Lucent Technologies: A Study in Fraud and Earnings Management

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Outline
Background of Lucent Timeline of events Perpetration of fraud Opportunities

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Company Background
Was spun off from AT&T on September 30, 1996 At the time, largest IPO Nations most widely held stock in Dec. 1999 Maintained reputation as a growth company
CEO pushed 20% sales growth

Sold software and hardware to phone companies and network operators

Software to detect cell phone fraud

Accused of aggressive accounting long before restatement

Pension fund accounting Acquisition accounting

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Timeline Selected events Pre-Restatement

Jul. 20, 2000 - Warns 4Q will miss Oct. 11, 2000 - 4Q estimate revised downward again Oct. 2000 - CEO fired, 1Q 01 warning, board learns of reporting problems and informs SEC Nov. 2000 - Internal investigation conducted Dec. 2000 - Paul ONeill resigns from audit committee to become Treasury Secretary, Dec. 2000 - Lawsuit filed against Lucent claiming Nina Aversano was fired for disputing unrealistic sales targets

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TimelineRestatement
Dec. 21, 2000 - Restates 4Q revenue
- $679 million restatement Restatement result of internal investigation, not SEC Lucent claimed that $125 million represented improper recognition, while the rest represented subsequent agreements with vendors

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TimelinePost Restatement
Jan. 24, 2001 - Reports sales have fallen 28% and restructuring charge announced Feb 8, 2001 - SEC investigation formalized Nov. 1, 2002 - WSJ article
Reports SEC investigation far broader than Lucent disclosed - Investigating earnings manipulations as far back as 1996 and role of audit committee - Looking into managements earnings projections - Examining potential overstatement of restructuring charge Lucent claims SEC investigation is almost complete

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Recap
Revenue recognition Restructuring charges Pension fund accounting Acquisition accounting

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Revenue
What the restatement consisted of:
$452 millionEquipment shipped to distributors but never sold (channel stuffing) $199 millionCredits offered to customers $28 millionPartial shipment of equipment

Documentary red flags:

The $125 million of improper revenue was attributable to false documents

Analytical red flags:

Fiscal 1999 revenue grew 20%, while receivables grew 49% Bad debt reserves decreased while accounts receivable and sales grew

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Restructuring Charge
$2.6 billion right before AT&T spin-off The issueUsing cookie-jar reserves to meet expectations by reversing the charge when needed From 1996 to 1999, Lucent reversed $540 million (28%) The resultLucent met expectations in three quarters that it otherwise would not have Similar to Xerox except for better disclosure

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Audit Committee
Paul Allaire - Former chairman and CEO of Xerox Franklin Thomas - Lucent director and Alcoa board member Betsy Atkins - Cofounder of Ascent Communication (a Lucent Acquisition) Paul ONeill - Alcoa CEO Donald Perkins - Committee chairman until Feb. 1999

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See Any Possible Red Flags?

Significant insider influence
All but Allaire are insiders

Potential ethical implications

Xerox

Peculiar timing of turnover

Why did Perkins leave

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Who Cooked Whos Books?

Fred Moldfoski posted earnings releases on Yahoo Finance on March 22-23, 2000
The fraudulent releases were designed to look like official Lucent releases The releases stated that Lucent would miss expectations The impact: Lucents stock opened at $62.125 and traded as low as $60.375

The ironyfrom what we know now, it is possible that Lucent had indeed missed expectations

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Charges included:
December 2000 - breach of contract suit filed by Nina Aversano May 17, 2004 - SEC against Lucent and 10 individuals changing them with fraud and violation of GAAP during reporting for fiscal 2000
$511 million revenue prematurely recognized; $637 million should not have been recognized [total $1.148 billion] $91 million pre-tax income prematurely recognized; $379 million should not have been recognized [total $470 million (16%)]

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Settlements included:
Lawsuit filed by Nina Aversano details undisclosed Shareholder lawsuits totaling $568 million Without admission or denial of charges, Lucent settled with SEC. As SEC believes Lucent did not fully cooperate, a $25 million civil fine was imposed.

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