ADM4341Lecture #1Sept 8, 10The Crisis of Confidence in the Auditing Profession

Enron & WorldComPresented by

Chris Liboiron BBA,CPA, CA, CIA, CFE, CRMA

What is this Course About?Course Objectives This course mixes lectures and student lead seminars. The objectives of this course are to:1. Examine and consider the role of the auditing profession and

of the audit in society;2. Develop knowledge of selected current issues facing the

auditing profession today;3. Give some helpful hints on how to be a better staff accountant

(and auditing student) at work4. Provide a greater understanding of the general assurance

framework and its underlying theories; and 5. Review specific topics that build upon general auditing

concepts.

Who are you? Why are you here? What about auditing interests

you? Future career paths? Expectations from me?

How Will I Be Graded?Course Grading – brief discussion

Participation 5% Midterm 20% Research Seminar 30% Final examination 45%

100 %

Participation (5%) Participation = Completely SUBJECTIVE Quality and quantity will be considered. Professionalism It is important that I know who you are… Attendance is NOT Participation… Quality and Quantity considered. Lots of “0”’s and “1”’s last semester. Name tags?

Midterm (20%)

All lectures, cases, articles Definitions, short answer, medium answer 2 hours October 17, 2015 DMS1150-DMS1130 13:00-

15:00

Seminar (30%)

Seminar rules Group effort – joint and several (story) Will require research Outline/Consultation How does my topic relate to the course? Balance of material Group Formation Challenges Research needed to get comfortable

Final (45%)

Cumulative Cases, lectures, readings, seminars

Course Materials i) Contemporary Auditing: Real Issues and

Cases, 9th, 10th edition, 2006, by Michael C. Knapp ii) Additional readings have been assigned and

may be assigned throughout the term, as appropriate.

Tips for the Class

Seminar based class – those who are interested in the material

Those who READ THE CASES and articles, research their topic; normally outgoing

Prepare, ask questions and are curious to learn and listen

Participate and interact I will not post answers to case questions

Miscellaneous My background Name tags QUESTIONS?? Or…

By appointment (including before class) Phone discussion at mutually agreeable time

Where to start?Tonite’s Enron, Andersen, WorldCom Learning Objectives

Understand the history of Enron/WC and Andersen; including brief overview of US public acctg profession

Understand how Enron/WC Execs may have been driven to fraud

Review recent recommendations to strengthen the indep audit function

Examine extent to which independent auditor should be involved in their client’s decisions regarding important accounting and financial reporting issues

Understand the basic mechanics of how the frauds were committed, including the understanding of SPE’s

Understand the “Crisis of Confidence” and Lessons Learned from the Enron/WC debacle

We know “What” Arthur Anderson is/was… but…Who was Arthur Andersen? Family immigrated to Ill from Norway

in 1881 Born 1885 Had fascination with numbers -

Discipline, honesty, and strong work ethic were key traits instilled in Arthur; education

Orphaned as teen Accepted position with PW (most

prominent firm) in 1908 (CPA at 23) Formed Andersen and Delaney, and

then Andersen.

1915 - Dilemma one audit client= operated several

steam freighters that delivered various commodities to ports located on Lake Michigan

Following close of fiscal year, but before Andersen had issued audit report, one of the ships sank in Lake Michigan

At time their were few formal rules for companies to follow in preparing their annual f/s and certainly no rule to report “subsequent event” occurring after years end like loss of major asset…

Who would this interest? WWYD? Describe the added importance to the

auditing profession in the early 1900’s

Cont…

Andersen insisted on client disclosure on f/s Reasoning…? 3rd parties would want to know about this

happening Client finally agreed to put event in f/s

Uncompromised integrity Another example - Dupont/Audit

team argue over how to define operating income

AA sided with team Refused to provide unqualified Dupont dismissed them and

hired another auditor relied on four word motto –

think straight, talk straight – insisted it of his staff and insisted it of his clients through talking through f/s

Andersen Qualities Qualities = opinionated, stubborn, difficult , but

honest and 100% integrity Businessman…realized the growth in economy in

1920’s = companies involved in the production and energy dept

Succ focus on utility type companies, was successful Great depression of the 30’s posed huge financial

problems for Andersen audit clients in electric utilities industry ;

Andersen’s rep assisted his clients in obtaining financing; referrals

Cont…

Andersen = Successful formula/motto: Mid 40’s AA = strong eastern half of the United States w/ 1000+ accountants.

