Corporate Fraud and Corruption Management[Materials for Student Contest – October 17, 2011]

Ozzie Mascarenhas S. J., Ph.D.Chairman: MBA Programs, AIMIT, Beeri

October 10, 2011

Corporate America is failing in its fiduciary duty and loyalty to its stakeholders. During the last two to six years, the media has reported hundreds of corporate frauds either in the form of accounting misdeeds or security frauds. Led by Enron, the list of giant corporate malfeasance grew steadily in 2002 and thereafter. In fact, there is a great fear that we have just scraped the tip of the corporate deviant behavioral iceberg. Corporate frauds (and hence, corporate failures and/or bankruptcies) are ever on the increase, reaching all-time highs in 2001-2002 (see Forbes 2002; Fortune 2002). Based on the listings of Forbes 2002 and Fortune 2002, Appendix 1 explores into the theory of insider trading irregularities, and Appendix 2 examines the companies that indulged in corporate fraudulent practices such as aggressive or creative deceptive accounting practices. Most of these corporate scandals also involved much racketeering and money laundering, and hence, resulted in cash flow crisis.

In the wake of these extraordinary scandals, discussions about the executive virtues of honestly and integrity are no longer academic or esoteric, but critically urgent and challenging. As representatives of the corporation, its products and services, corporate executives in general, and accounting, financial, and marketing executives in particular, must be the frontline public relations and good will ambassadors for their firms. As academicians of business education, we must analyze these corporate wrongdoings as objectively and ethically as possible. What is wrong must be declared wrong, what is right, must be affirmed as right. We owe it to our students, our profession, and to the business world. This chapter deals with corporate fraud, particularly in the domain of cash and cash flow reports. Detecting creative accounting practices and insider securities trading irregularities in time, and preventing or forestalling them is an important rescue strategy in business turnaround management.

Losing investors’ confidence in the securities market can be disastrous. Thousands of shareholders were shell-shocked and numbed when premium blue chip stock prices trading at the $100 and more levels suddenly plummeted to a few cents a share within a year. What happened? Did the stock market crash? Was it rigged? Neither. In reality, creative accountants fooled the markets – they cleverly inflated reported cash flow from operations by reclassifying items among the operating, investing and financing sections of the statement of cash flows – all this, presumably, well within the boundaries of the generally accepted accounting principles (GAAP). For instance, in acquisitions, cash paid for working capital could be shifted to the investment section rather than shown as a reduction in cash flow from operations (Mulford and Comiskey 2005: xi).

In an era of questionable accounting, cash flow is the only trustworthy measure of financial performance available. It is almost impossible for accountants to manipulate cash flow. The balance in cash and the total change in cash from one period to the next are generally not prone to misstatement. The balance in cash is readily verifiable from banks and other institutions holding reported balances. Hence, cash is a fact, while profit (which accountants can easily manipulate) is an opinion. Cash flow is real and is not easily subject to the vagaries of GAAP. Most investors rely more on cash flow than on reported statements such as the balance sheet and profit and loss statements. This Chapter deals with cash flow crisis management problems that originate from abnormal operations such as corporate frauds.

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Regardless whether corporate frauds have peaked or not, their intensity, frequency, and magnitude over the last eight years since 2000, should be a moral and ethical wake-up call for all and must be seriously scrutinized, objectively analyzed, effectively monitored, and expeditiously controlled. This Chapter is a step in this direction. For all practical purposes, corporate scandals represent the level of corporate greed that left unchecked will destroy American firms, industries, and our business system in general.

Some Definitions in Relation to Corporate Fraud

The Association of Corporate Fraud Examiners (ACFE) in 1996 defined an occupational fraud as “The use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets” (ACFE 1996: 4). This definition has remained more or less the same in 2004: an occupational fraud is “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s services or assets” (ACFE Report 2004).

The ACFE defines occupational fraud against one’s organization The ACFE also defines fraud as an activity that is: a) clandestine, b) which violates the employee’s fiduciary duties to the organization, c) is committed for the purpose of direct or indirect financial benefit to the employee and d) which costs the employing organization assets, revenues or reserves (ACFE 1996: 9). The term “employee” in this definition includes employees of all categories: blue- and white-collar labor, managers, corporate executives, including CEOs, CFOs, and presidents. Fraud can encompass any crime that uses deception as its primary method or modus operandi.

Webster’s Dictionary (4th edition, 2002) defines the following fraud synonyms or equivalents:

Deception: The act or practice of deceiving. The fact or condition of being deceived. Something that deceives, as an illusion, or is meant to deceive, as a fraud.

Fraud: Deliberate deception in dishonestly depriving a person of property, rights, etc. Mislead: To lead in a wrong direction, error of judgment or into wrongdoing. This may or may not

be intentional. Subterfuge: An artifice or stratagem used to deceive others in order to evade something or gain some

end. Trickery: Implies the use of tricks or ruses in deceiving others. Chicanery: Implies the use of petty trickery and subterfuge, especially, in legal actions. Beguile: To mislead people by one’s charm or persuasion of cheating or tricking.

Thus, deception is a broader term that applies to anything that deceives, whether by design (fraud), by delusion (trickery or illusion) or by device (subterfuge and chicanery). A fraud is a deliberate misrepresentation or nondisclosure of a material fact made with the intent that the other party will rely upon it. If the party did in fact rely upon such a misrepresented statement, and if this causes injury, then the person may bring an action to rescind the contract. Statements of opinion, however, may not be usually used as a basis for fraud or misrepresentation. If the seller says, "This car is the best buy in town," such a claim is treated as a statement of opinion or puffery, but not a statement of fact. However, if the person making such a claim has "superior knowledge" having specific expertise in the field, and the buyer relies on this expertise in the actual purchase, then such a claim may be equivalent to a misrepresentation. 1 The misrepresentation must be of a present or a past fact. False statements regarding

1 The "Recovery Theory" in the U. S. Law is also based on the definitions of "fraud" and "misrepresentation." A misrepresentation occurs when a person, by words or acts, creates in the mind of another person an impression not in accordance with the facts. Example: If the seller of a passenger car expressly states that the auto has been rebuilt to meet tougher road conditions, when it has not been, and if the buyer relies heavily upon this statement (hence a "material fact") in deciding the

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the future are not actionable. In addition, in general, silence or nondisclosure is not fraudulent, unless nondisclosure relates to “material” facts regarding an inherently dangerous product. If the manufacturers/sellers, however, choose to speak, they must tell the whole truth. Deceptive partial disclosures often amount to fraudulence.

Corporate frauds are deceptive trade practices. Traditionally, the concept of deceptive trade practices included all transactions that have a "tendency or capacity" to mislead consumers. One did not have to prove actual harm to any specific group of consumers. The courts have not changed the "tendency or capacity standard". However, the FTC has come out with new guidelines for deception. In the early 1970s, in the context of deceptive ads, the FTC used three tests to determine whether to take action against trade practices: 1) the FTC must conclude that the ad is "likely to mislead consumers"; 2) the misleading ad must be “material” to subsequent purchase, and 3) misled consumers must be "acting reasonably in the circumstances." All three criteria apply to corporate frauds as deceptive trade practices.

Similarly, lie is not the same as deception or fraud. The Oxford English Dictionary defines: "A lie is a deliberate false statement that is intended to deceive others". Thus, lie is a form and subset of deception. Deception does not always need a false statement to deceive. A lie is a deliberate false statement that is either intended to deceive others or foreseen to be likely to deceive others (Brandt and Preston 1977; Carney 1972). Most frauds in the form of creative accounting practices are “lies” in this sense.

Embezzlement means to take willfully, or convert to one’s own use, another’s money or property of which the wrongdoer acquired possession lawfully, because of some office or employment or position of trust. Embezzlement, therefore, implies three elements: a) fraudulent appropriation or conversion of money, b) that the wrongdoer acquired because of his office or position, and c) that the said money belongs to the employer or employing company. Thus, embezzlement is a special type of fraud.

Fraud is different from robbery. The latter uses physical force on someone to give the robber what he wants. Fraud deceives or tricks you out of your assets. Robbery often involves force and violence. Fraud involves surprise, cunning, deception and trickery by which one violates someone’s confidence, and gets an advantage by false misrepresentation. Fraud betrays trust of one’s customers or clients.

Fraud is different from larceny, which is a form of stealing. The legal term for stealing is larceny. According to Black’s Law Dictionary, larceny is felonious stealing, taking and carrying, leading, riding, or driving way another person’s personal property, with the intent to convert it or to deprive the owner thereof (Black 1979: 792). Thus, the essential elements of a larceny are a) an actual or constructive taking away of the goods of another, b) without the consent or against the will of the owner, and c) with a felonious intent. Obtaining possession of property by fraud, trick or devise with preconceived design or intent to appropriate, convert or steal is larceny. Thus, fraud is a subset of larceny.

Fraud is different from bribery or corruption. Bribery in the USA is giving or receiving of anything of value by a subcontractor to a prime contractor. Black’s Law Dictionary (1979: 311) defines bribery or corruption as “an act done with intent to give some advantage inconsistent with official duty and the rights of others. The act of an official or fiduciary person who unlawfully and wrongfully uses his station or character to procure some benefit for himself or for another person, contrary to duty and rights of others.” Bribery violates Title 18, US Code # 201; punishable by up to 15 years in prison + fines of 3 times the value of the bribe + bribing officer is disqualified. Bribery also violates Foreign Corrupt

purchase, then the latter’s decision was not freely and voluntarily made, but triggered by misrepresentation. A fact is "material" if the person trying to avoid the contract will not have entered into it had he/she known of the misrepresentation. The buyer may ask a court to free him/her of the contractual obligations of the purchase contract.

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Practices ACT (FCPA), Title 15, US Code # 78. Bribery in the form of kickbacks violates Title 41, US Code #s 51-58; up to 10 years in prison.

Fraud differs from skimming: a subtle practice of stealing a small portion of a resource (e.g., money, commodity) that presumably will not be noticed. Skimming is a subset of larceny. [See Turnaround Executive Exercises 5.1].

Types of Corporate Fraud

Albrecht and Albrecht (2004) classify occupational frauds as using one’s occupation to cheat ones

organization or for the benefit of one’s organization. Table 5.1 lists commonest frauds by type, perpetrators, and methods, victims, and costs of deception. The fraud types listed in Table 5.1 are in the descending order of the magnitude of fraud losses in relation to money, market valuation, brand equity, supplier goodwill and customer loyalty, cash crisis, insolvency and bankruptcy. Hence, our list heads with management fraud followed by securities scams or insider trading, investment scams, tax fraud, racketeering, vendor fraud, employee fraud, computer fraud, bribery, and customer fraud. Other things being equal, historically, the magnitude of money and non-monetary damages of frauds could be estimated along the rank order suggested in Table 5.1.

The most common occupational frauds on behalf of one’s organization are those of the top management that result in false financial reporting. Financial statement frauds occur in companies that are experiencing net losses or have profits much less than forecasts or expectations. Such frauds make corporate earnings look better and thus, increase the stock’s price. Often, executives misstate corporate earnings in order to draw larger year-end bonuses. [See Turnaround Executive Exercises 5.2].

Basic Instruments of Corporate Frauds

Several types or patterns of corporate scandals have been reported (e.g., See Yahoo! Finance, various reports):

1. Unscrupulous brokers: sale of fictitious limited partnerships to boost revenues.2. Wash Trades: sale of a product to another company with a simultaneous repurchase of the same

product at the same price; these swindles uniquely inflate sales by units and dollar volume without recording any profits.

3. Oil and gas schemes (scammers speculate on oil shortages or a rise of natural gas prices).4. Equipment leasing (scammers sell interest in pay phones, cash machines or Internet kiosks to seduce

thousands of investors). 5. Affinity frauds (scammers use their victims’ religious or ethnic identity to buy or gain their trust and

then steal their life savings).6. Promissory notes (e.g., short-term debt instruments sold by independent insurance agents and issued

by little-known or non-existent companies promising no-risk high returns).7. Prime-bank schemes (e.g., scammers promise investors triple-digit returns through access to the

investment portfolios of world’s elite banks such as Rothschild banking family or Saudi Royalty).8. Aggressive accounting (e.g., converting long-term debts to assets, purchase intentions to actual

purchases, future orders to current ones).9. Analyst research conflicts (e.g., Merrill Lynch issued misleading research reports, and had to pay

$100 million fine in May 2002, in New York, and had to institute several significant changes in the way it does business). (See Berkenbilt 2002)

All nine corporate scam-types involve selling or buying under fraudulent conditions, and hence, fall well within the domain of fraudulent marketing.

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The U. S. Federal Energy Regulatory Commission (FERC) defines “wash trading,” also known as

“round trip” trading or “sell/buyback” trading, as the sale of a product to another company with a simultaneous purchase of the same product at the same price. Essentially, wash trading is a false trading because it boosts the companies' trading volume, or even sets benchmark prices, but shows no gains or losses on the balance sheets. While this kind of trading may not be strictly illegal, (possibly, they are too recent frauds to receive federal scrutiny), it can manipulate the power market, which is illegal and it is downright unethical. An inflated balance sheet from round-trip trading misleads investors about the true value and volume of the company's business. Misled investors may tend to invest more, thus jacking up the corresponding stock price. Large volumes of "wash trades” raise the revenues but have no effect on earnings. For example, in the energy industry, round-trip trades involved the simultaneous purchases and sales of energy at the same quantity between the same parties; they inflated revenues in both companies but added no profit. For instance, in the energy trading market controlled by fraudulent energy companies such as Enron, CMS Energy, Duke Energy, Dynergy, and Reliant Energy, each company indulged in the same basic type of wash trading and thereby seriously affected market prices and shortages (see Forbes.com’s accounting tracker Internet service).

Wash trading also affects final consumers. For instance, wash energy trading created false congestions and the perception of energy shortage in the Californian market in 2001, and the price of electricity paid both by the industrial and home users skyrocketed (USA Today April 4, 12, 2002). In addition, on September 23, 2002, Allegheny Energy, a Maryland electric utility company, sued Merrill Lynch for $605 million and more unspecified punitive damages in a New York state court. The charge stated that Merrill inflated revenues of Global Energy Markets (GEM) through a series of “round-trip trades” with former industry giant Enron, before selling it to Allegheny for $490 million in 2001. The lawsuit also accused Merrill for misrepresenting the qualifications (e.g., age, experience) of Daniel Gordon, GEM’s head (Yahoo! News, Thursday, September 26, 2002, 9:25 am, EST).

Fraud versus Occupational Abuse

Occupational abuse is a form of fraud, presumably of smaller proportions. Nevertheless, abuses imply some form of cheating and cost to the employers. Consider the following typical employee abuses:

1. Use sick leave when not sick.2. Come to work late or leave work early.3. Take a long lunch break without approval.4. Indulge in slow and sloppy work.5. Declare or punch more hours than worked for and get paid.6. Work under the influence of alcohol or drugs.7. Take products or stationery belonging to the organization (pilferage).8. Pad your expense accounts. That is, collect more money than due on business expense

reimbursements.9. Use employee discounts to purchase goods for relatives or friends.10. Use company’s computers during office hours to engage in personal email or securities exchange.

All of these behaviors are examples of occupational fraud. According to the Association of Corporate Fraud Examiners (ACFE), an occupational fraud is “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s services or assets” (ACFE Report 2004). This definition is broad enough to include fraud schemes as simple as pilferage to complex financial statement frauds. Each of these abuses implies: a) some clandestine behavior, b) violation of perpetrator’s duties to the victim organization, c) some form of cheating the

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employer, d) which costs the employer some money, revenues or assets, and e) some direct or indirect financial benefit to the perpetrator.

The first five examples relate to cheating on time spent on work for which the employer must pay extra. The sixth case of alcohol or drugs cheats on the quality of work that you owe to the company. The next three abuses cheat on products and/or money. The tenth abuse cheats the company on everything: time spent on work, quality of work and using company’s products/services for one’s private business. All ten examples involve a corrupt practice, deception, and improper use of one’s fiduciary trust. Fiduciary duty implies that you are employed (entrusted with responsibilities) on the condition that you are trustworthy and that you do not betray the trust your employer has in you.

In practice, how do you distinguish fraud from abuse? The difference is a matter of perspective. Fraud implies more conspiracy and conspirators, more scheming, affects more people, involves greater losses, and negatively affects large assets of the company. In contrast, abuses are often single-handed actions that are ordinary and routine deceptions, which mostly benefit just the abuser, and involve smaller corporate losses. [See Turnaround Executive Exercises 5.3].

Let us illustrate the difference between corporate fraud and corporate abuse by an example. Jane is a bank-teller, and steals $100.00 each day for five different days of a quarter from her cash drawer. John is also a teller who earns $500.00 a week, and calls in sick (when he was healthy) five different days during the same period. Normally, the former crime would be called a fraud, and the latter action an abuse, even though the damage to the bank in both cases is the same amount, namely $500.00. Each offense implies a dishonest intent to benefit oneself at the expense of the company. Both violate their fiduciary duties to the employer and betray the trust the employer had in them. Yet the punishment meted out in each will be different. Jane would be fired for embezzlement and possibly prosecuted while John will be gently reprimanded, and for repeated offense, his pay may be docked for a day or two. Jane stole money, but John stole time (which is equivalent in money to Jane’s damage to the company). Jane’s action, however, will be treated as a crime of embezzlement or stealing, while that of John would be treated as misconduct or inappropriate behavior. It is a matter of perspective (Wells 2004: 4).

Based on Wells (2004: 46), Table 5.2 presents a detailed taxonomy of occupational fraud and abuse. Table 5.2 traces occupational fraud to three major action-sources: a) corruption practices, b) misappropriation of assets, and c) falsifying financial statements. Table 5.2 also includes several major types and sub-types of occupational fraud under each of these three heads. Vigilant managers could use this exhaustive list to check and identify occupational frauds in their companies.

Fraud has existed since the dawn of humanity and will continue until the end of times. Given human nature and its weaknesses, one’s avarice and greed for money, power and popularity has been the major stimulus for fraudulent crime. The landmark case of fraud is McKesson Robinson, a corporation involved in a 1937 financial statement balance fraud that reported $10 million of non-existent inventories and accounts receivable. This case marked the beginning of required generally accepted auditing standards (GAAS) for independent public auditors.

Fraud exists even today and can occur anytime in an organization. At the same time, there is no special recipe or checklist for detecting and preventing corporate or personal fraud at all times. No such thing exists and no such thing is truly capable of being developed to monitor and control all forms of fraud (Silverstone and Davia 2005: 5-6). Managers should be aware of fraud, deal with the human factors that generate fraud by hiring honest people and keep them honest by instituting strong deterrents of fraud, and deal with the environmental factors that cause crime by enforcing adequate monitors, controls, policies and procedures.

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Cash Flow Crisis from Abnormal Business Operations

Simply stated, corporate fraud is cooking books to show better earnings and profits. The cost of fighting fraud is very high, especially in high profile cases, such as frauds occurring in Fortune 500 companies. In such cases, defendants and plaintiffs could be spending tens of millions of dollars defending and prosecuting fraud over months, if not years. Large fraud cases of giant multinationals may involve multiple law firms, multiple lawyers from each firm, multiple investigators, and expert witnesses and large support staff. Often such lengthy and exorbitantly expensive prosecutions may suddenly end with a pre-trial settlement, with no public announcement of the terms of the settlement. Understanding the nature of fraud, detecting and preventing it in time, and appreciating the tremendous costs of fraud losses may someday mean the difference between saving one’s company or, losing it.

Investigating, detecting and deterring fraud is a multidisciplinary task and domain that includes accounting, law, investigative science, sociology and criminology. Corporate and occupational fraud and abuse are mostly financial in nature. Traditional accountants, traditional investigation personnel (e.g., FBI, CIA), general lawyers, and pure criminologists, however, are ill equipped to handle specialized and subtle financial crimes that occur in very sophisticated ways. Hence, sociologists and criminologists (e.g., Cressey), investigation specialists (e.g. Wells) and accountants (e.g. Albrecht) met together and conceived a new disciple called fraud examination, and founded organizations such as the Certified Fraud Examiners (CFE) and the Association of Certified Fraud Examiners (ACFE). Criminologist and former FBI agent Joseph T. Wells, CFE, CPA, is chairman and founder of the ACFE, as well as an advisory member of the Board of Regents. The ACFE was established in 1988, with headquarters in Austin, Texas, and currently has over 30,000 members spread in more than 100 countries and functions through more than 100 local chapters. ACFE oversees the globally recognized CFE credentials by setting standards for admission, administering the Uniform CFE examination, and maintaining and enforcing the ACFE Code for Professional Ethics.

The Incidence of Corporate Fraud and Corporate Damages

The top giant five fraudulent companies, Enron, WorldCom, Tyco, Qwest, and Global Crossings, destroyed a combined capital of $460 billion in shareholder value while moving inexorably toward bankruptcy (Stoller 2002; USA Today, October 10, 2002). The cascade of corporate accounting and securities scandals has rocked major security markets of the world, especially the New York Stock Exchange (NYSE) and the NASDAQ markets. The United States of America is the economic engine of world commerce and the cornerstone of the world economy, and therefore, American corporate frauds and scams have affected the stock markets around the world. However, not all of the stock associated with the offending companies has suffered in other markets the way it has in the United States.

