enron and worldcom scam

8/7/2019 Enron and worldcom scam

1/37

FINA 503

DATE: 02/18/10

JOSE CINTRON,MBA


2/37


3/37

WORLDCOM:

In 1998, the telecommunications industry began to slowdown and WorldCom's stock was declining. CEO came underincreasing pressure from banks to cover margin calls on his

WorldCom. Beginning in 1999 and continuing through May2002, WorldCom used shady accounting methods to mask itsdeclining financial condition by falsely professing financialgrowth and profitability to increase the price of WorldCom's

stock.


4/37

HOW THISHAPPEN

The fraud was accomplished in two main ways.

First, WorldCom's accounting departmentunderreported 'line costs' (expenses with other

telecommunication companies) by capitalizing thesecosts on the balance sheet rather than properlyexpensing them.

Second, the company inflated revenues with bogus

accounting entries from corporate unallocated revenueaccounts.


5/37

Revenues xxx

(no change)

COGS xxx

(no change)

Computer expenses:xxx

(Huge Decrease)

Fees companies phone

networks: xxx

(Huge Decrease)

NET INCOME

xxx (Huge Increase)

How the Fraud took place

CFOs directionsaffected the income

statement:


6/37

Overstating Asset Frauds (WorldCom)

y Overstatement of current assets(marketable securities)

y Overstating pension assets

y Capitalizing as assets amounts that should be expensed

y Failing to record depreciation/amortization expensey Overstating assets through mergers and acquisitions

y Overstating inventory and receivables


7/37

HOW WAS it DISCOVERThe first discovery of illegal activity was by WorldCom'sown internal audit department who uncovered $3.8 b. ofthe fraud in June 2002. The company's audit committee

and board of directors were notified of the fraud.The Securities and Exchange Commission (SEC)launched an investigation. By the end of2003, it wasestimated that the company's total assets had been

inflated by around $11 billion.


8/37


9/37

Largest Bankruptcy Filings

CompanyCompany Assets (Billions)Assets (Billions) When FiledWhen Filed

1. WorldCom1. WorldCom $103.9$103.9 July 2002July 2002

2. Enron2. Enron $63.4$63.4 Dec. 2001Dec. 2001

3. Conseco3. Conseco $61.4$61.4 Dec. 2002Dec. 20024. Texaco4. Texaco $35.9$35.9 April 1987April 1987

5. Financial Corp of America5. Financial Corp of America $33.9$33.9 Sept. 1988Sept. 1988

6. Global Crossing6. Global Crossing $30.2$30.2 Jan. 2002Jan. 2002

7. PG&E7. PG&E $29.8$29.8 April 2001April 2001

8. UAL8. UAL $25.2$25.2 Dec. 2002Dec. 2002

9. Adelphia9. Adelphia $21.5$21.5 June 2002June 2002

10. MCorp10. MCorp $20.2$20.2 March 1989March 1989


10/37

Z-scoreAnaly

sisfor

WorldC

om

The Z-score formula for predicting bankruptcy.Ratio Definition 1999 2000 2001

y X1 Working capital/total assets (0.08) (0.08) (0.00)

yX2 Retained earnings/total assets (0.01) 0.03 0.04

y X3 Earnings before interest and taxes/total assets 0.08 0.08 0.02

y X4 Market value of equity/book value of total liabilities 3.58 1.13 0.54

y X5 Sales/total assets 0.39 0.40 0.34

ZZ-score 2.697 1.274 0.798

y Z > 2.99 -Safe 1.8 < Z < 2.99 -Grey Z < 1.80 -Distress

Z-scores for WorldCom based on its annual 10-K reports .We foundthat the company indeed experienced a rapid deterioration in its

Z-score.


