This is the second in a series of eight articles examining different forms of accounting manipulation. Forthcoming articles will include pieces on channel stuffing and off-balance sheet transactions.
Accounting standards require that all assets be valued at their fair value. This can include tangible assets such as equipment and inventory, or intangible assets like brands and patents.
Companies frequently overstate or understate the true value of their assets. They inflate the value of assets to boost a company's financial health. They may understate assets to smooth earnings in good times or to manage tax liabilities. Depreciating assets too quickly is a common trick to hide earnings in good years, thus violating the matching principle.
While companies have wide latitude to exercise judgement when valuing assets, aggressive valuation misleads stakeholders and will eventually erode investor trust.
The best way to learn about improper accounting practices is to see real-life examples. With this in mind, we provide five famous examples of improper asset valuation: Parmalat, Autonomy Corporation, Enron, WorldCom, and Toshiba.
Three of these companies subsequently collapsed. Toshiba, once among Japan’s most-admired companies, is still eyed with caution by many. These examples illustrate the danger of aggressive accounting. Manipulation robs future earnings and allows management to hide problems that should be addressed, creating even greater difficulties at some future point. Those seeking a deeper understanding of improper asset valuation will find these companies a great place to start.
Where relevant, we complement the examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In some of the cases below, the TRE certainly picked up risky signals well before the problems bubbled to the surface.
Autonomy Corporation
Autonomy Corporation, a British software company, faced scrutiny and controversy following its acquisition by Hewlett-Packard (HP) in 2011. HP later alleged that Autonomy had engaged in aggressive accounting practices, particularly related to asset valuation, prior to the acquisition.
HP claimed that Autonomy had significantly overvalued its intangible assets, such as goodwill and intellectual property. It alleged these valuations were based on overly optimistic assumptions about future growth and profitability. HP also alleged that Autonomy had failed to take appropriate impairment charges on its assets when there was evidence of impairment, further inflating the company's reported value.
Following its acquisition, HP took an $8.8 billion write-down on the value of Autonomy, alleging that the company's accounting practices had inflated its value. HP filed lawsuits against former Autonomy executives, and the case sparked investigations by regulators in both the US and the UK.
The saga damaged the reputations of both companies and led to increased scrutiny of asset valuations in the software industry. The Autonomy case highlights the challenges of valuing intangible assets, which can be subjective and prone to manipulation. We highlighted Autonomy in our earlier article on improper revenue recognition.
For the first half of the 2000s, Autonomy averaged close to 70% for accounting risk, according to the Transparently Risk Engine. Its score peaked at 71% in 2002, putting it in the worst 5% of companies globally for accounting quality. Business manipulation featured as a top concern for the TRE that year.
Enron
Enron Corporation, an energy company in the late 1990s, provides stand-out examples of many types of improper accounting practices, including asset valuation.
Enron heavily relied on "mark-to-market" accounting, which allows companies to value certain assets (like energy contracts) at their estimated fair market value, even if those values are not yet realized. The company exploited the subjectivity of mark-to-market accounting to inflate the value of its energy trading contracts and other assets.
It used overly optimistic assumptions and manipulated valuation models to justify these inflated valuations. To further conceal its true financial position, Enron created complex off-balance-sheet entities (SPEs) to hide billions of dollars in toxic assets and debt.
Enron's actions were classic creative accounting: a deliberate and systematic scheme to defraud investors. The company collapsed in 2001 as its fraudulent accounting practices were eventually exposed. It was one of the largest corporate bankruptcies in US history and resulted in numerous lawsuits, regulatory reforms (like the Sarbanes-Oxley Act of 2002), and a loss of trust in corporate accounting practices.
From 1990-1997, when investment analysts consistently rated Enron as one of America’s best companies, the Transparently Risk Engine gave Enron risk scores between 93% and 95%, suggesting that it was among the absolute worst companies globally for risk of accounting fraud. The incidence of such a poor risk score for a large company was unprecedented.
