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FRANK BADUA, PH.D.AMERICAN ACCOUNTING ASSOCIATION ANNUAL MEETINGAUGUST 6, 2013

SCHOOLED BY SCANDAL: A BRIEF HISTORY OF SOME UNFORTUNATE EVENTS THAT SHAPED THE U.S. ACCOUNTING AND FINANCE REGULATORY ENVIRONMENT

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Introduction• The word “scandal” is derived from the Latin “scandalum” and

its Greek cognate both of which mean “trap” or “stumbling block.”

• The five cases described are – the accounting and finance fraud scandals surrounding Ivar Kreuger in

the 1920’s and 1930’s– the McKesson-Robbins fraud beginning in the same period but

extending over a longer time, – the Lockheed bribery scandal of the 1970’s, – the Enron accounting scandal at the end of the 20th century– and the banking and subprime mortgage crisis of the early 21st century.

• Each of these four events will be linked to legislation and regulatory initiatives that followed them, respectively: SEA 1934, AUD 1940, FCPA 1977, SOX 2002, and DF 2010.

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Purpose• Comparison of these events and their effects,

• Contextualization, comparison, and synthesis of the regulatory responses in the light of scholarly literature on various types of scandals

• Summary of possible future regulatory and research ramifications

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Kreuger and SEA 1934

• Kreuger’s family firm designed and manufactured safety matches.

• After World War I, with many European countries badly needing cash in order to rebuild, he offered loans to various countries in exchange for a national match monopoly, thereby generating returns by collecting interest on the loans and selling matches.

• He lured investors by– setting up phony subsidiaries to keep liabilities off the balance sheet– reporting non-existent profits, forging documents– managing to pay out dividends through a Ponzi scheme, funding the

payments with new investment– Kreuger was able to sustain the fraud by minimizing the amount of

information he reported, maintaining a policy of “silence, more silence, and even more silence”

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Kreuger and SEA 1934

• In March 1932, as the effects of the stock market crash worsened and proliferated, Kreuger was found dead in a hotel room in Paris, prior to a scheduled meeting with increasingly skeptical bankers, an apparent suicide

• America's Securities Act was passed in 1933 strengthening disclosure requirements for all public companies, with many of its safeguards “stemming directly from the Kreuger experience (The Economist, 2007).” – Section 2 of the 1934 Act states the need “to provide for regulation and

control of securities transactions and of practices and matters related thereto, including transactions by officers, directors, and principal security holders, (and) to require appropriate reports.” A far cry from Kreuger’s “silence… and more silence.”

– Sections 3 and 10 of SEA 1934 deal specifically with financial reporting, including the need for appropriate audits, audit committees, and procedures dealing with necessary remediation and auditor penalties.

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McKesson-Robbins and AUD 1940

• In 1924, pharmaceutical firm Mckesson and Robbins had been acquired by Philip Musica, a man who had previously been prosecuted and convicted for fraudulent business practices in the cheese and cosmetics industries.

• Over the next decade and a half– McKesson and Robbins became a front for bootlegging

operations– had fraudulently inflated the performance of its legitimate

business operations, essentially by recording fictitious inventories of chemicals, and concocting profits and proceeds from their supposed sale.

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McKesson-Robbins and AUD 1940

• At that time, auditors generally did not observe the counting of inventory, pleading that it was not always within their expertise to quantify and value inventories of various types. Instead auditors relied on written representation to support inventory amounts reported.

• “As a direct result of this fraud, two audit procedures - observing inventory and confirming receivables - were added to what were considered acceptable auditing procedures for the day under the guidelines of American Institute of Accountants’ 1936 bulletin, Examination of Financial Statements by Independent Public Accountants” (Foster and Strauch, 2009, p.1).

• As for Musica, like Krueger a decade earlier, he committed suicide as news of his fraud broke out to the public.

