Accounting Updates Accounting Updates

Southern Gas Southern Gas Association Accounting & Financial Association Accounting & Financial

Executives Conference Executives Conference

April 28, 2003April 28, 2003

Robert E. (Bob) JensenRobert E. (Bob) JensenTrinity UniversityTrinity University

San Antonio, TX 78212San Antonio, TX 78212http://www.trinity.edu/rjensen/http://www.trinity.edu/rjensen/

Why so many financial statementWhy so many financial statement frauds all of a sudden?frauds all of a sudden?

Systemic Problems of Accounting That Cannot or Will Not Be Solved: http://www.trinity.edu/rjensen/FraudConclusion.htm

•Behavior of CPA Firms: http://www.trinity.edu/rjensen/fraud.htm

Greed on Wall Street: Rotten to the Core http://www.trinity.edu/rjensen/fraud.htm#Cleland

Washington DC Prostitutes: Representative Fernand St Germain (D-Rhode Island) $32 Billion for 30 Years Senator Phil Gramm (R-Texas) & Wife Wendy $400 billion and counting

http://www.trinity.edu/rjensen/fraud.htm#WarningSigns

Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Good economy was masking many problemsGood economy was masking many problems

Moral decay in society

Executive incentives

Wall Street expectations—rewards for short-term behavior

Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Failure of Corporate Audit Committees

Board of Directors Failures and Greed

Financial Analyst Conflict of Interests and Greed: Rotten at the Core

•Education Failures: Graduates of Greed Rather Than Professionalism

Good economy was Good economy was masking problemsmasking problems….….

With increasing stock prices, profits and wealth for everyone, no one worried about potential problems.

Detailed Complicated RulesDetailed Complicated Rules

With Loop Holes Big Enough To Drive A Truck Through

RulesDetailed

Nature of Accounting RulesNature of Accounting RulesAllows companies and auditors to be

extremely creative when not specifically prohibited by standards.

“rules-based” vs. “principles based” rhetorical nonsense

Loop Hole Examples Include:SPEs and other types of off- balance sheet financing

Pension accountingMerger reserves

Other accounting schemes.

Revenue recognition approaches,

When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…”

Unaccountable Unaccountable ContractsContracts

Expect New Amendments in SFAS 149

GAAP CRITICISM

Fosters Short-Term Earnings Manipulations

Does Not Show Value Creation

Executive IncentivesExecutive Incentives•Meeting Wall Street’s ExpectationsMeeting Wall Street’s Expectations•Performance is based on earnings & stock price

–Focus is on short-term (quarterly) performance only

–Stock prices are tied to meeting Wall Street’s earnings forecasts

Companies are heavily punished for not meeting forecasts

–Moral Hazard: Employee Stock OptionsDid you ever hear the name Lou Pai?

Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999.

Princeton University

GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... "

Jack Welch,Former General Electric Chairman

Stock Fell 13% With This Revelation

Enron’s CEO of Enron Broadband Services, Ken Rice, had a $33,000 customized Hellcat motorcycle in his office just for a distinctive decoration.

Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land.

Beat The Numbers

How To Play

Numbers Game

Aggressive AccountingAggressive Accounting

Earnings ManagementEarnings ManagementIncome SmoothingIncome Smoothing

Fraudulent Financial ReportingFraudulent Financial ReportingCreative Accounting PracticesCreative Accounting Practices

Rewards of Rewards of The GameThe Game

Share Price EffectShare Price Effect

Borrowing Cost EffectBorrowing Cost Effect

Bonus Plan EffectBonus Plan Effect

Political Cost EffectPolitical Cost Effect

•How to value a dot.com company:

Take the reported pro forma loss for the year

Multiply the result by negative 1 to make it positive

Multiply that number by at least 100If stock price is less than the result…Buy, If Not?

Buy it anyway

Incentives for F.S. FraudIncentives for F.S. Fraud

Incentives to commit financial statement fraud are very strong. Investors want decreased risk and high returns.Risk is reduced when variability of earnings is decreased.Rewards are increased when income continuously improves.

