Financial Statement Fraud in Enron, WorldCom Scandals, Fraud Motivation Triangle And The SOX Act 2002

Introduction

From the late 1990’s to the early part of the 2000’s our financial markets underwent a fundamental shift that lead to a series of events surrounding Enron and WorldCom. Events such as fraudulent financial reporting by large firms, has progressed to one of the greatest financial crises in the United States pre-2008. Prior to this crisis public companies financial filing processes were not brought into question in light of strong market sentiment. Market sentiment did change in the millennium and government agencies had to respond. Analyst would now fully examine firm’s financial statements due to the new loss of market confidence.

It could be argued that companies operate on an outdated “honor system” for annual filings in a pre-2000 crisis era. Post crisis, companies with the help of governmental legislation help moved towards something with more checks and balances. As years passed and the crisis began to subside; legislation passed by the House of Representative (H.R. 3763) helped the crisis wane. Engaging a responsibility to restore market sentiment after a series of tremendous financial scandals. Sarbanes and Oxley Act 2002 (SOX) worked to aid auditors; it was drafted to address the issues of financial reporting of large companies. SOX legislation rewards accurate financial reporting and discouraged fraudulent financial activities. The CEO’s of both Enron and WorldCom are just two of the many reasons why SOX was needed to increase investor sentiment after these two major scandals.

Thesis

This paper covers the scandals of Enron, WorldCom, and plunges into the application of the Fraud Motivation Triangle, leading to the legislative act of the Sarbanes and Oxley 2002 section 404, and 307. The conclusion of this paper provides analysis and insight into problems of SOX while covering its strengths.

Enron Crisis

Enron a global Gas and Energy company incorporated in Omaha Nebraska and once distinguished as the Nations 7th largest company. Listed on Forbs Fortune 500 as being among the wealthiest companies listed on the stock exchange. Through this accumulation of “wealth” Enron at one point held a robust market valuation, which was higher other large global companies like AT&T. Many would call Enron a company that was “too big to fail”; this was due to the company’s reported revenue milestone accomplishment of 100 billion dollars. (Schilit, 2010)

Enron after the merger with a Texas based company started to produce year-over-year high-yield earnings for investors. The company’s upward momentum encouraged more shareholders to invest after making the Forbs Fortune 500 list. The tipping point was when Enron reported quarterly loss in the amount of 586 million dollars. (Neuman, 2005) “From August 2000 when Enron’s stock traded for its all-time high until the stock was delisted in December 2001, investors lost $64.2 billion.” (Neuman, 2005) Only a year prior the company reports 893 million dollars in net income in 1999 and 979 million dollars in 2000. (Schilit, 2010) Looking outside, these figures would not immediately show any signs of Enron having a liquidity issue.

Despite not showing warning, signs investors issued warnings for the early emergence of fraud symptoms gave reason for the escalation of concern. These symptoms emerged with the consolidated balance sheets under which Enron prepared an amended balance sheet for its investors. Enron’s auditor undertook the responsibility to work on the company’s amended balance sheet. This Enron’s auditors name is Author Anderson. The correction was valued at 586 million dollars of net income, which translated into a loss of 1.2 billion dollars in owner’s equity. (Schilit, 2010) The markets responded accordingly by liquidating Enron’s stocks due to this sudden accounting restatement. The CEO of Enron Jeffery Skilling and Chairman of the Board Ken Lay faced federal charges in court and loss the case. As a result of the loss in court, both are serving a 24-year prison term in federal confinement.

“In early December 2001, Enron filed for bankruptcy with assets of about $65 billion. It was the largest corporate bankruptcy in U.S. history — until WorldCom declared bankruptcy seven months later “ (Schilit, 2010)

WorldCom Crisis

In 1983 WorldCom filed to become an incorporated company. WorldCom or MCI Communications provided long distance discount services to its customers nationwide. WorldCom aggressively worked to complete a merger with Advantage Inc. In 1995 around the same period WorldCom became a publicly traded company under the name of LLDSWorldCom. This merger allowed for the write-off of large expense accounts on the balance sheets; the goal was to fraudulently evade the company from pending debts while securing future liquidity from institutional lenders. (Schilit, 2010)

