“Can Large Companies Be Trusted?: The Impact of Recent Financial Scandals in Corporate America”
ACKNOWLEDGEMENTS
I want to thank my family, colleagues and friends for their help, knowledge and experience while completing this writing.
I want to especially thank my husband Joe for his support, patience and encouragement through this final paper project for whenever I needed advice and input.
Lastly, I thank and appreciate my supervisor and friend who pushed me to study and make my dream of graduating college a reality.
Abstract of Final Project
“Can Large Companies Be Trusted?: The Impact of Recent Financial Scandals in Corporate America”
Statement of Observation
Business Ethics have changed over the last few years. While researching “Corporate Scandals” I could have gathered enough information over the internet to document this paper without ever leaving my chair. Even at this moment somewhere in the world a large company is being indicted for some kind of fraud stemming from misappropriated money management. It is hard to believe top management is now being held responsible after conning the American public out of trillions of dollars based on phony earning reports.
No longer are the days when we trusted our hard earned money to large corporation to invest and manage, it is time to return the ethical accounting standard which would mean reporting only real earnings. While still keeping the investors tempted by rising stocks prices and wide profits margins.
The never ending questions “what is the purpose of a company” proves to be more complex then it would seem at first glance. Due to recent scandals and increased uncertainty our first thoughts are “will we make a profit”. Investors now are cautious since all the publicity surrounding the scandals and how trusted companies have become cultured by greed and dishonesty. The message is clear: dollars are money; money symbolizes capitalism; capitalism is now immoral.
Aside from putting blame on third party auditors and by misleading the American people into a false sense of financial security; instead of laws and regulations we need people who knowingly commit this type of injustice to take responsibility. To be responsible means standing by your business’s practices without distorting figures and data to hide the company’s weak spots. Fraud and theft are illegal, the corporate executive who have violated their fiduciary duties are distorting the law and therefore should be punished. In order to prevent the future scandals we need a culture of responsibility rather than a system of regulations.
“Can Large Companies be Trusted?: The Impact of Recent
Financial Scandal in Corporate America”
Introduction
Over the past three decades accounting professionals have found themselves being pushed in many directions to change old business practices. The accounting industry has always shown its weakness, as early back as the 1970’s a prominent accountant was linked to the Watergate scandal which began on July 17, 1972 when burglars were caught in the act trying to remove bugs and photographing documents. In all, forty government officials were indicted with President Nixon who then resigned. In the 1980’s the scandal was the Savings and Loan Crisis which blossomed as the Bank of Credit and Commerce International (BCCI) came into focus. The story was important not because lots of people stole billions of dollars, but because they got away with it right under the noses of the authorities and none of the watchdogs agencies barked. In the 1990’s the reliability of audited financial statement began to decline because investors did not care about the bottom-line, all investors wanted were the potent to make profits which starting the out of control earnings game. In the same timeframe (1990’s) the big accounting firms also paid out millions of dollars in fines to the government for penalties prompted by failed business endeavors. The question now raised is “how did things get so out of hand” Some critics argue that this awakening so to speak is long overdue because the problem just does not lie with a few dishonest executive, simply put it takes a crisis to allow substantial change to bring back relevance into financial reporting.
The accounting function is a signal to potential buyers and the capacity of an organization is no longer revealed only in its financial statement. Today intellectual capital represents another key to value, investors demand more information than the traditional statement provides making reporting by traditional rules out dated. This problem affects all industries, this is the best opportunity to change the outdates rules and finally address the core of the future of financial reporting by issued guide lines to make it hard for companies to understate their assets and liabilities.
Since we were again awaken by the sudden realization of corporate piracy, the President and all Americans stood up and took notice. On March 7, 2002 the President took decisive action in combating corporate fraud and outlined a ten point plan to punish corporate wrongdoers. The ten point plan was instituted to protect America’s shareholders based on three core principals: Accurate information, Management accountability and Auditor independence (complete ten point plan see appendix 2).
Corporate Ethics is considered as the bulwark of a stable economic activity: public trust and specifically, shareholder and stakeholders trust rests on the assumption that accountants, auditors and business executives particularly in the upper echelon, practice corporate ethics. As such, the violation of that tenet extends not only on the financial and ethical aspect of the company and its officials but on the overall economic activity that takes place.
The United States has been considered as the legion of corporate principles and ethics. Its huge economy is propelled by the public trust to invest and be secured that their money will be in good hands. However, with the advent of successive financial scandal among large companies that started in the 1980s and reached its peak in the height of the Enron Scandal and further extended with the scandal of WorldCom, Global Crossing, Qwest Communications International, and several other companies (a complete chart, see Appendix 1).
Business schools, researchers, the government and the American public all pose the same question on how and why the financial scandal happened. This paper shall tackle the nature of large companies in the United States in lieu with the accounting and financial principles, the theories that seek to explain the financial scandal, the accounting and the corporate management practices of the large firms involved in fraudulent financial activities and the impact of such practices in corporate America.
Chapter 1
The Drive for Success: The nature of American Corporations
The theory of corporate control is based on the proposition that where agents have specific human capital investments in the firm, their firm-specific wealth is threatened by a hostile acquisition of the firm which may bring in a new management team (McCahery, Picciotto, and Scott, 1993). The threat of take-over is itself sufficient to induce managers to co-ordinate their strategic actions to meet the interests of the residual risk-bearers. However, the empirical evidence on the market for corporate control is contradictory, and contains many ambiguities. In the first place, it has concentrated on the issue of whether the threat of hostile take-over reduces the non-value-maximizing actions of agents: but post-merger studies in the UK and USA show only slight differences in profitability between companies that became takeover victims and those that did not (McCahery, Picciotto, and Scott, 1993). There has been much less attention given to the extent to which take-overs provide an avenue for managers to maximize self-interest by value-reducing defensive strategies, such as ‘poison pills’ and other forms of dilution of capital (McCahery, Picciotto, and Scott, 1993).
The consolidation of the giant firm in the 1920s, and the survival and recovery of such firms following the crash and great depression, were the basis for the development of managerialist theories (Chandler 1962). The dispersion of share ownership and legal changes introduced the flexibility necessary for management to organize large, multi-divisional companies, subject to minimal constraints on managerial behaviour (McCahery, Picciotto, and Scott, 1993). Managerialist theories emphasized the logic of size in terms of scale economies, and focused on the rationality of corporate decision making in hierarchical bureaucracies. Critics argued that the lack of accountability of management undermined efficacy and rationality, but they did not challenge the managerialist consensus (McCahery, Picciotto, and Scott, 1993). The managerialist theories were at their pinnacle in the post-war period of growth and relative stability, and it was perhaps not surprising that, with the transition to greater volatility in the financial markets in the 1980s, contract-based theories should come to the fore.
McCahery, Picciotto, and Scott (1993) collected a volume of a first sustained attempt to transcend the new institutionalist and contractarian visions, which, during the 1980s, became the mainstream perspectives in academic and policy-oriented discussions of the corporation. However, as the excesses of the market for corporate control reached their peak at the close of the 1980s and attention shifted to regulatory failures and the need for enhanced corporate accountability, the limits of the existing theoretical approaches became apparent. Based on a simplistic dualism of the firm and the market, and failing to draw on the richness of contemporary social theory, the predominant law and economics approaches are in many respects inadequate, especially to tackle the 1990s agenda (McCahery, Picciotto, and Scott, 1993).
