By Pete Miller, CPA|CFE, and Mike Nurse, CPA|CFE|CGMA
Has cheating and fraud always been a part of human history? According to Andrew Beattie in his article “The Pioneers of Financial Fraud,” evidence of fraud stretches all the way back to 300 B.C. when a Greek merchant named Hegestratos orchestrated a loan fraud that ultimately ended in his demise. In modern times, stories of financial fraud and corporate scandals have become ubiquitous in daily news feeds, providing a critical call to action for anyone involved in business.
For National Fraud Awareness week, we are highlighting five of the largest accounting scandals in U.S. history. Each day, we will bring you a short description of a prolific fraud in the hopes that raised awareness will ultimately help us to understand and mitigate fraud risk. In doing so, we can help to ensure ethical and sound business practices, which will benefit society as a whole.
“The last thing I would have expected to happen to me in life would be that, in fact, I would be accused of doing something wrong and maybe something even criminal.” – Kenneth Lay
The infamous Enron scandal and collapse was a culmination of multiple factors and would eventually become the largest bankruptcy of a publicly held company in history. Enron had literally become the “perfect financial storm” and the company came crashing down in 2001.
Enron began in 1985 as a Houston-based interstate pipeline company. The company quickly branched out into other areas, including energy and commodities. By 2000, the company’s annual revenue had reached $100 billion and was ranked as the seventh-largest company on the Fortune 500.
[click to view larger image] Infographic courtesy of accounting-degree.org.
Unknown to investors, Enron executives had begun engaging in extremely dubious and aggressive accounting practices to conceal billions of dollars in debt (due to several years of international and domestic expansion). This was done primarily through:
- Use of mark-to-market accounting for long-term contracts (derivatives). This required that when a long-term contract was signed, income was estimated at the present value of the net future value, causing a massive overstatement in earnings.
- Use and abuse of Special Purpose Entities (SPEs) to conceal debt. Huge amounts of debt were hidden to investors through the use of these separate entities, making the balance sheet look extremely favorable.
The schemes began unraveling in 2001, when Sherron Watkins (Vice President of Corporate Development) alerted the CEO of accounting irregularities in financial reports, which included seven pages of memos to him and memos to other top executives.
At its peak in August 2000, Enron’s shares were worth $90.75; shares dropped to $0.67 cents in January 2002. Shareholders lost $74 billion, thousands of employees and investors lost their retirement accounts, and many employees lost their jobs.
As a result of the investigations, Enron executives ended up being charged with crimes such as wire fraud, money laundering, securities fraud, mail fraud and conspiracy. Kenneth Lay, the company CEO, died of natural causes before serving any jail time.
Enron’s auditors (accounting firm Arthur Anderson) were also held accountable. Not only were they found guilty of reckless standards in its audit practices (including conflict of interest from consulting work and acting as the company’s outsourced internal audit department), but it was also uncovered that Arthur Anderson had engaged in destroying documents relevant to the SEC investigation. This action voided its license to audit public companies, effectively leading to the accounting firm’s downfall.
Takeaway: Whether it was due to executive moral failing, group-think or pure corruption, the devastation caused by the Enron scandal was far reaching and wide. The lessons that this scandal can teach us are equally as abundant and should be studied so that nothing like this ever happens again. One of those lessons that came from this case is the power of anonymous reporting mechanisms. Studies have consistently shown that anonymous tips are the #1 way that ongoing occupational fraud is uncovered. Ms. Watkins has essentially become a spokesperson for whistleblower hotlines, and her involvement in this case has thrust hotlines into the spotlight. Whether you feel that anonymous hotlines open a door for uncovering an ongoing fraud or you feel that they open the door for retaliation against the whistleblower, the fact remains that anonymous reporting lines are one of the most effective defenses against fraud that companies have at their disposal. Someone likely knows that the fraud is going on. These tip lines provide them an avenue to get that information off their chest and in the hands of someone that can do something about it.
Co-author Mike Nurse is a manager in the Accounting and Consulting Group at Clark Nuber PS. Reach him at firstname.lastname@example.org.
© Clark Nuber PS and Focus on Fraud, 2015. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Clark Nuber PS and Focus on Fraud with appropriate and specific direction to the original content.