Earnings Management and Earnings by fjhuangjun

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									Earnings Management
 and Earnings Quality
 Prospect Theory
Test 1:
 An 80% chance to win $4,000, 20% win nothing
 A certain gain of $3,000


Test 2:
 An 80% chance to lose $4,000, 20% to lose nothing
 A certain loss of $3,000


  Experimental economists found most of people
  choose B over A; and C over D. Therefore the value
  function can be demonstrated as follows.
       Value




Loss           Gain
Implications for the Prospect
Theory:
    People seem to respond to perceived gains
     or losses rather than to their hypothetical
     final wealth positions, the latter of which is
     assumed by expected utility theory.
    There is a diminishing marginal sensitivity
     to changes, regardless of the sign of the
     changes; and
    Loss looms larger than gains.
    What is Earnings Management?
   Arthur Levitt: ―practices by which earnings
    reports reflect the desires of management
    rather than the underlying financial
    performance of the company.‖
   Earnings management (or income smoothing)
    is often defined as the planned timing of
    revenues, expenses, gains and losses to
    smooth out bumps in earnings. In most
    cases, earnings management is used to
    increase income in the current year at the
    expense of income in future years. Earnings
    management can also be used to decrease
    current earnings in order to increase income in
    the future.
    The Public Perception of Earnings
    Management
   Earnings management has a negative effect on the
    quality of earnings if it distorts the information in a
    way that it less useful for predicting future cash
    flows. The term quality of earnings refers to the
    credibility of the earnings number reported. Earnings
    management reduces the reliability of income.
   The investing public does not necessarily view minor
    earnings management as unethical, but in fact as a
    common and necessary practice in the everyday
    business world. It is only when the impact of
    earnings management is great enough to affect the
    investors’ portfolio that they feel fraud has been
    committed.
How company smoothes earnings           Check list

   Does level discretionary cost conform to past
   Is there a drop in trend of discretionary costs as
    percentage of sales
   Does cost cutting program involve significant cut
    in discretionary costs
   Does cost cutting program eliminate fat?
   Do discretionary costs show fluctuations relative
    to sales
   Is there a sizable jump in discretionary costs?
The Impact of Earnings Management

   The practice of earnings management damages
    the perceived quality of reported earnings over
    the entire market, resulting in the belief that
    reported earnings do not reflect economic
    reality. This will eventually lead to unnecessary
    stock price fluctuation. This uncertainty
    ultimately has the potential to undermine the
    efficient flow of capital thereby damaging the
    markets as a whole.
Incentives to Manage Earning
A. EXTERNAL FORCES
• Analyst Forecasts –
• Debt markets and contractual obligations –
• Competition -
B. INTERNAL FACTORS
• Potential mergers -
• Management Compensation -
• Planning and budgets -
• Unlawful transactions -
C. PERSONAL FACTORS
• Personal bonuses -
• Promotions and job retention –
SEC Response to Earnings Management
   SAB 99 regarding Materiality in August of 1999: A
    favorite practice of corrupt management is to justify
    earnings management by claiming it is immaterial.
   SAB 100 was released in November of 1999 in an
    attempt to eradicate the common earnings
    management practice of taking a ―big bath‖ through
    the use of restructuring and impairment charges.
   SAB 101A concerning Revenue Recognition was
    released at March of 2000, and later SAB 101B.
   The issuance of SAB 102 concerning Loan Loss
    Allowances, which is another preferred tool of
    earnings management, July of 2001.
Types of Earnings Management and Manipulation
(by Scott McGregor)
 a. "Cookie-jar" Reserves
 b. Capitalization practices-Intangible
    assets, software capitalization, research and
    development.
