Accounting fraud is an international problem touch-ing all countries and most entities. Fraud affects companies of all sizes in a variety of industries. Transparency International is a global network whose goal is to fight fraud and corruption in the national arena by producing an annual Corruption Perceptions Index (CPI). Just some of the massive frauds within the past few years include those asso-ciated with Adelphia, Bernard Madoff (now serv-ing a 150-year prison sentence), Cendant, Computer Associates, Dell, Enron, Harris Scarfé, HealthSouth, Livedoor, Parmalat, Qwest, Royal Ahold, Satyam, Siemens, Sir Robert Allen Stanford, SK Global, Tyco, Vivendi, Waste Management, WorldCom, and Xerox. In the United States, 20 percent of the locations of fraud companies’ headquarters were in California, 10 percent in New York, and 8 percent in Texas and Florida.
A 2010 Committee on Sponsoring Organizations (COSO) study covering a 10-year period in the United States (1998–2007) found that fraudulent financial reporting results had significant negative consequences for executives and investors. The average cumulative misstatement or misappro-priation amount for 300 companies was $397.68 million, while the median cumulative misstatement was $12.05 million. The frauds of the early 2000s skewed the 1998–2007 total and mean cumulative misstatements or misappropriations upward. The median fraud in this study was almost three times larger than the previous 1999 COSO study. For the purposes of this discussion, accounting fraud is defined, as stated by the American Institute of Certified Public Accountants (ACFE), as “any inten-tional act or omission designed to deceive others, resulting in the victim suffering a loss and/or the per-petrator achieving a gain.” Coverage will emphasize financial statement fraud and not necessarily oth-ers, such as occupational fraud, white-collar crime, or computer fraud. For example, accounting fraud is the intentional manipulation of (rather than an error in) the recording of revenues (inflows) and expenses (outflows) in order to make the operating profit of an entity appear better. Typical examples would be overreporting of sales or revenue: Cendant Corporation created at least $500 million in ficti- tious revenues, and Barry Minkow created a $200 million corporation based upon fictitious sales.
Costs of Accounting Fraud
There have been some massive accounting frauds throughout the years, including the $11 billion WorldCom and $50 billion Madoff scandals. In an interview in the February 16, 2011, edition of the New York Times , Madoff spoke of the “will- ful blindness” of many hedge funds and banks that dealt with his investment advisory business: “They had to know. But the attitude was sort of, ‘if you’re doing something wrong, we don’t want to know.’” Financial scandals and their resulting fallout in the first few years of the 21st century in the United States drew comparisons with activities surrounding the stock market crash of 1929. Superstar compa- nies such as Enron and HealthSouth were caught in the fraudulent behaviors that seemed untenable for most investors and unfathomable for most people. The worldwide stock markets shook. One of the most respected, storied, and successful accounting firms, Arthur Andersen, became a casualty of the financial scandals.
Although there are no reliable statistics as to the cost of fraud, the 2010 Report to the Nations of the ACFE group reports that the typical organization loses 5 percent of its annual revenue to fraud. Based upon the estimated 2009 Gross World Product, this percentage translates to a total potential fraud loss of more than $2.9 trillion each year world-wide. Although asset misappropriation losses were the most common form of fraud (at $100,000 per scheme), financial statement frauds were the most costly (at $1,730,000 per scheme). Corruption schemes fell in the middle at $176,000 per scheme. Like a cold, it is hard to keep fraud from spreading.
With fraud there is often collusion. The president and chief financial officer of Continental Express established an insurance company with the same name in another state. The real company made pay-ments to the fraudulent insurance company and the executives paid themselves multiple salaries.
Lee Seidler (as reported by George Mannes) says that “auditors will continue to miss fraud because much of their work is predicated on the assumption that separation of duties—say, one person holds the money and another person keeps track of it—prevents fraud.” The equity funding scandal “shakes the foundations of auditing, in that so much is based on the assumption that people don’t collude, or they wouldn’t collude very long. But they do.”
“Cooking the books” is often a collaborative effort. For financial restatements between January 1, 1997, and June 30, 2002, 45 percent were accused of securities fraud and subject to shareholder suits. An average of seven individuals were implicated, including chief executive officers, chief financial officers, chief operating officers, general counsels, directors, and, internal/external auditors. In the case of WorldCom, at least 40 people knew about the fraud but were afraid to talk. Chief financial officer Scott Sullivan handed out $10,000 checks to seven individuals involved.
