; Corporate Accounting Scandals Insurance Agenda for Today  The diminishing audit quality of the 1990s  The bubble burst  Enron WorldCom Global Crossing Tyco Adelphia etc… 
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Corporate Accounting Scandals Insurance Agenda for Today  The diminishing audit quality of the 1990s  The bubble burst  Enron WorldCom Global Crossing Tyco Adelphia etc… 


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									Corporate Accounting
Scandals & Insurance
Agenda for Today
   The diminishing audit quality of the 1990s
   The bubble burst
   Enron, WorldCom, Global Crossing, Tyco,
    Adelphia, etc…
   Reform!!! Sarbanes-Oxley and newfound
    corporate accountability
   Newfound litigation grounds  New Need for
Why so many financial statement
frauds all of a sudden?
   Good economy was masking many problems
   Moral decay in society
   Executive incentives
   Wall Street expectations—rewards for short-term
   Nature of accounting rules
   Behavior of CPA firms
   Greed by investment banks, commercial banks, and
   Educator failures
These Are Interesting Times
   Number and size of financial statement frauds are
   Number and size of frauds against organizations are
   Some recent frauds include several people—as
    many as 20 or 30 (seems to indicate moral decay)
   Many investors have lost confidence in credibility of
    financial statements and corporate reports
   More interest in fraud than ever before—now a
    course on many college campuses
Why Was There Earnings
What is Earnings Management?

 Basically, it is manipulating the financial
 statements of a company to misrepresent the
 true financial health of the company.
Incentives for F.S. Fraud
  Incentives to commit financial statement fraud are very
  strong. Investors want decreased risk and high returns.
  Risk is reduced when variability of earnings is decreased.
  Rewards are increased when income continuously improves.

          Firm A                        Firm B

       Which firm will have the higher stock price?
Nature of Accounting Rules
   In the U.S., accounting standards are “rules-based”
    instead of “principles based.”
       Allows companies and auditors to be extremely creative
        when not specifically prohibited by standards.
       Examples are SPEs and other types of off-balance sheet
        financing, revenue recognition approaches, merger
        reserves, pension accounting, and other accounting
       When the client pushes, without specific rules in every
        situation, there is no room for the auditors to say, “You
        can’t do this…because it isn’t GAAP…”
       It is impossible to make rules for every situation
Why Was There Earnings
   Reasons are probably wide and varied.
   Complex problem.
   Earnings management almost became the
    norm in corporate America.
   Corporations needed to manage their
    earnings to remain competitive with other
Why Was There Earnings
   Audit quality was insufficient.
   Competition for business was driving the
    price of audits down. Not much of a premium
    paid for having accurate audits.
   Accounting firms focusing more on profitable
    services like consulting.
Why Was There Earnings
   Financial service firms offered consulting
    services in addition to audits.
   Consulting is Advisory services to help senior
    management improve the effectiveness of
    corporate strategy, process, or operations by
    assessing business needs and reviewing
    business functions, plans and directions.
Why Was There Earnings
   Possible conflict of interest with accounting
    firms providing both audit services and
    consulting services.
   Audit partners becoming more “friendly” with
    upper management. After all, they want to
    keep business!
   Audit partners compensated more on
    bringing in business than on their technical
The Scandals
   The culmination of the aforementioned
    accounting problems was the bubble burst of
    the late 1990s and the early 2000s.
   Some companies that we’ve all heard of
    failed as a result of corruption and fraud:
       Enron
       WorldCom
       Global Crossing
       Adelphi
Largest Bankruptcy Filings
(1980 to Present)
from BankruptcyData.com

