Court Cases

This session is about cooking the books. Creative accounting. Aggressively manipulating earnings.

Accounting isn’t black and white. Accounting requires judgement. Financial information can be pessimistically, optimistically or even fraudulently prepared.

Earnings drive value. So aggressively increasing earnings pushes up the value of a business.

Overstated earnings also means either assets are overstated or liabilities are understated. How do you know if your client is getting a rough deal?

• In a sales transaction is the vendor overstating earnings and so artificially inflating the sales price? Is your client paying too much?
• In a matrimonial matter, is the other party understating business earnings to artificially reduce the value of their equity stake?  Is your client getting less than they should?

This informative presentation, in association with the Queensland Law Society, is for all lawyers who deal with disputes or transactions.

In this seminar, Simon looks at some of the key ways earnings are manipulated and how accounting shenanigans led to some of the world’s largest corporate collapses.

Queensland Law Society Symposium 2017. Saturday 18 March 9.45 am to 10.30 am. More details here

Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the largest Bernie Madoff feeder fund. He has also held senior management positions with Deloitte and Crowe Horwath.

“Monetise” assets – turn future revenue into profit now

What’s the point in having assets which you know are going to create great future profits streams, when what your investors want is profits now? What you need to do, according to Jeff Skilling (former CEO to Enron), is to “monetise” those assets.

Make your best guess of what cash flows you think that asset will generate in the future (don’t be too conservative), work out the present value of those cash flows and then recognise that value in your financial statements.

NB. In very simple terms, the prudent approach in accounting is to adopt a cost approach to valuing assets. In some cases though this approach isn’t appropriate, for example, for valuing financial investments like traded stocks. In this case, under accounting standards, those investments can be valued at Fair Value, that is to say their market value. This is also also known as mark-to-market accounting. If the market value of the investments has increased over the year, then this increase is recognised as a gain in the income statement. Conversely, if the value of the investments has fallen in the year, this is a loss and reduces your earnings.

Mr Skilling, together with the former Enron CFO Mr Fastow, were “Monetising” geniuses (or is that genies). They aggressively adopted mark-to-market accounting for contracts. That is they inflated asset values and thus artificially increased earnings.

The Blockbuster Agreement

As a simple example, in July 2000 Enron signed a highly innovative joint venture agreement with the then video rental global leader Blockbuster. Blockbuster at its peak had 60,000 employees and over 8,000 stores.

Blockbuster were to supply internet video content over Enron’s fibre network. Enron worked out the cash flow this content service would achieve (using “managements’ best estimates”). Enron calculated the present value of the Blockbuster contract at $125 million and then sold the contract to an off balance sheet, special purpose vehicle, named Hawaii 125-0!

The discussions (and the agreement) with Blockbusters quickly collapsed. One of the reasons for the collapse was that the management team at Blockbusters considered themselves a major player in Hollywood; where as Enron were perceived to be an upstart in the communications world.

After the collapse, instead of writing down the value of the deal, Enron wrote up the value of the content service concept by another $58 million. The logic behind this was that Enron now had the freedom to start discussions with any other supplier; which was deemed more valuable than an exclusive content supply agreement with Blockbusters!

Ironically, Blockbusters filed for bankruptcy in 2010 due to a significant competition from video on demand services, such as Netflix.

The end result

The problem with optimistically recognising future revenue, is that you then have more to do in the following year to meet earnings targets and support the share price, ie. you have to be even more devious. Which is ultimately what happened. The accounting web at Enron became more complex and convoluted until it imploded and Enron filed for bankruptcy.

Fastow pleaded guilty to two charges of conspiracy and was sentenced to ten years with no parole. Skilling was convicted of federal felony charges and sentenced to 23 years.

Skilling’s closest friend at Enron, Clifford Baxter, the chief strategy officer, was sued personally for $30 million due to selling his Enron stock prior to the bankruptcy. A month prior to giving testimony, Baxter was found dead in his Mercedes, having committed suicide with a gunshot to his head.

Next Week: #1 Make the numbers up – Uncle Bernie

Simon Cook, Director, Lotus Amity

Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their national forensic practice. Simon has assisted in many legal matters, including transaction disputes, damages claims, shareholder disputes and matrimonial matters. Simon is a Fellow of the Institute of Chartered Accountants of England and Wales and a Certified Fraud Examiner.

Want to get rich quick? Need to quickly improve your bottom line to meet or beat market earnings expectations? No problem. These are five sure fire ways to magically fix your books – as practiced by the best. In this case Enron.

#3 Turn assets into equity – off balance sheet vehicles

Off balance sheet Special Purpose Vehicles (SPVs), allow a company to move assets and liabilities off a company’s balance sheet, whilst still potentially using those assets.

