Corporate Fraud Research Paper

I have researched several examples of corporate fraud and would like to discuss them in detail and show which role auditors have played in discovering the fraud. The paper also discusses which steps and procedures can be used to detect fraud.

The first case I would like to discuss is one of the most famous examples of corporate fraud. The company called Enron arose out of the merger of Internorth, an Omaha-based pipeline company, and Houston Natural Gs in 1985. Starting out as a regular gas pipeline company, Enron soon began to diversify its business by becoming an intermediary between gas producers and local utilities. In addition, Enron began to offer so-called ‘weather derivatives’, offering insurance coverage against, for instance, mild weather that could dig into utilities’ profits. As a result, Enron moved out of its core area of expertise and undertook projects and risks far removed from its core competence.

The result was financial loss, a common situation in any business. What differentiated Enron from other money-losing businesses was the choice of Enron executives to cover up the fact through fraud. One way in which they cooked their books was the creation of SPEs (special-purpose entities) that are supposed to be independent of the company, but in fact often represented entities directed controlled by Enron’s executives, facilitating questionable transactions. Thus, Enron sold an asset to the Raptors SPE, controlled by Enron’s CFO, at the end of the quarter, repurchasing it at the beginning of the next one (Stice, Stice & Skousen 2004:5-6). In December 1999, Merril Lynch’s managers helped Enron by paying “$7 million for a stake in the three energy-generating barges moored off the Nigerian coast” in return for the promise “to buy back Merrill’s investment, with interest, six months after the sale” (Calkins 2004). The transaction should have been accounted for as a loan, but Enron was able to show a profit.

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The fraud came to the surface when Enron reported a special accounting charge of $1 billion and promised to restate financial results for the previous four years. As a result, value of Enron’s stock dropped 91%, ending at $0.26 per share (Lerach Coughlin). Losing credibility with sellers and buyers, the company filed for Chapter 11 bankruptcy on December 2, 2001.

The direct consequence of the Enron fraud was the realization of the greater need for monitoring corporate activities and reporting. Accounting regulators rushed to cover loopholes that allowed Enron to overstate profits. The regulatory onslaught on fraudulent CEOs was most vividly demonstrated in the Sarbanes-Oxley Act of 2002. This law tightens accounting reporting rules for corporations and establishes Public Company Accounting Oversight Board to supervise auditors of public companies. Section 404, “which requires establishment of extensive new internal controls for financial reporting” has evoked energetic protest on the part of companies that complain of the excessive cost associated with compliance (Bartlett 2005). However, the post-Enron world is likely to see more regulations that will address the issue of strengthening corporate governance. The case of Enron will be often invoked to justify tightening of supervising and reporting procedures.

The second case of corporate fraud perpetrated in HealthSouth Corporation that boosted its cumulative earnings in the amount ranging from $3.8 billion to $4.6 billion, according to the data from PricewaterhouseCoopers January 2004 report. This case was considered to be of special interest, as it occurred in the post-Enron, and most importantly, post-Sarbanes-Oxley world, and demonstrates that accounting scandals did not vanish with the introduction of the new legislature.

The primary perpetrator of the fraud was found to be the company CEO Richard Scrushy, charged with accounting fraud by SEC on March 19, 2003. The chief executive bullied his subordinates into being his accomplices in the scheme, reminding them that they are already involved in the crime, promising them financial incentives and reassuring them that the fraud will turn out just fine as everything has been taken care of. Scrushy also used the recommendation of forgiving corporate loans to those people who participated in his scheme and controlled his co-conspirators by reading their e-mails.

The main driver for the CEO was the necessity to meet analysts’ forecasts and expectations. The executives of HealthSouth who faked financial records regularly received bonuses and other rewards based on financial results. Through inflating HealthSouth’s stock price they also raised the value of their stock compensation. The need to falsify records came ahead of a projected reform in health care industry, closure of reimbursement opportunities, when the company for the first time faced the threat of missing analysts’ projections.

