How Companies Try to Hide Their Problems - Financial Shenanigans

8/7/2019 How Companies Try to Hide Their Problems - Financial Shenanigans

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How Companies Try to Hide Their Problems

By Financial Shenanigans

Universiti Kebangsaan MalaysiaFakulti Undang-undangProgram PHD Undang-undang

P58462

MusbriMohamed

DIL; ADIL ( ITM )

MBL ( UK M )

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This paper will discuss about the understanding of financialshenanigans. Financial shenanigans range from benigntricks to outright fraud. They occur at companies of all sizes,from small, unknown firms to the most prominent globalones.

Enron's collapse gave the world a snapshot of a companythat projected an image of financial strength whilecrumbling internally. Enron's demise also dealt a blow to theaccounting profession. What the top people at Enron didwas clearly wrong. They victimized their shareholders andothers. And Arthur Anderson and many financial analystshelped by looking the other way. Enron exposed how evenso respected a firm of auditors as Anderson could work

hand-in-glove with their clients in destroying evidence.

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Enough books have been published aboutwhat went down at Enron to warrant their own publishing imprint.

Lay, Skilling and all the rest of Enron'shapless gang of latter-day robber barons are practically household names by now, andwe've all got our pet theories about their

complicity in one of the biggest businessdisasters of all time.

We know that, for example, for a couple of guys who were supposed to be really, reallysmart, Lay and Skilling were astoundingly bad at their jobs. It takes a not inconsiderablelevel of incompetence to destroy a companythe size of Enron -- at its height in 2000, theseventh-largest corporation in the UnitedStates, with 19,000 employees and reportedrevenues of $100.8 billion.

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The 21st Century is right on track, from the war in the Middle East to sectarian violence nearly

everywhere else. Hardly a day goes by withoutreligious conflicts being in the headlines.

Additionally, the news is filled with theshenanigans of Enron, WorldCom, and Madoff ² forcing hard questions about business ethics to

the forefront of most people¶s minds.

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In March 2009, Madoff pleaded guilty to 11 federal

crimes and admitted to turning his wealth management

business into a massive Ponzi scheme that defrauded

thousands of investors of billions of dollars. Madoff said

he began the Ponzi scheme in the early 1990s. However,

federal investigators believe the fraud began as early as

the 1980s, and that the investment operation may never have been legitimate. The amount missing from client

accounts, including fabricated gains, was almost $65

billion. The court-appointed trustee estimated actual

losses to investors of $18 billion. On June 29, 2009, he

was sentenced to 150 years in prison, the maximum

allowed. Jeffry Picower , rather than Madoff, appears to have been

the largest beneficiary of Madoff's Ponzi scheme, and his

estate settled the claims against it for $7.2 billion.

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Concerns about Madoff's business surfaced as early as 1999,when financial analyst Harry Markopolos informed the U.S

Securities and Exchange Commission (SEC) that he believed it

was legally and mathematically impossible to achieve the gains

Madoff claimed to deliver. He was ignored by the Boston SEC

in 2000 and 2001, as well as by Meaghan Cheung at the New

York SEC in 2005 and 2007 when he presented further

evidence. He has since published a book, No One Would Listen

, about the frustrating efforts he and his team made over a ten-

year period to alert the government, the industry, and the press

about the Madoff fraud.

Others also contended it was inconceivable that the growing

volume of Madoff accounts could be competently and

legitimately serviced by his documented accounting/auditingfirm, a three-person firm with only one active accountant.

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The Federal Bureau of Investigation complaint says that during thefirst week of December 2008, Madoff confided to a senior employee, identified by Bloomberg News as one of his sons, thathe said he was struggling to meet $7 billion in redemptions.According to the sons, Madoff told Mark Madoff on December 9that he planned to pay out $173 million in bonuses two monthsearly. Madoff said that ³he had recently made profits through business operations, and that now was a good time to distribute it."

