Tag Archives: #accounting

Board Independence is Less Effective at Deterring Accounting Fraud in Family Controlled than in Publicly Held Corporations

An Annotated Bibliography by Todd Benschneider

Prencipe, Annalisa. Bar-Yosef, Sasson. “Corporate Governance and Earnings Management in

Family-Controlled Companies.” Journal of Accounting, Auditing and Finance. April 2011,

Vol. 26 Issue 2, p199-227. 29p. Database: Business Source Alumni Edition.

Annalisa Prencipe, PhD. and senior lecturer at SDA Bocconi School of Management with her team of researchers conducted a study of 249 firms to compare the quality (long-term sustainability) of profits in family controlled firms to earnings of publicly held companies. The study investigated the impact of “earnings management strategies” a term that The Journal of Accountancy defines as “the discretionary distortion of revenue, expense and depreciation schedules to optimize short term goals such as executive bonuses, budget targets or manipulation of stock prices.”  The results of the study were intended to provide accounting firms with new tools for identifying ratios and patterns that detect shareholder fraud in family controlled firms.

In publicly held firms strong incentives such as performance bonuses, performance reviews and salary bonuses lure executives to portray company financials in the most positive light, while concealing negative information from financial reports. However, over reporting earnings provides inaccurate feedback to the product development, finance and marketing departments who rely on accurate reporting to steer future products and operations strategy. Extended periods of inaccurate market feedback can undermine the long term economic health of the company. Stockholders can reduce mismanagement by electing an independent board of directors who hire, evaluate, supervise and fire top level executives to ensure that strategic decisions represent the shareholders’ best interest.

Prencipe explains that “A typical board structure is composed of outside directors and top company officers. Outside directors are appointed by the company’s shareholders and are assumed to be acting in the shareholders’ interests. However, the inclusion of top management among board members may give rise to a conflict of interest as management may attempt to transfer wealth from stockholders by taking advantage of information asymmetry. The results show that the increase in shareholder wealth is significantly higher when the board is dominated by independent directors.”

Recent trends in corporate governance now encourage firms’ directors to enforce accurate financial reporting. Board oversight can identify executives who exploit short range strategies that inflate profits to capitalize on performance bonuses. By the time the earnings management schemes unravel, the executives involved have often retired or moved on to other companies, which limits the legal recourse available to the stakeholders. Public demand in response to recently publicized investor fraud cases have prompted legislators to issue regulations that hold board members accountable to shareholders for fraudulent reporting of the executives they oversee. Regulatory changes in corporate governance have been eliminating the participation of company executives from the board of directors to reduce their influence over the boards’ objectivity, especially by eliminating CEO’s from also serving as the Chairman of the Board.

However, family controlled companies face different incentives to publish inaccurate financials, and further compounding the distribution of power, the CEO is often times also the largest stockholder of the company, entitling them to serve as the Chairman of the Board.  Prencipe wrote “Current literature suggests that, although founding family ownership seems to be associated, on average, with higher earnings quality, the extent of earnings management remains an open issue for family controlled firms. Since most families with controlling interest in their company possess a long term vision for growth and therefore make decisions that favor long range goals rather than boosting quarterly profits.”

Prencipe believes that while experts agree that there is less incentive for family controlled firms to over report earnings, that instead those companies manage earnings to secure the family’s controlling interests, minimizing the distribution of wealth to minority shareholders. She hypothesized that recent corporate governance restructuring would be less effective in family controlled companies whose self-interest lies in underreporting earnings, especially present in where the family also served in salaried executive positions by increasing family members bonuses or siphoning private benefits at the expense of other shareholders such as supplier kickbacks, travel expenses and other concealable business write offs.

The study was expected to validate previous research that had shown a lower incidence of earnings management under a board of directors with independent decision making authority, especially those boards lacking a CEO chair holder.  A board possessing low levels of independence has many of the company executives voting on board decisions, with the CEO also serving as the chairman of the board. In cases of a highly independent board the CEO does not hold a seat and possesses only subordinate levels of authority in regulating corporate accounting. However this study would specifically compare results from widely held public corporations against those from private firms and measure the estimated earnings management strategies present in the financial reports. Levels of earnings management in the companies would be calculated from a fraudulent accounting indicator: abnormal working capital accruals (AWCA).