Andersen died in 1947 ; #1 protégé to top position – Leonard Spacek

Cont… Spacek had worked for AA

since 1928; sim to AA Belief = primary role of

independent auditor was to ensure that their clients reported fairly and honestly – as then auditors obligation is to the user

continued to lobby profession for more comparable stds so that different companies may be compared

EARLY ENRON

Northern Natural Gas Company , Omaha, NB, 1930

Principal inv =Texas based Company – Lone Star Gas Corporation.

Early Enron Cont… Depression = cheaper methods

for heating and many turned to natural gas

Problems with using natural gas in early 1930’s??

Cheap manual labor in the 30’s developed a pipeline to deliver product

As profits grew, company merged and acquired other smaller competitors

Continued growth over next two decades

Early Enron Cont… During 1970’s Northern =principal investor in

dev of Alaskan pipeline; tapped into CDN resources

1980 changed name to InterNorth Inc. Continued investing and growing through the

80’s mgmt extended scope by investing in

other ventures including oil exploration, chemical, coal mining and fuel trading operations

Early Enron Cont…

In 1985 Internorth purchased Houston Natural gas Company for $2.3B

Controlled 40,000 mile network of Nat Gas pipeline making it largest Nat gas Supplier in USA

1986 – changes name to Enron Kenneth Lay – former chairman of

Houston Nat Gas = top exec and based Enron HQ in Houston Texas

Continued aggressive growth strategies

Enron Cont…

1986 Hired Jeffrey Skilling During 1990’s Skilling developed plan to alter

Enron scope from being a Nat gas Provider to Energy Trading Company

2001 – Skilling became CEO – although Lay became chairman of board

Enron Pdt Lines

By 2001 E had 5 principle lines…? Enron Energy services(retail) Enron Transportation Services (pipeline) Enron Broadband (with Blockbuster) Capital & Risk Management Services Enron Wholesale Services (Enron Online)

EnronOnline - Transformation

In November 1999= Enron launched EnronOnline.

http://www.youtube.com/watch?v=W_NxYUpLE6A&feature=related

New venture… New venture requires =? What division of a business raises $ for

expansion? The Enron Global Finance department had to

keep working up more creative financing moves to keep the company running as Enron Online needed cash

Until now, how was energy bought and sold?

Enron 2001 Skilling letter to Shareholders: “Enron hardly resembles the company

we were in the early days – during 15 year history, we have stretched ourselves beyond our own expectations. We have grown from an asset based pipeline and power generating company to a marketing and logistics company whose biggest assets are its well established business approach and its innovative people”

Creative Financing…Smoke & Mirrors

Enron CFO Andrew Fastow awarded “excellence award in capital structure mgmt “ for work in pioneering unique financing techniques

Skilling was declared “No 1 CEO in USA”

Lay revealed ultimate goal to become “worlds greatest company”; banner in lobby

Although successful getting rep for being “cheeky”

Fortune 500

ENRON NAMED MOST INNOVATIVE FOR SIXTH YEAR

FOR IMMEDIATE RELEASE: Tuesday, February 6, 2001 HOUSTON -- Enron Corp. was named today the “Most Innovative Company in America” for the sixth consecutive year by Fortune magazine

Enron Stock

In 2001 – stock price drifted lower to $30 in Oct from high of $90

Execs blamed stock price to falling natural gas prices - long range concerns for EnronOnline and overall weakness in USA economy

Oct 16, 2001 On Oct 16, 2001, Enron issued

qtrly earnings report = There was a sudden MYSTERIOUS - $1.2 B reduction in OE and assets

= from reversal of previously recorded trans involving swap of stock for Notes receivable from a related 3rd party who had invested in limited partnerships organized by the Company

3 weeks later,Nov 8, Enron restates its reported earnings for previous 5 years, wiping out nearly $600 million of profits

Cont…

What happens to share price when you restate 5 years worth of profits?

Investors and critics?

The Restatement Killed Enron… Pressure from creditors , investigations from

authorities forced Enron into bankruptcy (70B) Public outcry - Obvious that 1990’s performance

had all been a hoax orchestrated by who? mgmt and…. crafty accountants / auditors Doubt became wiped out when Sherron Watkins -

letter to Lay discovered – posted virtually every where

Who was Sherron Watkins?

