Accounting Fraud in Times of Economic Uncertainty
By Neil Keenan
Posted: 24th June 2020 15:05
Past experience has shown that we should expect an increase in accounting related fraud during times of economic uncertainty. Given the current events surrounding Covid-19, we anticipate heightened instances of financial reporting fraud due to the sheer number of industries and geographies that have been impacted. The nature of accounting related fraud can take two forms, often combined. The first type will involve historical accounting fraud that will be brought to light as a consequence of the economic downturn. The second will arise from corporations taking advantage of the pandemic to misrepresent present and future performance.
As Warren Buffet once said, “only when the tide goes out do you discover who's been swimming naked.” Certain frauds cannot be maintained as business declines. Ponzi schemes, such as that run by Bernie Madoff, fold as investment income declines. Accounting fraud surrounding revenue recognition and earnings management often brings forward revenues and profits, effectively ‘pulling’ future sales into current periods. When future periods cannot keep pace as business declines, such schemes are often exposed as the sales and profits are not available to mask the past misconduct. The SEC at a recent virtual presentation cited as one of their priorities, the identification and enforcement of historical accounting fraud revealed as a consequence of the downturn.
The second form of accounting fraud is likely to take distinct forms. On one hand, companies may see the downturn in operations as an opportunity to under-report performance during, and in the immediate aftermath of, the lockdown. At this time, market expectations of company performance are lower and a fraudster may take advantage of this sentiment to record additional losses through the manipulation of accounting estimates or reserves. This could be to revise previously overstated assets or to increase under-reserved provisions or liabilities in an attempt to ‘clean’ a historically inaccurate balance sheet. Or it could be an attempt to overstate provisions and liabilities thereby creating ‘cookie jar’ reserves that can be released to enhance future results when market expectations increase. Areas where such fraud can occur include increases in provisions for doubtful debts or inventory write downs, ‘justified’ by the uncertainty of a customer’s financial health or the company’s ability to move inventory on a timely manner. Assets and other accounting entries that are dependent on estimates and fair values may also be manipulated downwards by intentionally changing the assumptions driving such calculations.
Overstatement of liabilities including contingent losses may also be subject to manipulation.
Such an approach is often seen with “turnaround” specialists who may overstate the depth of financial troubles of an entity in order to receive the plaudits following the significant upturn in results that arise under their leadership.
The bigger the hole, the greater the recovery. One prominent example of this involved Sunbeam Products, and its turnaround CEO Albert Dunlap. The SEC charged Dunlap, four other Sunbeam executives and the lead partner of the external auditor, in connection with a significant accounting fraud scheme. The investigation concluded that Dunlap had, through fraudulent accounting, created the impression of a greater loss in 1996 in order to make it look like the company had experienced a dramatic turnaround in 1997.
As many businesses seek to turnaround operations, similar schemes—even on a smaller scale—are likely to occur. Where a company has sought to create ‘cookie jar’ reserves to under-report performance, the subsequent release of such reserves in order to manage future performance also constitutes earnings management, another form of financial reporting fraud. Hence the fraud schemes continue.
Such an option may not be available to some companies who are just struggling to survive. Those with severe liquidity issues may be forced to convince lenders, external auditors and others that follow the company, such as credit agencies and press, that they continue to have a viable business and lending facilities should not be revoked or amended. Such pressures may incentivise officers to overstate corporate performance, the value of corporate assets, and the cash that is on hand. To accomplish this, companies may resort to incorrect revenue recognition that not only bolsters a company’s profits, but also suggests that it continues to grow and has a strong customer base, in addition to increasing balance sheet assets. Past significant earnings management schemes have also witnessed the incorrect capitalisation of expenses, transferring these from the income statements onto the balance sheet. The Worldcom accounting scandal was centred on the capitalisation of operating expenses to a capital expense account, thereby incorrectly spreading expenses over future periods.
One area to focus on is the potential overstatement of cash that an entity reports. It would seem very difficult for a company to overstate its cash balances given an auditor’s ability to seek confirmation from financial institutions.
However, there are numerous instances of alleged overstatement of cash. NMC Health, a former FTSE 100 company, disclosed overstated cash balances in the hundreds of millions of dollars, and unreported debt of approximately $4 billion. In Germany, Fintech giant Wildcard AG has allegedly been involved in accounting fraud with Philippines banks, recently reporting that “they don’t have and never have had” the “missing” $2 billion that they were reported to be holding on deposit for Wildcard. In India, outsourcing firm Satyam Computer Services reported nearly $1 billion—or 94% of the cash—on the books was fictitious. If overstatement of cash balances of this scale can occur at such prominent large public companies, it is most likely also occurring at smaller public and private entities.
As a consequence of the lockdowns and economic pressures impacting all industries, the ingredients for fraud occurring are all in place.
- Pressure:Senior management are under considerable pressure to stabilise and turn business operations around, to ensure a prompt recovery.
- Opportunity:The lockdown has changed the way companies operate; it is an entirely new environment and internal controls may not have adapted to address new procedures and risks. Add employee terminations and furloughs and the control environment may have been significantly compromised due to remote work arrangements or data security issues.
- Rationalization:The current predicament is not the fault of the business, it does not deserve to be in this position, and senior management are “only doing this to save the company and the jobs of employees who work there.”
Boards of Directors of companies and their Audit Committees play a vital role. Members should be aware of the increased risk of accounting fraud arising from the economic downturn and the motives and pressures that might influence senior management to engage in accounting fraud. Short seller reports, other financial press and internal reports from internal auditors or whistleblowers should not be quickly dismissed, and robust steps need to be in place to vet and investigate allegations of possible wrongdoing within the entities that Boards are tasked with overseeing and guiding. With such a background, is it not inevitable that we will witness a spike in accounting related fraud? The role of gatekeepers has never been more important!
Neil Keenan is a Partner at FRA based in the firm’s Washington, DC office. Prior to joining FRA, Neil was a Partner at PwC in their Washington DC, and Los Angeles, CA offices. Neil has a variety of experiences across accounting disciplines. He is a specialist in accounting fraud having completed numerous accounting investigations, served as a specialist for PwC when fraud was alleged at audit clients and acted an external and internal auditor. He also specialises in anti-corruption investigations and compliance, and asset misappropriation and embezzlement.
Beyond investigations, Neil brings broad experience that includes claims processing, M&A financial and compliance due diligence, corporate finance, corporate valuations, and business recovery and restructurings.
Neil can be contacted on + 1 (202) 849 4688 or by email at email@example.com