“In 2002, WorldCom, the number two U.S. long-distance telephone and data services provider, announced that it would have to revise its recent financial statement to the tune of $3.85 billion.” (Enofe 2010) The CEO Bernard Ebbers being a large key shareholder was given a 400 million dollar loan to prevent the selling of Bernard Ebbers personal holdings. CEO Bernard Ebbers attempts to initiate failed protective measures to avoid WorldCom’s stocks from being devalued. As a result the board moved to have John Sidgmore replace Mr. Ebbers as CEO. This was in a final distressed attempt to slow bankruptcy pressures. (Schilit, 2010)

Yet bankruptcy for WorldCom was inevitable. A bankruptcy agreement was settled and WorldCom was required to pay 750 million dollars, as well as to restate its financial statements for investors. All financial records had to be examined and resubmitted to counteract actions done by the fraud. The accounting restatement of WorldCom’s financial statements was in the amount of 70 billion dollars. (Schilit, 2010)

Enron Fraud Symptoms:

Enron had undergone a few important fraud symptoms that can be discussed in light of what evidence we have clearly determined post crisis today. The forensic accounting examination of the financial record reports all contained irregularities. These irregularities where discovered in light of an important contextual fact, “Few companies ever reach $100 billion in revenue, as Enron did in 2000, and the climb from $10 to $100 billion generally takes decades.” (Schilit, 2010)

Strangely Forbs Fortune 500 listing never reported how quickly a company increased in ranking in such a short period as Enron has. A “red flag” could be raised in this period for the “impossible” became “possible” with Enron in a few short years. Change for Enron happened quickly, being number 141 on Forbs Fortune 500 listing in 1995. (Schilit, 2010) The increase in Forbs ranking jumped in the year of 1999–2000; from number 14 to 7 on the Forbs Fortune 500 listing (Exhibit 1). (Schilit, 2010)

Large energy companies such as ExxonMobil who had formed in 1999 with net income of 17,720 million dollars have not achieved such notoriety. This would include other companies like Wal-Mart with net income of 6,295 million, General Motors 4,452 million, Ford 3,467 million, General Electric 12,735 million and Citi Group 13,519 million dollars (Exhibit 1). In 1999 no warnings were sent forth in this crisis. Enron had reported the highest revenues in the fiscal year of 2000 when the company made the Forbs Fortune 500 list. Enron also in the year 2000, Enron only reported net income of 979 million. (Schilit, 2010)

The fraud symptom that could have given investigators more conclusiveness existed in how sales revenues were increasing, yet net income was lower than other companies who had less revenue but posted more net income (Exhibit 2). This is a clear indicator for financial manipulation. Due to the billions of dollars reported on Enron’s financial statements that growth was acquired, in a short period of time should raise a red flag.

Fraud Triangle: Enron

It was in the case of Enron that the auditor Author Anderson, acquired 50 million dollars for his services in the company. Mr. Anderson’s services aided Enron in a massive financial statement fraud creating misstated financial figures and aggressively “cooked the books” which lead to one of the most distressing financial crisis in United States history. (Albrecht, 2003)

Perceived Opportunity, the opportunity comes from the authority given to Enron’s auditors Author Anderson. Mr. Anderson understood the ease associated with being able to “cook the books” with little or no resistance. He was the sole auditor for the company and just by overlooking or altering financial statements Mr. Anderson was able to retain his power and status with the firm ensuring the generous payout of 50 million dollars. In order to facilitate fraud of such magnitude internally; evidence suggests that internal controls were diminishing the material quality of all financial reports released by Enron in the year 2000. (Albrecht, 2003)

The market in this time period was described as: “In 1990, the distribution of corporate executive compensation was 92 percent cash and 8 percent equity. By the year 2001, this figure changed to 34 percent cash and 66 percent equity. Not only did the distribution change, but the size of the compensation also increased by more than 150 percent between 1992 and 1998.” (Enofe 2010) It is safe to conclude that the connections of monetary rearwards to management from 1990–2000 may have accelerated the “opportunity” to conduct fraud; thus, one reason why many companies may have failed for bankruptcy in the period of 1990’s to the early 2000’s.