Which firm will have the higher stock price?

Firm A Firm B

Auditors—the CPAsAuditors—the CPAs• Failed to accept responsibility for fraud detection (SEC, Supreme

Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is?

•Tradition of sending puppies out to yap at the receivables

•A few auditors got too close to their clients

•Audit became a loss leader–Easier to sell lucrative consulting services from the inside–Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture

•Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting rich

In a separate case in late September, a judge's divorce ruling unsheathed guarded financial information about accounting firm Ernst & Young, which is a private partnership that does not file public financial reports.

In divorce papers for Ernst & Young chief executive officer Richard S. Bobrow, a 45-page judge's opinion revealed how much the CEO was paid and put a dollar value on the company for the first time, giving competitors a rare peek into the firm's finances.

Annual Salary $ 3 Million $25 million in salary $US29 million in partnership earnings over the next decade.

Pension worth $1 million a year for life and had access to a corporate jet owned by Ernst & Young and a New York apartment.

$ 24 million to Janet Bobrow

Jan Bobrow makes $ 10 an hour part-time at Central Church of the Nazarene in Lenexa, Kan.

Moral DecayMoral Decay•Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed:

–67% of CFOs said they had been asked by senior company executives to misrepresent corporate financial results–12% of CFOs admitted they had actually misrepresented financial results…55% said they had fought off requests to “cook the books”

•Honesty studies–1961: 12%–1986: 31%–2002: ???

How Much Stanford MBA Worth?

a. $500,000 dollars

b. $ 10 Million dollars

c. $ 100 Million dollars

d. $ 1 billion dollars

The market lopped a cool $1 billion off Veritas' (VRTS) market cap yesterday when its CFO resigned after

revealing he lied about his academic credentials. The fundamental picture

hasn't changed—unless the CFO's duplicity extended to the books.                            

Executives at Vetrias, storage management software maker, found that CEO’s claim to have earned an MBA from Stanford Business School was false.

Financial Statement Fraud Will Destroy Your Shareholder Value

Financial Statement FraudFinancial Statement Fraud

• Financial statement fraud causes a decrease in market value of stock of approximately 500 to 1,000 times the amount of the fraud.

$7 million fraud $2 billion drop in stock value

These Are Interesting TimesThese Are Interesting Times• Number and size of financial statement frauds are increasing

• Number and size of frauds against organizations are increasing

• Some recent frauds involve several people—as many as 20 or 30 (seems to indicate moral decay)

• Many investors have lost confidence in credibility of financial statements and corporate reports

• More interest in fraud than ever before—now a course on many college campuses—from 3 or 4 to over 50 college campuses

Current Executive Fraud-Current Executive Fraud-Related ProblemsRelated Problems

• Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc.

•Executive Loans and Corporate Looting: John Rigas (Adelphia), Dennis Kozlowski (Tyco--$170 million—the $15,000 umbrella stand)IPO Favoritism: Bernie Ebbers ($11 million)•CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM (Consulting Contracts, Use of Corporate Planes, Executive Apartments with meals, maids, etc.)

Current Executive Fraud-Related Current Executive Fraud-Related ProblemsProblems

•Exorbitant Stock Options for Executives

Complaint in Fraud CaseComplaint in Fraud Case

• Several hundred million in earnings overstatement• Complaint:

“The goal of this scheme was to ensure that (the company) always met Wall Street’s growing earnings expectations for the company. (The company’s) management knew that meeting or exceeding these estimates was a key factor for the stock price of all publicly traded companies and therefore set out to ensure that the company met Wall Street’s targets every quarter regardless of the company’s actual earnings. During the period ___ to ___alone, management improperly inflated the company’s operating income by more than $500 million before taxes, which represents more than one-third of the total operating income reported by (the company.)”