Company                        Assets (Billions)   When Filed
1. WorldCom                    $103.9              July 2002
2. Enron                       $63.4               Dec. 2001
3. Conseco                     $61.4               Dec. 2002
4. Texaco                      $35.9               April 1987
5. Financial Corp of America   $33.9               Sept. 1988
6. Global Crossing             $30.2               Jan. 2002
7. PG&E                        $29.8               April 2001
8. UAL                         $25.2               Dec. 2002
9. Adelphia                    $21.5               June 2002
10. MCorp                      $20.2               March 1989
   Using Special Purpose Entities as a haven
    for debt, synthetic profit.
   Enron created several hundred of these
    special purpose entities.
   Auditors failed to stop the misstatements.
   Investors lost nearly $60 Billion in the
    collapse of the 5th largest corporation in the
   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.
   Enron incurred massive debt and no longer had exclusive rights
    to its pipelines.
   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
   His recommendation: that Enron create a “Gas Bank”—to buy
    and sell gas
Enron’s History (cont’d)
   Created Energy derivative
   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.
   Skilling hired the “best and brightest” traders and rewarded
    them handsomely—the reward system was eat what you kill
   Fastow was a Kellogg MBA hired by Skilling in 1990—
    Became CFO in 1998
   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 Use of Special Purpose
Entities (SPEs)
   To hide bad investments and poor-performing assets (Rhythms
    NetConnections). Declines in value of assets would not be
    recognized by Enron (Mark to Market).
   Earnings management—Blockbuster Video deal--$111 million
    gain (Bravehart, LJM1 and Chewco)
   Quick execution of related-party transactions at desired prices.
    (LJM1 and LJM2)
   To report over $1 billion of false income
   To hide debt (Borrowed money was not put on financial
    statements of Enron)
   To manipulate cash flows, especially in 4th quarters
   Many SPE transactions were timed (or illegally back-dated) just
    near end of quarters so that income could be booked just in time
    and in amounts needed, to meet investor expectations
What did Arthur Andersen Do?
   Andersen employees ordered tons of Enron
    paperwork to be shredded before the
    investigation of the fraud began.
       Rumor: U of I Arthur Andersen interns during
        2001 claim to have shredded a ton of documents!
   Capitalized their line costs.
   Line costs should have been expenses,
    however, the false capitalization overstated
    WorldCom's assets by billions of dollars.
Global Crossing
   Management had “unrealistic” revenue
   Tried everything they could to meet the
   “Swapped” fiber optic capacity to boost
   Revenue restatement of $19 million,
    overstated assets by $1.2 billion
   Several Vacation Homes and luxury
    apartments in Manhattan
   Several private jets
   Construction of a world-class 18-hole golf
   Majority ownership of the Buffalo Sabres
   $700,000 membership in an exclusive golf
   Investor backlash
   Billions lost in the frauds of 2001, 2002.
   US government determined to deter frauds of
    this magnitude in the future.
   Created in 2002 in the wake of the previously
    mentioned accounting scandals.
   Created accountability among corporate
SOX 2002
   Section 302 pertains to liability.
   CEO/CFO must sign off on financial statements- can
    be held criminally liable if financials are false.
       Material Accuracy- The amount listed in the financials has
        to be an accurate reflection of where the company is at.
       Fair presentation of financial information
       Disclose controls- so material information about a company
        gets presented to top management.
       Internal Accounting controls- provide assurance that the
        financials conform to GAAP.
SOX 2002 Section 302
   Based on the officer’s knowledge, the
    financial statements do not contain any
    material misstatements or omissions.
   The financial statements fairly state the
    company’s financial position and results from
    past operation.
New Grounds for Litigation
   In 2002, the U.S. Congress passed the Sarbanes
    Oxley Act, which has had a major impact on the
    liability of directors and officers. Although this
    legislation protects shareholders and is expected to
    improve corporate governance, it also bears the risk
    of increasing the number of litigations. This act
    establishes new fines and penalties for the
    corporate board for securities fraud violation
    involving accounting irregularities and financial
Directors & Officers Insurance
New Demand for Director’s
and Officer’s insurance
Think of the lawsuits facing some of Enron’s
Others Paying Out From Enron
    *Robert Belfer- a director of Enron
    *Norman Blake- a director of Enron
    *Ronnie Chan- a director of Enron
    *John Duncan- a director of Enron
    Paulo Ferraz-Pereira- a director of Enron
    *Joe Foy- a director of Enron
    *Wendy Gramm- a director of Enron
    *Robert Jaedicke- a director of Enron
    *Charles LeMaistre- a director of Enron
    *Rebecca Mark-Jusbasche- Chairman and CEO of Enron International and later Vice
    Chairman, and CEO of Azurix
    John Mendelsohn- a director of Enron
    Jerome Meyer- a director of Enron
    Frank Savage- a director of Enron and a member of its Finance Committee
    John Urquhart- a director of Enron and was senior advisor to the Chairman in 1998
    John Wakeham- a director of Enron
    Charls Walker- a director of Enron
    Herbert Winokur- a director of Enron
   Class action suits in the Hundreds of millions of dollars range. Part
    of which was paid out of pocket due to directors not carrying
    adequate Directors and Officers Insurance.
New Demand for Director’s
and Officer’s insurance
   Think of the liability for Arthur Andersen’s
    partners on the Enron account!!
Implications of Liability
   As a company officer, you are responsible for
    not only your actions, but those of your
    subordinates as well.
   Most technical information within a company
    gets passed up through the hierarchal layers
    for the company from bottom to top.
Professional Liability
   Most CGL policies exclude professional
    liability loss exposures.
   Legal fees for defending professional
    liabilities cases can be very costly.
Other Effects of Enron on DOL
   Approximately 50% of all Directors and Officers
    Liability claims are tied to Employment Practices
    Liability claims. Employees that were once silent
    about workplace harassment and discrimination are
    now speaking out and taking action against their
   Plant closings, layoffs, and mergers and acquisitions
    are commonplace events that are providing fertile
    ground for multi-million dollar class action claims.
   The case of Enron in late 2001, coupled with an
    already large downturn in the economy, has further
    affected the pricing for Directors and Officers
D&O Insurance
   The cost for Director's and Officer's
    Insurance has gone up dramatically, and the
    exclusions for coverage have increased.
A Twist to Enron’s D&O
   Some of Enron’s D&L claims were not paid
    because since the claims resulted from
    misrepresentation, the insurance companies
    refused to pay the claim!
       Self insurance retention
The Future?
   These scandals might be reduced by new
    laws, but they won’t totally disappear.
   Watch for new developments in regulations.
       SOX adjustments
   More large D&O claims.
   Some material taken from the AICPA

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