When Numbers Don't Add Up

Accounting Fraud and Financial Technology

Faisal Sheikh

• Verlag: Business Expert Press
• Jahr: 2020
• ISBN:
  9781948580908
• Thema: Business
• Thema: Financial Accounting

The author contextualized the phenomenon of accounting fraud using a framework he developed called "Corporate Governance Cosmos." The book contains an extensive literature review including an evaluation of the seminal theory in this area, namely, the Fraud Triangle. There is a comprehensive exploration of the motivations for accounting fraud and a growing realization that Dark Triad (psychopathy, narcissism, and machiavellianism) tendencies may explain why executives engage in accounting fraud. The author expands an established framework entitled Cooks Recipes Incentives Monitoring End results (C R I M E) by Rezaee (2005), to ''C R I M E L'', where L is the "Learning" from 33 international case studies of accounting fraud.

Accountants, auditors, antifraud practitioners, and graduate students will find the case studies of accounting fraud particularly useful as it makes the phenomenon tangible and more understandable. The penultimate chapter is a study of the likely impact of financial technology on accounting fraud.

The author concludes by marshalling various insights including a brief discussion of ethics, forwarding his International Code of Ethics for Professional Accountants (IFAC) ''Ethical Triangle'', his vision for the future accountant, which he refers to as ''accounting engineers'', and an ancient prescription for the curse of accounting fraud.

CHAPTER 1

The Growing Phenomenon of Accounting Fraud

To gain a deeper insight into why accounting fraud occurs, a thorough understanding of the concept is essential. Consequently, it is necessary to briefly explore the concept of white-collar crime, including corporate crime, which will give an overview of the phenomenon illustrated with important yet notorious accounting scandals such as Parmalat and ensuing consequences. This will provide a basis for further exploration of the significance, nature, and cost of accounting fraud.

Thereafter, the author will critically elaborate the important theoretical models of accounting fraud, beginning with the Donald Cressey’s Fraud Triangle, including sociological and psychological approaches that attempt to explain why accounting fraud takes place.

Outline of Corporate Crime

As stated earlier, corporate crimes are white-collar crimes executed by corporations or an individual in a position of authority such as a CEO. This includes all corporate activities that are prohibited and punishable by law. It is argued that what is being sought are organizational benefits instead of individual gains. Many corporate crimes are highly complex, involving multiple actors, and it is difficult to establish who is responsible for the harm. It is maintained that most ordinary people are unaware of the frequency and economic damage caused by corporate crimes. The socioeconomic fallout from criminal activities committed by companies can be devastating, resulting in tens of thousands of job losses, as in the case of WorldCom. It should not be a surprise when some commentators deem corporate crime to be one of the gravest crimes that occur in society.

It is believed that corporate crime wreaks more socioeconomic destruction than all street crime combined and is even claimed that corporate crime is a form of violent crime. Many social problems, tyranny of native and indigenous communities, food contamination, medical negligence, and unsafe working conditions, are a result of concerted corporate power. Furthermore, many of the penalties imposed on corporations have little or no impact on their finances and business practices; hence the requirement for alternative methods of restricting and effectively controlling corporate crime.

The author will now focus on the understanding, modeling, and analysis of accounting fraud. Hence, an overview of the accounting fraud phenomenon follows, including a review of the most notorious accounting scandals of modern times as evidence of the socioeconomic impact of fraudulent financial reporting or accounting fraud.

What Is Fraud?

Fraud has existed perhaps since the beginning of trade and commerce. According to some experts, basic body measurements and calculations or biometrics were used thousands of years ago as a method of gauging the trustworthiness of traders, implying that dishonest businesspeople have always existed. In general, fraud includes the intent to deceive, breaking the rule of law or established norms or protocols such as accounting standards, resulting in negative, if not harmful, consequences to its victims. KPMG (2017) noted that “[t]he total cost of fraudulent activity in the UK has surpassed a billion pounds (£1.1 billion) for the first time since 2011.”

