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

Misappropriation of assets

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

Fraudulent financial reporting

Fraudulent financial reporting is 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 the expectations of shareholders.[6]

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.

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]

Executive and managerial motivations for fraud

An executive can reduce the price of his company's stock due to information asymmetry. They can: accelerate accounting of expenses, delay accounting of revenue, engage in off-balance sheet transactions to make the company seem less profitable, or simply report very low estimates of future earnings. Executives may do this to make a company a more attractive takeover target. When the company is bought for less, the acquirer profits from the executive's actions to surreptitiously reduce the share price. This can represent tens of billions of dollars (questionably) transferred from former shareholders to the acquirer. The 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] Managerial opportunism plays a large role in these scandals.

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]

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

References

In Italian law the phrase "still subject to evaluation" now refers to material facts that are untrue: it was a clarification for "informations", but totally inconsistent with the "facts" reported in accounting documents: Giampiero Buonomo. Diritto societario: chiusa la discussione, approvazione a fine mese Diritto&Giustizia Edizione Online, 2001^
Marco Schreyer. Adversarial Learning of Deepfakes in Accounting October 9, 2019^
Steven Nickolas. What is accounting fraud?