Question

Describe the financial statement frauds: ENRON and PARMALAT

Answer 1

ENRON :

From the late 1990’s to the early part of the 2000’s financial markets underwent a fundamental shift that lead to a series of events surrounding "Enron and WorldCom". Events such as fraudulent financial reporting by various large firms, has progressed to one of the greatest financial crises in the USA 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It could be argued that companies operate on an outdated “Honor System” for annual filings in a Pre-2000 crisis era.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. 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 On 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.

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. “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.” Only a year prior the company reports 893 million dollars in net income in 1999 and 979 million dollars in 2000. 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. 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 after 7 months."

Enron Fraud Symptoms:

Enron had undergone a few important fraud symptoms that can be discussed in light of what evidence 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.”

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. The increase in Forbs ranking jumped in the year of 1999–2000; from number 14 to 7 on the Forbs Fortune 500 listing.

Even 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. 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.

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. 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 Into 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.

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.

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.” 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.

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.

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.” A rational was set in place by such actions.

PARMALAT SCAM :

Most of the Anglophone media world has been labeling the Parmalat mess a "European Enron." Sounds reasonable: Billions of dollars may have gone missing from the company's accounts.

But the truth is that the Enron pattern--off-balance-sheet investing in glamorous Caribbean tax havens, private deals involving management is an old Italian custom. Parmalat is reminiscent of several other florid Italian scandals, especially the Banco Ambrosiano affair. Parmalat's deceptions in part involve a phony letter, purportedly from Bank of America, that alleges the existence of a fictitious $3.9 billion account. Banco Ambrosiano's chairman, Roberto Calvi Roberto Calvi was in the same spot as was Parmalat's Callisto Tanzi Callisto Tanzi. Both were trying to keep creditors away from a fraudulent balance sheet.

In Calvi's case, the bank's money had been invested in a series of offshore New World companies and funds. That money had disappeared into a global black hole. This is exactly the Enron-Parmalat pattern: receivables from subsidiaries, offshore businesses and funds are carried as assets on the balance sheet, thus quieting the fears of the markets. No worries if a cash crunch develops; there's money in the Caymans, Panama or wherever.

But the money ain't there, and when a real cash crunch develops, inevitably some of the story, but never the whole story, comes out. Calvi kept pressure away when he induced the Vatican Bank to write "letters of guarantee," legally meaningless but impressive in terms of investor confidence, asserting that the investments were real and the funds could be retrieved. His technique was perhaps a bit more sophisticated than that of Tanzi and his Parmalat managers--at least the Vatican Bank letters weren't forgeries. But the fraudulent effect was the same.

Tanzi's Parmalat empire has been wobbly for years. The business got its first real expansion break when Italy, where the visible economy was about 75% state-owned until the early 1980s, began to privatize public companies. There began a process that bears some resemblance to the recent Russian experience in privatization, meaning that shadowy but mysteriously well-funded entrepreneurs were able to buy good businesses in a less-than-open process.

In the 1980s, Tanzi transformed Parmalat from a local milk processor and dairy food producer into a national power when Italian local governments privatized their local dairies. Tanzi bought them up, one after another, and many who watched the process wondered about the sources of his financing.

Now, Italian investigators allege that fraud may have characterized Parmalat's financial statements since 1989. Anyone who wonders how such maneuvers have gone undetected for so long just doesn't know the Italian regulatory thicket. CONSOB, the securities exchange regulatory agency, is a toothless tiger--underfinanced, powerless and in a continual war with the Bank of Italy. Milan Borsa regulation is perfunctory. Local accounting rules and practices, which look strong on paper, are weakly enforced. And, alas, official corruption is endemic.

To look back at Tanzi, as well as several other major Italian success stories, the question has to arise: From whence did the original funding arise? How did Tanzi buy seven or eight municipal dairies in the 1980s? And did the then-expanded business throw off enough money to finance a global expansion that took in big holdings in ten countries in the Americas?

Given that situation, it is not unreasonable to speculate that some of Tanzi's funding may have come from dubious sources--and that such sources, which presumably are not charitable organizations, wanted their investment back whether Parmalat was profitable or not. Perhaps they made Tanzi an offer he could not refuse. Meaning he had to pay back when he could not afford to do so. The Parmalat story simply does not fit into a global corporate-governance argument. It's beyond the pale; it's very Italian.

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.

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.

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)”.

“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.” 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.” “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).” 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.

“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’.” 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”.

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 case that leads shareholders to a loss of billion of dollars. Affecting the overall U.S economy in extremely problematic and irreversible way.

“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.” 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.