Perceived Pressure, Enron was noted to acquire leveraged capital through various institutional investors. This capital was issued based on certain financial projections that were derived from the financial statements of the company. The need to produce quarterly earnings for both shareholders and stakeholders was unprecedented. The financial slippery slope was underway in regards to the altering of financial statements; this could very quickly create a “perceived pressure” of maintaining the consistent quarterly increases. This creation of financial records would eventually lead to more to fraud the open fraudulent warning signs. Fraud coupled with pending debt issues would surly act as yet another “perceived pressure” to maintain the course in an act of producing financial statement fraud to keep the company solvent. Enron had motivations to continue mergers based on similar sediments to remain solvent. (Albrecht, 2003)

Rationalization, like other companies who encountered fraud creating a simple “rationalization” was a way to ensure the company’s stock price. The rationalization of using fraud to maintain WorldCom’s company stability for investor interest; would feed this company’s management millions of dollars in bonuses as the fraud and debt continued to increase. (Albrecht, 2003) “In 2001, the Enron Corporation, a major energy company, acknowledged fraudulent financial reporting over the previous five years. The company deviated from generally accepted accounting principles in preparation of its financial statement.” (Enofe 2010) A rational was set in place by such actions.

WorldCom Fraud Symptoms:

Through the course of WorldCom’s operation, the company conducted mergers to cover the outstanding long-term debt created by the company over its many years of operation. The result was in the form of “merger/acquisition fraud”. WorldCom, overstated assets in an attempt to look healthy as the company continued to acquire or merge into companies from 1985 to 1999. After a federal court-injunction that the stopped the proposed merger with Sprint (a large telecommunications company) for 129 billion dollars. This injunction leads investors to question a lot of relevant concerns of WorldCom establishing a monopoly in the industry. It was shortly after this point that the company filled for Chapter 11 bankruptcy, which led to the largest bankruptcy claim in United States history pre-2008 recession.

The excessive mergers conducted by WorldCom’s operational history along with a 400 million dollar loan to the CEO as a means to prevent a sell-off of company shares are clear signs of fraudulent wrongdoing. 750 million dollars was paid to the SEC and the company was forced to restate its financial statements for shareholders and stakeholders alike. (Schilit, 2010)

WorldCom’s Fraud Symptoms hidden within its financial statements did not present itself more clearly than through the company’s Free Cash-Flow (FCF). It was between the year of 1999 and 2000 that the company in one year lost all positive FCF and immediately went negative. In 1999 FCF is recorded as 351million dollars in December of the forth quarter. In the year 2000 FCF decreased considerably to negative -964 million only a year after being positive (Exhibit 3). This massive and quick decrease is a reason for alarm and also a reason why fraud symptoms were apparent quarter-to-quarter in the fiscal year of 2000. The first to the fourth financial quarter FCF has demonstrated a consistent positive distribution throughout the year. Q1 1999, 286 million, Q2 1999, 546 million, Q3 1999, 1106 million, and Q4 1999 351 million dollars; there is volatility in the distribution of FCF in 1999 yet the FCF is positive (Exhibit 3). In contrast: Q1 2000, -735 million, Q2 2000, -605 million, Q3 2000, -1,520 million, Q4 2000 -964 million dollar loss (Exhibit 3). This loss in Q3 of the year 2000 is quite significant and has no logical correlation in light of net income, which remained positive at 979 million dollars in the year 2000 (Exhibit 2). (Schilit, 2010)

Fraud Triangle: WorldCom

Perceived Opportunity, WorldCom using excess and aggressive acquisition merger activities muted warning signs for investors in regards to company debt. The opportunity was to eliminate debt and keep market capitalization high with a “perceived opportunity” of fraud. WorldCom’s management used the opportunity to take expenses and capitalize these expenses despite the fact that this is not allowed under U.S GAAP or “revenue recognition principles” (i.e recognizing revenue in the period in which it is earned.) (Albrecht, 2003) Not adhering strictly to GAAP allowed for WorldCom to post increases in revenue on all financial statements. This increased revenue created an “opportunity” to conduct company mergers despite the true net worth of the company.