Joseph Wells, the founder of ACFE, says that the actual cost of fraud is unknown and unknowable. It is a concept the criminologists call “the dark fig-ure.” Unlike visible crimes, such as robbery, not all frauds are uncovered. Of those uncovered, not all are reported. No agency is tasked with compiling com-prehensive data on fraud. More forensic techniques should become a part of both external and inter-nal auditing. However (as reported by Eric Krell), Stephen Seliskar says that “in terms of sheer labor, the magnitude of effort, time and expense required to do a single, very focused (forensic) investigation—as contrasted to auditing a set of the financial state-ments—the difference is incredible.” It is physically impossible to conduct a generic fraud investigation of an entire business.
Abusive Earnings Management
Financial statement fraud, fraudulent earnings management, or creative accounting has become an increasing concern to accounting regulators, especially in the post-Enron era (since 2002). The flexibility in generally accepted accounting prin-ciples (GAAP) gives management discretion to use its professional opinion to choose from a range of alternatives in selecting those standards that suit the needs of a company—such as “first-in, first-out” (FIFO) or “last-in, first-out” (LIFO) inven-tory methods. Different accounting methods result in different earnings and earnings per share, and most often management prefers to smooth earnings. Companies tend to use accounting techniques to try to smooth earnings from one period to the next. Under International Accounting Standards, management has even more discretion.
The U.S. Securities and Exchange Commission (SEC) defines abusive earnings management as an intentional and material misrepresentation of results. Nonfraudulent earnings management is accom-plished within the GAAP framework, whereas fraud-ulent earnings management does not follow GAAP (such as recording fictitious sales). The National Center for Continuing Education even offers a semi-nar, “How to Manage Earnings in the Conformance with GAAP.” Nothing, however, gives greater fear to a corporate officer or investor than when there is a rumor about “an accounting problem.” Glass, Lewis and Co. indicated that between 200 and 500 publicly traded companies listed in the United States, or about 5 to 12 percent of the total, have to restate their earnings each year.
Some motivations for fraudulent behavior are meeting external or internal expectations, conceal- ing bad performance, preparing for a debt/equity offering, improving management compensation (for example, through stock options), and covering up fraud.
Abusive earnings management would include the following:
- Improper revenue recognition (such as bill and hold sales)
- Improper expense recognition
- Using reserves to inflate earnings in years with falling revenues (cookie-jar accounting) • Shifting debt to a special-purpose entity (SPE)
- Channel stuffing
- Capitalizing rather than expensing marketing costs
- Extending useful lives and inflating salvage values
- Accelerating revenue from leasing equipment
- SPEs that are not consolidated
Early warning signs of earnings management include the following:
- Cash flows that are not correlated with earnings
- Receivables that are not correlated with revenues
- Allowances for uncollectible accounts that are not correlated with receivables
- Reserves that are not correlated with balance- sheet items
- Acquisitions with no apparent business purpose
- Earnings that consistently and precisely meet analyst’s expectations
The 2010 COSO fraud report indicates that revenue recognition schemes are used 61 percent of the time to cook the books, followed by over- stating assets (51 percent), understatement of expenses and liabilities (31 percent), and misap- propriation of assets (14 percent).
Revenue Recognition Schemes Companies use any of multiple methods to create fictitious revenues in order to inflate income on financial statements. A slightly different approach is simply to overstate income either by omitting ele- ments that would lower actual revenues (such as returns of purchases) or by using mark-to-market accounting to make records of (future) income more “flexible.”
One type of overstated-income scheme is the bill-and-hold transaction. The customer agrees to purchase goods and the seller invoices the customer but retains physical possession of the products until a later delivery date. Not all such transactions involve fraud, but the practice must be closely examined in light of accounting rules because it is open to abuse. Fraudsters may use this approach to count both sales and inventory on hand as revenue procedures. In a well-publicized scandal, Sunbeam created revenues in 1997 by using a bill-and-hold practice. The company sold products to customers but held onto the ship-ments with an agreement to deliver the goods later. Coca-Cola created income by loading up syrup trucks near the end of the year and driving the trucks outside the warehouse and parking them. After the end of the year, the trucks with spoiled syrup came back inside the warehouse and the inventory was written off.
Premature revenue recognition is a means of recording income as actual in order to inflate earn-ings totals when sales have not been completed, the products have not been delivered, or invoices have not been paid. In general, revenue from product sales should not be recognized on financial state-ments until it has been realized or realizable and earned. Based on the provisions of Staff Accounting Bulletin (SAB) 101, income should not be recog-nized under these circumstances because delivery has not actually occurred. Customers on the other side of early delivery schemes often return the unfin-ished product or demand more completion before payment is rendered.
