The purpose of this assignment is investigation how credit crunch issues is widespread in the world and what is the quality of financial statement. This will be shown by analyzing the fraud in financial statement of Enron and WorldCom.
Background:
The collapse of Enron and WorldCom
Company
Assets (Billions)
When filed
WorldCom
$103.9
July 2002
Enron
$63.4
Dec.2001
The financial statement Enron Corporate and The methods of Enron Corporation that used to the fraud of the financial statement
Table 1: Annual report 2000 (Enron corp. 2000)
Table 2: Compare revenues of the Enron during the period 3 years (Enron corp. 2000)
According to SEC in November 2001, Enron announced the new Financial Statement in, which was re-statement during the 4-year period from 1997 to second quarters of 2001.
Table 3: Consolides the statement of earnings (in millions) (U.S. Securities and Exchange Commission 2001)
1997
1998
1999
2000
1st Qtr 2001
2ndQtr 2001
Net income as reported
$ 105(a)
$ 703
$ 893
$979
$ 425
$ 404
Restatements:
-Consolidation of JEDI and Chewco
(28)
(133)
(153)
(91)
6
-
-Consolidation of LJM1 subsidiary
-
-
(95)
(8)
-
-
-Raptor period proposed audit adjustments
-
-
-
-
-
-
-Prior period proposed audit adjustments and reclassifications
(51)
(6)
(10)
(38)
29
5
Net income as restated
$26
$546
$635
$842
$460
$409
From the graph, we can see that there is a considerable increase in the Net income as report. In fact, net income is smaller than they reported causing Enron hided reduced income that the majority come from JEDI, Chewco.
Table 4: Enron corp. financial restatement (in millions) (U.S. Securities and Exchange Commission 2001)
1997
1998
1999
2000
1st Qtr 2001
2ndQtr 2001
Diluted shares outstanding, as report
555
695
769
814
872
891
DILUTED SHARES RESTATED
553
686
755
801
862
891
Diluted EPS as reported
0.16
1.01
1.1
1.12
0.49
0.45
DILUTED EPS RESTATED
0.02
0.82
0.87
0.97
0.53
0.46
Total assets as reported
$22,552
$29,350
$33,381
$65,503
$67,260
$63,392
Restatements:
Consolidation of JEDI and Chewco
451
160
181
(161)
6
6
Consolidation of LJM1 subsidiary
-
-
(222)
-
-
-
Raptor period proposed audit adjustments
-
-
-
(172)
(1,000)
(1,000)
Prior period proposed audit adjustments and reclassifications
(79)
(68)
(68)
(244)
(1,087)
431
TOTAL ASSETS RESTATED
$22,924
$29,442
$33,272
$64,926
$65,179
$62,829
Equity as reported
$ 5,618
$ 7,048
$ 9,570
$11,470
$11,727
$11,740
Restatements:
Consolidation of JEDI and Chewco
-258
-391
-544
-814
6
6
Consolidation of LJM1 subsidiary
-
-
-166
60
60
60
Raptor period proposed audit adjustments
-
-
-
-172
-1,000
-1,000
Prior period proposed audit adjustments and reclassifications
-51
-57
-136
-255
-287
-19
EQUITY RESTATED
$5,309
$6,600
$8,724
$10,289
$10,506
$10,787
Debt as reported
$ 6,254
$ 7,357
$ 8,152
$10,229
$11,922
$12,812
Restatements:
Consolidation of JEDI and Chewco
711
561
685
628
-
-
Consolidation of LJM1 subsidiary
-
-
-
-
-
-
Raptor period proposed audit adjustments
-
-
-
-
-
-
Prior period proposed audit adjustments and reclassifications
-
-
-
-
-
-
Debt restated
$6,965
$7,918
$8,837
$10,867
$10,506
$10,787
From the chart 2 and table four, we can see clearly In Enron were considerable number of partnerships (JEDI, Chewco), which had led to Enron hided a significant debt. The larger amount of Enron debt rose by borrowing JEDI and Chewco. This is one of the methods of Enron primarily used to cover debt (U.S. Securities and Exchange Commission 2001)
In brief, Enron did not announced adequate information in financial statement in order to reduce tax payments and blow-up income and profits and to raise the price of share (the high stock price was vital issues to the survived of Enron corporation (Peter 2002: 91) and credit rating. Furthermore, Enron created many partnerships and used partnerships to hide debts.