Perceived Pressure, pressure was to keep the debt-to-equity ratio low, concealing debt and using fraud to remain solvent. The use of “merger accusation fraud” became the most feasible way to conceal debt while maintaining a resilient share price. This was done by acquiring external assets and merging with other companies on fraudulent terms. The “perceived pressure” existed in a “sink or swim” attitude that drove WorldCom further into illegal financial reporting. (Albrecht, 2003) “In today’s global economy, business has become so complex. Business transactions are more complicated than ever before. Revenue recognition has become a major issue as business people construct complicated deals with different types of revenue streams and conditions.” (Enofe 2010) It’s these “complex” conditions that made WorldCom’s actions justifiable fraud for its corrupt management under “perceived pressure”.

Rationalization, management’s rationalization is that all actions to keep debt below critical levels, even if it means to conceal debt and show increases in net income would be beneficial to their careers and longevity with their company. (Albrecht, 2003) “Agency Theory” discusses how relations between owners and managers create agency pressures that can lead to damaging behavior. In some cases this can act as tension that can lead a company to failure. Yet, other reasons for “rationalizations” in the case of WorldCom was to continue to conceal debt for WorldCom’s pervious merger acquisitions worked in concealing debt from its investors. (Neuman, 2005)

In both WorldCom and Enron compensation of management occurred generously; this means that bonuses and massive salaries are connected to the success of their company’s. A “Rationalization” can be one of maintaining this status quo of compensation. A “second reason corporations and corporate executives commit corporate fraud or fraudulent financial reporting is greed. Equity based compensation encourages CEOs to engage in behaviors that will increase the corporate annual earnings, thereby increasing their personal wealth.” (Enofe 2010)

Enactment of Sarbanes and Oxley Act 2002

In the early 2000’s due to the Enron, WorldCom and other infamous scandals, created a turbulent time for the financial markets. Tyco International, Adelphia, Peregrine Systems, is also listed among companies that caused major financial disorder. After the bankruptcy claims of Enron and WorldCom, it resulted in a massive exposure of financial reporting fraud. These cases collectively led to one of the most far-reaching financial legislation to date called, “Sarbanes and Oxley Act 2002” (SOX). The goal of the SOX Act is to increase investor’s confidence and ensure accurate reporting from some of the world largest firms. Learning from the past SOX attempts to minimize investor’s risk by legislation, while at the same time fortifying the reporting process of companies and their internal controls. (Enofe 2010)

One of the unique features of SOX has reduced the period of reporting from 90 days for 10-K to 60 days. The expressed logic behind this is that SOX attempts to correct reporting concerns by adding urgency to the reporting process. It also requires a certain size firm a 3rd party auditing reporting process, in which auditors are required to report any financial misgivings. SOX, has been instrumental in improving the reporting process and the separation of duties in larger firms. (Enofe 2010)

Section 404

Section 404 (Under Title IV- Enhanced Financial Disclosures) of the SOX Act 2002; this section 404 directly impacts auditing practices attempting to improve the quality of annual reporting. “Under SOX Section 404, public companies need to design, document, analyze and test their Internal Controls Over Financial Reporting (ICOFR)”. (Ettredge, Sun, & Li 2006)

“After the Enron and WorldCom accounting scandals, Congress passed the landmark SOX Act in 2002 to restore investor confidence. Section 404 is one of the most significant provisions of the Act.” (Ettredge, Sun, & Li 2006) Section 404 has offered important contextual framework needed for auditors to evaluate ICOFR and to report in the context of ICOFR. Unlike pre-SOX and pre-section 404, there existed a lack of clarity in 10-K filings. As known form the past, annual reporting processes have held on to requirements that were more disjointed. Post section 404 differentiating on what companies are having issues with compliance has become more evident. “Companies with general material weaknesses in the ICOFR experience longer audit delays than companies with specific material weaknesses.” (Ettredge, Sun, & Li 2006) “ICOFR material weaknesses disclosed in firms’ 10-K filings after the implementation of Section 404. Types of material weaknesses documented in their study vary from account specific weaknesses (such as those specific to revenue recognition or current accruals) to general weaknesses (such as those affecting personnel training, technology issues, control environment).” (Ettredge, Sun, & Li 2006) As this paper discusses revenue recognition was a singular theme in the Enron Scandal, section 404 understood this complexity and compensated.

