(Updated Sept. 24, 2024 to add greater detail on types of accounting fraud, accounting misstatement, more examples and background on accounting standards.)
Accounting fraud occurs when a company manipulates its accounting records and financial statements to make its financial condition appear better than it is.
Companies commit accounting fraud with unethical accounting practices: "Fiddling the books" to inflate profits, hide insolvency or mask criminal activities such as embezzlement or money laundering.
There are significant ramifications for stock and credit markets. Investors are hyper-sensitive to earnings and the collective impact of seemingly insignificant accounting adjustments can boost a company's stock price or help it avoid a costly downgrade of its credit rating,
Longer term, accounting tricks worsen the sustainability of earnings, eventually leading to share price collapse or insolvency. The cost of accounting fraud to investors and creditors runs to hundreds of billions in the US alone every year, making it by far the most costly form of crime in terms of pure financial loss. Contrast this with street crime which, according to FBI estimates, costs $16 billion per year.
Table of contents
Part 1: Criminal accounting fraud
The concept of fiddling the books is not difficult to grasp. Complexity arises when we must decide where account manipulation sits in the hierarchy of crime; whether it is is unethical, illegal or criminal.
- Unethical accounting contravenes social norms and is considered morally unacceptable to the public;
- Illegal accounting encompasses all activities that are punishable by law; mostly by fines, sanctions and criminal law; and
- Criminal accounting encompasses only those activities that are punishable under criminal law.
Under law, accounting fraud might be considered unethical but not illegal, or illegal but not necessarily criminal.
Assigning this hierarchy can be difficult because accounting is complex and the principles of accounting are subject to wide interpretation. Accounting fraud is mostly grey, not black and white.
The General Electric Company (GE) affords a good example. After the 2008 financial crisis, this previously admired company employed numerous tricks to make its balance sheet appear strong.
In one example, GE cut its liabilities by more than 10 billion by simply increasing the interest rate assumption used to value its pension liabilities. Even more questionable, GE failed to report losses on a disastrous corporate acquisition, and failed to recognize insurance liabilities worth tens of billions. These and other adjustments meant that GE's financial health was far worse than reported.
At the time, some argued GE's accounting was criminal. Others said it was merely aggressive, which is a nice way of saying unethical. In 2020, the US regulator, the SEC, settled the matter. It found GE's accounting illegal and fined the company $200 million. GE paid the penalty but neither admitted nor denied the order’s findings. In other words, GE settled out of court.
In matters of accounting fraud, settlements are common. Government prosecutors have substantial discretion in determining whether or not accounting fraud cases should go to trial. In all but the most egregious cases, prosecutors pursue a settlement because accounting fraud is exceptionally difficult and costly to prove. To appreciate why this is so, one must understand where accounting fraud sits in the context of financial crime.
Legal definition of accounting fraud
Accounting fraud is subject to both a legal and an accounting interpretation. The distinction is important for understanding how accounting fraud is investigated and prosecuted.
In every jurisdiction, corporations and individuals are charged under criminal codes and statutes that were not designed for the complexity of accounting but rather were designed for the complexity of the law. This necessity causes legal and accounting interpretations of accounting fraud to differ.
Fraud refers to any deceptive act performed to achieve a gain.
Using a fake ID to enter a bar is a common example of fraud. Any accounting manipulation, however small, which hides a company's true financial position represents fraud under an accounting interpretation.
Fraud becomes a crime when it is a “knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment." In other words, criminal fraud involves deceit with the intention to illegally or unethically gain at the expense of another.
To achieve a conviction for fraud, prosecutors must demonstrate intent, that is, knowing and wilful falsification. They must also demonstrate damage. Falsification can involve lying, withholding key information, faking documents, or misuse of power or position in bribery and corruption cases.
Using a fake ID to enter a bar is not criminal fraud because no harm is inflicted. Using a fake ID to Induce a valet to hand over a Ferrari is criminal fraud because the owner of the car suffers damage.
