2.5 Worst Accounting Scandals

Waste Management

1998 Houston-based, publicly traded company. Reported 1.7 billion in fake earnings. The company allegedly falsely increased the depreciation time length for their property, plant, and equipment on the balance sheets. They didn't record expenses for decrease in value of landfills, capitalized a variety of expenses, a failed to establish sufficient liabilities for tax and other expenses. They got caught because a new CEO and management team went through the books. Settled a shareholder class-action suit for $457 million; SEC fined Arthur Andersen $7 million.

Enron

2001; a Houston-based commodities energy and service corporation. Shareholders lost $74 billion, thousands of employees and investors lost their retirement accounts, and many employees lost their jobs. They did it by keeping huge debts off the balance sheet. They were turned in by a whistle-blower (Sharron Watkins - high stock prices fueled suspicion). The old CEO Ken lay died before serving time and new CEO got 24 years in prison. The company filed for bankruptcy. Arthur Anderson was found guilty of fudging the company's accounts.

Tyco

2002; new jersey-based blue-chip swiss security systems company. CEO and CFO stole $150 million and inflated company income by $500 million. Siphoned money through unapproved loans and fraudulent stock sales. Money was smuggled out of the company disguised as executive bonuses or benefits. SEC and Manhattan DA investigations uncovered questionable accounting practices, including large loans made to CEO Kozlowski, there were then forgiven. Kozlowski and CFO Swartz were sentenced to 8-25 years in prison. A class-action lawsuit forced the company to pay $2.92 billion to investors.

Worldcom

2002; telecommunications company (now MCI, Inc.). Inflated assets by as much as $11 billion, leading to 30,00 lost jobs and $180 billion in losses for investors. Did this by underreported line costs by capitalizing rather than expensing, and inflated revenues with fake accounting entries. Got caught by the internal auditing department (uncovered $3.8 billion in fraud). CFO was fired, controller resigned, and the company filed for bankruptcy. The CEO was sentenced to 25 years for fraud, conspiracy and filing false documents with regulators.

Freddie Mac

2003; Federally backed mortgage-financing giant. $5 billion in earnings were misstated. They intentionally misstated and understated earnings and caught by an SEC investigation. $125 million and fines and the firing of Glenn (COO)

Healthsouth

2003; largest publicly traded health care company in the US. Earnings numbers were allegedly inflated $1.4 billion to meet stockholder expectations. CEO Richard Scrushy allegedly told underlings to make up numbers and transactions from 1996-2003. He got caught selling $75 million in stock a day before the company posted a huge loss, triggering SEC suspicion. Scrushy was acquitted of all 36 counts of accounting fraud, but convicted of bribing the governor of Alabama, leading to a 7-year prison sentence.

American Insurance Group

2005; multinational insurance corporation. Massive accounting fraud to the tune of $3.9 billion was alleged, along with bid-riggin and stock price manipulation. CEO Hank Greenberg allegedly had booked loans as revenue, steered clients to insurers with whom AIG had payoff agreements, and told traders to inflate stock prices. SEC regulator investigations caught them, possibly tipped off by a whistle-blower. Settled with the SEC for $10 million in 2003 and 1.64 billion in 2006, with a Louisiana pension fund for $115 million, and with 3 Ohio pension funds for $725 million. Greenberg was fired but faced no criminal charges

Bernie Madoff

2008; A wall street investment firm. Tricked investors out of $64.8 billion through the largest Ponzi scheme ever. Investors were paid returns out of their own money or that of other investors rather than profits. The CEO's sons reported him to the SEC and he was arrested the next day. 150 years in prison for CEO and $170 billion restitution.

Lehman Brothers

2008; global financial services firm. Hid over $50 billion in loans disguised as sales. Allegedly sold toxic assets to Cayman Island banks with the understanding that they would be bought back eventually. Created the impression they had $50 billion more cash and $50 billion less in toxic assets than it really did. They got caught when they went bankrupt. Forced into the largest bankruptcy in US history. SEC didn't prosecute due to lack of evidence.