If you can transfer an asset off your balance sheet to a separate entity for more that the value it’s sitting on your books, then you can potentially recognise that difference as a gain in earnings. Voila. Increased earnings!

Andrew Fastow, once the CFO to Enron, is the off-balance sheet vehicle legend. At Enron he created 3,000 separate, off balance sheet, corporate entities!

Smoke & mirrors

Fastow used the SPVs for a variety of purposes, including collateralizing debt and moving impaired assets. In simple terms, he created a web so complex that it was impossible to discern the true liability position of Enron and enabled him to inflate earnings. [To boot, Fastow invested his own money in some of the SPVs and took out $60 million in fees!]

How it should work

According to International Financial Reporting Standards if a company (parent) controls an entity (a subsidiary), then consolidated financial statements need preparing. That is to say, all the assets and liabilities of the parent and subsidiary SPVs are added together in to one set of accounts.

So if a company retains control of an SPV then the consolidation defeats the purpose of the arrangement, ie. the asset and liability would still show on the consolidated balance sheet.

When control isn’t control

Control is usually considered to exist if 50% or more of the equity is held.

Arthur Andersen, the auditors to Enron, advised (rather dubiously) that if an “oversight committee” was in place at an SPV, then Enron could retain more than 50% of equity without actually having control. Not having control meant the assets and liabilities could be moved off the balance sheet.

In reality, all the Enron SPVs were run by the Enron management team, directly or indirectly, i.e. Enron had full control!

Create artificial gains on disposal

A common use of the SPV’s was for Enron to sell assets at above their book values (the values in the balance sheet) to the SPVs. Selling an asset at above book value can results in a gain, which potentially goes to the income statement, ie. increasing earnings.

Classify gains on disposal as operating profit

A gain on the sale of a fixed asset or investment isn’t usually part of the core operations of a business – unless that’s what the business specialises in. So a gain on the sale of an investment needs to be classified in the income statement as a one off gain.

Enron very rarely recognised these SPV disposal gains as one off, but hid them in operating profit, ie. giving the impression that these were repeatable earnings. Which to an extend they were, because they kept repeating the sham in subsequent periods!

Don’t impair assets

The assets and investments that were sold to SPVs were often ones that were about to be impaired, ie reduced in value. This was because Enron had overpaid for or overvalued the asset in the first place – which happened a lot.

An asset impairment is recognised in the income statement, ie. it reduces earnings. Enron very rarely impaired assets!

Guarantee SPVs with equity

Enron were able to support selling assets at over value to an SPV because Enron guaranteed the investments, with Enron stock, to the outside investors. These guarantees don’t show on the balance sheet but are hidden in the disclosure notes of the financial statements. With 3,000 off balance sheet vehicles, the Enron disclosure notes were some what complex!

These SPV guarantees were all well and good while the Enron stock price was rising, but as soon as it started to fall, covenants were breached and the true liabilities came to fruition. All $23 billion of them!

End result

In 2001 Enron filed for bankruptcy, which was then the largest in history (until WorldCom’s bankruptcy a year later).

Fastow pleaded guilty to two charges of conspiracy and was sentenced to ten years with no parole.

While Enron was imploding, an email was sent round to Andersen staff about document retention policy, which led to the shredding of thousands of documents.

This resulted in Andersens being charged with obstruction of justice (the conviction was subsequently overturned). This, amongst other failings, led to the downfall of Andersens and its 80,000 employees.

Next Week: #4 “Monetise” assets – turns future revenue into profit now

Simon Cook, Director, Lotus Amity

Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their national forensic practice. Simon has assisted in many legal matters, including transaction disputes, damages claims, shareholder disputes and matrimonial matters. Simon is a Fellow of the Institute of Chartered Accountants of England and Wales and a Certified Fraud Examiner.

A little messy to cover up but a simple rule to follow. Rather than being over prudent with your customers and their debts, simply assume they are all going to pay and don’t make any provisions.

If a customer who hasn’t paid goes out of business, don’t write the debt off just leave it on the books, because hea, you never know what might happen in the long run. As the classic economist Keynes said “in the long run we are all dead”, so it doesn’t much matter.

N.B. Accountants have to make judgments about how to reflect future uncertain events in the financial statements. So for example, a judgement on the likelihood or not of collecting the customer accounts receivable balances. In accounting there are a number of fundamental concepts, one of which is the Prudence Concept. Under the Prudence Concept Accountants have to be prudent or cautious in their judgments so assets aren’t overstated and liabilities aren’t understated. Provisions are a means of being prudent, in effect accruing for costs now so that assets aren’t overstated.

MCI & Walter Pavlo

Walter Pavlo, a billing & payment executive at MCI Communications (before MCI was acquired by the mighty WorldCom), became an expert at “cleaning up” the resellers debtors book. Resellers sold on MCI line capacity and were notoriously bad payers (ie. dodgy). Coincidentally, or not, WorldCom was one of MCI’s biggest reseller customers.