Corporate fraud is a growing problem. The FBI has labeled fraud the fastest growing crime and hence, has committed almost 24 percent of its resources to fighting fraud. At any given time, the FBI is investigating several hundreds of cases of fraud and embezzlement, each averaging to over $100,000 in damages. These cases, however, relate just to FBI jurisdiction. Secondly, insurance companies, that provide fidelity bonding or other types of coverage against employee and other fraud, undertake regular investigations within their jurisdiction of employee bonding or similar insurance. Occasionally, researchers conduct studies about particular types of fraud in specific industrial sectors. Fourthly, victims of fraud report crime. All four sources of fraud, however, are incomplete, jurisdiction-specific, and

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periodical. They fail to provide a comprehensive and up-to-date picture of organizational fraud at the national level.

According to the 2002 Report of the Association of Certified Fraud Examiners (ACFE) on Occupational Fraud and Abuse, on average, U. S. organizations lose about six percent of revenues owing to dishonesty from within. When adjusted to U. S. Gross Domestic Product, the cost of occupational fraud and abuse amounts to over $600 billion annually. The ACFE had conducted a similar study in the mid 1990s based on voluntary reports of over 2,600 frauds, estimating losses to $400 billion annually, or about $9 per day per employee (ACFE 1996). Such abuses may include everything from disorders in the mailroom to the boardroom, from employee theft, purchasing managers’ kickbacks to corporate embezzlement, but corporate fraud takes the lions share of organizational fraud and abuse (Albrecht and Albrecht (2004: viii). These numbers understate the real damage, as it is impossible to know what percentage of fraud is really discovered, and what percentage of fraud perpetrators are eventually caught and brought to justice. In addition, many frauds that are discovered are handled out of court and clandestinely and never made public (Albrecht and Albrecht (2004: 3).

Each dollar lost in fraud is a dollar loss of net income, and hence, it takes significantly more sales revenue to recover the effect of fraud loss on net income. For example, a fraud loss of $100 million to an automobile manufacturer whose profit margin (i.e., net income divided by revenues) is ten percent would necessitate the manufacturer to generate additionally ten times the fraud loss, that is, $1billion in revenue to recover the effect on the net income. If the average ticket price of a car were $20,000, this would imply that the auto manufacturer would have to make and sell an additional 50,000 cars ($1 billion/$20,000) to counterbalance the fraud loss. Meanwhile, this loss could be easily passed on to the consumer via higher ticket prices. Alternately, if that amount is deducted from R&D, the opportunity loss of $1 billion could affect the quality of cars.

Whereas most employee crimes in the past were theft of physical goods (e.g., stationery, money, commodities) that were either in small amounts or infrequent, owing to fear of being caught, modern crime is much more sophisticated and electronic in nature. Telecommunications, particularly the computers and the Internet, have facilitated and stimulated corporate fraud. Employees now need only to make a telephone call, misdirect purchase invoices, bribe a supplier, manipulate a computer program, misplace company assets, and other fraudulent transactions by a mere push of a key on computer, PDA or Blackberry keyboards. Most of them take years to be detected.

Profiling Fraudulent Companies

In a report by the Committee of Sponsoring Organizations (COSO) commissioned by the Treadway Commission, entitled “Fraudulent Financial Reporting: 1987-1997, An Analysis of U. S. Public Companies,” COSO analyzed around 200 fraudulent financial statements during 1987-1997, and found the following characteristics on fraud (COSO Report 1999):

The frauds occurred mostly in midsize companies with less than $50 million in revenues or assets. The companies were concentrated in the technology, healthcare and financial services industries. The CEOs and CFOs were involved in the fraud. The founder/CFO appeared to dominate the organization. Boards and audit committees were either weak and/or owned a significant share of the company. The companies were experiencing net earnings loss or near break-even point prior to the fraud. The fraud was primarily a manipulation of revenues and/or assets; some involved false disclosures. The frauds resulted in major losses, often leading to bankruptcy.

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If COSO were to undertake similar research on corporate frauds: 1997-2007, the results would be the following: (see Forbes, July 2002 and Fortune, September 2002; USA Today, October 10, 2002)

The frauds have occurred mostly in gigantic companies with over $10 billion in revenues or assets. The companies have concentrated in the energy and information technology industries. The CEOs and CFOs were involved in the fraud. The founder CEO/CFO appeared to mastermind the fraud. Boards and audit committees were either weak and/or neglected to audit the accounts. The companies were experiencing both revenue and net earnings losses. The fraud was primarily an inflation of revenues and/or assets, or an understatement of debt. The fraud was geared to project revenue growth to SEC analysts for obtaining better ratings. Most companies had to restate corporate earnings to adjust for massive overstatements. The frauds resulted in massive losses, often leading to bankruptcy.

We illustrate abnormal cash flow crisis by actual corporate frauds that occurred in giant companies after 1997.

Recent Giant Corporate Frauds

The collapse of onetime corporate icons such as Enron, WorldCom, Tyco, Sunbeam, Healthsouth and Cendant chilled investors in general and burned them badly. Each of these companies represented a recent accounting cash-related fraud that totally baffled the investors.

The Enron Cash Crisis

Enron, a multinational company that specializes in electricity, natural gas and energy markets and other physical commodities, was established in 1985 from the merger of Houston Natural Gas and InterNorth of Omaha, Nebraska. In the year 2000, Enron employed 21,000, operated in over 40 countries, and reported revenues of $101 billion, thus wining the seventh rank among Fortune 500 that year. That same year, Enron posted $4.8 billion cash flow from operations, while its real, legitimate, sustainable cash flow was -$3.1 billion. That same year, it claimed a profit of $1 billion. In October 2001, however, Enron was suspected of a massive financial statement fraud. Chairman Kenneth Lay, former President Jeffrey Skilling, and former Chief Financial Officer Andrew Fastow, among others, were accused of shielding debt from public view, and overstating revenues and earnings, thus giving the impression of rapid profit growth. The same year, it declared bankruptcy, the then largest corporate failure in U. S. history. Its stock price plummeted from $90 in 2000 to $ 0.26 per share, just a few days before fling the petition.

The meltdown of Enron Corporation was one of the largest corporate bankruptcies in history, and certainly represented the biggest accounting scandal ever, and possibly, the largest cash crisis in corporate business. Once a stodgy focused gas pipeline company, Enron redefined itself into the nation’s leading marketer of natural gas, electric power, and bandwidth capacity. It struck hundreds of joint venture deals with domestic and foreign partners alike in projects that diffused its original focus. Revenues soared from $20 billion in 1997 to $31 billion in 1998 to $40 billion in 1999 until it jumped to $100 billion in 2000. Its NYSE annual-high price rose from $22.5625 in 1997 to $29.375 in 1998 to $44.875 in 1999, until it peaked at $90.5626 in 2000. Profits increased almost ten fold from $105 million in 1997 to $979 million in 2000. Its total assets expanded from $22.5 billion in 1997 to $65.50 billion in 2000.

Enron had such a strong following on Wall Street that its CEO Jeffrey Skilling could bluff his way around tough questions about the company’s operations. Yet what happened to force this giant icon to come down in 2001 when its stock plummeted to $0.26 and the company faced almost extinction? Among other things, it was massive cash flow crisis owing to loss of internal control of accounting operations.

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Andrew Fastow, CFO at Enron, wore two hats. As chief financial officer of Enron, Fastow negotiated and set up outside partnerships to conduct Enron business. As the principal in these partnerships, however, Fastow also negotiated with Enron on behalf of the partnerships. This is obviously conflict of interest: which entity did Fastow favor in these deals? Enron’s policies prohibited employees from wearing two hats, but Enron’s Board of Directors exempted Fastow from this rule. The result was a series of money-losing transactions for Enron, and consequently, Enron’s stockholders, creditors and employees all emerged as heavy losers.

Investors have sued Enron ever since, with the accumulated damage to them estimated at over $25 billion. New York-based Amalgamated Bank, which lost millions in the Enron fraud, sued 29 top Enron executives. Enron restated its financial statements, citing accounting errors, and cut profitability for the past three years by about 20 percent, or by around $586 million. Lawsuits against Enron claimed that its top executives reaped enormous personal gains from “off-the-book” partnerships. Meanwhile, Enron’s auditor, Arthur Andersen, allegedly instructed employees to shred critical documents involving fraud. Enron fired Fastow; he was later prosecuted, and was just recently (September 26, 2006) served a six-year prison sentence. Kenneth Lay is dead, and Jeffrey Skilling is currently serving a two-year prison sentence. This tragedy of enormous human, social, economic and monetary losses could have been prevented had Enron applied strict internal cash and accounting controls (Harrison and Horngren 2004).

Vice president Sherron Watkins, CPA at Enron, understood what was going on in the company. She had three alternatives each loaded with high risk: a) report her concerns about Fastow’s deals to Kenneth Lay, CEO of Enron; b) discuss these concerns with her boss, Andrew Fastow, CFO of Enron, or c) do nothing. Under (a) and (b), there was a high chance that Watkins could be ignored or resisted and penalized for blowing the whistle, but there was also a small chance that she could be heard and corrective action taken immediately. Under (c), Watkins would avoid confrontation with Lay or Fastow, but the public (investors, creditors, employees, customers) would suffer if they relied on faulty data. Watkins blew the whistle, reported the matter to the CEO and was severely penalized, but enough damage had already been done to Enron that the company filed for Chapter 11 bankruptcy protection from its creditors in September 2001.

Cash Crisis at Qwest Communications

Denver-based Qwest Communications International used bandwidth to manufacture illusory revenue streams in its recent deal with Enron. According to investigators, Qwest agreed to pay Enron $308 million for the use of “dark fiber” (or unused fiber optic) capacity. In exchange, Enron agreed to pay Qwest between $86 million to $195 million for access to active sections of Qwest’s network. Both deals turned out to be fake allowing both companies to record fat revenues for the period, and particularly helped Enron avoid reporting a loss for that period (Pizzo 2002).

Qwest Communications inflated revenue using network capacity “swaps” and improper securities for long-term deals. Qwest admitted that an internal review found that it incorrectly accounted for $1.6 billion in sales. It will restate results for 2000, 2001, and 2002. It is planning to sell its phone director unity for $7.05 billion in order to raise funds.

Qwest was also involved in illegal insider trading. Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion (See Forbes September 2002; Fortune, September 2002).

Cash Crisis at World.com

In 2002, WorldCom Inc., the telecommunications giant, filed Chapter 11 bankruptcy with an asset value of $103.9 billion, dwarfing Enron. Scott Sullivan, the fired WorldCom chief financial officer (CFO), Bernie Ebbers, CEO, and David Myers, the company’s former controller, were indicted on a variety of charges. Among these charges were securities fraud, mail and wire fraud, for hiding $3.85 billion in expenses, and

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falsely posting profits of over $9 billion over a five-quarter period beginning in early 2000 (Wall Street Journal (2002), July 25, A1). The same year 2002, Global Crossings Ltd. filed chapter 11 bankruptcy with assets $25.4 billion.

WorldCom made a "minor" alteration in its accounting records and ended up overstating its revenue by

a few billion dollars. In the process, it conveniently forgot that it lost well over $100 million. WorldCom also started treating everyday expenses (pencils, papers, etc.) as capital expenditures, that is, money used to improve assets or buy new ones. This accounting manipulation capitalizes the expenses, or puts on the balance sheet as an asset, instead of expensing them, which increases reported income. The truth was out on June 25, 2002, when the company announced a $3.85 billion earnings restatement, which would eventually mount to $11 billion. This forced the company into bankruptcy protection less than a month later on July 21.

When WorldCom collapsed, it cost investors more than $150 billion dollars and left 20,000 people unemployed. World.com also gave the founder, Bernard Ebbers, $400 million in off-the-book loans. Currently, the WorldCom fraud totals $16 billion. The company found another $3.3 billion in bogus securities, and may have to take a goodwill charge of $50 billion to write-off its debts. Former CFO Scott Sullivan and ex-controller David Myers have been arrested and criminally charged. David Myers agreed being guilty on September 26, 2002. Ebbers resigned just two months before the scandal hit the news. He was reeled back, however, for accounting fraud that originated during his time as CEO. In the end, when his defense failed, he was sentenced to 25 years in prison in 2005.

Cash Crisis at Related Companies

The same year 2002, Adelphia Communications filed Chapter 11 with assets of $24.4 billion. Founder John Rigas and two of his sons were arrested and charged with looting their cable-television company. The Securities and Exchange Commission (SEC) charged Adelphia for a massive financial cover-up that included fictitious receipts, falsified annual reports and lavish personal spending at the expense of shareholders. The Rigas family was found to use company jets for private parties, to have borrowed billions of dollars for their closely held private companies, and to have used $252 million of company funds to meet margin calls on their private stock (Wall Street Journal (2002), July 25, A3).

Global Crossing: February 2002, the company engaged in network capacity “swaps” with other carriers to inflate revenue; shredded documents related to securities practices. Company filed Chapter 11; Congress investigated the role of its securities firms in its bankruptcy.

AOL Time Warner: As the ad market faltered and AOL’s purchase of Time Warner loomed, AOL inflated sales by booking barter deals and ads it sold on behalf of others as revenue to keep its growth rate up and seal the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers. The Department of Justice (DOJ) has ordered AOL to preserve its documents. AOL confessed that it might have overstated revenue by $49 million. New concerns are that AOL may take another goodwill write down, after it took a $54 billion charge in April (Forbes, July 2002). The scandal went public in July 2002.

Cash Crisis at New Century Financial New Century Financial, Irvine, CA, reported some unusual creative accounting practices in 1998, a

period during which it was one of the nation’s fastest growing subprime lenders to homebuyers with blemished credit. The technique called “gain on sale” was promoted by Edward F. Gotschall, CEO, whereby the company reported profits before they actually existed, and hence, secured better loan ratings from Wall Street analysts.

Using gain on sale, New Century made money in two ways:

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a) Whole loan sales: The company organized pools of loans from big Wall Street investment banks at prime rates and lent the same money to subprime homebuyers at higher subprime rates and made money on the interest differential.

b) The company reduced its loans to home buyers, repackaged the loans into securities for sale to investors, a process called securitization, and made profits on high speculative security returns, residuals or derivatives.

On both counts, New Century could accelerate its profits. In 2005, the last year when it had reported annual earnings, New Century recorded income from “gain on sale” accounting practice of nearly $623 million out of a profit of $1.4 billion that year.

In either case, the paper profits were pegged to future earnings from loan sales to institutional investors. Traditional accounting practice recorded and reported profits only when cash was realized, and which were then used to make more loans to risky homebuyers. Gain on sale is seemingly legal but not safe, unless the lending institutions are big investment banks that could support themselves if expected earnings from gain on sale accounting did not materialize. However, this is not a safe practice for small specialty financial lenders like the New Century. New Century, moreover, used gain on sale to hide losses as the sub-prime market began to falter in 2006.

The problem with gain on sale is that a company can keep on escalating expected earnings with nothing to back them up until an insider or outsider blows the whistle or the company suddenly becomes insolvent. Companies using gain on sale will also report inflated balance sheets and profit & loss statements that were just imaginary but helped improving the company’s stock price. In the late 1990s, in the last downturn for subprime lenders, most abuses of gain on sale involved securitization (New York Times, May 1. 2007, C4).2

New Century Financial filed for bankruptcy protection on April 2, 2007 when federal prosecutors and securities regulators found serious accounting mistakes at the company. The company is expected to file restated earnings for all of 2006 by early May 2007.

What happened? New Century Financial knew it was engaging in aggressive accounting. It also knew how aggressive it was (New York Times, May 1. 2007, C4). The subprime lending industry had its worst downturn in the 1990s. The estimated $1.3 trillion subprime housing market industry experienced fast deterioration in 2005 – rising loan delinquencies and the decision by Wall Street to cut off billion dollar credit lines to subprime housing market lenders. The stock prices of subprime lenders like New Century collapsed because investors had based their decisions on terribly inflated income and balanced sheet statements that were based , in turn, on gain on sale accounting. Their hopes suddenly deflated because of the imaginary nature of such financial reports. The investor market woke up to the fact that there was nothing there.

At the same time, New Century had guaranteed to Wall Street investors that if the “whole loans” did not make as much money as it predicted (i.e., if homebuyers were late with or defaulted on payments) it would buy back the impaired loans from the banks. Obviously, New Century underestimated how many impaired loans it would have to repurchase and how much cash on hand it would need to do that.

As the subprime market began to melt down in Fall of 2006, New Century was forced to honor its guarantees to repurchase the impaired loans from investment banks and other institutional investors. New Century resold the loans at a loss. Third quarter 2006, New Century disclosed for the first time that it had repurchased $468 million in bad loans and resold them at $242 million. New Century’s stock price

2 Incidentally, the use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through 2000. For instance, Conseco, a large insurance and finance company that made loans to subprime homebuyers, filed for bankruptcy in 2002, one of the largest corporate bankruptcies ever. According to security filings, other bankrupt or struggling subprime lenders that used gain on sale accounting, or still do, include NovaStar Financial, Fieldstone Investment, Fremont General, and Accredited Home Lenders.

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plummeted. While gain on sale accounting may be still legal, the assumptions and presuppositions its forecasts of future earnings are based on may be very questionable.

Corporate Insolvencies and Fraudulent Practices

In general, more recently, corporate fraudulent business practices have precipitated cash crises and subsequent bankruptcies. For instance, consider Enron, WorldCom, Global Crossing, Qwest Communications, and Tyco. Fraudulent practices in the broad areas of accounting and financial management virtually destroyed their brand image and brand equity, their high stock prices plummeted down to a few cents, and their customers, suppliers and employees quickly switched to their competitors. All these companies had deployed enormous investments over many years building their company renown, brand image and equity, customer goodwill and loyalty, and supplier-employee long term relationships. All these fizzled out within months and the companies sought Chapter 11 bankruptcy protection.

Accounting and financial fraudulent practices (e.g., inflating sales, overstating accounts receivables, understating debt, and illegal security trading) have currently infested several industries like energy, gas pipelines, communications, information technology, retail, healthcare, and pharmaceutical companies (see listings of such practices in Fortune 2002 and Forbes 2002; see also Appendices 5.1 and 5.2). There are many ways to inflate revenues, and almost all of them involve savaging the GAAP system. The financial impact of such practices on their brand equity, market value and customer goodwill has exceeded well over a trillion dollars.

Fraud Investigation

Legally, a fraud must include seven elements: a) A deliberate misrepresentation about b) a material point, c) which is false, d) but which the victim believes, e) intentionally or recklessly, and f) acts upon it, g) thus causing significant damage to self.

Not all deceptions are frauds. To meet the legal definition of a fraud, there must be damage, usually in terms of money, to the victim. Under the common law, there are four general requirements for a fraud to exist:

1. A material false statement [(a), (b) and (c) above], 2. Knowledge that the statement was false when it was made, [(d) and (e) above], 3. Reliance on the false statement by the victim [(f) above], and 4. Damages the victim as a result [(g) above] (Wells 2004: 2).

Defined thus, fraud is different from unintentional errors. If an accountant mistakenly enters incorrect numbers on a financial statement, this may not be fraud, as this is not a deliberate act [element (a)] about a material point that is false [element (c)], but just an incorrect entry. An error does not involve a deliberate deception that violates confidence of people and obtains an advantage over them. Fraud is an intentional perversion of the truth (or facts) to induce another to part with some valuable thing belonging to him or her (Silverstone and Davia 2005: 224).

Common Fraudulent Operations

Defined thus, fraud occurs under many forms: (See Mulford and Comskey 2002; Silverstone and Davia 2005: 225).

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1. Fraud as defective delivery: Here, fraud is the receipt of products or services that are inferior in some manner, without appropriate disclosure or compensation to the recipient.

2. Fraud as defective pricing: Here, fraud involves charging the victim a price higher than the price that was agreed upon or falsely representing prices to deceive the victim.

3. Fraud as defective shipment: Here, fraud involves the transfer of products or services in excess of those authorized by the delivering entity without appropriate compensation. Invariably involves a conspiring employee.3

4. Fraud as duplicate payment: Fraud involves the intentional issuance of two or more identical checks to the same payee – one in genuine payment to the creditor, the others are fraudulent and recovered and cashed by the perpetrator.

5. Fraud as shell: Shell companies are corporations without active business operations or significant assets. Shell corporations are often formed before commencing operations to obtain financing. Sometimes, they may be used for tax evasion. Shell operations include payment for fictitious products, projects, materials or services, with all underlying documentation forged, with or without conspiracy with contractors or suppliers, and where all the payments are appropriated by the perpetrators.

6. Fraud as multiple payees: Involves two or more payments to different vendors or contractors for the same debt. One is honest; the others are deceptive.

7. Fraud rotation: Two ore more (usually, dominant and local) contractors conspire to submit alternately the lowest bid, and accordingly, share the booty, thus defeating the purpose of competitive bidding. It is a form of contract rigging.

8. Fraud as land flipping: An illegal practice that involves the purchase of real estate and subsequent resale of it a number of times between conspiring associates, each time raising the selling price substantially for the purpose of artificially raising the ultimate value. This is a form of round trip sales.

9. Fraud kickback: A share of a contract or purchase order profits returned to a victim’s employee in return for conspiratorial assistance.

10. Fraud as pseudo conspiracy: A situation where one or more people who are key participants in a fraud scheme are innocent of any criminal intent to commit fraud, but are seemingly involved in the scheme because of their negligence in performing a control function that enables the occurrence of the fraud.