Sherron Watkins was VP Corp Dev –(she had worked for AA previously for 8 years)

Skilling resigned 6 months into CEO role prompting Watkins to write letter to Lay which identified significant problems – attempts for to discuss were rebuffed – he said “he’d rather not see it”

Discuss Letter Points “Has Enron become a risky place to work… for those of us

who didn’t get rich over the last few years, can we afford to stay?...”

“Skilling’s abrupt departure will raise suspicions of accounting improprieties…”

“I am incredibly nervous that we will implode into a wave of scandals…”

“I realize that we have a lot of smart people looking at this and a lot of accountants including AA have blessed the accounting treatment. None of this will protect Enron if these transactions are ever disclosed in the bright light of day…”

“My concern is that the footnotes don’t adequately explain the transactions…

“Don’t you think that several interested companies, be they stock analysts, journalists, hedge fund managers are trying to discover the reason Skilling left?...”

Letter was in assigned readings - other thoughts re this article?

SPE’s Watkins very familiar with aggressive acctg –

series of large and complex transactions involving Enron and dozens of ltd partnerships created by the company

Partnerships called SPE’s – what are they? See Special Purpose Entities Are Often a Clever

Way To Raise Debt Levels” http://people.stern.nyu.edu/adamodar/

New_Home_Page/articles/specpurpentity.htm

SPE

A special purpose entity (SPE) (or “special purpose vehicle") is created by a company to fulfill narrow or temporary objectives, primarily to isolate financial risk.

Why use SPE’s?

Finance international projects ; IE: Investors wanted risk and reward

exposure limited to a project, not to the associated company

Corporations may use SPEs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk (ie: oil exploration).

SPE limited by charter Cash flow from SPE ops used to pay

investors Risk and reward rests with SPE

Critics…

At the time…SEC and FASB guidance: 1 – independent owner of SPE must

make substantive capital investment in SPE and have substantive risk and rewards of ownership = 3%

2 – independent owner must exercise control over SPE to avoid consolidation

As a result…

Companies could use the SPE for external parties to provide 3% and had the remaining 97% typically contributed by loans from outside lenders, loans arranged and collateralized by companies that formed the SPE

3% = Technical Minimum, practical maximum Fortune Magazine charged that SPE’s

were scalpels that ” performed cosmetic surgery on balance sheets

What Happened…

Enron used the SPE’s to move underperforming assets from the consolidated b/s

Enron would arrange a 3rd party to invest 3% capital in an SPE and then sell assets to that SPE. The SPE would finance the purchase of these assets (via bank loans) collateralized by…

Enron Common Stock

However…

Occurrence of side agreements insulating SPE Owners from any losses (where is risk/reward?)

sales of underperforming assets at grossly inflated prices to SPE’s = paper gains in f/s

*Some estimates of personal gains approximated 60-100M for Lay, Skilling

Example – setting up spe 1. Newco B/S 3 Cash 3 Equity 97 Cash 97 Liab (loan?)

2. Cash – 100 Debt - 97 Equity - 3

TransactionWhen each SPE was established, E mgmt would transfer

assets (and any related debt) to the SPE at an appraised value above the net cost of the assets, recording a gain on the transfer.

For example, assume that an asset that cost $600,000 (appraisal value, $750,000) and related debt of $250,000 are transferred to an SPE. This transaction was recorded on Enron's books as follows:   

Investment in Special Purpose Entities 500,00 Debt 250,000

Assets 600,000 Gain 150,000

Discussion

Using the previous example, how would you create a gain of 250K??

“Ethics, Enron and First Year Accounting” -http://college.cengage.com/accounting/resources/instructors/air/spring_2002/trends.html

Impact

Huge loophole in acctg practices, companies could create structures, SPE’s which effectively removed debt/losses from B/S I/S

Cont…

To convince lenders to continue pumping cash into Enron =need for E high credit rating = need for E to release impressive f/s each period

Same as expansion years; Stock price needed to be high; stock triggers & covenants

worst case scenario (ie: Price trigger due to stock price) Enron would need to dissolve a SPE and merge SPE into consolidated f/s

stock price declined in 2001, losses suffered by many of Enron’s SPE’s on assets purchased from Enron – Execs were forced to pour resources into SPE’s to keep them solvent, and eventually consolidate

Question

Why is it then that if SPE’s are legal, that there’s a problem here?

