Chapter 11 4370 Fletcher

How did Enron's president J. Skilling respond to those who questioned the veracity of the firm's reported earnings?

"Well thank you very much, we appreciate that... A******" (NOT TESTABLE)

According to security analysts, how did Enron make money?

"Wholesale services" - in reality analysts didn't know how they made money

Which accounting firm was Enron's auditor, and how did they respond to the firm's violation of basic accounting standards?

- According to GAAP, a stock sale cannot be recorded as equity until the issuing company receives cash - Arthur Anderson agreed to waive this requirement on the grounds this transaction was immaterial

What were some of the inconsistencies in Enron's financials spotted by McCullough Research?

- Enron's reported cash flow included California customer deposits that had to be repaid at a later date - net of this item, cash flow was negative

What two factors, identifiable from the financial statements, led Off Wall Street Consulting group to recommend a short sale of Enron in May 2001?

- The Mark-to-market on nontraded assets - related-party transactions with private partnerships

What was the reasoning behind Scrushy's overstatement of the impact of changes in Medicare reimbursement?

- The SEC complaint claimed Scrushy told investors on 8/27/02 that a change in Medicare reinbursements would cost HealthSouth $175MM annually - This was about a $150MM overstatement of the true impact

What reason did Merrill Lynch's analysts cite as their rationale for downgrading Parmalat to a SELL? What turned out to be the explanation for Parmalat's behavior?

- The company's frequent recourse to the bond market, while reporting high cash balances, threw into question its cash-generating ability. - They were also suspicious that it had a large amount of debt and cash that generated a lower interest rate, but was not paying off debt. (this was because the cash was fictitious).

Explain how Enron took liberties with mark-to-market accounting rules to inflate its earnings.

- Under GAAP, it is legitimate to include the profits of energy-related contracts and other derivatives that a company expects to earn over future periods for as long as 20 years - The potential for abuse arose when the quotes prices were only available for contracts that extended a few years out.

How did Scrushy capitalize on the prosecutor's decision not to seek a change in venue from Birmingham?

- admired as local boy who made good. Scrushy pushed this advantage by hosting a new television series on a Birmingham station. - was apart of black church ministry, 73% black population.

What classic and other dodges accounted for most of the $500 million of Enron's questionable accounting practices?

- it propped up its profits by failing to write off receivables that had little chance of being collected - it did not recognize losses when it sold assets that had declined in value - arm and leg braces bearing their logo were treated as inventory, even though the company would generate no revenue from handing them out free at its medical centers.

What are two crude examples of Enron's fraudulent activities?

1.Enron reportedly borrowed $500MM from a bank and bought treasury bills. A few days later, it sold the Treasury Bills and repaid the bank reporting the proceeds of the meaningless transaction as operating cash flow 2. They tried to impress visitors by pretending to be busy (Learn 1)

Which items in Parmalat's financial statements showed evidence of the fraud?

12/03: Unauthentic accounts of a $4.7B balance. BOGUS ACCOUNTS 6/04: a preliminary report revealed a net debt of $18B, almost $16B of which was not previously stated. Debt was stated as $2B, but actually $18Bb. Revenue was stated as $5.4B, but actually $4B. EBITDA was stated as $651M, but actually $121M

What role, if any, did insider trading have in the uncovering of HealthSouth's financial reporting fraud?

A large stock sale by Scrushy three months before that precipitous drop aroused the SEC's suspicions of insider trading. That trail ultimately led in the unexpected direction of financial reporting fraud. (NOT TESTABLE)

How does Beneish define manipulation of financial statements?

Actual fraud AND the management of earnings or disclosers within GAAP

When did skilled analysts identify some of the famous frauds?

After the schemes became unsustainable and the companies collapsed.

How far back did the Enron restatements announced in late 2001 go?

Covering reports beginning in 1997 (NOT TESTABLE)

Compare and contrast the answers given by truthful executives to those given by deceptive executives during conference calls made in connection with quarterly earnings releases.

Deceptive executives contain more references to general knowledge ("you know"), fewer non-extreme positive emotions ("solid/respectable"), and fewer references to SH value and creating value. Deceptive CEOs also make fewer references to themselves and more to impersonal third parties (the team, the company rather than I). They use more extreme positive emotions (fantastic) and less negative emotions, as well as fewer certainty and hesitation words. (NOT TESTABLE)

Contrast and compare Scrushy's statements in a 60 Minutes interview and in a congressional hearing.

During the congressional hearing he pleaded the 5th amendment but when asked on 60 minutes he denied any responsibility.

What was Enron's equivalent of saying: "trust me"?

Enron was telling you what they thought the answer was, but they didn't tell you how they got that answer

According to Beneish, what are the five factors whose presence increases the probability of earnings manipulation? Does the presence of any of these factors provide irrefutable evidence of accounting malfeasance?

