What Went Wrong? Accounting Fraud Andlessons from the Recent Scandals

Topics: Enron, Enron scandal, Accounting scandals Pages: 35 (10896 words) Published: March 8, 2011
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In the public eye, Enron's mission was nothing more than the cover story for a massive fraud.

--Bethany McLean and Peter Elkind

CORPORATE FRAUD, BANKRUPTCIES, AND VARIOUS ILLEGAL ACTS HAVE

always been part of the business environment. Every time fiascos erupt there is a shock, but business history records dozens of major failures, frauds, and other measures of massive corruption each decade. The big ones often hit during recessions or periods of other economic problems, as expected. The high-risk firms are the most vulnerable to economic shocks. The recent scandals are no exceptions. The most important scandals are the focus of this paper and are summarized in table 1.

Although the problems that exist are diverse, a few common characteristics stand out. The first is the obvious backdrop of corporate greed. Presumably, senior executives expect to get away with it. They also fit the financial-corporate culture described above. And earnings manipulation is part of (and usually central to) most of the scandals. Some of them used brazen and unsophisticated approaches (such as WorldCom), while others used new, sophisticated devices to defraud (like Enron). Determining the existence of criminal acts takes years.

Two industries were particularly prominent in the scandals: the energy companies and telecommunications. Deregulation allowed the stodgy energy companies that carried out such basic operations as transmitting natural gas to become high-tech energy traders using sophisticated derivatives and structured-finance deals. The result was giant profits for the lenders. Continued big profits meant increasing risks and more complex deals. For Enron and others it also meant hiding the losses in controversial and often fraudulent off-balance-sheet schemes. The telecommunications industry transformed from monopolist AT&T in the 1970s to a group of dynamic and competitive high-tech giants, all trying to integrate and dominate with new telecommunications methods. Overcapacity led to shady capacity-trading schemes booked as revenues and, despite the deceptive accounting, big losses and bankruptcies.

The various investment bank scandals are included because their deceptive practices encouraged earnings management and an environment of fraud. The recent mortgage-related scandals directly involve investment banks. Investment banking deals, especially those that were complicated and skirted the regulations, were very profitable. The banks would seemingly do any deal and locate it anywhere in the world for the right price. Rather than emphasizing financial and economic reality, analysts and brokers were encouraged to push stocks of companies doing investment-banking business with the parent company, irrespective of the underlying performance potential.

Enron and WorldCom were the largest scandals in American history in terms of the size of the companies (based on market capitalization). Both represent fraud on a large scale, although entirely different from one to the other. Enron used sophisticated fraud based on complex financial instruments, while WorldCom used an unsophisticated scheme of capitalizing operating expenses for several billion dollars. Many of the other corporate scandals around 2002 also involved relatively large companies. The shock of Enron led to congressional hearings and, after the fall of WorldCom some six months later, real financial reform with the passage of the Sarbanes-Oxley Act of 2002.

ENRON

Enron is the premier scandal, a "new economy" energy-trading company that seemed to succeed at everything it attempted. At its height, which occurred on August 23, 2000, Enron had a stock price over $90, which gave it a market value of almost $70 billion. Revenues for 2000 were over $100 billion, making it the seventh-largest American corporation (based on revenues); stated assets were $65.5 billion; earnings were $1.3 billion (if a $287 million write-off is ignored). Stock...


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