Cooking the Books: Accounting Scandals

What is a Financial Statement?

Financial statements are written documents that detail each activity and financial performance of a company. It is, in essence, a document created to provide users (investors, the government, and banks) with a fair and accurate representation of a company’s financial status and performance as well as its cash flow.

What is Fraudulent Accounting?

Accounting fraud is the false representation of a company’s financial condition in a financial statement by inflating the revenue and misrepresenting the company’s assets and liabilities. In turn, this creates a good outlook for the business and the value of its shares by deceiving investors, banks, and governmental organizations about the actual state of the company. As a result, investors are encouraged to raise their investments into the business by simply being misled and lied to .

The Fraud Triangle

The so-called “Fraud Triangle” is a result of businesses’ ongoing transmission of incorrect information to investors. This closed and continuous pattern is characterized by 3 phases: pressure, opportunity, and rationalization, which are three factors that increase the likelihood of accounting fraud.

The pressure is what spurs or motivates the fraud to be done. A potential for fraud might arise from either personal or financial hardship, such as a lack of income or debt pressure. People may turn to irrational and unlawful means or opportunities if the pressure is not relieved for an extended length of time.

This then leads us to the opportunity phase of the fraud triangle. The company’s assets are vulnerable to fraud when internal controls are loose, controls are not effectively monitored, and positions are abused in operational procedures. This then leads to the triangle’s final but not concluding stage, rationalization.

In the triangle’s rationalization phase, fraudsters assure themselves or their team that they would reimburse all of the conceived money and that everything they do is for the greater good. Therefore, it doesn’t deter fraudsters from conducting additional unlawful acts in the future.

One of the most common methods of committing accounting fraud is creative accounting. This means that the accounting practices follow required laws and regulations, but exploit loopholes to present misleading results.

~It is important to note that creative accounting doesn’t automatically mean fraudulent accounting but it can eventually lead to it.~

The Role of Financial Auditors

Auditors examine financial statements, confirm their accuracy, and ensure that businesses are following tax regulations. By doing so, they guard against fraud, expose inconsistencies in accounting practices, and assist firms in increasing the effectiveness of their operations. In addition, an auditor’s responsibilities include assisting investors in understanding a company’s activities, assessing risks, examining internal controls, and reporting any suspected fraud.

Recent Accounting Fraud Examples

#1: Enron

Background:

US energy, commodities & services company based in Texas. Once referred to as “America’s most innovative company” (2000) was accused of fraud in 2000. Enron management Jeff Skilling (CEO) and Ken Lay (former CEO) falsified financial statements to make the company appear more profitable and hide billions of dollars of debt. This was done through inflating earnings through mark-to-market accounting, which is an accounting method for determining the value of assets by assessing their current fair market value, and the use of Special Purpose Entities (SPEs’) and weak corporate governance

The consequences:

Shareholders lost over $74 billion as Enron’s share price collapsed from over $90 to under $1 within a year.
Skilling – 24 years in prison.
Enron went bankrupt; Arthur Anderson( American accounting firm based in Chicago) dissolved.
20,000 jobs lost.
Major alterations to corporate governance & accounting standards and creation of Sarbanes-Oxley Act

#2: Worldcom

Worldcom is a US telecommunication company that offered its clients discounted long-distance services, and by pursuing an aggressive acquisition strategy, it grew to become the biggest business of its sort in the country. However, in 2002 the internal audit department (Cooper) found almost $3.8b in fraudulent accounts & inflated assets by almost $11b. Fraud was committed in the form of underreported expenses and recording them as investments. Moreover, by inflating the company’s revenue through making false entries, they recorded a $1.4b profit instead of loss.

The consequences:

Bernie Ebbers (CEO) sentenced to 25 years
30,000 job losses and over $180 billion in losses by investors.
Worldcom filed for the largest Chapter 11 bankruptcy in U.S. history
WorldCom is stroll trying to pay its creditors

Conclusion

In conclusion, accounting scandals are one of the widespread forms of corporate deception. They have an impact on not just the shareholders, but also the staff members of the company who may lose their jobs and pensions as a result of these scandals. About 40% of businesses in the US are thought to have engaged in accounting irregularities during the previous few decades, which can further harm a company’s reputation, bring about harsh regulatory penalties, and even result in imprisonment. However, the increasing number of laws and strict control measures has lessened the issue and is still looking for ways to be improved.