First, there is an awareness of the greater variety of patterns of economic and social relationships institutionalized in the corporate form (McCahery, Picciotto, and Scott, 1993). Secondly, financial markets entered a new era, often referred to as the Big Bang, in which the increased velocity, complexity, and volatility of the markets disrupted existing forms of regulation and broke down barriers separating professional groups, while increasing competition for professional services (McCahery, Picciotto, and Scott, 1993).
Finally, and perhaps most importantly, a new phase of globalization has created greater awareness of contrasts between national patterns of financing and managing business activities, as well as styles of regulation (McCahery, Picciotto, and Scott, 1993). The dismantling of non-tariff protective walls has not only created new competition between firms in industries (especially in services and utilities) previously substantially shielded from world markets; it has also called into question the adequacy of existing business regulations that would manage the financial statements and portfolio of large companies.
The managerialist theories had already emphasized the asymmetries of information due to diffusion of share ownership and managers’ expertise and superior access to information, especially about the firm’s assets (McCahery, Picciotto, and Scott, 1993).
Conversely, there has been a process of more overt politicization of the fields of corporate regulation: for example, in both Europe and the USA the tensions between the political and regulatory criteria in decisions on mergers and take-overs are increasingly evident. A politics of corporate regulation can be seen to be emerging, which purely economic approaches cannot easily comprehend. In particular, important aspects of cultural differentiation are often neglected, especially in economic accounts.
There is no definitive link between good boardroom behavior and good financial performance. And it is difficult for regulators and shareholders to convince some companies to invest the time and money needed to improve their corporate governance. Lack of oversight and strategic planning by board members might not cause disasters, but it certainly creates a circumstance where disasters are more likely to take place (Maguire, 2002).
Corporate Governance: Watching Poorly Performing Companies.
Julian Franks, Colin Mayer, And Luc Renneboog ( October 2001) suggest that poor performing companies can be disciplined by five primary constituencies: existing holders of large share block, new acquirers of large stock blocks, take over bidders, outside directors, and investors and creditors during periods of financial distress. They analyze the importance of each of these constituencies over broad sampling of companies in the United States and the United Kingdom.
The financial markets reward successful run businesses in many ways, minimal research into how these capital markets discipline poor performers has been done. The authors examined the influences that outside stake brokers have on changing senior management of these financial laggards.
The research focuses on randomly selected, publicly traded companies listed on the London Stock Exchange from the period of 1988-1993. All the companies had data describing financial performance, personnel changes, stock ownership, directors and senior personnel changes. The authors analyzed and sorted through relative importance of ways for outsiders to influences the replacement of senor management.
The authors suggest five ways for outside stakeholders to disrupt senior management structure of poor financial performers:
- Shareholders may intervene directly and replace management when performance is poor even though results of actual disciplinary influence of large shareholders to be negligible caused by the fact that the main sources or large shareholders control is insiders, who tend to protect rather that discipline management.
- Pressure on Management transitions may result from purchase of large blocks of shares by outsiders. US studies show large block purchasers can help discipline poorly performing management; this type of influence does not appear in the UK.
- Corporate takeovers may discipline management of acquired companies; the authors’ support this hypothesis.
- Outside directors may attempt to represent shareholders and change managements when companies under perform. The authors’ explain that this type of influence is improbable in the UK because directors’ do not perform the disciplinary function. Instead, directors’ roles have traditionally been more advisory.
- Finally, struggling companies need for cash may lead to creditor or shareholder intervention if the company’s capital structure changes through the issuance of new debt or equity.
The authors’ analysis of UK companies shows that capital structure does matter. High leverage and low interest coverage are known to be associated with pressure for greater board turnover. The authors’ suggest that poor performers in the US are most likely to be disciplined by fiduciary directors and outside accumulators of large share blocks than are poor performers in the UK. In contrast, poor performers in the UK may be more apt to be disciplined by the requirements with secondary equity offerings than are poor performers in the US.
Ethical Analysis: A Professional Responsibility
Missing in most discussions of ethics is the fact that, by definition, ethics is the part of philosophy that deals with the practical application of those actions over which we have control. Professionals are expected to maintain “high standards of achievement and conduct. Therefore, ethics is very much an appropriate philosophical mode of analysis and is integral to the definition of a profession. While ethical decisions may appear to be strictly subjective, they are made in the context of personal as well as professional lives. Individual ethical conduct must be carried out in conjunction with other individuals as well as within the context of the organization. The individual dealing with a personal ethical response to a given situation does so within an organizational structure which itself has defined certain responses as ethical or unethical. When significant differences exist between the ethical beliefs of the individual and that of the organization, conflicts arise. The same is true when differences exist between the company and the societal context in which the company operates.
Whether a company chooses to address the importance of ethics in decision making in a formal manner (e.g., through the promulgation of a code of ethics) or otherwise, it is inevitable that the decision made is evaluated by all stakeholders and not just the stockholders. The stakeholders are all individuals or groups involved with the company, both internally and externally, who are affected by its decisions. The financial press is full of examples that indicate the impact that unethical decisions can have on a company and its relationship to the stakeholders who are part of the corporate culture.
These responses point to two critical factors that must be addressed by a company serious about incorporating ethics into its decision making process: the short-term versus the long-term view of what is good business, and the need to evaluate the ethical implications of a decision as part of the decision making process, rather than as a reaction to a third party’s criticism of the decision. Accordingly, to ensure its importance, ethical analysis must be institutionalized as an integral input into all phases of the decision making process.
The Flaw in the US Financial System
The fall-out from the ENRON scandal pointed to a number of apparent weaknesses in the US system of oversight, based on checks and balances, which appear to have allowed certain types of abuses to the detriment of investors, creditors, employees. In general the market has proved itself to be vulnerable to fraud and unable to ensure an adequate level of security. Several weak points may be identified (The Integrity of Financial Markets, 2002):
- Accounting Rules: the FASB rule n. 140 allowed Special Purpose Entities (SPEs) (see footnote 1) not to be included within the consolidated balance sheet, subject to meeting mechanical conditions that do not necessarily reflect economic substance. ENRON’s management made an extensive use of SPEs to hide losses from the company’s accounts. Interestingly enough, it was the failure to meet these specific requirements (e.g., a 3% ownership by independent parties) which led to the unraveling of the abuses. The marking to market system normally applies to the evaluation of contracts of goods and financial instruments according to the fair value principle, e.g. the price that would be paid in the current market in transaction between willing parties. The management misapplied it also to the company’s contracts of services and products, with an intentionally overly optimistic evaluation of (hypothetical) profits;
- Abuse of Stock options Incentive System: a massive use of stock options (which under US accounting rules are not required to be accounted for on the balance sheets as ‘costs’) led the management to inflate the (hypothetical) profits supporting the value of their shares on the market;
- Statutory Audit and Corporate Governance: interests or inattention of ‘independent’ directors, internal auditing committees and managers appear to have converged in a way that undermined their respective control functions, to the detriment of the company’s shareholders and other stakeholders;
- Independence of External Auditors and Supervision of the Accounting Industry: external accountants, responsible for auditing the company, were acting under an apparent conflict of interest when providing the same audited company, much more profitable consultancy services that might jeopardize their independence. Moreover, US rules provided no rotation amongst accounting companies, given the practical difficulties and inefficiencies of rotating the auditors of large multinational operations. Supervision of the accounting sector also suffered from a lack of independence, with auditing companies being scrutinized on a peer review basis and the body in charge of supervision being an ad hoc board; Intermediaries, Financial Analysts, Rating Agencies: certain commercial banks and investment banks appear to have had their incentive to be vigilant upon credits, loans, or investments weakened by a desire to obtain more lucrative advisory fees from the same company (issues and placement of securities, trading, M&A, etc.). Financial analysts and rating agencies appeared not to have been immune to the myth of the success of the company, with their objectivity or research suffering as a result The feeling of mistrust and diffidence that investors expressed in the markets following the last months’ accounting scandals, prompted a strong intervention by US legislators: On July 30, 2002 the President signed the Sarbanes-Oxley Act , (the ‘Public Company Accounting Reform and Investor Protection Act of 2002′ ), promoted by Senators Sarbanes and Oxley which gave an important new tool to prosecutors to improve corporate responsibly and aid in the reform for the future of corporate business and to instill renewed trust in the American people that mismanaged accounting practices will not be tolerated in the future.