11. Fraud as off-the-books: Here, fraud is a theft of assets not properly recorded in accounting records. Also called asset-theft fraud.

12. Fraud as skimming: The practice of stealing a small portion of a commodity (e.g., money, products, stationery) that presumably will not be noticed.

13. Fraudulent financial reporting: These are intentional misstatements, omissions or disclosures in financial statements done to deceive financial statement users. This term is also used interchangeably with accounting irregularities.

14. Fraudulent earnings management: The active and deceptive manipulation of earnings toward a predetermined target set by management, forecasts, or for SEC ratings (e.g., income smoothing, declaring fictitious revenues).

Accounting Irregularities

3 Fraud often occurs as sales of a defective product. Fraud as defective product comes under “recovery theories.” The common thread uniting recovery theories of negligence, warranty and strict liability is the defective product. Without a product defect, recovery is not allowed under any of these theories. Misrepresentation is tort recovery without a product defect; that is, without a product defect in manufacture. But there could be intended or unintended product defects and risks arising from design, advertising, promoting or in actual use of the product - this may be equivalent to innocent misrepresentation. An increasing number of plaintiffs have chosen to establish their case on the basis of innocent misrepresentation. Product Liabilityarises under innocent misrepresentation even though the seller never intended to mislead the public.

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Whatever the financial benefit, typical occupational frauds on behalf of one’s organization occur in one or more of the following accounting irregularity forms:

Aggressive Accounting: Intentional choice and application of accounting principles, in accordance with GAAP or not, done in an effort to achieve desired results, typically, higher current corporate earnings. Examples: Recording revenues too soon or of questionable quality; recording bogus revenues; recognizing revenues on disputed claims against customers; paying fictitious consulting or other fees to customers that were to be repaid to the company as licensing fee; shifting current expenses or sales to a later date; shifting future expenses or sales to the current period as a special charge, and influencing auditors.

Earnings Management: The active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother and more sustainable earnings stream.

Income Smoothing: A form of earnings management designed to flatten peaks and valleys from an actual earning series, including steps to reduce and “store” profits during good years for use during slower years.

Fraudulent Financial Reporting: These are deliberate misstatements or omissions of amounts or disclosures in financial statements, done to deceive financial statement users. Administrative, civil or criminal proceedings can determine such statements as fraudulent.

Creative Accounting Practices: This is a general euphemistic term for any of the above accounting malpractices or irregularities. Typical creative accounting practices include recognizing premature and fictitious revenues, aggressive capitalization and extended amortization policies, misreported assets and liabilities, massaging income statements, and deceptive cash-flow reporting.

Many corporate frauds are crimes committed within the accounting system of various companies. The accounting system comprises the methods by which companies record transactions and financial activities. Accounting is a method of tracking business activities in a particular time period (e.g., week, month, quarter, or a year). Some common frauds are: fraudulent disbursements when funds are disbursed through false invoices or forging company checks, skimming, where cash is stolen before it gets ever recorded, and cash larceny, where cash is stolen after it is recorded (Silverstone and Sheetz 2007: 25).

Miniscribe Corporation, a public company issuing publicly traded debt, is a clear case of creative accounting. Its sales revenues grew from $5 million in 1982 to $114 million in its fiscal year ending in 1985. Profits, however, were negative for the same period. In 1986, the company reported $185 million in sales and a profit of $24 million from the operations. Based on this strong financial performance, the company successfully issued $98 million in bonds. Later investigation, however, revealed inflated figures based on fictitious shipments to boost revenues and manipulated reserves to reduce expenses. The reported net income of $22.7 million for 1986 was later restated to a greatly reduced figure of $12.2 million. The company declared bankruptcy in 1990.

Corporate Fake Transactions:

We can generally classify most of the corporate accounting irregularities under two heads: a) Fake transactions like “round-Trip” sales, and b) manipulation of debts and assets to overstate the value of the company.

Documented examples of round-trip sales abound.

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1. CMS Energy (May 2002): It executed “round-trip” trades artificially to boost energy-trading volume. Thomas Webb, former CFO of Kellogg, has been appointed as its new CFO since August 2002. These companies have admitted that they have wash traded close to $6 billion in sales revenues, either between these two companies, or involving other energy companies involved in the fraud.

2. Dynergy (May 2002) also executed “round-trip” trades to boost artificially energy trading volume and cash flow. S&P cut Dynegy’s rating to “junk,” even though the company is conducting a re-audit.

3. El Paso (May 2002): It also executed “round-trip” trades artificially to boost energy-trading volume. Oscar Wyatt, a major shareholder and renowned wildcatter, may be engineering a management shake-up.

4. Halliburton (May 2002): Improperly booked $100 million in annual cost overruns before customers agreed to pay for them. Legal watchdog group Judicial Watch filed a securities fraud against Halliburton.

5. Homestore.com (January 2002): It inflated sales by booking barter transactions as revenue. The California State Teachers’ pension fund, which lost $9 million on a Homestore investment, has filed suit against the company.

6. K-Mart (January 2002): Allegedly, its securities practices intended to mislead investors about its financial health. The company is in bankruptcy situation; is undertaking a “stewardship” review to be completed by the end of 2002.

7. Merck (July 2002): It recorded $12.4 billion in consumer-to-pharmacy co-payments that Merck never collected. Even though SEC approved Medco’s IPO registration that would raise $1 billion, the company has withdrawn from it.

Inflating or Restating Revenues:

8. Enron in October 2001: Boosted profits and hid debts totaling over $1 billion by improperly using off-the-books partnerships; manipulated the Texas poser market; bribed foreign governments to win contracts abroad; manipulated California energy market. Ex-Enron executive, Michael Kopper, pled guilty to two felony charges; acting CEO Stephen Cooper said Enron might face $100 billion in claims and liabilities; company filed Chapter 11; its auditor, Arthur Anderson, was convicted of obstruction of justice for destroying Enron’s documents.

9. Peregrine Systems (May 2002): It overstated $100 million in sales by improperly recognizing revenue from third-party resellers. It slashed nearly 50% of its workforce to cut costs. Is on its 3rd auditor in 3 months and has yet to file its 10K for 2001; hence may be soon de-listed from the Nasdaq. Currently, it is restating revenues from April 1999 to December 2001, during which John Moores, Chairman, dumped $530 million of stock (Fortune, September 2, 2002).

10. Adelphia Communications (nation’s 6th largest cable TV company): April 2002, the founding Rigas family collected $3.1 billion in off-balance sheet loans backed by Adelphia; overstated results by inflating capital expenses and hiding debt. The company filed for Chapter 11 bankruptcy on June 25. Three Rigas family members and two other ex-executives were arrested for fraud on July 24, 2002. The company is suing the entire Rigas family for $1 billion for breach of fiduciary duties, among other things (Forbes, July 2002).

11. Bristol-Myers Squibb: It inflated its 2001 revenue by $1.5 billion by “channel stuffing” (i.e., forcing wholesalers to accept more inventory than they can sell to get it off manufacturer’s books). Efforts to get inventory back to acceptable size will reduce Squibb’s earnings by 61 cents per share through 2003 (Forbes, July 2002). The scandal was disclosed in July 2002.

12. Duke Energy (July 2002): Duke engaged in 23 “round-trip” trades to boost trading volumes and revenue. Duke claims that its round trip trades had no “material” impact on current or prior financial periods.

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13. Reliant Energy (May 2002): It executed “round-trip” trades artificially to boost energy trading volume and revenue.

Corporate Insider Trading Irregularities

Insider Trading: This is buying or selling some or all of one’s stock holdings, or facilitating such transactions for others, because of insider information that one has privileged access to as a corporate insider. There are legal as well as illegal insider trading activities that can be undertaken by corporate insiders. As of August 2002, the SEC has come up with newer rules requiring firms to report trades of company stock by officers, directors and majority shareholders within two days (Kristof 2002). This is a vast improvement over past rules that allowed companies at least 10 days, and sometimes more than a year, before they must reveal any such transactions. Of late, the SEC has been involved with more vigilance relative to insider trading. As a result, 57 insider-trading cases were filed in 1996, up from 38 in 1990 (Bryan-Low 2000).

Under SEC 2003, examples of insider trading cases would be:

Corporate officers, directors, and employees who traded the corporation’s securities after learning significant confidential corporate developments.

Friends, business associates, family members, and other tippees of such officers, directors, and employees who traded the securities after receiving such information.

Employees of law, banking, brokerage, and printing firms who were given such information to provide services to the corporation whose securities were traded.

Government employees who learned of such information because of their employment by the government, and

Other persons who misappropriated, and took advantage of confidential information from their employers.

Documented Insider-Trading Corporate Scams

Most insider-trading frauds relate to artificially fixed stock prices.4

1. As part of BellSouth’s deal to buy some of Qwest, Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion.

2. Tedd Waitt, founder and CEO of Gateway, spent $9.36 million in June to buy back 2 million Gateway shares trading around $4, when $82.5 was the stock peak price in November 1999: his haul was $1 billion.

3. With an unusually short post-IPO lockup period, several corporate executives of Ariba.com began selling their stock barely 4 months after Ariba went public in June 1999. Ron DeSantis, former EVP made 222 million, Keith Krach, Chairman hauled 191 million, Paul Heagarty, Director, Edward Kinsley, former CFO, each laundered 127 million and 114 million, respectively.

4. Founder, chairman and CEO of i2 Technologies, Sanjiv Siddhu, who still owns 27% of the company, sold most of these shares after the stock peaked at $110 in March 2000. I2 Technologies stock now trades at less than $1.0; his catch was 447 million; Ramesh Wadhwani, Vice-Chairman, and Sandeep Tungare, former Director, each did the same and made 160 million and 140 million, respectively.

4 For details on insider-trading irregularities, see recent studies reported in Forbes, July 2002; Fortune, September 2, 2002; USA Today, October 10, 2002; Security Exchange Commission (SEC) Reports since July 2002; and almost everyday, round-the-clock reports by Yahoo! Finance since July 2002.

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5. Enron’s Lou Pai, former Division Head, Ken Lay, former CEO, Rebecca Mark, former Division Head and Ken Rice, former Division Head, each cashed stock to mint 270 million, 108 million, 80 million and 74 million dollars respectively; Jeff Skilling and Andy Fastow cashed $68 million each worth of Enron stock, respectively.

6. Gary Winnick, Chairman, Global Crossings, cashed stock worth $508 million; Winnick also sold another $227 before January 1, 1999.

7. John Chambers, President, CEO, Cisco Systems, and Judith Estrin, former CIO, each cashed stock to gain $239 million and $ 72 million respectively in 2000. Estrin also cashed $61 million of stock in February 2000, a month before it peaked at $80.06; she left Cisco that April.

8. Craig McCaw, Director, Nextel Communications, cashed stock to the tune of $343 million in 2000. He also cashed $115 million from XO Communications, the Telecom he founded that went belly-up June 2001.

9. Last May, with stock down 96% from its high of $243, executives of Juniper Networks, Scott Kriens, Chairman, CEO, Pradeep Sindhu, Vice-chairman, and Peter Wexler, VP exchanged their booming options for ones priced at $10.31! They bagged each 148 million, 108 million and 87 million dollars, respectively.

Common Sources of Corporate Fraud

To understand how fraud occurs within businesses one must understand how the various cycles (e.g., operation cycle, cash cycle) work within an accounting system. Concretely, accounting profession recognizes five cash flow cycles:

a) Sales and accounts receivableb) Payment/expense and accounts payablec) Human resources and payrolld) Inventory and storage/warehousing, ande) Capital expenditures

Sales and Accounts Receivable: The fundamental concept of any business is to design new products and services, distribute, market and sell them, and collect revenues. Revenues from sales appear on the income statement, and corresponding accounts receivable from credit appear on the balance sheet. Cash sales directly affect the cash balance, which also appears on the balance sheet. In order to minimize fraud and financial risk in this cash cycle, various checkpoints are:

a) Marketing department: Identifying and soliciting customers, processing customer orders and fulfilling them exactly (e.g., timely sorting, packaging and shipping of products) - this is the marketing and sales function.

b) Accounting department: costing products, pricing products, sending invoices, guidelines for credit, approving credit, collecting receivables, record keeping and assessing bad debts - this is the credit function.

c) Finance department: collecting cash, cashing checks, banking cash and financing production and marketing - this is the financial function.

In minimizing fraud, keep these three functions separate. Accordingly, custody of data and customers, authorization of credit, and recordkeeping should be separate functions. That is, separate the credit function from the sales function, thereby avoiding granting credit to an unsuitable potential customer in order to force a sale. Similarly, sales recording and receipt of cash should be separated so that skimming of cash may be minimized. [See Turnaround Executive Exercises 5.4].

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Payments and Accounts Payable: Any production business involves procurement of goods and services and subsequent payment. In this accounting cycle, the expenses appear on a company’s income statement, and the respective accounts payable appear on the balance sheet. Cash purchases would directly affect the cash balance, a balance sheet item. Check points in this payment cycle are: identifying, selecting and approving vendors, due diligence and ensuring they actually exist and are legitimate businesses; proper processing of purchase orders; proper assessing, processing and posting of receipt of goods and services; recording defective products, theft, and pother liabilities; and processing of cash for payment.

Other safeguards are constant checking of cash, prepaid expenses, inventory, accounts payable, equipment, land and buildings, office equipment, depreciation, and other long-term assets and liabilities. One should be sure that the person who makes the bills, generates checks, signs the checks, mails the checks, and the person who reconciles the checks with bank accounts cannot be the same – this is a fundamental principle of accounting. [See Turnaround Executive Exercises 5.5].

Human Resources and Payroll: Any business systems need employee skills. This HR cycle includes identifying skills, recruiting, developing, promotion, and retention of employee talent, performance appraisal, and other related matters. Cash, payroll and taxes payables appear on the balance sheet, while salaries/payroll, tax, travels, training and entertainment appear in the income statement. Fraudulent practices prevalent in the HR cycle are ghost employees, falsified hours and overtime; false expense reports (e.g., padding); false medical claims; false sick leave; improper recruiting, hiring, firing, wages, salaries, promoting, appraising, and personnel development. [See Turnaround Executive Exercises 5.6].

Inventory and warehousing management: This purchase cycle includes ordering, transportation, logistics, receiving goods and reports, processing requisitions, control over requisitions, storage, warehousing, continuous inventory records, shipping documents, JIT inventory management, inventory costing, FIFO, LIFO, theft, spoilage, and other related functions. From an accounting perspective, inventory appears on the balance sheet, and cost of goods sold (CGS) in the income statement. Fraudulent practices prevalent in the inventory management function include overstocking, creating artificial shortages, creating production bottlenecks, overstating inventory as bank collateral, improper use of FIFO or LIFO, theft, spoilage, and the like. [See Turnaround Executive Exercises 5.7].

Capital Expenditures: This fifth part of the accounting cycle is also known as the capital acquisition and repayment cycle or the financing cycle. It includes borrowing of funds, payment of interest, debt structure of the company, debt amortization, leveraged buyouts, issuance of stock, stock repurchases, and the like. Several of these items feature in the financial statements, such as cash, liabilities (e.g., debt, mortgages), capital and retained earnings on the balance sheet, and interest paid and received, among others on the income statement.

Several sources of fraud can occur, especially in the recording of debt and interest, and payment of interest and dividends. Periodic monitoring and control should check bank deposits, loan authorizations, proper documentation of loans, journal entries, and stock certificates. Certain financial duties should be separated such as stock issuance and handling of cash and, in general, separating accounting from cash handling. [See Turnaround Executive Exercises 5.8]. Table 5.3 summarizes this discussion on the sources of corporate frauds by accounting cycles.

Journal Entries for Controlling Corporate Frauds

In general, control of frauds in the entire accounting cycle is critical. Transaction of a business (that underlie a corporation’s financial statements) are formally called accounting cycles. Such cycle can be

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periodic (e.g., weekend, month-end, quarter-end, or year-end) closing of books for reconciling various accounts and ensuring everything is in balance. In this connection, a journal is a chronological listing of transactions or business activities where each original transaction and the corresponding debit or credit entry is originally made. A general journal records all such entries, and identifies them to which specific journal it should next be posted.

Specific journals are:

Sales journal (records all sales revenues by date, customer, item specification quantity, amount, and transaction and number),

Purchase journal (records all purchases by date, supplier, item specification, quantity, amount, and transaction number),

Cash receipts journal (records all cash receipts by date, customer, item specification amount, and transaction number in the accounts receivable ledger), and

Cash payments journal (records all cash payments by date, creditor, item specification, amount, and transaction number in the accounts payables ledger).

Matching (i.e., debits should equal credits) of all specific journals by each weekend or month-end accounting cycle should be common practice. It detects and prevents frauds at their source. Each ledger or specific journal entry should correspond to an entry in the general journal. Each specific journal should also match. For instance, all accounts receivable from the sales journal should match all cash receipts with the cash receipts journal, and vice versa. Currently, several computer programs can do this very effectively (e.g., Quicken, QuickBooks of Intuit). [See Turnaround Executive Exercise 5.9].

Forensic Accounting and Forensic Accountants

The responsibilities of a year-end external auditor in a financial statement audit are different from those of an internal auditor in the day-to-day examinations of a company’s purchase, sales, cash, accounting and financial transactions. Both internal and external auditors differ from the so-called ad hoc forensic accountants or fraud investigators. While financial auditing enables the auditor to render an opinion as to whether a set of transactions is presented fairly in accordance with GAAP, forensic accounting enables the investigative auditor to assess financial transactions in relation to various authorities such as the Criminal Code, an insurance contract, institutional policies, or other guidelines for conduct and reporting.

With the growing interest in forensic investigation, it was only a matter of time until "investigative" accounting was renamed forensic accounting. Forensic accounting tries to piece together the circumstances of a crime by reviewing physical evidence. In the case of accounting, the physical evidence is found in the numbers. Forensic accountants search for the elusive smoking gun in the company's financial statements. Even expert manipulators of numbers leave a palpable "fingerprint" behind when they change things.

Currently, forensic accounting is a general term used to describe any financial investigation that can result in legal consequences. Forensic accounting evidence is oriented to a court of law. Table 5.5 distinguishes between internal and external auditors, fraud investigators and forensic accountants from the viewpoint of objective, scope, approach, standards and training.

Financial audit methodologies are not designed to detect fraud but only uncover material financial misstatements. Financial auditing is more procedural than forensic accounting – the former is an accounting data system analysis. The process of forensic accounting, on the other hand, is more intuitive

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than deductive, although both intuition and deductions play a major role. Forensic accountants are trained to react to complaints arising in criminal matters, to financial statement arising in civil litigation, and rumors and inquiries arising in corporate investigation (Singleton et al., 2006: 43-44).

Accounting professionals play two important roles in any forensic investigation: a) lead financial investigator, and b) potentially, an expert witness in any subsequent civil or criminal trials. As lead financial investigators, they are expected to understand accounting systems and internal controls and know how to trace the flow of funds, in and out of the company. They should also provide an independent and objective critique of the organization’s accounting system that allowed the frauds to occur so that they may be avoided in the future. As expert witnesses, forensic accountants should know the rules of evidence, what documents to request, whom they should interview, and, in civil cases, how to assess quantitatively damages arising from frauds to various stakeholders (Silverstone and Sheetz 64-65).

Fraud Auditing and Fraud Examiners

Fraud auditing is a specialized discipline within forensic accounting. It investigates a particular criminal activity, namely fraud. Forensic accounting on fraud refers to the comprehensive view of fraud investigation. It includes the audit of accounting records to prove or disprove a fraud. Fraud investigative auditing involves reviewing financial documentation for a specific purpose such as litigation support, insurance claims and other criminal matters (Singleton et al. 2006: 50). It also includes the interview process of all related parties to fraud, when applicable. It may also include the act of serving as an expert witness, when applicable.

Fraud detection is part art and part science. The science element, of course, comes from academic training in accounting theory, especially in auditing, and from knowledge of business practices and legal processes acquired through experience (Silverstone and Sheetz 63). The art part comes from innovative and creative thinking. Logic and problem-solving and detective skills are critical skills for fraud auditors and forensic accountants. Fraud accountants are actively involved in detecting and preventing fraud in a corporate, regulatory or government environment. [See Turnaround Executive Exercise 5.10].

Tony Bishop, past president and CEO of the ACFE, and Joseph Wells, founder of the ACFE, believe that “one of the most difficult issues facing the auditing profession is that there are no auditing procedures that can provide absolute assurance in detecting all fraudulent financial reporting.” Current fraud detection is based on best practices. Both believe that the profession would really benefit from a more holistic and systematic approach to the fraud detection (cited in Silverstone and Sheetz 2007: 62).

The legal definition of fraud is the same whether the offence of criminal or civil. The difference is that criminal cases must meet a higher burden of proof. Civil law is the body of law that provides remedies for violations of private rights. It deals with rights and duties between individuals. The purpose of a civil lawsuit is to compensate for harm done by one individual to another. Civil claims begin when one party sues against another, usually for the purpose of financial or equivalent restitution. Criminal law goes beyond compensation or restitution (compensatory damages) to punishment (retribution or punitive damages) to right the wrong, and hence, require stronger evidence and a broader judicial process. [See Turnaround Executive Exercise 5.11].

