Accounting scandals

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Accounting scandals are business scandals which 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. It involves an employee, account or corporation itself and is misleading to investor and shareholders.[2]

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.[3]

Two types of fraud[edit]

Misappropriation of assets[edit]

Misappropriation of assets, often called defalcation or employee fraud, occurs when an employee steals company's asset, whether those assets are of monetary or physical nature. Typically, assets stolen are cash or cash equivalents and company data or intellectual property.[4] However, misappropriation of assets also includes taking inventory out of a facility or using company assets for personal purpose without authorization. Company assets include everything from office supplies, inventory to intellectual property.[5]

Fraudulent financial reporting[edit]

Fraudulent financial reporting, also known as earnings management fraud. In this context, management intentionally manipulates accounting policies or accounting estimates to improve financial statements. Public and private corporations commit fraudulent financial reporting to secure investor interest or obtain bank approvals for financing, as justifications for bonuses or increased salaries or to meet expectations of shareholders.[6] The Securities and Exchange Commission has brought enforcement actions against corporations for many types of fraudulent financial reporting, including improper revenue recognition, period-end stuffing, fraudulent post-closing entries, improper asset valuations, and misleading non-GAAP financial measures.[7]

The Fraud Triangle[edit]

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/ 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]

Incentives/ Pressures: A common incentive for companies to manipulate financial statement 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, to achieve a bonus target based on earnings, or to artificially inflate stock prices. As for misappropriation of assets, financial pressures are a common incentive for employees. Employees with excessive financial obligations, or those with drug 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 they are overly concerned about the meeting analysts' earnings forecast, fraudulent financial reporting is more likely. Similarly, for misappropriation of assets, if management cheats customers through 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]

Causes[edit]

A weak internal control is an opportunity for fraudster.[12] Lack of transparency in financial transactions is an ideal method to hide a fraud. Poor management information where a company's management system does not produce results that are timely, accurate, sufficiently detailed and relevant. In such case, the warning signal of fraud such as ongoing theft from bank account can be obscured. Lack of an independent audit department within the company is also a sign of weak internal control.[13] Poor accounting practice is also part of a weak internal control. An example of poor accounting practice is failure to make monthly reconciliation of bank account.[14]

Top executive can reduce the price of his/her company's stock easily due to information asymmetry. The executive can accelerate accounting of expected expenses, delay accounting of expected revenue, engage in off balance sheet transactions to make the company's profitability appear temporarily poorer, or simply promote and report severely conservative (e.g. pessimistic) estimates of future earnings. Such seemingly adverse earnings news will be likely to (at least temporarily) reduce share price. (This is again due to information asymmetries since it is more common for top executives to do everything they can to window dress their company's earnings forecasts.

Top managers tend to share price to make a company an easier takeover target. When the company gets bought out (or taken private) – at a dramatically lower price – the takeover artist gains a windfall from the former top executive's actions to surreptitiously reduce share price. This can represent tens of billions of dollars (questionably) transferred from previous shareholders to the takeover artist. The former top executive is then rewarded with a golden handshake for presiding over the firesale that can sometimes be in the hundreds of millions of dollars for one or two years of work.[15]

Similar issues occur when a publicly held asset or non-profit organization undergoes privatization. Top executives often reap tremendous monetary benefits when a government-owned or non-profit entity is sold to private hands. Just as in the example above, they can facilitate this process by making the entity appear to be in financial crisis – this reduces the sale price (to the profit of the purchaser), and makes non-profits and governments more likely to sell. It can also contribute to a public perception that private entities are more efficiently run, thereby reinforcing the political will to sell off public assets. Again, due to asymmetric information, policy makers and the general public see a government-owned firm that was a financial 'disaster' – miraculously turned around by the private sector (and typically resold) within a few years.

