Corporate Fraud

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a case study on corporate fraud

Corporate Fraud and the Impact of Sarbanes-Oxley

Brian Olin
May 9, 2005
Table of Contents
1. Introduction2
2. Background4
2.1 The Need for Corporate Governance4
2.2 The U.S. Approach7
2.2.1 Free Market8
2.2.2 Directors9
2.2.3 Disclosure10
2.2.4 Management Compensation12
2.2.5 How it Should Work14
3. How Corporate Governance Was Abused And Why14
3.1 What Happened at Enron and WorldCom15
3.1.1 Enron15
3.1.2 WorldCom17
3.2 Why They Did It18
3.2.1 Short-Term Problem18
3.2.2 Pressure to Grow19
3.2.3 Protect Their Wealth20
3.3 Why They Thought They Could Get Away With It21
3.3.1 The Board of Directors21
3.3.2 Auditors23
3.3.3 Disclosure24
3.3.4 Low Occurrence of Past Scandals and Mild Consequences25 4. The Decision to Commit Fraud27
4.1 Pre-SOA Model28
4.2 The Sarbanes-Oxley Act30
4.3 Post-SOA Model32
5. Conclusion34

6. References36

Appendix A38
Appendix B39

1. Introduction
“It was one of the world’s most admired companies, with a market capitalization of $80 billion. Today, it’s in bankruptcy” (Berardino 2001). The company is Enron, which filed for chapter 11 bankruptcy in December of 2001 (Hirsch 2001). Enron was the seventh-largest U.S public company with $100 billion in revenue in 2000. When Enron filed for bankruptcy, it reported $13.15 billion in debt, as well as $31.24 billion in debt when its subsidiaries were accounted for (Sender 2001). Most of this debt had been hidden from investors through complex accounting techniques. “Enron was viewed as a company that always made its numbers” (Norris 2001). However, it is clear that investors did not really understand how it was making its numbers. As new information has been revealed, it has become clear that the company became over leveraged[1] and was able to hide its debt with the help of its external auditing firm Arthur Andersen. Enron used sophisticated financing vehicles known as Special Purpose Entities (SPEs) and other off-balance sheet structures to hide its debt from investors (Berardino 2001). Enron was able to increase its leverage (debt to assets) without having to report that debt on the balance sheet. However, the debt eventually caught up to the company and it could no longer pay its bills, causing it to file for bankruptcy. Enron’s bankruptcy has had far reaching consequences throughout the globe. Investors lost billions of dollars as Enron’s stock plunged. Enron employees alone lost approximately $1 billion worth of savings (Brennan 2003). Stockholders were basically out of luck in the bankruptcy proceedings and looked to lose everything they invested in Enron. As new corporate governance scandals have emerged, such as WorldCom and Adelphia, the need to examine corporate governance has amplified. But what is corporate governance? In the United States, Corporate Governance most often is referred to as “how to ensure the managers follow the interests of shareholders” (Vives 2000). As Vives points out, this can more generally be thought of as “ensuring that investors get a return on their money” (2000). It is assumed then, that what is in the best interest of shareholders is for them to get a return on their money. Since people most often choose to buy stock because of the potential for the stock price to increase, it follows that managers acting in the best interest of the shareholders would try to maximize the company’s stock price. The stock market generally reflects future expectations of profitability; a decision in the present will affect the stock price by how the market views the future effects of the decision. Thus, by making decisions that help the long-run health of the company, the present stock price will increase. Because of this relationship, the...
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