interpublic JDS Uniphase JP Morgan Chase Kimberly Clark Kmart LUCENT Martha Stewart Merck Merrill Lynch Microstrategy

7. 7 Scandals and Transgressions (Cont’d) Mirand Nicor Energy Nine West Nortel North Face/VF Corp Parmalat Peregrine Systems QUEST Reliant Energy ($6 billion) Rite-Aid Royal Dutch/Shell Solomon Smith Barney SUNBEAM

8. 8 Scandals and Transgressions (Cont’d) Squibb Sybase Symbol 3Com TYCO Vail Resorts Veritas Waste Management ($6 billion) WORLDCOM ($11 billion) XEROX ($6.5 billion)

9. 9 Why the Scandals? Blamed high tech boom Meeting quarterly earnings Stock options, greed and short-term price manipulation Historically, same result - speculative bubbles followed by crashes Fiascos, corruption, business failures follow economic booms

10. 10 Why the Scandals? (Cont’d) “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.” Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (Toffler)

11. 11 Why the Scandals? (Cont’d) “Just a few”- rotten apple theory Specific incentives – bonuses, excessive options Institutional environment turns blind eye to unethical or illegal acts Culture allows egregious acts “It pays to do it, it’s easy to do, and it’s unlikely that you’ll be caught.” [Schilit]

12. 12 Why the Scandals? (Cont’d) Incentives: Greed, power, ego Opportunity: –Weak governance – Corporate culture – Ineffective auditing – Lax regulation – Haphazard enforcement

13. 13 Why the Scandals?(Cont’d) Rationalization: – “Everyone’s doing it.” “Wall Street expects it.” “Investment bankers engineered it.” “Our attorneys blessed it.” “Our auditors accepted it.”

14. 14 Lessons of History It’s the incentives - GREED! Irrational exuberance - booms & bubbles Regulations not fool-proof Corporate culture Ethics, particularly at the top is key

15. 15 TRUST BETRAYED All fraud by those we trust! CEO and/or CFO 80% of cases Anonymous survey of CFO’s: Two-thirds asked to participate One-third admitted to doing so

16. 16 Recent Scandals Greed — more widespread than previous? Prominent industries - energy, high tech,telecommunications Giant firms – largest bankruptcies in history Earnings manipulation central

17. EARNINGS MANAGEMENT What is it? How is it accomplished? How is detected?

18. 18 Earnings Management Defined “Active manipulation of earnings toward predetermined target” {Mulford & Comisky} “Purposeful intervention in external financial reporting process with intent of obtaining private gain” {Shipper} “Intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading” {ACFE}

19. 19 Gimmicks and Illusions:What? How? When? “Big Bath” charges –write-offs, over reserves, “cushions” ensure higher future earnings “Merger Magic”– write-offs, misclassifications & disguised costs so no future “drag” “Cookie-Jar Reserves” – income smoothing– “good time” over accruals and reserves used in “bad times”

20. 20 Earnings Management Tricks and Gimmicks “Materiality"– Intentionally recording errors within ceiling – “too small to matter” Revenue recognition – Accelerated, premature before delivery and with contingencies Consignment Channel stuffing Round-trips, swaps & barters to gross up sales Bill and hold Related party

21. 21 Other Tricks & Gimmicks Earnings management - manipulation and outright fraud Discretionarypolicies & estimates– capitalization, amortization, deferred expenses, inventory, judgments - bad debts, contingencies Liability deception – Off-books complex schemes & webs, special purpose entities

22. 22 Other Tricks & Gimmicks Related party loan guarantees, obligations, synthetic leases Extreme tax avoidance (evasion ?), off-shore havens, questionable legal/tax interpretations Blatant misstatements–disguised transactions and misclassifications- capitalized repair and maintenance

23. 23 Self-Dealing – Questionable and Unauthorized Disguised executive compensation “Evergreen” stock options Excessive perks & misused funds Undisclosed related party transactions and self-dealing – personal “piggy-bank”

24. 24 Earnings Management Environment Overbearing CEO with substantial ego Few independent directors Inadequate board committee structure Excess executive compensation and perks Poor control structure and culture – “tone at the top”

25. 25 DECEPTION– LIABILITIES Special purpose entities Off-books complex schemes and webs - nonconsolidated debt Related party loan guarantees, contractual obligations, synthetic leases

26. 26 Aggressive Tax Shelters Off-shore tax havens, shelter deals, questionable legal/tax accounting interpretations Complex series of loans, extreme tax avoidance and possible evasion