Not all accounting scandals are caused by top executives. Often managers and employees are pressured or willingly alter financial statements for the personal benefit of the individuals over the company. Managerial opportunism plays a large role in these scandals. For example, managers who would be compensated more for short-term results would report inaccurate information, since short-term benefits outweigh the long-term ones such as pension obligations.[16]

List of reported accounting scandals[edit]

Company Year Audit Firm Country Notes
Lockheed Corporation 1976[17] United States
Nugan Hand Bank 1980[18] Australia
ZZZZ Best 1986[19] United States Ponzi scheme run by Barry Minkow
Northguard Acceptance Ltd. 1980 to 1982 [20] Ernst & Young Canada
Bankers Trust 1988[21] Arthur Young & Co United States Hid a $80 million mis-pricing of derivatives contributing to profits by cutting bonuses.
Barlow Clowes 1988[22] United Kingdom Gilts management service. £110 million missing
MiniScribe 1989[23] United States
Livent 1989 to 1998 Deloitte & Touche [24] Canada fraud and forgery
Polly Peck 1990[25] United Kingdom
Bank of Credit and Commerce International 1991[26] United Kingdom
Phar-Mor 1992[27] Coopers & Lybrand United States mail fraud, wire fraud, bank fraud, and transportation of funds obtained by theft or fraud
Informix Corporation 1996[28] Ernst & Young[29] United States
Sybase 1997[30][31][32] Ernst & Young[33] United States
Cendant 1998[34] Ernst & Young United States
Cinar 1998 [35] Ernst & Young Canada Misuse of corporate funds
Waste Management, Inc. 1999[36] Arthur Andersen United States Financial misstatements
MicroStrategy 2000[37] PWC United States Michael Saylor
Unify Corporation 2000[38] Deloitte & Touche United States
Computer Associates 2000[39] KPMG United States Sanjay Kumar, Stephen Richards
Lernout & Hauspie 2000[citation needed] KPMG Belgium Fictitious transactions in Korea and improper accounting methodologies elsewhere
Xerox 2000[40] KPMG United States Falsifying financial results
One.Tel 2001[41] Ernst & Young Australia
Amir-Mansour Aria 2011 IAO (Audit organization) and other Audit firms Iran Business Loans Without Putting any Collateral and financial system
Bank Saderat Iran 2011 IAO (Audit organization) and other Audit firms Iran financial transactions among banks and Getting a lot of Business Loans Without Putting any Collateral
Enron 2001[42] Arthur Andersen United States Jeffrey Skilling, Kenneth Lay, Andrew Fastow
Swissair 2001 PricewaterhouseCoopers Switzerland
Adelphia 2002[43] Deloitte & Touche United States John Rigas
AOL 2002[40] Ernst & Young United States Inflated sales
Bristol-Myers Squibb 2002[40][44] PricewaterhouseCoopers United States Inflated revenues
CMS Energy 2002[40][45] Arthur Andersen United States Round trip trades
Duke Energy 2002[40] Deloitte & Touche United States Round trip trades
Vivendi Universal 2002[40] Arthur Andersen France Financial reshuffling
Dynegy 2002[40] Arthur Andersen United States Round trip trades
El Paso Corporation 2002[40] Deloitte & Touche United States Round trip trades
Freddie Mac 2002[46] PricewaterhouseCoopers United States Understated earnings
Global Crossing 2002[40] Arthur Andersen Bermuda Network capacity swaps to inflate revenues
Halliburton 2002[40] Arthur Andersen United States Improper booking of cost overruns
Homestore.com 2002[40][47] PricewaterhouseCoopers United States Improper booking of sales
ImClone Systems 2002[48] KPMG United States Samuel D. Waksal
Kmart 2002[40][49] PricewaterhouseCoopers United States Misleading accounting practices
Merck & Co. 2002[40] Pricewaterhouse Coopers United States Recorded co-payments that were not collected
Merrill Lynch 2002[50] Deloitte & Touche United States Conflict of interest
Mirant 2002[40] KPMG United States Overstated assets and liabilities
Nicor 2002[40] Arthur Andersen United States Overstated assets, understated liabilities
Peregrine Systems 2002[40] KPMG United States Overstated sales
Qwest Communications 2002[40] 1999, 2000, 2001 Arthur Andersen 2002 October KPMG United States Inflated revenues
Reliant Energy 2002[40] Deloitte & Touche United States Round trip trades
Sunbeam 2002[51] Arthur Andersen United States Overstated sales and revenues
Symbol Technologies 2002[52][53] United States Overstated sales and revenues
Tyco International 2002[40] PricewaterhouseCoopers Bermuda Improper accounting, Dennis Kozlowski
WorldCom 2002[40][54] Arthur Andersen United States Overstated cash flows, Bernard Ebbers
Royal Ahold 2003[55] Deloitte & Touche United States Inflating promotional allowances
Parmalat 2003[56][57] Grant Thornton SpA Italy Falsified accounting documents, Calisto Tanzi
HealthSouth Corporation 2003[58] Ernst & Young United States Richard M. Scrushy
Nortel 2003[59] Deloitte & Touche Canada Distributed ill-advised corporate bonuses to top 43 managers
Chiquita Brands International 2004[60] Ernst & Young United States Illegal payments
AIG 2004[61] PricewaterhouseCoopers United States Accounting of structured financial deals
Bernard L. Madoff Investment Securities LLC 2008[62] Friehling & Horowitz United States Massive Ponzi scheme.[63]
Anglo Irish Bank 2008[64] Ernst & Young Ireland Anglo Irish Bank hidden loans controversy
Satyam Computer Services 2009[65] PricewaterhouseCoopers India Falsified accounts
Biovail 2009 [66] Canada False Statements
Taylor, Bean & Whitaker 2009 [67] PricewaterhouseCoopers United States Fraudulent spending
Monsanto 2009 to 2011 [68] Deloitte United States Improper accounting for incentive rebates
Kinross Gold 2010 [69] KPMG Canada Overstated asset values
Lehman Brothers 2010[70] Ernst & Young United States Failure to disclose Repo 105 transactions to investors
Sino-Forest Corporation 2011[71] Ernst & Young Canada-China ponzi scheme, falsifying assets
Olympus Corporation 2011[72] Ernst & Young Japan tobashi using acquisitions
Autonomy Corporation 2012[73] Deloitte & Touche United States Subsidiary of HP.
Penn West Exploration 2012 to 2014 [74] KPMG Canada Overstated profits
Toshiba 2015[75] Ernst & Young Japan Overstated profits
Valeant Pharmaceuticals 2015 [76] Canada Overstated revenues
Alberta Motor Association 2016 [77][78] Canada Fraudulent invoices
Odebrecht 2016 [79] Brazil Government bribes