 c. "Big bath" one-time charges
 d. Operating activities
 e. Merger and acquisition activities
    1. Pooling on interests
    2. Purchase accounting and goodwill
 f. Revenue Recognition
 g. Immaterial misapplication
 h. Reserve one-time charges
    Examples of Fraudulent
    Earnings Management (I)
   Aug.22, 2005: The SEC filed civil fraud charges
    against former officers of BMS
   “Fraudulent Earnings Management Scheme”
   Deceiving investors about the true
    performance, profitability and growth trends of the
    company
   Sold excessive amounts of its products to
    wholesalers ahead of demand and improperly
    recognized revenue of $1.5 billion
   Used “cookie jar” reserves to further inflate its
    earnings
Examples of Fraudulent
Earnings Management (II)
   Nov.30, 2004: The SEC announced filing and
    settling charges against AIG
   ―Offer and sale of an Earnings Management
    product‖
   Special Purpose Entities to enable the buyer to
    remove troubled or other potentially volatile
    assets from its balance sheet
   Enabling the buyer to avoid charges to its
    reported earnings from declines in the value of
    theses assets
Examples of cases of earnings manipulation

a. Cendant
b. Manhattan Bagel
c. Sunbeam
d. Tyco
e. Sensormatic
f. 3Com
g. W.R. Grace
h. MicroStrategy
i. Lucent
    Cendant
   Cendant was created in 1997 by merge of equals
    between CUC and HFS.
   HFS later found CUC recorded 500M phony profit
    before merger.
   This is driven by management‟s determination to meet
    Wall Street analysts‟ expectations.
   CUC management maintained an annual schedule
    setting forth opportunities that were available to inflate
    operating income.
   Top down approach. Top management allocate the
    amount that each subsidiary needs to come up with the
    earnings. Then the management make additional
    adjustment to ensure the earnings and expenses ratios
    are similar to that of previous year.
Cendant
   1996 CUC established merger reserve that is double its
    cost, simply view as opportunity the viability of future
    earnings at CUC.
   1997 CUC used merger with HFS as another chance to
    cover up its shortfall of earnings.
   In April 1998, Cendant suited 7 former CUC executives
    for accounting fraud. SEC brought similar charges in
    June 1998.
   The day after fraudulent financial reporting was
    announced in April 1998, Cendant‟s stock price drop
    46.5%, eliminating $14 billion in market capitalization.
   1998 December, Ernst and Young, CUC‟s auditors
    agreed to pay $335M to Cendant stockholders.
MicroStrategy
   MicroStrategy's reporting failures were primarily the
    result of premature recognition of revenue.
   Management did not sign contracts received near the
    end of quarters until after it determined how much
    revenue was required to achieve desired quarterly
    results.
   MicroStrategy engage in complex transactions
    involving the sale of software as well as extensive
    software application development and consulting
    services. The nature of the multiple element deals at
    MicroStrategy gave rise to accounting practices that
    were not in accordance with GAAP.
MicroStrategy
   SEC documents detail a transaction in which
    MicroStrategy negotiated a $4.5 million
    transaction to provide software licenses and
    extensive consulting and development
    services. The majority of the software licenses
    were to be used in conjunction with to-be
    developed applications, indicating that the
    product and service elements were
    interdependent.
   However, MicroStrategy recognized the entire
    $4.5 million received in the transaction as
    software product license revenue, allocating no
    revenue to the extensive service obligations.
MicroStrategy
   MicroStrategy also entered into an agreement
    in which it agreed to provide software licenses,
    maintenance and services to a large retailer. In
    a side letter to the agreement, MicroStrategy's
    sales staff promised the retailer future product
    at no cost, although the product had not yet
    been developed.
   Under GAAP, the revenue should have been
    deferred because the value of the future
    product could not be determined.
MicroStrategy
   MicroStrategy announced that it would restate
    earnings for three years to comply with GAAP. After
    the announcement, MicroStrategy stock fell 62
    percent in one day. Its stock price dropped from a
    high of $333 per share to $33 per share.
   In April 2001, the company settled a class action suit
    alleging fraud arising from its accounting practices.
    Three of its executive officers at the time of the
    restatement agreed to fraud injunctions and paid
    penalties of $350,000 each.
   The company agreed to undertake corporate
    governance changes and implement a system of
    internal controls.
Lucent
   Lucent Technologies, an AT&T spin-off, started trading
    publicly in 1996 with an initial public offering that was,
    at the time, the largest in domestic history.
   In December 1999, Lucent's stock was selling at
    $77.78 and was the nation's fourth most widely held
    stock. However, by July 2001, Lucent's stock was
    trading at $6.43, the SEC was investigating its
    accounting practices and several former, high-level
    managers.
   The decline in Lucent's stock value has been
    attributed to a Nov. 21, 2000 announcement in which
    Lucent said it had voluntarily reported accounting
    irregularities to the SEC. As a result of its own internal
    investigation, Lucent restated its Sept. 30, 2000
    financial statements, reducing revenue by $679
    million.