Prencipe and Bar-Yosef conducted a study of Italian corporations by applying AWAC audit calculations to a sample of 249 Italian corporations consisting of four publicly traded corporate governance structures:

1-      Family Controlled with CEO on the Board of Directors

2-      Family Controlled with no executives on the Board of Directors

3-      Publicly Held with CEO on the Board of Directors

4-      Publicly Held with no executives on the Board of Directors

The intent of their study was to see if a correlation could be found that suggested that any of these four governance structures yielded a higher quality long range financial growth. The results validated several previous studies that found higher quality earnings generated by publicly held corporations with a highly independent board of directors. The results also supported Prencipe’s hypothesis that family controlled firms outperformed publicly held firms in earnings quality; however there was a less pronounced advantage to private firms with a highly independent board when compared to public firms with an identical governance structure.

Prencipe’s closed her article with:

“Our conclusions may lead regulators and academics to reevaluate the effectiveness of some corporate governance models when applied to family controlled companies. In particular, our results suggest that regulators should pay special attention to the selection of board members. For the benefit of all shareholders, it is important to guarantee substantial independence of the board. Our results are also useful to users of financial statements, suggesting that a company’s ownership structure and its corporate governance characteristics should be taken into account when accounting numbers are used.”

Enron Collapse: A Case Study in Audit Failure

August 29th, 2015

News broke in October of 2001 that energy conglomerate Enron was declared insolvent; the story that followed revealed the largest case of accounting fraud in history. As a result, Enron declared bankruptcy and one of the nation’s largest accounting firms Arthur Anderson was forced out of business. Analysts were shocked to discover how long Enron had been able to manipulate its reported earnings without discovery by auditors or the board of directors (Catanach. 2012).

Today it is still uncertain whether auditors from Arthur Anderson’s Houston office were compensated to overlook the numerous accounting discrepancies or instead, simply unqualified to decipher the unique accounting procedures developed by the Enron management. The catastrophic loss to shareholders and employees pensions serves as a warning to auditors of the devastation that inadequate accounting procedures can cause (Mclean. 2001).

As a result of the intentional manipulation of reported profits, sixteen Enron executives were convicted of defrauding investors. The primary defendant, company founder and financial advisor to President Busch: Kenneth Lay was sentenced to 45 years for his crimes, but died of heart failure before serving his sentence. CFO Andrew Faustow cooperated with SEC investigators and was sentenced to 10 years without parole for insider trading, tax evasion and defrauding investors. CEO Jeffrey Skilling was sentenced to 24 years. Accounting firm Arthur Edwards and several key employees were convicted of obstructing justice by shredding thousands of pounds of documents and deleting thousands of emails as the scandal made the news. The Arthur Anderson employee convictions were later overturned by US Supreme Court (Mclean. 2001).

The combined losses of over $150 billion dollars to shareholders, creditors and employee pension funds negatively impacted the US economy in a sum equal to that of every American man, woman and child losing $533 for 2002. Public outcry over corporate irresponsibility resulted in the drafting of the Sarbanes-Oxley Act of 2002 which was created to address every loophole that Enron used to elude detection. Today SOA regulations dictate many of the federal accounting reporting standards and policies. Despite SOA guidelines, many privately held companies and several major publicly held companies continue to fail after earnings management schemes unravel (Jain. 2013).

The catalyst to Enron’s aggresive cycle of earnings management tactics was ignited by the deregulation of the electric power industry in the years prior to the scandal. With newfound freedom from government oversight, Enron management was able to sell hedge contracts on energy futures and report hedge values as actual sales; this practice greatly overstated annual revenue and gave the illusion of record breaking growth and profits. Enron management gradually created a highly competitive corporate culture that rewarded high performing employees for generating short term solutions that would make the company look good in quarterly reports and continue to attract investors and drive stock prices. Many employees even at lower and middle management received large percentages of their salary as stock options for hitting bonus levels or at least creating the illusion of achieving performance goals (Watkins. 2002).