Although fraud can be a criminal act, the law does not recognize a single cause of action known as "fraud." One cannot be indicted for simply "fraud" or for "accounting fraud." The concept does not exist because, as noted above, the criminal code is designed for legal not accounting complexity. When it comes to criminal conviction, the law is not overly concerned with accounting standards and principles. It cares about demonstration of intent to deceive and of damage.
An action for fraud must be broken into a set of claims under the penal code, each of which must be proven separately. Evidence of account manipulation will be just one element of the burden of proof needed to secure a conviction.
Unless a witness, an email trail or some other evidence suggests otherwise, it's exceptionally difficult to prove intent.
Proof of manipulation must be backed by demonstration of intent to deceive, which can be onerous. The standard defense in a fraud case isn’t that fraud didn’t happen; it’s that the perpetrators didn’t know they were breaking the law.
Unless a witness, an email trail or some other evidence suggests otherwise, it's exceptionally difficult to prove intent. This complication explains why prosecutions for corporate crime are rare.
Figure 1: US corporate prosecutions by fiscal year, 1992 to 2022
Source: Citizen.org
In 2022, for example, the US Department of Justice prosecuted just 99 companies. The vast majority were for non-financial crimes, such as breach of environmental or health & safety codes. Out of the 99 prosecutions in 2022, there was only one conviction for accounting fraud, that being for counts of embezzlement and of making false statements to the SEC by the former CFO of the PR firm, Weber Shandwick.
Of course convictions are even rarer. The difficulty of obtaining convictions for corporate crime is illustrated by the corporate criminal justice funnel in Figure 2.
Figure 2: The corporate criminal justice funnel
Source: Annualreviews.org
In any given year, there are millions of reports of ethical misconduct by US companies. From this, several thousand are typically referred to federal prosecutors as having the severity and evidence to be worthy of criminal trial. This leads to between 100 and 300 prosecutions per year. Of these, about 60-to-70% result in conviction.
This horrendous conviction rate explains why regulators typically rely on out of court settlement rather than criminal prosecution, not just in the US but in most jurisdictions. US corporations have paid more than $1 trillion in regulatory fines, criminal penalties, and class-action settlements since 2000.
Accounting fraud as a financial crime
Understanding accounting fraud in a legal context requires some understanding of the criminal code, which varies from country to country. Legal systems based on common law traditionally distinguish between fraud (obtaining with consent through deception) and theft (taking without consent).
In some jurisdictions, however, fraud is simply considered a type of theft and might be prosecuted somewhat differently than in the discussion that follows. In particular, the need for demonstration of intent can be less burdensome in jurisdictions that do not follow English law.
In most jurisdictions, accounting fraud falls under the umbrella of financial crime. Investigations of corporate financial fraud are typically undertaken by regulatory bodies in charge of securities markets, such as the SEC in the US or BaFin in Germany.
Unlike law enforcement agencies charged with policing street crime, these agencies have expertise in assessing financial fraud. They are often supported by, or run investigations in parallel with, national policing agencies, such as the FBI in the US or the Royal Canadian Mounted Police.
Virtually all financial crime involves some kind of fraud. This might be accounting fraud or it could be another kind of fraud.
Financial crime can be corporate or white collar. There is a misconception that white collar and corporate crime are the same thing, but they are not.
White-collar crime is committed by an individual or group of individuals for personal gain. Corporate crime is committed by the agents of a company for the benefit of the business or its shareholders. Cases involving accounting fraud commonly have a mix of both white collar and corporate indictments. The former are often easier to prosecute because the financial accounts of an individual are more transparent than those of a corporation.
In white-collar crime, accounting fraud is most commonly associated with embezzlement and securities fraud, particularly insider trading, pump and dump and Ponzi schemes. Examples of white-collar crime not associated with accounting fraud would include identity theft, cyber crime, credit card fraud and insurance fraud. Small-scale embezzlement might not involve accounting fraud.
It can be argued that all corporate financial crime involves some degree of accounting fraud.
