Accounting scandals

Accounting scandals are business scandals that arise from intentional manipulation of financial statements, with the disclosure of financial misdeeds by trusted executives of corporations or governments. Such misdeeds typically involve complex methods for misusing or misdirecting funds, overstating revenues, understating expenses, overstating[1] the value of corporate assets, or underreporting the existence of liabilities; these can be detected either manually or by means of deep learning.[2] It involves an employee, an accountant, or the corporation itself and is misleading to investors and shareholders.[3]

This type of "creative accounting" can amount to fraud, and investigations are typically launched by government oversight agencies, such as the Securities and Exchange Commission (SEC) in the United States. Employees who commit accounting fraud at the request of their employers are subject to personal criminal prosecution.[4]

Two types of fraud

The fraud triangle

The fraud triangle is a model for explaining the factors that cause someone to commit fraudulent behaviors in accounting. It consists of three components, which, together, lead to fraudulent behavior: Incentives/pressures: A common incentive for companies to manipulate financial statements is a decline in the company's financial prospects. Companies may also manipulate earnings to meet analysts' forecasts or benchmarks such as prior-year earnings, to meet debt covenant restrictions, achieve a bonus target based on earnings, or artificially inflate stock prices. As for the misappropriation of assets, financial pressures are a common incentive for employees. Employees with excessive financial obligations, or those with substance abuse or gambling problems, may steal to meet their personal needs.[9]

Opportunities: Although the financial statements of all companies are potentially subject to manipulation, the risk is greater for companies in industries where significant judgments and accounting estimates are involved. Turnover in accounting personnel or other deficiencies in accounting and information processes can create an opportunity for misstatement. As for misappropriation of assets, opportunities are greater in companies with accessible cash or with inventory or other valuable assets, especially if the assets are small or easily removed. A lack of controls over payments to vendors or payroll systems can allow employees to create fictitious vendors or employees and bill the company for services or time.[10]

Attitudes/rationalization: The attitude of top management toward financial reporting is a critical risk factor in assessing the likelihood of fraudulent financial statements. If the CEO or other top managers display a significant disregard for the financial reporting process, such as consistently issuing overly optimistic forecasts, or if they are overly concerned about meeting analysts' earnings forecasts, fraudulent financial reporting is more likely. Similarly, for misappropriation of assets, if management cheats customers by overcharging for goods or engaging in high-pressure sales tactics, employees may feel that it is acceptable for them to behave in the same fashion.[11]

Several extensions to the fraud triangle have been proposed in the literature. The "fraud diamond" adds a fourth element, capability, emphasizing the perpetrator’s skills and position to exploit opportunities.[12] Subsequent work introduced the "fraud pentagon," which further incorporates arrogance (or ego) to capture the attitude of superiority that can facilitate rule-breaking; this model has been examined empirically in studies of financial reporting fraud.[13]

• Incentives/pressure: Management or other employees have incentives or pressures to commit fraud.
• Opportunities: Circumstances provide opportunities for management or employees to commit fraud.
• Attitudes/rationalization: An attitude, character, or set of ethical values exists that allows management or employees to commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.[8]

Causes

Frauds such as embezzlement are easy to conceal when company records are opaque to begin with. Poor accounting, such as the absence of monthly reconciliations or an independent audit function, also indicates vulnerability to fraud.[14]

List of the biggest accounting scandals

Notable outcomes

The Enron scandal turned into the indictment and criminal conviction of Big Five auditor Arthur Andersen on June 15, 2002. Although the conviction was overturned on May 31, 2005, by the Supreme Court of the United States, the firm ceased performing audits and split into multiple entities. The Enron scandal was defined as one of the biggest audit failures of all time. The scandal included utilizing loopholes that were found within the Generally Accepted Accounting Principles (GAAP). For auditing a large-sized company such as Enron, the auditors were criticized for having brief meetings a few times a year that covered large amounts of material. By January 17, 2002, Enron decided to discontinue its business with Arthur Andersen, claiming they had failed in accounting advice and related documents. Arthur Andersen was judged guilty of obstruction of justice for disposing of many emails and documents that were related to auditing Enron. Since the SEC is not allowed to accept audits from convicted felons, the firm was forced to give up its CPA licenses later in 2002, costing over 113,000 employees their jobs. Although the ruling was later overturned by the U.S. Supreme Court, the once-proud firm's image was tarnished beyond repair, and it has not returned as a viable business even on a limited scale.