Mark told Andrew Madoff, and the next morning they asked their father to explain how he could pay bonuses if he was havingtrouble paying clients. They went to Madoff's apartment, with RuthMadoff nearby. Madoff told them he was ³finished,´ that he had³absolutely nothing´ left, that his investment fund was ³just one big lie´ and ³a giant Ponzi scheme . According to their attorney,Madoff's sons then reported their father to federal authorities. OnDecember 11, 2008, he was arrested and charged with securities

fraud.

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Affinity fraud

Affected institutions include Yeshiva University , the Women µs ZionistOrganisation of America , the Elie Wiesel Foundation and Steven Spielberg µ sWunderkinder Foundation. Jewish federations and hospitals have lost millionsof dollars, forcing some organizations to close. The Lappin Foundation, for instance, was temporarily forced to halt operations because it had invested itsentire $8 million endowment with Madoff.

Size of loss to investors

David Sheehan, chief counsel to trustee Picard, stated on September 27, 2009,that about $36 billion was invested into the scam, returning $18 billion toinvestors, with $18 billion missing. About half of Madoff's investors were "netwinners," earning more than their investment. The withdrawal amounts in thefinal six years are subject to "clawback" (return of money) lawsuits.

Former SEC Chairman Harvey Pitt has estimated the actual net fraud to be between $10 and $17 billion. Erin Arvedlund , who publicly questionedMadoff's reported investment performance in 2001, stated that the actualamount of the fraud will never be known, but is likely between $12 and $20 billion. As of September 2010 approximately $1.5 billion have been recoveredfor distribution to the net losers that were invested in BLMIS directly. Mr.Picard currently has approved approximately $5.6 billion in claims.

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The Center for Financial Research

and Analysis (CFRA) has identifiedabout 30 techniques (grouped intoseven categories) that companiesuse to trick investors and other stakeholders. The seven groups of financial shenanigans are asfollows:

Recording revenue too soon or of questionable quality

Recording bogus revenues

Boosting income with one-timegains

Shifting current expenses to a later or earlier period

Failing to record or improperly

reducing liabilities Shifting current revenue to a later

period

Shifting future expenses to thecurrent period as a special charge

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The following are two basic strategies underlying all accounting tricks:

To inflate current-period earnings by inflating current-periodrevenue and gains or by deflating current-period expenses.

To deflate current-period earnings (and, consequently; inflatefuture periods¶ results) by deflating current-period revenue or byinflating current-period expenses.

Certain shenanigans can be fairly benign, whereas others may bemore harmful for investors. In general, shenanigans that inflaterevenue should be considered more serious than those that effectexpenses.

Not surprisingly, the share price invariably performs poorly after acompany begins using financial shenanigans. Moreover, when

companies use particularly egregious shenanigans, the stock pricedecline will generally be steeper and more permanent.

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There are two obvious reasonsfor this:

Generally, companies that usesuch accounting chicanery areattempting to cover some major

operational deterioration in the business. The truth concerningthe operating problem willsoon become known byinvestors.

Such chicanery leads investorsto lose faith in management¶sintergrity, causing the stock toremain out of favour for a longtime.

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Warning Sign and Lesson from Enron

Investors should be vary whenever acompany dramatically changes its businessmodel, particularly from one easilyunderstood by investors to another, far moreobtuse and difficult to evaluate and monitor.

Other warning signs in the Enron debacleinclude numerous related-party activitiesand self-dealing by senior executives, largestock sales by directors and officers, and themysterious resignation of a rather youngCEO.

Also, the company showed arrogance in itstreatment of financial analysts who were

asking probing questions about itsaccounting and disclosure policies.

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Malaysian Case

Transmile, the highest-profile example of financial irregularities that rocked

the Malaysian market after a special audit, somewhere in June 2007, found it

had incurred losses and not profits, for its last two fiscal years.

"The Securities Commission has already commenced their investigations and

will decide on the appropriate action upon completion of the investigations."It

is important that when these breaches occur, immediate action is taken against

wrongdoers," the Securities Commission said in its statement in The Star dated 17 July 2007.

"In this regard, the Securities Commission has built a strong set of

investigative and enforcement capabilities and as evidenced by the actions

taken, those committing breaches of securities laws are dealt with severely."