The sheer complexity of accounting the true values of energy futures hedging using market to market costing and uncovering the management earnings schemes that were created by the 20,000 employee army who were all being encouraged to boost their bonuses by finding creative ways to manipulate Enron’s stock prices (Helman. 2013). The corporate culture snowballed out of controlled as management began to actively recruiting new hires who showed promise of financial creativity and also held flexible attitudes towards ethics, with this strategy the managers of Enron were able to create an ingenious army of professional corporate swindlers, and provided them a rich environment to capitalize on those talents. These and other factors created an accounting system so elaborate and deceptive that investigators had difficulty uncovering the flow of cash even after the scandal unraveled (Watkins. 2003).

Enron for several of their final years poached the best and the brightest performers from competing firms by offering salaries at twice the market rate being offered by competitors. Recruiting top talent combined with a policy of automatically culling the lowest 15% performers from the workforce every year generated a culture where every employee carefully avoided  bearing bad news and their mistakes or losses were swept under the rug to protect jobs (Watkins. 2003).

Not only were the salaries aggressive but perks and extravagant expense accounts made available jobs at Enron highly sought after. This ultra-competitive culture pushed all employees to find creative and innovative ways to inflate their own contributions to the company’s bottom line, at least for short term gains with little regard for long term repercussions (Jain. 2013).

A recurring theme to Enron’s development was the massive expansion into industries and locations that Enron was poorly equipped to compete in. The corporate background in supplying natural gas to the western US could not have prepared them for the projects they would undertake such as building a $900 million power plant in India that failed to ever produce revenue after disagreements with the government of India. Another failed “get rich quick scheme” was the Wessex Water Co in England which Enron paid $3 billion for and then offered its shares to the public in an IPO which lost nearly $100 million per month until its collapse in August 2000 (Watkins. 2003).

Possibly the nail in the Enron coffin was their overconfidence in their ability to provide the distribution of utilities to the public. In 20000 Enron invested billions in fiber optic technology to provide cable television and internet to over half the households in the US. The fiber optic division managed to lose over $10 million per month (Catanach. 2012)

Enron initially built a track record of performance while under the guidance of CEO from 1990-1996 Rich Kinder, a business attorney, who in comparison was credited for his conservative management style. Under Kinder’s leadership Enron earned much of the credibility that would later be used to attract investment capital and industry credibility. The talents of Kinder are later substantiated as the driving talent, as he later went on to build multibillion dollar energy conglomerate Kinder-Morgan (Mclean. 2001).

The rise and fall of Enron ends with the losses in billions of dollars to defrauded investors. These losses resulted from a decade of greed driven earnings management schemes that enabled Enron employees to participate in a Ponzi like deception of stockholder funds. A corporate culture is created from the top down and exaggerated by recruiting and hiring policies. One of the defining points of Enron’s downward spiral was hiring the most intelligent candidates who also exhibited a moral flexibility toward earnings management policies and held a Robin Hood disdain for constrictive industry regulations. While it is important that we hone our auditing policies to detect earnings management schemes such as those at Enron, we cannot overlook that a recurring theme is the human resources failure to screen out candidates who would overlook long term sustainability for personal gain for their share in the corporate greed (Watkins. 2003).

Work Cited

Catanach Jr., Anthony H., and J. Edward Ketz. “ENRON Ten Years Later: Lessons To       Remember. (Cover Story).” CPA Journal 82.5 (2012): 16-23. Business Source Premier.

Helman, Christopher. “10 Reasons Why Houston No Longer Cares About Enron Or Whether          Jeff Skilling Gets Out Of Jail Early.” Forbes.Com (2013): 1. Business Source Premier.          Web. 10 Jan. 2014 Web. 10 Jan. 2014.

Jain, Pravin. “Confessions Of An Enron Executive: We Lacked Finesse.” Emergence:           Complexity & Organization 15.2 (2013): 104-109. Business Source Premier. Web. 10 Jan.           2014.

