Accounting Fraud

Gary Giroux

• Publisher: Business Expert Press
• Year: 2017
• ISBN:
  9781947098756
• Edition: 2
• Topic: Business
• Subtopic: Principi contabili
• Index: Business

Scandals relating to manipulation and fraud have dominated much of the history of business and the accounting profession in America since it's founding. Crooks, corruption, scandals, and panics have been regular features of the business landscape, with regulations and the expansion of financial disclosure, auditing, and regulatory agencies following major debacles.

Prior to the creation of the Securities and Exchange Commission (SEC) in the 1930s and the development of generally accepted accounting principles (GAAP), few accounting rules existed and it is difficult to identify "accounting" scandals. Beginning with the New Deal of the 1930s, regulations of financial markets (including the SEC); the creation of generally accepted accounting principles (GAAP) and organizations to improve and keep GAAP current (now in the hands of the Financial Accounting Standards Board); and auditing (currently under the Public Company Accounting Oversight Board) improved accounting and audit practices and financial disclosures. Despite these efforts, accounting frauds continue—many in new and innovative ways.

This book brings to light the importance of incentive structures of key players, consideration of economic and psychological perspectives on behavior, and the need for increasingly effective regulation, which become more obvious by considering decades of abuse. Executive compensation, pensions, market values, special purpose entities, and derivatives continue to be problematic accounting issues as they have for decades.

Inside, you'll get exposure to financial disclosure issues and other accounting risks, plus additional knowledge of accounting fraud and risk areas.

CHAPTER 1

Accounting Scandals, A Historical Perspective

Is it possible that scandal is somehow an essential ingredient in capitalism? That a healthy free-market economy must tempt a certain number of people to behave corruptly, and that a certain number of these will do so? That the crooks are not a sign that something is rotten but that something is working more or less as it was meant to work?

—Michael Lewis

The Role of Accounting, Financial Disclosure, and Auditing

Accounting, defined broadly, includes all aspects of keeping track of monetary and other business transactions for individuals, corporations, and other institutions. These records are used internally for management control and decisions. Periodic financial statements are issued to provide information to investors and other interested outsiders. Accounting started with the use of barter by merchant traders before the dawn of history, with archeological findings suggesting the starting point of record-keeping in the Fertile Crescent some 10,000 years ago. Italian merchants in the late Middle Ages developed double-entry bookkeeping. Accounting sophistication increased as business expanded and economic complexity increased. Those mastering double entry had a competitive advantage and became more likely to succeed.

Northern Europe innovations included the joint stock company, stock exchanges, and the many inventions leading to the Industrial Revolution and factory production. Factory owners typically made little use of accounting until forced by desperation to figure out costs and how they made money, usually during depressions when sales collapsed. The vast majority of the firms did not adjust and failed. Eighteenth-century British Potter Josiah Wedgwood was one who used accounting to avoid bankruptcy during the depression of 1772 and build an increasingly thriving business. He had to understand cost accounting in enough detail to know the costs of specific products, where to save money, and how to adjust prices. Wedgwood improved the record-keeping in enough detail to determine expenses for materials and labor for each manufacturing step for each product. For the first time, he discovered specifically what each product cost and adjusted sales prices accordingly. Wedgwood figured out that his high fixed costs encouraged increasing volume. His markets were roughly divided between high-price high-quality products for richer customers and lower-cost lower-price products for the rest. Focusing only on the needs of the wealthy, although lucrative, did not produce enough sales to make money, given the high fixed costs.

In the United States, accounting was initially primitive (not much different from Italian counterparts of the late Middle Ages) and improved as the need arose for better information, for roughly the same reasons as Wedgwood. Progress was made in New England textile manufacturing as it became larger, integrated, and more complex. Considerable progress was made by railroads especially in cost and managerial accounting as professional managers needed considerable timely information on railroad operations that became increasingly complex and costly. Andrew Carnegie adapted many of the accounting methods developed at the Pennsylvania Railroad (where he received his initial training) to make his steel empire the most efficient and lowest-cost producer in the country. Other manufacturing companies were making similar progress. By early in the 20th century, Du Pont developed the most advanced cost accounting system around, including the use of return on investment (ROI) and the Du Pont model for decomposing income.

Industrial accounting reached its mid-20th-century zenith at General Motors (GM) under President Alfred Sloan and controller Donaldson Brown. The accounting system of Du Pont was adopted and expanded (Du Pont acquired a controlling interest in GM before 1920). GM became the biggest manufacturing firm in the world by the mid-20th century, with arguably the most efficient manufacturing system in a decentralized structure. This structure worked because of the detailed accounting records maintained at the factory floor level and quickly delivered and analyzed by the centralized staff. By the 1960s, a host of problems including the rise of efficient Japanese and other foreign manufacturers began a relative decline at GM and other American manufacturers. Japanese systems focused on quality and various forms of efficiency eventually revolutionized manufacturing literally around the world. The rise of computers, the Internet, and robots and other forms of automation again changed the nature of manufacturing accounting.

Financial Disclosure

Financial statement and other disclosures typically presented in an annual report summarize the financial position, earnings, and cash flows to allow outsiders to have a reasonable financial understanding of the underlying business for the fiscal year. While most companies viewed financial information as proprietary and refused to release information unless absolutely necessary (such as to get a bank loan), balance sheets and other financial disclosure became more common in the 19th century as railroads and other large businesses issued financial reports to attract investors into their stocks and bonds in the capital markets.