The Oxford Dictionary describes fraud in the following way:

“Wrongful or criminal deception intended to result in financial or personal gain.”

The above definition describes the fundamental nature of fraud but does not explain its nature and features. As already discussed, fraud is not a recent trend, nor is it limited to humankind. Animals also engage in what could be argued, at minimum, as manipulative behavior or fraudulent activities, such as chameleons changing color. A more comprehensive definition of fraud is supplied by Van Vlasselaer et al. (2016):

“Fraud is an uncommon, well-considered, imperceptibly concealed, time-evolving and often carefully organized crime which appears in many types of form.”

Why Companies Produce Financial Statements and How Accounting Fraud Is Different

Financial statements are prepared because they assist in decision making, planning, and controlling processes. In most of the world it is also a statutory requirement to produce financial statements according to country-specific Generally Accepted Accounting Principles (GAAP) such as U.S. GAAP or International Financial Reporting Standards. Furthermore, the financial statements are vital tools for senior managers, because they help to communicate past achievements and are a basis for future expectations or plans. The figures reported in the financial statements provide an important source of information regarding the evaluation of performance, going concern, and the story of the company’s history. Thus, the accuracy of these documents is exceedingly important because they reflect the actual financial position of a company at any given time. External stakeholders such as analysts scrutinize the financial information supplied by financial statements in order to consider the financial performance of the company and make investments/recommendations accordingly. Specifically, equity investors and creditors will be concerned with the quality and sustainability of profitability and cash flow, these being the key sources of financing for the operation of the company. Financial statements for public listed companies are authenticated by both internal and external auditors in order to give more reliability to the reported financial position.

Jackson (2015) suggests that accounting fraud (also referred to as “corporate fraud” or “financial reporting fraud” or “financial statement fraud”) is a special kind of fraud that necessitates the manipulation of financial statements. The Association of Certified Fraud Examiners (ACFE) is a renowned American professional antifraud body that globally provides antifraud training and education. In the ACFEs 2018 Fraud Examiners Manual, accounting fraud is defined as “the deliberate misrepresentation of the financial condition of an enterprise accomplished through the intentional misstatement or omission of amounts or disclosures in the financial statements to deceive financial statement users.” It is suggested that the first recorded example of accounting fraud was the one that occurred in the 1600s to the British East India Company. Others argue that accounting fraud does not result in an explicit financial advantage to anyone. Instead, it supplies an implicit gain, in the shape of higher share prices, superior stock options for managers, and continued lines of credit.

Major corporate scandals have occurred that have shaken the confidence of all stakeholders, the public, and investors, and, worryingly in the financial system itself. The phenomenon of accounting fraud underpinned almost all cases of recent corporate scandals such as, the UK-based, Carillion in 2018. It is argued that when financial statements are not accurate as a result of accounting irregularities, they change from a highly useful tool into a way of deceiving the public.

Research suggests that unethical conduct and fraudulent activities such as manipulation of accounting information does not occur in a vacuum; rather, there must be specific factors that make it possible. It is claimed that most examples of corporate failure occur for various reasons, including fraudulent financial reporting, misuse of power, insider trading, corruption, bribery, unsuitable investment practices, pursuing short-term profits to the detriment of shareholders, poor internal control environment, and ineffective management.

Leading fraud examiner Wells (2005a,b) argues that fraud is not merely an accounting problem but a social phenomenon and that there are three methods of unlawfully taking money from a victim, namely, by force, stealth, or trickery. Hence, a weak internal control environment in an organization is an opportunity for a fraudster. Where an accounting information system does not supply timely, accurate, sufficiently detailed, and relevant results, it is susceptible to theft and concealment from the company bank account. A weak internal audit function, or lack of one, is also a sign of poor internal control. A specific example of deficient accounting practice is failure to ensure monthly bank reconciliations.

