DETECTING ACCOUNTING FRAUD BEFORE IT’S TOO LATE Flashcards
Inflating the Benefits of Coca-Cola In Japan with Actual Transactions
Between 1997 and 1999, Coca-Cola Japan modified the commercial conditions to its distributors so they would buy more, although it excessively increased their warehouse inventories. At the end of 1999, the distributors’ warehouse levels had increased by 60% and were unsustainable. Coca-Cola told the SEC that it would modify its policy to reduce the distributors’ warehouse, but the SEC described this whole operation as “misleading” and that it had been done to fictitiously inflate profits to meet the analysts’ profit estimates.
Income Smoothing at Nortel
In 2007, Nortel Networks, an American company of telecommunications and IT, was accused by the Securities and Exchange Commission (SEC) of accounting fraud for fraudulently reducing (with an excess of provisions) the earnings of 2002 by 350 million dollars. This accounting fraud allowed transforming the losses of 2003 into profits by annulling the excess of provisions of the previous year.
Income Smoothing at a Bank
A real bank, in year 2, considerably raised the goodwill’s impairment of several subsidiaries, with the aim of reducing that year’s earnings that had been very high. This manipulation, consisting of some extremely pessimistic estimates regarding the future of the subsidiaries, enabled increasing the profits of years 3 and 4. On the other hand, the declared earnings increase every year, which presents a more favorable situation. Income smoothing gives those who do it an additional advantage that allows making use of privileged information. For example, if a company lowers its prof- its aiming to increase them in the future, it is information that allows anticipating that in the future, the price of the company’s shares will increase (when the increase in profit is reported).
ACCOUNTING FRAUDS IN ANCIENTMESOPOTAMIA
Accounting frauds occurred when workers and scribes sent by the temple kept a part of the tribute, after modifying the profits of the harvests. When there were suspicions that the clay tablets or papyruses had been manipulated, it was investigated and if the suspicions were con- firmed, the offenders were punished with fines that, according to the Hammurabi Code (from the year 1780 BC), could reach six times the embezzled amount. This code was engraved in a basalt block almost 2.5 meters high and was based in the law of retaliation. In the most serious cases of fraud, the sentences could consist of mutilations or even death. If the fraud was done harming the king, the author should compensate with 30 times the embezzled amount. If the author couldn’t pay, he was executed.
THE DUTCH EAST INDIA COMPANY
This company, founded in 1602, is considered one of the first multinationals and the first company whose shares were traded in Amsterdam’s official stock market. A few years later, significant problems occurred due to bad corporate governance caused by several circumstances. Among them, we can highlight the election of the administrators, since a small group of shareholders, who had over 50% of the capital, elected themselves as administrators and lifetime account supervisors. The rest of the shareholders, who were a few hundred, couldn’t participate in the election. Further, the administrators were also great merchants and the company’s main customers. Therefore, they had conflicts of interest. Finally, since a shareholder’s right for information wasn’t regulated, they did not report its accounts to small shareholders. In fact, the first information was provided ten years after its creation, after suffering major losses. The main shareholders, however, did receive information on the company’s progress at all times. Later, in 1622, minority shareholders rebelled at the suspicion that the accounts were being manipulated and demanded a review of the accounts and that the results be made public. For this, they designated a few shareholders to ensure that the accounting was accurate. However, these people lacked the time or the knowledge to ensure an effective control of the accounts and the management of the company.
Over the years, these shortcomings improved. The company lived years of glory and in 1669 it had over 150 merchant ships, 40 war- ships, 50,000 employees and 10,000 soldiers. Most years it distributed dividends. Nevertheless, strong competition from similar companies in other European countries, and the wars with England, wiped out most of their ships and possessions. In 1800 it dissolved.