One of the elements of the fraud was the concealment of fraudulent assets through the active acquisition of assets. HealthSouth bought a string of rehabilitation clinics and outpatient surgery centers to expand its business in the 1990s, even though the return on investment was decreasing at that time. Weld, Bergevin and Magrath have found that “all of the components of investment return decreased in the later four-year period” that elapsed between 1998 and 2001 (Weld, et al.).
This shrinking return on investment could raise the natural concerns of the auditors or analysts and served as a warning sign, or symptom: Why did the management pursue such an active acquisition strategy amid the decline in return rates?

One of the early symptoms that could have alerted the financial community to the possibility of a fraud going on was the volatility in the percentage of receivables estimated as uncollectible that ranged from 38.9% of gross accounts receivable to 12.2%. Besides, the provision for doubtful accounts for 1999 is distinctly higher than its average previous level. Also, the write-offs for uncollectible receivables were inconsistent (Weld et al).

Magrath and Weld described “reserves that are not correlated with balance sheet item” (Weld et al) as one of the warning signs that can be used by investors and auditors to detect possibility of fraud in a company. “Acquisitions with no apparent business purpose” are also on this list of potential warning signs that can be employed in the fraud detection (Weld et al).

HealthSouth used its bad-debt expenses to manipulate earnings, attempting to raise them in the years when the company was expected to perform poorly, and keeping these expenses low at the time when the company had to do well to meet expectations. Thus, the 1999 large write-off that constituted about 8.4% of the corporation’s revenues happened at a time when HealthSouth learned about the drop in analysts’ targets for its earnings.

The perpetrators of fraud at HealthSouth boosted patient statistical data in order to make these numbers chime in with the fraudulent financial information. The company made false entries in its income statements in order to boost its earnings to meet projections. The entries were not, however, made in those states where separate audits were required or where HealthSouth owned assets in partnership with doctors.

The company had weak internal controls as the whole process was controlled by the chief executive who kept a tab on the internal circulation of falsified financial records and supplied the auditing teams with false records.

HealthSouth added $175 million to its assets intentionally misinterpreting Medicare’s guidelined for reimbursement. HealthSouth also intentionally inflated the size of the company’s assets.

To conceal the fraud, the HealthSouth executives put millions of dollars into the capital expenditures account, that eventually led to an overstatement of earnings, according to Merrill Lynch analyst A.J. Rice who testified in the HealthSouth trial. She said that the numbers of HealthSouth’s capital expenditures were “significantly higher” than the numbers for companies in the same business. In the period from 1999 through 2001 HealthSouth’s capital expenditures twice exceeded the industry average (Reeves).

In an attempt to hide the misstatements, HealthSouth paid $300 million in tax on its US overstated profits that were overstated by $2,5 billion. In fact, however, the corporation was forced to borrow to cover that obligation. The company also artificially inflated its losses in 1998 that were caused by the alterations in Medicare policies. This fraud was perpetrated twice, the other time in 2002 when HealthSouth claimed that it had incurred expenses in prior years but did not fully assess the impact of those changes at the time. (HealthSouth: The Accountancy Fraud).

The fraud at HealthSouth was committed primarily through the creation of bogus revenue, and shifting of future expenses. Provoked by the trite reason of meeting analysts’ expectations, the fraud was originated by the CEO who could not reconcile to the loss of HealthSouth’s glamour. The scandal grew out of the ambitious corporate culture that opted for “fixing the numbers” rather than portraying the true nature of the company’s problems.

The third example I would like to discuss in the paper is corporate fraud done by Comverse Technology. Comverse Technology (OTC:CMVT) was founded in 1982 by Israeli Kobi Alexander. Through its 3 main subsidiaries, Comverse Inc., Verint and Ulticom, the company developed and supplied communication, recording and communication security solutions. Comverse was the inventor of the voice recording software that stands in the heart of the cell phones’ voice mail.

On March 14, 2006, the Company announced the creation of a special committee to investigate the company’s stock option grants to its executives and will postpone its filings to the 4th quarter of 2005.

Throughout the following days it has been made clear that during the years 1994-2001 several executives received “backdated” options, meaning that they were given at lower prices than their the true value of the stock at the day of issue. Wall Street Journal (2007) has found the odds for a random selection of these days (which were obviously always at low points) as about 1 to 6 billion.