Accounting Scandals

The spectacular rise of corporate accounting scandals at the start of the 21st century has exacerbated the phenomenon of accounting fraud that causes corporate bankruptcy, unnecessary market corrections, and socioeconomic malaise. The following examples are the most notorious instances of accounting fraud scandals that highlight the unintended consequences of unethical behavior.

Enron, 2001

Enron Corporation, founded in 1985, was a large energy company that was engaged in an enormous fraudulent scheme that climaxed in 2001 when the company suffered the largest Chapter 11 bankruptcy in history (since exceeded by WorldCom during 2002 and Lehman Brothers during 2008).

Enron was a darling of the stock market and had been considered a blue-chip stock investment, so this was an unparalleled event in the financial world. Enron’s passing occurred after the revelation that the bulk of its profits and revenue were the result of deals with special purpose entities. Thus, many of Enron’s debts and the losses that it suffered were not reported in its financial statements, i.e., accounting fraud. At the end of 2001, it was discovered that Enron’s financial statements were underpinned by institutionalized, systematic, and creatively planned accounting fraud.

The main actors in the debacle were Chairman Jen Kay, CEO Jeffrey Skilling, and CFO Andrew Fastow, who engaged in highly aggressive off-balance sheet finance that resulted in billions of dollars in long-term debt being kept off the records. Ultimately, the figures did not correlate, and the inevitable decrease in net income led to an estimated billion-­dollar reduction in the equity of shareholders. As expected, investors reacted negatively, and quickly Enron’s stock price collapsed, from US$90.56 during the summer of 2000 to just pennies (January 11, 2002—$0.12), quickening the company’s bankruptcy. Enron’s shareholders lost nearly $74 billion, and 4,500 employees lost their jobs and pension funds without proper notice.

It is argued that the fiasco could have been avoided if previous financial statements had been forensically examined. The remarkable revenue growth from $9.2 billion in 1995 to $100.8 billion in 2000 should have warned interested stakeholders that this was not underpinned by a similar increase in profitability.

The scandal highlighted aggressive accounting practices and activities of many corporations in the United States and was a major factor in the enactment of the Sarbanes–Oxley Act of 2002. The scandal also affected the wider business world by causing the closure of the renowned audit firm Arthur Andersen, which had been in business for nearly 100 years and was Enron’s main auditor.

WorldCom, 2002

Less than a year after the financial earthquake caused by Enron, another scandal shook the markets in the telecommunication services supplier WorldCom, now known as MCI.

According to the U.S. Securities and Exchange Commission (SEC) (2003), company CEO Bernard Ebbers, CFO Scott Sullivan, Controller David Myers, and Director of General Accounting Buford Yates used duplicitous accounting techniques to conceal its decreasing earnings to maintain the price of WorldCom’s share price.

The fraud was executed by capitalizing rather than expensing approximately $3.8 billion of expenditure and inflating revenues with false accounting entries, creating an image of growth in order to exaggerate profits. The company filed for bankruptcy protection shortly after the revelation of the fraudulent scheme, causing 17,000 redundancies and losses of $180 billion.

Adelphia, 2002

Adelphia was local cable franchise that was transformed by John Rigas into a giant of the telecommunications industry that included high-speed Internet, cable, and long-distance telephone service. During May 2002, Adelphia declared earnings restatement for 2000 and 2001, which included billions of dollars in off-balance sheet liabilities linked with “coborrowing agreements.” The financial statements of Adelphia highlighted a myriad of issues. According to the last 10-K filed by the company (for the year ended December 31, 2000) it showed a net loss of $548 million; of $21.5 billion in total assets, of which $14.1 billion were intangibles, liabilities totaled $16.3 billion and equity was a modest $4.2 billion. Adelphia subsequently filed for bankruptcy in June 2002, after being investigated by the SEC, which resulted in company executives being charged with accounting fraud: “Adelphia, at the direction of the individual defendants: (1) fraudulently excluded billions of dollars of liabilities from its consolidated financial statements by hiding them in off-balance-sheet affiliates; (2) falsified operation statistics and inflated Adelphia’s earnings to meet Wall Street expectations; and (3) concealed rampant self-dealing by the Rigas family” (Gao, 2002:122).

