Fraud

Front 1

Enron Schemes

Back 1

#1- Abuse of Mark-to-market accounting via mariner energy
#2- Abuse of SPEs
Special Purpose Entity #1- Jedi
Special Purpose entity #2- Chewco
Special Purpose Entity #3: LJM1
Special Purpose Entity #4: LJM2 and the raptors
Special Purpose Entity #5 and #6: Whitewing and Osprey
#3 Prepay Transactions

Front 2

Enron Signals (7)
Signals of Enron’s Fictitious reporting schemes of using SPE’s to understate debt and overstate earnings

Back 2

1. Assets and liabilities of unconsolidated affiliates or SPE’s increasing significantly
2. Vague References to unconsolidated affiliates in notes to the financial statements
3. Unconsolidated affiliates used to generate significant profits
4. Related party transactions note to the financial statements referring to transactions with unconsolidated SPEs
5. Securitization of current assets
6. Retaining partial ownership in assets sold
7. A company guaranteeing the debt of its SPEs

Front 3

General signals of Enron’s assorted financial problems (7)

Back 3

1. Account Receivable increasing as a percentage of revenue
2. CFFO lagging behind operating income
3. Late publication of financial statement
4. High interest expense in relation to income
5. Substantial growth of debt
6. Use of “Death-Spiral” financing
7. Straying from Core Business

Front 4

LIVENT: mainly an example of improper expense recognition via failure to record expenses and via improper deferral of expenses

Back 4

Schemes:
1. Understatement of expenses via removing invoices from the records
2. Improper deferral of expenses
3. Improper capitalization of expenses
4. Additional misc schemes- misstated revenues (improperly timed revenue or false revenue)

Front 5

Signals of Livent Scheme #1: Understating expenses (3)

Back 5

1. Decrease in expense as a percentage of sales
2. Decrease in current liabilities as a percentage of current assets or of sales
3. Regular vendor not on accounts payable list

Front 6

Signals of Livent Scheme #2: Understating expenses via deferral of expenses (4)

Back 6

1. Increase in deferred costs or prepaid expenses as a percentage of total assets
2. Decrease of expenses as a percentage of sales
3. Unusually long period for depreciation of assets
4. Increase in ratio of deferred assets to sales

Front 7

Signals of Livent Scheme #3- understating expenses via capitalization of expenses (4)

Back 7

1. Lower asset-turnover ratio
2. Change in policy for capitalization of costs
3. Write off of costs previously capitalized
4. Unusual capitalization policy

Front 8

RITE AID- example of overstating ending inventory values to reduces COGS

Back 8

Schemes
1. Overstating ending inventory values to reduce COGS
2. Adjusting gross profit entries to reduce COGS
3. Improper recognition of vendor rebates to reduce COGS
4. Other manipulations- failed to write off capitalized costs, reverse the a/p from prescription medication, into profit and failed to accrue an expense each quarter with respect to stock appreciation rights (sars)

Front 9

Signals of Rite Aid's fictitious reporting schemes of reducing COGS (4)

Back 9

1. Increase in inventory as a percentage of COGS
2. Unexpected and unusually large increases in gross margin as a percentage of sales
3. Reduction in inventory reserve as a percentage of inventory
4. CFFO dropping below operating income

Front 10

ALLEGHENY (AHERF)- an example of understating reserves for bad debts

Back 10

Schemes
1. Understating Bad debt
2. Transferred millions of reserves to avoid recognizing the expense in its income statement

Front 11

Allegheny Signals (4)

Back 11

1. Unusually large net accounts receivable
2. Decrease in reserve for bad debt as a percentage of accounts receivable
3. Increase in accounts receivable as a percentage of total current assets
4. CFFO lagging behind operating income

Front 12

LOCKHEED- an example of failing to record impairments of assets

Back 12

Scheme
1. Failing to account for asset impairments

Front 13

Lockheed Signals (5)

Back 13

1. Significant intangible assets accompanied by operating or production problems
2. Company with large intangible assets incurring a loss
3. Decrease in a company’s asset-turnover ratio
4. Accounting policy indicating slow asset write-off
5. Unusual restructuring charges

Front 14

EDISON Schools- an example of inadequate disclosures in its MD&A

Back 14

• Signals- no specific signals, however it is important to be aware of different reporting methods and to question why one method was chosen rather than another

Front 15

ALDELPHIA COMMUNICATIONS CORPORATION- presented mainly as an example of
1) failure to disclose related-party transactions and improper use of related-party transaction
2) improper use of NON-GAAP financial measures

Back 15

Reporting Schemes
1. improper use and misleading disclosure of related-party transaction
2. Improper use of Non-GAAP financial measures

