Accounting Updates

Southern Gas
Association Accounting & Financial
Executives Conference
April 28, 2003
Robert
Robert E.
E. (Bob)
(Bob) Jensen
Jensen
Trinity University
San Antonio,
Antonio, TX
TX 78212
78212
http://www.trinity.edu/rjensen/
 Why so many financial statement
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
frauds all of a sudden?

Good economy was masking many problems

Moral decay in society

Executive incentives

Wall Street expectations—rewards for

short-term behavior
Why so many financial statement
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
masking problems ….

With increasing stock prices,

profits and wealth for
everyone, no one worried
about potential problems.
 Detailed
Rules

Detailed Complicated Rules

With Loop Holes Big Enough

To Drive A Truck Through
 Nature of Accounting Rules
Allows 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

Revenue recognition approaches,

Merger reserves
Pension accounting

Other accounting schemes.

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
Contracts

Expect New Amendments in SFAS 149

 GAAP CRITICISM

Fosters Short-Term Earnings Manipulations

Does Not Show Value Creation

 Executive Incentives
•Meeting 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
–Moral Hazard: Employee Stock Options
Did you ever hear the name Lou Pai?

Companies are heavily punished for

not meeting forecasts
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
 Stock
Stock Fell
Fell 13%
13%
With
With This
This
Revelation
Revelation
Jack Welch,
Former General
Electric Chairman

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...
"
Lou
Lou Pai,
Pai, CEO
CEO of of Energy
Energy Services
Services was
was such
such aa
big
big shot
shot that
that he
he refused
refused toto commute
commute to to
Houston’s
Houston’s Intercontenental
Intercontenental Airport
Airport toto board
board
Enron’s
Enron’s corporate
corporate jets.
jets. A
A Falcon
Falcon 900900 jet
jet had
had
to
to be
be dispatched
dispatched to to his
his home
home inin the
the Houston
Houston
suburb
suburb ofof Sugar
Sugar Land.
Land.

Enron’s CEO of Enron Broadband Services, Ken

Rice, had a $33,000 customized Hellcat motorcycle
in his office just for a distinctive decoration.
Beat The Numbers
 How To Play
Numbers Game
Aggressive Accounting
Earnings Management
Income Smoothing
Fraudulent Financial Reporting
Creative Accounting Practices
 Rewards of
The Game

Share Price Effect

Borrowing Cost Effect

Bonus Plan Effect

Political 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 100

If stock price is less than the
result…Buy, If Not?
Buy it anyway
 Incentives 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.

Firm A Firm B

Which firm will have the higher stock price?

 Auditors—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?

•Became greedy--$500,000 per year per partner

compensation wasn’t enough; saw everyone else getting rich

•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

•A few auditors got too close to their clients

•Tradition of sending puppies out to yap at the receivables

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.
$$ 24
24 million
million to
to Janet
Janet Bobrow
Bobrow
Jan
Jan Bobrow
Bobrow makes
makes $$ 1010 an
an hour
hour part-time
part-time at
at
Central
Central Church
Church of
of the
the Nazarene
Nazarene inin Lenexa,
Lenexa, Kan.
Kan.
 Moral 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 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 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-
Related 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,
Current Executive Fraud-Related
Problems

•Exorbitant
Stock Options
for Executives
 Complaint 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 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 Internationally
• 1. Denmark • 13 Germany
• 2. Finland • 14. United Kingdom
• 3. Sweden • 16. U.S.A.
• 4. New Zealand • 36. Brazil
• 5. Canada • 40. Philippines
• 6. Netherlands • 47. Mexico
• 7. Norway • 49. Russia
• 8. Australia • 52. Nigeria
 Largest Bankruptcy Filings
(1980 to Present)

Company Assets (Billions) When Filed

1. WorldCom $101.9 July, 2002
2. Enron $63.4 Dec., 2001
3. Texaco $35.9 April, 1987
4. Financial Corp $33.9 Sept., 1988
of America
5. Global Crossing $25.5 Jan., 2002
6. Adelphia $24.4 June, 2002
7. PG&E $21.5 April, 2001
8. MCorp $20.2 March, 1989
9. Kmart $17.0 Jan., 2002
10. NTL $16.8 May, 2002
Recent Financial Statement
Frauds
• Enron
• WorldCom
• Adelphia
• Global Crossing
• Xerox
• Qwest
• Many others
 Enron’s Use of Special
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
 Special Purpose Entities & Off-Balance Sheet Financing
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
 LJM1 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 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 SPE
Raptors 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…….
•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)

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

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?
Enron’s Audit
Committee
Auditor
Enron’s Executives
(Arthur Andersen)

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.
 Anderson Shredding
The 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. Odom
Date: 10/12/2001 10:53 a.m.
From: Nancy A. Temple
Subject: Document retention policy
Mike-
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”
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
various
in obligations to partnerships.
A $23 billion merger offer from rival
Dynegy was dropped Nov. 28 after lenders
downgraded Enron's debt to junk-bond
status.
THE INVESTIGATION
Dozens 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
 Andrew Fastow, former
Enron Chief Financial
Officer (ousted Oct. 24,
2001)

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

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.
 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 Andersen
The 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.
Employees
Thousands 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.
Banks
One 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 IMPACT
Investors
Enron'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 IMPACT
Politicians
Several 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 IMPACT
Arthur Andersen
Its 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