At the heart of the accounting fraud were false transactions, with supporting documents suggesting that debts were repaid; instead, they were transferred to affiliates. In addition, the company was run as a personal fiefdom by the Rigas family, who, for example, used company funds to buy stock for the Rigas family and even built a golf club. It is important to note that five members of the nine-member board were John Rigas’s immediate relatives, including his son, who was CFO, suggesting poor corporate governance and management override was potentially endemic in the company. Eventually, two former Adelphia executives were charged with criminal charges for conspiracy, bank fraud, and securities fraud. In 2004 John Rigas and his son were both convicted of conspiracy and fraud.

Global Crossing, 2002

Global Crossing was an integrated telecommunications solutions company that was founded in 1997 by an investment banker called Gary Winnick. Its headquarters were in Bermuda, but it operated primarily in the United States and 27 other countries and in excess of 200 cities across the globe. After a series of accounting indiscretions, the company announced Chapter 11 Bankruptcy Protection on January 28, 2002. Investors, analysts, and regulators were left stunned as Global Crossing was considered a darling of the market. The Chapter 11 statement also announced that two companies, namely, Hutchinson Whampoa and Singapore Technologies Telemedia (STT), had signed a letter of intent that they would inject a $750-million cash investment in exchange for a combined majority share of 60 percent or more in the business.

A closer inspection of the financial statements revealed mounting debts of $12 billion coupled with unsecured creditors and affiliates numbering over one thousand. The latter covered a wide spectrum of lenders, equipment vendors, and other carriers. U.S. Trust Co., one of the secured creditors, was owed $3.6 billion, approximately 25 percent of Global Crossing’s total debts. The company was highly valued on the market but had a poor cash flow and working capital position. The company had engaged in a dubious and complex earnings management technique, called “capacity swaps.” Global Crossing would record traffic on other fiber-optic telecommunications systems such as Qwest and in return booked traffic on its own network. Thus, each counterparty in this complex accounting fraud reported an increase in recorded revenue, although there was no actual increase in economic activity. The swaps were also undertaken to conceal different costs and exceed market expectations. Global Crossing went on to lure more customers and investors by overstating the reach and attractiveness of its network. However, this was not underpinned by sound financials, including profitability and crucially cash flow, which is the lifeblood of any business. Consequently, Global Crossing became highly leveraged with unsustainable levels of liabilities coupled with questionable assets and became the largest telecom bankruptcy filing ever,—the fourth largest of any kind in American corporate history. Unfortunately, the company was also plagued by poor governance, and even after its bankruptcy it lent $15 million to John Legere, its then CEO, and, surprisingly, agreed to let him keep the money if he stayed on until February 2003.

Parmalat S.p.A, 2004

Parmalat S.p.A was an Italian multinational dairy and food company and at one time became the leading global producer of long-life milk, but the company folded in 2003 with a £13-billion hole in its financial statements in what remains Europe’s biggest liquidation to date. The SEC (2003) described the European ...

Inhaltsverzeichnis

• Cover Page
• Title Page
• Copyright Page
• Dedication
• Contents
• Acknowledgments
• Foreword: Audit Partner’s Perspective
• Foreword: Counter-Fraud Practitioner’s Assessment
• Chapter 1 The Growing Phenomenon of Accounting Fraud
• Chapter 2 The Fraud Literature
• Chapter 3 C R I M E L—33 International Stories of Accounting Fraud
• Chapter 4 “Cooking the Books”
• Chapter 5 Fintech and the Impact on Accounting Fraud
• Chapter 6 Conclusion
• Bibliography
• About the Author
• Index