MCI finance chiefs set the ethical path for Pavlo, cleverly converting a debtor amount to a promissory note. Caribbean customer CT&T owed $55 million and even though the debt was highly unlikely to be collected (and it never was), it made more sense having it as a promissory note asset rather than appearing on the pesky aged receivables report.

Pavlo introduced an innovative collection practice. As cash came in it was allocated to aged receivable balances that were due (as you do) but not necessarily to the customer who paid it – otherwise known as Lapping receipts. The following month the cash got properly reassigned to the account of the customer that actually paid it and the old bad debt it was covering would go on the books as a new balance that wasn’t yet due. Happy days.

Pavlo got quite Lappy Happy and thought it would be helpful if he, and his business partner, personally took discounted payments of $6 million (through the Cayman Islands) from struggling customers and made their MCI debts “disappear”. Unfortunately, bad debts don’t “disappear” for very long. The FBI caught up with him and he was sentenced to three and half years in prison.

Three months after Pavlo went to prison, a class action was filed against WorldCom, alleging that of the telecom reseller accounts WorldCom had inherited from MCI, half were three-to-seven years past due. Of course when you’re in an industry boom, who needs due diligence!

Next week: #3 Turn assets into equity – off balance sheet vehicles

Simon Cook, Director, Lotus Amity

Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their national forensic practice. Simon has assisted in many legal matters, including transaction disputes, damages claims, shareholder disputes and matrimonial matters. Simon is a Fellow of the Institute of Chartered Accountants of England and Wales and a Certified Fraud Examiner.

Source. “Stolen without a gun”, Walter Pavlo Jr.

For valuation purposes Fair Market Value and Fair Value aren’t the same. Not knowing the difference could be a costly mistake.

Fair Market Value

Fair Market Value is a commonly defined in the valuation world. It’s the negotiated price between a willing buyer and willing seller in an open and unrestricted market. Where the buyer and seller are acting at arms-length. The parties are knowledgeable and not anxious to do a deal.

So in efficient free global stock markets, where share prices reflect all relevant information, then we could assume that the stock price indicates the Fair Market Value of a small parcel of shares (not control) of a listed company. Of course, this depends on a number of further assumptions, such as there being plenty of buyers and sellers for the stock, ie. the stock is liquid (which many smaller caps are not).

Bid Price?

As an example, say we take a business to market in a structured way. We contact all potential buyers all over the world, including competitors, private equity, wealthy individuals, consolidators, etc. We create a orderly, timely and competitive bid process. So would the various bids give us a Fair Market Value range?

Probably (hopefully) not. If the competitive bid process was so good, it would artificially push up the price as the buyers become anxious to buy. Which is of course exactly what we do want to happen.

Buyers might start to incorporate synergy benefits in their offer pricing, ie. share some of the future anticipated value with the seller. The Fair Market Value definition doesn’t include any synergy benefits.

Price v Market Value

As Warren Buffet famously points out:

“Price is what you pay. Value is what you get”

Mr Buffet should know. He’s made his vast fortune in identifying and exploiting the difference – to the chagrin of a number of seemingly hoodwinked business owners charmed by Mr Buffet’s amiable advances.

Just because the market says a stock price is so and so it doesn’t necessarily hold that is the value of the stock. Price is an objective guide. Valuation is subjective.

Fair Value

Fair Value is a whole different beast. Where as Fair Market Value is commonly defined by the valuation bodies, Fair Value is a term often incorporated in legislation and so we need to look to the courts for interpretation.

As an example, in the Delaware Courts in the US, where there is significant Fair Value related litigation, the courts have generally found the following in relation to defining Fair Value:

• there should be no discount for lack of marketability¹
• Fair Value represents a proportionate interest in a going concern²
• Fair Value represents the investment position of the shareholder³

Simply put, this would mean that the Fair Value could potentially be worth (significantly) more than Fair Market Value.

Which practically seems to makes sense. If you’re a minority shareholder (say 5%) in a privately held small business and you’re being oppressed by the other majority shareholder (95%), then the Fair Market Value of your stake isn’t going to be very much. Who is practically going to buy the shares?

However, your pro-rata share of the value of a 100% controlled business as a going concern investment is going to be quite different. Or simply putting it another way, if all the shares were sold in an orderly market transaction and you got your 5% what would that be worth. A whole heap more!

1. Swope v Siegel-Robert, Inc, United States District Court, 1999
2. Tri-Continental Corp v Battye, Delaware Supreme Court, 1950
3. Cavalier Oil Corp. v. Harnett, Delaware Supreme Court, 1989

“In its report into the company’s failure, not presented to court, liquidator McGrathNicol found that as sales fell, Dick Smith increasingly made purchasing decisions based on rebates the company could earn rather than what customers actually wanted to buy.”