2.2.1. The system of operation to product the financial statement of Enron
Looking first at how Enron can cheat in their financial statement. This will be explanation by analyzing their process of making financial statement (Peter 2002: 41-2) in the graph below in order to have clearly understanding.
Former Enron (Chief Financial Officer Andrew Fastow)
)
Enron Board of Directors
Audit Committee
Auditors Arthur Anderson
Financial statement
The culture of Enron Corporation was concentrate profit and how to create greater profits (Peter 2002: 47). Thus, every individual in Enron need do like what Directors want do including accountants and the another firms have the same benefit.
2.2.2. The methods of Enron Corporation that used to the fraud of the financial statement
One of the methods that Andrew Fastow used on financial statement fraud is he set up the use of Special Purpose Entities(SPEs) so that to finance the purchases and take out of accounting report. In 1997, there are arguments in SPE issue which known like Chewco (Peter 2002: 61).
Some summary about SPEs:
Original had a good business purposes
Really a joint venture between sponsoring company and a group of outside investors.
Cash flows from the SPE operations are used to pay investors.
However, Enron had used SPEs to:
Hide bad investments and poor-performing assets (Rhythms Net connections). Declines in value of asset would not be recognized by Enron (Mark to Market)
Hide debt (borrowed money was not put on financial statements of Enron)
Quick execution of related-party transactions at desired prices. (LJM1 and LJM2)
To report over $1billion of false income.
Many SPE transactions were timed ( or illegally back-dated) just near end of quarters in order to income could be booked just in time and in amounts needed, to meet investor expectations.
Mark-to-Market accounting means that it is re-assessed in the valuable in each asset and changes in value are reflected in balance sheet and income statement in the company.
Forced sales in illiquid markets set prices
Drive asset values to insolvent levels ( despite the absurdity that mark-down of liabilities increase profits)
Risk of facing an insolvent counter-party generates runs: wholsesale and quasi-retail
Table 5: The different in financial statement frauds between 2 company WorldCom and Enron
WorldCom
Enron
Overstating Asset Frauds by used EBITDA
Understating Liability/ Expense Frauds
The frauds was simple
The frauds was very complicated: many compound transactions and accounting issues
The company, which the second largest in USA is WorldCom, during the 2-year period from 2001 to 2002, WorldCom had overstating income by 3.8 billion dollar in order to evade reporting losses. In fact, there was not the relevance of access fees that paid to local telephone firms with revenues. Because the access fees known as operating costs that will be minus from EBITDA, so EBITDA would reduce. On the contrary, there was not only an increase in the current EBITDA, but also increase in the future EBITDA by capitalizing the costs (Stephen 2007:48-9)
The price of WorldCom share traded at 64 dollar per share over the period telecom bubble, but in 2002, the share price had decreased rapidly to just under 1 dollar per share. This had led to the collapse of WorldCom (Stephen 2007:48)
3. Credit crunch and quality of financial statement
3.1. Credit crunch
There is undeniable that credit crunch reveal in the recent global recession. For find out that reason, this quite appropriate to looking at why and how credit crunch occurs.
There are number of reason why this financial crisis happened (credit crunch). The credit crunch started in 2007 with the bankrupt of Lehman Brothers, which is one of the most important in the US institutions. When looking at accounting practice, some author have argued that when using fair value accounting, this led to the credit crunch has been getting worsen. This will be difficult to value what is fair value have; thus, many people who control stock market and politicians have arguments for these issues with excessive political preventive in the worldwide (Emerald 2009).
On the other hand, in the collapse of Enron and WorldCom, auditors play the important role in the credit crunch occur, which received limited information with opaque reporting. For instance, auditors have change audit report; the role of banking and business; in addition the compound financial instruments (Emerald 2009).
3.2. Quality of financial statement
There is evidence to suggest that increasing in the number of financial statement frauds in many firms in order to increase earning; however, these frauds can just sustain in the short term and then this will effect on the stock price in this company. For example, the fraud in financial statement of Enron and WorldCom had led to sudden drop in their price of share during the bubble stock market burst in 2001(Stephen 2007:632)
This wills obsever who is the person that responsibility for quality of financial statement. There is no doubt that with good quality of financial statement leading to do not occur credit crunch. Because financial statements include income statement, balance sheet, and so on that is open information (Jorion 2003).Therefore, How to avoid financial statement frauds is essential.
Solution
