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The year 2002 saw the end of an era of skyrocketing stock prices and booming
businesses. Things that had seemed to be too good to be true were just that.
Companies that we previously thought of as unstoppable didn't have the earnings they
told us they did.
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Instead, they had been "cooking the books" to create the appearance of earnings that
really didn't exist. A company is guilty of cooking the books when it knowingly includes
incorrect information on its financial statements -- manipulating expenses and earnings
to improve their earnings per share of stock (EPS).
In this article, we'll look at the tricks that some companies used to beef up their financial
documents as well as why they do it. We'll also examine some of the fallen giants like
Enron and WorldCom to see what happened and where they are now.
Managing earnings (or "cooking the books"), is simply a way of making things look
better than they actually are to keep stockholders happy, entice new investors, meet
budgets, and most importantly, earn executive bonuses. Executive bonuses are tied to
specific levels of earnings, making it extremely tempting to do just about anything to
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meet -- or appear to meet -- the goal. But not all book cooking is motivated by greed. By
making revenues appear larger than they actually are, a struggling company could stay
afloat with investors' money until it can turn a true profit.
Here's an example. Imagine you're a kid with a lemonade stand and you want to build a
roof over it so that you and your customers aren't in the hot sun. You don't have the
money because business hasn't been that good. Your brother has the money, but he
won't lend it to you unless he knows that he'll make something in the deal. You're sure
that having a covered lemonade stand will make all the dierence for your business
because your customers will enjoy sipping their drinks in the cool shade. So you decide
to creatively boost your current sales figures and oer your brother a chance to invest in
your business. He gives you the money to build your roof in exchange for 25 percent of
your profits. For reasons unknown to you, the covered stand doesn't really sell any more
lemonade than the uncovered stand did. Now your brother is mad, because the profit
he thought he was going to make was based on phony sales figures. At this rate, it'll take
four summers to break even and much more to actually make a profit.
Investors are attracted by rising stock prices of public companies, which make the
company's financial statements extremely important documents. Wall Street analysts
depend on the documents and input from the companies themselves for their
recommendations. The public company depends on the infusion of cash from investors
to fund company growth. Stockholders expect the price per share to go up once they
buy stock. When the price goes down, they lose money. (See How the Stock Market
Works for more on stock prices and earnings per share.)
Thank you
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Thank you to Michael W. Williams for his assistance with this article.
Accounting Background
The most important documents that a company puts together are its financial
statements. These include a balance sheet, a cash flow statement, and a profit and loss
statement. These documents quantitatively describe the financial health of a company
and are used by almost every entity that deals with the company, including the
company executives and managers themselves.
The following financial statements are usually compiled on a quarterly and annual
basis:
The balance sheet gives a snapshot or bird's eye view of the company's
financial situation at a given date in time. It includes assets and liabilities
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In 2002, President Bush signed the Sarbanes-Oxley Act into law to "re-establish
investor confidence in the integrity of corporate disclosures and financial reporting"
[ref].The act was brought on by the large number of corporate financial fraud cases
(such as those of Enron, WorldCom, Tyco, Adelphia, AOL, and others) and by the end of
the "boom" years for the stock market. The Act requires all public companies to submit
both quarterly and annual assessments of the eectiveness of their internal financial
auditing controls to the Securities and Exchange Commission.
Each company's external auditors must also audit and report on the internal control
reports of management and any other areas that may aect internal controls. The
company's principal executive oicer and principal financial oicer must personally
certify that the financial reports are true and that everything has been disclosed. Many
of the Act's provisions apply to all companies, United States and foreign. However, some
provisions apply only to companies that have equity securities listed on an exchange or
NASDAQ.
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The details of the Sarbanes-Oxley Act address many of the tactics companies have used
to "cook the books" over the years. In the next few sections, we'll go over some of the
more popular methods of improving a company's bottom line -- if only on paper.
