Accounting Updates Accounting Updates

Southern Gas Southern Gas Association Accounting & Financial Association Accounting & Financial

Executives Conference Executives Conference

April 28, 2003April 28, 2003

Robert E. (Bob) JensenRobert E. (Bob) JensenTrinity UniversityTrinity University

San Antonio, TX 78212San Antonio, TX 78212http://www.trinity.edu/rjensen/http://www.trinity.edu/rjensen/

Accounting Updates Accounting Updates

Southern Gas Southern Gas Association Accounting & Financial Association Accounting & Financial

Executives Conference Executives Conference

April 28, 2003April 28, 2003

Robert E. (Bob) JensenRobert E. (Bob) JensenTrinity UniversityTrinity University

San Antonio, TX 78212San Antonio, TX 78212http://www.trinity.edu/rjensen/http://www.trinity.edu/rjensen/

Why so many financial statementWhy so many financial statement frauds all of a sudden?frauds all of a sudden?

Systemic Problems of Accounting That Cannot or Will Not Be Solved: http://www.trinity.edu/rjensen/FraudConclusion.htm

•Behavior of CPA Firms: http://www.trinity.edu/rjensen/fraud.htm

Greed on Wall Street: Rotten to the Core http://www.trinity.edu/rjensen/fraud.htm#Cleland

Washington DC Prostitutes: Representative Fernand St Germain (D-Rhode Island) $32 Billion for 30 Years Senator Phil Gramm (R-Texas) & Wife Wendy $400 billion and counting

http://www.trinity.edu/rjensen/fraud.htm#WarningSigns

Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Good economy was masking many problemsGood economy was masking many problems

Moral decay in society

Executive incentives

Wall Street expectations—rewards for short-term behavior

Why so many financial statement Why so many financial statement frauds all of a sudden?frauds all of a sudden?

Failure of Corporate Audit Committees

Board of Directors Failures and Greed

Financial Analyst Conflict of Interests and Greed: Rotten at the Core

•Education Failures: Graduates of Greed Rather Than Professionalism

Good economy was Good economy was masking problemsmasking problems….….

With increasing stock prices, profits and wealth for everyone, no one worried about potential problems.

Detailed Complicated RulesDetailed Complicated Rules

With Loop Holes Big Enough To Drive A Truck Through

RulesDetailed

Nature of Accounting RulesNature of Accounting RulesAllows companies and auditors to be

extremely creative when not specifically prohibited by standards.

“rules-based” vs. “principles based” rhetorical nonsense

Loop Hole Examples Include:SPEs and other types of off- balance sheet financing

Pension accounting

Merger reserves

Other accounting schemes.

Revenue recognition approaches,

When the client pushes, without specific rules in every situation, there is no room for the auditors to say, “You can’t do this…because it isn’t GAAP…”

Unaccountable Unaccountable ContractsContracts

Expect New Amendments in SFAS 149

GAAP CRITICISM

Fosters Short-Term Earnings Manipulations

Does Not Show Value Creation

Executive IncentivesExecutive Incentives•Meeting Wall Street’s ExpectationsMeeting Wall Street’s Expectations•Performance is based on earnings & stock price

–Focus is on short-term (quarterly) performance only

–Stock prices are tied to meeting Wall Street’s earnings forecasts

Companies are heavily punished for not meeting forecasts

–Moral Hazard: Employee Stock OptionsDid you ever hear the name Lou Pai?

Average compensation of America's top 100 CEOs has risen from 39 times that of the ordinary worker in 1970 to 1,000 times in 1999.

Princeton University

GE had not disclosed those perks -- which included courtside sports tickets, a Manhattan apartment, and use of a corporate jet -- beyond a vague statement in an SEC filing that Welch would have "continued lifetime access to company facilities and services... "

Jack Welch,Former General Electric Chairman

Stock Fell 13% With This Revelation

Stock Fell 13% With This Revelation

Enron’s CEO of Enron Broadband Services, Ken Rice, had a $33,000 customized Hellcat motorcycle in his office just for a distinctive decoration.

Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land.

Lou Pai, CEO of Energy Services was such a big shot that he refused to commute to Houston’s Intercontenental Airport to board Enron’s corporate jets. A Falcon 900 jet had to be dispatched to his home in the Houston suburb of Sugar Land.

Beat The Numbers

How To Play

Numbers Game

Aggressive AccountingAggressive Accounting

Earnings ManagementEarnings Management

Income SmoothingIncome Smoothing

Fraudulent Financial ReportingFraudulent Financial Reporting

Creative Accounting PracticesCreative Accounting Practices

Rewards of Rewards of The GameThe Game

Share Price EffectShare Price Effect

Borrowing Cost EffectBorrowing Cost Effect

Bonus Plan EffectBonus Plan Effect

Political Cost EffectPolitical Cost Effect

•How to value a dot.com company:

Take the reported pro forma loss for the year

Multiply the result by negative 1 to make it positive

Multiply that number by at least 100

If stock price is less than the result…Buy, If Not?

Buy it anyway

Incentives for F.S. FraudIncentives for F.S. Fraud

Incentives to commit financial statement fraud are very strong. Investors want decreased risk and high returns.Risk is reduced when variability of earnings is decreased.Rewards are increased when income continuously improves.

Which firm will have the higher stock price?

Firm A Firm B

Auditors—the CPAsAuditors—the CPAs• Failed to accept responsibility for fraud detection (SEC, Supreme

Court, public expects them to detect fraud) If auditors aren’t the watchdogs, then who is?

