Lucent Technologies: A Study in Fraud and Earnings Management

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Outline Background of Lucent Timeline of events Perpetration of fraud Opportunities To start out our presentation of the Lucent fraud, I will first talk about the company background and give a timeline of selected events. I will then talk about some of the major ways fraud was perpetrated. I will then discuss a possible opportunity that acted as a fraud catalyst.

Company Background Was spun off from AT&T on September 30, 1996 At the time, largest IPO Nation’s most widely held stock in Dec. 1999 Maintained reputation as a growth company CEO pushed 20% sales growth Sold software and hardware to phone companies and network operators Software to detect cell phone fraud Accused of aggressive accounting long before restatement Pension fund accounting Acquisition accounting Lucent is an AT&T spinoff. At the time, Lucent’s IPO was the largest IPO to date. Until 2000, the company had an exceptional record of meeting analyst expectations. As such, in 1999 it was the nations most widely held stock. The company maintained a reputation of a growing technology company. In fact, management strongly pushed 20% sales growth—an obvious perceived pressure. The company sold (and sells) software and hardware to telephone companies and network operators. Ironically, one of Lucent’s products was software that helped companies detect cell phone fraud. Even before Lucent’s restatement, analysts accused the company of being aggressive in its accounting. Some of the more common accusations was that the company was using pension fund accounting to book revenue (not an uncommon practice at the time). Investors also accused the company of using creative acquisition accounting (mainly through research and development accounts) to write off the goodwill of acquired companies. Thought these accounting conventions are worth the time to study, they are beyond the content scope of this presentation. After all, we have bigger fish to fry.

Timeline – Selected events Pre-Restatement Jul. 20, 2000 - Warns 4Q will miss Oct. 11, 2000 - 4Q estimate revised downward again Oct. 2000 - CEO fired, 1Q ’01 warning, board learns of reporting problems and informs SEC Nov. 2000 - Internal investigation conducted Dec. 2000 - Paul O’Neill resigns from audit committee to become Treasury Secretary, Dec. 2000 - Lawsuit filed against Lucent claiming Nina Aversano was fired for disputing unrealistic sales targets We will start our timeline of selected events in Jul. of 2000 when Lucent informs investors that it will miss fourth quarter earnings. The company issued two similar downward revisions of earnings estimates in October—another one for 4Q 2000 as well as one for 1Q 2003. Lucent also fired its CEO and learned of reporting problems within the company in October. As a result, the company initiates an internal investigation and informs the SEC. In December Paul O’Neill resigned from Lucent’s audit committee to become Treasury Secretary of the USA. In the same month, an executive filed a lawsuit against Lucent claiming that she was fired when she disputed unrealistic sales expectations.

Timeline—Restatement Dec. 21, 2000 - Restates 4Q revenue $679 million restatement Restatement result of internal investigation, not SEC Lucent claimed that $125 million represented improper recognition, while the rest represented subsequent agreements with vendors December 21, 2000 was when the big bomb hit investors. After Lucent's 4Q earnings release had been issued, Lucent restated its fourth quarter revenues by 679 million. It is important to note that this restatement was a result of an internal investigation and not a result of SEC enforcement. In fact, what sets Lucent apart from many other frauds is that the company seems to maintain a certain degree of honesty. According to Lucent, $125 million of the restatement represented improper recognition, while the rest represented subsequent agreements with vendors to return items. We’ll talk about the specifics of the $679 a little later in the presentation.

Timeline—Post Restatement Jan. 24, 2001 - Reports sales have fallen 28% and restructuring charge announced Feb 8, 2001 - SEC investigation formalized Nov. 1, 2002 - WSJ article Reports SEC investigation far broader than Lucent disclosed Investigating earnings manipulations as far back as 1996 and role of audit committee Looking into management’s earnings projections Examining potential overstatement of restructuring charge Lucent claims SEC investigation is almost complete I include Jan. 24, the day the company announces a 28% decrease in revenue and a restructuring initiative, to show that Lucent really was experiencing hard times. On Feb. 8, the SEC confirmed that a formal investigation of accounting irregularities and aggressive accounting at Lucent had been initiated. Just recently, the Wall Street Journal reported that the SEC’s investigation was far broader than Lucent initially disclosed. It included investigation of earnings manipulation as far back as 1996. It also included management’s role in the fraud—especially in its issuing of potentially unobtainable earnings projections. Furthermore, the SEC is apparently looking into the overstatement of restructuring charges—something we will look at a little later in the presentation. According to Lucent, the SEC’s investigation, now at two years and counting, is almost complete.