11/37

CONSOLIDATING BALANCE SHEET (10K SEC)(IN MILLIONS) AT DECEMBER 31, 2000

WORLDCOM MCI GROUP ELIMINATIONS WORLDCOM

Current assets...................................... $ 9,068 $ 2,312 $(1,625) $ 9,755

Property and equipment, net......................... 35,177 2,246 -- 37,423

Goodwill and other intangibles...................... 36,685 9,909 -- 46,594

Other assets........................................ 4,963 168 -- 5,131

Total assets...................................... $85,893 $14,635 $(1,625) $98,903

Current liabilities................................. $14,213 $ 5,085 $(1,625) $17,673

Long-term debt...................................... 11,696 6,000 -- 17,696Noncurrent liabilities.............................. 3,648 1,087 -- 4,735Minority interests.................................. 2,592 -- -- 2,592Company redeemable preferred securities...... 798 -- -- 798

Shareholders' investment............................ 52,946 2,463 -- 55,409

Total liabilities and shareholders' investment.... $85,893 $14,635 $(1,625) $98,903

======= ======= ======= =======

y $ 9,755 / 17,673=(7,918) WORKING CAPITAL OR .55 CURRENT RATIOTHE HIGHER THIS RATIO THE BETTER TO MEET THEIR CURRENT OBLIGATIONS.


12/37

WorldCom Statement of Cash flowCash flows from operating activities: 2000 2001

Net income Operating Activities $4,153 $1,501

OriginallyReported Revised as ofApril 15, 2004

2000 2001 2002

N Net loss $ -48,909 -15,597 -9,173


13/37


14/37

What do these dates have in

common?y December 2, 2001

y July 19, 2002

y

August 31, 2002

Enron declaresbankruptcy

MCI WorldCom declaresbankruptcy

Arthur Anderson agrees tostop auditing publiccompanies


15/37

How did this happen?

y Earnings pressure

y Lack of mandated disclosureof company reporting model

y Minimal oversight intocorporate business practices

y No documented or enforcedinternal controls

y Dependency on consulting fees

y Assumed good intent of theirclient

y Inability to continuously monitora companys internal controls

y Unable to identify violations ofinternal controls

Corporate Issues Audit Firm Issues


16/37


17/37

Sarbanes Oxley Act

y Section 103: Your auditor (and therefore, you should)maintain all audit related records, including electronic

ones, for seven years.

y Section 201: Firms that audit your companys bookscan no longer provide you with IT related services.

y Section 301: You must provide systems or proceduresthat allow employees to communicate effectively with

the audit committee.

Highlights


18/37

Sarbanes Oxley Act

y Section 302: Your CEO and CFO must signstatements verifying the completeness and accuracy offinancial reports.

y Sections 404 CEOs, CFOs and outside auditors mustattest to the effectiveness and accuracy of financialreports.

y Section 409: Companies must report material

changes in their financial conditions on a rapid andcurrent basis. The act calls it real-time disclosure butis unclear on what it means.

Highlights(continued)


19/37

SarbanesOxley Act

Behavior Consequence

Any CEO or CFO who recklessly violates hisor her certification of the companys financialstatements.

If willfully violates.

Fine of up to $1,000,000 and/or up to 10 yearsimprisonment.

Fine of up to $5 million and/or up to 20 yearsimprisonment.

Any person who corruptly alters, destroys,conceals, etc., any records or documents with

the intent of impairing the integrity of the record

or document or use in an official proceeding.

Fine and/or up to 20 years imprisonment.

SarbanesOxley Law


20/37

Sarbanes- Oxley

Impact onInformation Systems


21/37

The 3 Cs ofSarbanes-Oxley

The jobs of the CEO, CFO & CIO got tougher onJuly 30, 2002 -- the day the Sarbanes-Oxley Act

was signed. The legislation requires significantchanges to financial practices and corporategovernance, and touches all corporate areas --including technology. For the first time ever, the

CFO and CEO can look a CIO in the eye and say,'Guess what, you're on the hook with us.'