THE IMPACT
SEC files suit against
KPMG and partners over
Xerox Accounting
They have been charged with
allowing Xerox to report false
financial 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 tricks to prop up its
earnings.
 Response
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."
• 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
$10 Billion
Billion
Expenses
Expenses
Treated
Treated As
As
Assets
Assets
John Rigas (former CEO)

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.
  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 Stewart
A 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
Boo Hoo
Hoo
II Lost
Lost
$400
$400
Million
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 Frauds
• Large Fraud of $2.6
Billion over 9 years
3,000,000,000
– Year 1 $600K
2,500,000,000
– Year 3 $4 million
– Year 5 $80 million 2,000,000,000

– Year 7 $600 million 1,500,000,000

– Year 9 $2.6 billion
1,000,000,000
• In years 8 and 9, four of
500,000,000
the world’s largest banks
were involved and lost 0
Year 1 Year 3 Year 5 Year 7 Year 9
over $500 million
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
must be addressed by corporate executives

• Fraud Losses Reduce • Fraud Robs Income

Net Income $ for $
• If Profit Margin is 10%,
Revenues Must Increase
by 10 times Losses to Revenues $100 100%
Expenses 90 90%
Recover Affect on Net Net Income $ 10 10%
Income Fraud 1
– Losses……. $1 Million Remaining $ 9

– Revenue….$1 Billion To restore income to $10, need

$10 more dollars of revenue to
generate $1 more dollar of
income.
 Fraud Cost…Two Examples
• General Motors • Bank
– $436 Million Fraud – $100 Million Fraud
– Profit Margin = 10% – Profit Margin = 10 %
– $4.36 Billion in – $1 Billion in Revenues
Revenues Needed Needed
– At $20,000 per Car, – At $100 per year per
218,000 Cars Checking Account,
10 Million New
Accounts
 Educators
• 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
 Educators

– We have done what is easiest for us and

easiest for our students
 Accounting Education and Learning
Theory
• 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
Theory
– 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 with
Accounting Education
1. Teach outdated stuff—replaced by technology
—teach to the past, not the future
2. Too narrow and specialized
3. 150-hour programs—more of the same
4. Ph.D. programs reinforce specialization
5. Don’t cover important topics in the right ways
a. Globalization
b. Technology
c. Various business models
 Problems with
Accounting Education
1. Rule-based, memorization, test-for-content,
prepare for certification model, doesn’t add
significant value
2. Does not expose students to ambiguity enough
3. Lacks creativity
a. Not enough teaching of skills
b. Not enough out-of-classroom activities
c. Not enough focus on technology

Technology has changed everything

 What are we teaching our
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 Focus

• 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?
•Is it because this type of teaching is
easier to teach and much easier to
assess?
 Using Constructivist Teaching
•Critical in the new environment—to
help our students think analytically
•Can no longer use textbook (or CDs) to
drive everything we do
• Best class is combination of reading (text),
video, cases, experiential learning (field
studies, service-learning, etc.), group
work, etc.
•Let’s look at why this is important—the Enron
example
 Some Thoughts
• Doing what’s easiest—our “train
monkey” or “operant conditioning”
approach to teaching has led to:

–Inhibiting their ability to assess risks and

think analytically

–Rule-based standards that allow firms to

basically do whatever they want—you can’t
legislate everything
–An ethical and public relations nightmare for
accountants and the accounting profession
 Types of Fraud
• Fraudulent Financial • The common element
Statements is deceit!
• Employee Fraud
• Vendor Fraud
• Customer Fraud
• Investment Scams
• Bankruptcy Frauds
• Miscellaneous Frauds
 What’s Hot in Accounting--7
Sizzling Areas
• Assurance services--Elder care
• Consulting services
• Environmental accounting
• Forensic accounting
• Information technology services
• International accounting
• Tax and financial planning
Corporate Accountability
Sarbanes Bill
Whistleblower Protection

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

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
New and Increased Felonies + Civil Action
Destruction of of Documents
Longer Periods For Civil Fraud
Increased Criminal Penalties
Lower Thresholds To Bar for Unfitness
No Bankruptcy Discharge of Securities Law
Liability
 Auditor
Independence
&
Rotation
Rotation of Audit/Review Partners
every 5 years

Prohibits Some Non Audit Services

 8K
Disclosures

Expanded 8 K Disclosures

Accelerated 8 K Reporting – 2 Days

Accounting Issues
New 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
 NYSE and
NASDAQ
Have Made
Proposals For
the SEC To
Consider

NASDAQ NYSE
Enhanced Disclosures
Material Off-Balance Sheet
Transactions

Reconciliation of Pro Form F/S

SEC Review – 3 Years

“Real Time” Disclosures Expenses

of Material Changes To
Financial Condition
Accelerated Due Dates For Periodic
Reports
MD&A Disclosures of Critical
Accounting Policies

Detailed Quantitative & Qualitative

Matters – No Boilerplate
 Management Transactions

Loans

8K

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 Majority of
Restatements Due Directors Must
to Misconduct Be Independent
Dynamic Duo
Once The Camel Stick Its Head In
the Tent, We Will Have Problems
 The Sarbanes-Oxley Act
apparently did not go far
enough to suit California
lawmakers.
Under a law that took effect
this month, public companies
based in California or doing
business there have to give the
state extra layers of detail on
insider activity.
 Key Elements of Public Trust

Spirit of Transparency
Culture of Accountability
People of Integrity