For instance, civil lawsuit starts with the filing of a claim or many claims by a plaintiff for obtaining restitution of damage. It is judged usually by a jury of less than 12 members and with a less than unanimous verdict based on “preponderance of evidence.” On the other hand, criminal cases deal with only one claim-action at a time. Moreover, they determined by a grand jury of at least 12 members who must arrive at a unanimous verdict that sufficient evidence exists to indict “beyond a reasonable doubt”

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that the wrongdoer did the crime, and who must not only restitute the damages, but also serve jail and/or pay fines.

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The Sarbanes-Oxley Act to Control Corporate Frauds

Hurriedly passed by the U. S. Congress in 2002 in the wake of Enron and other giant corporate scandals of 2000-2002, the Sarbanes-Oxley (SOX) Act 5 seeks to reduce the likelihood of fraud by making public company CEOs and CFOs directly accountable for the internal disclosures and financial statement of their organizations. Senior managers will also be subject to greater oversight from boards that are more independent, internal audit committees and external audits. A major objective of SOX Act was to control and combat corporate fraud by: a) developing better reliable information about company’s operations to avoid making bad decisions, and thus, b) improving the reliability of financial reporting, and c) restoring investor confidence. The ACT went into effect in 2002, and public CEOs and CFOs had to implement it by fiscal year 2004. The SOX, also known as Public Company Accounting Reform and Investor Protection Act of 2002, was intended to provide a proper accounting framework and rules for public companies by improving the accuracy and reliability of corporate financial statements and disclosures made pursuant to the securities laws. The goal of SOX is for internal controls to be so effective that degradation of the system through fraud is virtually impossible (Silverstone and Davia 2005: 23).

SOX seeks to prevent and punish corporate corruption. SOX created a Public Company Accounting Oversight Board (PCAOB) whose functions are to register, oversee, investigate and discipline all Public Accounting Firms (PAF) that audit public companies. SOX requires the creation of an audit committee comprising of independent directors of the issuer company. The issuer company’s PAF auditor will be under the control of the audit committee. The CEO and the CFO of the issuer company will sign all its official financial statements and disclosures.

Compliances with SOX are enshrined in three brief Sections: 302, 404 and 906.

Section 302 (Title III): Corporate Responsibility for Financial Reports: Section 302 requires that CEOs and CFOs personally certify:

1. The accuracy of financial statements and disclosures in the periodic reports issued by the corporation,

2. That these statements fairly represent in all material aspects the results of operations and financial condition of the company,

3. That the financial controls and procedures of sox have been implemented and evaluated, and 4. Any changes to the system of internal control since the previous quarter will have been

noted.

Section 404 (Title IV – Enhanced Financial Disclosures): Management Assessment of Internal Controls: Reports filed with the SEC must include all material off-balance sheet transactions and relationships that may have material effect on the financial status of an issuer. Additionally, Section 404 requires:

5 On June 18, 2002, the Senate Banking Committee passed a bill (#2673), a legislation crafted by Senator Paul Sarbanes (D-MD), mostly in reaction to the confusion and distrust in the US financial markets caused by a series of gigantic corporate scandals involving Enron, Global Crossing, Arthur Anderson etc., in late 2001. The bill was expected to die in the House owing to its draconian implications, but got triggered on June 25, 2002 when WorldCom’s announced overstating earnings in their previous five quarters by over $3.8 billion due to improper accounting procedures. On July 15, 2002, the Senate passed the Sarbanes’ bill by a 97-0 vote. In the House, Michael Oxley (R-OH) made a few significant changes to the bill and sent it to the House floor where it passed almost unanimously. Later, the new version of the bill (now called Sarbanes-Oxley) was passed by the Senate 99-0 and in the House with a 423-3 vote. On July 30, 2002, President Bush signed the Sarbanes-Oxley Act of 2002 as law, describing it as “the most far-reaching reforms of American business since the time of Franklin Delano Roosevelt,” (Whalen 2003).

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a) An annual statement of the issuer to contain an internal control report which shall state that the management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting;

b) CEOs and CFOs to periodically assess and vouch for their effectiveness, and c) That no loans be extended to senior executives.

Section 906 (Title IX – White-Collar Crime and Penalty Enhancements): Corporate Responsibility for Financial reports: Section 906 requires CEOs and CFOs to sign and certify the report containing financial statements; they must confirm that the document complies with SEC reporting requirements and fairly represents the company’s financial condition and results. Willful failure to comply with this requirement can result in fines up to $5 million and imprisonment from five to 20 years.

Moreover, Title VIII on Corporate Criminal Fraud and Accountability adds other injunctions:

a) It is a felony for knowingly destroying, concealing or falsifying a document to impede and investigation;

b) All auditors should maintain audit work papers for five years; c) The statute of limitations and securities fraud will be increased to five years; d) Imprisonment for defrauding shareholders will increase to 25 years, and e) All whistleblowers will be protected from management retaliation.

By Section 404, companies are also obliged to include an internal-control report as part of the annual report that should minimally include the following:

a) A statement acknowledging responsibility for establishing and maintaining adequate internal control over financial reporting.

b)A statement identifying and specifying the internal-control framework to evaluate the effectiveness of internal control over financial reporting.

c) An assessment of the company’s internal control over financial reporting as of the end of the most recent fiscal year.

d)Disclosure of any material weakness in the company’s internal control over financial reporting (the latter is deemed ineffective if any material weakness exists).

e) A statement that the independent external auditor has issued a report on the company’s assessment of internal control over financial reporting, and

f) A statement that the company’s external auditor has examined and reported his/her assessment of requirements under (c) and (d) above.

The first step toward SOX compliance is the establishment of an audit committee composed of financially experienced members of the board of directors, who are independent (in the sense, they perform no other corporate duty, receive no compensation other than their directors’ fees). At least one member of the audit committee must be a financial expert (the SEC will judge the level of expertise based on previous responsibilities, education, and experience with internal controls and the preparation of financial statements). The audit committee will not have members with close family ties among directors such that concentration of power in too few hands is avoided. The audit committee is responsible for hiring and compensating both internal and external auditors and any other consultant, and is thus, a logical body to oversee the entire SOX compliance process. Without meddling with everyday company affairs, the audit committee must be able periodically to access all major financial and accounting transactions to identify, monitor and question any unusual transactions and novel practices within the company. [See Turnaround Executive Exercise 5.12].

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By Section 406, titled “Code of Ethics for Senior Financial Officers,” corporations must have a Code of Ethics “applicable to its principal financial officer and comptrollers or principal accounting officer, or persons performing similar functions.” That is, the senior management together with the audit committee must devise a Code of Ethics for the company that focuses on:

1. Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of professional and personal interest;

2. Full, fair, accurate, timely and understandable disclosure of relevant matters in the company’s regular filings, and

3. Compliance with applicable government rules and regulations.

The Code will also prevent improper insider trading. The senior management must explain the code of ethics to all levels of employees, each of whom should receive a copy. The Code should provide for the segregation of conflicting duties, periodic reconciling of accounts, and have these reconciliations

reviewed by someone independent of the reconciliation process. [See Turnaround Executive Exercise 5.13].

Costs and Benefits of Sarbanes-Oxley Act

SOX’s benefits to the investor public are obvious (Yallapragada 2007: 69):

a) It has established an accounting industry watchdog; b) It makes CEOs and CFOs responsible for all official financial statements, their procedures of

internal controls and their contents; c) It mandates the companies and their auditors to assess the effectiveness of internal controls; d) It strengthens the role of the board of directors, and e) It forbids cozy relationships between accountants and executives.

The major problems with the SOX, however, relate to interpreting of and complying with Section 404. Audit fees have skyrocketed – average cost for a midsize company of implementing SOX, especially Section 404, have been over $1 million. The costs may not justify the benefits of compliance. In fact, implementing SOX has been minting money to accounting firms and trial lawyers (Powell 2005). In this regard, SOX particularly hurts smaller and midsize public companies. SOX also places too much burden on CEOs and CFOs who must divert time from business decisions to internal controls and their effectiveness. Hence, many companies have stopped dealing with NYSE and, instead, chosen foreign stock exchanges, especially the London Stock Exchange (Factor 2006). Whereas from the 1990s, when the vast majority of IPOs were made in the US financial markets, since 2002, there has been a steady migration of IPOs to foreign stock exchanges (Murray 2006).

SOX, moreover, has many ethical challenges. Under SOX, if the company is indicted, the CEO and the board must prove they are directly overseeing and monitoring an ongoing comprehensive ethics program that assures SOX compliance throughout the company. SOX also implies that ethical guidance and reinforcement should come from the top management (Galla, Cavico and Mujitaba 2007). Before SOX, business ethics was important; after SOX, it is mandatory. SOX, however, does not provide clear ethical criteria, leaving the responsibility for ethical and moral education within the company to each organization. SOX assumes that ethical behavior can be enjoined by laws and rules, even though conventional thinking on moral development (e.g., Kohlberg 1969, 1984; Rest and Narvaez 1994) believes that people develop ethical behavior in response to social norms and organizational ethical climate in the environment they work and live, and not from rules. The corporate frauds that plagued the companies were not because existing laws and rules were inadequate. Corporate frauds were executive

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ethical failures. Corporate executives with their concern for demonstrating high financial performance to shareholders and Wall Street analysts devised creative accounting practices with the collaboration of their accountants, and hence, set a tone for unethical behavior (Verschoor 2004). Can SOX change this unethical behavior through mere rules and penalties?

In 2006, year two of implementing SOX, many companies are still struggling setting effective internal control systems that CEOs, CFOs, and the independent and external auditors can assess and vouch for (Wagner and Dittmar 2006). In this regard, the Public Company Accounting Oversight Board (PCAOB) has come up with various rules, standards, and elaborations that may help companies with SOX compliance. If a company, however, can demonstrate a strong control environment, then it can reduce the overall scope of its internal-control evaluation, reduce in the sense that the company need not carry out as many internal tests and the auditors may do less corroborating, resulting in lower compliance costs.

Why Do Corporate Frauds Occur?

A significant majority of the more recent corporate securities scams and accounting frauds have been reported in energy related or high technology services industries. For instance, both Forbes (July 25, 2002) and Fortune (September 2, 2002) listings feature several energy-trading companies (e.g., Enron, CMS Energy, Duke Energy, Dynergy, El Paso, Halliburton, and Reliant Energy) and IT technology-trading companies (e.g. Adelphia, AOL Time Warner, Broadcom, Cisco Systems, Gateway, Global Crossing, i2 Technologies, Nextel Communications, Peregrine Systems, Qwest Communications, Sun Microsystems, Sycamore Networks, Tyco, and World.com). A third large group of fraudulent behavior has been reported in the services industry: AOL Time Warner (computer services industry), Citigroup, Merrill Lynch, J. P. Morgan Chase, and Morgan Stanley (financial services industry), Global Crossing, Kmart (retailing), KPMG (consulting), MCI and World.com (telecommunications), Xerox (office equipment industry) and Waste Management (waste disposal industry) [see USA Today, 10/21/2002]. Hence, it seems certain industries, by the very nature of their market offerings, are more prone to corporate scams than others are. For instance, service companies do not deal with tangible products, thus allowing more subjective accounting practices and overstatement of earnings.

All these companies belong to the so-called “fuzzy” sectors that produce mostly intangible products or services where it is easy for top executives to hide and manipulate segments in the short term without being caught. Moreover, companies within the energy and IT industries have grown so significantly over the recent years that the average shareholders are allured to invest heavily in them, a fact that top executives can comfortably exploit to feed their corporate money-greed egoism.

Further, most of the reported corporate securities scams relate to 1) insider trading, 2) fake transactions to boost revenues, and 3) inflation (and restatement) of earnings. All these transactions relate to internal operations of a firm that take place close-doors within small departments in a company, and normally do not get disclosed or reported, but which can be detected only years after some auditors have analyzed the annual reports. Other than these generalized statements as to how and where corporate scams originate, there is no systematic research reported to date that has probed into the real reasons behind such illegal and unethical transactions.

Corporate scams are often the results of short-term profit maximizing strategies. There is an almost obsessive desire among many managers to show improvements in the bottom line, year after year, by finagling, creative accounting, aggressive financing, takeovers and mergers, acquisitions and speculations. Outrageously high executive salaries, bonuses and perks are often pegged to executive profit performance. In the anxious process of demonstrating short-term profitability, corporate

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executives, additionally motivated by money greed, tend to cut corners and often overstate earnings or understate debt, thus padding financial statements (Boyle 2002; David 2002). Further, there is always the pressure to please the Wall Street analysts in order to meet their expectations and thus, score better stock and bond ratings (Pelofsky 2002).

CEOs these days are compensated largely in stock options. Thus, given that their compensation is valued by stock performance, CEOs would be severely tempted to make their companies appear as fiscally attractive as possible for high returns. This would explain several fake transactions such as “round trip deals” to inflate revenues. For example, in 2002, CMS Energy, Dynergy and El Paso, all three energy-based companies, executed “round-trip” trades to boost artificially energy-trading volume. Duke Energy engaged in 23 “round-trip” trades in 2002 to boost trading volumes and revenue; Duke claimed that its round trip trades had no “material” impact on current or prior financial periods (See Fortune September 2, 2002; Forbes, July 25, 2002). Despite these fake transactions, however, when those at the top realized their ships were about to sink, sold their stock options while the companies were still performing well. These were massive securities trading executed on insider information, and the company stocks soon began to nose-dive to almost nothing, of course, impoverishing shareholders, employees, creditors and other stakeholders.

Corporate psychologists, however, also connect corporate creative accounting irregularities to boredom and not money, to loneliness and not wealth, to insecurity and not power, to unrealistic fantasy and not greed, to negative self-images (low self-esteem) and not corporate egos (see Horowitz, 2002).

In any case, this area needs serious research; the earlier the causes of corporate fraud are identified, the better they may be treated, and further disasters to the organization, economy and stakeholders might be averted.

Moral Theories Explaining why Occupational Frauds Occur

Aristotle raised a fundamental question in responsibility: Under what conditions of the agent and the action could one say that the agent deserves to be praised or blamed, rewarded or punished, for the action the agent performs? The answer would depend upon how we understand an action, how an action is distinguishable from its consequences, and what it means for a person to be the cause of an action, and in particular, a “moral” cause of a “moral action.” All these questions are still highly debated. In the Western philosophical tradition, “moral causation” is associated with an action resulting from the unique property of human beings, freedom. Freedom is the necessary presupposition for responsible action, that is, for an action that deserves praise or blame, reward or punishment. 6

Philosophical Theories of Occupational Frauds

Three major philosophers, David Hume, Karl Marx and John Stuart Mill, question the existence of free will that responsibility presupposes. All three deny free will on the grounds that too many external circumstances determine our decisions and actions. David Hume asserts that external factors render our actions temporary and perishing, and hence, that they do not originate from the durable and constant

6 Thomas Aquinas argued for the existence of free choice thus: “Man has free choice, otherwise counsels, exhortations, commands, prohibitions, rewards and punishments would be in vain” (Summa Theologiae I, 83.1). Kant argued for freedom as a postulate of the “practical reason” - the unconditioned ought of the law requires a can on the part of the rational will (Critique of Practical Reason, 1.2.2). Responsible action, then, presupposes the existence of a free cause - a human being that is self-determining and capable of choosing.

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character of the moral agent. Actions may be blamable in themselves but we may not be held responsible for them. Karl Marx overemphasizes the external determinant factors and circumstances, and accordingly, proposes the thesis of historical determinism – social consciousness and social choices determine the economy of products, production and profits, and these, in turn, determine individual decisions and actions. Hence, our freedom is a historical necessity. Stuart Mill concludes: responsibility is retributive punishment [For details see Mascarenhas 2007: 23-44].

David Hume (1711-1776) denies the necessary logical connection between freedom and responsibility. Responsibility does not need a free cause, but only the absence of impediments to the realization of one’s wishes and desires, which themselves are caused by many determining factors . In fact, moral responsibility, argued Hume, far from presupposing freedom, presupposes determinism. In order to associate objectively an agent with his or her act, the rational desires of the agent must be the determining cause of consequences; instead, praise and blame, reward and punishment are themselves causes that modify the character of the agent. Hence, wrote Hume:

“Actions are, by their very nature, temporary and perishing, and whereas they proceed not from some cause in the character and disposition of the person performing them, they can neither redound to his honor if good, nor to infamy if evil. The actions themselves may be blamable; they may be contrary to all the rules of morality and religion. But the person is not answerable for them, and as they proceed from nothing in him that is durable and constant, and leave nothing of that nature behind them, it is impossible he can, upon their account, become the object of punishment and vengeance." (See Concerning Human Understanding, VIII, 2).

Thus, according to Hume, it is only in terms of something "durable and constant" (which defines a character) that one can judge or assess responsibility for an act.7 In doing so, one need to know whether the agent intended to perform the act (intention), what the underlying motivation was, and whether there was a clear possibility and opportunity for deliberation. However, this information is inferential for the most part. The judge must deduce this from the agent, and the agent's character is the most important premise for this sort of inference and reflection. Does the act reflect what we know of the person in the light of his habitual conduct? Would the agent intend this sort of act? Would the agent act on such a motive? Would the agent normally investigate other courses of action before choosing one? In short, is the agent a criminal type just because he or she committed this crime?

Hume’s deterministic position on personal responsibility is obviously an extreme caricature of human conduct. Some determinism, however, in a few of the routine corporate behaviors and strategic decisions and tactics cannot be ruled out. Typical examples of turnaround executive decisions that have moral implications and that for the most part are "temporary and perishing" are: plant closings and massive layoffs to cut down costs; pressurizing suppliers to reduce prices of supplies below break-even points; forcing retailers to overstock their shelves with slow-moving products or force them to channel stuffing; to over-promote products to vulnerable customers with persuasive and attractive price and product bundling; overstating revenues and understating debts to obtain better SEC ratings, and the like. Most of these decisions may not be much planned or deliberate, nor purposively deceitful. Hence, they may be “temporary and perishing.”

7 Incidentally, even Aristotle maintained that an act could be called virtuous only if it "springs from a firm and stable character" (Nichomachean Ethics 2.14, 1105a30, p. 40). Vice, the opposite of virtue, should, therefore, be logically condemned or punished only if it stems from one's character (Hauerwas 1981). "A Person's faulty action is registrable to him only if it reveals the kind of person he is" (Feinberg 1965: 140-141).

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On the other hand, some executive decisions and actions that have a moral content may stem from the "durable and constant" aspects of the executive's character. Hence, several moral philosophers (e.g., Aristotle, Thomas Aquinas, Kant, Francis Bradley, Max Weber, John Dewey, and Dietrich Bonhoeffer) affirm freedom as the foundation of moral responsibility (for details see Mascarenhas 2007: 23-70). Typical fraudulent behaviors are deliberate persistent exorbitant pricing of life-saving products, planned subliminal advertising directed to children, exploitative under-supplying or over pricing of products and services in inner city ghetto markets, creating artificial shortages to jack-up prices, and deliberate under-evaluation of sales-performance of minority salespersons. The more these decisions reflect serious planning and deliberation, the more do they seem to originate in one’s “durable and constant” character.

However, according to Hume, deviant or fraudulent behavior is deterministic; it stems from the “durable and constant” aspects of one’s life; it may indicate real responsible agency. In this Humean sense, fraudulent behaviors may be partly exonerated because of one’s "deterministic" character or by overpowering circumstances.

Sociological Theories of Occupational Frauds

Despite their enormous economic, social and emotional impact, there is relatively little research on the origins and causes of occupational frauds and abuses. Major theories are:

The Theory of Differential Association

Edwin H. Sutherland (1883-1950), a pioneer criminologist at Indiana University, was the first to propose a theory in this regard. Sutherland focused on white-collar crime, a word that he coined in 1939, relating to crime perpetrated by corporate executives in their corporate capacity against shareholders, investors, employees, suppliers and the public. In the late 1930s, Sutherland postulated and developed the “theory of differential association,” a landmark theory that would prove to be the foundation of modern criminology. Prior to Sutherland’s theory, most criminologists and sociologists believed that the propensity to crime was genetically inherited – criminals beget criminal offspring. Opposed to this doctrine, Sutherland maintained that crime is learnt, primarily from one’s environment in the process of interactive communication (Siegel 1989: 193). Criminality, Sutherland argued, cannot occur without the assistance and influence of other people. Potential criminals learn crime within intimate personal groups (e.g., dysfunctional family, street gangsters, high school peers, neighborhood clans, and close workmates).

The learning process involves two elements: a) the techniques to commit the crime, and b) the attitudes, motives, drives and rationalizations. The incidence, frequency, and intensity of crime are dependent upon both elements, but more so on drives and rationalizations.

Social Psychology of Embezzlement: The Fraud Triangle

Donald R.Cressey (1919-1987), Sutherland’s student, focused on embezzlement and embezzlers. His primary data was derived from interviewing 200 prison inmates serving jail for embezzlement. He called embezzlers as “trust violators.” Cressey argued that trusted persons become trust violators when they face insurmountable financial problems that are “non-sharable.” If they shared the financial problem with others, possibly they could have helped them. Crimes occur, Cressey hypothesized, when financial problems become non-sharable, when they exert pressure on the embezzler, and when the embezzler rationalizes that the crime (embezzlement) under such circumstances is justified and not totally dishonest. The embezzler with this frame of mind waits for the right time and opportunity, and perpetrates the crime.

