Question

Fraud is an intentional act to misappropriate (steal) assets or to misstate financial statements. There are many documented high-profile collapses of companies due to fraud. As the Enron and WorldCom scandals unfolded, many people asked, “How can these things happen? If such large companies that we have trusted commit such acts, how can we trust any company to be telling the truth in its financial statements? Where were the auditors?”

These scandals caused the creation of the Sarbanes-Oxley Act in the US (NI52-109 Canadian Equivalent) requiring companies to maintain adequate internal controls and for senior officers to sign-off on the company financial statements, among other things.

Discuss one company which has committed an accounting scandal. Provide details on the fraud committed and preventative measures which could have been taken by the company, tying in textbook knowledge where appropriate.

Answer 1

ENRON SCANDAL

This scandal led to the bankruptcy of Enron corporation. It is one of the largest accounting and audit failure. After 7 years of the formation of Enron, Jeffery Skilling along with other executives used accounting loopholes to hide billions in Debt. due to failure in projects. This was the result of poor financial reporting and these executives mislead the Directors and Audit committee.

$40 Billion lawsuit was filed by shareholders after share price fell from $90.75 to less than $1 in just one year during 2000-2001. SEC began an investigation. Enron filed for Bankruptcy in December 2001. Many executives were charged and sentenced.

After this scandal new regulations and legislation were formed for accuracy in financial reporting. Sarbanes-Oxley Act was one of them which included penalties for destroying, altering records to defraud various parties. Also certain regulations were formed for auditing firms.

Accounting Scandal 1:

Enron created hundreds of special purpose entities. Some were used to hide foreign income from US taxation and others were used to hide huge amounts of debt financing.

An SPE is a shell company created by a sponsor (Enron) and financed by independent third parties. Under current accounting rules, Enron was not required to consolidate their financial statements as long as an independent party had an equity stake of 3% of the SPE' s assets .

Enron used large amounts of debt to finance the activities of the SPE s and their principle asset was Enron stock.

When the stick prices was increasing everything was fine. But shareholders did not understood that Enron had taken huge amounts of debt.

When the stock price fell , assets of SPE could not cover the debt and Enron was forced to take over it

Accounting Scandal 2:

Fair value accounting. With mark-to-market accounting, the value of a position is fairly easy if market values are observable.

In certain cases, asset values could be based on a model when market valuations are not available.

All models need inputs but managers are expected to make reasonable estimates. However Enron executives picked those that painted the rosiest picture.

Accounting Scandal 3: reporting future profits in current year

Enron entered a deal with blockbuster video on July 19,2000 for a 20 year period to deliver video on demand through Enron intelligent network. Their announcement indicated that they would introduce entertainment on demand in multiple us markets by the end of year.

Enron recognized $110 million in profits Even Though there were serious concerns about its potential. In March 2001, the agreement was terminated and in October 2001 Enron had to reverse the profits.

Preventive Measures -

1. Fewer Incentives for short term gains

Enron had a bonus structure that used to provide strong incentives to executives who pursued short term profits at the cost of long term profits.

A more sustainable incentives structure could have prevented the fall. .

2. Tighter Financial Regulation

After Enron , US Congress passed the landmark Sarbanes-Oxley Act designed to prevent or reduce the probability of corporate fraud at such a huge level.

If an act like this would have been present in 1990 s , Enron could have been prevented.

3. Better Audit and Risk management

Enron used complex derivative instruments that few executives and regulators actually understood. it employed these instruments recklessly as hedges against fluctuations in energy price.