The Bankruptcy of the South Sea Company
This company, created in 1711, secured the monopoly of all English trade with South America. Shortly after, it started to disclose accounting information that indicated it was obtaining large profits, trading with gold from Peru, which was false because its activities had not yet begun. In less than a year, shares went from being worth 100 pounds to over 700 pounds. During that time, the company made increases in capital that were subscribed within hours by crazed investors who paid increasingly more money for the shares. Given that the company remained inactive, but had a lot of money as a result of its continuous increases in capital, it started paying dividends to shareholders. Soon after, panic began to spread among investors when news broke that the company’s business activities would not start for the time being. Within days the shares dropped 85%. The company ended up going bankrupt without generating any kind of positive result in its operations in America. One of the shareholders who was ruined was Isaac Newton, who lost 20,000 pounds (which today would be worth 268 million pounds) and stated: “I can calculate the movement of stars, but not the madness of men.”
The Collapse of the City of Glasgow Bank
The bank was founded in 1839. It specialized in raising deposits to invest in loans and shares in US mining companies. Everything seemed to be going well until mid-1878 when it had 133 offices, financially sound accounts, and paid annual dividends of 12% to its shareholders. On October 2nd of that year, the management announced the closure of the bank. A subsequent investigation proved that it was bankrupt and that the accounts had been forged, as well as the certificates of the valuation of the mining investments that it had in the United States. The banks’ leadership was sentenced to prison, but since the share- holders had unlimited responsibility, they had to pay from their pockets the compensation to depositors. 254 of the 1,200 shareholders filed for bankruptcy.
THE McKESSON & ROBBINS FRAUD
In 1938 it was discovered that this company had fraudulently inflated its inventory and customers’ balances for over 10 years, through fake delivery notes and invoices. From a total of $87 million in assets, McKesson & Robbins forged $10 million of inventory and $9 million of clients’ money. These are very high amounts, taking into account the time at which the fraud occurred. The auditors had given their approval to the accounts, since in those years it wasn’t mandatory to make a list of physical goods or to confirm the balances with third parties (customers, suppliers, banks, etc.).
ENRON: FROM MOST ADMIRED COMPANY TO BANKRUPTCY
At the beginning of 2000 Enron was one of the most admired companies in the world and the seventh largest in the United States. It had a turnover of $100,000 million per year and was the largest energy company in the world.
It was also huge in its accounting fraud, which started in 1997, coinciding with the arrival of Jeffrey Skilling, one of Harvard’s top MBA graduates. Enron didn’t include in its accounts from 1997 to 2000 the accounts corresponding to three thousand subsidiaries established in the Cayman Islands. These companies were financed by bank loans (especially from J.P.Morgan Chase, Wachovia, Credit Suisse, Citigroup, First Boston and Merrill Lynch), which were endorsed by Enron. With these loans, the subsidiaries acquired assets from Enron at above-market prices, thus generating fictitious profits at Enron worth $591 million in four years. In addition, Enron inflated assets and hid debts through its subsidiaries in the Cayman Islands.
When the fraud was discovered, shares went from $90 to $0, and shareholders lost $70,000 million. Soon after, in 2001, the company went bankrupt. 20,000 workers lost their jobs. The managers, who hid the problem until the last moment, had sold all their shares just before the scandal broke out. We will return to this case later.
LEHMAN BROTHERS
In 2008, this global entity of financial services was the protagonist of one of the biggest bankruptcies in the world. Until that moment, it had been able to hide a massive accounting manipulation that consisted in transferring garbage loans from insolvent clients to subsidiaries in the Cayman Islands. Once again, these paradisiacal islands were once more associated to accounting problems. This way, it gave the image of having $50 billion in its treasury, instead of loans that were worth nothing. Therefore, it was concealing multimillion-dollar losses.
Due to this scandal, that caused Lehman’s bankruptcy, investors and financial markets started to panic, which was the detonator of a global financial crisis from which many countries still haven’t recovered.
Later, we will expand the information on this case.
THE ROLE OF THE AUDITOR AND T RUPTCY OF KINGSTON COTTON MILLS CO.