One of the main implications was that the company would be obliged to review its financial statements of the former six years, since the change of the grant dates has led to two material changes in the company’s financial results: It has decreased the company’s expanse for the benefit it gave to the employees and as a result increased its profits or reduced its losses. The company was soon erased from NASDAQ and now it is traded in the pink sheet’s OTC list.

The SEC and US attorney’s office have commenced a thorough criminal investigation against the company. Executives Alexander (chairmen and CEO), David Kreinberg (CFO) and William Sorin (general counsel) resigned immediately afterwards and later were charged with criminal fraud. In addition to the act of backdating, the subpoena indicated other criminal acts, including that options were granted to at least 35 fictional workers, all were registered under the home address of Alexander’s personal assistant.

The criminal charge against the three executives was issued on August 9 2006. The FBI arrested Kreinberg and Sorin the same day and declared Alexander, who did not showed up to court, as fugitive. His investment accounts in the US were frozen. Several months later Alexander was located in Namibia, where his extradition trial is far from its end.

David Kreinberg pleaded guilty and became a witness in Alexander’s extradition trial. Former general counsel Sorin was sentenced to 12 months and one day in prison. He was also fined by 100,000 USD and agreed to pay a 3.1 million USD as compensation to the SEC.

The company has gone through radical changes, but recovered thanks to its strong technological capabilities. Traded over-the-counter, the company does not meet minimal SEC requirements (including financial reports) and therefore considered as relatively risky.

The initial announcement of the company was presumably published after knowing The Wall Street Journal is researching its option granting activities. During the following months the stock lost more than 40 percent of its value at the begging of March. In January 2007 the stock has been removed from the NASDAQ exchange and it is traded under Pink Sheets, after it has already been removed from the NASDAQ 100 and S&P 500 lists. Its current stock price is about 14 USD.

One year after the backdating scandal exploded the company’s March 2007 reports gave interesting insights on the internal implications of unethical behaviour.

First, the management and board were obviously completely different. Almost all of its Israeli executives left the company, although Comverse new CEO, André Dahan, was still a member of the company’s Israeli core.

Due to its strong product line and a growing demand, the company’s FY 2006 (ended in January 2007) revenues exceeded the former year. Its sales rose by more than 400 million USD, or 33%. The orders backlog (signed purchase orders) was also higher by 12% than the former year.

However, the bottom line was heavily affected from the backdating investigation. The company reported a “Special Committee investigation expenses” of 52.6 million. In addition, it had to adjust its stock option compensation since 1991 until 2005 by 314 million USD. As a result, the company finished 2006 with an operational loss of $40m, compared to a profit of $89 million the former year. Moreover, several material accounting mistakes were found, calling for additional costly adjustments.

Throughout 2007 Comverse Technology’s new management implemented several strategic decisions, including reducing at least 5% of its workforce and selling some of its operations, using the cash to repurchase its bonds.

In January 2008, following two years without financial reports, Standard and Poor’s slashed Comverse’s credit rating from a level of BB- to B+. However, most analysts have good estimations of the stock, setting its target price on an average of 21 USD.

Jacob “Kobi” Alexander still hides in Namibia, where he reinvented himself as a philanthropic and an investor. It is not clear if and whenever he will be extradited to face a US court.

Very little is known today about the true financial state of Comverse Technologies and its subsidiaries. The company keeps postponing the filings of its financial reports and therefore any financial analysis is merely based on rough estimations.

However, it appears that the despite its past fraud behaviour, the company is active and stable as ever before. I allow myself to assume that Comverse’s new management concentrates in recovering its financial reporting standards and general corporate governance and that this rather volatile stock will stabilize and leave the Pink Sheets.

Comverse Technologies is another example of corporate America’s main disease – greed. Executive compensation has lost proportions during the last 20 years. As revealed in a series of cases since 2006, stock option’s backdating was a normal practice in many large corporations. The market does not always punish the market for fraudulent conduct, although it is always the investor who pays the price for this behaviour. In the case of Comverse, it seems that backdating was a part of its generally problematic accounting standards, but its strong activity and real assets will help the company to find the way out of the crises.

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