“Guns are legal in Texas, but you’re not allowed to rob a bank with them…” – Enron the Smartest Guys in the Room

1. Technical Compliance 2. Economic Substance 3. Disclosure & Transparency

Cont… October 2001 the falling price of Enron’s

stock, weight of losses of SPE’s and concerns raised by Andersen Auditors = Execs had to transfer some of the SPE’s to consolidated f/s…. this was the restatement

6 months earlier Skilling… ” So in conclusion, 1st quarter results were

great. We are very optimistic about our new business and are confident that our record of growth is sustainable for many years to come…”

Lay and Fastow (fired Oct 24, 2001) invoked 5th amendment rights against self incrimination when asked to testify … Skilling did not. When asked about acctg and reporting decisions, he calmly replied “I am not an accountant…” Thoughts?

Harvard comment Corp execs are responsible for integrity of

their company’s f/s…frustrated with lack of answers Public focused attention on the……

AUDITORS Public outcry as to why AA audits failed to

provide a transparent, reliable f/s for the company over 15 year history

Cont… Joseph Berardino succeeded

Leonard Spacek. Andersen partners and legal had

become fully aware of Enron’s rapidly deteriorating condition (and the repercussions involved) and became deeply involved with Enron to cope.

Efforts included restructuring several of the SPE’s so they could requalify as unconsolidated.

Documentation showed that Andersen officials suggested dropping them as a client

Andersen & SPE’s

Dec 12, 2001 – Berardino testified re SPE analysis “we made a professional judgment about the appropriate acctg treatment that turned to be wrong” When Andersen discovered the error, they notified Enron Execs and told them to correct it. … 20% of the $600 Million restatement of prior earnings was due to this item

LJM1

Cont…

The remaining 80%=another SPE that Enron had created in 1997… Unknown to Andersen half of the 3% external equity had been contributed by Enron… as a result the entity did not qualify and should have qualified for SPE treatment…

Chewco

In addition…

AA also claimed they had been minimally involved in transaction that resulted in $1.2B reduction of OE reported on Oct 16, 2001

bulk of transactions had been prepared preceding 2001 y/e audit and quarterly f/s not required for audit

Cont… Failed to impress Andersen critics specifically on 3

issues: ? 1. Scope of Services – acctg firms extended product

line to include prof services. Study showed that for every $1 audit – had $2.69 of non audit services (consulting) – feasibility studies, IA, acctg system design, other IT…

Cont… 2. Andersen’s role in aggressive accounting –

that Andersen personnel had been involved in many SPE creations “analyzing and reviewing” SPE transactions

3. Shredding of Documents – Houston office “destroyed significant but undetermined amount of documents relating to the company and its finances – suggestion was that prevention of conducting justice

Cont… Jan. 15 - Andersen fires auditor David

Duncan for shredding documents. The New York Stock Exchange removes Enron from the board. The stock closes at 67 cents per share, down from a high of $83 per share on Jan. 24, 2001.

Andersen business plummets

Cont…

Berardino defense was to repeat that poor business decisions, responsible for downfall…”At the end of the day, we do not cause companies to fail…”

Chief Editor of Accounting Today said “If you accept the audit and collect the fee then be prepared to accept the blame -Otherwise you’re not part of the solution, but rather part of the problem…”

WHAT DO YOU THINK???

Could This Have Been Foreseen??? “Is Enron Overpriced?” – Maclean http://www.youtube.com/watch?

v=OsINoW2zLXo&feature=related Read For Next Week…

Conclusion Andersen found guilty on obstruction of justice;

Results saw immediate layoffs of 25% of workforce David Duncan testified against former firm…and in

June 2002 … had to sever all ties with remaining public clients.

Partners and Employees were finished… jokes and ridicule regarding Andersen embarrassing ALL accountants

Fastow

Pleaded guilty- 10 years (reduced to 6) and forfeit of $25M of personal assets; cooperated with Prosecution

Released December 17, 2011 June of 2013, Fastow addressed more than

2,000 anti-fraud professionals at the Association of Certified Fraud Examiners' 24th Annual ACFE Global Fraud Conference

What About the Banks? http://www.youtube.com/watch?v=9zxAJO7owy8

The Enron Nine J.P. Morgan Chase, Citigroup, Credit Suisse First

Boston, Canadian Imperial Bank of Commerce, Bank of America, Merrill Lynch, Barclays, Deutsche Bank and Lehman Brothers – most if not all settled

http://www.youtube.com/watch?v=9zxAJO7owy8

The Enron Nine J.P. Morgan Chase, Citigroup, Credit Suisse First

Boston, Canadian Imperial Bank of Commerce, Bank of America, Merrill Lynch, Barclays, Deutsche Bank and Lehman Brothers – most if not all settled

May 25, 2006 Lay, Skilling = guilty

Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading.