With o-balance sheet accounting, a company didn't have to include certain assets
and liabilities in its balance sheet -- it was "o-sheet" and therefore not part of their
financial statements. We'll talk more later about how the Sarbanes-Oxley Act changed
this practice. While there are legitimate reasons for o-balance-sheet accounting, it is
oen used to make a company look like it has far less debt than it actually does. Some
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Synthetic Leases
Synthetic leases oen use SPEs to hold title to a company's property and lease that
property back to the company. Because of o-balance-sheet accounting, synthetic
leases allowed companies to reap the tax benefits of ownership without having to list it
as a liability on their balance sheets.
Synthetic leases could also be signed with some entity other than an SPE. Banks, for
example, would oen purchase property for businesses and lease it back to them via a
synthetic lease. The company leasing the property avoids the liability on the balance
sheet but still gets to deduct interest and depreciation from its tax bill.
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New requirements from the Financial Accounting Standards Board now require SPEs to
be listed on a company's balance sheet. Section 401(a) of the Sarbanes-Oxley Act
requires that annual and quarterly financial reports disclose all material o-balance
sheet transactions, arrangements, and obligations. The rules also require most
companies to provide an overview of known contractual obligations in an "easy-to-read
tabular format"[ref].
This new ruling has essentially ended the days of the SPE and the synthetic lease -- even
though they are still legitimate practices.
Expense Manipulation
Accelerating a company's expenses may not seem to be the way to boost the
appearance of earnings, but it depends on when those earnings need to be boosted.
There are legitimate and illegitimate reasons to accelerate expenses. A legitimate
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example would be making equipment purchases when earnings are high rather than
when they were planned.
Here's an example of a less legitimate earnings acceleration. A manager's bonus is
based on his meeting a certain earnings goal. Once the target earning level has been
exceeded, that manager might decide to spend money now that was budgeted to be
spent in the next year because having higher earnings this year won't mean a bigger
bonus for him. Spending money this year that was budgeted for next year, however,
could help ensure he meets next year's level as well.
While this may seem like the same thing as making purchases when earnings are high, it
depends on the circumstances. If making those purchases earlier than planned has no
adverse aect on the business, then perhaps there is no problem. In many instances
there is an adverse aect, however. For instance, buying computer equipment six
months earlier than expected can mean a big dierence in the actual equipment
purchased -- power, features, and price can all change dramatically.
Delaying Expenses
Companies that are cooking the books have been known to capitalize expenses that are
really everyday expenses. AOL was charged with engaging in various acts of securities
fraud -- among other things -- between 1992 and 1996. In one part of a larger case, AOL
was accused of listing advertising expenses (the cost of creating those CDs and diskettes
they send out) as capital expenses rather than regular expenses. This presented a false
picture of the company's profitability and boosted the stock price. The disks should
have been expensed as they were mailed.
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In an upcoming case study, you'll see that WorldCom capitalized expenses that should
have been operating expenses to the tune of billions of dollars.
When companies land a big contract to provide a product or service over a long period
of time, they're supposed to spread the revenue over the cost of the service contract.
Some companies have been known to show the sale and revenue in the quarter in
which the contract was signed.
Here are some other examples of premature revenue booking:
Recording sales aer the products were ordered but before they were
shipped to the customer
Recording revenues when the sales involved contingencies that allowed
the customer to return the merchandise
Overstating revenues by speeding up the estimated percentage of
completion for a project in process
Recording revenues by shipping products that weren't ordered by the
customer or by shipping defective products and recording revenues at full
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While this category of expenses was meant for things that would only occur once in
order to keep it from aecting regular operating expenses, it has been abused in the
world of "managed earnings." By over-budgeting for a "non-recurring" expense,
companies have been known to then move the excess money over as earnings.
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Once the seventh largest company in America, Enron was formed in 1985 when
InterNorth acquired Houston Natural Gas. The company branched into many nonenergy-related fields over the next several years, including such areas as Internet
bandwidth, risk management, and weather derivatives (a type of weather insurance for
seasonal businesses). Although their core business remained in the transmission and
distribution of power, their phenomenal growth was occurring through their other
interests. Fortune Magazine selected Enron as "America's most innovative company" for
six straight years from 1996 to 2001. Then came the investigations into their complex
network of o-shore partnerships and accounting practices.