Complaint in Fraud CaseComplaint in Fraud Case

• “The participants in the illegal scheme included virtually the entire senior management of (the company), including but not limited to its former chairman and chief executive officer, its former president, two former chief financial officers and various other senior accounting personnel. In total, there were over 20 individuals involved in the earnings overstatement schemes.”

Fraud InternationallyFraud Internationally

• 1. Denmark• 2. Finland• 3. Sweden• 4. New Zealand• 5. Canada• 6. Netherlands• 7. Norway• 8. Australia

• 13 Germany• 14. United Kingdom• 16. U.S.A.• 36. Brazil• 40. Philippines• 47. Mexico• 49. Russia• 52. Nigeria

Largest Bankruptcy FilingsLargest Bankruptcy Filings (1980 to Present)(1980 to Present)

Company Assets (Billions) When Filed1. WorldCom $101.9 July, 20022. Enron $63.4 Dec., 20013. Texaco $35.9 April, 19874. Financial Corp of America

$33.9 Sept., 1988

5. Global Crossing $25.5 Jan., 20026. Adelphia $24.4 June, 20027. PG&E $21.5 April, 20018. MCorp $20.2 March, 19899. Kmart $17.0 Jan., 200210. NTL $16.8 May, 2002

Recent Financial Statement Recent Financial Statement FraudsFrauds• Enron

• WorldCom• Adelphia

• Global Crossing• Xerox• Qwest

• Many others

Enron’s Use of Special Enron’s Use of Special Purpose Entities (SPEs)Purpose Entities (SPEs)

• To hide bad investments and poor-performing assets (Rhythms Net Connections). Declines in value of assets would not be recognized by Enron (Market to Market.)

• Earnings management—Blockbuster Video deal--$111 million gain (Bravehart, LJM1 and Chewco)

• Quick execution of related-party transactions at desired prices. (LJM1 and LJM2)

• To report over $1 billion of false income• To hide debt (Borrowed money and not put on financial

statements of Enron)• To manipulate cash flows, especially in 4th quarters• Many SPE transactions were timed (or illegally back-dated)

just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations

What is the business purpose? To transfer risks and losses to someone else

One Enron Example (the “Rhythms” transaction):• Enron holds Internet stock in company called Rhythms NetConnections• Stock is restricted (can’t be sold for a certain period of time• Enron doesn’t want exposure to risk of a price drop• The solution is simple! Find someone else who believes the Rhythms stock

price will rise and is willing to sell a contract (a put option) to buy the stock in the future at a set price (a hedge!)

• The problem is that Enron can’t find anyone willing to “do the deal”• Another simple solution! Start a company (a Special Purpose Entity or SPE) to

take the other side of the transaction (Enron called it LJM1)• Where does the financing come from?

– 97% from bank loan Guaranteed with Enron stock – 3% from entity other than Enron Andrew Fastow and others!

Now “Do the Deal” • Enron gives $168 million in Enron shares to LJM1 (LJM1’s primary asset)• LJM1 gives Enron a note for $64 million and a put option valued at $104 million• When everything “settles out,” Fastow receives $15 million for his $1 million investment• Enron gets to “hedge” (i.e., not report) a $103 million market loss on its stock

investment

Special Purpose Entities & Off-Balance Sheet FinancingSpecial Purpose Entities & Off-Balance Sheet Financing

LJM1 SPELJM1 SPE•Responsible for 20% of SPE restatement or $100 million•Should have been consolidated—an error in judgment by Andersen (per Andersen)•After Andersen’s initial review in 1999, Enron created a subsidiary within LJM1, referred to as Swap Sub. As a result, the 3% rule for residual equity was no longer met. •Andersen was reviewing this transaction again at the time problems were made public—involved complex issues concerning the valuation of various assets and liabilities.