    Lucent
   According to a January 2000 Wall Street Journal
    article, Lucent had used "a whole myriad of aggressive
    accounting moves to boost its growth." One analyst
    estimated that Lucent added about 27 cents a share to
    its earnings through "deft accounting moves," including
    creative acquisition accounting.
   In October 1998, Business Week reported that Lucent
    avoided some goodwill amortization by writing off $2.3
    billion of in-process research and development as
    companies were acquired. Lucent's earnings also
    benefited from a $2.8 billion reserve for "big bath"
    restructuring charges that were recorded as part of
    Lucent's spin-off from AT&T. Some analysts believe
    Lucent put aside far more than was needed to cover
    restructuring expenses and used the excess reserves
    to smooth earnings .
    Lucent
   Although revenue and accounts receivable increased in
    fiscal 1999, Lucent lowered its bad-debt reserves. In
    addition, some observers believe that Lucent improperly
    lowered its reserves for obsolete inventory in 1999.
   Lucent's December 2000 restatement in which revenues
    were reduced by $679 million, created doubt. Two-thirds of
    the $679 million reduction in revenue, or $452 million, was
    attributed to "channel stuffing" sales, in which transfers of
    products to distributors are recorded as sales although the
    products are not yet sold to end-users.
   The restatement also reduced revenues by $199 million
    because customers were promised discounts, credits and
    rights of return.
   Lucent also nullified $28 million in revenue recognized on a
    partial shipment of equipment.
  The Cendant, MicroStrategy and Lucent cases
  share several common characteristics
1. The earnings management activities took place over
   extended periods of time, escalating from questionable and
   improper revenue recognition practices to other forms of
   earnings management;
2. The earnings management practices were initiated "at the
   top," but eventually involved high-level managers and their
   subordinates; and
3. The earnings management practices were not uncovered by
   external auditors or audit committees.

  These characteristics and the SEC's announced policy of
  enforcing action against companies engaging in abusive
  earnings management suggest that accountants and
  auditors should be vigilant in their attempts to identify
  earnings management activity in its early stages.
A survey of fraudulent accounting management --
When earnings management becomes fraud?
 Done by Internal Auditing, Sept./Oct. 2002
 1.   In most cases, top management is involved
      with perpetrating the fraud.
 2.   Those industries in Computer
      Software, Medical Service, and
      Telecommunications are most likely to
      conduct fraudulent accounting management.
 3.   Improper revenue recognition is the most often
      seen violation of GAAP.
Corporate Mechanisms to avoid fraudulent
Earnings Management (by Raymund Breu)
   Board oversight
   External Audit
   Internal Audit reporting to Audit Committee
    of Board
   Accounting manuals
   Training
   Whistleblower procedures
   Code of Conduct
   Code of Ethics of Financial Officer
    Special Purpose Entity (SPE)
   SPEs typically are defined as entities created for a limited
    purpose, with a limited life and limited activities, and
    designed to benefit a single company. They may take
    form of a partnership, corporation, trust, or joint venture.
   The financial risk of the sponsor is limited to its investment
    or explicit recourse obligation in the SPE or SPV. In many
    instances, creditors of a bankrupt SPE or SPV cannot
    seek additional assets from the sponsor beyond what was
    invested or contracted for by that sponsor.
   The net assets of the SPE or SPV may be protected from
    creditors of its sponsors such that the SPE or SPV is not
    the deep pockets in the event that any sponsor goes
    bankrupt.
    Cash Flow Structure (Sponsors Receive
    Cash for Asset Sales to the SPE)
    Each sponsor factors (sells) ownership of actual assets
     (e.g., receivables "factoring") to the structure. Assets are
     deleted from the sponsor's balance sheet.
    The sponsors record the transfer of the assets as a sales
     under FAS 140 or other GAAP rules. Gains and losses
     are based upon estimated fair value at the time of the
     transfer.
    The transferred assets are protected from lawsuits
     against the sponsor, although the sponsors may have to
     add more "assets" based upon contractual trigger
     events.
    Enron corporation estimate fair values well above
     realistic fair values and, thereby, beef up their own
     earnings per share with questionable levels of
     recorded sales to SPEs.