24 years coming in prison, 60 million assets liquidated

Lay was convicted of all six counts of securities and wire fraud for which he had been tried, and could have faced a total sentence of up to 45 years in prison. Died July 5, 2006 of heart attack.

GUILTY:

“The jury sent an unmistakable message: You can’t lie to shareholders. No matter how rich and powerful, you must play by the rules,” - prosecutor Sean Berkowitz

So Who Lost?

Employees Executives worldwide Auditors Shareholders Financial Institutions Profession

Question

The Enron debacle created what one public official reported was “a crisis of confidence” on the part of the public in the accounting profession.

List the parties who you believe are most responsible for that crisis.

Briefly justify your choices

Who do you blame?

Leadership of Andersen Firm

Internal Auditors? Enron Corp Executives Analysts Individual auditors

Regulatory authorities Academics

Sherron Watkins

Enron "Whistleblower" and TIME Magazine "Person of the Year"

Has embraced spotlight as whistleblower – has co-authored a book , involved in whistleblower protection.

Popular public speaker; yet proclaims she is now “unemployable” in Corp America

Part 2 – WorldCom

Rise of WorldCom 1983 Bernie Ebbers founded Long Distance Discount Services

(later LDDS) and went public in 1989 through a merger with Advantage Companies, Inc.

LDDS purchased long dist capacity at wholesale from the major long distance carriers and resold it to the public.

In 1995 the company changed its name to WorldCom Under Ebbers, WorldCom grew steadily throughout the 1990s,

chiefly through acq’s of other LDC’s in which WorldCom's common stock was used as currency.

One of these acquisitions brought on board Scott Sullivan, who became WorldCom’s CFO.

Sullivan worked closely with Ebbers; rep as whiz kid among telecommunication executives.

Acquisitions Decision making process lacked certain

protocols Like:

Strategic planning Board’s role = passive Multibillion $ Intermedia Comm acquired in 60

minutes of due diligence and 35 minute conf call with Board

No written materials re acq’s!!! = Awful Corporate Governance

Rise of WorldCom

1998, WC made its largest acq ever, purchasing MCI for $40B of WorldCom's common stock.

At the time of the acquisition, MCI's revenues were more than 2.5XWC's.

= moved WorldCom ahead of Sprint to become 2nd largest US telecom provider

Rise of WorldCom During 1990s, WC’s revenues grew at a tremendous

rate. Stock $=$8.17 in 1994 to $47.91 at q3 1999. What did WC pay acquisitions with? stock; vital to the success of the company's growth

strategy to have its stock price constantly increase.

Beginning of Problems

WorldCom stumble in October 1999 – proposal to acquire Sprint -a deal valued at unprecedented $115 billion. Refused by the Justice Department's Antitrust Department to approve the merger and the deal was called off.

significant event to WorldCom strategically… why??

Beginning of Problems WC philosophy= through

acquisitions of other telecom companies, rather than through growth in operations.

no other large telecommunications companies available for merger

without mergers the company's phenomenal revenue growth would come to a halt.

Beginning of Problems Then – the dot.com bubble popped WC discovered that increases in bandwidth had significantly

outpaced the growth in demand = glut of capacity in an overbuilt market. Supply far exceeded demand…

4Q1999, demand, prices softened and revenues fell dramatically.

Operational problem, as revenue decrease compounded by the fixed expenses that WorldCom had committed to through long-term lease contracts for line costs.

What are line costs? Line costs are the costs of carrying voice or data transmissions

from its starting point to its ending point. Would W/C own all of their lines?

Beginning of Problems

WC LEASED majority of lines - only maintained its own lines for local service in heavily populated areas (and then largely for business customers),

Was single biggest WC I/S Expense (half of expenses)

Beginning of Problems With demand issues, the ratio of these line costs to total

revenues began to increase. E & S = commitment to analysts that synergies of m&a’s would

keep line costs down Touted to analysts that a ratio of line cost expense to revenues

of only 42 percent, while that of AT&T and Sprint were above 50 percent.