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Opportunity

The FraudTriangle

Pressure Rationalization

Figure 5.1: The Fraud Triangle

The crime incidence behavior can be explained by the “Fraud Triangle” as in Figure 5.1. All three elements in Figure 4.1 are often needed to initiate a crime: opportunity, pressure and rationalization (Cressey 972: 139). In the Fraud Triangle, “pressure” relates to a non-sharable financial need. This is the key element of the model. The need is current, almost insurmountable, and one, that under the circumstances, could not be shared.

Cressey (1972: 30-54) distinguished six types of un-sharable problems:

Violation of Ascribed Obligation: Financial obligations incurred in violation of one’s role and position as a trusted person in the corporation or society and the specter of being unable to pay one’s debts make people secretive about their debts. Resolving such debts becomes a non-sharable financial problem.

Personal Failure Problems: Several personal and family expenses could exceed budgets and drive one into accumulated debts. Such debtors do not like to share the debt problem owing to fear of status loss, fear of disclosing one’s stupidity or lack of judgment that drove them to debts.

Business Reversals: Accumulated debts, short and long term, because of overspending and bad financial planning, can make business executives desperate, secretive, and refusing to share with others their problems, lest they be thrown into false light.

Physical Isolation: The person in financial trouble is physically isolated, by design or choice, from the people who could help him.

Status Gaining: People quickly live beyond their means and incur debts, but now must trim their lifestyles, and hence, feel disabled to meet with their one-time peers.

Employer-Employee Relations: The employee resents the status within the organization in which he is trusted. This resentment is presumably triggered by perceived economic inequities (e.g., in job stress, work hours, pay, promotions, bonuses, and recognitions). Such persons nurture their resentment quietly and seek to “get even” with their employers by embezzlement.

Embezzlement can occur because of any one or more of the above six factors. For instance, accumulating personal and work-related financial problems can become serious as to become non-sharable, fearing that any disclosure would lose one’s approval rating with others or lose one’s face with

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one’s family. This in turn drives to physical isolation from trusted persons who could help. The wrongdoer wants to solve his/her problems secretly. Crime of secret embezzlement follows. The crime supposes that the trust violator does have the technical skills required: a) to pull the fraud off in secret, and b) also use the funds in secret to resolve the un-sharable financial problem. Some criminals felt it was more difficult to return the stolen funds than to steal them in the first place, and claimed they did not pay back their ill-gotten goods lest they should be detected and punished.

Similarly, most teenager crime is for getting even with bosses (e.g., parents, teachers, and part-time-work supervisors) that have humiliated, wronged or angered them. This becomes an un-sharable problem that is resolved by cheating the person you want to get even with.

In any case, how does the trust violator justify the crime? Cressey (1972) argued that criminals rationalize or justify their crime by viewing it as: a) non-criminal (it is ok, good, “cool” and non-harming), b) justified (it is reasonable, compensatory, and collateral) and c) something they cannot control (it is necessary, inevitable, and organizationally determined). Such rationalizations can take place before, during and after the crime (Cressey 1972: 94). The first fraud may be difficult to rationalize, execute and conceal. Subsequent crimes become easier to rationalize, execute and conceal. Callousness sets in, and the trust violator may feel even religiously impelled to bring about justice by embezzlement or terrorism. Most trust violators embezzled to keep their families from shame, want or disgrace. Others felt that there was no other way to bring their dishonest employers to justice. The employees strongly believed that their employers were already cheating and exploiting them and the corporation financially and handsomely. Embezzlement was the only means for making the playing field even. Some felt that they were just “borrowing” funds temporarily in the hope of restituting them eventually. Some offenders felt that they already had gone too deep into crime, and there was no looking back now. The best they could do was to support crime by crime.

Some embezzlers absconded with entrusted funds as they could not share with others what their financial problems were, why they stole, and what they intend to do with stolen assets. These are “absconders” who take the money and run; they are mostly unmarried, divorced or separated, with few connections with their primary group associations (Cressey 1972: 128).

A major factor in lessening occupational crime is to build employee loyalty to the company. Loyal workers or partners do not commit crime, cheat or embezzle. However, with the recent wave of plant closings, massive labor attrition, outsourcing of labor, and the resultant increase in non-contractual labor, loyalty may be eroded, and crime could step up. This could diminish worker productivity, since it is difficult to justify how employees stealing from organizations can be beneficial to anyone (Wells 2004: 10).

Opportunism and Opportunistic Behavior as Determinants of Fraud

Opportunism is a strategic behavior whereby one makes false or empty "threats and promises in the expectation that individual advantage will thereby be realized" (Williamson 1975: 26). Opportunism is "seeking self-interest with guile" (Williamson 1985) or seeking "self-interest unconstrained by morality" (Milgrom and Roberts 1992). Opportunistic behavior manifests itself in various ways, such as lying, stealing, cheating or other "calculated efforts to mislead, distort, disagree, obfuscate, or otherwise, confuse" (Williamson 1985: 47) partners in business. Opportunism is "the ultimate cause for the failure of markets and for the existence of organizations" (Williamson 1993: 102). However, but for

32

opportunism, "most forms of complex contracting and hierarchy would vanish", and markets alone would be sufficient for handling most transactions through autonomous contracting (Williamson 1993: 97).

Opportunism is a central concept in Transactions Cost Economics (TCE) theory originally proposed and developed by Williamson (1975, 1985, 1990, 1991 and 1993). According to TCE, organizations exist because of their superior abilities to attenuate opportunism through the exercise of hierarchical (both rational and social) controls that, in general, are not accessible to "markets." 8 In this regard, TCE makes two behavioral assumptions: a) one cannot predict others' behavior, and b) one cannot identify one's own best behavior. Not all are inclined to opportunistic behavior; those who do, the "determined minority" (Williamson 1993: 98), may do because of the above two assumptions. Some may be inclined to "instrumental behavior" in which there is no necessary self-awareness that the interests of a particular party are being furthered by opportunism (Williamson 1975). These people, without being aware, are instrumental in opportunistic outcomes of others.

There is much scope for opportunistic behavior (acts of self-interest with guile or unconstrained by morality) in business, especially in accounting and reporting financial statements. According to Williamson (1993: 102), opportunism is primarily a "human condition", a human tendency or attitude (inclination, proclivity, and propensity). Opportunistic attitudes are "rudimentary attributes of human nature" (Williamson 1991: 8). Opportunism is distinguished from opportunistic behavior; the latter constitutes acts of self-interest with guile (Goshal and Moral 1996).9 [See Turnaround Executive Exercise 5.13].

Scholars identify various factors that spur opportunism. All these very well apply to the corporate executive. We highlight a few. Other things being equal, opportunism can thrive:

When the transaction partner has invested much capital and technology in the transaction-exchangethat cannot be used for other products, (this phenomenon is called “asset specificity” in TCE theory); the predator can "hold-up" such assets by being opportunistic. Such “hostage” type of terrorist opportunism is the ultimate cause of the failure of the free markets and for the existence of organization. When “asset specificity” is high, it acts as a "locomotive" for opportunism (Williamson 1985: 56).

Analogously, when the outcomes of transaction-exchanges are highly uncertain, opportunistic behavior can go undetected (Hill 1990: 508) and un-tethered, and hence, can get stimulated.

8 However, recently some critics of TCE (e.g., Bromiley and Cummings 1992, 1993; Chiles and McMackin 1996; Goshal and Moran 1996; Moran and Goshal 1996) have shown that hierarchical controls need not necessarily curtail opportunistic behavior. Indeed, they are more likely to cause the opposite effect (Goshal and Moran 1996). Non-control mechanisms have been suggested instead such as joint ventures or strategic alliances (Balakrishnan and Koza 1993), trust (Bromiley and Cummings 1992, 1993; Chiles and McMackin 1996), leveraging work-force ability to take initiative, to cooperate and to learn (Goshal and Moran 1996). Organizations created to attenuate opportunistic behavior fail when they are unable to create the social context necessary to build the trust and commitment that are needed for maintaining cooperation in transaction-exchanges.

9 Opportunism also differs from mere "self-interested behavior." The latter is presumed to be constrained by obedience to rules and faithfulness to promises, while opportunism (which is self-interest with guile) is not. Opportunism seeks self-advantages with no concern for the advantages of the other. Williamson (1991), however, does not specify the mechanisms (e.g., economic institutions, markets) through which opportunism is created or reduced and instead assumes it to be a "human condition" (1993: 102). Even though this behavioral assumption of opportunism is regarded as an "extreme caricature" of human nature (Milgrom and Roberts 1992: 42), Williamson believed that opportunistic behavior (specific acts of self-interest with guile) might be controlled by proper social sanctions.

33

When behaviors of individuals and of the outcomes of those behaviors become uncertain, and this uncertainty, in turn, makes measurability of individual or group performance uncertain, and when rational control of such behaviors cannot be cost-effectively enforced, then opportunism abounds.

When short-term gains of opportunistic behavior are very large.

When opportunistic behaviors are facilitated by a high-discretion (that is, non-fiat, non-monitored) environment within an organization (Goshal and Moran 1996).

When the predator nurses negative feelings for or an unfavorable assessment of the specific transaction partner (Goshal and Moran 1996).

When the predator perceives biases, inequities or unfairness in the organization he or she works for (Goshal and Moran 1996).

Opportunism under any form is not a typical “constraint” as Aristotle (1985) understands it, nor is it “ignorance” as Aristotle defined it. Hence, actions resulting from opportunism cannot be “involuntary” as defined by Aristotle (1985). Moreover, Aristotle (1985) maintained that certain conditions do not make an action involuntary, such as compelling pleasure, emotions or appetites howsoever strong, and willed ignorance, or ignorance without regret. To our understanding, opportunism is best described in Aristotelian terminology as a “compelling pleasure” or a “strong appetite.” Such conditions cannot make opportunistic actions involuntary but voluntary. Hence, despite opportunistic challenges in a corporation, executives can and should always exercise moral restraint and responsibility.

Table 5.5 details some of these executive responsibilities, both transactional-contractual and transactional-relational. Table 5.5 defines opportunism in some of its main features and enabling factors (Column 2). Against each enabling factor, counter-opportunistic contractual (Column 3) and relational (Column 4) executive responsibilities are suggested. According to TCE, however, opportunistic behavioris positively related to the opportunity (i.e., expected benefits) for such behavior.

Opportunistic behavior is also positively influenced by opportunism itself as a tendency, which in turn, may be conditioned by one's upbringing, childhood and adolescent exposures, and social heredity (Goshal and Moran 1996). Opportunistic behavior is negatively related to organizational sanctions such as fiat, monitoring and incentives. Hence, opportunism is not a fixed trait, unaffected by context, but a covariant of opportunity determinants (Williamson 1985, 1991). 10

It is not hard to identify factors listed above that can also trigger opportunistic behavior among corporate executives, such as “asset specificity” in major purchase or selling decisions, high uncertainty of the behavior of the partners of exchange and of the outcomes of transactions-exchange, high gains of short-term opportunistic behavior, the high-discretion domain of many executive decisions, high negative feelings

10 Several scholars carefully critique Williamson's (1985, 1991) theory of TCE. Common weaknesses detected are: a) TCE exaggerates opportunism in markets; over time the invisible hand of the markets will weed out habitual opportunism (Hill 1990). b) According to TCE, organizations primarily exist because of their ability to attenuate opportunism through control. That is, organizations begin where markets fail. On the one hand, organizations may not weed out all opportunism by rational or socialcontrol, and on the other, in the bureaucratic process of doing so, they may generate more opportunism, as is argued by the "self-fulfillment prophecy" theory advocated by Goshal and Moran (1996). c) The distinction between markets and hierarchies is overstated; most markets function within an organizational economy that continuously generates innovations and new products in the market place; thus, the reverse may be equally true: that is, ‘markets begin where organizations begin to fail’ may be a more realistic assumption. d) TCE over-focuses control; although control is necessary in all organizations, a preoccupation with control obscures and weakens an organization's fundamental source of advantage over markets (Goshal and Moran 1996).

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for a competitor predator, and when opportunistic behavior within a firm may be unsanctioned if not encouraged. Table 5.5, however, points out counter-opportunistic responsibility opportunities.

Concluding Remarks

Currently, accounting irregularities come under various euphemistic labels: aggressive accounting, creative accounting, overstating earnings, earnings management, income smoothing, and fraudulent financial reporting. Under whatever name, it is a financial numbers game with a singular ultimate objective – creating an altered impression of the firm’s business performance (Mulford and Comiskey 2002: 2). Most of these practices could be well within the flexible rules of GAAP. These questionable practices have even measurable rewards, including approval of Wall Street analysts, improved credit quality, improved debt ratings and reduced interest costs on borrowed capital. They can create additional slack and reduce restrictions on debt covenants. They have definite positive effects on share prices such as higher share prices, reduced share-price volatility, increased value of stock options, lower cost of equity capital, and increased market evaluation. Additionally, they can boost profit-based bonuses, and other corporate benefits.

Nevertheless, they all mislead and misreport financial results that appear in corporate official financial statements that investment bankers, investors, creditors and shareholders read and on which they base their investment decisions. When these fraudulent acts are discovered, the companies undertake several “adjustments,” often restating financial statements of prior years. Unfortunately, the investor public comes to know of these fraudulent acts much too late – that is, long after investment-decisions have been made and share prices have fallen precipitously.

Whether corporate scams are described as accounting frauds, deceptive accounting practices, inflating revenues, round-trip trades, understating debts, overstating financial worth to boost stock prices and consequent corporate insider trading, or just, “cooking” the books, they are all corporate failures of public trust. They are failures of corporate accountability and social responsibility. In the wake of these escalating corporate scandals, several ethical and moral questions arise. Are these corporate accounting frauds legal or quasi-legal? Even if they are legal and, therefore, non-criminalizable, are these practices ethically and morally justifiable? How could these frauds occur in such exemplary corporations traditionally known for their corporate executive virtues of honesty and integrity? As frontline ambassadors and representatives of the corporation, its products and services, how could corporate executives in general, and accounting, financial and marketing executives in particular, represent the best of themselves and their companies through such frauds? One needs to address these questions with serious objective and ethical analysis. We plan to do this in a later undertaking (Mascarenhas 2008).

35

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Table 5.1: Commonest Frauds by Type, Perpetrators, Methods, Victims, and Costs of Deception

Type of Fraud

Fraud Perpetrators

Method of Deception

Victims of Deception

Costs of Deception

Management Fraud

Top executives such as CEO, CFO and chief accounting officer (CAO)

Creative and aggressive accounting such as earnings management;Income smoothingGain on sale and Wash trading

Organization,Investors,Employees, Suppliers,CustomersShareholders,Creditors or lenders

Loss of market valuation, Tobin’s Q, brand equity, supplier goodwill and customer loyalty and investment opportunity; loss of earnings, share price, and corporate imagePossible bankruptcyLoss in financial performance ratios such as P/E, EPS, ROIC, RONA, ROI, ROE & total shareholder return (TSR)

Securities Fraud

Top executives with insider information

Illegal insider trading Public investors who do not have access to inside information

All of the above, plus violation of insider trading laws with litigation losses

Investment Scams

Any individual involved in such scams

Tricking or conning into worthless investmentsTelemarketing fraud

Unsuspecting investors, especially the elderly, teenagers, the marginalized

False prizes/sweepstakesUnnecessary magazine salesWorthless buyer club feesUnrealized advance fee-loansWork-at-home schemesDeceptive travel/vacation packages

Tax Fraud Corporate and non-corporate tax evaders

Failure to report income from fraud or bribes; filing false returns

IRS State and local tax authorities

Violation of Title 26, US Code # 7201Bribes may not lawfully be deducted as business expensesLoss of tax money to governments

Racketeering

RacketeersCorrupt organizations

Criminal violations of commercial exchange laws and ordinances;Money laundering

Commercial exchange partners affected by racketeering

Racketeer influenced and Corrupt Organizations (RICO) statue violated; Title 18, US Code # 1961

Vendor Fraud

VendorsSuppliersBrokersDistributorsRetailers

Significant over-charging either singly or by collusion Non-shipment of goods paid for

Government with defense contracts;Innocent corporations and customers

Shipment of inferior or fake goodsOvercharge for purchased goodsDeprivation of goods paid forCounterfeit goods

Employee fraud or embezzle-ment

EmployeesAt all non-executive levels

Skimming, theft;Cheating on time, money, quality of work

Employers,Shareholders,Customers,Other employees

Losses in cash, kind, morale, work-efficiency, sales and performance due to occupational fraud

Computer Fraud

Computer hackers, code-breakers, and classified data destroyers

Illegal access to a protected computer vaulting or classified data; hacking

The public, defense, national security and all governments affected by classified data

Violates Title 18, US Code # 1030

Bribery and Kickbacks

All those engaged in bribery, kickbacks, and foreign corrupt practices

Bribery & kickbacks; strategies

Suppliers Prime contractors of government projects

Bribery violates Title 18, US Code # 201, and the Foreign Corrupt Practices ACT (FCPA), Title 15, US Code # 78.Kickbacks violate Title 41, US Code #s 51-58.

Customer Fraud

Some customersSome borrowers

Not paying for goods purchased; getting

The vendorsRetailers

Consumer theft costsBad debts; consumer credit abuse;

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Angered customers getting even with employers

something for nothing; conning banks to make loans or transfer funds

Banks tricked into granting loans or funds transfers

Violated loan covenantsFree rider costs; Unpaid interestNon-amortized capital

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Table 5.2: A Taxonomy of Occupational Fraud and Abuse[See Wells (2004:46)].

Fraud Action

Major Types

Sub-types

Corruption as Abuse

Conflict of Interest

Purchase schemes

Sales schemes Joint venture schemes

Strategic alliance schemes

Other

Bribery Invoice kickbacks

Bid rigging Concealed perks Family favors

Other

Illegal gratuities

To self To subjects To other groups Gratuities in kind

Gratuities in stocks

Economic extortion

Purchase undercharges

Sales surcharges

Extorting commissions

Distorting Sales

performance

Other

AssetMisappro-priation as

Fraud

Cash related

Larceny Of cash on hand

From the deposit From marketable securities

Other

FraudulentDisbursements

Billing schemes

Shell company Non-accomplice

vendor

Personal purchases

Payroll schemes;

falsified wages

Ghost employees Commission schemes

Workers compensation

Expense reimbursemen

tschemes

Mischaracterizing expenses

Overstate expenses

Fictitious expenses; multiple

reimbursements

Check tampering

Forged maker or endorsement

Altered payee

Concealed checks

Register disbursements

False voids False refunds

Other

Skimming

Sales Unrecorded Understated

Other

Receivables Write-off schemes

Lapping schemes

Unconcealed

Refunds Used returns Tampered returns

Stolen returns

Inventory & All Other Assets

Misuse Misuse of inventories

Misuse of payables

Misuse of receivables

Misuse of other liquid assets

LarcenyAsset

requisitions and transfers

False sales & shipping

Purchasing & receiving

Unconcealed larceny

Fraudulent

Statements

Financial

Asset/revenueOverstatements

Timing differences

Fictitious revenues

Concealed liabilities &

expenses

Improper disclosures;

improper asset valuations

Asset/revenueUnderstatement

s

To make lean years look

good

To provide for future leaner

years

To jeopardize

budgets

Other harms

Non-financial

Employment credentials

Fudging Internal

documents

Doctoring External

documents

Overstating credentials

Understating credentials

42

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Table 5.3: Sources of Corporate Frauds by Accounting Cycles

Accounting Cycle

FunctionalDepartments Involved

Operations in the Functional Cycle

Sources of Fraud in the Functional Cycle

Sales and Accounts Receivable

Marketing Identifying and soliciting customers; processing purchase orders; fulfilling purchase orders

Billing non-existent customers;Overstating orders; round-trip sales

Accounting Costing products, pricing products, sending invoices, guidelines for credit, approving credit, collecting receivables, record keeping and assessing bad debts .

Over-costing to inflate expenses or under-costing products to justify dumping; price gouging; predatory pricing; easy credit scandals; theft; bad debts

Finance Collecting cash, banking cash and financing production and marketing

Skimming cash; banking cash much lower than cash received

Expenses and payments: Accounts Payable

Purchasing Identifying and processing vendors; vendor knowledge; due diligence; approving vendors

Vendor background checks; billing non-existent or non-legitimate vendors; false trade credit; violating credit limits; collusion; price cartels; bad supplier relationships

Accounting Proper assessing, processing and posting of receipt of goods and services; audit trails through proper documentation; recording defective products, theft, and other liabilities

Double accounting and bookkeeping; over-invoicing bills for inflating expenses; under-invoicing bills to obtain kickbacks; not reconciling cash receipts with bank accounts

Finance Purchase requisitions; open competitive bidding for high purchases; processing purchase orders; processing cash for payment

Undue prepaid trade bills; forcing lower prices on suppliers that leads them to bankruptcy

Human resources and payroll

Human Resources (HR)

Identifying and processing employee skills, recruiting, remuneration, training, retention and development, time cards, time sheets and time-keeping, firing, due process, and complaints handling.

Ghost employees, falsified hours and overtime, false expense reports, false medical claims; false sick leave, improper recruiting, hiring, firing, wages, salaries, promoting, appraising, and personnel development.