This gives more background onto how important the SOX Act is in regards to improving current 10-K annual filings. Section 404, has been important in improving investor’s sentiment post-scandal with more diligent financial reporting from companies that are listed publicly.

As covered in this paper SOX has highlighted the important aspects of the auditing process to ensure that fraudulent financial reporting does not accrue. Both Enron and WorldCom were lacking in fundamental areas of risk assessment, reporting, and fraud detection. The most prevalent force in SOX section 404 deals with key rules to ensure that these dynamics are completely active to deter fraud in publicly listed companies. (Ettredge, Sun, & Li 2006)

SOX has implemented actionable features that acts as deterrents to reduce the numerous fraudulent activities that have been recorded over the years. One of these deterrents functions in the creation of the Public Company Accounting Oversight Board (PCAOB); PCAOB primary incentive is to protect investors by ensuring quality reporting. This is accomplished by the issuing of various reports for the public. (Enofe 2010) An important feature of PCAOB, is in how it prevents auditors on relying on the work of others. “PCAOB also limits the extent to which external auditors can rely on the work of others, even though internal auditors may already have tested the processes.” (Ettredge, Sun, & Li 2006) This will result in less managerial influence on auditors.

“The PCAOB’s inspection reports for Big 4 auditors state that auditors relied on some companies’ ICOFR controls, without proper testing of those controls, which indicates the auditors were not ‘404 ready’.” (Ettredge, Sun, & Li 2006) The concept of “404 ready” signifies again how the increased level of awareness in the industry has been stimulated; in response to the passing of the Sarbanes and Oxley Act 2002 Legislation. Accuracy in financial reporting is no longer about an “honor system”. (Ettredge, Sun, & Li 2006)

Section 307

Within the SOX legislation, it contains section 307, which deals with “whistle-blowing” and not allowing criminal charges to be issued against accounting practitioners who “blow the whistle” against his or her employer. The following statistic shows the importance of such a protection for internal auditing employees. “33 percent of all frauds were detected through tips, while only 18 percent were detected by auditors.” (Albrecht, 2003) This statistic would seem like internal investigations are not successful. Yet, it sheds light on why Section 307 of SOX is such an important tool. Whistle Blowing without harming a “tipsters” career is very crucial in keeping auditing teams ethical. Despite this legislative section 307 the industry must work in ensuring management does not hinder “whistle-blowing” channels.

“Section 307 of the Sarbanes-Oxley Act of 2002 requires all public companies to have a whistle-blower system that make it easy for employees and others to report suspicious activates.” (Albrecht, 2003) One of the most prevalent reasons why this is important is if companies lack the culture, anonymity, awareness, independence, accessibility and follow-up. If one of these components are missing then the whistle-blowing system will be inadequate in serving a company. (Albrecht, 2003) This feature in SOX section 307 has helped with the mandate to ensure accurate financial reporting with the required “whistle-blowing” channels.

Conclusion

Enron’s leadership made decisive illegal moves to ensure that the company continued to engage in the market despite high debt levels. The overt limitations of the company’s solvency and inadequate controls fed a complex cocktail to investors. Former CEO Jeffery Skilling had no intentions to discourage fraudulent actions that eventually lead Enron into collapse. The impact of the loss of billions of dollars of employee pensions even for 20-year Enron veteran employees, gives this case all the markings of a major fraud case. Looking backwards fraud symptoms existed, but there was no company culture to detect these symptoms or “whistle-blowing” channels. Employees might not have been aware of the accessibility of government “whistle-blowing” agencies that are equipped to deal with such crimes. It is within corrupt environments such as the Enron / WorldCom case that leads shareholders to a loss of billion of dollars. Affecting the overall U.S economy in extremely problematic and irreversible way.