The Chewco SPEThe Chewco SPE• Accounted for 80% of SPE restatement or $400 million—hid losses• In 1993, Enron and the California Public Employees Retirement

System (Calpers) formed a 50/50 partnership—Joint Energy Development Investments Limited (JEDI)

• In 1997, Enron bought out Calpers’ interest in JEDI• Chewco Financing

– $240 million loan from Barclays, guaranteed by Enron– $132 million loan from JEDI– $11.4 million loan from Barclays; called Equity– $0.1 million from Enron employee

• Financial reward to Enron employee– $2 million management fee over 3 years (remained full-time

Enron employee)– $10 million liquidation ($125K investment)

LJM2 SPELJM2 SPERaptors I-IVRaptors I-IV

• Established by Enron CFO to provide a quick buyer for Enron assets

• By December 2000, $1.5 billion in “hedged” investments, $500 million Enron “gain”

• Financial reward to Enron CFO—at least $15 million

• Enron Financial Statement Impact—Hedged $1 billion in losses over 5 quarters; reported earnings of $1.5 billion.

Insufficient Disclosure…….Insufficient Disclosure…….•2000 Proxy Statement “During 2000, certain Enron subsidiaries…entered into a number of transactions with LJM2 Co-Investment…Andrew S. Fastow, Executive Vice President and Chief Financial Officer of Enron, is the managing member of LJM2’s general partner.”

•Paragraph outlining the transactions•“These transactions occurred in the ordinary course of Enron’s business and were negotiated on an arm’s length basis with senior officers of Enron other than Mr. Fastow. Management believes that the terms of the transactions were reasonable and no less favorable than the terms of similar arrangements with unrelated third parties.”

Fastow’s Explanation of Partnerships (SPEs)Fastow’s Explanation of Partnerships (SPEs)

• The partnerships were used for “unbundling and reassembling” the various components of a contract. “We strip out price risk, we strip out interest rate risk,” he said. “What’s left may not be something that we want.”

• The obvious question is “Why would anyone want whatever was left?”

•Was paid $52 million in 2000, the majority of which was for non-audit related consulting services.

Role of AndersenRole of Andersen

Failed to spot many of Enron’s losses

Kept a whole floor of auditors assigned at Enron year around

•Enron was Andersen’s second largest client

Did both external and internal audits• CFOs and controllers were former Andersen

executives• Accused of document destruction—was criminally

indicted• Went out of business• One Partner “I had $4 million in my retirement account

and lost it all.” Some partners who transferred to other firms now have two equity loans and no retirement savings.

Where was Anderson?Where was Anderson?

Did they know?• 2/5/01: Andersen partners meet to discuss Enron’s accounting, related parties,

fees, etc.• Issue: For a significant amount of time, according to notes of the meeting, the

Andersen accountants debated a critical point: What should they do about two SPEs, LJM1 and LJM2, that had been set up 18 months earlier by Fastow?

• Resolution: They drew up a "to do" list:– Recommend a special committee of the Board to review LJM deals.– Review the SPE accounting tests.

• 2/12/01: The Big Meeting: Andersen partners meet with Enron board's audit and compliance committee.

• All Enron executives were excused from the room.• And then………..no evidence of any discussion• Interesting side note: From 1997 to 2001, Enron paid Andersen $5.7 million in

connection with work performed specifically on the LJM and Chewco transactions.

Enron’s AuditCommittee

Enron’s ExecutivesAuditor(Arthur Andersen)

Anderson ShreddingAnderson ShreddingThe Document Destruction Chronology• October 12 – Nancy Temple sends “Document retention policy” email to Michael

Odom.• October 17 – SEC asks Enron for information about its accounting.• October 23 – David Duncan calls urgent meeting, organizes effort to shred and

dispose.• The topics of discussion, according to a typed agenda, included:• "SEC probe/shareholder lawsuits" and• "soft and hard copy file review."• November 8 – Andersen receives subpoena from SEC.• November 9 – Duncan’s assistant sends email to secretaries: “no more

shredding.”

