Accounting scandals are political and/or business scandals which arise with the disclosure of
financial misdeeds by trusted executives of corporations or governments.
Such misdeeds typically involve complex methods for misusing or misdirecting funds, overstating
revenues, understating expenses, overstating the value of corporate assets or underreporting
the existence of liabilities, sometimes with the cooperation of officials in other corporations
or affiliates.
In public companies, this type of "creative accounting" can amount to fraud, and investigations
are typically launched by government oversight agencies, such as the Securities and Exchange
Commission in the United States.
Causes It is fairly easy for a top executive to reduce
the price of his/her company's stock – due to information asymmetry.
The executive can accelerate accounting of expected expenses, delay accounting of expected
revenue, engage in off balance sheet transactions to make the company's profitability appear
temporarily poorer, or simply promote and report severely conservative estimates of
future earnings.
Such seemingly adverse earnings news will be likely to reduce share price..
There are typically very few legal risks to being 'too conservative' in one's accounting
and earnings estimates.
A reduced share price makes a company an easier takeover target.
When the company gets bought out – at a dramatically lower price – the takeover
artist gains a windfall from the former top executive's actions to surreptitiously reduce
share price.
This can represent tens of billions of dollars transferred from previous shareholders to
the takeover artist.
The former top executive is then rewarded with a golden handshake for presiding over
the firesale that can sometimes be in the hundreds of millions of dollars for one or
two years of work.
Similar issues occur when a publicly held asset or non-profit organization undergoes
privatization.
Top executives often reap tremendous monetary benefits when a government-owned or non-profit
entity is sold to private hands.
Just as in the example above, they can facilitate this process by making the entity appear to
be in financial crisis – this reduces the sale price, and makes non-profits and governments
more likely to sell.
It can also contribute to a public perception that private entities are more efficiently
run, thereby reinforcing the political will to sell off public assets.
Again, due to asymmetric information, policy makers and the general public see a government-owned
firm that was a financial 'disaster' – miraculously turned around by the private sector within
a few years.
Not all accounting scandals are caused by top executives.
Often managers and employees are pressured or willingly alter financial statements for
the personal benefit of the individuals over the company.
Managerial opportunism plays a large role in these scandals.
For example, managers who would be compensated more for short-term results would report inaccurate
information, since short-term benefits outweigh the long-term ones such as pension obligations.
List of reported accounting scandals Notable outcomes
The Enron scandal turned in the indictment and criminal conviction of one of the Big
Five auditor Arthur Andersen on June 15, 2002.
Although the conviction was overturned on May 31, 2005, by the Supreme Court of the
United States, the firm ceased performing audits and is currently unwinding its business
operations.
The Enron scandal was defined as being one of the biggest audit failures.
The scandal included utilizing loopholes that were found within the GAAP.
For auditing a big sized company such as Enron, the auditors were criticized for having brief
meetings a few times a year that covered large amounts of material.
By January 17, 2002, Enron decided to discontinue its business with Arthur Andersen claiming
they had failed in accounting advice and related documents.
Arthur Andersen was judged guilty of obstruction of justice for getting rid of many emails
and documents that were related to auditing Enron.
Since the SEC is not allowed to accept audits from convicted felons, the firm was forced
to give up its CPA licenses later in 2002, costing over 113,000 employees their jobs.
Although later the ruling was overturned by the U.S. Supreme Court, the once-proud firm's
image was tarnished beyond repair, and it has not returned as a viable business even
on a limited scale.
On July 9, 2002 George W. Bush gave a speech about recent accounting scandals that had
been uncovered.
In spite of its stern tone, the speech did not focus on establishing new policy, but
instead focused on actually enforcing current laws, which include holding CEOs and directors
personally responsible for accountancy fraud.
In July, 2002, WorldCom filed for bankruptcy protection, in what was considered the largest
corporate insolvency ever at the time.
These scandals reignited the debate over the relative merits of US GAAP, which takes a
"rules-based" approach to accounting, versus International Accounting Standards and UK
GAAP, which takes a "principles-based" approach.
The Financial Accounting Standards Board announced that it intends to introduce more principles-based
standards.
More radical means of accounting reform have been proposed, but so far have very little
support.
The debate itself, however, overlooks the difficulties of classifying any system of
knowledge, including accounting, as rules-based or principles-based.This also led to the establishment
of Sarbanes-Oxley.
On a lighter note, the 2002 Ig Nobel Prize in Economics went to the CEOs of those companies
involved in the corporate accounting scandals of that year for "adapting the mathematical
concept of imaginary numbers for use in the business world".
In 2003, Nortel made a big contribution to this list of scandals by incorrectly reporting
a one cent per share earnings directly after their massive layoff period.
They used this money to pay the top 43 managers of the company.
The SEC and the Ontario securities commission eventually settled civil action with Nortel.
However, a separate civil action will be taken up against top Nortel executives including
former CEO Frank A. Dunn, Douglas C. Beatty, Michael J. Gollogly and MaryAnne E. Pahapill
and Hamilton.
These proceedings have been postponed pending criminal proceedings in Canada, which opened
in Toronto on January 12, 2012.
Crown lawyers at this fraud trial of three former Nortel Networks executives say the
men defrauded the shareholders of Nortel of more than $5 million.
According to the prosecutor this was accomplished by engineering a financial loss in 2002, and
a profit in 2003 thereby triggering Return to Profit bonuses of $70 million for top executives.
In 2005, after a scandal on insurance and mutual funds the year before, AIG was investigated
for accounting fraud.
The company already lost over 45 billion US dollars' worth of market capitalisation because
of the scandal.
Investigations also discovered over a billion US dollars worth of errors in accounting transactions.
The New York Attorney General's investigation led to a $1.6 billion fine for AIG and criminal
charges for some of its executives.
CEO Maurice R. "Hank" Greenberg was forced to step down and is still fighting civil charges
being pursued by New York state.
Well before Bernard Madoff's massive Ponzi scheme came to light, observers doubted whether
his listed accounting firm—an unknown two-person firm with only one active accountant in a
rural area north of New York City—was competent to handle a multi-million dollar operation.
Ultimately, Madoff's accountant, David G. Friehling, admitted to simply rubber-stamping
Madoff's filings with the SEC.
He also revealed that he continued to audit Madoff even though he had invested a substantial
amount of money with him.
Accountants aren't allowed to audit broker-dealers with whom they're investing.
He agreed to forfeit $3.18 million in accounting fees and withdrawals from his account with
Madoff.
His involvement makes the Madoff scheme the largest accounting fraud in world history.
See also Accounting ethics
Corporate abuse Corporate scandal
Dotcom bubble Financial crisis of 2007-2010
Philosophy of accounting Forensic accounting
Penny stock scam Sarbanes-Oxley Act
Savings and loan crisis Securities fraud
Tobashi scheme Vivien v. Worldcom
White-collar crime References
Further reading John R. Emshwiller and Rebecca Smith, 24 Days:
How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate
America or Infectious Greed, HarperInformation, 2003, ISBN 0-06-052073-6
Lawrence A. Cunningham, The Sarbanes-Oxley Yawn: Heavy Rhetoric, Light Reform
Zabihollah Rezaee, Financial Statement Fraud: Prevention and Detection, Wiley 2002.
External links U.S. Securities and Exchange Commission website
U.S. President Bush's speech, 2002-07-09 NPR report
"Why didn't our auditors find the fraud?", Wisconsin Law Journal, January 25, 2006
"GMI Warns of Accounting Risks at 40 Companies", Accounting Today, November 27, 2012
"The Impact of Fraud on Shareholder Value", Business Insider, June 18, 2013