But they weren’t…

Accrued Line Cost Expense

What is an ACCRUED LINE COSTS? WHAT if you accrued too much? GAAP requires that any reduction in the

accrued line cost liability be offset against line cost expense in the period in which it is determined that the excess accrual exists.

difficult to accurately accrue foreign/ external costs and the estimates ( given changes in demand industry wide!)

How Fraud Began – Hindsight is 20/20 But… Pre 2000 - Senior management had little interest in

controlling costs. Focused instead on increasing revenues (as

opposed to net income) and building a network to take advantage of the perceived boom in the technology sector.

Legacy systems did not reconcile; competition within WC based on succeed at all cost culture, GROW REVENUES

How Fraud Began False picture to the market painted by

Ebbers, the burden fell to… Sullivan to "make the numbers work"

-- that is, to make Ebbers predictions come true.

not possible using WC actual operating results, (or business Model) so beginning in 1999 Sullivan became "creative.“

WC Manipulated F/S in 3 Main Ways

1. Accruals were reversed without any apparent analysis of whether the company actually had excess accrual in its accounts.

2. When there were excess accruals, the company did not reverse them in the period in which they were identified.

Instead, WC planned and managed the release of those over accrued liabilities in a regular manner over time to smooth operating results and avoid sharp spikes in reported line costs.

3. WorldCom reduced line costs by reversing accruals that had been established for other purposes. These included:

$75 million accrued for Universal Service Fee, $281 million in the federal income tax accrual, $127 million moved from the allowance for bad debts – all of which

were offset as a reduction to line cost expense.

How Fraud Began Beginning in the second quarter of 1999, Sullivan began reducing

various accruals against line cost expense. The totals of inappropriate releases of accruals were as follows:

Quarter 2 1999 $40,000,000 Quarter 3 1999 131,000,000 Quarter 4 1999 329,000,000 Quarter 1 2000 493,000,000 Quarter 2 2000 679,000,000 Quarter 3 2000 828,000,000 Quarter 4 2000 797,000,000 Total $ 3,297,000,000

Most of the releases had several things in common.

They were all directed by senior management.

They did not occur as part of the month-to-month operations, but instead were recorded just days before the quarterly reports were filed with the SEC.

The timing and amounts of the releases were not supported by analysis or documentation (often there was none).

WC employees understood this was wrong... (Myers)

Now What? - Capitalization of Line Costs

By the end of 2000, WC ran out of excess accruals…

In the first quarter of 2001, Sullivan decided that the company would begin capitalizing a portion of the line cost expense as a long life asset. The leases related to the line cost were clearly operating leases under GAAP and, therefore, had to be recorded as an expense over the life of the lease.

There is no evidence that any attempt was made by management or the accounting department to justify the accounting treatment of capitalizing the costs.

Cap of Line Costs The amounts of the adjustments were determined by Sullivan

and the entries were made in large, round-dollar amounts a few days prior to the quarterly SEC filings (45 days after the end of the quarter).:

Quarter 1 2001 $ 771,000,000 Quarter 2, 2001 610,000,000 Quarter 3 2001 743,000,000 Quarter 4 2001 941,000,000 Quarter 1 2002 818,000,000 Total $ 3,883,000,000

The Fraud – Meeting Expectations WC consistently emphasized throughout 2001 that its

line cost E/R ratio (expense to revenue) stayed the same – about 42 percent – quarter after quarter.

If the company had not improperly capitalized line costs, WorldCom's line cost E/R ration would have exceed 50 percent in most periods, bringing it into line with other telecom companies.

So this is in simple terms outright cheating…

WorldCom Culture Many WorldCom employees became aware in varying degrees

of senior management's misconduct Who could they have gone to?

L egal department, the Internal Audit Department (IA), the Audit Committee of the Board

Board of Directors, Arthur Andersen, or the SEC.

Why didn’t they?

Tone at the Top

Profit motivated; greed Ego Unreasonable targets blind trust in senior officers even in the face

of evidence that they were action improperly. This environment left few, if any, outlets

through which employees believed they could safely raise their objections.