Since the beginning of the Administration, the Department of Justice has investigated more than 400 matters involving possible corporation fraud for falsification of financial information or obstruction of justice relating to destruction or fabrication of evidence. More than 150 defendants have already been charged with civil/and or criminal wrongdoing.
Hoping to restore investors’ confidence in American corporations President Bush and his newly former task force has placed a clear message to CEO’s that if you think you can fudge your books in order to make your company appear in better financial standing, were going to find you, we’re going to arrest you, and we’re going to hold you accountable. On the evening of the signing, investors demonstrated that the law is what the stock market needed. The Dow Jones Industrial average closed up 447.49 points, a 5.4 percent gain and the NASDAQ was also up 5.8 percent.
With renewed morals in place the focus is now, managing your business and not just the numbers. A business that is well managed will have good numbers that follow. In this new environment the market is clearly going to reward companies that are both reputable and honest. It is up to top management to ensure the most relevant account principals are being used to ensure the accuracy for financial reporting of the bottom line
The Ethical Issues among Accountants: The Architect of Financial Management
In the business community, the resolution of ethical conflicts does not easily lend itself to objective quantitative analysis. Managers frequently leave ethical discussions open to a number of interpretations, and subordinates are left to sort out the issues and forever wonder if they have done the right thing. (Cohen and Turner, 1990) There is little guidance in the form of specific rules or case studies as to how a particular ethical problem should be addressed. It is as if ethics in general terms must be left to philosophers and theologians.
A high ethical standard is presumed of the CPA in public practice. This is especially relevant now because the AICPA Code of Professional Conduct has recently been extended to include all CPAs, not just those in public accounting (Cohen and Turner, 1990). There are initiatives emanating from both the public and private sectors that address the concerns raised by companies, employees, and society at large about ethical standards. These serve as a backdrop to reinforce the CPA’s obligation to be armed with a consciously developed set of high ethical standards. In addition, examples of ethical dilemmas that confront the CPA in industry can be used to raise the consciousness of professional accountants involved in decision-making.
There is evidence from surveys of practitioners that accountants in the private sector might be under pressure to ensure that financial results meet expectations, both internal and external to the company. This raises a practical question about whether ethical behavior is at odds with the notion of maximizing reported profitability.
The belief in corporate social responsibility does not deny the importance of profits and financial viability to the company. Rather, it sees ethical decision making as an integral part of sound business decision-making and as having a positive effect on its long-term financial success. Support for this exists in the popular financial press. In a Fortune article ranking America’s most admired corporations, one of the eight criteria used for evaluation was a sense of responsibility to community and environment (Davenport, 1989). The well-known management analyst Peter Drucker goes further, encouraging a company to turn a social problem into an economic opportunity and benefit rather than viewing it as a cost to be absorbed (Drucker, 1987).
Just as companies adopt models for decision making in their approach to responsibility accounting or capital budgeting, it is imperative that they also provide a framework within which to evaluate the ethical implications of their decisions. This extends beyond the adoption of a corporate “code of ethics” to the implementation of a working model that can serve to provide guidance to employees in their every day handling of complex and ambiguous situations. Failure to adopt this working model can result in the creation of a “moral vacuum” that allows each of the employees to decide for themselves what will, or will not, constitute ethical behavior. While some have dismissed the entire process on the basis that ethics cannot be taught, others have decided that, at a minimum, it is critical to raise the ethical consciousness of those who work within the company (Cohen and Turner, 1990).
This process of consciousness raising can be accomplished from a number of perspectives. A corporate code of ethics is certainly a beginning, but it has been well documented that the code must become a living document that begins with the “tone at the top (Business Week, 1988).” Unless ethical questions are discussed before the situations arise, the response may not be well thought out but will represent an attempt based on different and possibly conflicting views of what constitutes the most appropriate response.
CPA Ethical Practices
If one accepts the tenet that a code of conduct directing ethical behavior is a critical part of the definition of a profession, then it is important that a mechanism exist for incorporating ethics into the decision making framework. While professional organizations and numerous companies have put emphasis on this process for years, there has been a renewed call on many fronts during the past decade. In part, this is a result of violations of ethical behavior in every aspect of society and, from a purely pragmatic point of view, actions to avoid excessive regulation and costly litigation. Three major initiatives affecting the CPA are emanating from professional accounting organizations, educational institutions, and the business community at large (Cohen and Turner, 1990).
The National Association of Accountants (NAA), the world’s largest organization of management accountants, has also been actively involved in promoting ethical behavior among accountants in the private sector. The NAA’s Standards of Ethical Conduct for Management Accountants has emphasized the obligation of management accountants to organizations they serve, their profession, the public, and themselves to maintain the highest standards of ethical conduct (National Association of Accountants. 1983). Since accountants produce and monitor financial reports both for internal and external use, it is imperative that their integrity be beyond reproach.
Despite these initiatives promulgated by the professional accounting organizations, Stephen Zeff (1987) in an article entitled “Does the CPA Belong to a Profession?” has raised two issues that may adversely affect the CPA’s professional status. The first issue he discusses is that diversified services draw firms into competition with other disciplines that have few or no professional/competitive restraints. He suggests that this may erode the professional judgment of the accountant. The CPAs in private practice face these same issues of competition and diversification that impinge on their ability to maintain an appropriate professional response to ethical questions.
Zeff (1987) also argues that ethical and judgmental problems may arise because of the increase in a rule-dominated practice. The problem of a rule-dominated practice is that it may lull us into a false sense of what is right and wrong by viewing decision making through a legal/illegal lens. Here the concern becomes one of form over substance with ethical decision making being replaced by legal decision making (Zeff, 1987).