On July 9, 2002, George W. Bush gave a speech about recent accounting scandals that had been uncovered. In spite of its stern tone, the speech did not focus on establishing new policy, but instead focused on actually enforcing current laws, which include holding CEOs and directors personally responsible for accountancy fraud.[109]

In July 2002, WorldCom filed for bankruptcy protection in what was considered at the time the largest corporate insolvency ever.[110] A month earlier, the company's internal auditors discovered over $3.8 billion in illicit accounting entries intended to mask WorldCom's dwindling earnings, which was by itself more than the accounting fraud uncovered at Enron less than a year earlier.[111] Ultimately, WorldCom admitted to inflating its assets by $11 billion.[112]

These scandals reignited the debate over the relative merits of US GAAP, which takes a "rules-based" approach to accounting, versus International Accounting Standards and UK GAAP, which takes a "principles-based" approach.[113][114] The Financial Accounting Standards Board announced that it intends to introduce more principles-based standards. More radical means of accounting reform have been proposed, but so far have very little support. The debate itself overlooks the difficulties of classifying any system of knowledge, including accounting, as rules-based or principles-based. This also led to the establishment of the Sarbanes-Oxley Act. On a lighter note, the 2002 Ig Nobel Prize in Economics went to the CEOs of those companies involved in the corporate accounting scandals of that year for "adapting the mathematical concept of imaginary numbers for use in the business world."

In 2003, Nortel made a big contribution to this list of scandals by incorrectly reporting a one-cent per share earnings directly after their massive layoff period. They used this money to pay the top 43 managers of the company. The SEC and the Ontario Securities Commission eventually settled a civil action with Nortel. A separate civil action was taken against top Nortel executives, including former CEO Frank A. Dunn, Douglas C. Beatty, Michael J. Gollogly, and MaryAnne E. Pahapill and Hamilton. These proceedings were postponed pending criminal proceedings in Canada, which opened in Toronto on January 12, 2012. Crown lawyers at this fraud trial of three former Nortel Networks executives say the men defrauded the shareholders of Nortel of more than $5 million. According to the prosecutor, this was accomplished by engineering a financial loss in 2002, and a profit in 2003, thereby triggering Return to Profit bonuses of $70 million for top executives.[115][116][117][118][119] In 2007, Dunn, Beatty, Gollogly, Pahapill, Hamilton, Craig A. Johnson, James B. Kinney, and Kenneth R.W. Taylor were charged with engaging in accounting fraud by "manipulating reserves to manage Nortel's earnings."[120]

In 2005, after a scandal involving insurance and mutual funds the year before, AIG was investigated for accounting fraud. The company already lost over $45 billion worth of market capitalization because of the scandal. Investigations also discovered over $1 billion worth of errors in accounting transactions. The New York Attorney General's investigation led to a $1.6 billion fine for AIG and criminal charges for some of its executives.[121] CEO Maurice R. "Hank" Greenberg was forced to step down and fought fraud charges until 2017, when the 91-year-old reached a $9.9 million settlement.[122][123] Howard Smith, AIG's chief financial officer, also reached a settlement.

Well before Bernard Madoff's massive Ponzi scheme came to light, observers doubted whether his listed accounting firm – an unknown two-person firm in a rural area north of New York City – was competent to service a multibillion-dollar operation, especially since it had only one active accountant, David G. Friehling.[124] Friehling's practice was so small that for years, he operated out of his house; he only moved into an office when Madoff customers wanted to know more about who was auditing his accounts.[125] Ultimately, Friehling admitted to simply rubber-stamping at least 18 years' worth of Madoff's filings with the SEC. He also revealed that he continued to audit Madoff even though he had invested a substantial amount of money with him; accountants are not allowed to audit broker-dealers with whom they are investing. He agreed to forfeit $3.18 million in accounting fees and withdrawals from his account with Madoff. His involvement makes the Madoff scheme not only the largest Ponzi scheme ever uncovered, but the largest accounting fraud in world history.[126] The $64.8 billion claimed to be in Madoff accounts dwarfed the $11 billion fraud at WorldCom.

See also

• 2008 financial crisis
• Accounting ethics
• Corporate crime
• Creative accounting
• Dot-com bubble
• Forensic accounting
• Hollywood accounting
• List of corporate collapses and scandals
• Microcap stock fraud
• Philosophy of accounting
• Repo 105
• Sarbanes–Oxley Act
• Savings and loan crisis
• Securities fraud
• Tobashi scheme
• Vivien v. WorldCom
• White-collar crime

Further reading

• John R. Emshwiller and Rebecca Smith, 24 Days: How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America or Infectious Greed, HarperInformation, 2003, ISBN 0-06-052073-6
• Lawrence A. Cunningham, The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform (And It Might Just Work)
• Zabihollah Rezaee, Financial Statement Fraud: Prevention and Detection, Wiley 2002.

External links

• U.S. Securities and Exchange Commission website
• U.S. President Bush's speech, 2002-07-09 NPR report (audio recording)
• "GMI Warns of Accounting Risks at 40 Companies", Accounting Today, November 27, 2012
• "The Impact of Fraud on Shareholder Value", Business Insider, June 18, 2013