Question

1. Companies are often under pressure to meet or beat Wall Street earnings projections in order to increase stock prices and also to increase the value of stock options. Some resort to earnings management practices to artificially create desired results. What are some examples of things companies have done? Describe one company that was caught doing this and what happened to the company? Stockholders? CFO?

2. The Damon Investment Company manages a Mutual fund composed mostly of speculative stocks. You recently saw an ad claiming that investments in the funds have been earning a rate of return of 21%. This rate seemed quite high, so you called a friend who works for one of Damon’s competitors. The friend told you that the 21% return figure was determined by dividing the 2-year appreciation on investments in the fund by the average investment. In other works, $100 invested in the fund 2 years ago would have grown to $121 ($21 / $100 = 21%). Discuss the ethics of the 21% claim.

Answer 1

Question 1)

Publicly traded companies are under a constant pressure to meet or beat the earnings and profitability forecasts at Wall Street and thereby increase their stock prices. This pressure often leads them committing financial reporting frauds in order to conceal their actual financial health and overstate profits.

1. A well trained accountant can easily find the loopholes in accounts reporting and show a flowery picture of the assest and liabilities of a Company, i.e, overstating the profits and assets, understating the liabilities.

2. Companies have also also recorded sales before they were realizable, which is against GAAP rules

3. Recording fictitious sales

4. overstating inventory by false transactions

5. false audited reports

6. understating expenses to show false sales

One such company which resorted to accounting fraud was Enron which used specila purpose vehicles to hide hige amounts of debt from investors and creditors and toxic assets. This led to a healthy Balance sheet and prices remained stable for sometime. By 2001, Enron's fraud was out in public which led to its srock prices crashing to new lows. Enron had losses of $591 million and had $690 million in debt by the end of 2000. By Dec. 2, 2001, Enron had filed for bankruptcy. Enron's shareholders were hugely impacted as their holding were in huge losses. The Company's CFO Andrew Fastow served more than 5 years in prision for the fraud.