Recap Revenue recognition Restructuring charges Pension fund accounting Acquisition accounting As a quick recap, we have identified at least four areas in which Lucent allegedly perpetrated fraud. We will only address the first two in this presentation.

Revenue What the restatement consisted of: Documentary red flags: $452 million—Equipment shipped to distributors but never sold (channel stuffing) $199 million—Credits offered to customers $28 million—Partial shipment of equipment Documentary red flags: The $125 million of “improper” revenue was attributable to false documents Analytical red flags: Fiscal 1999 revenue grew 20%, while receivables grew 49% Bad debt reserves decreased while accounts receivable and sales grew From Lucent we have learned that 452 million of the restatement consisted of equipment that was shipped to distributors but never sold. This practice is known as channel stuffing. 199 million was associated with credits offered to customers. Specially, the company was apparently offering special one-time discounts to customers. The 28 million is associated with partial shipment of equipment. All things considered, Lucent was heavily borrowing from future sales to meet present expectations. 125 million, the portion of the restatement that Lucent said represented improper recognition, was attributable to fraudulent sales documents. This is definitely a documentary red flag. There were also plenty of analytical red flags. Specifically, receivables were growing much faster than revenue and bad debt reserves were actually decreasing as both sales and receivables grew. Unless there were obvious operational changes (which there doesn’t appear to be), these factors combined are definite causes for concern

Restructuring Charge $2.6 billion right before AT&T spin-off The issue—Using “cookie-jar” reserves to meet expectations by reversing the charge when needed From 1996 to 1999, Lucent reversed $540 million (28%) The result—Lucent met expectations in three quarters that it otherwise would not have Similar to Xerox except for better disclosure Before its spin off, Lucent recorded a 2.6 billion restructuring charge. This in its self isn’t bad. The problem is that the company was apparently using the charge to meet expectations by reversing the charge when needed. From 1996 to 1999, Lucent reversed about 28% of the original charge. According to some experts, this allowed Lucent to meet expectations in three quarters that it wouldn’t have otherwise. This practice is very similar to what Xerox did, but with one exception. Lucent had much better disclosure than Xerox did.

Audit Committee Paul Allaire - Former chairman and CEO of Xerox Franklin Thomas - Lucent director and Alcoa board member Betsy Atkins - Cofounder of Ascent Communication (a Lucent Acquisition) Paul O’Neill - Alcoa CEO Donald Perkins - Committee chairman until Feb. 1999 We will discuss one possible opportunity that allowed Lucent to manipulate earnings—the audit committee. With the exception of Donald Perkins, all of those listed on the slide comprised of the audit committee at the time of the revision. Perkins resigned less than two years before the restatement.

See Any Possible Red Flags? Significant insider influence All but Allaire are insiders Potential ethical implications Xerox Peculiar timing of turnover Why did Perkins leave Did you notice any red flags. The majority of the audit committee comprised of insiders. There were potential ethical implications as Allaire was involved with Xerox. Also, another possible red flag was the uncanny timing of turnover. Specifically, it would be nice to know why Perkins left the committee.

Who Cooked Who’s Books? Fred Moldfoski posted “earnings releases” on Yahoo Finance on March 22-23, 2000 The fraudulent releases were designed to look like official Lucent releases The releases stated that Lucent would miss expectations The impact: Lucent’s stock opened at $62.125 and traded as low as $60.375 The irony—from what we know now, it is possible that Lucent had indeed missed expectations An ironic side note is that Fred Moldfowki, a day trader, posted fraudulent earnings on Yahoo Finance in March 2000. These releases were designed to look like real releases and stated that Lucent would miss expectations. The company’s stock price dropped that day—possibly as a result of the fraud. The irony is that from what we now know about Lucent’s accounting practices, it is possible that Moldfoski was right. We will just have to wait and see.

Charges included: December 2000 - breach of contract suit filed by Nina Aversano May 17, 2004 - SEC against Lucent and 10 individuals changing them with fraud and violation of GAAP during reporting for fiscal 2000 $511 million revenue prematurely recognized; $637 million should not have been recognized [total $1.148 billion] $91 million pre-tax income prematurely recognized; $379 million should not have been recognized [total $470 million (16%)]

Settlements included: Lawsuit filed by Nina Aversano – details undisclosed Shareholder lawsuits totaling $568 million Without admission or denial of charges, Lucent settled with SEC. As SEC believes Lucent did not fully cooperate, a $25 million civil fine was imposed.