Accounting fraud is more prevalent in corporate crime than in white-collar crime. Indeed, it can be argued that all corporate financial crime involves some degree of accounting fraud. Put another way, in a corporate context, if there is evidence of significant accounting fraud, there is almost certainly an indictable crime. As we shall see, government regulators use this line of argument to impose fines.
Figure 1 illustrates the main types of corporate crime associated with accounting fraud under US law. Each crime requires some degree of account manipulation. Bribery, for example, cannot simply be recorded as a payment to Governor X. It must be linked to some fake good or service provided by a fake supplier. All this fakery requires a misstatement of the accounts.
Figure 3: Types of corporate financial crime involving accounting fraud
Source: Transparently.AI
This example is based on the US criminal code. The taxonomy of crime will be different in other jurisdictions. The name of the crime will differ, but the essential nature of the crime will be the same.
In the US, prosecutors mostly rely on securities law, and on wire fraud and bank fraud statutes within the criminal code to secure convictions. Cases involving the misappropriation of assets can be prosecuted as embezzlement under state or federal law, sometimes both, depending on ease of likely prosecution. Embezzlement cases normally also incorporate indictments based on securities law.
Common accounting fraud indictments
Far and away the most common indictments linked to accounting fraud involve securities fraud. Securities fraud occurs when an agent induces investors to make purchase or sale decisions on the basis of false information. Securities fraud can take many forms, ranging from boiler room fraud as per The Wolf of Wall Street to Ponzi schemes such as that orchestrated by Bernie Madoff.
Wire fraud occurs when a person intentionally and voluntarily uses a communication device that sends information over state lines as part of a scheme to defraud another out of money or other valuables. It can involve the use of a landline telephone, cell phone, computer, or any electronic device.
Bank fraud includes any “scheme or artifice” intended to “defraud a financial institution,” or the use of deceptive means to obtain something of value that a financial institution owns or controls.
In summary, perpetrators of accounting fraud are not tried on on accounting violations. They are tried on specific fraud actions under the criminal code, within which accounting violations represent part of the burden of proof. The most common prosecutions are for securities fraud, wire fraud and providing false information. The complexity of cases involving accounting fraud means that convictions are rare.
Examples of criminal accounting fraud: Enron, FTX, Wirecard
Enron, FTX and Wirecard all resulted in criminal charges because these companies collapsed. Once a company collapses, liquidating auditors can dissect a company’s books, uncovering evidence that financial statement auditors can only dream of.
As noted, when offenders are indicted, they are not charged on the basis that they breached a particular accounting rule, they are charged on a breach of the criminal code, which varies from country to country.
By way of example, the former CEO of Enron was indicted on 38 crimes. He was convicted on 19 counts: 1 count of conspiracy, 5 counts of making false statements to auditors and 13 counts of securities fraud including one count of insider trading.
Convictions for securities fraud require solid accounting evidence. When accounting evidence is scant, typically due to document destruction, prosecutors will often seek assistance from one of the conspirators in return for a plea bargain.
Anthony Fastow, the former CFO of Enron, for example, was indicted on 78 counts, including fraud, money laundering, and conspiracy. In return for his testimony, he pleaded guilty to just two counts of wire and securities fraud, and agreed to serve a reduced ten-year prison sentence.
In the absence of witness support, prosecutors will sometimes pursue indictments on related financial crimes where the burden of accounting proof is less onerous, such as wire fraud, conspiracy to commit crime or making false statements to the government or auditors. The CEO of WorldCom, for example, was convicted with just one count of securities fraud, one count of conspiracy and 7 counts related to false SEC filings,
In an extreme example, FTX did not have a functioning accounts department in the traditional sense. As such, it was challenging to charge the founder, Sam Bankman-Fried, under traditional corporate financial law. He was convicted on 7 criminal counts, including one count of wire fraud, two counts of conspiracy to commit fraud, and one count of money laundering conspiracy over the theft of funds.
He was also convicted of bank fraud and foreign bribery conspiracy. Thus, Bankman-Fried was mostly charged on conspiracy to commit fraud and other crimes, rather than on the crimes themselves.
