ESM Government Securities, Inc. ("ESM") was in the business of selling and repurchasing government securities through repurchase and reverse repurchase transactions. ESM is wholly owned by ESM Group, Inc. ("Group") who also owned Financial Group, Inc. ("Financial"). Financial has been insolvent since 1978. A repurchase transaction is one in which ESM would purchase government securities and then sell the securities to a customer with the stipulation that at the maturity of the security, ESM would buy back, or repurchase, the security from the customer. These repurchase transactions had a defined term, and were therefore called term repos. A reverse purchase transaction is the opposite of a term repo; ESM would agree to purchase securities from a customer with the understanding that the securities would be repurchased upon the maturity of those securities. At the end of 1984, the intercompany account between Group and Financial showed Financial owed Group $246,922,347 and the net amount owed by Group to ESM on net intercompany repos was $297,009,000. Financial made significant personal loans to individual officers of ESM companies which had grown to approximately $38,000,000 as ofMarch 31,1985. 1. Using these facts, and the financial statements on the following two pages, describe the potential fraud schemes employed by ESM. 2. Are there any other issues that tweak your curiosity with respect to these financial statements? 3. Should the disclosures in ESM's financial statements report the intercompany transactions with Group?

ESM Government Securities STATEMENT OF INCOME 12/31/81 12/31/82 12/31/83 12/31/84 (In Thousands) (unaudited) (unaudited) (unaudited) (unaudited) Security Income $ 64,857 $ 27,415 $ 6,080 $ 12,882 Other Income (29,550) 29,040 28,112 15,543 Interest Income 128,250 132,939 175,262 346.223 Total Income 163,557 189,394 209,454 374,648 Bond Process Exp 6,621 9,711 9,153 6,098 Officer Salaries 801 1,806 2,846 3,106 Other Salaries 407 500 714 278 Salesmen Commission 439 580 477 1,026 Other Expenses 980 1,141 7,706 1,396 Interest Expense 128.250 132.939 166,203 346.223 Total Expenses 137.498 146.677 187,099 358.127 Net Income $ 26.059 $ 42.717 $ 22,355 $ 16,521BALANCE SHEET 12/31/81 12/31/82 12/31/83 12/31/84 (In Thousands) (audited) (audited) (audited) (audited) ASSETS Cash $ 1,767 $ 1,046 $ 339 $ 421 Deposits with Clearing Org's 25 25 25 182 Rec from Brokers 60 1,084 2,192 3,643 Rec from Customers 40,523 21,073 16,163 73,050 Securities Purchesell Agreement 1,323,340 738,924 2,252,555 2,945,953 Accrued Interest 433 1,257 7,375 406 Securities Purchat Market 161,484 182,674 402,004 26,059 Due From Parent O O O 2,550 Other 0 61 TOTAL ASSETS $1,527.632 $946,083 $2.680.653 $3.052.325 LIABILITIES & EQUITY S/T Bank Loans 57,282 80,350 91,832 47,258 Payable to Brokers 478 3,624 4,815 12,266 Payable to Customers 4,047 1,426 3,683 9,304 Securities Sold-Resell Agreement 1,323,340 738,924 2,457,555 2,945,953 Accrued Expenses 796 596 927 799 A/P to Parent & Affiliates 127,604 95.861 92,183 . 0 TOTAL LIABILITIES 1,513,547 920,781 2,650,995 3,015,580 Common Stock Add'l Contribcapital 4,160 4,160 4,160 4,160 Retained Earnings 9,924 21,141 25.497 32,584 TOTAL LIABILITIES & EQUITY $1,527,632 $946.083 $2,680,653 $3.052,325