Chapter 2
The Financial Scandal Among Large Companies
While recent accounting scandals have taken down highfliers like Houston-based Enron corp. and shaken investors, the news that there is something terribly wrong hidden in the financial statements of major companies comes as no surprise (Gray, 2002). More and more businesses are looking to forensic accountants to put that puzzle together long before they are exposed to financial losses that can stem from either fraud or accounting shenanigans (Gray, 2002). In the past, companies undertook a forensic audit when they had a suspicion that fraud had occurred, or needed experts in court to help quantify damages from a contract that had gone bad or some other business dispute. But now investors, venture capitalists and potential business partners are hiring forensic accountants to investigate a company before they enter a contract, contemplate a merger, or merely invest in the company’s stock (Gray, 2002).
Bankers can watch these scandals unfold and think that it could never happen to them. But when seemingly reputable businesses run afoul of legal and ethical rules, one of two things has happened (Barefoot, 2002): (1) Employees have broken the rules intentionally and; (2) They have broken the rules without realizing it. At Enron, the alleged wrong-doing occurred at the very top of the company–the CEO and other senior executives stand accused of it personally. At the heart of the Enron scandal is the allegation that the independent judgment of the firm’s outside accountants, lawyers, consultants, and board was compromised.
The fall of Enron presents speculative capital with a particularly vexing crisis; its history reflects in many ways the role and workings of speculative capital (Davis, 2003). Skilling’s success in the speculative side of Enron propelled him past the assets development group, which focused on old-style projects like building power plants, and in 1997 he became President and Chief Operating Officer of Enron (Davis, 2003). Although the process was never completed, Skilling pushed to shed Enron of its `hard assets’ in power plants and pipelines. Enron built a sophisticated speculation operation, EnronOnline, and then began branching out past energy trading, introducing trading in weather futures (Business Week, 2001). Enron dabbled with moving into water trading through its Azurix spin-off. It invested some .2 billion in building a fiber optic network with the intention of creating a market in data network capacity (at the same time, a dozen or more other companies were also rapidly laying new cable). In July 2000, it launched an online metals speculation operation; two months later, it also started an online speculation operation in wood products (Business Week, 2001).
As the stock started to slide, Enron executives began to unload stock; Skilling’s personal take was .5 million (Business Week, 2001). One lawsuit suggests that Enron executives made billion from stock sales before the company collapsed. After Skilling’s departure, the stock continued to fall to half of its value a year earlier, destroying the collateral Enron had used in its partnerships. In October, the company started lying off people and announced a quarterly loss after taking over billion in `charges’. By November, the company’s debt had been downgraded to junk status and stockholder lawsuits had begun. In December, following the collapse of merger talks with competitor Dynergy (after Enron revealed that it had additional, previously undisclosed, debt), the company filed for bankruptcy, the largest ever in US history. It later emerged that Enron paid over million in bonuses to 500 employee’s days before filing for bankruptcy. 4,000 employees lost their jobs and their retirement money tied up in Enron stock. State pension and endowment funds in twenty-one states lost a total of .5 billion. The collapse touched even more people through the hundreds of mutual funds that held Enron stock (Zuckermann, 2002).
It wasn’t long ago that bringing up accounting matters would produce bored, vacant expressions. That’s because the profession was widely viewed as dull, although trustworthy enough. Last year, a study prepared by financial services research firm Kroll Associates for the Canadian Institute of Chartered Accountants (CICA) found that CAs are “esteemed for their ethics” and that the business community rated CAs the most ethical among 10 professions (Mcclearn, 2002). “The quality of audited financial reporting is also rated highly,” it found. But suddenly, raise the word accounting and you could be confronted with cynicism, anger and tales of rogue accountants juicing stock prices and shredding documents with a zeal not seen since Watergate.
You needn’t look far for the reasons behind this abrupt attitude shift. Over the past two years, volumes of shareholder wealth evaporated as the audited financial statements of certain companies were revealed as creative fiction (Mcclearn, 2002). The most poignant example is the scandal surrounding Enron Corp.: the Houston-based energy trader overstated profits and hid debt from investors for years, its audit committee permitted obfuscation in public disclosures, and auditors at Arthur Andersen LLP (one of the world’s “Big Five” accounting firms, a group that also includes Ernst & Young LLP, PricewaterhouseCoopers LLP, Deloitte & Touche LLP and KPMG LLP) rubber-stamped Enron’s bogus financial statements (Mcclearn, 2002). After Enron’s malfeasance came to light, Andersen employees went so far as to destroy documents. The fact that Enron’s imaginative accounting went on for so long exposes an end-to-end failure of the system–and, predictably, the tab has been left with investors, creditors and employees.
The Impact of the Financial Scandal
Over the past two decades the economy has experienced a gradual erosion of ethical values on the part of corporate America (The International Economy. 2002). A raging bull market, either a byproduct or consequence of the moral decline, seduced investors and created the kinds of excesses that ultimately resulted in the bear market and severe investor backlash. The kind of hype and exaggeration that has always been present in bull markets becomes exacerbated by the leverage inherent in products such as derivatives and options. This gives greater velocity to the consequences of all investment decisions. The euphoria of the period persuaded analysts, brokers, and investors that all of their decisions made money and that their wisdom and insights would invariably lead to success (The International Economy. 2002).
Time for self-regulation has passed, and to restore public confidence the country need to have the kind of oversight promised by the Sarbanes-Oxley bill. The bill also does a number of other very important things by giving the SEC badly needed resources and providing independent funding to the Financial Accounting Standards Board (The International Economy. 2002).
All of these ethical breakdowns in the financial markets have raised a lot of arguments again that large corporations may have gone too far, with deregulation and that even though there were a lot of flaws in old laws like Glass-Steagall, there were also some important protections like prohibitions and firewalls (The International Economy. 2002). More and more countries realize that a strong securities law and a strong regulator are fundamental to the creation of a world-class market.
In the wake of apparently dishonest practices by Enron Corp. executives, and apparent negligence by members of its board of directors, many are asking how people believed to be so smart could have lacked the moral courage to seek and tell the truth (Berlau, 2002). As there is after every financial scandal, a call is being made for more courses in “business ethics” in the leading universities. This pervasive view among faculty that successful businesses are by their very nature corrupt is itself corrupting to students in business-ethics classes, says Stephen Hicks, chairman of the philosophy department at Rockford College in Rockford, Ill (Berlau, 2002). Hicks says business-ethics professors need to stress that business is a creative endeavor, like art or music, in which integrity must play a central role (Berlau, 2002).
The events of the past 10 months have certainly provided a lot of evidence about the U.S. economy’s enduring resilience and strength. Despite the worst terrorist attack on U.S. soil, fears that it could happen again soon, and a string of sordid corporate scandals that have undermined investor confidence and sent stocks into a nosedive, the economy is still growing at a healthy rate. As the latest accounting scandal struck the once-mighty WorldCom telecommunications empire – casting another dark cloud over Wall Street’s gloominess – there were also signs of economic vitality across much of the country (The Washington Times. 2002).
However, still there is sufficient evidence that the financial scandals that hit WorldCom, Enron, Global Crossings, Tyco International and Qwest Communications have shattered investor confidence (The Washington Times. 2002).
In most of these cases, the courts have yet to determine legal culpability. But public opinion, already convinced that something was terribly amiss, has mercilessly punished the businesses involved (Barefoot, 2002).
Nevertheless, since the initial Enron disclosure, we’ve seen a rising tide of unambiguous evidence that what many of us suspected throughout the Wall Street-driven economic boom is true: The whole thing always seemed uncomfortably like a Ponzi scheme (Reed, 2002).