Wirecard's ex-CEO, Markus Braun, was formally charged with commercial gang fraud (similar to racketeering under US law), breach of trust (found within bank law in the US), 25 cases of market manipulation (securities fraud in the US) and false accounting (providing false information in the US legal code). The fact that he was not charged with embezzlement might suggest innocence or might mean that the accounts were so muddied that theft could not be demonstrated.
The standard defense in a fraud case isn’t that fraud didn’t happen; it’s that the perpetrators didn’t know they were breaking the law. As mentioned earlier in this article, unless a witness, an email trail or some other evidence suggests otherwise, intent is difficult to prove.
Thus, in the case of Marvell Technology, the Department of Justice did not press criminal charges even though the company admitted fault in the matter of the backdating of options and restating earnings by more than $300 million.
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Part 2: Illegal accounting fraud
The complexity and cost of demonstrating criminal accounting fraud means that corporate law enforcement has seen a discernable shift in discretion from judges to prosecutors over the past decade. The emphasis has shifted from enforcing criminal accounting fraud to enforcing illegal accounting fraud. Prosecution for illegal accounting does not require any demonstration of intent.
In this new regime, government regulators are charged with not only investigating but also prosecuting the worst offenders of accounting fraud.
Prosecuting agencies follow prosecutorial guidelines by which discretionary fines dictate the kind and quality of corporate punishment.
Prosecutorial guidelines are based on the extent to which accounting standards and principles are violated. This approach relies on our previous observation that all corporate financial crime involves some degree of account manipulation. The greater the accounting violation, the worse the probable crime.
In the US justice system, the SEC can impose fines based on its guidelines, or can bring civil or criminal action in the federal court in coordination with the Department of Justice (DOJ). Unless it expects a conviction, the SEC will interpret accounting fraud as an accounting violation.
The greatest problem faced by regulators is that of identifying cases of fraud. It is estimated that only one third of corporate fraud instances are ever detected. To circumvent the problem, regulators increasingly rely on whistleblower strategies to identify fraudulent companies.
Whistleblowers are rewarded with a percentage of the fines collected. In the US, fines are typically referred to as financial remedies, and the average fine has risen sharply in recent years. In fiscal 2023, the SEC obtained orders for $4.95 billion in financial remedies.
Companies and individuals can challenge financial remedies in court but few choose this route due to cost and reputational risk from media coverage. In most cases, prosecutors seek financial damages from companies where they feel they could build a criminal case if necessary. Thus, the criminal code remains relevant.
What accounting practices are illegal?
The rulings and actions of government regulators effectively set the boundary between illegal (read excessive) versus unethical (read aggressive) account manipulation.
Illegal manipulation need not necessarily imply criminal activity. In practice, what matters to regulators, and indeed to investors and creditors, is the extent to which a company’s accounts distort its true financial condition, that is, the extent to which account manipulation might mislead investment or lending decisions. Thus, in terms of our previous sections, the primary legal focus is securities fraud.
This determination does not require legal judgement. It requires accounting judgement of the extent to which a company has violated accounting standards and principles.
Accounting standards and principles aim to ensure that the financial accounts of a public company give an accurate representation its true financial condition and to ensure that the financial statements of different companies are comparable.
Under an accounting interpretation, any violation of accepted accounting standards, however slight, represents fraud regardless of legal interpretation...
Under an accounting interpretation, any violation of accepted accounting standards, however slight, represents fraud regardless of legal interpretation. Fraud is not limited to violations that inflate a company's performance because violations are often used to smooth results to give the false impression of financial stability.
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Accounting standards: IFRS & GAAP
Two bodies set the financial reporting standards for publicly held companies. They are the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB).
The IASB, headquartered in London, develops and approves a code of standards known as IFRS (International Financial Reporting Standards). The FASB, headquartered in Connecticut, focuses mainly on setting standards and rules for accounting firms and individual certified public accountants practicing in the United States. It develops and approves the accounting standard known as GAAP (Generally Accepted Accounting Principles).