Front 16

Aldelphia Signals (2)

Back 16

1. Notes in the f/s indicating that the company is involved in business transactions with related parties
2. Mixing a company’s assets or liabilities with those of other parties

Front 17

BELLSOUTH- presented as an example of improper accounting for foreign payments in violation of the Foreign corrupt parties act (FCPA)

Back 17

SCHEMES
1. Use of fabricated invoices at telcel
2. Use of inappropriate payments and the failure to keep accurate records at telefonia
3. Improper accounting in violation of the FCPA

Front 18

KRISPY KREME- an example of inappropriate accounting for round-trip transactions

Back 18

Fraud Schemes-
1. Inappropriate accounting for round-trip transactions
2. Recording of early shipments of equipment sales to franchisees
3. Failing to accrue the full amount of incentive compensation expense in accordance with the company’s incentive plan

Front 19

Krispy Kreme SIGNALS of operational problem of opening too many franchises (2)

Back 19

1. Rise in franchise acquisition rights
2. Growth of existing store sales less than growth in company sales

Front 20

Signals of Krispy Kreme’s fictions reporting scheme of misusing round-trip transactions (2)

Back 20

1. Account receivable increasing as a percentage of sales
2. CFFO lagging operating income

Front 21

MORTGAGE- Countrywide Signals of underestimation of allowance for loan losses (3)

Back 21

1. Allowance for loan losses not growing in proportion to the increase in riskier loans
2. Allowance for loan losses not growing in proportion to the increase in troubles loans
3. Allowance for loan losses not increasing significantly as house prices fall

Front 22

Countrywide Fraud Schemes

Back 22

1) Misleading Description of Loans in SEC Filings 2) Underestimating of Allowance for Loan Losses

Front 23

Securitization

Back 23

Pool together large quantitiesof loan and sell interests in these loans to investors in the form ofsecurities

Front 24

Mortgage-backed Security

Back 24

Financial instrumentthat gives the owner an interest in a mortgage loan or a partial interest in apool of mortgage loans

Front 25

Tranching

Back 25

Process of carving up or separating apool of mortgages into different classes, tranches, of securities which absorbdifferent default loses

Front 26

Credit Default Swaps

Back 26

One can invest in a copperderivative security that requires that the holder must be paid an amount determinedby reference to the level of a copper price index on a specific date. Insurancecompanies such as AIG and some investment banks began to write instruments thatgave the holder of the instrument the right to be paid if the borrowers of theunderlying mortgages backing the MBSs and CDOs defaulted.

Front 27

Management fees and Chewco

Back 27

Recognized present value of entire 5 year period’smanagement fees of 25.7 million in its income statement. Mangement fees arepaid to Enron employees for running these SPE’s

Front 28

Contrived Put Options and LJM1

Back 28

Enron used LJM1 to create afalse put option hedge for its investments in Rhythm Netconnections. The stockpricewent up but Enron was not allowed to trade its Rhytms stock before the endof 1999. Andy Fastow wanted to recognize the profit in Enron’s booksimmediately. Since it was not guaranteed that Enron would make that minimumprofit from selling the stocks to LJM1, enron could use mark-to-marketaccounting to revalue the Rhythm stocks and it could book at least that amountof profit.

Front 29

Related party sales and LJM1

Back 29

Enron was involved in buildinga power plant in Brazil, things went south and environmentalists were opposingit. They wanted to sell it but couldn’t find a buyer so Andy Fasto created LJM1to buy a 13% stake in Cuiaba. Pretty much Enron sold part of its own share ofthe Brazilian company back to itself, like a dog chasing its tail.

Front 30

Mark to market accounting and LJM1

Back 30

Enron figured if the 13%share that it sold was work 11.3 million, then using mark-to-market accounting,the remainder of its share must be worth an extra $34 million in the incomestatement. He also used mark-to-market accounting from time to time to revaluethe remaining unsold part of the poorly performing assets.

Front 31

What Qualifies Under Riskier Loans?

Back 31

1) High LTV Loans

2) Pay-Option ARM Loans

3) 80/20 Loans

4) Undocumented Loans

5) Nonconforming Loans

6) Subprime Loans

Front 32

What Qualified Under Troubled Loans?

Back 32

1) Loan Delinquencies

2) Nonperforming Loans

3) Loans with interest that is no longer being accrued

4) Loans with negative amortization

5) Troubled debt restructuring

Front 33

Steps Leading to the Mortgage Crisis

Back 33

1) The Housing Bubble

2) Easy Credit: Securitization

3) Easy Profit: Tranching

4) Easy Banking: Regulations Repealed

5) Easy Investing: Credit Default Swaps