Email message about Document Policy:To: Michael C. OdomDate: 10/12/2001 10:53 a.m.From: Nancy A. TempleSubject: Document retention policyMike-It might be useful to consider reminding the engagement team of our documentation and retention policy. It will be helpful to make sure that we have complied with the policy. Let me know if you have any questions.Nancy

The Cost of “Bad Press”The Cost of “Bad Press”

Some partnerships' losses would have to be paid for out of Enron stock or cash in 2003, bringing the debts back home. There are indications that Enron executives and its accounting firm, Arthur Andersen, had warnings of problems nearly a year ago. According to a Feb. Andersen considered dropping Enron as a client. In August, Enron Vice President Sherron Watkins wrote an anonymous memo to former Chairman Kenneth L. Lay, detailing reasons she thought Enron "might implode in a wave of accounting scandals."

On Oct. 16, Enron announced a $638 million loss for the third quarter, and Wall Street reduced the value of stockholders' equity by $1.2 billion. Enron announced Nov. 8 that it had overstated earnings over the past four years by $586 million and that it was responsible for up to $3 billion in obligations to various partnerships. A $23 billion merger offer from rival Dynegy was dropped Nov. 28 after lenders downgraded Enron's debt to junk-bond status.

THE INVESTIGATIONDozens of lawsuits have been filed against the company by an array of pension funds. Dozens more are directed at former Chairman Kenneth L. Lay, former CEO Jeffrey Skilling and former Chief Financial Officer Andrew Fastow.

Kenneth L. Lay, former Enron Chairman and CEO (resigned Jan. 23, 2002)

Lay and Enron poured millions of dollars into both political parties, cultivating access and using the entree to lobby Congress, the White House and regulatory agencies for action that was critical to the energy company's spectacular growth. In addition to being one of the single largest financial backers of President George W. Bush's political career, Lay is also one of the president's friends.

Greed

Fastow was removed as Enron's CFO on Oct. 24, 2001 as the SEC began a probe into conflicts of interest in two partnerships he created and managed. Those partnerships earned him around $30 million in management fees from the deals in addition to his Enron salary.

Andrew Fastow, former Enron Chief Financial Officer (ousted Oct. 24, 2001)

In early October, Fastow was charged with securities, wire and mail fraud, money laundering and conspiring to inflate Enron's profit

                

                    

Kopper and his domestic partner, William D. Dodson, reaped $10.5 million based on a $125,000 investment in a partnership called Chewco, according to an investigative report issued by Enron's board of directors.

In August 2002, Kopper pleaded guilty to financial wrongdoing and agreed to surrender $12 million in the first criminal case against a company official.

Senior Enron executives criticized former CEO Skilling about possible conflicts of interest in two partnerships he created with former Chief Financial Officer Andrew Fastow. Jeffrey McMahon, then Enron's treasurer, was "highly vexed" about the conflicts, "complained mightily" and suggested a list of remedies.

Jeffrey Skilling, former Enron Chief Executive Officer (resigned Aug. 14, 2001)

Clifford Baxter, former Enron Vice Chairman (resigned May 2, 2001)

Baxter was one of 29 former and current Enron executives and board members named as defendants in a federal lawsuit, after he sold 577,436 shares of Enron for $35.2 million before Enron's collapse.

He was found shot to death in a car Jan. 15, 2002, in an apparent suicide.

Watkins is the internal whistleblower who in August of 2001, more than two months before Enron disclosed it had overstated its profits and understated its debts, warned Kenneth L. Lay that the company might "implode in a wave of accounting scandals." Shortly after Enron Chief Executive Officer Jeffrey Skilling suddenly resigned. Watkins described "a veil of secrecy" around partnerships involving the energy-trading company's former chief financial officer, Andrew Fastow

Arthur AndersenThe job of Arthur Andersen, one of the nation's largest accounting firms, was to make sure investors could rely on Enron's financial statements. But Andersen also was a major business partner-soliciting and selling millions in consulting services to Enron. Andersen was also responsible for some of Enron's internal bookkeeping, and some Andersen executives ended up taking jobs at Enron.