Kingston Cotton Mills Co. was a textile company created in 1845. However, the moment in which Kingston Cotton Mills Co. was created wasn’t the best, since the British Government had raised, in 1843, the prohibition of exporting textile machinery to other countries. At that moment, the competitive advantage that British cotton companies had disappeared. Despite that, Kingston Cotton Mills Co. started to operate, producing and exporting to many countries, especially the United States. However, the American Civil War affected it, generating great losses due to lost goods and uncollected sales. When the war was over, the company returned to work but things would no longer be as before. In 1894, when it had 1,300 employees, the company went bankrupt due to being unable to repay its loans. Until that moment, auditors’ reports had reflected that the company was doing well and there was nothing to suggest that it actually generated losses. Later, it was revealed that the auditor approved the stock balance in the warehouses without doing a physical inventory, since he only had a certificate from the company that declared a value for the warehouse, which was then shown to be very inflated.
The shareholders sued management and the auditors. Nevertheless, the auditors were declared not guilty in the trial that ended in 1896. Judge Lord Lopes, exonerating the auditors, stated:
“An auditor isn’t obliged to be a detective . . . it’s a guard dog, not a bloodhound.”
ARTHUR ANDERSEN DECLARED NOT GUILTY
We have already referred to the Enron scandal, which caused, among other consequences, the end of Arthur Andersen, one of the five biggest auditing companies, ending a successful 89-year career. In 2002 the jury found Arthur Andersen guilty of obstruction of justice. In particular, it was accused of ordering its employees, in 2001, to destroy documents related to the Enron fraud.
Although the audit firm always denied these accusations, the jury’s decision caused its disappearance. At that time, it had tens of thousands of employees and was internationally renowned. Nevertheless, in 2005, the United States Supreme Court nullified the sentence and found Arthur Andersen not guilty of the crimes it had been imputed. According to the Supreme Court, the culprits were the managers. It isn’t the first time the auditor ends up paying for the sins of unethical managers, who deceive everyone, including its auditors.
The problem with Arthur Andersen’s exculpatory sentence is that it came too late, as the audit firm had already disappeared. In any case, Arthur Andersen’s three main auditors, who participated in the Enron audit, lost their license to audit.
MERRILL LYNCH’S RECOMMENDATIONS
After the 2002 wave of accounting scandals, New York’s attorney general showed that Merrill Lynch recommended to their clients buying stocks from companies that were internally classified as garbage. In the end, in order to avoid trial, it accepted to compensate affected clients with $100 million.
THE ROLE OF SOME ANALYSTS IN THE ENRON SCANDAL
Frequently, analysts complain they get pressured, even by their own company, to issue favorable reports on the companies they analyze. On August 23, 2001, an analyst at the BNP Paribas investment Bank was fired, who had issued a few days earlier a negative recommendation concerning Enron. He was the first analyst to issue an opinion questioning Enron’s benefits, which in fact was accurate taking into account the company’s actual impairment that became public a few weeks later.
Afterward, on May 21, 2002, Merrill Lynch came to an agreement with the New York prosecutor to pay a fine of $110 million to avoid going to trial for misleading recommendations to investors. It also pledged to separate the pay of its analysts from the progress of the investment banking business and to set the incentives based on the accuracy of their analysis (Nieto, 2002).
Medco: Fictitious Sales Motivated by the IPO (Initial Public Offering)
Medco is a subsidiary of Merck, which in 2012 was about to do an IPO (a circumstance that could be a motivation to embezzle). During the previous three years, Medco posted $12.4 billion in sales that never existed. This practice didn’t have an impact in the earnings since the fictitious sales were accompanied by purchases, also fictitious, for the same amount. These were charges that pharmacies made directly to their customers and whose amounts were not reverted to Merck. However, it posted a sale to the pharmacy, accompanied by a purchase for the same amount, also to the pharmacy. Thus, the net impact on Merck’s income statement was zero. This posting allowed Merck to report a higher sales figure.