Parmalat
Parmalat, an Italian dairy and food corporation, was involved in one of the largest European financial scandals in the early 2000s. Aggressive accounting related to asset valuation was a key aspect of its fraudulent activities.
Parmalat mis-stated assets in three ways:
- It created fictitious assets, including a massive bank account supposedly holding billions of dollars that didn't exist. The company used forged documents and complex financial transactions to create the illusion of these assets.
- It inflated the value of existing assets, such as of subsidiaries and brands, using questionable appraisals and accounting maneuvers.
- By inflating its assets, Parmalat masked its true financial position, concealing billions of euros in debt and losses.
Parmalat's fraudulent accounting practices eventually unraveled, leading to its eventual collapse in 2003. It was one of the largest corporate bankruptcies in European history.
Several Parmalat executives, including the founder, were convicted of financial fraud and other crimes. The scandal shook investor confidence in Italian corporate governance and led to increased regulatory scrutiny of accounting practices in Europe.
A streamlined version of the company was relisted on the Milan stock exchange in 2005. The French dairy company Lactalis eventually acquired control of Parmalat and delisted the company in 2019.
In 2005, the relisted Parmalat scored 76% for accounting risk, according to the Transparently Risk Engine, putting it in the worst 1% of companies globally for accounting quality. The system flagged concerns with working capital, cash quality and asset quality that year.
Toshiba
The Japanese multinational, Toshiba, offers a well-known example of a scandal involving improper asset valuation.
Toshiba was found to have been involved in a long-running accounting scandal in which it inflated profits by delaying impairment charges on long-term projects, particularly in its nuclear power plant construction division. The company clung to overly optimistic assumptions about the future profitability of these projects, even when evidence suggested they were likely to suffer losses. This practice resulted in Toshiba carrying assets on their balance sheet at grossly inflated values. By delaying impairment charges, Toshiba concealed significant losses and presented a misleading picture of its financial health for several years.
The accounting scandal, revealed in 2015, led to a massive loss for Toshiba, the resignation of its senior management, and a significant restructuring of the company. Toshiba faced heavy fines from regulators and lawsuits from investors. The scandal severely damaged Toshiba's reputation to this day.
From 1993 to 2019, the rnsparently Risk Engine gave Toshiba’s accounts an average score of 64%, consistently placing it in the bottom third of all companies globally for accounting quality. Risk scores in this zone are typically dominated by small caps and recent start-ups, not large well-established companies.
WorldCom
WorldCom was a telecommunications giant during the late 1990s and early 2000s. While primarily known for its expense manipulation (capitalizing line costs), the company also engaged in aggressive asset valuation practices, mostly in relation to an acquisition.
When WorldCom acquired MCI Communications in 1998 for $37 billion, it recorded a significant amount of goodwill on its balance sheet. Goodwill is an intangible asset that represents the excess of the purchase price over the fair market value of identifiable net assets.
WorldCom allegedly overstated the value of MCI's assets and future earnings potential to justify the large goodwill allocation. This manipulation allowed WorldCom to avoid taking significant impairment charges that would have reduced reported earnings. By inflating goodwill, WorldCom masked the true financial health of the MCI acquisition and propped up its balance sheet. This practice concealed the fact that it had massively overpaid for MCI.
WorldCom's expense recognition manipulations, combined with the improper valuation of MCI, represented a massive accounting fraud and ultimately led to collapse in 2002. WorldCom's bankruptcy resulted in billions of losses for investors and shook confidence in the telecommunications industry.
The scandal led to increased scrutiny of goodwill accounting and prompted regulators to consider stricter rules for valuing and impairing goodwill.
WorldCom emerged from bankruptcy as a rebranded MCI entity in 2004, which was acquired by Verizon Communications two years later. WorldCom’s network assets are now part of a Verizon division that serves corporate and government customers.
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