Accounting and Reporting Fraud
By: Steve Y. Lehrer, CPA
As we continue our series on the topic of Fraud, this article is the second of ten topics, which will focus on the types of frauds that can be committed in accounting and reporting.
Accounting and Reporting Fraud
Accounting fraud is any act or attempt to falsify accounting records for financial gain. Over the past decade the financial world has experienced some of the largest frauds in history, all stemming from known, intentional and reckless falsification and misrepresentation of accounting records, and from the pursuit of personal financial gain and greed. These frauds, some to the tune of billions of dollars, destroyed jobs, wiped out retirement accounts, shattered investor confidence and shook the global economy.
I. Major Fraud Examples
Examples of massive frauds of historical proportions that have rocked the accounting world over the past decade include:
Enron was a Houston-based energy giant that collapsed and declared bankruptcy in 2001. The fraud involved hiding debts and inflating revenues. After many years of global expansion through complex business deals, Enron found itself to be billions of dollars in debt. The debt was not disclosed to shareholders and was concealed through partnerships with other companies, fraudulent accounting, and illegal loans. Losses to shareholders were $74 billion, and employees’ losses were in the billions as well. It also caused the unfortunate dissolution of Arthur Andersen, a Big 5 accounting firm. This case subsequently became the catalyst behind the passage of the Sarbanes-Oxley Act of 2002.
- Tyco International
Tyco was an international manufacturing company. They were involved in a massive financial scandal, which erupted in 2002. The source of the fraud was the improper use of company funds by the former CEO and ex-CFO. Both were found guilty of stealing $120 million and taking part in inflating the firm’s financial condition by over $500 million. Ultimately, both men were convicted of stealing hundreds of millions of dollars and using fraudulent accounting practices and falsifying records to conceal their crimes.
WorldCom, the second largest of America’s long distance telephone companies, found itself in an $11 billion accounting fraud, which was exposed in 2002. The company’s executive management perpetrated this fraud in masking the company’s failing profitability by inflating total assets through capitalization of operating costs and overstating cash flows by $3.8 billion.
AIG, at the time, one of the world’s largest companies, was shaken by a $2.7 billion scandal in 2004. The improper accounting resulted from loans that were classified as revenue. AIG was also accused of bid rigging of insurance contracts and received a $1.6 billion fine. AIG subsequently received the largest government bailout of a private company in US history.
- Satyam Computer Services
In 2009, the company Chairman shocked India and the rest of the financial world by resigning and publicly announcing that he had fraudulently misrepresented the balance sheet. He admitted to inflating cash and bank balances by $1.5 billion, overstating receivables by $100 million, and understating liabilities by $250 million. The Chairman was quoted as saying that committing these frauds was “like riding a tiger, not knowing how to get off without being eaten”. In 2011, the United States Securities and Exchange Commission (SEC) penalized the auditor of Satyam $7.5 million, charging that the auditor routinely failed to follow the most basic audit procedures.
- Bernard Madoff
In 2009, Bernard Madoff, the former NASDAQ chairman, pled guilty to 11 federal crimes and admitted to operating the largest Ponzi scheme in history. Prosecutors estimated the size of the fraud to be approximately $65 billion. Madoff and his accountant were charged with fraud and arrested as a result of preparing phony accounting records for the fictitious trading activity, which appeared on bogus investor account statements that were distributed periodically to unsuspecting investors.
- Lehman Brothers
Lehman Brothers was involved in the largest bankruptcy in American history, which caused a panic and brought the global economy to the brink of disaster. In 2010 a bankruptcy examiner provided a 2,200 page report detailing exactly how Lehman had been cooking their books from as far back as 2007. In short, Lehman entered into repurchase agreements with off shore banks. Under the deal, Lehman would sell toxic assets to those banks and buy them back in a short time. The effect was that Lehman had $50 billion more in cash on its books, and $50 billion less in toxic mortgage assets. In practice, banks use these repo tactics all the time, except they have to disclose them as liabilities and not assets.
Lehman was unable to find an American law firm that would write an opinion allowing this type of accounting treatment, and instead found an English law firm from London who found that this was acceptable under English law. Further, the company’s auditor signed off on it as well.
II. Facilitators and Contributors
The most common facilitators and contributors at the root of this type of fraud, which are all considered weaknesses in the internal control structure, though not a complete list, are:
- Lack of segregation of duties between the operations, accounting and monitoring functions
- Transactions not recorded accurately or timely
- Accounts not reconciled accurately or timely
- Improper authorization levels especially when recording reserves an estimates
- Lack of monitoring and oversight over non-routine transactions
- No transparency to the Board or another independent objective body
- Management override of established controls
- Ineffective Board who may not understand the nature or complexity of the business
- Lax or no internal audit procedures
- Collusion among two or more fraudsters
As previously discussed in my article titled “Occupational Fraud”, there are three elements that must be present in order for fraud to occur. These elements combined are known as the fraud triangle. The three elements of the fraud triangle are (a) Incentive / Pressure, (b) Opportunity and (c) Rationalization / Attitude. In the above major fraud examples, all three elements presented themselves and enabled the fraudsters to engage in their respective unlawful activities.