Like Enron, WorldCom once an industry leader, conducted actions of merger acquisition fraud. Fraud that occurred in a period of 10 years; “mergers” conducted in an attempt to preserve shareholder value of WorldCom. The size of the company’s fines from the Security Exchange Commission (SEC) speaks to the fraudulent activities of the firm. The near miss of an economical disaster with the proposed merger with Sprint; could have easily became one of the largest bankruptcy claims of all time to date.

The Fraud Triangle of both Enron and WorldCom presented further assessments. The fraud triangle’s case of management greed from both Enron and WorldCom’s CEO’s has added context. Each of the respective CEO’s was a large shareholder and held millions of dollars of shares within the companies they worked for. These crises have brought up the question of ethics and issues that arise around fraud post 2008 crisis. Lehman Brothers like WorldCom brought up questions of the legality of the corporate reward programs surrounding around management bonuses. The question of rewarding management for actions that have had tremendous consequences globally is a problem that will forever pervade the corporate culture. This is where future ratifications of Sarbanes and Oxley Act can make headway for the best protection of shareholders and stakeholders.

Sarbanes and Oxley Act 2002: many of SOX critics complain that the act does not work in light of the 2008 crisis. Yet, this hypothesis is based on what each individual has deemed would have worked as a deterrent if implemented with the faculties they have been awarded which would be an estimation post crisis. The stock market prefers low governmental intervention this means that legislators had to work very carefully not to hinder market growth. This is a challenge after the WorldCom and Enron crisis. There was a desire to add legislative limits on market activity. As a result of SOX legislation market sentiment increased all the way up until the 2008 recession. It was only until after the 2008 recession ended that the market proceeded back into an uptrend again. The crucial features to SOX are the reporting requirements and mandatory “whistle-blowing” components. All have proven to be effective in providing internal auditors an option against company culture that may harbor fraudulent behavior all while preserving their careers.

Section 404, Section 307 and the creation of PCAOB have offered support to the markets in ways that have shown improvement in reporting quality. It is an issue of information asymmetry; smaller companies misappropriate how information trickles down from upper management to lower employees. This can produce accounting irregularities that can lead to accounting restatements. (Elayan, Li, & Meyer, 2008)

“The amount of the average restatement equals 363.5 per cent of net income and this suggests that the irregularities were committed to disguise significant losses.” (Elayan, Li, & Meyer, 2008) So the issue of financial statement fraud exists in this space between accounting restatements and financial reporting. SOX, is not the perfect fix to these issues, for they could be systemic. Yet SOX proposes the slow reversal of restatements, which in the end will be handled more openly and accurately.

Work Sited

Schilit, H. (2010). Financial shenanigans: How to detect accounting gimmicks and fraud in financial reports (1st ed., Vol. 1,). New York, New York: McGraw-Hill.

Enofe, A. (2010). REAPING THE FRUITS OF EVIL: HOW SCANDALS HELP RESHAPE THE ACCOUNTING PROFESSION. International Journal Of Business, Accounting, & Finance, 4(2), 53–69.

Neuman, E. J. (2005). THE IMPACT OF THE ENRON ACCOUNTING SCANDAL ON IMPRESSIONS OF MANAGERIAL CONTROL. Academy Of Management Annual Meeting Proceedings, S1-S6. doi:10.5465/AMBPP.2005.18783289

Elayan, F. A., Li, J., & Meyer, T. O. (2008). Accounting irregularities, management compensation structure and information asymmetry. Accounting & Finance, 48(5), 741–760. doi:10.1111/j.1467–629X.2008.00266.x

Albrecht, W., & Albrecht, C. (2003). Fraud examination. Mason, Ohio: Thomson South-Western.

Ettredge, M. L., Sun, L., & Li, C. (2006). The Impact of SOX Section 404 Internal Control Quality Assessment on Audit Delay in the SOX Era. Auditing: A Journal Of Practice & Theory, 25(2), 1–23.

U.S. Securities and Exchange Commission (SEC). 2002. Acceleration of Periodic Report Filing Dates and Disclosure Concerning Website Access to Reports. (September 5). Washington, D.C.: Government Printing Office.