Saytam

2009; Indian IT services and back-office accounting firm. Falsely boosted revenue by $1.5 billion. Founder/chairman Ramalinga Raju falsified revenues, margins, and cash balances to the tune of 50 billion rupees. He admitted the fraud in a letter to the company's board of directors. Raju and his brother charged with breach of trust, conspiracy, cheating and falsification of records. Released after the Central Bureau of Investigation failed to file charges on time

105% (Repo 105)

Accounting rules permit recording of a repo as a "sale" if the assets transferred had a value of at least this much of the cash received. Lehman used this to remove "high grade" assets from its books (high-risk mortgage-backed securities), and to record revenue rather than a liability. Lehman would then buy these assets back at the beginning of each quarter per the agreement with cash received from the "Sale" of other assets. The buybacks were hidden from the SEC and shareholders. Removing these assets and liabilities allowed Lehman to show lower leverage and have lower reserves. They began "selling" billions worth of assets to reduce the leverage shown on their BS. Reduced BS leverage, but significantly increased their actual leverage.

yes

Are auditors responsible for detecting material errors?

AS 2405

Audit standards of fraud and illegal acts: Illegal acts by clients

AS 2401

Audit standards of fraud and illegal acts: consideration of fraud in a financial statement audit

speculative assets

Enron hid these generating mark-to-market losses by selling the assets to the 3000 SPEs created. This guaranteed assets with Enron stock. Over $1 billion by 2002. Bought out some SPE investor's that wanted out through shell companies (with Enron stock) and had these shell companies get loans from banks to maintain the 3% outside interest

mark-to-market

Enron was able to get this accounting treatment for its assets - this is when you record assets at fair value (this is good when asset value is increasing but not good when decreasing). Losses were having an increasingly adverse effect on net income. Enron got caught trying to make themselves look more profitable than they were

David Duncan

Enron's chief auditor at Anderson. Accused of ordering the shredding of thousands of Enron-related documents in an effort to hide them from Securities and Exchange Commission investigators

fraud

If the auditor determines that a MATERIAL MISSTATEMENT is or may be the result of this, the auditor should: 1) attempt to obtain audit evidence to determine whether, in fact, this has occurred (if so, its effect) 2) consider the implications for other aspects of the audit 3) discuss the matter and the approach to further investigate an appropriate level of management that is at least one level above those involved in committing this and with senior management. 4) Suggest that the appropriate level of management consult with legal counsel 5) Consider withdrawing from the engagement

line costs

Manipulated in the Worldcom Scandal; paid outside service providers for carrying Worldcom customers on their lines. Most of lines were leased. High fees for unutilized leased networks. Costs should be expense (worldcom capitalized nearly $11 billion)

3% (SPE 3% Rule)

No consolidation of financial statements if at least this much of SPE total capital was owned independent from the company. (Enron)

repurchase agreements

These are a common form of short-term financing. These are agreements where one party transfers an asset to another party as collateral for a short-term borrowing of cash, while concurrently agreeing to repay the cash plus interest and take back the collateral at a specific time. Because it is really a financing arrangement, assets are left off books and a liability is recorded. Manipulated by Lehman brothers

Netting

Waste management used this to hide a one-time gain (like the sale of an asset) used to eliminate unrelated current expenses or accounting misstatements from past periods. This is not allowed by GAAP

special purpose entities (SPEs)

partnerships that could borrow from outside investors and not have to be consolidated on the company's financial statements. Ex: want to sell your receivables (an asset on your books) but you need short term financing (cash). You can sell receivables to get cash; create this to transfer receivables to that entity. Then, have other investors buy those assets. That entity is governed by a contract but essentially the only thing it will do is collect receivables and pay them to investors. In essence, this is a short-term loan that can be used in operations. This allows you to record assets without showing the liability on the books.

gas bank

this was Enron's CEO Jeff Skilling's plan; Enron created a future's market for gas-generated energy, also known as this. Bets could be made on the future movements in the price of gas-generated energy. With every trade, Enron took a cut for transaction costs. Using the internet to promote trading, Enron become the most successful player in the futures game; 90% of Enron's income came from trade

Friehling and Horowitz

who were the auditors for the Bernie Madoff scandal? This is a three person firm based out of NYC; not registered with PCAOB. Stated for 15 years in writing to AICPA that it does not perform audits. No peer review

no

are auditors responsible for communicating immaterial errors?

yes (one level above)

are auditors responsible for communicating immaterial fraud?

yes (one level above)

are auditors responsible for communicating immaterial illegal acts?

yes (audit committee)

are auditors responsible for communicating material errors?

yes (audit committee)

are auditors responsible for communicating material fraud?

yes (audit committee)

are auditors responsible for communicating material illegal acts?

no

are auditors responsible for detecting immaterial errors?

no

are auditors responsible for detecting immaterial fraud?

no

are auditors responsible for detecting immaterial illegal acts?

yes

are auditors responsible for detecting material fraud?

yes (direct effect)

are auditors responsible for detecting material illegal acts?