IFRS is used in more than 110 countries around the world, including the EU and many Asian and South American countries. GAAP, on the other hand, is only used in the United States. The number of companies following each standard is roughly equal.
The primary difference between the two systems is that GAAP is rules-based and IFRS is principles-based. This difference exists because a principles-based standard is easier to implement across multiple countries than a rules-based standard.
The IASB and FASB work cooperatively towards establishing unified global accounting standards but key differences remain.
Both IFRS and GAAP offer considerable latitude for interpretation and all companies massage their accounts to a certain extent. One study claims that 41% of companies “misrepresent their financial reports.” It further alleges that 10% of “large, publicly traded companies” commit securities fraud,
If these numbers are even half right, thousands of public companies are in violation of accounting standards and regulators have much work to do.
What is accounting misstatement?
When regulators fine corporates for illegal accounting, they typically charge them for what is known as misstatement. A misstatement occurs when accounting method violates accounting standards. There are two types:
- Misstatement arising from fraudulent financial reporting
- Misstatement arising from misappropriation of assets
In serious cases of fraud, the two sources of misstatement will co-exist.
According to the Public Company Accounting Oversight Board (PCAOB), the independent body that oversees audit standards in US public companies , misstatements arising from fraudulent financial reporting are:
"Intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles (GAAP)."
Fraudulent financial reporting is defined as:
- Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared;
- Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information; or
- Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.
In plain English, misstatement arising from fraudulent accounting consists of falsifying accounting records such as sales receipts, misrepresenting or omitting key transactions such as loans, or deliberately violating accounting standards and principles.
Once again deferring to the PCAOB, misstatements arising from misappropriation of assets involve "the theft of an entity's assets where the effect of the theft causes the financial statements not to be presented, in all material respects, in conformity with GAAP.”
In plain English, misstatement arising from asset misappropriation consists of accounting manipulation to hide the theft of a company's assets. Misappropriation of assets can include:
- Embezzling receipts;
- Stealing assets; or
- Causing an entity to pay for goods or services that have not been received.
Misappropriation of assets is essentially theft and can be easier to prosecute than fraudulent financial reporting. Thus, this type of misstatement more frequently ends in court.
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Understanding accounting standards and principles
Since misstatement is determined with reference to accounting standards, one must have some knowledge of accounting standards and principles to have a meaningful understanding of accounting fraud:
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Accounting standards are specific, objective, and provide clear instructions for achieving specific outcomes. They can be thought of as rules for specific accounting treatments, such as how to account for a lease or M&A.
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Accounting principles, by contrast, are general, subjective, and provide a framework for ethical decision-making. For example, when to recognize revenue or potential losses on an asset.
Standards and principles serve distinct purposes. Both are valuable tools in different contexts and both are relevant in regulatory actions.
The IFRS Foundation publishes 17 standards that apply to specific aspects of accounting:
- IFRS 1: First-time adoption of international financial reporting standards
- IFRS 2: Share-based payment
- IFRS 3: Business combinations
- IFRS 4: Insurance contracts
- IFRS 5: Noncurrent assets held for sale and discontinued operations
- IFRS 6: Exploration for and evaluation of mineral resources
- IFRS 7: Financial instruments: disclosures
- IFRS 8: Operating segments
- IFRS 9: Financial instruments
- IFRS 10: Consolidated financial statements
- IFRS 11: Joint arrangements
- IFRS 12: Disclosure of interests in other entities
- IFRS 13: Fair value measurement
- IFRS 14: Regulatory deferral accounts
- IFRS 15: Revenue from contracts with customers
- IFRS 16: Leases
- IFRS 17: Insurance contracts
In addition, IFRS-compliant entities must also follow 25 international accounting standards (IAS) issued by the International Accounting Standards Board (IASB):
- IAS 1: Presentation of financial statements
- IAS 2: Inventories
- IAS 7: Statement of cash flows
- IAS 8: Accounting policies, changes in accounting estimates and errors
- IAS 10: Events after the reporting period
- IAS 12: Income taxes
- IAS 16: Property, plant and equipment
- IAS 19: Employee benefits
- IAS 20: Accounting for government grants and disclosure of government assistance
- IAS 21: The effects of changes in foreign exchange rates
- IAS 23: Borrowing costs
- IAS 24: Related party disclosures
- IAS 26: Accounting and reporting by retirement benefit plans
- IAS 27: Separate financial statements
- IAS 28: Investments in associates and joint ventures
- IAS 29: Financial reporting in hyperinflationary countries
- IAS 32: Financial instruments: presentation
- IAS 33: Earnings per share
- IAS 34: Interim financial reporting
- IAS 36: Impairment of assets
- IAS 37: Provisions contingent liabilities and contingent assets
- IAS 38: Intangible assets
- IAS 39: Financial instruments: recognition and measurement
- IAS 40: Investment properties
- IAS 41: Agriculture
Each standard provides explicit guidance for specific accounting treatments in situations where the opportunity for misstatement is high. Most of these IFRS standards have matching standards under GAAP although differences remain.