Led by then-chief executive Joseph F. Berardino, Arthur Andersen took its case public, saying it would take "all appropriate steps" to defend its integrity. Berardino also suggested that the company might stop selling consulting services to firms it audits. Barardino has since resigned from the firm.

EmployeesThousands of Enron employees, many with similar skills, were left unemployed. Enron encouraged employees to invest in the company, matched their 401(k) contributions with company stock, and briefly froze the plan in late October, barring employee sales, before the stock's final plunge. Thousands of employees and retirees have next to nothing in their accounts.

THE IMPACTTHE IMPACT

BanksOne of Enron's biggest lenders, J.P. Morgan Chase, announced losses of $456 million as of Jan. 2002 related to Enron's demise. Citigroup recorded $228 million as of Jan. 2002 in Enron-related losses. But banks and regulators said the overall impact would be minimal, because no one bank is overinvested in Enron.

THE IMPACTTHE IMPACT

InvestorsEnron's stock lost nearly all its value, dropping from almost $34 on Oct. 16, 2001. Billions of dollars in stock value were erased. The stock has been delisted from the New York Stock Exchange.

THE IMPACTTHE IMPACT

PoliticiansSeveral prominent politicians from both parties returned Enron contribution money to the company or contributing it to charity. Others have been asked about their relationships with Enron.

THE IMPACTTHE IMPACT

Arthur AndersenIts reputation was badly damaged. Divisions of the business have been sold to other companies. There is also the possibility of staggering liability claims.

And Now there are 4

SEC files suit against KPMG and partners over Xerox Accounting

They have been charged with allowing Xerox to report false report false financial resultsfinancial results between 1997 and 2000, rather than risk losing a key audit client. Office equipment maker Xerox last June was forced to restate more than US 6 Billion in revenues over 5 years after regulators accused it of using accounting tricksaccounting tricks to prop up its earnings.

Specifically, KPMG offered a detailed description of events as they unfolded in the Xerox case and argued that it did the "right thing" by refusing to sign off on the company's 2000 financial statements in the face of what it called "strong client resistance."

Response

• FBI Agent Coleen Rowley, who called the bureau on the carpet for ignoring evidence hinting at the September 11 terrorist attacks. Former Enron vice president Sherron Watkins, whose memos warning company chairman Ken Lay about accounting irregularities failed to stop Enron's collapse.

Cynthia Cooper, a WorldCom vice president who told the company's board of directors about nearly $4 billion in accounting irregularities.

$10 Billion

Expenses

Treated As

Assets

http://www.realtyworldgga.com/images/Adelphia.gif

The founder and former head of Adelphia, and two of his sons have been charged with looting the nation's No. 6 cable company to pay for luxury condos, a golf course and to cover personal investment losses.

John Rigas (former CEO)

  Sam Waksal (former CEO)

The former CEO of ImClone was arrested earlier this month on charges of insider trading for allegedly trying to sell his company's stock and tipping off family members after learning of the impending FDA decision on its new cancer drug Erbitux.

Martha StewartA close friend of Sam Waksal, has repeatedly denied any wrongdoing in selling nearly 4,000 ImClone shares on Dec. 27, a day before federal regulators said they would not consider the drugmaker's application for its new cancer drug. ImClone's shares plummeted after the news came out.

Boo Hoo I Lost $400 Million

Dennis Kozlowski (former CEO)Pleads innocent to charges of evidence tampering after earlier pleading the same to charges of evading taxes on purchases of valuable paintings.

--Dennis Kozlowski, the CEO until he was indicted and resigned in June, borrowed more than $40 million from the company, and the loans were later forgiven, reports the Wall Street Journal. The SEC rules governing disclosure of CEO pay are quite clear on those matters, and there is simply no way to avoid disclosing the forgiveness of such loans. Yet Tyco never did. The company neither confirms nor denies any of this, declining to comment pending the completion of an internal investigation.