Stock valuations surged wildly beyond firms’ profitability; even companies that never showed a profit at all became the market’s darlings in the orgy of speculation (Reed, 2002). Attractiveness for investors was driven as much by reports of cost-cutting and “downsizing”–at is, breaking unions, speeding up and lying off workers, and cutting full-time jobs and benefits–as by sales or production figures. Companies increasingly supplanted defined-benefit pension plans with defined-contribution plans, like the now notorious 401(k) plans, and supplanted–often pressured or coerced–workers to buy company stocks (Reed, 2002).
Pundits and hypesters roundly hailed the stock market as the real democratizing force in America and the world: Anyone, regardless of station, with proper diligence and effort could attain wealth, luxury, and independence. At the height of its exuberance this rhetoric sanctified day-trading as the zenith of human freedom, a kind of Ayn Rand utopia. In reality, it was really just a form of video poker that preyed on compulsive gamblers with more liquid assets (Reed, 2002).
The scandals of Enron, WorldCom, Global Crossing, Tyco, et al., have exposed a cesspool of fraud and corruption at the highest reaches of corporate power. Even prodigious corporate tool Tom DeLay now chirps about the need for more federal oversight (Reed, 2002).
The line between insider-trading and the acceptable use of contacts and intuition is very fine and porous. Similarly, large firms with multiple divisions operating semi-autonomously, often trading back and forth internally, can only be expected to record their transactions in the ways most favorable to enhancing the firm’s stock position. Accounting firms–even large, prestigious ones–know who their clients are and what those clients need or prefer. The bigger the account, the more the accounting firm will aim to please. And there are enough gray areas, with all the funny-money transactions that occur between divisions and subsidiaries, to hide or misrepresent revenues, expenses, profits, and losses almost at will.
The current exposures of corporate flimflams threaten a crisis of confidence in the market partly because the firms involved were so large, but partly also because the pool of those who were able to protect themselves is so tiny. That bracing fact is what has led to a revival of regulatory spirit within the corporate elite itself, though the converts’ zeal may not be very deep or genuine.
There are larger lessons to take from this corporate crisis, as well. First of all, capitalism is capitalism, and the tendency to produce this kind of crisis is endemic to it as an economic system. There’s no technical fix, no new technology or religion that can eliminate that tendency. The more complex and more extensive a capitalist economy becomes, the deeper and more devastating its periodic crises will be, particularly in the absence of efforts to equilibrate market forces in the interest of social stability and the common good (Reed, 2002).
Change is already underway. A few US companies, such as IBM Corp. and General Electric Co., have amended some accounting practices and increased disclosure in recent months to placate concern (Mcclearn, 2002). Brokerages such as Merrill Lynch & Co. are instructing analysts to look beyond the sunny financial pronouncements of management when researching companies (Mcclearn, 2002). Infosys Technologies in India trades stock in India and on the NASDAQ has hired well educated low cost talent to develop software for numerous U.S. clients. Infosys has one of the most extensive disclosure policies making its annual report detailed for both India and The United States. To further disclose their earnings Infosys takes into account intangibles such as brand names. Nandan Nilekani the CFO states ‘we think that in today’s economy, the intangible assets of a corporation are more valuable than land, building and cash” The 13,000 employees have created intellectual capital that clients recognize and pay a premium price for. Infosys also includes “Additional Information for Shareholders” to include:
Intangible assets score sheet
Human resources accounting statement
A statement of brand value
An economic value added or EVA statement
Although the company’s fiscal statement ran 208 pages Nilekani says “when in doubt we disclose”
In the past seven months, the Financial Accounting Standards Board has reviewed the rules regarding special- purpose entities such as lease accounting. The rules for lease accounting provide the ability to make sure no lease goes to the balance sheet. Companies today are using leasing options for copy machine to coffee machines and if companies don’t declare this expense there is too much space and room to speculate that something will or can go wrong.
During Congressional testimony chairman Robert H. Herz neglected to mention lease accounting which has not been overhauled since 1976. The uncertainty is beginning to have any impact, although an outright elimination of operating leases is unlikely. I think we can expect small changes to restrict the number of transaction that are considered operating leases. Mr. Michael Fleming president the Equipment Leasing association predicts “they’re going to raise the cost of capital” as a number of lessees have begun to request indemnities or guarantees which would allow them to unwind leases if the rules change.
Mr. Nader announced the formation of the Association for Integrity in Accounting (AIA). This public interest group will keep an eye on the Security and Exchange Commission (SEC) and other regulatory groups because the “industry dogs need watching themselves”. With increased pressure in corporate America Mr. Nader feels “it is very important that people feel they have someone on the outside supporting their decisions”.
The AIA is comprised of accountants and accounting professionals to stake out accounting issues presented before congress. The SEC writes “Mr. Nader encourages more fearless publication of what’s on the mind of accountants around the country”. The AIA is set to monitor the Public Company Accounting Oversight Board (PCAOB) which was created following the Enron collapse. Mr. Nader’s group has also turned up the heat on the FASB; and says “the FASB has fine pretensions, but it doesn’t deliver, it has allowed itself to be beaten up despite trying to do the right thing” at the time of my research FASB declined comment. With all the new agencies that have been created there will always be room for conflict of interest:
Generally accepted accounting principles, or GAAP, are the conventions, procedures and guidelines that govern how the accounting profession goes about its work. GAAP has been roundly criticized because it permits unscrupulous executives and accountants to use stock options, special purpose entities (such as the partnerships Enron used to mislead investors) and other instruments to distort their company’s financial performance, while technically staying within the letter of the law. CICA is already working to modify how special purpose entities, derivatives and other instruments are accounted for (Mcclearn, 2002). But some critics want rigid rules on everything from stock options to pension accounting.
In March, 2002 the OSC announced the results of a recent review of quarterly reporting. Of the interim reports of 150 issuers, it found problems with 77-and 17 were reified due to noncompliance (Mcclearn, 2002). In the US, the SEC decreed that companies could be sued for failing to explain in detail how they calculate pro forma or adjusted earnings.
SEC: Funded on an annual appropriation by congress makes them vulnerable to congressional pressure.
FASB: Is funded by the Financial Accounting Foundation.
FAF: Is financed by large clients of the big four and by the big four itself. When I think about this scenario the auditees are appointing the auditors can only lead to conflicts of interest.
One thing seems clear: reforms under consideration by the accounting profession are far less radical than those advocated by outside critics. The detritus of the Enron collapse, however, as well as other irregularities, may compel companies to reconsider its moderate approach.
Financial markets are not new to cyclic crises and economic contraction and expansion (and nor are they to fraud). But what has made the present situation so critical is its dimension (no longer national but global), and the fear that more than one ‘pillar’ of the system has been showing the signs of age and calls now for an urgent update.