Cash Flow Structure
   The transferred assets may serve as security
    (securitization) for borrowing by the SPE, and the cash
    flows from the assets and borrowings may be used to
    purchase additional assets from the sponsors.
   Some SPEs may purchase equity shares of the
    sponsor for cash, or equity shares may be directly
    transferred to cover trigger event declines in an SPE's
    net asset value.
   It is alleged that the collapse of Enron would not have
    arisen in late 2001 had Enron share prices not fallen
    below $80. Plunging share prices hit SPE trigger
    points that allowed the SPEs' creditors to demand early
    collections on an SPEs' debt.
    Derivatives Financial Instrument
    Structure in Lieu of an Asset Transfer
   Enron enters forward energy contracts with a new power
    plant built by Enron. Suppose the plant is originally financed
    with floating rate, short-term debt until the plant begins to
    generate electricity.
   Once the plant is operational, the sponsor's forward contracts
    can be transferred to an SPE that in turn uses these forward
    contracts as collateral to borrow on fixed rate notes at lower
    rates than the sponsor could otherwise obtain on its own.
   After using the sale proceeds to pay off construction loan, the
    sponsor (e.g., Enron) no longer has floating rate interest risk
    and retains title to the plant, although the plant itself may have
    to serve as additional collateral to obtain the fixed rate debt.
   When the forward sales contracts mature over time, those
    energy sales at forward prices are used to service the SPE
    fixed rate debt.
    Diamond Structure
   A diamond structure arises when three or more sponsors
    form an SPE where no one sponsor has control over the
    SPE. Diamond structures may be separate corporations
    that not even meet the definition of a SPE and yet function
    exactly like an SPE.
   Suppose three major oil companies (sponsors) want to build
    a pipeline. A pipeline corporation is formed with each
    sponsor owning a third of the voting shares. The sponsors
    invest little if any cash in the pipeline company.
   The pipeline company can borrow millions or even billions
    based upon long-term throughput contracts signed by the
    partners to purchase millions of gallons of fuel carried each
    year in the completed pipeline.
   The throughput contracts are essentially forward contracts to
    purchase throughput, revenues from which go to service the
    pipeline's debt and to operate the pipeline.
Defeasance (In Substance Defeasance)
   Defeasance OBSF was invented over 20 years ago by Exxon in
    order to report a $132 million gain on removing $515 million in
    bond debt from its balance sheet.
    An SPE was formed in a bank's trust department. The bond
    debt was transferred to the SPE and the trustee purchased risk-
    free government bonds that, at the future maturity date of the
    bonds, would exactly pay off the balance due on the bonds as
    well as the periodic interest.
   At the time of the bond transfer, Exxon captured the $132
    million gain that arose because the bond interest rate on the
    debt was lower than the current market interest rates.
    FASB Statement No. 125 requires de-recognition of a liability if
    and only if either (a) the debtor pays the creditor and is relieved
    of its obligation for the liability or (b) the debtor is legally
    released from being the primary obligor under the liability.
    Synthetic Lease Structure (sales and
    lease back)
   The sponsor sell the asset to the SPE and then lease it
    back from the SPE.
   A synthetic lease is structured under FAS 140 rules such
    that a sale/leaseback transaction takes place where the
    fair value of the assets "sold" can be reported by the
    sponsor as "revenue" for financial reporting.
   In a synthetic lease, this "revenue" does not have to be
    reported up-front for tax purposes even though it is
    reported up-front for financial reporting purposes.
   Proceeds from the sale to an SPE in this instance are
    generally long-term receivables rather than cash.
   The synthetic leaseback terms are generally such that
    the sponsor does not have to book the leased asset or
    the lease liability under FAS 13 as a capital lease.
    Enron‟s History
   In 1985 after federal deregulation of natural gas
    pipelines, Enron was born from the merger of Houston
    Natural Gas and InterNorth, a Nebraska pipeline company.
   Needed new and innovative business strategy Kenneth
    Lay, CEO, hired McKinsey & Company to assist in
    developing business strategy. They assigned a young
    consultant named Jeffrey Skilling. His background was in
    banking and asset and liability management.
   His recommendation that Enron create a ―Gas Bank‖ to
    buy and sell gas. Lay created a new division in 1990
    called Enron Finance Corp. and hired Skilling to run it.
   Enron soon had more contracts than any of its
    competitors and, with market dominance, could predict
    future prices with great accuracy, thereby guaranteeing
    superior profits.