This all sounds very familiar to the aggressive accounting Tesco adopted in relation to supplier receipts.

In the case of Tesco, supplier contributions, that were dependent on hitting future retail sales targets, were booked even when those sales targets were unlikely to be achieved. Thus overstating sales. This aggressive accounting can be hidden to a degree providing sales keep growing. As soon as sales begin to decline, as they inevitably did, there is nowhere to hide!

In the case of Dick Smith, it appears that supplier rebates were booked as a reduction in marketing expense, rather than a reduction in the value of stock. Thus inflating profit and stock. Happy days. The problem is the stock proved to be unsaleable.

What is a rebate and what do you do with it?

“A rebate is an amount paid by way of reduction, return, or refund on what has already been paid or contributed.” So unlike a discount it is money that comes back to customers after the purchase.

In terms of treatment, according to PWC “Rebates typically relate to cost of goods sold and are therefore captured under AASB 102 Inventories. These should then be recognised as a reduction in cost of sales when the inventory is sold rather than recorded as income upfront.”. Which seems the obvious prudent approach.

But oh dear, as PWC go on to explain, it is not that straight forward. “In reality, rebates are often complex arrangements reflecting the different elements of the goods and services exchanged between suppliers and retailers. These include not only the purchase of the inventory from the supplier, but also the marketing and promotion services retailers may coordinate and provide to suppliers. The accounting should follow the substance of these arrangements.”

All of a sudden life’s got a bit complicated! But to my simple mind this sounds (from the allegations) like an aggressive accounting timing technique, bringing forward profits now when in fact they haven’t (and may not) be achieved. Which ultimately comes from the blinded obsession with earnings and earnings growth and ignoring cash flow and working capital management.

Simon Cook, Director, Lotus Amity

Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their national forensic practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the largest Bernie Madoff feeder fund. He has also held senior management positions with Deloitte and Crowe Horwath.

The old and easy classic. As exemplified by the railway companies in the mid 1800’s. Too much operating cost burning up your bottom line? Move it over to your balance sheet and depreciate it over a nice long period of time. Hey presto, improved profit and a healthy balance sheet.

Scott Sullivan is the expense capitalisation guru. Sullivan was the CFO at WorldCom. WorldCom, through aggressive acquisition, became the second largest long distance telephone company in the US and at its peak had a market cap of $186 billion.

Under cleverly titled “prepaid capacity” journals, Sullivan successfully capitalised $3.8 billion of leased fibre line costs; which were otherwise interfering with operating profits. With the implosion of the telecom boom, there was little usage of these leased fibre lines. Sullivan used the accounting Matching concept to justify deferring these costs until revenue picked up.

[The Matching concept states that a business must charge expenses to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned. The problem is those expenses were monthly fibre leases, ie. the fibre could only generate revenue in the month the fibre was leased.]

Internal audit and the external auditors, Arthur Andersons, also didn’t agree with Sullivan’s interpretation of the Matching concept and handed him over to the authorities. Scott cut a deal to testify against his boss and pleaded guilty to securities fraud and was sentenced to five years. A good result for Scott, given that his boss, cowboy booted Bernie Ebbers, got 25 years for fraud and conspiracy.

Interestingly, Anderson’s in their audits hadn’t picked up on the $3.8 billion expense capitalisation, as the auditors concentrated on Control Testing and Analytical Review. Analytical Review is where the auditors compare figures to prior periods and look at industry benchmarks to check to see if the ratios are sensible. WorldCom had great looking ratios and expense margins were consistent with the industry players. When asked how the “prepaid capacity” costs were calculated, Sullivan said they were based on what they thought the margins should be, ie. the industry benchmarks!

To be fair to Andersons, they did do some capitalisation sample testing and kindly gave advanced notice to the management team of the fixed asset accounts they would be reviewing. One of those accounts to be tested did include some of the $3.8 billion “prepaid capacity” transactions. The management team promptly made sure that transactions moved to another account before the audit team arrived.

In 2002 WorldCom became the largest US bankruptcy with the loss of nearly 30,000 jobs.

Next week: #4 under state your provisions

Simon Cook, Director, Lotus Amity

Simon specialises in providing forensic accounting services. Prior to founding Lotus Amity, he was a Forensic Accounting and Corporate Finance partner with BDO Australia and led their national forensic practice. Simon has assisted in many legal matters, including transaction disputes, damages claims, shareholder disputes and matrimonial matters. Simon is a Fellow of the Institute of Chartered Accountants of England and Wales and a Certified Fraud Examiner.

Reference: “Extraordinary Circumstance: The Journey of a Corporate Whistleblower”, Cynthia Cooper