Accounting Scandals: What we have learned from Enron and World Com Debacle? Pertemuan 04 Matakuliah: F0122 – Seminar Akuntansi Tahun: 2009

Accounting Scandals: What we have learned from Enron and World Com Debacle? Accounting Seminar Week 9 Prepared by: Gatot Soepriyanto SE. Ak., M.Buss (Acc)

The Recent Scandals The obvious corporate greed—is it more widespread than in earlier periods? Earnings manipulation is part of (and usually central to) most of the scandals Prominent industries included energy companies and telecommunications (+ accommodations by investment banks)—importance of deregulations Scale: these were big firms involved

Enron Stogy gas transmission company started with massive debt Formed a gas trading company, expanded into electricity, risk mgt. & telecom; expanded internationally Based on economic reality, many of these were failures Based on earnings magic, all were successful

Enron 2 Gas trading: deregulated & volatile, need for spot market purchases & related derivatives, volatility increased trading profits Problem of massive & potential junk bond ratings Use of special purpose entities (SPEs) to reduce perception of too much debt

Enron 3 Importance of meeting quarterly earnings, initially through cost savings, then increasingly more gimmicks Scheme 1: revalue physical assets using “fair value” models (SFAS 125, designed for financial assets)—front- loading profits Scheme 2: using SPEs in virtually any complex context to record earnings

Enron 4 SPEs were mishandled CFO Andy Fastow manipulated these for his own enrichment + independence problem Particularly shady SPEs approved by auditor Arthur Andersen, attorneys, & board of directors; accommodated by investment banks & no obvious oversight by SEC

Enron 5 Some operations were successful, others were major blunders; the net effect was to dramatically increase financial risk, & Enron’s unwillingness to disclose real losses as they occurred Mid-2001: stock price dropped, executives bailed out of stock options, bond ratings back to junk status Enron restated earnings in 3 rd quarter 2001 With no credibility, Enron declared bankruptcy in December 2001, the biggest bankruptcy until …

WorldCom Bernie Ebbers started long-distance telecom company in 1983 (name changed to WorldCom in 1995) Growth through merger strategy (note earnings magic of business combinations) WorldCom “looked” solid, with total assets of $104 billion & debt-to-equity of 79.3%, but half the assets were goodwill & other intangibles In 2002 internal audit found operating expenses capitalized

WorldCom 2 New auditor KPMG reviewed the books, old auditor Arthur Andersen was fired; Ebbers resigned in April In June 2002 WorldCom announced $3.8 billion in accounting errors, mainly by capitalizing “line costs” (fees to other telecom companies for network access rights—these are operating expenses)

WorldCom 3 WorldCom restated earnings, CFO was fired Actual capitalization misstatements totaled over $11 billion WorldCom filed for bankruptcy in July 2002, replacing Enron as the largest bankruptcy in US history

What do Enron & WorldCom Have in Common? Deception on a massive scale—manipulation at the highest levels of the companies Growth through acquisitions plus related Business combination accounting abuse Importance of meeting quarterly earnings targets at all costs—related enrichment of senior executives Accommodating auditors, attorneys & boards of directors All two restated earnings

What Happened at Arthur Andersen? One of original Big 8, founded in 1913, stressing integrity & consistency Especially since the 1980s, AA had a history of “aggressive auditing,” clients became too valuable to defy (Toffler) Associated with many of the big scandals: Sunbeam, Waste Management, Enron, WorldCom & Global Crossing Found guilty of obstruction of justice in Enron case

The Lessons of History It’s the incentives, stupid Irrational exuberance Corporate culture Regulation follows the business environment Regulations are not fool-proof The political environment Financial, operating and credit risks The economy is global

Assignments: Discuss and present your answer related to the WORLDCOM CASE STUDY. You may use external sources other than those provided in this teaching materials.