Chapter 3
The Financial Scandal Among Large Companies
The Future of Financial Compensation
The quality of financial reporting is another issue that has cycled around again. The idea of quality financial reporting is often confused with the idea of quality earnings. Having quality financial reporting means not only having clearly stated principals that can be understood and applied in such a way that similar economic transactions are accounted for in a similar manner by all parties but also having financial statements that are transparent enough for the user to understand the economics behind it (Patricia A. McConnell). The recent issues that were cited as the under lying causes for the recent scandals are not new. The parallels between the situation now and back in the early 1970’s are different as the United States experienced an economic boom similar in the 1990’s that also led to numbers in excess. These earlier debacles involved such companies as National Student Marketing, Sterling Homex Corporation, U.S. Financial Corporation, Equity Funding Corporation of America, W.T. Grant Company and lastly the Penn Central Corporation. As a result a number if blue ribbon panels were formed to propose change to the structure of US accounting and auditing professionals.
In the past thirty years, the change from a principle-based system to a rule based system led to both improvements and complication in financial reporting. The quality and amount of information available to analysts were enhanced, but questions have emerged about issues related to earnings quality. Major unresolved problems included the treatment of special purpose entities, Synthetic leases, employee stock options, the form and content of financial statements, revenue recognition, and smoothing of earning volatility (Patricia A. McConnell).
Beyond these individual corporate fraud cases, there is the bigger picture of the economic framework within which chicanery has been conducted. The combination of the decade-long bull market, with its inflated values through executive stock option grants, and the apparent unwillingness of corporate boards to realistically value executive compensation, have produced soaring executive pay levels unequaled anywhere else on the globe(Stan Lomax April 2003).
In no other country is there such an earning spared the CEO and the rank-and file-employees. Consider the following: over the past ten years in the United States, compensation rates for the CEOs rose an average of 340 percent, compared to just 36 percent for rank-and file workers. And, the average annual pay for the CEO in 2000 was .1 million up from .8 million in 1992. (2) Were their Job performances really worth it (Stan Lomax April 2003)?
What measure to the bottom line have the compensation committees and their outside consultants been using for such escalations? Possible answer: the CEO almost always hand picks committee members and pay experts. Consequently, assistant “corporate chefs” have been adding a leavening agent to build up the executive-reward-pie dimension.
Executives often found a convenient vehicle to deliver this extraordinary value: the executive stock option. Indeed, the decade long bull market’s effect on even the poorest performing organization’s stock price opened the way to the tempting mechanism for executives to reap huge rewards that had little connection to their job performance.
In a down market, the spotlight always shines on CEO compensation, but will the scrutiny actually drive change this time-or is this yet another passing storm? (Jennifer Rheingold June 2003) The outrage was impossible to miss. “We are appalled and just disgusted” said John Ward, president of the Association of Professional Flight Attendants, at an April 17 press conference. “It’s equivalent of an obscene gesture from management.” Ward was referring to the discovery that while American Airline was asking its employees for a massive pay cut to avoid bankruptcy, it hadn’t disclosed that top executives were being paid up to twice their base salary in retention bonuses and having their own pensions put in a bankruptcy-protected trust. Chastened, Donald Carty, CEO of American’s parent company AMR, agreed to drop the bonuses, but the damage was done and he later was forces to resign.
Times are changing, there was a time when Carty and colleagues sat in their corner offices and could do no wrong, the recent litany of financial scandals have punctured CEO’s once-unassailable armor, changing their images from brilliant leaders and heroes to villains. A CNN/USA Today/Gallup poll taken in 2002 ranked CEOs of large corporation just above car dealers in trustworthiness, with 73 percent of respondents agreed that you “can’t be too careful with them.”
All of this mistrust means that the system by which executives are paid is coming under extreme scrutiny. Today shareholders, directors, journalists and legislators are focused on how much CEOs are paid and whether they deserve it. “The stock market bubble has burst, the economy is in recession, and there are a number of layoffs and restructuring,” say James Rodgers, CEO of Cincinnati energy company CINergy. “As a consequence, there is greater emphasis on the disparity in earning (between workers and executives). For CEOs, the pressure is greater than it’s ever been.”
The pressure may be greater, but what about the money itself? Despite a huge amount of publicly available information on the subject, it’s hard to find any consensus on whether pay is up, down or sideways overall. There are a wide variety of different methods by which annual compensation is measured, and each publication that issue, eager to stake out its own turf, jumps to a different conclusion. Says Judith Fischer, managing director of ECAS, a unit of Towers Perrin: “[The level of] executive compensation is in the eye of the beholder.”
On the individual level, there are certainly high-profile cases of abuse. The press happily hoisted executives such as Tenet Healthcare’s Jeffery Barbakow-who exercised stock options worth 1 million in a year when the company was being investigated for Medicare abuse-upon their own petards. Still other CEOs, such as Tyco’s Dennis Zozlowski and HealthSouth’s Richard Scrushy, cashed in consistency over the past few years- and then found themselves under criminal indictment (Jennifer Rheingold). This makes for ugly and embarrassing reading when thousands of jobs were lost. A study released last year by United for Fair Economy showed that CEOs involved in accounting of financial scandals had earned 70 percent more than CEOs of other companies between 1999 and 2001, while their companies last 73 percent of their value. “It’s not healthy if the world out there thinks that CEOs and top people are getting outrageous compensation compared to the workers”, say Corning Chairman and CEO James R. Houghton.
Whatever the perception, one thing is clear: There are Major changes afoot in the way executives are paid. “Compensation committees are going to be much more intense about reviewing pay-for-performance-based systems”, says Larry Hirsch, chairman and CEO of Centrex. There was another clear reason for options’ popularity: There were not counted on a company’s income statement as a compensation expense. Yet they did have a major cost. They diluted the value of existing shareholders shares, causing a hangover that has now made it impossible for some smaller companies to grant any new shares even if they wanted to (Jennifer Rheingold).
Less Pay, more pressure, bad press, higher penalties for messing up. Will some CEOs simply throw in the towel, creating a talent vacuum in the executive suite? No way says Dan Ryterband, managing director at pay consultancy Frederic W. Cook & Co. “That is such B.S.”, “I spent my whole life talking to CEOs and that is not what’s happening. Being the CEO of a major publicly-traded company is about a lot more than dollars and cents. It’s about power and the ability to impact things like society and their communities.” In my opinion only those value-creating honest executives will cash in at the end of the day.
Special Purpose Entities
Special purpose entities (SPEs) have acquired a bad reputation because they often result on off-balance sheet financing. I do no believe, however, that they are inherently evil (Patricia A. McConnell). An SPE is an entity, whether corporation, partnership, or trust, whose purpose is narrowly defined and set out in its corporate charter, partnership agreement, or trust documents. There are sound business and economics reasons for an organization to use an SPE to engage in a particular transaction, and the legal and economic benefits are not negated if the organization has to consolidate the SPE onto its balance sheet.
For example, an SPE is often used by a parent company to isolate an activity, asset, or operation from the bankruptcy of its core business. An SPE keeps the transferred assets or operations legally distanced from the original company. This allows the parent to borrow, using the assets as collateral, often at a much lower interest rate. An SPE also allows the risk of holding a particular asset to be diversified by directing its cash flows to investors with different risk tolerances. The FASB’s project on SPEs will require consolidation of only certain SPEs, with synthetic leases among those likely to be affected (Patricia A. McConnell).
Synthetic Leases
A synthetic lease is merely a type of operating lease. The primary difference between a synthetic lease and a traditional lease is that in a synthetic lease, the lessee reaps the tax benefits – the deduction for depreciation and interest- whereas in an ordinary operating lease, the tax benefits goes to the lessor. Operating leases are classic forms of off-balance-sheet financing, synthetic leases have never been hidden from analysts. Anyone paying attention has no reason to be concerned about companies’ potential consolidating synthetic leases into their financial statements (Patricia A McConnell).
