A former auditor looks to the accounting frauds of the past and examines whether the present is any different.
Once upon a time I was an auditor with Andersen in Dubai. I had joined in December 2000. Exactly two years later and my career and that of tens of thousands of others worldwide was in serious danger because of what had happened thousands of miles away in Houston.
Ever since Enron went bust in late 2002 I’ve been fascinated by accounting scandals and there have been many including some big names; WorldCom, Global Crossing, Parmalat, Lehman Brothers, Xerox, Halliburton, Tyco etc. They happened due to three reasons- Pressures, Opportunities and Rationalizations.
Common examples of pressures are high debt levels, impending breach of a debt covenant, increasing competition, declining industry fortunes, operating losses, personal guarantees in debts of the entity, significant financial interests in the entity, new accounting or regulatory requirements, high revenue or profit targets and compensation tied to stock prices/sales/profits.
The Opportunities are many. Significant related party transactions. Domination of management by a single person/group of people. But the most common manipulations happen when estimates and judgements are required and accounting is rife with such instances. Useful lives of depreciable assets. Salvage values. Selling prices for calculating net realizable value of inventory. Impairment of fixed assets, goodwill and investments. Fair value of investments. Percentage completion for revenue and cost recognition. Goodwill on acquisition. Provision for doubtful debts and obsolete inventory. Pension liability and pension expense (for a defined benefit pension plan). The list goes on and it is truly a treasure chest for a cunning CFO.
Rationalization is the weirdest of the three as it is mainly psychological and invisible. It’s all about attitude. It’s the fraudster convincing himself that it’s OK. That it is only a small amount. That is a big amount but it is just temporary. That it is big but I won’t do it again. That it didn’t hurt anyone. That everyone else is doing it……. One big red flag is frequent change in external auditors.
One important part of rationalization is the culture of the company. Enron had a toxic culture, a dog eat dog world where revenues and profits were paramount. The weekly Andersen partner meetings with the Anderson CEO (Joe Berardino) always focused on one thing- new clients and firm revenues. Andersen was the only Big 5 audit firm to allow the partner in charge of an audit to override a ruling made by the quality control partner. In Fannie Mae, if you ever dissented your career was over.
All three factors must be present for fraud to take place. Of the three elements, a company can only control opportunity. So, if a company wants to reduce the chances of fraud, they need to eliminate the one element they can: opportunity. One way opportunity can be controlled is by implementing and enforcing good internal controls.
LOOKING TO THE PAST
If you look at history, neither external nor internal auditors have come out of all these accounting scandals smelling of roses. There is a spectrum here: from proactivity to inertia to outright collaboration in the fraud:
In the case of WorldCom, it was the team led by Cynthia Cooper, Head of Internal Audit, that picked up the nearly USD 3.8 billion overstatement of profit (Done by the relatively simple expedient of capitalizing expenses!).
In most of the other scandals, the internal auditors didn’t bring the scandal to the public eye. Either they were incompetent or they were simply too scared to tell the truth.
Inaction is unacceptable but the prize for outright collaboration goes to the boys at Satyam, the large Indian IT company. Satyam inflated revenue by creating fictitious invoices on fake clients which led to fake receivables, fake cash, fake interest on the fake cash etc. All this fell apart in 2008 and it was discovered that the Head of Internal Audit helped in setting up the fake customer accounts
IS THE PRESENT ANY DIFFERENT?
No it is not! According to a recent study, internal auditors only detected fraud in 16.5% of the cases with tips from employees being the most common way fraud is detected. In the Middle East, internal auditors seem to do a better job at detecting fraud, as they detected fraud in 25.3% of the cases. When it comes to external auditors, the results are even worse. Globally they detected 3.8% of fraud while in the Middle East the percentage dropped to 1.3% of cases.
Today, accounting fraud is alive and well both globally and in the Middle East; recently a global accounting firm was banned from conducting audits in Saudi Arabia, allegedly for not picking up accounting fraud.
So, as an investor, supplier or lender what’s the lesson here? Be aware of incentives and opportunities to manipulate the financials. And be skeptical when reviewing the numbers- if something looks like a fish, smells like a fish and moves like a fish it IS most likely a fish.
Binod has been teaching advanced finance and accounting courses since 1996. He quit corporate life (where he worked for firms like KPMG, Arthur Andersen and Ernst & Young in Oman, Nakheel in Dubai and Gulf Finance House in Bahrain) in 2009 to help set up and run Genesis Institute. Binod says that his focus as a Trainer, Mentor and Speaker is to deliver conceptual clarity, get to the core issues, build relationships, keep things simple (and fun!) and talk of practical and effective solutions.