    Enron’s Strategy
   Skilling began hiring the ―best and brightest‖
    traders and rewarded them handsomely—they
    were allowed to ―eat what they killed‖.
   Started Enron Online Trading in late 90s
   Created Performance Review Committee (PRC)
    that became known as the harshest employee
    ranking system in the country—based on
    earnings generated, creating fierce internal
    competition.
   Enron’s core business (transportation) was
    losing money—shifted its focus from bricks-
    and-mortar energy business to trading of
    derivatives.
Enron’s Strategy
   Most derivatives profits were more imagined
    than real with many employees lying and
    misstating systematically their profits and
    losses in order to make their trading
    businesses appear less volatile than they
    were.
   Enron’s top management gave its managers a
    blank order to ―just do it‖
   Deals in unrelated areas such as weather
    derivatives, water services, metals
    trading, broadband supply and power plant
    were all justified.
    Enron’s Strategy
   Enron delivered smoothly growing earnings (but not
    cash flows). In its last 5 years, Enron reported 20
    straight quarters of increasing income.
   Wall Street took Enron on its word, but didn’t
    understand its financial statements. Enron was a
    trading company and Wall Street normally doesn’t
    reward volatile earnings of trading companies.
    (Goldman Sachs is a trading company. Its stock price
    was 20 times earnings while Enron’s was 70 times
    earnings.)
   Enron, that had once made its money from hard assets
    like pipelines, generated more than 80% of its earnings
    from its vaguer business known as ―wholesale energy
    operations and services.‖
Aggressive Nature of Enron
   Because Enron believed it was leading a
    revolution, it pushed the rules. Employees
    attempted to crush not just outsiders but
    each other.
   ―Enron was built to maximize value by
    maximizing the individual parts. ―Enron
    traders were afraid to go to the bathroom
    because the guy sitting next to them
    might use information off their screen to
    trade against them.‖
    Enron’s Arrogance
   ―Those whom the Gods would destroy
    they first make proud.‖
   Enron’s banner in lobby: Changed from
    ―The World’s Leading Energy Company‖
    to ―THE WORLD’S LEADING COMPANY‖
   ―Older, stodgier companies will topple
    over from their own weight‖ (Jeff Skilling)
   Conference of Utility Executives in 2000:
    ―We’re going to eat your lunch‖ (Jeff
    Skilling)
    Special-purpose Entities (SPEs).
   The parent can bankroll up to 97% of the initial
    investment in an SPE without having to
    consolidate it into its own accounts.
    Normally, once a company owns >50% of
    another, it must consolidate it under the 1959
    rules. The controversial exception: outsiders
    need invest only 3% of an SPE's capital.

(it is changed to 10% by FASB on January, 2003)
    Chewco
   In 1993, Enron and the California Public Employees'
    Retirement System ("CALPERS") entered into a joint
    venture investment partnership called Joint Energy
    Development Investments LP ("JEDI"). Enron was the
    general partner of JEDI and contributed $250 million in
    Enron stock; CALPERS was the limited partner and
    contributed $250 million in cash.
   In approximately the summer of 1997, Enron began to seek
    a buyer for CALPERS‟ share of the JEDI partnership so that
    CALPERS would agree to invest additional funds in an even
    larger partnership to be called JEDI II. CALPERS imposed
    a deadline of November 6, 1997 for the buyout to occur at
    the negotiated price of $383 million.
Chewco
   Fastow proposed the formation of Chewco to buy out
    CALPERS' JEDI interest.
   Before the November 6, 1997 deadline, Fastow and
    others arranged to fund the buyout temporarily through
    "bridge" loans from Barclays Bank PLC ("Barclays") and
    Chase Manhattan Bank ("Chase"). Each bank loaned
    $191.5 million to Chewco, with repayment guaranteed by
    Enron, and Chewco used those loan proceeds to buy
    CALPERS' interest in JEDI.
Chewco
   Fastow and others knew that Chewco failed to comply with SPE non-
    consolidation rules because Chewco had no genuine outside equity
    investment, and because Enron guaranteed Barclays and Chase
    against risk of loss.