Inventory and storage/warehousing

Inventory, logistics, warehousing

Ordering, transportation, logistics, receiving goods and reports, processing requisitions, control over requisitions, storage, warehousing, shipping documents, JIT inventory management, depletion and repletion

Overstocking, under stocking and creating artificial shortages, creating production bottlenecks, improper replenishment or depletion of inventory; theft, spoilage, and the like

Accounting Continuous inventory records, inventory costing, FIFO, LIFO,

Overstating inventory as bank collateral, improper use of FIFO or LIFO

Capital Expenditures

Finance Borrowing of funds, payment of interest, debt structure of the company, debt amortization, leveraged buyouts, issuance of stock, stock repurchases

Improper bank deposits, loan authorizations, issuance of stock, stock certificates

Accounting Recording of debt and interest, proper documentation of loans, and journal entries on interest payments

Improper recording of debt and interest, improper documentation of loans, unusual journal entries on

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and receipts interest payments and receipts

45

Table 5.4: Distinguishing between External and Internal Auditors, Fraud Investigators and Forensic Accountants

Controlling Method

Objective Scope Approach Standards Training

Internal Auditing

Examination of daily business transactions in purchasing, sales, cash transactions and journal entries

Cross matching debits versus entries, payments versus disbursements, of almost all company transactions on a daily basis.

As a professional accountant, one wants to safeguard the veracity and accuracy of company entries in all journals. This is a proactive approach.

All entries should conform to generally accepted accounting principles (GAAP) and pronouncements.

CPA; training in internal auditing with technical audit training. The internal auditor is an employee of the firm.

External Auditing

Examines year-end financial statements to obtain reasonable assurance that they are free from misstatements, whether caused by error or fraud

Check for material misstatements in annual financial statements by reviewing only a sample of selected but representative transactions.

As a professional accountant, one approaches the analysis with professional skepticism: i.e., with a questioning mind, and critical assessment of audit evidence. This is a proactive watchdog approach.

All financial statement audits should additionally conform to generally accepted auditing standards (GAAS). Statement of Auditing Standards (SAS) No 99 helps auditors to detect material misstatements in financial statements.

CPA; training in independent auditing with technical audit training. The external auditor is not an employee of the firm, and hence, acts in an independent capacity.

Fraud Investigating

Examines if fraud exists, regardless whether it is material or immaterial, in the company’s financial statements

Thoroughly examines only those transactions where corporate fraud is suspected.

Professional investigative accountant with a higher degree of skepticism, with heightened scrutiny of all evidence and sources of information relating to questioned accounts. This is a reactive bloodhound investigative approach given the existence of fraud.

Fraud investigators are corporate fraud examiners (CFE) that had no standards, other than the recent Sarbanes-Oxley guidelines. Moreover, SAS 99 can also help to detect fraud in financial statements.

CPA, CFE, CIRA; training in forensic accounting and tax fraud investigative examinations.

Forensic Accounting

Forensic accountants are hired when fraud is suspected seriously and in big magnitudes, and is due for litigation.

Fraud accountants seek corroboration of information, public document reviews, background investigations, interviews with top management, and other analytic procedures to establish evidence in courts.

Fraud accountants have a different mindset: they do not maintain the neutrality of traditional auditors. A forensic approach dovetailed to represent the fraud in courts.

Fraud accountants use investigative techniques, evidence gathering and the litigation process to report frauds in court of law.

CPA, CFE, JUD; training in forensic accounting, fraud examination, and civil and criminal litigation.

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Table 5.5: Corporate Executive Responsibilities under Opportunistic Conditions to Prevent Fraud

[See Mascarenhas 2007: 140]

DefinitionsofOpportunism

FactorsStimulatingOpportunism and Fraud

Corporate Executive ResponsibilitiesUnder Exchange that imply:

TransactionalContracts

TransactionalRelations

Is seeking self-interest with guile or seeking self-interest unconstrained by morality.

Opportunistic behavior manifests itself in various ways such as lying, stealing,and cheating;

Or, in other calculated efforts to mislead, distort, disagree, obfuscate, or otherwise, confuse partners in business.

Opportunism itself is a tendency, which in turn, may conditionor be conditioned by one's upbringing, childhood and adolescent exposures, and social heredity.

“Asset specificity” whereby predators can hold large assets or asset-specific skills and investments as hostagefor control.

Resist intentions to hostage asset-specific skills, investments or transactions for lucrative gains.

Encourage long-term asset specific investments to promote long-term relationships.

When outcomes of transaction-exchanges are highly uncertain, opportunistic behavior can go undetected and un-tethered.

Be accountable for all outcomes even though they may be uncertain. and hence, are not controllable.

Long-term relationships thrive in integrity and honesty, especially when opportunistic behaviors cannot be detected.

When measurability of individual or group performance is uncertain, and when rational control on such behaviors cannot be cost-effectively enforced.

Reduce transaction costs by honest behavior, especially when detecting and controlling opportunistic behaviors is cost-prohibitive.

Long-term open relationships can make-up for uncertainty of individual or group performance measures.

When short-term gains of opportunistic behavior are very large.

Resist opportunism especially when short-term gains of opportunism are very attractive.

Preserve and nurture long-term honest relationships, despite large short-term opportunistic gains.

When the predator nurses negative feelings regarding transaction partners.

Minimize negative feelings in every exchange transaction.

Avoiding negative feelings about transaction partners can nurture long-term relationships.

When the predator perceives biases, inequities or unfairness in her organization.

Minimize biases, inequities or any other prejudices in any business transactions.

Avoid all biases, injustices, prejudices and other unfair practices to generate long-term healthy exchange-partner relationships.

Opportunism may be a tendency in the executive ingrained from upbringing and environment.

Hiring policy should detect and avoid innate opportunistic tendencies. Also, watch for such tendencies in every transaction.

Foster ethical climate within the firm to counteract innate executive tendency for opportunism.

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Turnaround Executive Exercises

5.1 In understanding and investigating the nature of corporate fraud and its related crimes in your company, discuss the following:

a) What is fraud? What are its essential legal elements?b) What is occupational fraud? How is it different from corporate fraud?c) What is corporate fraud? What are its legally constitutive elements?d) What is corporate abuse? What are its basic elements?e) How is corporate fraud different from corporate abuse?f) How is fraud different from deception?g) How is fraud different from misleading?h) How is fraud different from deliberate misrepresentation?i) How is fraud different from unintentional errors?j) How is fraud different from trickery?k) How is fraud different from chicanery?l) How is fraud different from larceny?m) How is fraud different from robbery?n) How is fraud different from embezzlement?o) How is fraud different from stealing?p) How is fraud different from skimming?

5.2 Investigate the following corporate frauds and estimate their impact in relation to: a) corporate cash flow crisis, b) employee jobs and pensions, c) company stock prices, and d) social economic loss.

a) During 1998-2000, Andrew Fastow, CFO at Enron, negotiated and set up outside partnerships to conduct Enron business. As the principal in these partnerships, however, Fastow also negotiated with Enron on behalf of the partnerships.

b) During 1999-2001, Qwest Communications inflated revenue using network capacity “swaps” with Enron and improper securities for long-term deals.

c) During 2001-2002, AOL inflated sales by booking barter deals and ads it sold on behalf of others as revenue to keep its growth rate up and seal the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers.

d) In 2002, Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion.

e) In February 2002, World Crossings engaged in network capacity “swaps” with other carriers to inflate revenue.

f) In February 2002, Global Crossings engaged in similar network capacity “swaps” with other carriers to inflate revenue. It also shredded documents related to securities practices.

g) In March 2002, WorldCom booked $3.8 billion in operating expenses as capital expenses.h) In March 2002, WorldCom gave founder, Bernard Ebbers, $400 million in off-the-book loans.

5.3 Examine the following employee occupational abuses. In what way are they different from fraud? How are they different from corrupt practices? How are they different from crimes? How are they economically harmful to the employer? How are they morally harmful to the employees? How are they socially harmful to the economy, society and the nation? What employee’s fiduciary duties to the organization do they violate? How do they violate employee’s moral duties of honesty and self-esteem to themselves?

a) Use sick leave when not sick.b) Come to work late or leave work early.c) Take a long lunch or break without approval.

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d) Indulge in slow and sloppy work.e) Declare or punch more hours than worked for and be paid.f) Work under the influence of alcohol or drugs.g) Take products or stationery belonging to the organization (pilferage).h) Pad your expense accounts. That is, collect more money than due on business expense reimbursements.i) Use employee discounts to purchase goods for relatives or friends.

5.4 Consider the following case of accounts receivable fraud. The bookkeeper of a small but growing bread

company prepared bills to be sent to customers and was responsible for collecting payments. Recently, sales have been increasing because of new customers and augmented sales revenue from existing customers. A surprise internal audit, however, revealed that bank deposits were not growing proportionately to the increasing sales revenues. On examining the customer copies of sales invoices, a fraud examiner found that the amounts being billed were higher than the amounts being recorded in the cash receipts journal for the same transaction. Office copies of the invoices had been altered to reflect the falsified journal entry. The bookkeeper had stolen over $15,000 before the fraud was discovered. The bookkeeper was dismissed. He agreed to pay back $15,000, however, lest he should be prosecuted (see Silverstone and Sheetz 2007: 28).

a) How do you classify this fraud?b) Which of the five traditional accounting cycles is its source?c) How do you identify exceptional and questionable account balances and variations?d) Also, how could you detect it much earlier before the damage it created?e) Which fundamental rule of accounting does this fraud violate, and why?f) Hence, how would you prevent such frauds in the future?

5.5 Consider the following case of accounts payables fraud. An administrator of a school board in a small city had full authority for all items payable from the board’s annual budget. As an administrator, he traveled frequently to education conventions and meetings of administrators in the state capitol and across the country. An excellent CPA but a non-pleasant personality, he was not endeared to the board, and the board was slow in approving his travel budgets. Frustrated and embittered, the administrator used his own signing authority to approve personal expenditures and write checks to himself. He started padding the expense accounts. For instance, he would charge mileage when using company’s leased car. He used the board’s credit card to fill gas in his own private car. He submitted and approved several bills regarding meals and entertainment on weekends and repairs to his car. His secretary blew the whistle on him, and forensic fraud examiners found that invoices for many transactions did not exist. He was dismissed from the job, but no specific charges were laid against him (see Silverstone and Sheetz 2007: 30).

a) How do you classify this fraud?b) Which of the five traditional accounting cycles is its source?c) Hence, how could you detect it much earlier before the damage it created?d) How do you identify exceptional and questionable transactions?e) Which fundamental rule of accounting does this fraud violate, and why?f) Hence, how would you prevent such frauds in the future?

5.6 Consider the following case of payroll fraud. A suburban construction company employed several hundred laborers at any given time. For an efficient lean operation management, the home-office included a one-person accounting department, with a long-serving bookkeeper/controller who coordinated the weekly payroll, printed the payroll checks, signed the checks with the owner’s stamp, and hand-delivered the checks to the job sites, and reconciled the company’s bank account. Owing to lack of any checks and balances, the payroll clerk continued paying checks to several laborers long after they were gone, i.e., to ghost employees. He would endorse the checks and deposit them in his own account. At the same time, he paid the withholding taxes, union dues, and other deductions at source. An alert bank teller eventually noticed the

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fraud, but only after several years and when the clerk had taken over $600,000 (see Silverstone and Sheetz 2007: 31).

a) How do you classify this fraud?b) Which of the five traditional accounting cycles is its source?c) Hence, how could you detect it much earlier before the damage it created?d) How do you identify exceptional and questionable transactions?e) Which fundamental rule of accounting does this fraud violate, and why?f) Hence, how would you prevent such frauds in the future?

5.7 Consider the following case of inventory fraud. Suspecting some flow play, the board of directors of a gold refiner company hired some forensic investigators to check the inventory of gold in the company. The investigators discovered several brass bars of exactly the same weight as a gold bar on the inventory. An interview with a smelter worker revealed that brass scrap had been melted down, cast into bars and added to the inventory. There was no record of brass bars, however, on the inventory list. Instead, forty-five bars had been valued at $8 million on the balance sheet. Another $5 million was classified as gold bars “in transit.” The fraud had been going on for five years when it was discovered. On further investigation, it was found that the CEO had perpetrated the crime together with his VP of Finance, in an attempt to hide operating losses that would have jeopardized their positions and depressed the stock value of the company. The CEO and the VP of Finance were both charged with fraud, convicted, and served a prison sentence (see Silverstone and Sheetz 2007: 32-33).

a) How do you classify this fraud?b) Which of the five traditional accounting cycles is its source?c) Hence, how could you detect it much earlier before the damage it created?d) How do you identify exceptional and questionable inventory evaluations?e) Which fundamental rule of accounting does this fraud violate, and why?f) Hence, how would you prevent such frauds in the future?

5.8 Consider the following case of capital expenditures fraud. By law, mortgage brokers are limited in their business activities to specific mortgages, and investors to invest in them. For example, an investor would give the broker $50,000 to be invested in a particular mortgage at the prevailing rate per annum to be paid monthly. Often, certain brokers would violate their investment limits and issue other money instruments. A government agency responsible for overseeing mortgage brokers was concerned that many brokers were borrowing and lending money as if they were licensed as banks or trust companies. The agency hired some forensic investigators to examine the books of a randomly selected group of mortgage brokers. The investigators found that one broker had exceeded his authority by issuing so-called corporate notes secured by the company’s guarantee rather than by a mortgage. This broker used the money instead to purchase property for himself, who then reduced his risk by selling partial interests to his family members or other relatives. By the time the forensic investigators discovered this fraud, the broker had taken in more than $5 million by issuing corporate notes and invested in high-risk ventures that failed to pay rates of return required to service the corporate notes. The broker, however, met his monthly obligations to his investors through borrowing on a bank line of credit and was quickly overextended. The government agency revoked the broker’s license, and closed his operations with the help of several banks who took over the mortgages to protect the investors (see Silverstone and Sheetz 2007: 33-34).

a) How do you classify this fraud?b) Which of the five traditional accounting cycles is its source?c) Hence, how could you detect it much earlier before the damage it created?d) How do you identify such exceptional and questionable mortgage transactions?e) Which fundamental rule of accounting does this fraud violate, and why?f) Hence, how would you prevent such frauds in the future?

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5.9 The traditional but effective on-going method for controlling and preventing corporate frauds in your company is by maintaining a double-entry (credit versus debit) in various journals. Specifically, discuss how you will maintain the following journals and how you plan to monitor, control and prevent both accounting and financial irregularities in your company:

a) Sales journal (records all sales revenues by date, customer, quantity, amount, and transaction number), b) Purchase journal (records all purchases by date, supplier, item specification, quantity, amount, and

transaction number), c) Cash receipts journal (records all cash receipts by date, customer, amount, and transaction number in

the accounts receivable ledger), and d) Cash payments journal (records all cash payments by date, creditor, amount, and transaction number in

the accounts payables ledger).

5.10 In understanding the nature of corporate fraud control, discuss the following: [See Table 5.2; also Singleton et al. 2006: 43-73].

a)What is internal auditing? How does it differ from external auditing?b)What is financial auditing? Illustrate by examples.c)What is fraud auditing? Illustrate by examples.d)How is it different from financial auditing?e)What is forensic accounting? Illustrate by examples.f) How is it different from fraud auditing?g)What is fraud investigation? Illustrate by examples.h)How is it different from fraud auditing? i) What skills are specific to and expectations from fraud investigation?j) What skills are specific to and expectations from fraud auditing?k)What skills are specific to and expectations from forensic accounting?l) What skills are specific to and expectations from financial auditing?m) What skills are specific to and expectations from internal accounts auditing? n)What skills are specific to and expectations from external accounts auditing?

5.11 Fraud is an intentional perversion of the truth (or facts) to induce another to part with some valuable thing belonging to him or her (Silverstone and Davia 2005: 224). Defined thus, what specific guards will you set up in your company to monitor, detect and prevent the following fraudulent operations?

a) Fraud as defective delivery b) Fraud as defective pricing c) Fraud as defective shipment d) Fraud as duplicate payment e) Fraud shell f) Fraud as multiple payee g) Fraud rotation h) Fraud as contract riggingi) Fraud as land flippingj) Fraud as round trip salesk) Fraud kickback l) Fraud as pseudo conspiracy m) Fraud as off-the-books n) Fraud as asset theft fraud o) Fraud as skimming p) Fraudulent financial reporting q) Fraudulent accounting irregularities

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r) Fraudulent earnings management s) Fraud as income smoothingt) Fraud as declaring fictitious revenuesu) Fraud as declaring fictitious expenses.

5.12 By Section 404 of the Sarbanes Oxley Act of 2002, companies must include an internal-control report as part of the annual report that ensures detection, monitoring and prevention of all fraud. To this effect, how will you minimally include the following directives for your company?

a) A statement acknowledging responsibility for establishing and maintaining adequate internal control over financial reporting.

b) A statement identifying and specifying the internal-control framework to evaluate the effectiveness of internal control over financial reporting.

c) An assessment of the company’s internal control over financial reporting as of the end of the most recent fiscal year.

d) Disclosure of any material weakness in the company’s internal control over financial reporting (the latter is deemed ineffective if any material weakness exists).

e) A statement that the independent external auditor has issued a report on the company’s assessment of internal control over financial reporting, and

f) A statement that the company’s external auditor has examined and reported his/her assessment of requirements under (c) and (d) above.

5.13 By Section 406 of the Sarbanes Oxley Act of 2002, corporations must have a Code of Ethics “applicable to its principal financial officer and comptrollers or principal accounting officer, or persons performing similar functions.” That is, the senior management together with the audit committee must devise a Code of Ethics for the company that focuses on: 1) Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of professional and personal interest; 2) full, fair, accurate, timely and understandable disclosure of relevant matters in the company’s regular filings, and 3) compliance with applicable government rules and regulations.

a) How would you go about devising this Code of Ethics, with what major ethical principles and guidelines?b) How could such ethical principles and guidelines enable you to handle objectively actual conflicts of

professional and personal interest?c) How could such ethical principles and guidelines restrain your senior management from creative or

aggressive accounting practices? d) How could such ethical principles and guidelines control your senior accountants from earnings

management and income smoothing? e) How could such ethical principles and guidelines refrain your senior comptrollers from overstating

revenues and income and understating payables and debt? f) How could such ethical principles and guidelines discourage your senior management from engaging in

insider securities trading irregularities? g) How could such ethical principles and guidelines empower your senior management to engage in full, fair,

timely, accurate and understandable disclosure of relevant matters in their annual SEC filings? h) How could such ethical principles and guidelines ensure your senior management’s compliance with

applicable government rules and regulations?

5.14 Opportunism abounds under accrual accounting procedures, and as manager, you could easily indulge in unethical reporting in your financial statements that the CEO and CFO must endorse. Examine the following:

a) Your client prepays you $ 1.5 million on August 31, 2006 for services to be rendered for the next six months. You report $1.5 million as revenue in your fiscal year ending in September 30, 2006.

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b) To avoid taxes, you report no revenue from this transaction in your fiscal year ending in September 30, 2006.

c) To lessen taxes, on August 31, 2006 you prepay $25,000 as office rent for the next six months.d) To look good for the next year, on August 31, 2006 you prepay $25,000 as office rent for the next six

months, and report it as rent expenses for your fiscal year ending in September 30, 2006.e) To jack up your 2006 net income, you pre-pone $2 million in sales agreements (realizable in October 2006

and thereafter) to your fiscal year ending in September 30, 2006.f) To jack up your 2006 net income, you anticipate $2 million in proposed sales agreements of October 2006

and thereafter to your fiscal year ending in September 30, 2006.

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Appendix 1:A Note on Corporate Accounting Irregularities

This note is on corporate accounting irregularities. Such irregularities include overselling shares to depress stock prices, overstating financial worth to boost stock prices, and overstating revenues by “round-trip” sales, understating debts, or, in general, “cooking” the books to influence better SEC ratings.

A Brief Listing of Corporate Accounting Irregularities

We can generally classify most of the corporate accounting irregularities under two heads: a) Fake transactions like “round-Trip” sales, and b) manipulation of debts and assets to overstate the value of the company. The U. S. Federal Energy Regulatory Commission (FERC) defines wash trading, also known as "round trip" or "sell/buyback" trading, as the sale of a product, e.g. electricity, to another company with a simultaneous purchase of the same product at the same price.

Essentially, wash trading is false trading because it boosts the companies' trading volume, or even sets benchmark prices, but shows no gains or losses on the balance sheets. While this kind of trading may not be illegal, it can manipulate the power market, which is illegal. Most of the largest scams recently uncovered were in the utility business (See Forbes 2002, July 25; Fortune 2002, September 2). Several wholesale power traders revealed that they participated in the so called "round trip" or "wash trading." For instance, wash-trading practices among some energy companies created false congestion and generated the perception of an energy shortage in the troubled California energy market in 2001-2002. Some would even argue that this practice contributed to the bankruptcy of the two largest California electric utilities and forced subsequent government support to keep power flowing there. The price of electricity skyrocketed and in the end, it was the consumer who had to pay the price for corporate accounting frauds. An inflated balance sheet from round-trip trading misleads investors about the true nature and volume of the company's business. Large volumes of "wash" trades raise the revenues but have no effect on earnings.

Recent Corporate Accounting Irregularities

Round-trip Sales:

1. Enron and Qwest Communications: Denver-based Qwest Communications used bandwidth to manufacture illusory revenue streams in its recent deal with Enron. According to investigators, Qwest agreed to pay Enron $308 million for the use of “dark fiber” (or unused fiber optic) capacity. In exchange, Enron agreed to pay Qwest between $86-195 million for access to active sections of Qwest’s network. Both deals turned out to be fake allowing both companies to record fat revenues for the period, and particularly helped Enron avoid reporting a loss for that period (Pizzo 2002). Qwest admitted that an internal review found that it incorrectly accounted for $1.6 billion in sales. It will restate results for 2000, 2001, and 2002. It is planning to sell its phone director unity for $7.05 billion in order to raise funds.