Five factors: 1. Increasing days sales in receivables (DSO) 2. Deteriorating gross margins 3. Decreasing rates of depreciation 4. Decreasing asset quality (increase in ratio of noncurrent assets other than PPE to total assets) 5. Growing sales -These indicators are not irrefutable evidence of accounting malfeasance

Parmalat was founded in 1961; became internationally known by 1970; went public in the 1990s; and filed for bankruptcy in 2003. How long was Parmalat falsifying financial statements?

For at least a decade

What was the eventual outcome of Scrushy's legal problems?

Four months later, he was indicted on charges of bribing the former governor of Alabama to appoint him to the state board responsible for approving hospital construction. In addition, he faced a shareholder suit and SEC civil charges arising from the accounting fraud. He was eventually arrested.

What was behind HealthSouth success in its early years?

Generous Medicare reimbursement policy for physical rehabilitation of an aging population keen on sports and exercise

How did Scrushy react to the SEC charges?

He denied that he was involved in the fraud. Even after all five chief financial officers who worked under Scrushy during the company's history confessed to participating in the fraud, the defense team maintained that Scrushy was unaware of the financial statement manipulation. "I'm not an accountant,"

How did Scrushy's indictment in 2003 make history?

He was the first CEO accused of violating the Sarbanes-Oxley Act because he signed the Financial Statements

How did HealthSouth respond when auditors questioned some of the accounting entries related to the fraud?

HealthSouth executives reportedly created a phony document to validate the item.

What does Warren Buffett have to say about footnotes to financial statements?

If you cannot understand them management did that on purpose

Why should analysts keep track of senior management turnover?

It is a classic warning sign of financial misrepresentation.

What role did the Sarbox provision play in the HealthSouth fraud?

It stated CEOs and CFOs must attest to accuracy of financial statements which was a weapon for prosecutors against falsifiers, but HealthSouth's fraud dispelled any notion that the tough new law would end financial misreporting altogether.

HealthSouth was founded in 1984; its operating margins and profits took a hit in 1997; and was charged by the SEC in 2003. When did the falsification of financial statements begin?

It was started in 1986 shortly after going public. Warning sign is changing auditors from year to year (NOT TESTABLE).

What would have been the consequences of Enron's debt being downgraded to speculative grade?

It would cause it to issue tens of millions of common stock to cover the $3.3B bank line guaranteed driving down share prices through dilution. It could also cripple Enron's trading business by inducing other traders to stop doing business with Enron.

What was CEO Lay's response when questioned about Enron's complex transactions?

Lay responded that the questions were getting over his head

What elaborate financial engineering technique was disclosed in the footnotes of Parmalat's Brazilian unit? How did it affect shareholder's equity? How is this technique an example of hedging?

NOT TESTABLE

Arthur Andersen was forced out of the accounting business as a result of what actions as Enron's auditor?

Obstruction of justice conviction for shredding documents related to the Enron audit

What enabled Enron to make itself less debt-laden than it really was?

Off-balance-sheet entities (Special Purpose Entities) were used to keep debt off Enron's books based on accounting rules under which Enron could assert it did not exert control - these SPEs were put together by CFO Andrew Fastow as general partner and funded by various investment banks

Is the evidence of criminal misrepresentation obvious after the fact?

Often, yes

What actions did Enron's management take once it conceded that it was overly indebted?

On 11/19/01, Enron told its investors $9.15B in debt was due at the end of 2002 and only had 1.75B in cash and availability under its existing lines of credit lines: - Management tried to restructure the debt - arrange additional borrowings - obtain equity infusions - raise cash by selling overseas assets.

What other reasons existed for questioning whether HealthSouth's board was sufficiently independent?

Particularly troubling were directors' transactions with HealthSouth and Scrushy. One director earned $250M a year in consulting fees from the company, and another received a $5.6 million contract to install glass at a hospital constructed by HealthSouth. Another director bought a $395,000 resort property in conjunction with Scrushy. NOT TESTABLE MATERIAL

How did Enron raise the bar for financial statement analysts?

Rather than just taking liberties with accounting standard ratio analysis would reveal, they also kept many of the most important sourced of reported earnings off the balance sheet and intimidated anyone who complained about inadequate disclosure.

What event caused Enron's investors to become alarmed about the lack of clarity regarding the partnerships?

Shareholders saw conflict of interest in Fastow's dual role as a senior executive of Enron and a managing member of LJM Cayman, and worried about the vagueness of disclosures regarding LJM and related partnerships.

What disturbing statement did HealthSouth's internal auditor make? What was Ernst & Young's response?

She said she did not have full access to the company's books, but Ernst and Young responded by saying their accounting was legitimate. They took no action to not having full access

Did Parmalat actually engage in currency hedging?

Since Parmalat units engaged in currency hedges with related parties, the economic impact of such transaction does not truly constitute a hedge.

What are some of the limitations of financial statement analysis highlighted by Enron's success in sustaining its fraud over a long period?

The auditors failure to curb flagrant abuses of GAAP posed a huge obstacle to analystsb. The company did its best to make its financial reports unfathomablec. Analysts should be especially weary when a strong likelihood of financial manipulation, as indicated by tools such as the Benish model, coincides with nontransparent financial reporting.

