Accounting is the process of keeping track of financial transactions and the incomes, expenses, assets, liabilities and cash flows of a business. Accounting is stereotypically known as a boring subject but creative accounting is nothing new. Since financial statements are usually used as a representation of a business’s success and may be used to attract more funding, every accounting firm manipulates its numbers to a small extent. This may be something as small as asking its supplier to bill them next quarter. But some companies cross the line to accounting fraud.
One well known example is Enron. Enron executives knowingly cooked the books to portray the existence of billions of dollars of non-existent assets with the intention of portraying itself to investors as a successful business when it was actually in financial troubles.
Today we’ll talk about 5 ways companies commit accounting fraud. Accounting fraud is not commonly talked about in accounting courses but this is an important part of finance since it teaches you what not to do as an accountant. Also, it helps investors to look for any accounting malpractices and not to trust any financial statement that’s been audited by a reputable accounting firm.
Hopefully, this will help you to spot accounting fraud in businesses that you’re analysing and may be planning to invest in. Accounting fraud is also an interesting topic since it shows how creative people can get with finding loopholes in accounting regulations and rules.
#1- Record Future Revenues Ahead of Time
Recording future revenues ahead of time is one of the most commonly seen accounting frauds. This is also called “accelerating revenues”.
Take a toy manufacturer who signs an agreement with a toy distributor who agrees to buy 100 boxes of toys every month across the period of four years. The toy manufacturer may offer a discount to the retailer and receive a large upfront payment. Instead of recording that payment over the period of four years, the manufacturer will record that under a single year in its income statement which gives the illusion of an exceptionally high revenue for that first year. Instead, the toy manufacturer should be amortising the payment received over four years.
#2- Record Accruals Without Any Concrete Evidence of Future Purchases
Recording future expected payments without any concrete evidence is something that Oracle was accused back in 2016. This is often done by businesses to make their income statement and revenues look much higher when there’s no guarantee of future sales. Oracle is in the cloud computing industry which runs on a subscription basis payment plan.
Business executives may expect clients to continue staying on the subscription basis but there’s no guarantee of this and former Oracle senior finance manager Svetlana Blackburn accuses Oracle of pressuring her to “add millions of dollars of accruals for expected business” despite “no concrete or forseeable billing”. In short, Oracle wanted to record millions of dollars of sales without any evidence of customers renewing their cloud subscriptions with Oracle.
#3- Accelerate Pre-Merger Expenses
Mergers and acquisitions are commonly done on Wall Street and usually benefits both parties to become more cost effective. Mergers help both companies to take advantage of economies of scale, while combining market share to better compete with other competitors.
Prior to the completion of the merger, the acquired company will try to prepay as many expenses as possible. This is to intentionally decrease their EPS (Earnings Per Share) prior to the merger. After the merger, the acquired company will have less expenses to pay and thus have a higher EPS, assuming that no changes to the operations are made. This will give the illusion of an EPS growth compared to the past and previous quarter as a result of the merger although nothing was changed.
#4- Keep Liabilities Off the Balance Sheet
A serious accounting fraud is keeping off-balance-sheet items. A company can create legal entities to hold its liabilities that it wants to keep off the books and incur expenses that the company doesn’t want to incur on its own income statement. Assuming that the legal entities aren’t wholly owned by the company, these expenses and liabilities don’t have to be recorded on the company’s financial statements, which allows the company to hide these losses and liabilities that may deter investors from investing in the company.
Enron is one famous example that committed this accounting fraud. Enron used SPVs (Special Purpose Vehicles) and SPE (Special Purpose Entities) to hide its debt and bad assets from investors. SPVs and SPEs are legal corporate entities that Enron started. Enron then borrowed money using their SPVs and SPEs, but used Enron stock instead of cash as collateral. The problem was when the price of Enron stock fell. Like a margin call, banks required Enron’s SPVs and SPEs to either provide cash as collateral, or more Enron stock or other valuable assets. This is a serious malpractice because it hid the large amount of debt indirectly Enron’s name from investors who never even knew of Enron’s shaky financial situation that depended on their stock price.
#5- Use the MTM Accounting Method
MTM stands for Mark To Market and it is an accounting method to measure the value of assets and liabilities that can fluctuate over time. These assets and liabilities’ values can change over time depending on the market. They’re usually mutual funds and futures, which can have very volatile valuations depending on market conditions.
Most companies don’t need to use the MTM accounting method because their assets and liabilities aren’t dependent on volatile markets. For example, Toys R Us has a lot of inventory and the valuation of toys are fairly stable and don’t increase or decrease tenfold on a weekly basis.
However, companies like Enron can use the MTM accounting method to commit accounting fraud by overvaluing its assets and underestimating its expenses. Enron was an energy company. Since the price of energy materials like gas changes over time, they were given the approval to use the MTM accounting fraud. However, the freedom of estimating the value of its assets and liabilities meant that Enron was now able to inflate the value of their assets and deflate the value of their liabilities without any oversight. Thus they were easily able to deceive investors and the public through using the MTM accounting method to manipulate their books.