Ten Point Plan adds Pressure in Europe
The financial scandals in the United States involving Enron and other companies shocked investors internationally. Hugh Williamson of the Financial Times reports that scandals in Germany itself arising from the Neuer Markt boom in the late 1990s also led to call for tighter rules, especially on the quality and reliability of corporate information to investors. In addition, the government is fulfilling requirements of European Union directive on market regulations. Hans Eichel, the financial minister, and his cabinet colleagues hope the ten-point plan launched in February will make Germany more attractive for financial investors, with new rules on issue ranging from corporate crime to full disclosure of executive pay. Tighter rules on the activities of auditors are also envisaged, including a more strict separation between companies’ auditing and consultancy activities (Hugh Williamson). Two related investments laws being prepared by Mr. Eichel’s ministry are aimed to end tax discrimination against foreign investment funds by extending Germany’s “half-taxation” approach – which exempts investors in domestic funds from half of their tax liability on dividends – to foreign funds.
Earlier this year, foreign funds managers had threatened legal action against Germany over what they saw as discrimination. The law will ease access to Germany for foreign funds by cutting taxes on investments in such funds. A code of conduct for credit rating agencies may also be included. German companies are less open on executive pay that others, arguing that openness creates completion and jealously. Only eight out of the thirty companies on the blue-chip Dax index now disclose their chief executives’ pay. The companies are: Altana, Bayer, Deutsche Bank, Deutsche Telekomm, SAP, Schering and ThyssenKrupp. “This is a good move towards transparency. Shareholders have a right to know what executives earn,” says Mr. Gerke.
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`The Enron way’, Business Week (12 February 2001.
Barefoot, JA. 2002. What can you learn from Enron? How to know if you are creating a climate of rule-breaking. ABA Banking Journal, Vol. 94, 2002
Berlau, J. 2002. Is big business ethically bankrupt? a boom in business-ethics courses is likely in the wake of the Enron scandal, but critics say these classes need to focus on moral rather than political, correctness. Insight on the News, Vol. 18, March 18.
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Davenport, Carol. “America’s Most Admired Corporations,” Fortune, January 30, 1989.
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Gray, J. 2002. Paper trails: They may lack the allure of sleuths like Sam Spade, but forensic accountants uncover crimes in company books. Canadian Business, Vol. 75, April 1.
Maguire, M. 2002. Business as usual: while news organizations have energetically uncovered corporate abuses and editorialized for reforms, their parent companies have been less than enthusiastic in applying the new standards to their own operations. American Journalism Review, Vol. 24, October.
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Mcclearn, M. 2002. Balancing act: Accountants are taking a lot of heat these days. What steps can they take to protect their reputation?
Magazine article by Matthew Mcclearn; Canadian Business, Vol. 75, April 1.
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The Integrity of Financial Markets Accounting Scandals and Corporate Governance. 2002. European Parliamentary Financial Services, 5 November.
The International Economy. 2002. The prophet: an exclusive TIE interview. Former SEC Chairman Arthur Levitt, who warned of potential U.S. accounting irregularities, surveys the post-scandal landscape. Vol. 16, Fall 2002.
The Washington Times. 2002. Restoring trust in the economy. July 1, 2002.
Williamson, Hugh – Financial Times ‘Ten point plan aims for greater Transparency and Stability. June 10, 2003
Zeff, Stephan A. “Does the CPA Belong to a Profession?,” Accounting Horizons, June, 1987.
Zuckerman, G. 2002. `The rise and fall of intangible assets leads to shorter company life spans: why high-fliers like telecom Winstar, built on big ideas, tumble so quickly’, Wall Street Journal (4 November 2002).
Appendix 1: THE Corporate Scandal Sheet
Company
When Scandal Went Public
Allegations
Investigating Agencies
Latest Developments
Company Comment
Adelphia Communications (otc: ADELA – news – people )
April 2002
Founding Rigas family collected .1 billion in off-balance-sheet loans backed by Adelphia; overstated results by inflating capital expenses and hiding debt.
SEC; Pennsylvania and New York federal grand juries
Three Rigas family members and two other ex-executives have been arrested for fraud. The company is suing the entire Rigas family for billion for breach of fiduciary duties, among other things.
Did not return repeated calls for comment.
AOL Time Warner (nyse: AOL – news – people )
July 2002
As the ad market faltered and AOL’s purchase of Time Warner loomed, AOL inflated sales by booking barter deals and ads it sold on behalf of others as revenue to keep its growth rate up and seal the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers.
SEC; DOJ
Fears about the inquiry intensified when the DOJ ordered the company to preserve its documents. AOL said it may have overstated revenue by million. New concerns are afoot that the company may take another goodwill write-down, after it took a billion charge in April.
No comment.
Arthur Andersen
November 2001
Shredding documents related to audit client Enron after the SEC launched an inquiry into Enron
SEC; DOJ
Andersen was convicted of obstruction of justice in June and will cease auditing public firms by Aug. 31. Andersen lost hundreds of clients and has seen massive employee defections.
Did not return repeated calls for comment.
Bristol-Myers Squibb (nyse: BMY – news – people )
July 2002
Inflated its 2001 revenue by .5 billion by “channel stuffing,” or forcing wholesalers to accept more inventory than they can sell to get it off the manufacturer’s books
SEC
Efforts to get inventory back to acceptable size will reduce earnings by 61 cents per share through 2003.
Bristol will continue to cooperate fully with the SEC. We believe that the accounting treatment of the domestic wholesaler inventory buildup has been completely appropriate.
CMS Energy (nyse: CMS – news – people )
May 2002
Executing “round-trip” trades to artificially boost energy trading volume
SEC; CFTC; Houston U.S. attorney’s office; U.S. Attorney’s Office for the Southern District of New York
Appointed Thomas J. Webb, a former Kellogg’s CFO, as its new chief financial officer, effective in August.
No comment.
Duke Energy (nyse: DUK – news – people )
July 2002
Engaged in 23 “round-trip” trades to boost trading volumes and revenue.
SEC; CFTC; Houston U.S. attorney’s office; Federal Energy Regulatory Commission
The company says an internal investigation concluded that its round-trip trades had “no material impact on current or prior” financial periods.
Although the effect [of these trades] on the company’s financial statements was immaterial, we consider improper trades in conflict with the company’s policies. To address this we have made changes to our organization, personnel and procedures.
Dynegy (nyse: DYN – news – people )
May 2002
Executing “round-trip” trades to artificially boost energy trading volume and cash flow
SEC; CFTC; Houston U.S. attorney’s office
Currently conducting a re-audit. Standard & Poor’s cut its credit rating to “junk,” and the company said it expects to fall as much as 0 million short of the billion in cash flow it originally projected for 2002.
Dynegy believes that it has not executed any simultaneous buy-and-sell trades for the purpose of artificially increasing its trading volume or revenue.
El Paso (nyse: EP – news – people )
May 2002
Executing “round-trip” trades to artificially boost energy trading volume
SEC; Houston U.S. attorney’s office
Oscar Wyatt, a major shareholder and renowned wildcatter, may be engineering a management shakeup.