27. 27 Questionable, Unauthorized Funds Disguised executive compensation “Evergreen” stock options Undisclosed related party transactions/self-dealing Inadequate, ineffective corporate governance

28. 28 Earnings Restatements Previously rare, increasingly common Highly suspect manipulation & deception Over 900 restatements 1999-mid-2003 (GAO) Nearly 1,000 recent restatements Predominantly revenue recognition 20% of 2001 SEC enforcements accounting related, increasing in 2002 - 2004 Market reaction: Significant stock price declines

29. 29 ENRON Largest bankruptcy 2001 7th largest corporation - $1.2 billion equity reduction in quarter Manipulation and deception -- special purpose entities Congressional hearings, revolutionary changes -- regulatory, governance, scrutiny

30. 30 Enron Extreme use SPEs for blatant manipulation Initial use to grow company, managing risk More complex SPEs to record future services as current income using “mark-to-market” Extensive conflicts of interest & related-party transactions

31. 31 Enron (Cont’d) Gas trading to electricity, risk management, telecom, and expanding internationally Based on economic-based assessments, many ventures were failures Based on manipulations and deception, all were successful

32. 32 Enron (Cont’d) Energy trading: spot market purchases volatility drove demand for risk management and related derivatives Massive debt and potential junk bond ratings Used special purpose entities to reduce perception of too much debt

33. 33 Enron (Cont’d) Focused on meeting quarterly earnings Initially cost savings, but increasingly more gimmicks Scheme 1: Revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front-loading profits Scheme 2: Complex and mishandled SPEs to record earnings

34. 34 Enron(Cont’d) CFO manipulated for own enrichment - independence problem Questionable SPEs approved by attorneys, auditor/Andersen and board Accommodated by investment banks and no apparent SEC oversight

35. 35 Enron(Cont’d) Some operations major blunders Dramatic increased risk but unwillingness to disclose losses Stock price dropped, executives bailed out of stock, ratings to junk Restatements in 2001and subsequent bankruptcy Largest ever bankruptcy until …

36. 36 WorldCom Growth through mergers & acquisitions $100+ billion assets (with half intangibles) Debt to equity of 79.3% $11 billion + capitalized operating expenses

37. 37 WorldCom(Cont’d) WorldCom restated earnings Andersen fired CFO and CEO fired WorldCom bankruptcy 2002 Replaced Enron as largest bankruptcy in US history,

38. 38 Tyco Conglomerate through acquisitions “Deal a Day Dennis” Kozlowski acquired 750 companies Merger magic CIT acquisition fiasco showed Tyco’s shenanigans

39. 39 Tyco(Cont’d) CIT $9.4 billion loss for 2002 Kozlowski indicted for evading taxes & “raiding” Tyco Obvious manipulation & deception Not clear criminal acts

40. 40 Adelphia Fifth cable & communications Restatements - billions off-balance-sheet “co-borrowing agreements” Rigas family fraud and significant self-dealing Bankruptcy 2002

41. 41 What do Enron, WorldCom, Tyco, Adelphia have in common? Massive deception, manipulation, self-dealing Growth through acquisitions Acquisition accounting abuse Targeted earnings focused Enrichment of senior executives Accommodating auditors & boards of directors Restated financials

42. 42 What Happened at Andersen? Long-time reputation for integrity and professionalism “Aggressive auditing” beginning in ‘80s Clients too valuable to defy (Toffler) Major client scandals: Sunbeam, Global Crossing, Waste Management, Enron, WorldCom & Guilty of obstruction of justice

43. 43 Governance Red Flags CEO also board chairman Executive ego and dominance Permissive governance structure - manipulation more likely Lax board committees - audit, compensation, nominating and governance

44. 44 Corporate Governance Majority independent board members – fraud less likely Board and executive compensation —performance based Conservative accounting Transparent reporting – full and understandable

45. 45 Corporate Governance Board oversight and “tone at the top” Independent directors fact and appearance Competent & vigilant – not asleep at wheel Audit committee focus – audit, expertise, SEC investigations & past restatements Compensation committee oversight, executive compensation, insider trading Investment banking relationships

46. 46 Legislative Reaction: SOX Strengthened governance -- independent directors, mandatory committees Independent audit committee members and “financial expert” Internal control attestation CEO and CFO certifications Tougher penalties

47. 47 Legislative Reaction: SOX (Cont’d) Established PCAOB A new regulatory structure for accounting firms Tighter corporate controls New disclosure requirements New record retention requirements

48. 48 Corporate Transgressions and Financial Gimmickry Jim Davidson, CFE, CPA, CFS Certified Corporate Director

49. 49 QUESTIONS?