   As a result, Enron's year-end financial statements for the years 1997,
    1998, 1999, and 2000 were materially false and misleading. In
    November 2001, Enron announced that it would consolidate Chewco
    and JEDI retroactive to 1997. This resulted in a massive reduction in
    Enron's reported net income and a massive increase in its reported
    debt. The consolidation revealed the following effect, according to
    Enron: reduction of net income in the amounts of $45 million (1997),
    $107 million (1998), $153 million (1999), and $91 million (2000), and
    debt increased in the amounts of $711 million (1997), $561 million
    (1998), $685 million (1999), and $628 million (2000).
    Chewco SPE
   The CEO of Andersen testified -the firm had performed
    unspecified "audit procedures" on the transaction in
    1997, was aware at the time that $11.4 million had
    come from "a large international financial institution"
    (presumably Barclays), and concluded that it met the
    test for 3% residual equity.
   Kopper received $2 million in "management" and
    other fees relating to Chewco. The participation of
    an Enron employee as a principal of Chewco
    appears to have been accomplished without any
    presentation to, or approval by, Enron's Board of
    Directors.
    JEDI Enron stock gains
   From 1993 through the first quarter of 2000, Enron
    picked up its share of income from JEDI using the equity
    method of accounting.
   Changes in fair value of the assets were recorded in
    JEDI's income statement. JEDI held 12 million shares of
    Enron stock, at fair value. Enron and Andersen
    apparently developed a formula in 1996
   The first quarter of 2000 - Enron recorded $126 million
    in Enron stock appreciation
   The third quarter of 2000 decision that income from
    Enron stock held by JEDI could no longer be recorded
    on Enron's income
    JEDI Enron stock gains
   In the first quarter of 2001, Enron stock held by
    JEDI declined in value by approximately $94
    million. Enron share $90 million.
   Enron's internal accountants decided not to
    record this loss based on discussions with
    Andersen.
   According to the Enron accountants, they were
    told by Andersen that Enron was not recording
    increases in value of Enron stock held by JEDI
    and therefore should not record decreases.
    LJM
   In 1999, two partnerships in which Fastow was the manager
    and an investor. LJM 1 and LJM 2. The purposes of the
    LJMs
   (1) manipulate Enron's financial results by fraudulently
    moving poorly performing assets off-balance-sheet;
   (2) manufacture earnings for Enron through sham
    transactions with the LJM entities when Enron was having
    trouble otherwise meeting its goals for a quarter; and
   (3) improperly inflate the value of Enron's investments by
    backdating transaction documents to dates advantageous to
    Enron.
    LJM
   Near the end of the third and fourth quarters of
    1999, Enron sold interests in seven assets to LJM1
    and LJM2. The legitimacy of the sales…
   (1) Enron bought back five of the seven assets after
    the close of the financial reporting period
   (2) the LJM partnerships made a profit on every
    transaction
   (3) according to a presentation Fastow made to the
    Board's Finance Committee, those transactions
    generated, "earnings" to Enron of $229 million in
    the second half of 1999
LJM
   Fastow and the LJM entities engaged in these transactions
    because:
   (1) as CFO,Fastow readily could rid Enron of poorly
    performing assets and thereby improve Enron's reported
    financial results, which in turn would enable Fastow to earn
    continued prestige, salary, bonuses, and other benefits from
    Enron;
   (2) the LJM entities would make money on their dealings with
    Enron, since Enron illegally and secretly guaranteed that the
    LJM entities would not lose money and, if they did, would be
    made whole in future transactions; and
   (3) Fastow and others at the LJM entities personally reaped
    huge sums of money from such transactions, both in the form
    of management fees and skimmed deal profits.
    Raptor I/AVICI
   Enron invested in other companies, including start-up ventures
    that later did initial public offerings ("IPO") of their shares. At the
    time of an IPO, Enron often owned millions of shares of the
    newly public company. Following the IPO, Enron was at risk for
    market price fluctuations in the shares.
   Raptor I was created in April 2000 through an off-balance-sheet
    SPE called Talon LLC ("Talon"). Talon was designed to generate
    accounting gains which would offset Enron's significant mark to
    market losses on certain investments. Talon would enter into
    transactions with an Enron subsidiary that would lock in the
    value of Enron's stock portfolio. If the price of Enron's stock
    portfolio increased, Talon would be entitled to the upside gain,
    and if the stock portfolio declined, Talon would be obligated to
    pay the Enron subsidiary the amount of the loss.