Mclean, Bethany, et al. “Why Enron Went Bust. (Cover Story).” Fortune 144.13 (2001): 58-68.           Business Source Premier. Web. 10 Jan. 2014

Watkins, Thayer. “The Rise and Fall of Enron” 2003.            Web. http://www.sjsu.edu/faculty/watkins/enron.htm

Regulatory Failure: Peregrine Financial Group Accounting Scandal of 2012 – Todd Benschneider

On July 9, 2012 CEO and founder of Peregrin Financial Group, Ralph Wasendorf drafted a detailed suicide note, rigged a hose from his car exhaust through a window, started the engine, and drifted off to sleep. However, his suicide attempt failed, the following morning a passerby noticed the car running and called police. Paramedics removed Wasendorf unconscious but alive, the suicide note was passed onto the regulatory office of the Commodity Futures Trading Commission (Touryalai. 2012).

Despite Wasendorf’s brilliance in brokering futures trades, he had much to learn about the genius of clean air automotive emissions controls. Todays automobiles generate only trace levels of poisonous carbon monoxide, so instead of death by poison gas, Wasendorf was merely exposed to about 8 hours of low oxygen levels and made a complete recovery. Had Wasendorf used today’s mobile browser technology and Googled “suicide by car exhaust”, Google would have guided him to choose the much deadlier 1959 Thunderbird over the 2001 Chevrolet Cavalier Convertible from his car collection.

The suicide note contained a detailed confession for defrauding PFGBest investors for the past 20 years. The letter apologized to his family for disgracing the family name; however, the note justified his fraud by directing blame toward vindictive regulators who he had long believed were jealous of his success and unnecessarily burdened his firm with regulatory expenses that made the success of honest small firms cost-prohibitive. The note also belittled the regulatory agencies for their incompetence at detecting fraud and alleged that they were so consumed with punishing honest mistakes made by traders that they could never find deliberate fraud that they were assigned to be investigating.

Wasendorf claimed that regulatory failures for verifying bank records allowed him to create false bank records for over 20 years, forgeries that were being mailed back to auditors from a fake PO Box he had created in bank’s name. In a melodramatic closing, the suicide note announced that Wasendorf had punished himself far harsher than he would suffer at the hands of prosecutors by sentencing himself to death (Reinitz. 2012). However it could be argued that prosecutors trumped his death sentence with their alternative: 50 years of maximum security prison, $215 million in restitution and a life sentence of isolation, shame and regret.

The path toward uncovering the fraud began in 2009, in response to a string of high profile financial scandals; new advancements in audit technology were being developed that would soon to plug loopholes that had made accurate auditing a challenge. The changes included a newly developed electronic clearinghouse which allowed for an immediate and simultaneous verification of all account balances, discrepancies in those balances would quickly reveal PFG’s falsified bank statements. However regulators met with strong resistance to the new audit technology, which resulted in many firms such as FGBest being carefully scrutinized for their refusal to participate in the new verification clearinghouse (TN-Confirmation.com 2012).

The beginning of the end for PFG came the wake of a multitude of regulatory scandals caused by PFG traders, which resluted in an agreement to open the company books for a detailed audit to ensure future compliance. That final audit came to a head on the afternoon of Wasendorf’s  suicide attempt when the National Futures Association froze all PFGBest accounts after discovering that $220 million dollars in investor deposits were unaccounted for and that Wasendorf himself had forged bank documents to hide those missing funds from auditors. Wasendorf was warned by a tipster that the following morning he would be arrested on embezzlement charges (Zwick. 2013).

Some company insiders believe that the motive for suicide was to protect his personal assets from prosecutors. In the final weeks before the scandal was exposed, Wasendorf secretly married his girlfriend and changed his will to name her as his sole beneficiary. He also deposited $50,000 in a bank account for his new stepdaughter under the guise of a college fund; money that she quickly withdrew the day of the suicide attempt. If his suicide had been a success, the reassignment of his estate, would have created a unique challenge for prosecutors to return the misappropriated funds from Wasendorf heirs to the victims of his fraud and ultimately he may have enjoyed a final victory of once again outwitting regulators. However, death with dignity would be denied, as emergency crews resuscitated the Wasendorf forcing him to witness his own disgrace and watch his new wife file for divorce the following week. With no assets at his disposal and no allies to offer financial assistance, Wasendorf was unable to afford his own attorney, with his defense case presented by an inexperienced public defender and Wasendorf found himself sentenced to 50 years of maximum security prison (Reuters. 2012).

