Accounting Fraud

 
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Companies must follow a common set of rules when reporting sales, earnings, profit margins, and company growth.

As management  of publicly traded companies fall under greater pressure to please Wall Street, the rules are sometimes compromised. Though most company executives go out of their way to avoid any misrepresentation of financial statements, a slate of accounting scandals has shown a greater and greater tendency to exaggerate earnings and growth in spectacular fashion – from much publicized Enron, Worldcom, and Tyco, to less prominent but equally flagrant accounting scams, companies have taken creative accounting to a new level.

Quarterly earnings are broadcast worldwide on cable news media and the internet with swift action on stock prices, while long-term vision and performance too often run a distant second but build the backbone of truly strong businesses.

Each accounting scandal seems to grow larger, with more reckless fraud than the scandal before it. Enron, for example, had listed assets of $66 billion before declaring bankruptcy in December of 2001. Seven months later Worldcom declared bankruptcy with assets listed at $104 billion. The financial crisis of 2008 exposed even greater recklessness and accounting gimmicks that led to the largest bankruptcies in history, with Washington Mutual declaring bankruptcy with $328 billion in listed assets, and Lehman Brothers declaring bankruptcy with $691 billion in listed assets.

Top Bankruptcies of All Time

Company Assets Date Auditor
Lehman Brothers $691 billion Sept. 15, 2008 Ernst & Young
Washington Mutual $327.9 billion Sept. 26, 2008 Deloitte
Worldcom $104 billion July 21, 2002 Arthur Andersen
GM $91 billion June 1, 2009 Deloitte
Cit Group $80.4 billion Nov. 1, 2009 PricewaterhouseCoopers
Enron $66 billion Dec. 2, 2001 Arthur Andersen

Signs of Accounting Fraud

Just as Bernie Madoff could not realistically bring consistent returns of 12% per year to investors, so companies cannot show strong growth in perpetuity without a strong possibility that something is amiss.

Growing and successful companies face tough times like everyone else. This leads to some years of inevitable underperformance, slow or disrupted growth, or disappointing earnings. Successful management responds to business challenges by creating an even stronger business poised for long-term growth, though the short-term returns will inevitably suffer with some bumps and bruises along the way.

Consistent, unrealisitc growth quarter after quarter and year after year is one of the more glaring signs of fraud. When Enron grew to $100 billion in revenues, it was almost unheard of for a company to reach that level of growth in only a few short years. It takes most companies many years, and even decades, to reach that level of success. Enron reported revenue topping $100 billion, placing it in the ranks of GE, Exxon and Wal-Mart in a fraction of the time it took other companies to reach this milestone.

Another sign of fraud is when expected earnings just meet Wall Street expectations quarter after quarter and year after year. Usually this is done on paper to align earnings with earnings expectations. In reality analysts estimates are just that – estimates that rarely predict with precision business outcomes and events from period to period. You are more likely to see some periods that exceed estimates, and some periods that disappoint Wall Street from quarter to quarter, and from year to year, even if the long-term trend is moving in a healthy pattern of growth.

Just hitting estimates from period to period is a warning sign that accountants are “rounding up,” and sometimes way up, to conveniently meet analysts expectations.

Consolidation of Accounting Firms

In the past 20 years accounting firms have gone from the Big Eight to the Big Six to the Big Four. The consolidation creates an oligopoly of auditing firms controlling just about every audit in public companies.

In the UK, for example, the Big Four accounting firms of PwC, Deloitte, KPMG, and Ernst & Young earned 99% of all audit fees paid by top companies. According to John Fingleton, chief executive of the Office of Fair Trading, this creates an environment that does not work well for customers due to limited competition and barriers to entry. The European Commission came to the same conclusion (Croft, Jane, “Big Four Auditors Face Competition Inquiry,” Financial Times,  October 21, 2011).

The U.S. General Accounting Office, on the other hand, in its July 2003 report mandated by Sarbanes-Oxley Act to study independence and competition among Big Four auditing firms in the wake of the Enron scandal, did not find any significant problems in this marketplace, though the Big Four also represent 99% of public company audit sales in the U.S.

Consolidation of power breeds complacency and accounting fraud when partners spend years in relationships with clients that go unchecked and unchanged. Most employees of accounting firms execute due diligence and strict independence to detect any accounting fraud, but in cases where close partner relationships exist with the client, the relationships can transition from independence to concurrence and finally complicity in accounting fraud.

Here are just a few examples of missed accounting frauds:

  • Arthur Andersen imploded after its failed audits of Enron and Worldcom, two of the biggest accounting  frauds in history.
  • Ernst & Young failed to stop Lehman Brothers from hiding massive losses on its balance sheet, and is currently being sued by New York for helping its client “engage in a massive accounting fraud.”
  • PricewaterhouseCoopers failed to spot $1 billion of fraudulent cash balances in a company called Satyam, though the CEO stated it was obvious fraud.

Yes, financial statements are audited, but as an investor you must be aware of the signs of accounting fraud. After all, the biggest accounting frauds in history all had a Big Four auditing firms sign off on the financial statements.

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