In addition to the suspicious financial items, to what else should readers pay attention?

The behavior of senior managers as the validity of their stated profits is challenged.

Compare and contrast Enron's method of booking revenue with the method employed by a brokerage firm.

The company booked revenue from its derivatives contracts on the basis of gross value rather than net value. If a brokerage firm trades stock for a customer, it books as revenue either its commission or the spread between the bid and asked priced. Enron would book the full amount (i.e. 10K shares at $50, would book $500K), which is a thousand times what a brokerage firm would record.

What is a prepaid swap and how did Enron use it to disguise the magnitude of its debt burden?

These transactions required Enron's counterparties to make their payments upfront while Enron's payments were spread over a multiyear period

What did HealthSouth do to meet analysts' expectations?

They did it by stretching the truth. It was stated that they overstated earnings by 1.4 billion, and it was later raised to 2.5 billion.

What does the record indicate about analysts' ability to detect Enron's fraud?

They didn't recognize the depth of fraud and Enron successfully concealed the worst of its misdeeds until most of the investors' money had been lost

What was the most dismaying action of HealthSouth's auditor? Would the standard auditing practice have uncovered the fraud?

They failed to look at the large increases in cash balances, and yes it would have uncovered fraud.

How much advanced notice did investors have before Parmalat's collapse?

They had no warning until a month before the collapse. Furthermore, the company's debt carried an investment grade rating until nine days before the bankruptcy filing.

How did HealthSouth avoid detention of its financial fraud? How did this avoidance affect its Balance Sheet?

They made small adjustments over many different categories as opposed to large adjustments in a single category including inventory, intangible assets, and property, plant, and equipment (PP&E).

How did Enron address the difficulties resulting from not having market prices for long-dated contracts?

They stated that they tended to conservatively value the long-term contracts and there was not a concentration on gains and losses on the long-term contracts

Why couldn't shareholder and bondholders "vote with their feet" and close their positions in HealthSouth once the scandals came to light? How large were the losses?

Trading was suspended on March 19th, and when it resumed on March 21st, the convertable subordinated bonds closed at 20, down from earlier in the week. Stock went from 3.91 to .085

What hint about Enron's deceptive methods emerged as the company was attempting to save itself through sale to Dynegy?

When they asked if the can report profits earned in one subsidiary but not report losses at the other

When did the analysts proclaim that Enron's financial statements were unreliable? When did Enron file for bankruptcy?

a. A few days before Enron's collapse b. December 2, 2001 (NOT TESTABLE)

What was a major red flag of Parmalat's impending collapse? What was the CFO's response when challenged on this point?

a. A major red flag was Parmalat's voracious appetite for debt, despite claiming to have a huge cash balance. b. Chief Financial Officer Fausto Tonna consistently replied that the company was on the acquisition trail and that its liquid balances were earning good returns.

Outside the financial statements, where else can one find evidence of financial reporting manipulation? Is this method more accurate than a model based on discretionary accruals?

a. Conference calls by corporate senior executives in connection with quarterly earnings releases may give verbal cues of questionable reporting in the Q&A section b. They are more accurate than a model based on discretionary accruals.

What event in 1997 caused HealthSouth's operating margins and profits to plummet? How did Scrushy respond?

a. Congress cut back on Medicade reimbursements.b. Scrushy responded by slashing salaries and divesting unprofitable sidelines. When those measures failed to revive profits, he tightened operations, cutting average patient's stays from 21.5 to 17.5 days

On what date did Enron file for bankruptcy? When was Enron ranked among the 25 most admired companies in the world?

a. December 2, 2001 b. October 2000 (NOT TESTABLE)

What were some of the conventional tactics employed by Scrushy's defense?

a. He hoped to gain sympathy from the jurors, and he played the religion card by becoming a nondenominational preacher and giving guest sermons at local churches. He also attacked one government witness on his broadcast, accusing him of infidelity. His lawyers hammered at the light sentences meted out to HealthSouth executives who confessed and testified against Scrushy. Perhaps effective as well was the lead defense attorney's appearance in a necktie decorated with an image of rats eating cheese, echoing his description of a key prosecution witness's character.NOT TESTABLE MATERIAL

How did HealthSouth exaggerate its earnings? How did it affect its Balance Sheet?

a. It understated the gap between the cost of the treatment and the amount the insurance would cover. It allowed the company to set aside an unrealistically small amount in allowance for doubtful accounts.b. Each time the company overstated its net revenue and earnings in this way, it made a corresponding balance sheet adjustment, raising the value of an asset such as property, plant, and equipment.c. They would smooth their earnings

What were the danger signs that something was amiss in Parmalat's financial statements?

a. They had reported suspiciously high profitability. Their margin was reported at 12 percent when a Milan banker noted it should be at 6 to 7 percent. Also a lack of transparency in financial reports

What did prosecutors disclose in July 2003 that compounded Scrushy's legal problems?

they had uncovered evidence of tax fraud, obstruction of justice, witness intimidation, money laundering and public corruption