Besides Transmile, recordable disc maker Megan Media Holdings, state-

controlled lender Bumiputra-Commerce Holdings and small technology firm

Wimems Corp. were among local firms that have reported some form of

financial irregularities recently.

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On 17 Dec 2007, The Star,Malaysia's SecuritiesCommission (SC) said it hascharged three directors of air cargo company TransmileGroup Bhd for providingmisleading information on

the company's financialstatements for 2006.

The three directors are GanBoon Aun, Khiudin binMohd and Lo Chok Ping.Gan is the founder of Transmile and was chief

executive officer until thetime he resigned voluntarilyon June 19.

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Watch for poor Internal Control

Management may have littledifficulty distorting financial reportsif the company has weak internalcontrol. Such controls relate to theorganizational structure and tocorporate procedure to safeguardingassets against losses and ensuring therealiability for financial records for external reporting purposes.

Strong control (i.e.checks and balances) tend to reduce thetemptation for management toengage in shenanigans. If safeguardand control are lacking, however,unethical employees may engage inshenanigans with impunity. Whileindependent auditors scrutinize the

adequacy of these controls, it may bedifficult for readers of financialstatements to ascertain whether thecontrol contain weaknesses.

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R egulators

Regulations provide a framework inwhich to govern the conduct of companies, directors, management and professionals. So long as there is anincentive to cheat, the temptation willalways exist and we see corporate

scandals occur even in highlydeveloped jurisdictions and all the parties involve from regulators toindustry professionals to investors, willalways need to be vigilant.

Front-line control is exercised by boards of directors, senior managementand the auditing profession. In thisregard, building a strong internalculture of integrity and compliance isthe most effective tool in pre-emptingoccurrences of fraud.

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The government should encouragecompanies not just on business performance but also on environmentaland social performance. There is also aneed to educate and create awareness of the benefits of reporting beyondcompliance or minimal reporting. Wherecontrols are ineffective or breached, andirregularities surface, the board of directors must take accountability and pursue the necessary actions such asundertaking special audits. In someinstances, the regulator is able to detectthese developments early and, sometimes,they may be alerted later. However, the

boards of directors must meet their responsibilities and it is important toensure that any action on the regulator partdoes not dilute the accountability of the board.

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When discussing corporate corruption,

we need to take a long hard look at theauditing profession and the role

played by auditors. In Malaysia, we

have had so many banking and

financial scandals involving billions of

ringgit, but can anyone remember the

last time where an audit firm exposed

major corruption and fraud or when an

audit firm was charged with

negligence for not exposing fraud?

True, external auditors are only

supposed to be watchdogs (to certify

that a firm¶s accounts reflect a ³true

and fair´ view of its performance) andnot bloodhounds (out to detect all

corrupt practices). Nonetheless, they

should be able to detect obvious and

major fraud staring in their face.

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Auditors are supposed to be independent and professional.Far too often though, the partners of audit firms develop acosy relationship with their clients. Auditors rely for their income on audit and consultancy fees paid by their clients.In these circumstances, how independent can auditors be if one of their major clients decides to ³massage´ the figuresand indulge in ³creative accounting´?

Will auditors be willing to act as whistleblowers if

prominent politicians are involved in dubious corporate practices.

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Enron exposed how even so respected a firm of auditors asAnderson could work hand-in-glove with their clients in destroying

evidence. On the local front, what do the external auditors of

Perwaja Steel, for instance, have to say for themselves for not

signalling that something was seriously wrong with firm?

In this regard, it is heartening to note that whistleblowers will be

protected under the new Act (CMSA) aimed at improving corporate

governance. But it is not enough for whistleblowers only in the

private sector to be protected. What is needed is a comprehensive

Whistleblowers Act to provide wide-ranging protection for

whistleblowers in all sectors - whether in political parties, NGOs,

the private sector or the government.

If Mark Twain had lived to see the first decade of the

21st century he'd have modified his famous quote to

say, "There are lies, damn lies and CFE's (creative

financial engineers)«..Thank You

MusbriMohamed

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How Companies Try to Hide Their Problems - Financial Shenanigans

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