Xerox, for example, overstated revenue for more than four years by accelerating the recognition of $3 billion in revenue and inflating earnings by $1.5 bil-lion. It allegedly included the recognition of revenue on Xerox office copy equipment leases too early in the cycle. Parmalat, an Italian milk company, invented $620 million sales of powdered milk to Cuba. If the “sales” were true, Cuba would have been “swimming in milk.” The company also used double invoicing: one real and one fake invoice. Both invoices were entered into the books, but only one was sent to the customer. U.S. Foodservice, Inc., was offered rebates from its vendors for volume purchases. The company recognized these vendor rebates as a reduction of cost of goods sold (thereby increasing income), which should not have been recognized.
Overstating Assets
Assets may be overvalued or expenses may be capi- talized. Overvalued assets comprise property for which executives set prices that are unsupportable using standard business valuation approaches. These assets might be bought to essentially pay off parties to which the fraudsters are beholden, sold to artifi- cially boost income, or simple held and recorded on statements at far more than their actual worth.
Gain-on-sale accounting is a technique enabling fraudulent executives to use special-purpose entities to purchase or sell overvalued ventures at unsup- portable values, which are recorded by the corpora- tion as massive losses/revenues.
Accounts receivables offer myriad opportuni- ties for valuation schemes. GAAP require accounts receivable to be reported at net realizable value—the gross value of the receivable minus an estimated allowance for uncollectible accounts. Companies circumvent GAAP by underestimating the uncol- lectible portion of a receivable. Underestimating the value of the provision (the amount deemed uncol- lectible) artificially inflates the receivables value and records it at an amount greater than net realizable value. A related fraud is failing or delaying to write off receivables that have become uncollectible.
Inventory is another area ripe for earnings man- agement and misclassification by manipulating the quantity or value. GAAP require that inventory be reported at the lower of replacement cost or market value (current replacement cost). Inflating inven- tory value achieves the same impact on earnings as manipulating the physical count. Fraudulent manag- ers can accomplish this creative accounting simply by creating false journal entries that increase the balance in the inventory account. Another common way to inflate inventory value is to delay the write- down of obsolete or slow-moving inventory, since a write-down would require a charge against earnings.
Although GAAP require expenses to be rec- ognized in the period in which they are incurred, Symbol Technologies, Inc., deferred $3.5 million of FICA expenses to a later year in order to boost its net income. WorldCom initially properly expensed its operating line costs. However, near the end of various quarters it would reverse these expenses by creating various huge assets. Parmalat had a nonex-istent Bank of America account worth $4.83 billion. Apparently, the auditors Grant Thornton relied on a fake Bankers’ Automated Clearing Services (BACS) confirmation prepared by Parmalat. No auditor took the time to call or e-mail the bank.
Understating or Omitting Liabilities and Expenses
Omitted liabilities are the mirror image of fictitious revenues and assets: Fraudsters hide debt or employ other off-balance-sheet financing to avoid having to include the negative picture on corporate financial statements. Special-purpose entities (SPEs) may be used to bury poorly performing assets because their transactions are not part of the corporate financial statements. Decreasing liabilities increase the net worth of the company.
By the time Enron declared bankruptcy in December 2001, it was reported to have hidden billions of dollars of off-balance-sheet debt using SPEs. Also, Enron entered into futures contracts with financing organizations such as J. P. Morgan that were thinly disguised loans not actually based on delivery of energy commodities. Enron also used prepaid swaps through its Delta subsidiary, wherein CitiGroup paid the fair value of its por-tion of the swaps, but Enron was allowed repay-ments spread over five years—in effect, obtaining loans. Enron never disclosed these transactions as such on its financial statements, accounting for the deals as “assets from price risk management” and as “accounts receivable.”
Waste Management shifted current expenses to a later period by debiting rather than expensing asset accounts. In 1999, AMR Corporation changed the depreciation schedule from 20 years to 25 years on some planes, which reduced depreciation expense in 2000 by $158 million. Adelphia Communications omitted at least $1.8 billion of debt from its balance sheet.
Misappropriation of Assets
Misappropriation of assets is generally considered to be individual fraud by employees or outsiders. However, the Rigas family, who owned Adelphia Communications, a cable operator, was accused by the U.S. Department of Justice of looting Adelphia on a massive scale and using it as a personal piggy bank. This area involves situations where a manager misappropriates assets and then covers up the theft by manipulating the financial statements.
One problem fraudsters have is getting the assets into their pockets. Tyco solved this problem by granting large, interest-free loans to the officers ($8.71 million). The company then forgave the loans. Unauthorized bonuses also were given to the officers without the approval of the board of directors.
Chung Moung-koo, chairman of Hyundai Motors, South Korea’s largest car maker, was sen- tenced to three years in prison in February 2007 for embezzlement, breach of trust, and secretively setting up slush funds. He embezzled about $100 million in company funds, although he owned only 5 percent of the company.