In the months that followed prosecutors began an online auction to sell Wasnedorf’s personal assets including estate items as trivial as his clothing and kitchenware, most importantly to the press was his vintage wine collection. His estate including a home that was built for $1.4 million along with two vacation homes, sold for pennies on the dollar and in total netted just over $4 million. The newly built  PFG $24 million corporate headquarters brought a mere $2.8 million and still carried a mortgage balance of $6 million which was co-signed for by Wasendorf’s only son Russell Wasendorf Jr.

The son, Russell Jr.former COO of PFG later relocated to Orlando, FL and was forced into a bankruptcy by the mortgage shortage, along with hundreds of thousands of dollars in legal bills from investor suits (Bunge. 2013).  After the liquidation of Wasendorf Sr personal assets the bankruptcy trustee estimated that $190 million in misappropriated funds were lost or missing, the bulk of those losses occurred at the peak of the recession (Reintz. 2013).

In the final years of PFG several long term employees began to question Wasendorf’s mental health. Former employee Phil Flynn an employee of five years, who left months before the scandal was revealed began to see a recurring theme of inappropriate behavior. For Flynn, the final warning came in February of 2012 after PFG admitted some wrongdoing and agreed to pay the NFA $700,000 in trading violations. Flynn also retold a story of the final PFG Christmas party in 2011: “Wasendorf Sr. gave an awkward, rambling speech at the company Christmas party about his early business career and what it takes to become a success. It was kind of a downbeat thing for a Christmas party, kind of out of place and weird (Reinitz. 2013).”

Following the discovery, analysts were shocked by the transparency of the PFG fraud and questioned how so many obvious red flags could be ignored by auditors and regulators in regards to PFG’s finances. Investigators suspect that the small accounting firm Veraja-Snelling had been cooperating with Wasendorf to aid in defrauding regulators. Critics now question why a small, locally-owned  firm was allowed to audit the complex books of a commodities trading firm with over $500 million in assets (Reuters. 2013).

While in comparison to the Enron scandal, which was remarkable by how intricately complicated and untraceable the flow of money became as it flowed from deal to deal and back and forth through subsidiary accounts; however,  in contrast the PFGBest scandal will be remembered by how amazingly detectable the fraud would seem to any investigator with fraud training. Using a remarkable lack of technology tools, Wasendorf’s scheme relied solely on doctoring PFG’s paper bank statements with a scanner and household grade Photoshop software, later having those falsified documents mailed in preaddressed envelopes that he provided from auditors to his fake post office box. The simplicity of the process left industry analysts in shock that in 20 years the red flags were continually failed to uncover this simple forgery (Reintz. 2012).

Work Cited

Finkelstein Thompson, LLP. “Finkelstein Thompson Investigates Peregrine Financial Group,

Inc. and PFGBest’s Alleged $200 Million Shortfall.” Business Wire (English) Nov. 0007:

Regional Business News. Web. 11 Jan. 2014.

McFarlin, Michael. “Restoring confidence in the post-MF Global world: customer confidence

was shattered after the MF Global and PFGBest bankruptcies revealed gaping holes in the

supposed bulwark of segregated funds. The industry has responded, but is it enough?(MF

GLOBAL: 1 YEAR LATER).” Futures (Cedar Falls, Iowa) 2012: 42. General OneFile.

Web. 11 Jan. 2014.

“-Regulators Fault US Bank For Fraud At Peregrine Financial.” Global Banking News (GBN)

(2013): Regional Business News. Web. 10 Jan. 2014.

“The end of a 20-year-old fraud; Lessons for auditors from the Peregrine scandal.(assurance).”

Accounting Today 2012: Academic OneFile. Web. 10 Jan. 2014.

Touryalai, Halah. “Peregrine Files For Bankruptcy After $215M Goes Missing, Where Were The

Regulators?.” Forbes.Com (2012): 37. Business Source Premier. Web. 10 Jan. 2014

Zwick, Steve. “In PFG Fraud, Everyone Loses — Except The Lawyers.” Futures: News, Analysis

         & Strategies For Futures, Options & Derivatives Traders 41.10 (2012): 32-34. Business   

         Source Premier. Web. 11 Jan. 2014.