III. Schemes and Outcomes
Accounting and reporting fraud typically occurs in larger corporations as a result of presenting false information usually for financial gain. This type of fraud involves keeping inaccurate books. When a corporation keeps inaccurate books it means that they are not reporting all of the necessary and / or accurate information. Inaccurate books and presenting false information are two of the most common forms of accounting fraud that takes place in corporations today, and typically are the target of most SEC investigations. In general, the frauds may come in the following forms:
b) Overstating or understating revenues and expenses,
c) Overstating assets such as cash, receivables, inventories pre-paid assets, fixed assets, leases and capital improvement,
d) Understating or concealing liabilities, both short term and / or long term, reserves and estimates, deferred revenue, tax liabilities, off Balance Sheet liabilities.
Embezzlement is when a person misappropriates the assets entrusted to them. In essence, it is a breach of the fiduciary responsibilities placed upon a person. In this type of fraud the assets are obtained lawfully, as in the case of Madoff, and the embezzler has the right to possess them, but the assets are then used for unintended purposes. A recent example of embezzlement is Evelyn Reynolds, an assistant to the COO at a non-profit organization. With access ranging from credit card purchases to purchase order requests, she perpetrated a multi-faceted fraud totaling more than $100,000 in less than ten months. In large companies, embezzlement usually occurs when executives or other trusted employees falsely expense millions of dollars, transferring the funds into personal accounts. Embezzlement may be punishable by significant fines and a prison sentence.
A corporation may present false information to their financial advisors, employees, clients and other professionals when it comes to their accounting practices and other financial entities. Practices that fall into this category may include the delay of expenses, the acceleration of expected or deferred revenue, engaging in off balance sheet transactions or reporting and estimating inflated estimates of future earnings of the company. A corporation may also fail to report a segment of its income to the Internal Revenue Service in order to minimize the tax liability or overstating its income, thereby deceiving its investors and creditors.
Overstating assets may produce falsely overstated cash flows, overstated revenues and a false sense of security for investors resulting from an increase in stock price. They can also be fraudulently used as non-existent collateral to obtain financing and may also skew critical ratios and indicators used for financial planning and projection. Understated liabilities will also result in overstated revenues, and may misrepresent the liquidity and solvency of a company, thereby fraudulently disguising and avoiding the potential of bankruptcy.
IV. Fraud Detection
Effective internal accounting controls will help minimize, detect and help prevent accounting fraud. These controls are necessary both at the control activity level as well as at the entity level. Some of these controls should include, but are not limited to:
- A positive tone at the top, which conveys a sense of honesty, integrity and cooperation
- Adequately designed and effectively operating internal controls over accounting and reporting
- Segregation of duties and adequate authorization levels
- Complete transparency and accurate disclosures
- Timely analytic review of the balance sheets, operating results, profit margins, cash flows, financial ratios and industry trends
- An effective and skilled Board that participates and understands the complexities of the business
- Ongoing monitoring of internal controls and mitigation of identified control weaknesses
- An internal audit department that identifies areas of opportunity and has management’s support
A comforting thought is that given adequate and effective internal controls in place, financial statement fraud will most likely not go undetected for an extended period of time.
V. New Regulations
New regulations have been introduced pertaining to accounting fraud. These regulations include:
- Whistleblower Rules, which, given certain limitations and conditions, will compensate whistleblowers who provide the SEC with information regarding a securities laws violation, which leads to a successful enforcement of an action brought by the SEC, ultimately resulting in monetary penalties exceeding $1,000,000. The amount of the award will be equal 10-30% of the monetary sanction.
- Mandatory Executive Compensation Clawback provision, which requires every public company to: (1) disclose incentive-based compensation that is based on financial information required to be reported, and (2) adopt a policy whereby, in the event of a restatement, the company will recover from current and former executives any incentive-based compensation, for the three years preceding the restatement, that would not have been awarded under the restated financial statements. Under the Act, a failure to do so will result in delisting.
- Pay to Play rule, which is designed to prevent an adviser from seeking to influence government officials’ awards of advisory contracts through political contributions
Given the new Accounting rules and reforms over the past decade, is the financial world now truly a safer place? The two major financial reforms are the Sarbanes-Oxley Act of 2002 (SOX), and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Most regulations are mere knee jerk reactions to the schemes and frauds that have already been discovered. We can only hope that regulators do a good job at poking holes at proposed regulations and make meaningful suggestions in anticipation of any new schemes that fraudsters may think of in lieu of the new regulation.
SOX introduced a slew of new Accounting rules and criminal penalties, with a focus on greater levels of internal controls, making the CEO and CFO criminally liable for material misstatements on the Financial Statements. Dodd –Frank was designed for protecting the consumer and investor, eliminating bailouts for certain systematically important financial institutions (SIFI) and too big to fail companies, identifying and mitigating systemic risk, providing transparency & accountability over exotic instruments, managing executive compensation, enforce existing regulations, and empowering the Federal Reserve. In the case of Dodd-Frank however, it is yet unclear to what extent the provisions of this Act will ultimately be enforced.
VI. The End of the Road
Accounting and reporting fraud may occur anywhere anytime. When discovered, the end results are usually stiff penalties coupled with criminal prosecution, which leads to a conviction and a long prison sentence. Civil lawsuits can also be brought not only on the corporation entangled in the fraud but also personally against the officers and other individuals behind the fraud as well.