Figure 4 shows the eight most important principles common to both GAAP and IFRS. An accountant must apply these principles when preparing the financial statements of an entity. These eight principles figure prominently in enforcement actions by regulators.
Figure 4: The eight most important accounting principles
Source: Transparently.AI
By far the most common principle investigated in enforcement actions is revenue recognition, followed by the conservativism principle. Violations will then refer to both the section of the standards where the violation occurred.
Fraudulent financial reporting need not be the result of a grand plan or conspiracy. It may be that management representatives rationalize the appropriateness of a material misstatement, for example, as an aggressive rather than indefensible interpretation of complex accounting rules, or as a temporary misstatement of financial statements, including interim statements, expected to be corrected later when operational results improve.
Accounting fraud, a.k.a. misstatement, can occur anywhere in a company’s financial statements but most commonly occurs in the income statement and the balance sheet. Revenue, expenses, assets and liabilities are the items most commonly affected. Cash is more difficult to misstate unless a company is willing to falsify records.
There are many types of accounting fraud and we can’t examine them all here. Our intention is simply to give a sense of what accounting fraud looks like.
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Account manipulation versus account misstatement
From the outset, we must distinguish between account manipulation and account misstatement, a frequent cause of confusion.
Account manipulation occurs when accounting discretion is used to improve or change the impression given by a company’s accounts, for example, to boost earnings. Done properly, account manipulation is perfectly legal.
Many forms of account manipulation reflect accounting decisions that are allowable within the rules of GAAP or IFRS. Frequent forms of manipulation relate to:
- the timing of revenue or expense recognition,
- the re-valuation of assets and obligations,
- the treatment of income from related businesses,
- the treatment of non-cash expenses such as depreciation and amortization, and
- the reporting of related party transactions.
For example, a company might use accruals to recognize revenue before a product has been delivered. Property companies are a great example. They typically book sales well before apartment construction is completed.
This is a great way to boost earnings because revenue is recognized sometimes years before the expense associated with the sale is recorded. This can inflate earnings and gross margin to a wondrous extent.
The practice works well in a growing real estate market but typically leads to dire consequences in a property downturn. This explains why real estate companies the world over collapse with great regularity. Chinese property developers employed very aggressive accrual accounting.
This accruals example also illustrates how account manipulation weakens a company’s true financial situation. Anything that makes the accounts look better today will cause them to be worse in the future.
Account misstatement occurs when account manipulation is taken too far and contravenes accounting standards. Thus, in terms of the above it would be:
- Premature revenue recognition,
- Improper capitalization of expenses,
- Improper valuation of assets and liabilities,
- Incorrect treatment of income from related businesses,
- Improper treatment of non-cash expenses such as depreciation and amortization,
- Failure to report related party transactions, and
- Failure to recognize losses in a timely manner.