CEOs, CFOs andCIOs


22/37

System Control Examples

y Financial Statement Generationy Report parameter changes are documented

y Data that generates financial statements is accurate

y Inventory

Item Creation

y Costing is accurately assigned

y Purchasingy Approved suppliers are used

y Approval limits cannot be easily manipulated

y Customer Creationy Duplicate customers

y Credit limits


23/37

Oversight of Financial Data Examples

y Standard Data Entry is Enforced

y Accurate reporting

y Segregation of Dutiesy Separation of functions to minimize risk of fraud

y Audit changes to sensitive data

y Approval processes for creation of financial data

y versight into Financial Processesy Ensure all month/year end activities are completed


24/37

Benefits of the New Oxley Act1. Increased confidence of CEO/CFO in meeting requirements

2. Improved coordination of Company Management Team

3. Improved and clarified Corporate Governance process

4. Systematized process for early identification of business

risks/ whistle blowing issues/incident management

5. Systematized approach to dealing with change (i.e.,

transactions, personnel, accounting principles, internal

controls and operating procedures)

6. Increased operational effectiveness


25/37


26/37

The Enron Scandaly On October 22, 2001, the Securities and

Exchange Commission (SEC) begins an

inquiry into Enrons accounting practices.

y On December 2, 2001, Enron files for bankruptcy,the largest bankruptcy in US history up to that time


27/37


28/37

How this happeny The company used shortcomings ofRule-Based US

GAAP , special purpose entities, and poor financialreporting to hide billions in debt from failed dealsand projects.

y Enron's audit committee failed to follow up onhigh-risk accounting issues

y Andersen was pressured by the company to ignoreaccounting practices.


29/37

How this happen.Continued

1993-2001: Enron senior management used.

Complex and foggy accounting schemes

y to reduce Enrons tax payments;

y to inflate Enrons income and profits;

y to inflate Enrons stock price and credit rating;

y to hide losses in off-balance-sheet subsidiaries;

y to engineer off-balance-sheet schemes to directmoney to themselves, friends, and family;

y to fraudulently misrepresent Enrons financial

condition in public reports.


30/37


31/37

Example of one scheme Continuedy Enron used partnerships to hide bad bets it made

on speculative assets by selling these assets to thepartnerships in return for IOUs backed by Enronstock as collateral! (over $1 billion by 2002)

y In November 1997, Calpers wanted to cash out ofJEDI.

y To keep JEDI afloat, Enron needed a new 3%

partner.y It created another partnership Chewco to buy

out Calpers stake in JEDI.


32/37

Example of one scheme Continued

y Chewco needs $383 million to give Calpers

y It gets..

$240 million loan from Barclays bank

guaranteed by Enron $132 million credit from JEDI (whose only asset

is Enron stock)

y Chewco still must get 3% from some

outside source to avoid inclusion in

Enrons books


33/37


Chewco Capital Structure: Outside 3%

y $115,000 from M. Kopper (worked at

the time for Enron)y $11.4 million loans from Big River and

Little River (two new companies formed

expressly by Enron for this purpose who

get a loan from Barclays Bank)


34/37


y Barclays Bank begins to doubt the strength of the newcompanies Big River

and Little River.

y It requires a cash reserve to be deposited (as security)for the $11.4 million dollar loans.

y This cash reserve is paid by JEDI, whose net worth bythis time consists solely of Enron stock, putting Enron

in the at-risk position for this amount


35/37

Profit to Enron from all this?

y $10 million in guarantee fee + fee based on loanbalance to JEDI. A total of $25.7 million revenues fromthis source.

y

Increase in price of Enron stock held byJEDI. Enron recognized $126 million in

the first quarter of 2000 from this.

y But everything began to fall apart

when Enrons share price started to

drop in Fall 2000.


36/37

Generally Accepted Accounting

Principles prior to 2002.y Auditing companies often consult for the

companies they audit (conflict of interest).

y

Audit company partners often later acceptjobs from their client companies.

y Companies often retain the same auditing

company for long periods of time.

y

Auditing companies have been allowed to policethemselves.

y Appointment of auditor company is in theory byshareholders but in practice by senior management


37/37

REFERENCESWorldCom Scandal-Retrieved-February15, 2010 from:

http://www.associatedcontent.com/article/162656/worldcom

WorldCom finds accounting errors-February15, 2010 from:

http://www.networkworld.com/news/2002/0626wcom.htmlhttp://secfilings.com/searchresultswide.aspx?Tab Index=2&FilingID=317601&type=html&companyid=11628&ppu=%2fdefault.aspx%3fticker%3d%26amp%

3bname%3dWORLDCOM%26amp%3

enron and worldcom scam

Documents