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Lockheed and FCPA 1977

• In 1976, Representative Les Aspin released a list of questionable payments compiled by a Library of Congress report (Solomon and Linville, 1976). The 20 US firms cited had paid out over the preceding years a total of $306,000,600. Lockheed was the biggest briber ($202,000,000).

• The Lockheed bribes were spread across several nations, and involved (and ruined) many prominent personages.

• At that time, such a practice was widely condoned. In those days “it seemed to be that Lockheed and other aerospace companies really would lose sales—to open-handed British, French, German, Japanese and Soviet concerns—if they did not make such payments. (TIME, 1975)”

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Lockheed and FCPA 1977

• The result of the Lockheed and similar scandals was a flurry of SEC and Congressional investigations, culminating in FCPA 1977.

• The FCPA makes it unlawful to bribe foreign government officials to obtain or retain business

• The FCPA also requires companies whose securities are listed in the United States to meet its accounting provisions. – designed to operate in tandem with the anti-bribery provisions of the FCPA– require corporations covered by the provisions to make and keep books

and records that accurately and fairly reflect the transactions of the corporation

– firms must devise and maintain an adequate system of internal accounting controls.

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Enron and Sox 2002

• Enron started as an old economy energy firm that drilled for oil and gas and then sold it, but later became an energy brokerage- services firm whose new and nebulous business model gave them opportunity to abuse the financial reporting process.

• Eventually, Enron expanded this new business model into other areas, seeking for instance, to become a broker of broadband internet access as well, a move that eventually lead to other frauds as well.

• Abuses included earnings manipulation and asset inflation (mark-to-market accounting), obscuring liabilities and losses (special purpose entities or SPEs), and abuse of relationships with their auditor (Arthur Andersen).

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Enron and Sox 2002

• The regulatory response culminated in SOX 2002. According to Senator Sarbanes, there was “remarkable consensus on the nature of the problems” which included – inadequate oversight of accountants– lack of auditor independence– weak corporate governance procedures and lack of internal

controls.

• Accordingly, SOX 2002 focuses on auditor oversight in Sections 101 to 109, auditor independence in Sections 201 to 209, and corporate governance in Section 302.

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Banking Crisis and DF 2010

• The main events in the crisis to date involve both the private sector and public sector, and cuts across national borders.

• Irresponsible lending to finance a real estate bubble was accompanied

• Simultaneous creation and sale to other financial institutions and in some cases sovereign states of derivatives based on those mortgage receivables (called securitization).

• The bursting of the real estate bubble and the collapse in the market for the securitized assets necessitated the bailout of banks by governments. The onerous burden of rescuing the private sector subsequently necessitated the bailout of governments by international financial institutions.

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Banking Crisis and DF 2010

• The main events in the crisis to date involve both the private sector and public sector, and cuts across national borders.

• Irresponsible lending to finance a real estate bubble was accompanied

• Simultaneous creation and sale to other financial institutions and in some cases sovereign states of derivatives based on those mortgage receivables (called securitization).

• The bursting of the real estate bubble and the collapse in the market for the securitized assets necessitated the bailout of banks by governments. The onerous burden of rescuing the private sector subsequently necessitated the bailout of governments by international financial institutions.

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Banking Crisis and DF 2010

• The regulatory response in the US took the form of DF 2010. It has focused primarily on the private sector, particularly on financial services firms, and affects auditing and accounting practices in several ways.

• “Companies that normally sell loans and receivables through securitizations… will need to determine whether the risk retention provisions will apply to their current programs, including applicability of exemptions… raising the question of whether the financial assets transferred to the securitization vehicle should be derecognized.” (KPMG, 2011) Thus, the classification of a significant portion of a financial firm’s balance sheet would be affected by DF 2010.

• “Under the (DF 2010), auditors of nonpublic broker-dealers are now subject to PCAOB oversight, including its rulemaking power to require an inspection program for such auditors and the ability to set standards for their audits.” (Deloitte, 2010)

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Concluding questions

• Three possible outcomes (Thompson, 2000)– Successful reform– Trivialization– Subversion