There are many possibilities for account misstatement arising from accounting fraud, especially once a company decides to lie. These might include:
- Fictitious sales and expenses,
- Concealment of liabilities or obligations,
- Improper or inadequate disclosure of material contracts or relationships, and
- Faking cash balances
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Examples of misstatements
Misstatement due to asset misappropriation typically leads to overstated assets, overstated cash holdings, understated sales or excessive payments on discretionary expenses.
Misstatement example #1: Fictitious sales
To pick one of the above examples, fictitious revenue involves claiming sales that did not occur. Common examples would include double-counting sales, creating phantom customers or overstating or otherwise altering the legitimate invoices of existing customers.
Companies that undertake this kind of fraud sometimes reverse the false sales at the end of the reporting period to conceal the deceit.
Remarkably, this is what Wells Fargo did in a fraud case that surfaced in 2016. Wells Fargo employees were given impossible sales goals. To meet targets, employees created millions of checking and savings accounts on behalf of clients — but without their consent. The accounts were then cancelled after the reporting period.
A good example of a somewhat more elaborate misstatement is channel stuffing, in which a company ships more goods to distributors and retailers along its distribution channel than end-users are likely to buy in a normal inventory cycle.
This is usually achieved by offering deep discounts, rebates, and extended payment terms, to persuade distributors and retailers to buy quantities in excess of their current needs. In most cases, distributors retain the right to return any unsold inventory which makes it dubious that a final sale has occurred.
Unless fully documented, channel stuffing is considered illegal. It helps to boost sales and profit numbers, sometimes for as long as 6 to 9 months. It is typically evidenced by a sharp jump in accounts receivable. Since channel stuffing comes at the expense of future sales, it always leads to a deterioration in financial performance.
Misstatement example #2: Improper capitalization of expenses
A very simple example of expense misstatement would be to classify an operating expense as capital expenditure (capex).
Companies frequently capitalize operating expenses such as sales and marketing costs or maintenance as an investment activity. Thus, the expense is capitalized and becomes a depreciation expense, realized slowly over time, rather than an operating expense that is recognized immediately. The effect is to improve the company's operating margin and operating profit.
Agricultural businesses, restaurants, miners and companies with a lot of R&D have been notorious for this kind of expense manipulation in the past. Pharmaceutical and biotech companies are good examples.
Misstatement example #3: Equity accounting
Asset valuations are another popular avenue for account manipulation, especially investments using the equity accounting method.
When a company invests in a new product or buys another business it can choose to buy it entirely and incorporate the business within its own accounts, buy more than 50% and run it as a subsidiary, or it can acquire between 20% and 50% and keep it as an equity investment on its accounts.
In Asia, it is very common for entrepreneurs to invest alongside their companies in equity investments.
The choice of acquisition methods typically says volumes about the way a company manages its accounts. Companies with conservative accounting will typically just fold acquisitions and investment in innovations into their existing business.
Companies with aggressive accounting will prefer to keep investments at arms-length, either as subsidiaries or as equity investments. They will prefer to develop new businesses as a JV or some other kind of start-up. We have documented the role of subsidiaries in accounting manipulation in a separate article.
Companies that practice aggressive accounting will typically use the equity accounting method for subsidiaries (where it is optional) and equity investments (where it is compulsory). Under equity accounting, the initial investment is recorded at cost and each reporting period adjustments are made, depending on the assessed value of the investment at the end of the period.
Any profit or income on the investment will also reflect in changes in the value of the investment in direct proportion to the ownership percentage. As you might imagine, this of kind of set-up allows tremendous scope for account manipulation.
Part 3: How accounting manipulation hurts the financial system
Financial market participants cannot observe account misstatement but they can observe evidence of account manipulation. Evidence suggests that companies with signs of aggressive account manipulation are frequently guilty of accounting fraud. In fact, the Transparently.AI business model is based on this relationship between manipulation and misstatement.
In spite of this strong link between manipulation and fraud, investors are frequently willing and indeed excited to invest in companies demonstrating aggressive manipulation or companies alleged to have committed accounting fraud.