Raptor I/AVICI
   Talon was funded mainly by Enron through a promissory note and
    Enron's own stock. The remainder of Talon's funding, $30 million,
    was from LJM2, representing the purported three percent outside
    equity required for Talon to be off Enron's balance sheet.
   Talon should have been consolidated on Enron's financial
    statements because of an undisclosed side deal engineered by
    Fastow. Pursuant to the side deal, Enron agreed that, prior to
    conducting any hedging activity with Talon, Enron would return to
    LJM2 its full investment in Talon plus a guaranteed return.
   To conceal the side deal, Fastow and others devised a scheme to
    manufacture a $41 million payment to LJM2. Fastow and others
    made it appear that the payment represented the premium paid on a
    "put option" on Enron shares. The put option was a bet by Enron
    that its own stock price would decline. There was no true business
    purpose for the put option other than to generate funds to pay LJM2
    under the undisclosed side deal.
Raptor I/AVICI
   One Raptor I hedges related to its attempt to lock in substantial
    gains from its stock holdings in AVICI Systems, Inc., an Internet
    company that had recently engaged in an IPO. The stock price
    of AVICI had declined by the end of Enron's third quarter 2000,
    Fastow engaged in a fraudulent scheme to backdate the AVICI
    hedge to achieve a significant economic advantage for Enron.
   Fastow caused the AVICI hedge to be backdated to August 3,
    2000. Fastow chose this date because he knew it was the date
    AVICI traded at an all time high price of $163.50. By back-dating
    the AVICI hedge in this manner, Fastow and Enron fraudulently
    locked in the recognition of a substantial gain and booked $75
    million in additional mark to market gains that they otherwise
    would not have recognized. To facilitate the fraud, the put option
    was purportedly settled early, also on August 3, 2000, so that
    Enron could use Raptor I for hedging purposes.
    Rhythms/Southampton
   Enron had an investment in an Internet company called Rhythms
    NetConnections, Inc. ("Rhythms"). Enron owned 5.4 million
    shares of Rhythms stock, and following an IPO in April 1999,
    Enron was at risk for market price fluctuations in the stock.
    Because Enron was restricted from selling its shares until
    November 1999, it sought to reduce the impact on its financial
    results of a possible dramatic decline in the share price of
    Rhythms stock.
   In June 1999, Enron devised a "hedge“ through LJM1 created a
    subsidiary known as LJM Swap Sub, L.P. ("Swap Sub"), which
    was funded with cash and Enron shares. Swap Sub thereafter
    entered into a series of transactions These transactions included
    a "put," which gave Enron the right to sell its Rhythms shares to
    Swap Sub for a set price on certain future dates even if the
    market value of the Rhythms Net shares was below the set price.
Rhythms/Southampton
   In the third and fourth quarters 1999, the share price of
    Rythms Net decreased significantly and Enron was able to
    record gains from its transaction with Swap Sub to offset
    losses it incurred on its Rythms Net investment.
   In January-February 2000, both Enron and Rhythms shares
    increased in price, making Swap Sub's main asset (its Enron
    shares) more valuable while decreasing its potential liability
    on the Rhythms put option. Thus, Swap Sub had significantly
    more value than previously. Fastow was prohibited from
    having any direct pecuniary interest in Enron's stock held by
    LJM1. Nevertheless, in approximately February 2000, Fastow,
    Kopper, and three NatWest bankers devised and later
    executed a scheme to capture the increase in Swap Sub's
    value for themselves.
Rhythms/Southampton
   (i) causing Enron to pay $30 million to buy out, or
    "unwind," the banks„ interests in Swap Sub;
   (ii) causing NatWest to accept only $1 million for its
    interest in Swap Sub, while representing to Enron that
    NatWest was getting $20 million, and
   (iii) splitting the $19 million balance among themselves
    and certain Enron and LJM employees.
    Enron Issues
   Consolidation Issues
       In 2001, Enron and Andersen concluded that
        Chewco lacked sufficient outside equity at risk to
        qualify for non-consolidation.
       This retroactive consolidation decreased Enron's
        reported net income by $95 million (of $893 million
        total) in 1999 and by $8 million (of $979 million
        total) in 2000.
   Self-Dealing Issues
       These related-party transactions facilitated
       - accounting and financial reporting abuses by
        Enron
       - extraordinarily lucrative for Fastow and others.

								
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