2. CMS Energy (May 2002): It executed several “round-trip” trades with Reliant Energy artificially to boost energy-trading volume. Thomas Webb, former CFO of Kellogg, has been appointed as its new CFO since August 2002. These companies have admitted that they have wash traded close to $6 Billion in sales revenues, either between these two companies, or involving other energy companies involved in the fraud.

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3. Dynergy (May 2002): also executed “round-trip” trades artificially to raise its energy trading volume and cash flow. S&P cut Dynegy’s rating to “junk,” even though the company is conducting a re-audit.

4. El Paso (May 2002): Also executed “round-trip” trades artificially to enhance energy-trading volume. Oscar Wyatt, a major shareholder and renowned wildcatter, may be engineering a management shake-up.

5. Duke Energy (July 2002): Duke engaged in 23 “round-trip” trades to boost trading volumes and revenue. Duke claims that its round trip trades had no “material” impact on current or prior financial periods.

6. Global Crossing: February 2002, the company engaged in network capacity “swaps” with other carriers to inflate revenue and shredded documents related to securities practices. Company filed Chapter 11 bankruptcy protection. The Congress is investigating the role of its securities firms in its bankruptcy.

7. Homestore.com (January 2002): Inflated sales by booking barter transactions as revenue. The California State Teachers’ pension fund, which lost $9 million on a Homestore investment, has filed suit against the company.

8. Merck (July 2002): Recorded $12.4 billion in consumer-to-pharmacy co-payments that Merck never collected. Even though SEC approved Medco’s IPO registration that would raise $1 billion, the company has withdrawn from it.

Thus far, the FERC has demanded disclosure on wash trading from almost 150 energy companies from all over the United Sates. Only when the investigation is complete and other wash trading information is uncovered will we be able to assess how widespread this trading actually was.

Inflating or Restating Revenues:

9. Halliburton (May 2002): Improperly booked $100 million in annual cost overruns before customers agreed to pay for them. The legal watchdog group Judicial Watch filed a securities fraud against Halliburton.

10. Enron in October 2001: Boosted profits and hid debts totaling over $1 billion by improperly using off-the-books partnerships, manipulated the Texas poser market, bribed foreign governments to win contracts abroad, and manipulated California energy market. Ex-Enron executive, Michael Kopper, pled guilty to two felony charges. Acting CEO Stephen Cooper said Enron might face $100 billion in claims and liabilities. Enron filed Chapter 11, and its auditor, Arthur Anderson, was convicted of obstruction of justice for destroying Enron’s documents.

11. WorldCom: (March 2002): It overstated cash flow by booking $3.8 billion in operating expenses as capital expenses. It gave founder, Bernard Ebbers, $400 million in off-the-book loans. By the end of 2002, the WorldCom scam totaled $16 billion. The company found another $3.3 billion in bogus securities, and may have to take a goodwill charge of $50 billion to write-off its debts. Former CFO Scott Sullivan and ex-controller David Myers have been arrested and criminally charged. David Myers agreed to be guilty on September 26, 2002.

12. Peregrine Systems (May 2002): It overstated $100 million in sales by improperly recognizing revenue from third-party resellers. It slashed nearly 50% of its workforce to cut costs. With a third auditor in 3 months, it has yet to file its 10K for 2001; hence, it may be soon de-listed from the NASDAQ. Currently, it is restating revenues from April 1999 to December 2001, during which John Moores, Chairman, dumped $530 million of stock (Fortune, September 2, 2002).

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13. Adelphia Communications (nation’s 6th largest cable TV company): April 2002, the founding Rigas family collected $3.1 billion in off-balance sheet loans backed by Adelphia, and overstated results by inflating capital expenses and hiding debt. The company filed for Chapter 11 bankruptcy on June 25, 2002. Three Rigas family members and two other ex-executives were arrested for fraud on July 24, 2002. The company is suing the entire Rigas family for $1 billion for breach of fiduciary duties, among other things (Forbes, July 2002).

14. AOL Time Warner: As the media market faltered and AOL’s purchase of Time Warner loomed, AOL inflated sales by booking barter deals and advertisements it sold on behalf of others as revenue to keep its growth rate up and seal the deal. AOL also boosted sales via “round-trip” deals with advertisers and suppliers. The Department of Justice (DOJ) has ordered AOL to preserve it documents. AOL confessed that it might have overstated revenue by $49 million. New concerns are that AOL may take another goodwill writedown, after it took a $54 billion charge in April (Forbes, July 2002). The scandal went public in July 2002.

15. Bristol-Myers Squibb: Inflated its 2001 revenue by $1.5 billion by “channel stuffing” (i.e., forcing wholesalers to accept more inventory than they can sell to get it off manufacturer’s books). Efforts to get inventory back to acceptable size will reduce Squibb’s earnings by 61 cents per share through 2003 (Forbes, July 2002). The scandal was disclosed in July 2002.

16. K-Mart (January 2002): Allegedly, its securities practices were intended to mislead investors about its financial health. The company, then in a bankruptcy situation, was undertaking a “stewardship” review to be completed by the end of 2002. February 26, 2003, two Kmart executives were indicted by a Detroit grand jury on federal charges of fraud, conspiracy and making false statements over their recording of a $42 million payment that resulted in an overstatement of Kmart’s results (Hays 2003).

Table A.1 summarizes and synthesizes Recent Corporate Accounting Irregularities.

Discussion and Implications

Deliberate accounting irregularities are failures of corporate accountability. In the wake of these escalating corporate accounting scandals, several ethical and moral questions arise. As responsible ambassadors and representatives of the corporation, its mission, products and services, corporate executives in general, and accounting executives in particular, must represent integrity, honesty and corporate responsibility to customers and shareholders.

The Enron bankruptcy raised questions about the validity of the independent audits and of the business practices of the accounting industry itself. It is clear that the auditors failed to pinpoint the accounting irregularity problems with companies involved in corporate scams. Given the fact that the accounting practices are relatively simple, it is hard to believe how easily the accounting firms disguised the truth, presumably in collusion with the audit and accounting branches of the implicated firms. It is just hard to accept that the accountants did not assess the magnitude of these frauds. Clearly, the accounting principles and rules were not followed.

There were systems level failures at several points that allowed many corporate frauds and scams to remain undetected until they were so large that they bankrupted large companies, with billions of dollars of loss in shareholder equity. Some of the biggest and most prestigious U. S. accounting firms (e.g., Arthur Anderson, Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers) offered consulting services to the same companies, they also audited. These firms clearly compromised their credibility and independence when they had to audit their own work. The Securities and Exchange Commission (SEC) failed to bar accountants from also being consultants for the same company due to

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extensive pressure from the accounting lobbying groups. The same groups have contributed millions of dollars to individuals, PAC's, and soft money contributions to fight any SEC rules change. Some of the largest scams recently uncovered were in the utility business. Several wholesale power traders revealed that they participated in the so-called "round trip" or "wash trading" practices.

All businesses have a responsibility to the common good. Because corporate executives and organizations are both economic and social institutional forces, their responsibilities to the public are large and go beyond the sanctions of law and demands of competition. In serving each other, they must strike at some unity that goes beyond a mere melding of self-interests to sharing of socially responsible values and ideals. Howsoever defined, the social good of investors is very high, and the investing public recognizes this good. Corporate irregularities of whatever form reduce this potential for social good by depriving investors of necessary, objective and timely securities information to which they are entitled. This goal may be achieved through existing organizations such GAO, SEC, DOJ, and CFTC.

It is possible that corporate executives would justify their improper action under the guise of situationism. The latter affirms that when confronted with conflicting rights or duties, it is usual to let the situation with all its circumstances define whose rights should prevail. But this does not mean that the rights of shareholders, investors, employees with 401K moneys invested in the company, and other stakeholders should be totally disregarded, as seems to be the case with the corporate irregularities. In fact, moralists (e.g., Rawls 1971) prescribe that under situationism one is obliged to give additional protection to the rights of the disadvantaged.

Concluding Remarks

There are three dimensions to any corporate fraud: the human, the technology, and the legal dimension. The most important one is the human. People will always try to find ways to get around any regulatory system if it is to their advantage to do so. Any legal or technology system is only as good as people that designed it. Consequently, there will always be someone smarter and more knowledgeable that is willing to take the risk of exploiting the system for one’s own benefit.

There are several issues that make it difficult to predict, uncover or control corporate corruption and fraud. When the top-level business executives are corrupt, it is difficult for the mid level managers to detect or uncover the deceptive acts and the problems underlying them. Moreover, the mid-managers would be worried about their jobs, especially if whistle blowing is punished in corporations. Additionally, corporate executives involved in fraudulent activities that could launder billions of unearned personal profit to them would not hesitate to pressurize and bribe subordinates into silence even if the latter detected something irregular. Some subordinated could be could be easily seduced to keep quiet "for the good of the company" or "only until the mess is straightened out." A sense of personal loyalty may deter some from resigning their jobs under such strenuous situations.

As managers move from one place to another, it is possible they inherit an already messy business from a previous executive, and would be reluctant to expose the situation for any number of personal or professional reasons. Thus, many instances internal audits do not work and are just another form of unnecessary nuisance in the bureaucracy. The Enron bankruptcy raised questions about the validity of the independent audits and of the business practices of the accounting industry itself. It is clear that the auditors failed to pinpoint the problems with companies involved in corporate scams. The accounting practices are relatively simple. It is just hard to believe how easy it was for the accounting firms to disguise the truth, without resorting to collusion between the audits and accounting branches of the implicated firms as an explanation. It is just hard to believe that the accountants would miss the

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magnitude of these frauds. Clearly, the Enron executives did not abide by the usual accounting principles and rules.

There were systems level failures at several points that allowed many corporate frauds and scams to remain undetected until they were so large and unredeemable. Some of the biggest accounting firms such as Arthur Anderson, Deloitte & Touche, Ernst & Young, KPMG, and Pricewaterhouse Coopers increased their earnings by offering consulting services to the same companies they audited. These firms clearly compromised their credibility and independence when they had to audit their own work. The Securities and Exchange Commission failed to bar accountants from also being consultants for the same company due to extensive pressure from the accounting lobbying groups. The same groups have contributed millions of dollars to individuals, PAC's, and soft money contributions to fight any SEC rules change.

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Table A.1: Recent Corporate Accounting Irregularities[Source: Fortune, September 2, 2002, pp. 64-74].

Company Total Haul

($Billions)

Biggest Takers Individual Haul

($Millions)

Remarks

QwestCommunications

2,260 Phil Anschutz, Director,Jo Pe Nacchio, former CEO

1,570230

As part of BellSouth’s deal to buy some of Qwest, Anschutz sold his Qwest stock of 33.228 million shares to BellSouth at $47.25 for $1.57 billion when its market price was $39.44.

Broadcom 2,080 Henry Samueli, CIO,Henry Cicholas, CEO,(both co-chairmen)

810799

Nicolas boasts that he pays Broadcom employees so little that they have to sell their stock to pay their bills.

AOL Time Warner

1,790 Steve Case, Chairman,Bob Pitman, former COO,Jim Barksdale, Director

475225213

Ex CEO Gerald Levin, who masterminded the AOL-Time Warner merger, and left it May 2001, did not cash in single share over this period.

Gateway 1,270 Ted Waitt, CEO 1,100 Founder Waitt spent $9.36 million in June to buy back 2 million Gateway stock trading around $4 in June 2002. The stock peaked at $82.5 in November 1999.

Ariba 1,240 Ron DeSantis, former EVP,Keith Krach, Chairman,Paul Heagarty, Director,Edward Kinsley, former CFO

222191127114

With an unusually short post-IPO lockup period, these executives began selling their stock barely 4 months after Ariba went public in June 1999.

JDS Uniphase 1,150 Kevin Kalkhoven, former CEO,Danny Pettit, former CFO,Josef Strauss, CEO & Co-Chair

246206175

“I have made zero sales in 2002.” says Strauss, CEO since May 2000. Today all my options are underwater. I need a submarine to read them.”

I2 Technologies

1,030 Sanjiv Siddhu, Chairman, CEO,Ramesh Wadhwani, Vice-Chairman,Sandeep Tungare, former Director

447

160

144

Founder Siddhu, who still owns 27% of the company, sold most of these shares after the stock peaked at $110 in March 2000. I2 Tech. now trades at less than $1.0.

Sun Microsystems

1,030 Bill Joy, CTO,Ed Zander, former President

103100

Joy sold one million Sun shares in October 2000, 15% of his stake. He sold all his other tech holdings around the same time.

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Company Total Haul

($Billions)

Biggest Takers Individual Haul

($Millions)

Remarks

Enron 994 Lou Pai, former Division Head,Ken Lay, former CEO,Rebecca Mark, former Div. Hd.Ken Rice, former Division Head

2701028074

Jeff Skilling and Andy Fastow cashed $68 million each worth of Enron stock, respectively.

Global Crossing

951 Gary Winnick, Chairman 508 Winnick also sold another $227 before January 1, 1999.

Charles Schwab

951 Charles Schwab, Chairman, CEO,David Pottruck, President, CEO

353

188

Schwab’s sales “have never amounted to more than a few percentage points of his total holdings in any one year,” says a spokesperson.

Yahoo 901 Tim Koogle, former CEO,Jeff Mallett, former COO,Gary Valenzuela, former CFO

160148116

Co-founders Jerry Yang sold only $30 million during this period, while David Filo sold none.

Cisco Systems 851 John Chambers, President, CEO,Judith Estrin, former CIO

23972

Estrin also cashed $61 million of stock in February 2000, a month before it peaked at $80.06; she left Cisco that April.

Peregrine Systems

818 John Moores, Chairman 646 Peregrine is restating revenues from April 1999 to December 2001, during which Moores dumped $530 million of stock.

Sycamore Networks

726 Gururaj Deshpande, Chairman,Dan Smith, President, CEO, Director,Chi Kong Shue, EVP

137129

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BY the time main customer, Williams Communications, went bankrupt last April, these insiders had done most of their selling.

Nextel Communications

615 Craig McCaw, Director,Daniel Akerson, former CEO

343117

McCaw also cashed $115 million from XO Communications, the Telecom he founded that went belly-up June 2001.

Foundry Networks

582 Bobby Johnson, Chairman, CEO

308 We are going to create shareholder wealth the old fashioned way, said Bobby in January 2000. Market cap has since fallen 95%!

Juniper Networks

557 Scott Kriens, Chairman, CEO,Pradeep Sindhu, Vice-chairman,

14810887

Last May, with stock down 96% from its high of $243, executives exchanged their booming options for ones priced at $10.31!

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Peter Wexler, VP

Company Total Haul

($Billions)

Biggest Takers Individual Haul

($Millions)

Remarks

Infospace 541 Naveen Jain, Chairman, CEO

406 Jain claims he plowed much of this gain into Net stocks; “I lost $80-100 million just on Inktomi and Verisign.”

Commerce One 531 Thomas Gonzales, former CTO,Jay Tenenbaum, former Director

11575

Tenenbaum who got a chunk of Commerce One stock when he sold Vio Systems to the company in January 1999, left last April. Gonzales died last fall.

AT&T 475 John Malone 348 AT&T bought Malone’s company, TCJ, in a stock deal in March 1999. Malone left his post as an AT&T director in 2001.

Network Appliance

470 David Hitz, EVP,Thomas Mendoza, President,Daniel Warmenhoven, CEO, Director

1115848

Hitz says his selling is systematic: “It’s an extremely consistent pattern of about 2.5% of my remaining shares per quarter.”

Inktomi 431 Paul Gauthier, former CTO,David Peterschmidt, Chairman, CEO

10784

Peterschmidt hasn’t sold any Inktomi shares since February 2001. “Investors would flip if they found they did,” says a spokesperson.

Priceline 417 Jay Walker, former Vice-chairman,Timothy Brier, former EVP

27645

Walker bought $125 million of Priceline shares from Delta Airlines in November 1999, before the stock began falling.

Vignette 413 Ross Garber, former CEO,Neil Webber, former CTO

9892

Founders Garber and Webber did most of their selling after they left Vignette’s Board in July 1999 and October 1999, respectively.

Totals:No. of Companies:

Sum MeanStd. Dev.

25

23, 074923502

Totals:No. of Executives involved:

Sum:Mean haul per executive:Std. Dev.

55

14,147257262

This the total accounting irregularity haul from 25 companies listed here with 55 top executives involved.

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Appendix 2: A Note on Corporate Insider Trading Irregularities

Early 2000 marked the beginning of some of the worst corporate security irregularities in history. Rapidly rising stock prices followed by the eventual market collapse might have led these executives to unusual activities and practices in corporate transactions that were either questionable in terms of their ethical and moral implications, or were outright violations of the law. For instance, Forbes (July 25, 2002) listed top 25 securities irregularities among top management executives, and little later, Fortune (September 2, 2002) featured another list of 25 largest corporate irregularities in the form of corporate accounting frauds and security scandals. The latter list of securities irregularities involved a total haul of $23.074 billion dollars, averaging to 923 million per company. The list named 55 top executives laundering $14.147 billion with over 257 million dollars per person. The Fortune report resulted from a research conducted during 2001 in conjunction with the University of Chicago, School of Business. The current avalanche of security irregularities could represent just the tip of the iceberg. Each business week of the last two years, the media has been featuring at least one or other top corporate executives of the country confessing either accounting frauds or securities irregularities or both.

Definitions and Discussion of some Key Terms

Security: A security includes any note, stock, bond, pre-organization subscription, and investment contract. An investment contract is an investment of money or property made in expectation of receiving a financial return solely from the efforts of others. Securities not subject to the registration requirements of the 1933 SEC Act are “exempt securities;” these include short-term commercial paper, municipal bonds, and certain insurance policies and annuity contracts. Non-exempt securities come under 1933 Act such as notes, stocks, bonds and some investment contracts. Similarly, exempt transactions are issuance of securities that do not come under the registration requirements of the 1933 Act (e.g., limited offers, intrastate issues). Disclosure of accurate material information is required in all public offerings of non-exempt securities unless offering is an exempt transaction.

Disclosure requirements: these are statements disclosing specified information that must be filed with the SEC and furnished to each offeree. Insiders are liable under Rule 10b-5 for failing to disclose material, nonpublic information to the SEC and each offeree before trading on the information.

Antifraud Provision: Rule 10b-5 makes it unlawful to 1) employ any device, scheme, or artifice to defraud; 2) make any untrue statement of a material fact; 3) omit to state a material fact without which the information is misleading; 4) engage in act, practice, or course of business that operates or would operate as a fraud or deceit upon any person. Recovery of damages under Rule 10b-5 require proof of: 1) a misstatement of omission; 2) materiality; 3) scienter (intentional and knowing conduct), and 4) relied upon 5) in connection with the purchase or sale of a security. In an action for damages under Rule 10b-5, it must be shown that the violation was committed with scienter or intentional misconduct. Negligence is not sufficient.

Material: A misstatement or omission is material if there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to purchase or sell a security. Examples of material facts include substantial changes in dividends or earnings, significant misstatements of asset value, and the fact that the issuer is about to become a target of a tender offer.

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Insider Trader: The term insider is specially defined in Section 16b of the U. S, Securities Exchange Act of 1934 that limits short-term transactions by insider parties (Vagts 1979: 827). Section 16b of the 1934 SEC Act imposes express liability upon insiders - directors, officers, and any person owning more than ten percent of the stock of a corporation listed on a national stock exchange or registered with the SEC - for all profits resulting from their “short-swing” trading in such stock. The insiders are assumed to have special access to insider information concerning a corporation either because of financial interests and/or a managerial position. If any insider sells such stock within six months from the date of its purchase or purchases such stock within six months from the date of its sale, the corporation is entitled to recover any and all profit the insider realizes from these transactions. The “profit” recoverable is calculated by matching the highest sale price against the lowest purchase price within the relevant six-month period, and losses cannot be offset against profits (Mann and Roberts 2000: 961). Individuals classified as insiders are subject to special restrictions in using such data in trading in securities. Insider trading during a tender offer is prohibited by Rule 14e-3 of the 1934 SEC Act (Mann and Roberts 2000: 963). A tender offer is a general invitation to shareholders to purchase their shares at a specified price for a specified time. Section 14e imposes civil liability for false and material statements or omissions or fraudulent, deceptive, or manipulated practices in connection with any tender offer.

Tippers – These pass on insider information that they had a legal obligation to keep secret even though they do not trade on it themselves. Correspondingly, a Tippee is someone who accepts insider information from a person who should not have revealed it, and trades on it.

Insiders, for the purpose of SEC Rule 10b-5, include directors, officers, employees, and agents of the security issuer, as well as those with whom the issuer has entrusted information solely for corporate purposes, such as underwriters, accountants, lawyers, and consultants. In some instance, the rule also precludes persons (tippees) who receive material, nonpublic information from insiders (tippers) from trading on that information. A tippee who knows or should know that an insider has breached his fiduciary duty to the shareholders by disclosing inside information to the tippee is under a duty not to trade on such information (Mann and Roberts 2000, p. 962).