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the company's general tax counsel at the time, was told by Skilling that their accounting
method allowed Enron to make money and grow without bringing in a lot of taxable
cash.
Enron had been buying any new venture that looked promising as a new profit center.
Their acquisitions were growing exponentially. Enron had also been forming o balance
sheet entities (LJM, LJM2, and others) to move debt o of the balance sheet and transfer
risk for their other business ventures. These SPEs were also established to keep Enron's
credit rating high, which was very important in their fields of business. Because the
executives believed Enron's long-term stock values would remain high, they looked for
ways to use the company's stock to hedge its investments in these other entities. They
did this through a complex arrangement of special purpose entities they called the
Raptors. The Raptors were established to cover their losses if the stocks in their start-up
businesses fell.
When the telecom industry suered its first downturn, Enron suered as well. Business
analysts began trying to unravel the source of Enron's money. The Raptors would
collapse if Enron stock fell below a certain point, because they were ultimately backed
only by Enron stock. Accounting rules required an independent investor in order for a
hedge to work, but Enron used one of their SPEs.
The deals were so complex that no one could really determine what was legal and what
wasn't. Eventually, the house of cards began falling. When Enron's stock began to
decline, the Raptors began to decline as well. On August 14, 2001, Enron's CEO, Je
Skilling, resigned due to "family issues." This shocked both the industry and Enron
employees. Enron chairman Ken Lay stepped in as CEO.
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In the next section we'll look at how the fraud was discovered.
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WorldCom took the telecom industry by storm when it began a frenzy of acquisitions in
the 1990s. The low margins that the industry was accustomed to weren't enough for
Bernie Ebbers, CEO of WorldCom. From 1995 until 2000, WorldCom purchased over sixty
other telecom firms. In 1997 it bought MCI for $37 billion. WorldCom moved into Internet
and data communications, handling 50 percent of all United States Internet traic and
50 percent of all e-mails worldwide. By 2001, WorldCom owned one-third of all data
cables in the United States. In addition, they were the second-largest long distance
carrier in 1998 and 2002.
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These changes turned WorldCom's losses into profits to the tune of $1.38 billion in 2001.
It also made WorldCom's assets appear more valuable.
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funds. As many as 40 Tyco executives took loans that were later "forgiven" as part of
Tyco's loan-forgiveness program, although it was said that many did not know they were
doing anything wrong. Hush money was also paid to those the company feared would
"rat out" Kozlowski.
Essentially, they concealed their illegal actions by keeping them out of the accounting
books and away from the eyes of shareholders and board members.
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The SEC asked Kozlowski, Swartz, and Belnick to restore the funds that they took from
Tyco in the form of undisclosed loans and compensations.
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Sources
Beasley, M., Carcello, J., and Hermanson, D. "COSO's new fraud study:
what it means for CPAs." Journal of Accountancy, May, 1999.
FindArticles.com.
http://www.findarticles.com/p/articles/mi_m6280/is_5_187/ai_54636916
Corporate Scandal Primer. Washington Post.
http://www.washingtonpost.com/wpsrv/business/scandals/primer/index.html
Domash, Harry. "3 'creative accounting' flags for investors." MSN Money,
2005. http://moneycentral.msn.com/content/Investing/Simplestrategies/
P82399.asp?Printer
Donaldson, William H. "SEC Testimony: Impact of the Sarbanes-Oxley Act."
Securities and Exchange Commission. April 21, 2005.
http://www.sec.gov/news/testimony/ts042105whd.htm
Elstrom, Peter. "How to Hide $3.8 Billion in Expenses." Business Week
Online, June 28, 2002.
http://www.businessweek.com/bwdaily/dnflash/jun2002/nf20020628_9459.
htm
The Enron Fraud. http://www.enronfraud.com/
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