Lessons can be learned from the mistakes of firms such as General Electric. Richard Drew/AP
Lessons can be learned from the mistakes of firms such as General Electric. Richard Drew/AP

Scandals to learn from: Enron, GE, Crazy Eddie



They say that those who fail to learn from history are doomed to repeat it.

Let’s learn from the world’s worst financial scandals so that we may avoid repeating them.

Enron

Enron is by far the most interesting modern day scandal to look at. Why? Because Enron’s bankruptcy on December 2, 2001, led to the destruction of Arthur Andersen, one of the big five audit firms that also included KPMG, PwC, Ernst & Young, and Deloitte. More frightening, it is credited with triggering the 2002 Sarbanes-Oxley (SOX) Act of US Congress. SOX sought, quite forcefully, to improve transparency and protect investors.

There were, in my opinion, three main issues that led to Enron’s bankruptcy. The first was the use of special purpose entities, think of them as companies, to hide debt. This is related to the issue of having multiple related companies or, worse, deconsolidating subsidiaries so that their books do not show up on the parent’s books, allowing the parent to hide liabilities in the subsidiary that are not transparent in Enron’s books. The second issue was revenue recognition. There were multiple problems but the main one was Enron generating revenue by entering into artificial transactions with its subsidiaries. The final issue is basically “wasta,” Enron successfully lobbied for its energy trading arm to be exempt from financial regulation.

General Electric

General Electric (GE) has always been viewed as a blue chip global conglomerate. However, in 2009 the Securities and Exchange Commission, America’s main market regulator, fined GE US$50 million for fraud. GE was accused of manipulating its earnings in multiple ways. One was the recognition of revenue from the sale of locomotive and aircraft spare parts before the actual sale was effected. Another was an interesting accounting irregularity in managing the volatility of GE’s interest rate swaps: GE would classify an interest rate swap as a hedge or not, only after it became clear what would have the least impact on earnings. This is illegal. The astounding thing about the GE scandal was that it took four years and cost them an estimated US$200m in lawyer’s fees. The impact of reversing these false profits was also about $200m. If GE, that blue chip of blue chips, can stumble in this way then what company is immune?

Crazy Eddie

If you were in the US in the 1980’s or early 1990’s then you have probably heard of Crazy Eddie, a consumer electronics chain. His jingle was “Crazy Eddie, his prices are insane!” The initial fraud perpetuated by Eddie Antar, the titular Eddie in Crazy Eddie, was basic; mostly the skimming of cash. But that was a fraud on the tax collectors. The fraud on the public, however, is what is instructive for the GCC. Eddie decided to IPO his stores and to get a higher price he did two things. First he slowly decreased his skimming so that the profit margin for the company looked like it was going through the roof. But the true criminal innovation was that Eddie used the money he had skimmed to generate fake sales, boosting both revenue and profit. This boosted the IPO price.

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Read more:

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So what have we learnt so far?

From Enron we learnt that subsidiaries can be used to both hide debt and losses as well as increase profit via artificial transactions with those same subsidiaries. From GE we learnt that timing of revenue recognition as well as classification of revenue can easily be tampered with. From Crazy Eddie we learnt how self-dealing can easily inflate revenue and profit.

What does that mean for investors?

Companies with multiple subsidiaries are at risk of hiding negative financial results in the books of the subsidiaries. At the same time, fake or low quality profits can be generated by trading with those subsidiaries. Investors in such companies should demand from the board clear and separate reporting of all relevant financials as well as clearly highlighting inter-company transactions and the basis for the pricing in such transactions.

The second conclusion is that companies must provide a clear explanation of their revenue classification and recognition policies for every line item. Investors need to learn to review all the notes of the financial statements of a company.

The third conclusion is to be on the lookout for sudden inflation of financial performance. Crazy Eddie did this by decreasing the amount he was skimming as well as using previously skimmed funds to pump up revenues. But it does not have to be so convoluted. You can improve a share price not only by inflating revenue and profit but by also manipulating the market. This can include, but is not limited to, starting rumours, buying and selling between related parties to create the appearance of investor interest, or ramping up prices by buying a small amount of shares in an illiquid stock.

One indicator of potential fraud that I have found useful is the difference between the income statement and cash flow statement. There will always be a difference in timing of revenue and expense recognition, but if profit is consistently increasing whilst cash flow is consistently decreasing and/or negative, then you might want to dig a little deeper.

COMPANY PROFILE
Name: Almnssa
Started: August 2020
Founder: Areej Selmi
Based: Gaza
Sectors: Internet, e-commerce
Investments: Grants/private funding

 

 

 

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GRAN%20TURISMO
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2019 ASIA CUP POTS

Pot 1
UAE, Iran, Australia, Japan, South Korea, Saudi Arabia

Pot 2
China, Syria, Uzbekistan, Iraq, Qatar, Thailand

Pot 3
Kyrgyzstan, Lebanon, Palestine, Oman, India, Vietnam

Pot 4
North Korea, Philippines, Bahrain, Jordan, Yemen, Turkmenistan

Key Points
  • Protests against President Omar Al Bashir enter their sixth day
  • Reports of President Bashir's resignation and arrests of senior government officials
COMPANY%20PROFILE%20
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THE BIO

Favourite author - Paulo Coelho 

Favourite holiday destination - Cuba 

New York Times or Jordan Times? NYT is a school and JT was my practice field

Role model - My Grandfather 

Dream interviewee - Che Guevara

The specs

  Engine: 2-litre or 3-litre 4Motion all-wheel-drive Power: 250Nm (2-litre); 340 (3-litre) Torque: 450Nm Transmission: 8-speed automatic Starting price: From Dh212,000 On sale: Now

COMPANY%20PROFILE
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COMPANY PROFILE
Name: ARDH Collective
Based: Dubai
Founders: Alhaan Ahmed, Alyina Ahmed and Maximo Tettamanzi
Sector: Sustainability
Total funding: Self funded
Number of employees: 4
The Melbourne Mercer Global Pension Index

The Melbourne Mercer Global Pension Index

Mazen Abukhater, principal and actuary at global consultancy Mercer, Middle East, says the company’s Melbourne Mercer Global Pension Index - which benchmarks 34 pension schemes across the globe to assess their adequacy, sustainability and integrity - included Saudi Arabia for the first time this year to offer a glimpse into the region.

The index highlighted fundamental issues for all 34 countries, such as a rapid ageing population and a low growth / low interest environment putting pressure on expected returns. It also highlighted the increasing popularity around the world of defined contribution schemes.

“Average life expectancy has been increasing by about three years every 10 years. Someone born in 1947 is expected to live until 85 whereas someone born in 2007 is expected to live to 103,” Mr Abukhater told the Mena Pensions Conference.

“Are our systems equipped to handle these kind of life expectancies in the future? If so many people retire at 60, they are going to be in retirement for 43 years – so we need to adapt our retirement age to our changing life expectancy.”

Saudi Arabia came in the middle of Mercer’s ranking with a score of 58.9. The report said the country's index could be raised by improving the minimum level of support for the poorest aged individuals and increasing the labour force participation rate at older ages as life expectancies rise.

Mr Abukhater said the challenges of an ageing population, increased life expectancy and some individuals relying solely on their government for financial support in their retirement years will put the system under strain.

“To relieve that pressure, governments need to consider whether it is time to switch to a defined contribution scheme so that individuals can supplement their own future with the help of government support,” he said.


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