Thus, although both Section 16b and Rule 10b-5 address the problem of insider trading and both apply to the same transaction (i.e., trading securities), yet these two legal sources differ in many aspects: 1) Section 16b applies only to transactions involving registered equity securities, whereas Rule 10b-5 applies to all securities. 2) The insiders by Section 16b are only directors, officers, and those who own more than 10% of the a company’s stock, while the insiders by Rule 15b-5 extends to other categories such as agents of the security issuer, underwriters, accountant, lawyers and consultants. 3) Section 16b does not require that the insider possess material, nonpublic information; the liability is strict; whereas Rule 10b-5 applies to insider trading only where such information is not disclosed. 4) Section 16b applies only to transactions occurring within six months of each other, while Rule 10b-5 has no such limitation. 5) Under Section 16b, although shareholders may bring suit, any recovery of damages is on behalf of the corporation; but under Rule 10b-5, injured investors may recover damages on their own behalf (Mann and Roberts 2000, p. 962).

In 1988, the Congress amended the 1934 Act by adding Section 20A that imposes express civil liability upon any person who violates the Act by purchasing or selling a security while in possession of material, nonpublic information. Any person who contemporaneously sold or purchased securities of the same class as those improperly traded may bring a private action against the improper traders to recover damages for the violation. The action must be filed within five years after the date of the last transaction that is the subject of the violation. Tippers are jointly and severally liable with tippees who commit a violation by trading on the insider information (Mann and Roberts 2000, p. 963).

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Further, any person who distributes a materially false or misleading proxy statement may be liable to a shareholder who relies upon the statement in purchasing or selling a security and thereby suffers a loss. A misstatement or omission is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote or buy/sell shares, even if this misstatement or omission occurred merely through negligence. Similarly, by Section 14e of the SEC Act of 1934, it is unlawful for any person to make any untrue statement of material fact, to omit to state any material fact, or to engage in any fraudulent, deceptive or manipulative practices in connection with any tender offer. This provision applies even if the target company is not subject to the 1934 Act’s reporting requirements. Some courts maintain civil liability for violations of Section 14e; however, the requirements for such an action are not entirely clear because relatively few cases have involved such violations. At present, the target company may seek an injunction, and a shareholder of the target company may be able to recover damages or obtain rescission (Mann and Roberts 2000, p. 963).

By legislations enacted in 1984 and 1988, the SEC is authorized to bring an action in a U. S. district court to have a civil penalty imposed upon: 1) any person who purchases or sells securities while in possession of material, nonpublic information; 2) any person who by communicating material, nonpublic information aids and abets another in committing such a violation; 3) any person who directly or indirectly controlled a person who ultimately committed a violation, even though the controlling person knew or recklessly disregarded the fact that the controlled person was likely to commit a violation and consequently failed to take appropriate steps to prevent the transgression. Violation in all three cases must be on or through the facilities of a national security exchange or from a broker or dealer. Purchases that are part of a public offering by an issuer of securities are not subject to this provision (Mann and Roberts 2000, p. 963). Insider Trading: SEC Rule 10b-5 applies to sales or purchases of securities made by an “insider” who possesses material information that is not available to the public (Mann and Roberts 2000, p. 961). More specifically, it is the attempt to benefit from stock market fluctuations by using unpublicized information gained on the job (Mescon, Bovée and Thill 2002, p. 58). An insider who fails to disclose the material, nonpublic information before trading on the information will be liable under Rule 10b-5, unless he or she waits for the information to become public.

The U. S, Supreme Court has upheld the misappropriation theory as an additional and complementary basis for imposing liability for insider trading. Under this theory, persons may be held liable for insider trading under Rule 10b-5 if they trade in securities for personal profit using confidential information misappropriated in breach of a fiduciary duty to the source of the information; this liability applies even though the source of information is not the issuer of the securities that were traded (Mann and Roberts 2000, p. 262).

Insider Information: Insider information is data or news that has not been publicly released and that could affect a shareholder’s decision to buy or sell stock in a publicly traded company utilizing material, nonpublic information (Markon and Schmitt 2002). The law bars trading in a material nonpublic information. In terms of defining just what kind of information fits this category, prosecutors have some leeway. The most clear-cut examples include market-moving news such as an impending merger or bad earnings report before it is made public. But, gray areas abound.

Numerous other issues abound. For example, many companies attend professional conferences each year and they may provide information about new products to attendees, while at the same time bar members of the general public from any of the above information (Business Week, April 26, 2002). The American Society of Oncology (ASCO) is a case in point. At each of their annual conferences a great deal of information is released to those attending these gatherings. This is akin to insider trading if the attendees begin trading on the information provided to them.

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Despite vast evidence of insiders trading and beating the market, there is little academic research explaining just what insiders know before the rest of us. For instance, do insiders correctly anticipate declines in company’s profits. However, a recent survey looked at 3,952 companies that from 1994 to 1997 broke a string of quarterly profit gains; apparently, insiders dumped stock before the break in profit gain (Business Week, 2001, April 2). They did, often and early. Insider selling, the survey discovered, jumped markedly above its average level as early as nine quarters before a break in profit increases. Stocks of growth companies saw more intense selling, and it started even earlier. Insider sales of growth stocks on average shot up 11 quarters before the decline in profits. At its peak, four quarters before a break in profit gains, insider selling in growth stocks nearly quadrupled its usual rate. The longer the string (of profit gains), the more evident is the insider selling. It appears that insiders, as a group, know a long time in advance when their corporations are going to suffer an earnings drop.

The above begs the question. Do these trades cross the boundary into illegal insider trading? The survey does not assert that, and regulators are not anxious to paint bright lines around what makes an illegal trade. Insiders may be acting not just on hard data but may also be using soft information. Examples may include the onset of new competition or the firm’s narrowing technological lead that may represent trends that an alert outsider also might exploit.

Legal Insider Trading: Insiders need to follow certain procedures when they wish to sell some or all of their holdings. First, the potential inside trader needs to consult with legal consul so as to determine the appropriateness of an insider purchase and/or sale at a given point in time such as a pending merger. Then a Form 144 must be filed with the Securities Exchange Commission (SEC) indicating the number of as well as the precise timing of the desired sale. Finally, an opinion letter must be sent from the appropriate legal counsel and filed along with the above, to the Securities Exchange Commission (SEC). All these procedures are meant to ensure that the corporate insiders do not trade on or tip others with insider information thus negatively affecting the company and/or its shareholders.

Corporate insiders for some time have been forbidden to trade while knowing about material, nonpublic information such as earnings announcements or a possible merger. Currently, insiders need only be aware of confidential market-moving information, as based on SEC Rule 10b-5. A second rule (105b-2) extends liability for illegal insider trading to family members and other non-business relationships that have agreed to keep secret the information they receive. Further, as of August 2002, SEC has come up with newer rules requiring firms to report trades of company stock by officers, directors and majority shareholders within two (2) days (Kristof 2002). This is a vast improvement over past sales that allowed companies at least 10 days - and sometimes more than a year - to reveal whether the top officers within the firm were buying or selling their equity or portions thereof. Recently, the SEC is involved with more activities relative to insider trading cases: as a result, 57 insider trading related cases were filed in 1996, up from 38 in 1990 (Bryan-Low 2000).

It should be noted that there are situations that can lead to somewhat different types of complications relative to just what is considered as an appropriate insider behavior. For instance, insiders to IPO (initial public offerings) have considerable leeway as to when they can begin selling shares after the lock-up period has begun, which is a specified number of days during out-and-out forbids the sale of that firm’s equity. Typically, the lockup period can last from 90 to 180 years, and shares can be unlocked in stages (Business Week 2000, March 8). Also, lockup periods can be shortened and/or lengthened with approval from the investment banker responsible for taking the firm public in the first place. This can lead, among other things, to problems regarding the perception of just why an insider may be selling a portion (or all) of their holdings. Also, public company holdings may suffer price loss after the expiration of the lock up period.

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There may be other factors that contribute to the falling of equity values of these companies. Some of these may include competitive difficulties and/or changing market conditions, which explains why one-half of all IPOs trade below their opening price after one year. Insider trading may contribute, and probably does in many cases, to a fall of value, but it is difficult to pinpoint exactly why.

Illegal Insider Trading: This concerns what constitutes a violation of insider trading rules. In general, any insider trading that is not legal as per rules specified above. Some examples may clarify when insider trading is legal or illegal:

1. What if a member of your tennis foursome passes along the following tip: “XYZ Corp’s stock is about to go up. You may want to buy.” This is a classic market rumor, and you would not get in trouble if you trade on it. The tipper hasn’t given you enough information - such as how he knows the stock is about to rise - for it to cause you a problem. If however, you know that he is the chief executive of XYZ, however, you could be in trouble.

2. What if the tipper says he has a friend who works at XYZ Corp., who says that the company has a hot, new product in development and you should buy the stock? It depends on precisely what was said. If your tennis partner made it clear that the information isn’t yet public and that it came from someone who works at the company, you could face legal problems. The employee has breached his legal duty to the company not to disclose the information, and you know or should know that.

3. Does it matter whether the tip comes from someone who works at the company or a third party in a position to know? No, because the test is whether the person who gets the information has reason to believe that the information ultimately came from a tainted source. These sources could include employees of law firms, printing companies or even newspaper reporters that have come into possession of market-moving confidential information.

Consider the following insider trading allegations:

4. In 2001, Quest Communications International Inc., a Denver telecom giant, saw its stock slide 64 percent. Quest disclosed that the SEC had opened an informal inquiry into its accounting policies. Quest founder Philip F. Anschutz sold 10 million shares for $408 million and these sales may be critical because they occurred just before Qwest’s stock nose-dived (Fortune, September 2, 2002). Also, the SEC is investigating whether Quest and Global Crossing, among others, sold each other network capacity to inflate their financial statements, all of which occurred in the same month that Anschutz sold his ten million stock. It may all be a coincidence, but there were certainly a lot of shares being sold at a curious time.

5. Imclone’s founder CEO, Sam Waksal, was arrested in New York on charges of insider trading. Along with his close friend Martha Stewart, Waksal’s two daughters, his father and sister all sold large blocks of Imclone’s stock on December 27, a day before the Food & Drug Administration (FDA) rejected its application for Erbitux, a potential cancer treatment drug (Fortune, September 2, 2002). The investigation may be expanded to include other people Waksal contacted.

6. Keith Krach, chairman of Ariba Inc., sold $239 million worth of stock 122 days after Ariba’s IPO and two days after the expiration of their short four-month post IPO lockup (Fortune, September 2, 2002). As a shareholder, he as well as others had a right to sell a portion of their holdings. Questions have been asked regarding the short lock-up period, but nonetheless, it was still legal. Insiders of IPOs have typically been involved with their company for some time and their desire to sell when the company goes public is

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perfectly legitimate. Diversifying their personal portfolio of investments is one reason why companies go public.

Cases 4 and 5 are illegal insider trading. The corporate insiders: a) acted on market-moving insider information, b) which they had a privileged access to as insiders, and c) because such transaction significantly affected the shareholders. Moreover, d) there was no evidence that they followed procedures for insider training noted above. Case 6 of insider trading may be legally defensible for the reason stated.

A Brief Description of Recent Corporate Securities Irregularities

Most of the reported corporate securities irregularities relate to insider trading, fake transactions to boost revenues, and inflation (and restatement) of earnings.

Insider Trading Irregularities: (See Fortune, September 2, 2002).

Qwest Communications: As part of BellSouth’s deal to buy some of Qwest, Phil Anschutz, Director of Qwest, sold his stock to BellSouth at $47.25 when its market price was $39.44: his haul was $1.57 billion.

Gateway: Tedd Waitt, founder and CEO of Gateway, spent $9.36 million in June to buy back 2 million Gateway trading around $4, when $82.5 was the stock peak price in November 1999: his haul was $1.00 billion.

Ariba.com: With an unusually short post-IPO lockup period, several corporate executives of Ariba.com began selling their stock barely 4 months after Ariba went public in June 1999. Ron DeSantis, former EVP made 222 million, Keith Krach, Chairman hauled 191 million, Paul Heagarty, Director, Edward Kinsley, former CFO, each laundered 127 million and 114 million, respectively.

I2Technologies: Founder, chairman and CEO of I2 Technologies, Sanjiv Siddhu, who still owns 27% of the company, sold most of these shares after the stock peaked at $110 in March 2000. I2 Technologies stock now trades at less than $1.0; his catch was 447 million; Ramesh Wadhwani, Vice-Chairman, and Sandeep Tungare, former Director each did the same and made 160 million and 140 million, respectively.

Enron: Enron’s Lou Pai, former Division Head, Ken Lay, former CEO, Rebecca Mark, former Division Head and Ken Rice, former Division Head, each cashed stock to mint 270 million, 108 million, 80 million and 74 million dollars respectively; Jeff Skilling and Andy Fastow cashed $68 million each worth of Enron stock, respectively.

Global Crossings: Gary Winnick, Chairman, Global Crossings, cashed stock worth $508 million; Winnick also sold another $227 before January 1, 1999.

Cisco Systems: John Chambers, President, CEO, Cisco Systems, and Judith Estrin, former CIO, each cashed stock to gain $239 million and $ 72 million respectively in 2000. Estrin also cashed $61 million of stock in February 2000, a month before it peaked at $80.06; she left Cisco that April.

Nextel Communications: Craig McCaw, Director, Nextel Communications, cashed stock to the tune of $343 million in 2000. He also cashed $115 million from XO Communications, the Telecom he founded that went belly-up June 2001.

Juniper Networks: Last May, with stock down 96% from its high of $243, executives of Juniper Networks, Scott Kriens, Chairman, CEO, Pradeep Sindhu, Vice-chairman, and Peter Wexler, VP exchanged their booming options for ones priced at $10.31! They bagged each 148 million, 108 million and 87 million dollars, respectively.

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Table A.2 summarizes and synthesizes recent corporate financial insider irregularities.

Difficulties in Detecting Illegal Insider Trading

There are enforcement-related difficulties relative to insider trading. In general, enforcing insider regulations is not easy because regulators must start by identifying irregular trading patterns, working backward to establish what occurred at that time. Recent changes regarding insider-related trading activities might help the SEC bring cases forward.

First, there are numerous situations when insider trading may be legal. For instance, if there are possible earnings problems on the horizon, stock trades at this time (on the buy side) may or may not represent insider-trading violations. Insider trading rules are designed to ensure that no corporate agent can benefit, directly or indirectly, from self-dealing in confidential corporate information that belongs to the corporation and all of its shareholders. As for outsiders, establishing the affirmative use of material nonpublic information is essential to establishing Rule 10b-5 liabilities in the context of securities trading by non-officer, temporary insiders, and other tippees (Fortune, September 2, 2002). Investors still may sell some or all of their holdings for any number of legitimate reasons.

One more difficulty regarding the investigative process relative to insider trading concerns the timing of securities transactions and the release of bad news pertaining to the company. Insiders can design plans to sell/buy shares of stock in that particular company. Bad news could be delayed so that a pre-existing plan to sell shares could be carried out at a higher pre-announcement price, or release of good news could be delayed so that a pre-existing plan to purchase shares could be executed at the lower pre-announcement price. The above machinations could be actionable as a fraud under Rule 10b-5 (SEC, April 24, 2000). Yet, as former SEC Commissioner Robert Karmel has recognized, it is far less complicated to approve the facts of an insider trading case than to prove that a publicly traded company or corporate insider committed fraud in terms of the timing of the release of information.

Thirdly, academic research is revealing some interesting and possibly important clues as to the patterns of insider selling. In fact, there is a sub-industry devoted to tracking and interpreting the trading reports insiders are supposed to make to the SEC. With the Web and the spread of sites (including Business Week Online) posting free insider-trading data, it is a snap for individual investors to clue in to what insiders are up to. Popular personal-finance spots on the Web, including pages featured by American Online (AOL) and Yahoo! Finance, typically focus on the past 3, 6, or 12 months regarding insider trades. New research suggests insiders begin dumping stock over two years before a company’s earnings fall. If more research supports these findings, investors may need to rethink how they assess insiders’ moves.

One additional issue tangentially related to this notion of insider trading concerns the recently minted Regulation FD (Financial Disclosure). This represents a new development that may have relevance to insider trading-related issues. Financial Disclosure, adopted in August 2000, was designed to put individual investors on an even footing with professionals when companies disclose potential market-moving information (Business Week, February 2, 2002). Before its adoption, the public was routinely barred from management’s conference calls with stock analysts. Now, Regulation FD requires that companies immediately report any important corporate developments to the public. This has caused a blizzard of information from public companies. But in many cases, Regulation FD tends to confuse rather than enlighten because the information provided may be incomplete (Marcial 2002). Privately, corporate executives appear

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to reveal or leak important information to relatives, close friends, or favored partners. The basic ingredients for insider trading violations are still present. WE need more research in this area.

Concluding Remarks

Opportunism is rampant in every area of business, and corporate finance is no exception as the long list of corporate securities irregularities (e.g., Fortune September 2, 2002) demonstrates. The risk of opportunism can be very high, and considerable resources might have to be spent in controlling and monitoring it, resources that could have deployed more productively elsewhere in the company. Opportunism is hard to detect owing to information asymmetry between the party engaging in opportunistic behavior and the other exchange partner, even harder to control, and strategies for suppressing opportunistic behavior may undermine existing exchange relationships (Murry and Heide 1998) as well as forfeit valuable deals in the process. While several strategies of “external” control of opportunism have been devised, tried, and often failed (e.g. reduction of information asymmetry, closer monitoring, higher monetary incentives to discourage opportunism, higher contracted penalties for opportunistic behavior), very few “internal” control mechanisms have been tried. A major “internal” control such as selecting, contracting, and rewarding marketing or securities managers whose virtues of honesty, prudence, commitment, and fiduciary responsibility have been tested and proven may help control opportunism far more effectively than external monitors.

Corporate irregularities are bred by corporate greed that in turn is stimulated by the corporate “virtue” of selfishness (Rand 1964). What we need at this juncture is a real return to virtue, specifically the virtue of caring for others, specifically advocated by recent feminist ethical scholars (see Gilligan 1982; Noddings 1984). Unless corporate executives “aim higher” (see Bollier 1997), and incorporate virtue in their corporate strategies (see Morris 1997), they will never appreciate the “social contracts” they have implicitly signed with society by their corporate position (Donaldson and Dunfee 1995, 1999).

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Table A.2: Recent Corporate Securities Scams[Source: Fortune, September 2, 2002, pp. 64-74].

Company Total Haul

($Billions)

Biggest Takers Individual Haul

($Millions)

Remarks

QwestCommunications

2,260 Phil Anschutz, Director,Jo Pe Nacchio, former CEO

1,570230

As part of BellSouth’s deal to buy some of Qwest, Anschutz sold his Qwest stock of 33.228 million shares to BellSouth at $47.25 for $1.57 billion when its market price was $39.44.

Gateway 1,270 Ted Waitt, CEO 1,100 Founder Waitt spent $9.36 million in June to buy back 2 million Gateway stock trading around $4 in June 2002. The stock peaked at $82.5 in November 1999.

Ariba 1,240 Ron DeSantis, former EVP,Keith Krach, Chairman,Paul Heagarty, Director,Edward Kinsley, former CFO

222191127114

With an unusually short post-IPO lockup period, these executives began selling their stock barely 4 months after Ariba went public in June 1999.

I2 Technologies

1,030 Sanjiv Siddhu, Chairman, CEO,Ramesh Wadhwani, Vice-Chairman,Sandeep Tungare, former Director

447

160

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Founder Siddhu, who still owns 27% of the company, sold most of these shares after the stock peaked at $110 in March 2000. I2 Tech. now trades at less than $1.0.

Sun Microsystems

1,030 Bill Joy, CTO,Ed Zander, former President

103100

Joy sold one million Sun shares in October 2000, 15% of his stake. He sold all his other tech holdings around the same time.

Enron 994 Lou Pai, former Division Head,Ken Lay, former CEO,Rebecca Mark, former Div. Hd.Ken Rice, former Division Head

2701028074

Jeff Skilling and Andy Fastow cashed $68 million each worth of Enron stock, respectively.

Global Crossing

951 Gary Winnick, Chairman 508 Winnick also sold another $227 before January 1, 1999.

Cisco Systems 851 John Chambers, President, CEO,Judith Estrin, former CIO

23972

Estrin also cashed $61 million of stock in February 2000, a month before it peaked at $80.06; she left Cisco that April.

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Company Total Haul

($Billions)

Biggest Takers Individual Haul

($Millions)

Remarks

Sycamore Networks

726 Gururaj Deshpande, Chairman,Dan Smith, President, CEO, Director,Chi Kong Shue, EVP

137129

122

By the time main customer, Williams Communications, went bankrupt last April, these insiders had done most of their selling.

Nextel Communications

615 Craig McCaw, Director,Daniel Akerson, former CEO

343117

McCaw also cashed $115 million from XO Communications, the Telecom he founded that went belly-up June 2001.

Juniper Networks

557 Scott Kriens, Chairman, CEO,Pradeep Sindhu, Vice-chairman,Peter Wexler, VP

14810887

Last May, with stock down 96% from its high of $243, executives exchanged their booming options for ones priced at $10.31!

Priceline 417 Jay Walker, former Vice-chairman,Timothy Brier, former EVP

27645

Walker bought $125 million of Priceline shares from Delta Airlines in November 1999, before the stock began falling.

Vignette 413 Ross Garber, former CEO,Neil Webber, former CTO

9892

Founders Garber and Webber did most of their selling after they left Vignette’s Board in July 1999 and October 1999, respectively.

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