Sample FraudsSample Frauds

• Large Fraud of $2.6 Billion over 9 years– Year 1 $600K– Year 3 $4 million– Year 5 $80 million– Year 7 $600 million– Year 9 $2.6 billion

• In years 8 and 9, four of the world’s largest banks were involved and lost over $500 million

0

500,000,000

1,000,000,000

1,500,000,000

2,000,000,000

2,500,000,000

3,000,000,000

Year 1 Year 3 Year 5 Year 7 Year 9

Some of the organizations involved: Merrill Lynch, Chase, J.P. Morgan, Union Bank of Switzerland, Credit Lynnaise, Sumitomo, and others.

Why Fraud is a Costly Business Problem that Why Fraud is a Costly Business Problem that must be addressed by corporate executivesmust be addressed by corporate executives

• Fraud Losses Reduce Net Income $ for $

• If Profit Margin is 10%, Revenues Must Increase by 10 times Losses to Recover Affect on Net Income– Losses……. $1 Million– Revenue….$1 Billion

• Fraud Robs Income

Revenues $100 100%Expenses 90 90%Net Income $ 10 10%Fraud 1Remaining $ 9

To restore income to $10, need $10 more dollars of revenue to generate $1 more dollar of income.

Fraud Cost…Two Examples Fraud Cost…Two Examples

• General Motors– $436 Million Fraud– Profit Margin = 10%– $4.36 Billion in

Revenues Needed– At $20,000 per Car,

218,000 Cars

• Bank– $100 Million Fraud– Profit Margin = 10 %– $1 Billion in Revenues

Needed– At $100 per year per

Checking Account, 10 Million New Accounts

EducatorsEducators• Haven’t taught “ethics” enough (can’t

make up own rules to meet own needs”•Need to teach students about fraud—need a “fraud” course Need to teach students how to think

•Need to teach students how to think–We have taught them how to copy, not think

We have asked them to memorize, not think

EducatorsEducators

– We have done what is easiest for us and easiest for our students

Accounting Education and Learning Accounting Education and Learning TheoryTheory

• Behaviorist Approach – Learners are seen as empty vessels that

instructors pour knowledge into

–Professors use primarily lecture-based teaching

–Students are provided with information needed to produce the desired behavior—high scores on content-based examinations.

Professors assign homework problems similar to examples used in class, examples in textbooks, and problems on examinations.

Accounting Education and Learning Accounting Education and Learning TheoryTheory

–Students use text or lecture notes as guides and solutions manuals.

–Students need not define the problem or understand why something is done the way it is or what other alternatives are available—only how something is done.

Problems withProblems withAccounting EducationAccounting Education

1. Teach outdated stuff—replaced by technology—teach to the past, not the future

2. Too narrow and specialized3. 150-hour programs—more of the same4. Ph.D. programs reinforce specialization5. Don’t cover important topics in the right ways

a. Globalizationb. Technologyc. Various business models

Problems withProblems withAccounting EducationAccounting Education

1. Rule-based, memorization, test-for-content, prepare for certification model, doesn’t add significant value

2. Does not expose students to ambiguity enough3. Lacks creativity

a. Not enough teaching of skillsb. Not enough out-of-classroom activitiesc. Not enough focus on technology

Technology has changed everything

What are we teaching our What are we teaching our students?students?

• One of the main things we are teaching is “how to copy.” – Not from a solutions manual or from other students (because

that is prohibited), but from examples in the chapter or from other students.

• Students are not developing higher-level thinking skills or learning to identify issues or define unstructured problems.

• When they graduate and find themselves performing an audit or completing a tax return, they do what we taught them to do--they reference what was done last year (a similar example) and copy (with different numbers and slight changes in format)

• They don’t think analytically about what has changed or even what is going on

• They don’t consider what the risks and substance of transactions are, or what changes in the numbers mean.

• They are copying because we taught them how to copy

Educational FocusEducational Focus

•Is it because this type of teaching is easier to teach and much easier to assess?