Throughout the 19th century, stock and bond investors relied on cash dividend and interest payments rather than earnings (an income statement was viewed with skepticism before formal accounting standards were developed in the mid-20th century). Standardized financial disclosures evolved as the Securities and Exchange Commission (SEC) and the private sector bodies issued accounting standards (the Committee on Accounting Procedure, Accounting Principles Board, and the Financial Accounting Standards Board or FASB) increasingly focused on the content of the annual (and later quarterly) reports.

The standard annual report was the 10-K submitted to the SEC based on the SEC format, which included Management Discussion and Analysis (MD&A) and the financial statement section. Currently, corporations subject to SEC regulations (basically those listed on stock exchanges) must submit their 10-K to the SEC within 60 days of the end of the fiscal year. MD&A explains management’s perspective of performance, financial condition, and future expectations. Included in MD&A is an extensive discussion of corporate risks and how the corporation manages those risks (especially the use of derivatives).

According to the SEC, four financial statements are required: the balance sheet, income statement, cash flow statement, and statement of equity (www.sec.gov/investor/pubs/begfinstmtguide.htm). The balance sheet summarizes the financial positions (assets, liabilities, and equity), whereas the income statement describes the major revenue and expense (plus gains and losses) categories to arrive at net income and earnings per share. The cash flow statement reanalyzes financial information from a cash perspective, separating cash from operations, investment, and financing. The equity statement provides additional information on changes in equity from stock issues, repurchase of shares (treasury stock), and other comprehensive income and losses (gains and losses recorded directly to equity rather than through the income statement, also called “dirty surplus”).

Investors and other financial statement users have more faith in the accuracy of the annual reports, primarily because of the requirements of corporations to have a financial audit based on SEC requirements and to follow generally accepted accounting principles (GAAP). The FASB was established in 1973 as an independent organization (the previous two boards were under the American Institute of Certified Public Accountants (AICPA), the professional association of certified public accountants [CPAs]). Since 2009, accounting standard changes are made through the Accounting Standards Codification. Prior to the codification, the FASB issued 168 statements of financial accounting standards (SFASs) plus many other professional standards (interpretation, concept statements, staff positions, and so on). The current codification essentially represents a comprehensive summary of U.S. GAAP.

The format of the financial statements and the composition of the notes in the 10-K are primarily determined by SEC requirements and the FASB’s codification. The first note generally is a summary of accounting principles used by the company topic by topic (e.g., describing the company and business segments, new pronouncements, revenue recognition, financial instruments). A large corporation may have 50 pages of notes and in some industries many more. Large business acquisitions are described in some detail; companies with defined benefit pension plans may have multiple pages of tables and descriptions; executive and employee compensation may be complex and also have detailed notes. And on it goes.

Users might get by with summary financial information (these are available online at sites such as Yahoo Finance). Alternatively, considerable information is available from the 10-K, 10-Q (quarterly report), other SEC reports, the company’s website, and various finance Internet sites and other business media sources. For rather large fees, several huge data bases can be accessed for additional analyses. Unlike a century ago, there is no shortage of information, from raw data to detailed financial analysis.

Disclosure is critical in economic theory. Buyers and sellers (or agents and principals according to agency theory) have different amounts of critical information; usually, the seller has the relevant information useful for the buyers. Economists call this asymmetric information, which often leads to inefficient and sometimes disastrous decision-making. Financial disclosures are one mechanism to reduce the information asymmetries between market participants. Of course, executives and other participants with a vested interest in manipulation or other illicit activities have considerable incentives to hide or massage financial information.

Auditing

A textbook definition of auditing is as follows: “a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users” (Hermanson et al. 1993, p. 3). Fundamentally, an audit firm reviews the financial information of the corporation based on formal audit standards to issue an auditor’s opinion on whether or not the company conforms to GAAP. Thanks to the Sarbanes–Oxley Act of 2002; the audit firm also issues a report on the effectiveness of internal controls of the firm.

The audit profession was well established by 1900 and most of the original firms that became the “Big Eight” had been established in England or the United States. A century ago auditors typically checked every transaction: from the journal entry to the ledgers and back to every voucher or invoice; this was a simple, but time-consuming process. The point was to search for fraud and clerical errors. The audit role continued to expand as investors needed reliable information from major corporations and capital markets.

Audit regulations started in New York state, which first licensed CPAs in 1896. All states had licensing requirement for CPAs by the early 1920s. A national exam (the uniform CPA exam) started in 1917. In addition to state regulations, the majority of CPAs became members of professional societies (eventually the AICPAs became the most significant). There also were attempts to standardize both accounting and auditing practices. The Federal Reserve Board published Uniform Accounting in 1917, which basically standardized the audit process using a checklist for each balance sheet account and a standardized audit report.

A major source of new auditing standards came from audit results, with the failures the most noteworthy. An audit failure occurs when the auditor’s report states the financial statements are unqualified (i.e., in accordance with generally accepted accounting principles), when, in fact, the financial statements are false or misleading. (A business failure, on the other hand, usually refers to bankruptcy.) The botched audit of McKesson Robbins in the 1930s, which did not uncover massive fraud, led to formal auditing standards established by a committee of the AICPA.

The use of the computer was perhaps the greatest business innovation of the second half of the 20th century, but it took decades for the audit profession to effectively audit around or through the computer. Of course, audit failures continued, as did continued regulations to overcome deficiencies. Sarbanes–Oxley, in response to the bankruptcies (and audit failures) of Enron, WorldCom, and the rest, included substantial regulatory changes, including the establishment of a new government-sponsored regulator, the Public Company Accounting Oversight Board (PCAOB).

What Are Accounting Manipulation and Fraud?

Fraud is defined as intentional deception for personal gain.¹ Accounting deception and fraud, the deliberate misstatement of financial...