How the Fraud was Discovered

IA focus on cost reduction; vs financial audit

IA discovery of Pre paid Capacity (PPC) came with Cap Exp audit that commenced in 2002

Was follow up to 2001operational audit of cap ex

2001 audit raised suspicions; de ided to conduct fin audit

How the Fraud was Discovered IA met with personnel resp for approving capex to

obtain understanding re differences Explanation that accrual basis included “line-cost labor”

and “corporate accruals and adjustments” including PPC

IA had never heard of PPC ; requested support for PPC – none provided

Continued to reconcile $3B difference btwn cash and accrual #’s

Cooper went to Sullivan, who insisted she stop audit = waste of time

How the Fraud was Discovered Cooper met with Chair of A/C and informed of

discrepancies on June 12, 2002 At request of Chair; met with new auditors KPMG June 20 A/C meetings

KPMG indicated that cap of line costs did not comply with GAAP

Sullivan attempted to explain in writing his rationale Submitted rationale that WorldCom’s attempt to

defer these costs so there would be better matching of costs with associated revenues

He was terminated 5 days later

How the Fraud was Discovered

Meeting June 24 - Andersen said they could not accept cap of line costs as compliant with GAAP

Also could not explain why their audit failed to uncover cap line costs

How the Fraud was Discovered

June 25 WorldCom would restate f/s for 2001 and 1st Q

2002 KPMG engaged to reaudit 2001 Inform SEC Issue press release announcing reduction of

$3.8B in EBITDA for 2001

Potential Reasons Why Andersen Did Not Discover the Fraud WHAT do you think? Independence - Anderson had 20 yr

relationship with WorldCom; served as auditor since 1990.

Considered WorldCom a “flagship client and a ‘Crown jewel’” and “a committed member of (WorldCom’s) team.”

Potential Reasons Why Andersen Did Not Discover the Fraud

Andersen claimed blatant misrep by WorldCom personnel did not provide Andersen all the information it needed

(access to GL) altered documents, were not forthcoming in a number of other respects. Thoughts? Previously rated as Max risk client

Guess What? PwC found “hundreds of huge,

round dollar journal entries made by the staff of the accounting department without proper support.” This apparently took 2 hours… concluded that these deficiencies alone made reliance on internal controls impossible and stated that they could not understand how this could have escaped Andersen in audit

WorldCom Legal Fallout Bernard Ebbers guilty =

25 years

Guilty plea = Sullivan gets 5 years; sell all assets   

In summary – What Went Wrong?

What caused this fraud? Who do you blame?

Who to blame?

Corporate Governance/ Audit Committee: No appreciation for accounting issues Wrongly assumed coordination between IA/EA No appreciation for “risk-based” audit approach

by AA No input into changes made to Annual IA Audit

plan Fully relied on representations by Sullivan,

Cooper, Andersen

Who to blame? Internal Audit

scope of operations; narrow focus on operational audits

Little coordination with EA Reporting relationship to CFO Lacked comprehensive risk based audit plan where

risk and effectiveness of controls evaluated Evaluated ways to control costs rather than function as

I/C police

Who to Blame? Andersen Deficient audits Failed to perform sub tests in many areas

warranted by risks Extensively relied on reps by WorldCom mgmt Failed to detect material weaknesses relating to

i/c Failed to communicate info to A/C including

disagreements, difficulties w audits

Who to Blame?

The Company No support for journal entries Unresolved reconciling items with legacy systems of

acquired co’s and WorldCom Lacked procedures re g/l reconciliation, rec on sub

ledgers Failure to review interco accounts Needed seg of duties, responsibilities, mgmt review

Review 1. What similarities/ differences do you see

between Enron and WorldCom? 2. Lessons Learned?

Recap: Additional Assigned Readings 1. “Special-Purpose Entities Are Often A Clever Way to Raise Debt Levels”

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/specpurpentity.htm

2. “Ethics, Enron and First Year Accounting” – Needles http://college.hmco.com/accounting/resources/instructors/air/spring_2002/

trends.html

3. “Accounting Issues at Enron” - Alan Reinstein and Thomas R. Weirich - http://www.nysscpa.org/cpajournal/2002/1202/features/f122002.htm

4. “Is Enron Overpriced?” http://money.cnn.com/2006/01/13/news/companies/enronoriginal_fortune/

index.htm 5. Sherron Watkins letter to Enron http://www.itmweb.com/f012002.htm