• Why do educators spend so much time focusing on content when content memorization has such a short useful life and when skills are transferable across positions and last so much longer?

Using Constructivist TeachingUsing Constructivist Teaching

• Best class is combination of reading (text), video, cases, experiential learning (field studies, service-learning, etc.), group work, etc.

•Critical in the new environment—to help our students think analytically•Can no longer use textbook (or CDs) to drive everything we do

•Let’s look at why this is important—the Enron example

Some ThoughtsSome Thoughts• Doing what’s easiest—our “train

monkey” or “operant conditioning” approach to teaching has led to:

–An ethical and public relations nightmare for accountants and the accounting profession

–Rule-based standards that allow firms to basically do whatever they want—you can’t legislate everything

–Inhibiting their ability to assess risks and think analytically

Types of FraudTypes of Fraud

• Fraudulent Financial Statements

• Employee Fraud• Vendor Fraud• Customer Fraud• Investment Scams• Bankruptcy Frauds• Miscellaneous Frauds

• The common element is deceit!

What’s Hot in Accounting--7 What’s Hot in Accounting--7 Sizzling AreasSizzling Areas

• Assurance services--Elder care• Consulting services• Environmental accounting• Forensic accounting • Information technology services• International accounting• Tax and financial planning

Corporate AccountabilityCorporate AccountabilitySarbanes Bill

Whistleblower Protection

Prohibits Disciplining or Discriminating against employees who provide information regarding securities law violations

Requires Attorney’s to Report Material Violations of Securities or Breaches of Fiduciary Duty to the Company’s CEO or Chief Legal Officer or if necessary to the Board of Directors

Attorney Professional Conduct

New and Increased Felonies + Civil ActionDestruction of of Documents

Longer Periods For Civil Fraud

Increased Criminal Penalties

No Bankruptcy Discharge of Securities Law Liability

Lower Thresholds To Bar for Unfitness

Auditor Independence

&

Rotation

Rotation of Audit/Review Partners every 5 years

Prohibits Some Non Audit Services

Expanded 8 K Disclosures

Accelerated 8 K Reporting – 2 Days

8KDisclosures

Accounting IssuesNew Issuer Fees

SEC Adopt Principles-based Accounting System

Unlawful to Fraudulently Influence Auditors

New Rules for Financial Experts on Audit Committee

New Management Assessment of Internal Control

Non-US Companies Not Exempt

New CEO/CFO Apply To Foreign Private Issuers

NASDAQ NYSE

NYSE and NASDAQ

Have Made Proposals For

the SEC To Consider

Enhanced Disclosures

Expenses

Material Off-Balance Sheet Transactions

Reconciliation of Pro Form F/S

SEC Review – 3 Years

“Real Time” Disclosures of Material Changes To Financial Condition

Accelerated Due Dates For Periodic ReportsMD&A Disclosures of Critical Accounting Policies

Detailed Quantitative & Qualitative Matters – No Boilerplate

8 K

Management Transactions

Loans

Security Transactions Including Preplanned Purchase/Sale

The SEC Sets New Ground Rules on

Selective Disclosure & Insider Trading

CEO/CFO Certification and

Disclosure Process

Corporate Code of Ethics

Enhanced Audit Committee

Forfeiture of Bonuses, and Stock Incentives For Restatements Due to Misconduct

Majority of Directors Must Be Independent

Dynamic Duo

Once The Camel Stick Its Head In the Tent, We Will Have Problems

Under a law that took effect Under a law that took effect this month, public companies this month, public companies based in California or doing based in California or doing business there have to give business there have to give the state extra layers of detail the state extra layers of detail on insider activity.on insider activity.

The Sarbanes-Oxley Act The Sarbanes-Oxley Act apparently did not go far apparently did not go far enough to suit California enough to suit California lawmakers.lawmakers.

Key Elements of Public TrustKey Elements of Public Trust

Spirit of Transparency

Culture of Accountability

People of Integrity