Notable outcomes[edit]

The Enron scandal turned in the indictment and criminal conviction of one of the 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 is currently unwinding its business operations. The Enron scandal was defined as being one of the biggest audit failures. The scandal included utilizing loopholes that were found within the GAAP (General Accepted Accounting Principles). For auditing a big 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 getting rid 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 later the ruling was 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.

In July 2002, WorldCom filed for bankruptcy protection, in what was considered the largest corporate insolvency ever at the time.

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. 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, however, overlooks the difficulties of classifying any system of knowledge, including accounting, as rules-based or principles-based. This also led to the establishment of Sarbanes-Oxley.

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 civil action with Nortel. However, a separate civil action will be taken up against top Nortel executives including former CEO Frank A. Dunn, Douglas C. Beatty, Michael J. Gollogly and MaryAnne E. Pahapill and Hamilton. These proceedings have been postponed pending criminal proceedings in Canada, which opened in Toronto on January 12, 2012.[80] 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.[81][82][83][84][85]

In 2005, after a scandal on insurance and mutual funds the year before, AIG was investigated for accounting fraud. The company already lost over 45 billion US dollars' worth of market capitalisation because of the scandal. Investigations also discovered over a billion US dollars' 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.[86] CEO Maurice R. "Hank" Greenberg was forced to step down and is still fighting civil charges being pursued by New York state.[87][88]

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 multimillion-dollar operation, especially since it had only one active accountant.[89] Ultimately, Madoff's accountant, David G. Friehling, admitted to simply rubber-stamping 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 aren't allowed to audit broker-dealers with whom they're investing. He agreed to forfeit $3.18 million in accounting fees and withdrawals from his account with Madoff. His involvement makes the Madoff scheme the largest accounting fraud in world history.[90]

See also[edit]

References[edit]

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Further reading[edit]

External links[edit]