Other Fraudulent Financial Reporting Schemes
Companies can manipulate reserves by placing a contingency or liability on the balance sheet dur- ing a poor performance period (so-called cookie-jar accounting). In subsequent years, these reserves are reduced in order to pump up revenues. Alternatively, these reserves can be created in high-revenue years, and then fraudsters can dip into the cookie-jar reserves during difficult times. Both Xerox and Sunbeam engaged in cookie-jar accounting.
For example, a large Canadian telecommunica- tions manufacturer, Nortel Network, was accused by the SEC of establishing more than $400 million in excess reserves. Eventually Nortel restated an excess of $2 billion in revenues. Cendant Corporation over- stated acquisition-related reserves and then reversed portions back into earnings. In the early 1990s, W. R. Grace had earnings far exceeding estimates, so the company deferred some of its income by estab- lishing and increasing reserves. Grace then released these reserves to report steady earnings growth in subsequent years. Freddie Mac understated its income from 2000 to 2002 by $5 billion using a tac- tic called wrong-way earnings management.
Related parties can be used to increase revenues and hide liabilities. The 2010 COSO report found that firms that engaged in fraud disclosed sig- nificantly more related-party transactions than no- fraud companies. CEC Industries Corp., a Nevada Corporation, created a substantial portion of its revenue as a result of an asset exchange transac-tion with a related party. Enron shifted a massive amount of liability to special-purpose entities. Tyco had undisclosed real estate transactions with related parties, and Adelphia moved debts to subsidiaries, which were not consolidated. Baptist Foundation of Arizona (BFA) set up subsidiaries owned by insiders to buy real estate (which had crashed in value) from BFA. Nikko Cordial (Japan) was fined for failure to consolidate a special-purpose entity that was 100 percent owned by its subsidiary.
Afinsa, a Spanish stamp company, controlled 72 percent of Escala, a U.S. stamp company. Escala said all sales to Afinsa took place at independent estab-lished prices. However, Escala’s reported gross mar-gin on stamp sales to Afinsa exceeded 44 percent, compared to less than 14 percent on those to U.S. clients. Therefore, Escala was manipulating the value of stamps sold to Afinsa in order to boost its own bottom line artificially. Escala’s stock fell from $32 to $5 in five days after the May 8, 2006, arrests of seven executives. Police found $12.6 million behind one dealer’s freshly plastered walls in his home.
Conclusion
Thomas Ray, chief auditor of the Public Company Accounting Oversight Board (PCAOB), says that a large number of financial frauds are accomplished by simply booking late entries. “It’s the easiest way to commit fraud. It’s the easiest thing to find.” Nevertheless, Dell, Inc., cooked the books for four years, overstating profits by $50 million without Price Waterhouse Coopers’ knowledge. Just as ter-mites never sleep, fraud never sleeps, and just like ter-mites, fraud can destroy the foundation of an entity.
D. Larry Crumbley
Louisiana State University
See also Charity Fraud; Financial Fraud; Investment Crimes; Money Laundering: Countermeasures; Money Laundering: Methods; Sales Tax; Tax Evasion; Value-Added Tax Fraud.
Further Readings
American Institute of Certified Public Accountants. Managing the Business Risk of Fraud: A Practical Guide. 2008. http://www.acfe.com/uploadedFiles/ACFE_Website/Content/documents/managing-business-risk.pdf (Accessed February 2011).
Beasley, M. S. et al. Fraudulent Financial Reporting, 1998–2007: An Analysis of U.S. Public Companies . New York: Committee on Sponsoring Organizations, 2010.
Blumenstein, Rebecca and Susan Pullian. “WorldCom Fraud Was Widespread.” Wall Street Journal (June 10, 2003).
Crumbley, D. Larry. Forensic and Investigative Accounting . Chicago: Commerce Cleaning House, 2011.
Financial Week . “Auditors Told to Go Harder on Fraud.” December 17, 2007. http://www.financialweek.com/ apps/pbcs.dll/article?AID=/20071217/REG/71214031 (Accessed February 2011).
Glass, Lewis and Co. “Trend Report: Restatements.” March 19, 2009.
Henriques, D. B. “Madoff Said From Prison That Banks Had to Know.” The New York Times (February 16, 2011).
Jones, M. Creative Accounting, Fraud and International Accounting Scandals . New York: Wiley, 2011.
Krell, Eric. “Will Forensic Accounting Go Mainstream?” Business Finance Journal (October 2002).
Mannes, George. “Cracking the Books II: Reliving Equity Funding.” October 22, 1999. http://www.thestreet.com/story/791614/cracking-the-books-ii-reliving-equity-funding-part-2.html (Accessed February 2011).
Tillman, Robert and Michael Indergaard. “Control Overrides in Financial Statement Fraud.” http://www.theifp.org/research-grants/tillman_final_report.pdf (Accessed February 2011).
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