Accounting Fraud - Creative Accounting Gone Criminal

Accounting fraud is often characterized by the:

1. Misuse/misdirection of funds
2. Understating/overstating of revenues
3. Understating/overstating of expenses
4. Overstating of corporate asset values
5. Underreporting of liabilities

Prosecuting accounting fraud is often aided by a whistleblower disclosing unethical practices or unlawful tactics. At times, the whistleblower is someone who also participated in the accounting fraud.

Law enforcers may offer a plea bargain with a diminished sentence or penalties to the whistleblower for exposing his "guiltier" associates. Protection from retaliation may also be provided. In extreme cases, the whistleblower (along with his family) may also go into the government's witness protection program.

In publicly listed companies, creative accounting tactics, not necessarily among those listed above, may be regarded as fraud. When such tactics are detected, a government oversight agency, like the Securities and Exchange Commission, may launch an investigation.

Sarbox Response

The Public Company Accounting Reform and Investor Protection Act, also called the Sarbanes-Oxley Act (or Sarbox), was speedily passed in 2002 in response to the wave of accounting scandals that occurred in corporate America that year.

It was in 2002 that the countries biggest accounting firms, like Arthur Andersen, Ernst & Young, Pricewaterhouse Coopers, etc., were charged in court or admitted negligence in their duties.

The government held that these accounting firms were tasked with identifying and preventing the publication of bogus financial reports. As a result of their neglect or collusion, their clients were able to publish reports that gave a misleading impression of the client company's financial status. Accounting fraud reached billions of dollars in some cases.

Sarbox contains provisions, such as the following:

1. Public companies must assess and divulge the effectiveness of their internal financial reporting controls.
2. Independent auditors must vet these assessments and disclosures.
3. Financial reports must be certified by CEOs and CFOs.
4. Personal loans to any director or executive officer are banned in most cases.
5. A stock-exchange-listed company must have a 100% independent audit committee whose sole task is to oversee the relations between the company and auditor
6. More severe civil and criminal penalties for violating SEC rules and longer jail sentences plus bigger fines for execs who intentionally misstate their company's financial status
7. Protection for whistleblowers to win
a. Reinstatement
b. Back pay
c. Benefits
d. Compensatory damages
e. Abatement orders
f. Attorney's fees and legal expenses within reason

Fallout from Fraud

In the three-year period before Sarbox became a law, the SEC reported that accounting fraud showed a 41% increase: from only 79 cases in 1998 to 112 in 2001.

Many believe that the stock market downturn of 2002 was caused by a widespread perception that many publicly listed companies (such as Enron and WorldCom) may be cooking the books.

More recently, an accounting fraud scandal arose to rival Enron and WorldCom. AIG is still being investigated for accounting fraud as a result of the mutual funds and insurance fiasco of 2004. But recent investigations uncovered more than a billion dollars in accounting transaction errors.

Oftentimes, the worse punishment is loss of support for the offending company. So far, AIG has already lost around 50 billion dollars in market capital as a result of the investigations.