More often than not, sell-side brokers will staunchly defend companies accused of fraud. In fact, brokers typically have overwhelming buy recommendations on companies that demonstrate evidence of extreme account manipulation; Enron and Wirecard are good examples but the list is endless.
In a current example, our system detected aggressive accounting at PDD, which has been accused of accounting fraud by short sellers. As recently as September 17, 2024, analysts had 44 buy/overweight recommendations on the stock, 3 holds and no sells or underweight recommendations. On August 28, 2024, Motley Fool issued a note advocating "4 Reasons to Buy PDD Stock Like There's No Tomorrow".
This situation suggest that many financial market participants are not overly concerned about accounting issues.
This attitude is misguided. There are three major reasons why accounting fraud is most definitely bad:
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It inflicts massive losses
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It reduces the efficiency of financial markets, and
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Acceptance of fraud promotes a culture of dishonesty
Accounting fraud causes losses
Since account manipulation artificially raises current profit at the expense of future profit, absorbs working capital and hides balance sheet weakness, it always affects the future prospects of a company. It is deceptive and if it persists always leads to some degree of share-price collapse, causing losses to deceived investors and creditors.
The cumulative damage caused means that account manipulation can be a slippery slope. Minor manipulation today frequently lead to greater manipulation in subsequent years.
We see this pattern of escalation time and again in some of the biggest cases of accounting fraud over the past half century; good companies turning bad due to increasingly aggressive accounting practices. Enron, WorldCom, GE, Parmalat, Tesco, and Valeant Pharmaceuticals are good examples of this pattern. The list is long.
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Accounting fraud reduces financial market efficiency
Modern financial markets allocate scarce capital according to the relative profitability and solvency of companies. If 40% of companies are manipulating their accounts, this means that far too much capital is being allocated to companies with weak business models and questionable management.
The cost to society from such a misallocation of resources is incalculable. When compounded over time, the costs must be enormous.
Financial markets are lubricated with trust. Once a company is suspected of account manipulation, investors will typically extrapolate the problem. Accenture’s Competitive Agility Index, a 7,000-company, 20-industry analysis, has been used to quantify how a decline in stakeholder trust impacts a company’s financial performance.
Following a material drop in trust, a company’s agility index score fell 2 points on average, negatively impacting revenue growth by 6% and EBITDA by 10% on average.
In other words, once a company is perceived to be fraudulent, whether fraudulent or not, its actual performance suffers. This is likely because good people do not wish to work for an employer perceived to be fraudulent.
Seen in this light, fiddling the books can cause more damage to corporate and global economic performance than is commonly perceived. The feedback effects are strong.
Accounting fraud promotes a culture of dishonesty
Neurological research supports the contention that aggressive accounting can be a gateway drug to accounting fraud. Physiological studies of the brain show that lying becomes easier the more we lie and thus lying tends to be habit forming.
The study of lying within organizations is comparatively new. Nevertheless, a growing body of evidence suggests that a pattern of lying, even small lies, by an organization’s leader can have a big impact on the organization’s culture. In other words, small lies tend to encourage dishonesty.
Research in accounting has typically focused on the ‘fraud triangle.' Under the fraud triangle, corporate fraud requires each of the following circumstances to prevail: (i) motivation/pressure; (ii) opportunity and (iii) rationalization of actions.
In the context of the fraud triangle, even a small amount of manipulation will tend to foster increasing future manipulation because opportunity and rationalization become easier as a corporate culture becomes desensitized to dishonesty.
Moreover, motivation/pressure will build over time because every accounting manipulation technique boosts current profit at the expense of future profit.
About the author: Mark Jolley has been an investment strategist for almost 40 years and has advised some of the world’s biggest investment funds, public companies and notable investors. In the mid-1990s, as a global investment strategist with Deutsche Bank, Mark produced a daily note read by more than 16,000 investment professionals including voting members of the Federal Reserve and the European Central Bank. In the 2000s, Mark worked as Deutsche Bank’s Asian strategist and then as strategist for China Construction Bank. He is now an independent analyst.