•Tradition of sending puppies out to yap at the receivables

•A few auditors got too close to their clients

•Audit became a loss leader–Easier to sell lucrative consulting services from the inside

–Became largest consulting firms in the U.S. very quickly (Andersen Consulting grew to compete with Accenture

•Became greedy--$500,000 per year per partner compensation wasn’t enough; saw everyone else getting rich

In a separate case in late September, a judge's divorce ruling unsheathed guarded financial information about accounting firm Ernst & Young, which is a private partnership that does not file public financial reports.

In divorce papers for Ernst & Young chief executive officer Richard S. Bobrow, a 45-page judge's opinion revealed how much the CEO was paid and put a dollar value on the company for the first time, giving competitors a rare peek into the firm's finances.

Annual Salary $ 3 Million

$25 million in salary $US29 million in partnership earnings over the next decade.

Pension worth $1 million a year for life and had access to a corporate jet owned by Ernst & Young and a New York apartment.

$ 24 million to Janet Bobrow$ 24 million to Janet Bobrow

Jan Bobrow makes $ 10 an hour part-time at Central Church of the Nazarene in Lenexa, Kan.

Jan Bobrow makes $ 10 an hour part-time at Central Church of the Nazarene in Lenexa, Kan.

Moral DecayMoral Decay•Attendees at the April, 1998 Business Week Forum of Chief Financial Officers revealed:

–67% of CFOs said they had been asked by senior company executives to misrepresent corporate financial results–12% of CFOs admitted they had actually misrepresented financial results…55% said they had fought off requests to “cook the books”

•Honesty studies–1961: 12%

–1986: 31%

–2002: ???

How Much Stanford MBA Worth?

a. $500,000 dollars

b. $ 10 Million dollars

c. $ 100 Million dollars

d. $ 1 billion dollars

The market lopped a cool $1 billion off Veritas' (VRTS)

market cap yesterday when its CFO resigned after

revealing he lied about his academic credentials. The fundamental picture

hasn't changed—unless the CFO's duplicity extended to the books.                            

Executives at Vetrias, storage management software maker, found that CEO’s claim to have earned an MBA from Stanford Business School was false.

Financial Statement Fraud Will Destroy Your Shareholder Value

Financial Statement FraudFinancial Statement Fraud

• Financial statement fraud causes a decrease in market value of stock of approximately 500 to 1,000 times the amount of the fraud.

$7 million fraud $2 billion drop in stock value

These Are Interesting TimesThese Are Interesting Times• Number and size of financial statement frauds are increasing

• Number and size of frauds against organizations are increasing

• Some recent frauds involve several people—as many as 20 or 30 (seems to indicate moral decay)

• Many investors have lost confidence in credibility of financial statements and corporate reports

• More interest in fraud than ever before—now a course on many college campuses—from 3 or 4 to over 50 college campuses

Current Executive Fraud-Current Executive Fraud-Related ProblemsRelated Problems

• Misstating Financial Statements: Quest, Enron, Global Crossing, WorldCom, etc.

•Executive Loans and Corporate Looting: John Rigas (Adelphia), Dennis Kozlowski (Tyco--$170 million—the $15,000 umbrella stand)

IPO Favoritism: Bernie Ebbers ($11 million)

•CEO Retirement Perks: Delta, PepsiCo, AOL Time Warner, Ford, GE, IBM (Consulting Contracts, Use of Corporate Planes, Executive Apartments with meals, maids, etc.)

Current Executive Fraud-Related Current Executive Fraud-Related ProblemsProblems

•Exorbitant Stock Options

Who owns his own 14,000-foot mountain in Colorado?

Complaint in Fraud CaseComplaint in Fraud Case

• Several hundred million in earnings overstatement• Complaint:

“The goal of this scheme was to ensure that (the company) always met Wall Street’s growing earnings expectations for the company. (The company’s) management knew that meeting or exceeding these estimates was a key factor for the stock price of all publicly traded companies and therefore set out to ensure that the company met Wall Street’s targets every quarter regardless of the company’s actual earnings. During the period ___ to ___alone, management improperly inflated the company’s operating income by more than $500 million before taxes, which represents more than one-third of the total operating income reported by (the company.)”

Complaint in Fraud CaseComplaint in Fraud Case

• “The participants in the illegal scheme included virtually the entire senior management of (the company), including but not limited to its former chairman and chief executive officer, its former president, two former chief financial officers and various other senior accounting personnel. In total, there were over 20 individuals involved in the earnings overstatement schemes.”

Fraud InternationallyFraud Internationally

• 1. Denmark• 2. Finland• 3. Sweden• 4. New Zealand• 5. Canada• 6. Netherlands• 7. Norway• 8. Australia

• 13 Germany• 14. United Kingdom• 16. U.S.A.• 36. Brazil• 40. Philippines• 47. Mexico• 49. Russia• 52. Nigeria

Largest Bankruptcy FilingsLargest Bankruptcy Filings

(1980 to Present)(1980 to Present)

Company Assets (Billions) When Filed

1. WorldCom $101.9 July, 2002

2. Enron $63.4 Dec., 2001

3. Texaco $35.9 April, 1987

4. Financial Corp of America

$33.9 Sept., 1988

5. Global Crossing $25.5 Jan., 2002

6. Adelphia $24.4 June, 2002

7. PG&E $21.5 April, 2001

8. MCorp $20.2 March, 1989

9. Kmart $17.0 Jan., 2002

10. NTL $16.8 May, 2002

Recent Financial Statement Recent Financial Statement FraudsFrauds

• Enron

• WorldCom

• Adelphia

• Global Crossing

• Xerox

• Qwest

• Many others

Key Elements of Public TrustKey Elements of Public Trust

Spirit of Transparency

Culture of Accountability

People of Integrity