There have been no allegations or accusations, only requests for information. The company has confirmed in multiple affidavits that it did not engage in “round-trip” trades to artificially inflate volume or revenue.
Enron (otc: ENRNQ – news – people )
October 2001
Boosted profits and hid debts totaling over billion by improperly using off-the-books partnerships; manipulated the Texas power market; bribed foreign governments to win contracts abroad; manipulated California energy market
DOJ; SEC; FERC; various congressional committees; Public Utility Commission of Texas
Ex-Enron executive Michael Kopper pled guilty to two felony charges; acting CEO Stephen Cooper said Enron may face 0 billion in claims and liabilities; company filed Chapter 11; its auditor Andersen was convicted of obstruction of justice for destroying Enron documents.
No comment.
Global Crossing (otc: GBLXQ – news – people )
February 2002
Engaged in network capacity “swaps” with other carriers to inflate revenue; shredded documents related to accounting practices
DOJ; SEC; various congressional committees
Company filed Chapter 11; Hutchison Telecommunications Limited and Singapore Technologies Telemedia will pay 0 million for a 61.5% majority interest in the firm when it emerges from bankruptcy; Congress is examining the role that company’s accounting firms played in its bankruptcy.
No comment.
Halliburton (nyse: HAL – news – people )
May 2002
Improperly booked 0 million in annual construction cost overruns before customers agreed to pay for them.
SEC
Legal watchdog group Judicial Watch filed an accounting fraud lawsuit against Halliburton and its former CEO, Vice President Dick Cheney, among others.
Halliburton follows the guidelines set by experts, including GAAP (generally accepted accounting principles).
Homestore.com (nasdaq: HOMS – news – people )
January 2002
Inflating sales by booking barter transactions as revenue.
SEC
The California State Teachers’ Retirement pension fund, which lost million on a Homestore investment, has filed suit against the company.
No comment.
Kmart (nyse: KM – news – people )
January 2002
Anonymous letters from people claiming to be Kmart employees allege that the company’s accounting practices intended to mislead investors about its financial health.
SEC; House Energy and Commerce Committee; U.S. Attorney for the Eastern District of Michigan
The company, which is in bankruptcy, said the “stewardship review” it promised to complete by Labor Day won’t be done until the end of the year.
Did not return repeated calls for comment.
Merck (nyse: MRK – news – people )
July 2002
Recorded .4 billion in consumer-to-pharmacy co-payments that Merck never collected.
None
The SEC approved Medco’s IPO registration, including its sales accounting. The company has since withdrawn the registration for the IPO, which was expected to raise billion.
Our accounting practices accurately reflect the results of Medco’s business and are in accordance with GAAP. Recognizing retail co-payments has no impact on Merck’s net income or earnings per share.
Mirant (nyse: MIR – news – people )
July 2002
The company said it may have overstated various assets and liabilities.
SEC
An internal review revealed errors that may have inflated revenue by .1 billion.
This is an informal inquiry, and we will cooperate fully with this request for information.
Nicor Energy, LLC, a joint venture between Nicor (nyse: GAS – news – people ) and Dynegy (nyse: DYN – news – people )
July 2002
Independent audit uncovered accounting problems that boosted revenue and underestimated expenses.
None
Nicor restated results to reflect proper accounting in the first half of this year.
Our focus now is to stabilize this venture and put some certainty to its financial results. The company is evaluating its continued involvement in this venture.
Peregrine Systems (nasdaq: PRGNE – news – people )
May 2002
Overstated 0 million in sales by improperly recognizing revenue from third-party resellers
SEC; various congressional committees
Said it will restate results dating back to 2000; slashed nearly 50% of its workforce to cut costs; is on its third auditor in three months and has yet to file its 2001 10-K and so, consequently, is in danger of being delisted from the Nasdaq.
We have been and will continue to cooperate with the SEC and the Congressional committee.
Qwest Communications International (nyse: Q – news – people )
February 2002
Inflated revenue using network capacity “swaps” and improper accounting for long-term deals.
DOJ; SEC; FBI; Denver U.S. attorney’s office
Qwest admitted that an internal review found that it incorrectly accounted for .16 billion in sales. It will restate results for 2000, 2001 and 2002. To raise funds, Qwest says it is selling its phone-directory unit for .05 billion.
We are continuing to cooperate fully with the investigations.
Reliant Energy (nyse: REI – news – people )
May 2002
Engaging in “round-trip” trades to boost trading volumes and revenue.
SEC; CFTC
Recently replaced Chief Financial Officer Steve Naeve with Mark M. Jacobs, a managing director of Goldman Sachs and a Reliant adviser.
We’re cooperating with the investigations.
Tyco (nyse: TYC – news – people )
May 2002
Ex-CEO L. Dennis Kozlowski indicted for tax evasion. SEC investigating whether the company was aware of his actions, possible improper use of company funds and related-party transactions, as well as improper merger accounting practices.
Manhattan district attorney; SEC
Said it will not certify its financial results until after an internal investigation is completed. The Bermuda-based company is not required to meet the SEC’s Aug. 14 deadline. Investors looking to unseat all board members who served under Kozlowski may launch a proxy fight to do so.
The company is conducting an internal investigation and we cannot comment on its specifics, but we will file an 8-K on the initial results around Sept. 15.
WorldCom (nasdaq: WCOEQ – news – people )
March 2002
Overstated cash flow by booking .8 billion in operating expenses as capital expenses; gave founder Bernard Ebbers 0 million in off-the-books loans.
DOJ; SEC; U.S. Attorney’s Office for the Southern District of New York; various congressional committees
The company stunned the Street when it found another .3 billion in improperly booked funds, which will bring its total restatement up to .2 billion, and that it may have to take a goodwill charge of billion. Former CFO Scott Sullivan and ex-controller David Myers have been arrested and criminally charged, while rumors of Bernie Ebbers’ impending indictment persist.
WorldCom is continuing to cooperate with all ongoing investigations.
Xerox (nyse: XRX – news – people )
June 2000
Falsifying financial results for five years, boosting income by .5 billion
SEC
Xerox agreed to pay a million and to restate its financials dating back to 1997.
We chose to settle with the SEC in April so we can put the matter behind us. We have restated our financials and certified our financials for the new SEC requirements.
SEC: Securities and Exchange Commission. CFTC: Commodity Futures Trading Commission. DOJ: U.S. Department of Justice
Appendix 2: The Ten-Point Plan
President’s Ten-Point Plan
1. Each investor should have quarterly access to the information needed to judge a firm’s financial performance, condition, and risks.
2. Each investor should have prompt access to critical information.
3. CEOs [chief executive officers] should personally vouch for the veracity, timeliness, and fairness of their companies’ public disclosures, including their financial statements.
4. CEOs or other officers should not be allowed to profit from erroneous financial statements.
5. CEOs or other officers who clearly abuse their power should lose their right to serve in any corporate leadership positions.
6. Corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain.
7. Investors should have complete confidence in the independence and integrity of companies’ auditors.
8. An independent regulatory board should ensure that the accounting profession is held to the highest ethical standards.
9. The authors of accounting standards must be responsive to the needs of investors.
10. Firms’ accounting systems should be compared with best practices, not simply against minimum standards.
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